Patrick McGuire, professor of economics at HWS, was included in a “Chronicle of Higher Education” article that asked professors whether or not the financial crisis affected how economic theory should be taught. McGuire, who is currently leading the semester in Washington, D.C., program, replied, “No. Economic breakdowns, such as the current financial crisis, illustrate how economic theory works.” He went on to explain that it did work in this case as well because, “The information indicated that liquidity for the financial markets disappeared almost overnight when the supply of under-performing assets vastly exceeded the demand at the stated price or even at any price.” The following is the excerpt of his written reply as it appeared in the “Chronicle of Higher Education”:
“Perfectly competitive markets clear at the equilibrium price, and there are winners and losers. However, markets in the real world are never perfect, and breakdowns occur. In this case, the breakdown threatens the most venerable of market participants, individuals and businesses that create wealth in the economy. The real losers will be those firms that need to sell their underperforming assets at well below their cost. The winners will be those who need the markets to operate their daily lives. Economic theory is alive and well…a bit battered…but functioning.”
McGuire has been a member of the HWS faculty for more than three decades. He has co-taught the “Two Cities” bi-disciplinary course with Jim Spates of the sociology department for more than 20 years, has directed the Galway Ireland semester abroad and regularly leads the Washington, D.C. internship program (where he is currently studying). He earned his Bachelor of Science degree from St. Peter’s, and his Master of Arts and Ph.D. from Fordham University.
The full article from the “Chronicle of Higher Education” appears below.
Chronicle of Higher Education
“Does the Financial Crisis Affect How Economic Theory Should be Taught?”
Alexander C. Kafka • October 10, 2008
That’s what we asked professors of economics, business, and related fields. Here are some excerpts from their answers:
Michael W. Klein, professor of international economics, Fletcher School, Tufts University: Seismologists have earthquakes. Epidemiologists have outbreaks of disease. Political scientists have constitutional crises. And economists have financial collapses.
While no one welcomes these events, they do offer professors unique teaching moments. Incentives, the importance of information, the consequences of moral hazard, the role of regulation: These are all ideas that have been familiar to my students since they were exposed to them in their course work. But they had less background for thinking about the consequences of financial distress for the performance of the macroeconomy, or for the role of the financial sector in long-run economic growth. Even intermediate-level macroeconomics texts will not mention those topics, which have been a focus of analysis for the past 15 years.
In the future, there will be sections of macroeconomics texts that present results from these lines of current research. Years from now, when I use these texts and lecture about the events of the autumn of 2008, I hope I’ll be able to talk about how the country dodged a bullet through the application of regulations and policies based on sound economic principles.
Kevin P. Christ, associate professor of economics, Rose-Hulman Institute of Technology: I am often surprised (and a bit frightened) by the hubris that we’ve somehow nurtured in our students, who often reflexively espouse a level of faith in unfettered markets that many of us once would have viewed with suspicion. Our students know that individuals always make the best decisions, and that the wisdom of crowds always provides the best answers, even to the most complex questions.
At some point, and this is as good as any, we have to ask ourselves if we have been teaching theory or ideology.
What about a return to the idea that economic theory does not offer settled answers but instead offers only an engine of analysis? Are we fearful that if we allow for too much ambiguity in the use of our theories, we will no longer be perceived as proper scientists? If anything, this episode should remind us to remind our students that there may not always be a unique right answer.
Amyaz A. Moledina, assistant professor of economics, College of Wooster: Before the crisis, it was widely believed that financial innovation was a good thing, and that the derivatives responsible for some of the credit crunch were a benefit to the financial system. What was ignored was the systemic risk that such instruments caused and the difficulty and challenges of a consistent and flexible regulatory response. With that in mind, I did change my presentation of derivatives to incorporate discussion of financial-system risk. I also encouraged my students to think differently by exposing them to alternative financial systems, such as those in the Islamic world, which, in principle, prohibit the use of derivatives, not because that is what I want them to do, but because broad exposure to different economic systems could give us clues about how to better regulate ours.
Cristian Ioan Tiu, assistant professor of finance and managerial economics, School of Management, State University of New York at Buffalo: We are used to seeing finance as somewhat of an elitist discipline. Year after year we focus on how to teach our students to be the best hedge-fund managers of tomorrow. In all this grand plan, we don’t bother to make sure that notions such as risk, market efficiency, and time value of money can be simplified enough to trickle down from our ivory towers into Main Street. Why can’t we teach the unemployed guy sitting on the porch of a crumbling house that the price of that house may go down and not just up? Why can’t we teach him what an adjustable-rate mortgage is? Why can’t we take all we know about risk aversion and translate it into prudence? If we taught all that to the average Joe, I bet you that he would have said no to all the greedy mortgage salesmen in the world.
This crisis is built on the foundations of financial illiteracy.
Michael Szenberg, chair and distinguished professor of finance and economics, Lubin School of Business, Pace University: No change is necessary in the way scholars view and teach economic theory.
There is one common, simple factor which brought the collapse of the Soviet Union and the credit crunch to the United States, and that is misplaced application of incentives.
Absence of proper pricing in the Soviet Union and absence of adequate risk as an allocative feature in the United States are equally to blame for the mismanagement of both economies. One advantage the United States has is that we have the built-in political flexibility to peacefully change things.
It is very ironic that the end result of the misplaced application of incentives in the Soviet Union led to the increased role of the market system in that country. In the United States, the misplaced application of incentives is bringing about greater government intervention in the economy.
Douglas K. Pearce, professor and department head, economics, North Carolina State University: It is not that the crisis should change our economic theory. It is that when times are good, some investors and regulators ignore the warnings that economic theory provides.
Mason Gaffney, professor of economics, University of California at Riverside: The key concept that is missing today is land value. Classical economics divided factors of production into three: land, labor, and capital. Beginning around 1920, scholars conflated land with capital. That left them totally unprepared to cope with or explain the crash of 1929. At that time macroeconomics, as we now call it, rose to the fore. For a time it eclipsed microeconomics, which had degenerated into the explanation of the allocation of resources among competing ends. Gradually, microeconomics came back to be integrated with macro, but in the process land value almost disappeared.
Few or no texts recognize that expanding banks, by taking land under and around speculative developments, in effect monetize those speculative land values. When the wave of land values ebbs, and debtors default, banks have to contract, as they are now. Yet economic theorists, and those statesmen whom they have trained, attend mainly to the froth on the waves, ignoring the basic wave of land value that drives the cycle.
Stephen Foreman, associate professor of health-care administration, Robert Morris University: When I began my teaching career, I was able to contrast the economy of the United States with state-managed economies to illustrate how a nation with a market-based economy outperformed central planners. The response to turmoil in U.S. financial markets has forced a total reorientation of my teaching examples: how abandonment of market principles leads to chaos, suffering, instability, and inefficiency. The United States has joined the ranks of state-run economies. Teaching examples now focus on competitive disadvantage and structural inefficiency that follow abandonment of market principles.
Patrick McGuire, professor of economics, Hobart and William Smith Colleges: Perfectly competitive markets clear at the equilibrium price, and there are winners and losers. However, markets in the real world are never perfect, and breakdowns occur. In this case, the breakdown threatens the most venerable of market participants, individuals and businesses that create wealth in the economy. The real losers will be those firms that need to sell their underperforming assets at well below their cost. The winners will be those who need the markets to operate their daily lives.
Economic theory is alive and well – a bit battered but functioning.
Section: The Chronicle Review
Volume 55, Issue 7, Page B99