Here is a quote:
"Mr. Blinder, a professor of economics and public affairs at Princeton and a former vice chairman of the Federal Reserve Board, reminds us that the disaster was years in the making. Starting in the late 1990s and continuing through 2007, he writes, Americans had “built a fragile house of financial cards” that was just waiting to be toppled: “The intricate but precarious construction was based on asset-price bubbles, exaggerated by irresponsible leverage, encouraged by crazy compensation schemes and excessive complexity, and aided and abetted by embarrassingly bad underwriting standards, dismal performances by the statistical rating agencies and lax financial regulation.”"
Where are the game theorists here? If by backwards induction, we know that this will happen --- why didn't this unravel earlier? Or was there an expectation that there would be a Federal bailout so that moral hazard lurked everywhere here?
The interplay between Wall Street investment and Federal Reserve Policy and bailouts creates quite a game that the best game theorists would have trouble solving.
If you don't believe me, consider Board Governor Jeremy Stein's remarks in today's NY Times. When he was a Harvard Professor, Stein was a world famous academic. I see that he has generated 10,000s of thousands of citations for his economic research. In St. Louis yesterday, he was quoted on "bubbles" in the junk bond market; read this.
"We are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” Mr. Stein said in St. Louis. He added, however, “It need not follow that this risk-taking has ominous systemic implications.”
Mr. Stein gave no indication that Fed officials were contemplating any change in their aggressive efforts to hold down interest rates. Rather, he described the signs of overheating as an emerging trend that might require a response if it intensified over the next 18 months.
But the speech nonetheless underscored that the Fed regards investment bubbles, rather than inflation, as the most likely negative consequence of its push to reduce unemployment by stimulating economic growth."
So, this is a game within a game. If you are a Wall Street guy and you read this, do you now short these bonds? How have your expectations changed? If government's cheap talk affects individual firm behavior does this roil markets? How do individual changes in expectations aggregate up? The game theorists and the macro economists need to spend more time together because macro just keeps getting harder.
UPDATE: How do policy makers make policy when they learning about how the economy works at the same time that the investment community is forming expectations over the likely policies that the policy makers will make. The investment community recognizes that the policy makers are divided between Congress, the President and the Fed and that these 3 entities may have shifting priorities over "fighting inflation versus promoting growth". In the midst of this mist, you can see how many reasonable economists can become "rules over discretion" guys. Discretion offers the policy makers a chance to have a lot of fun but it creates a lot of equilibrium and this retards investment through the uncertainty channel.
