Econ Professors Lament Financial Crisis

Calling this week’s turmoil on Wall Street “the worst financial crisis since the ’30s” and “the most dramatic event in a lifetime,” Harvard’s often-reserved economic experts did not mince words in describing the ongoing financial crisis that has seen the disappearance of three of the nation’s five major independent investment banks and the government rescue of one of the world’s largest insurers.

Professor of economics Kenneth S. Rogoff echoed the sentiments he expressed at an April panel discussion at Harvard in which he said the ongoing economic crisis “looks like a really bad one.”

“It’s a very, very difficult situation,” Rogoff said in a phone interview yesterday. “You really can’t overstate it. The whole system is incapacitated—I just don’t see how to clean it up.”

Jeffrey A. Frankel, a professor of capital formation and growth at the Harvard Kennedy School, said he expected the financial sector to contract for some time into the future.

“This has just been going on and on,” he said. “There have been so many huge firms collapsing, most of which people would not have considered in danger a year ago. The amazing thing it hasn’t yet caused a recession, but I would bet that’s coming.”

Rogoff agreed, and speculated that there may not be any standalone investment banks left by next week.

“I’ve long felt the financial sector is bloated,” he said. “It’s had epic profits for two decades. It was bound to shrink.”

The economists agreed that this week has been historic for Wall Street. The Dow Jones Industrial Average, a common market metric comprising 30 widely-held companies, has tumbled 7.1 percent in just three days.

On Monday, the Dow registered its largest fall since the first day of trading after the Sept. 11 attacks. The S&P 500 index, a broader index which typically is less volatile than the Dow, is down 7.6 percent this week.

The market’s downward spiral reflects a larger atmosphere of worry in light of the collapse and liquidation of Lehman Brothers and the sale of Merrill Lynch to Bank of America at the beginning of the week.

The two prominent investment banks became the latest casualties in the financial sector, following in the footsteps of Bear Stearns, which was sold to J.P. Morgan in March in a deal orchestrated—and partially insured—by the Federal Reserve.

Just yesterday came news that one other venerable investment bank, Morgan Stanley, was considering a merger with the commercial bank Wachovia.

Harvard economists had mixed views on the Federal Reserve’s Tuesday bailout of insurer American International Group, Inc., in which the government will effectively take control of AIG with an $85 billion loan.

Economics department chair James H. Stock, who had been optimistic until recently, said the AIG deal convinced him of the severity of the crisis.

He said that the Fed’s willingness to take on “bad debt” in light of its high-quality information indicates the market’s predicament is “really serious.”

Rogoff and Frankel both said that the Fed is best positioned to walk the tightrope between encouraging future risky behavior by intervening too much, and potentially damaging the financial system by intervening too little.

But economics professor Jeffrey Miron, known for his libertarian views, disagreed, saying that the bailout amounts to “a huge transfer of wealth from the taxpayers to the stakeholders in AIG who made bad bets.”

As to where to assign blame for the ongoing market turmoil, the economists named the usual suspects: reckless mortgage lenders, government mortgage bond insurers Fannie Mae and Freddie Mac, bond rating agencies, the investment bankers who bought securitized home loans, and the government for failing to properly regulate investment banks and other less transparent securities markets.

“There are so many people to blame you don’t know where to start,” Rogoff said.

While many on Wall Street have lost or are in line to lose their jobs, N. Gregory Mankiw, the economics professor who teaches Harvard’s introductory economics course, took a more light-hearted view in a blog post on Monday.

“I would like to thank all my friends on Wall Street for doing so much to spark interest in economic issues,” Mankiw wrote. “You have gone beyond the call of duty, and your timing could not have been better.”

—Staff writer Maxwell L. Child can be reached at mchild@fas.harvard.edu.