What have we learned from the financial crisis?

Lucrezia Reichlin

Lucrezia Reichlin interviewed by Julian Morgan

The fourth in our series of seminars with economic experts took place on 4 March. It was a discussion on the lessons from the financial crisis with Lucrezia Reichlin (professor of economics and chair of the economics department at the London Business School). Below is a brief overview of our stimulating discussion, with short audio clips. 

Lucrezia has made her name through highly influential research on applied time series, business cycles and monetary policy. She is particularly known for developing econometric methods for what is sometimes known as ‘nowcasting’, the very short term forecasting of economic variables. This is important because economists often don’t have a good understanding of what is actually happening now in the economy, let alone what will happen next month or next year. Unlike meteorologists, we can’t simply look out the window to see the weather, so we need tools such as those developed by Lucrezia to understand the current state of the economy.

What’s behind a financial crisis?
I began by asking what we mean by a financial crisis and what its distinguishing features are. Lucrezia described it as a process involving a disruption of financial intermediation, usually accompanied by a collapse in asset prices. These developments in financial markets then feed through to the real economy affecting investment, consumer spending and ultimately the labour market. Financial crises are relatively common and there have been many in developed economies over the years. [3.07 mins]

I then asked what had caused the most recent crisis. Lucrezia described how it began with a relatively small slowdown in the US in 2007 which had a ‘vicious’ propagation through financial markets and then back to the real economy. This was linked to the fragility introduced by the large accumulation of debt throughout the economy which, in turn, was associated with poorly understood financial innovation. [4.11 mins]

Can we grow without debt?
This led to the question of why the economy had become so leveraged and whether it was possible to grow without debt. Lucrezia stressed that, whilst there was nothing wrong with debt per se, it needed to be possible for it to be repaid. To some extent there was overconfidence in the strength of the economy in relation to the technology boom in the US. But there had also been an accumulation of debt to maintain consumption as the real wages of those on low to middle incomes stagnated. [6.51 mins]

I queried whether the accumulation of debt was also a symptom of over consumption. Although Lucrezia saw declining investment across the G7 as a concern, she was sceptical about whether there was too much consumption. Indeed, she saw more danger in cutting back consumption too quickly which could hold back the recovery. [2.54 mins]

What are the lessons of the crisis?
We then turned to the lessons from the crisis for macroeconomists. Lucrezia felt that there had been a misunderstanding of the benefits of additional financialisation of our economies, which are probably rather limited for developed economies and may turn negative at some point. There had been a mistrust of financial regulations and a feeling that it was better to try to repair the economy after financial bubbles, rather than try to prevent them emerging in the first place. She also felt that economists needed to be much more aware of political economy considerations influencing the behaviours of the economic actors. [4.43 mins]

The impact of ideas beyond  the mainstream
I asked Lucrezia in which areas mainstream economists could learn from the range of heterodox challenges to orthodox economic thinking. Lucrezia saw important challenges coming from the work on inequality (eg Thomas Piketty’s work) and some of the thinking on how expectations are formed from thinkers in the Austrian school. She also felt that economists were necessarily becoming more eclectic and that adopting a pluralist approach was important for economics. [5.32 mins]

In response to a range of questions from the audience, Lucrezia discussed the economic and financial challenges facing China and the role of fiat currency (ie money issued by the state with no intrinsic value) versus the commodity based money (eg the Gold Standard) used  in  the past [5.42 mins]

A point about whether securitisation was necessarily a bad idea was also raised. [3.56 mins]

Lucrezia felt that the success of post war demand management showed that it was reasonable to aim at moderating the severity of recessions. Clearly more regulation would be needed to stabilise the financial system, but it was a major challenge for regulators to keep ahead of it. [2.44 mins]

Finally, she discussed the challenges associated with exiting from quantitative easing as the economy recovers. [2.51 mins]

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