By Lauren Otis, Staff Writer
PLAINSBORO — The economic crisis gripping the country across multiple business sectors has its roots in the fact that while credit markets are not, like other markets, inherently self-regulating, the government treated them as if they were, said Eric Maskin, a 2007 Nobel laureate in economics and professor at the Institute for Advanced Study in Princeton.
Mr. Maskin addressed a luncheon meeting of the Princeton Regional Chamber of Commerce at the Princeton Marriott Hotel on Thursday.
”Sadly, in the euphoria of the past 10 years, we forgot the principle that the credit market does not self-regulate, that small shocks can magnify, and the government (through oversight and regulation) does play an important role,” he said.
Mr. Maskin said the crisis in the credit market is different from crises in other business sectors because it is not inherently self-correcting, requiring government intervention, and has the capacity to hobble the economy as a whole.
As a result, “a problem that started out as a local and confined problem within the housing and mortgage markets has expanded everywhere to envelop the entire credit market,” he said.
”If the whole economy is the body, the credit market is the circulatory system, responsible for nourishing the rest of the system,” he said.
If banks curtail the extension of credit, this affects the broader economy of business sectors, which need financing to function and expand, he said.
Unlike a market for a commodity, such as potatoes, where a crop failure in one part of the world will result in short-term price increases and incentives to boost supplies from other producing regions without government intervention, “failures in the credit markets are not necessarily self-correcting,” Mr. Maskin said.
Banks do not self-correct in a credit crisis by moving in to extend credit to businesses who have lost financing when a weak bank calls in loans, but, instead, pull back on lending themselves as job growth stalls and economic indicators fall, Mr. Maskin said. As a result, without quick government action, an isolated financial weakness accelerates and spreads across the financial sector and to the broader business community as it currently has, he said.
”There is a clear need for government intervention when things go wrong in the credit markets. The important thing is to keep these banks in business, not for these banks’ sake but for the other banks.” Mr. Maskin said.
A government bailout is necessary, but must also be coupled with regulation to ensure that, in anticipating bailouts, banks relax risk standards, he said.
Unfortunately, he said, credit crises will continue in the future, no matter how effective the stimulus and bailout package is in stemming the current crisis. That is because government regulation is incapable of discerning between good innovation — “creativity and innovation in the financial sector, which our future prosperity depends on” — from harmful innovations, such as financial derivatives that neither the buyer or seller understands.
