Resemblance to the Great Depression
At an open seminar held on September 18, Professor Robert E. Lucas Jr. of the University of Chicago expressed his views on the current financial crisis in the U.S.* Professor Lucas is the architect of the modern macroeconomic paradigm.
Professor Lucas said that bank runs in which money "evaporates," such as those occurring during the Great Depression, are the essence of financial crises. Money in this instance refers to scrip money created by financial institutions, with bank deposits serving that role in the 1930s and de facto short-term borrowings through repurchase transactions, etc., doing the same at present. Economic activity deteriorated substantially because these forms of money evaporated. Professor Lucas also argued that both financial policy and fiscal policy have certain roles to play in alleviating the sudden scarcity of money in financial crises.
There are several related issues of great interest. In a chat prior to the seminar, Professor Lucas said, "(Keynesian) price rigidity is likely a major factor in the current crisis." Underlying Professor Lucas' argument that the evaporation of money has a negative impact on economic activity is the silent assumption that price levels will not change much. If there is no price rigidity, then halving the volume of money would simply cause a simultaneous halving of prices and wages, with no deterioration of real economic activity expected. "Price rigidity" - the failure of changes in price levels to keep up with rapid changes in the volume of money - may indeed be playing an important role within the mechanisms of the crisis.
Nevertheless, it was somewhat surprising to hear a flexible Keynesian comment from Professor Lucas, the father of New Classical Macroeconomics.
Professor Lucas also asserted that regulations designed to protect the settlement system should be introduced to prevent a crisis from occurring. The reason that we saw a phenomenon similar to a bank run is that high-risk financial assets connected with subprime loans made their way into the settlement system. Investment banks and hedge funds had taken on short-term debt and invested it in high-risk assets. Their short-term debt was money, i.e., a means of settlement, in the same sense as Depression-era bank deposits but, similar to these bank deposits, they were not backed by government guarantees but were instead simply collateralized with high-risk assets.
This situation was much the same as that in the 1920s, when banks had large holdings of high-risk company stocks. Concerns grew in the 1930s about the possibility of bank failures triggered by a decline in stock prices, and depositors rushed to withdraw their deposits. In the current crisis, concerns arose about possible failures of financial institutions caused by a decline in subprime-related securities, and a run occurred in short-term debt. Just as banking regulations were tightened after the Great Depression, therefore, regulations governing an even broader range of financial institutions (not just banks, but all financial institutions related to the settlement system) need to be strengthened now.
Following the Great Depression, the mixing of commercial banking activities and securities activities was prohibited by the Glass Steagall Act, and banks become unable to invest in high-risk company shares. Bank deposits were also protected by deposit insurance up to an established ceiling. Such banking regulation undoubtedly prevented the recurrence of a Great Depression for several decades. Professor Lucas asserted that similar steps should be taken vis-a-vis financial institutions constituting the present settlement system.
Distinguishing regulations by degree of involvement in the settlement system
If my understanding is correct, Professor Lucas' prescription is as follows. First, regulations drawing sharp distinctions between financial institutions constituting the settlement system (institutions that borrow and invest deposits and short-term debt) and financial institutions not connected with the settlement system (institutions that invest using only equity-type funds) should be imposed to ensure that the former cannot invest in high-risk assets (capital adequacy requirements would likely be part of such regulations). Second, some form of government guarantee with a prescribed limit should be given to marketable short-term debt, perhaps using a guarantee framework similar to that of deposit insurance. These ideas aim to restore stability to the settlement system and prevent the recurrence of a financial crisis.
If one regards the fundamental nature of financial crises to be "the evaporation of money due to bank runs," then this is an extremely natural and blunt prescription. Professor Lucas' view could certainly be termed a point of reference in considering future financial regulations.
There is still considerable room for debate, however, on whether such a policy recommendation would be advisable for the world economy and the financial system henceforth, and there are doubts about its practical feasibility. Advances in financial techniques and changes in business models had left post-Depression regulations far removed from the actual circumstances of the financial industry, and the Glass Steagall Act had been repealed. I asked the following question of Professor Lucas: even if one seeks to insulate the settlement system from high-risk assets through financial regulation, would it not be inevitable that financial institutions within the settlement system would find ways to invest in high-risk assets?
Professor Lucas' reply was characteristically practical. Some of the barriers erected by regulations would certainly be overcome one day and spark a new bubble or financial crisis. Even so, the post-Depression banking system provided the economy with stability for several decades. Introducing new regulations now would seek to stabilize the economy for some time to come (hopefully several decades), and one cannot really expect more than that.
Professor Lucas has consistently adopted a practical style in his academic research, distinguishing between the possible and the impossible, determining the scope of the possible and framing issues in that context to produce exact results. This style is apparent in his policy recommendations on finance as well.
On a note aside, Professor Lucas' analysis does not address the issue of how to regenerate the money (scrip money) that evaporates in financial crises. To anticipate the conclusion of this series of articles, I believe that this will involve the disposal of nonperforming assets.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the October 19, 2009 issue of Kinzai Financial Weekly
