Are we really so ignorant?

José Marí O´Kean. Professor. IE Business School

29 April 2010

The economic crisis has taught us an important lesson, namely that increases in wealth have to be based on real business, not on rises in the price of financial assets.

We now have different books and reports on the financial crisis and they all have one common denominator: our ignorance of what happened and the difficulty involved in predicting it.

But if we stop and think for a minute, we can perhaps see that we aren’t really so ignorant:

a)We know that the market is what works best, but it has its faults. Several of them led to this crisis, namely the lack of information and the low-level transparency of financial markets, the principal-agent problem in bank management, behaviour among brokers that gave rise to moral risk, and inappropriate choices made by savers regarding financial assets and by banks regarding mortgage borrowers.

b)For better or for worse, states have intervened to correct these faults in economies, but we have no regulators to correct the faults of the global economy.

c)We operate in a global environment and this has made it possible to channel savings from where they were made to where they were needed with relative ease. The appearance of an emerging country such as China, with a savings rate of more than 40% of its revenue and a current-account surplus of 6% of its GDP, has brought an influx of funds available for loans on global financial markets.

d)And the newest facet of this crisis is perhaps that a generalized mega-expansionary monetary policy has been put in place coupled with the controlled inflation of the prices of goods and services, but nobody thought to control the significant increases in price it brought to financial and real assets.

Indeed, this is where the main difference lies. When the Keynesian model failed in its attempt to explain stagflation (inflation and unemployment) in the 1970s with the aggregate supply and demand model, we learned that commercial, monetary, fiscal and expansive demand policies cause inflation. This model also made it possible to control inflation by combining income policies with a moderate expansion of the monetary supply and, in such a scenario, the independent central banks grew accustomed to creating money and lowering interest rates if prices were under control; however, they monitored the prices of goods and not the prices of financial and real assets. And this is what we need to learn and correct.

Creating money increases the prices of financial assets and reduces the interest rate of said assets. And it is well-known that such a reduction makes credit cheaper, encourages investment in equipment and housing and the consumption of non-perishable goods that are usually bought with loans, increasing the aggregate demand, production and employment.

In the years before the crisis, with the huge supply of funds for loans from international saving, monetary expansion has been excessive and constant and it has inflated the financial asset price bubble. What we have learned is that controlling the prices of goods is as necessary for a successful economy as it is for preventing the prices of financial and real assets from generating the dangerous rises in value we have grown used to in recent years. Increases in wealth should come from the production of goods and services and not from increases in the prices of financial assets caused by speculation as a result of expansive monetary policies.

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