Ask Nobel prize winning economist Robert Solow why those of us who toil away diligently in the real economy should be required to come up with vast amounts of money to pay the gambling debts of Wall Street, and he begins his answer with what he calls the standard analogy.

“That is this: if your neighbor likes to smoke in bed and as a result sets his house on fire, it’s still in your interest to put out that fire, or else your own house will burn.”

And the unpalatable fact is that the economic conflagration which began due to the irresponsible practices of the financial sector — the over-leveraging, the careless use of dangerous instruments like credit default swaps — quickly spread to adjacent parts of the real economy.

And that, he said, is why we have had to spend hundreds of billions in taxpayer money to, as he puts it “bail out these jerks who created all this trouble.”

But the analogy also carries within it two possible avenues of preventative action. First, you could avoid the blaze by stopping the irresponsible behavior. Second, you could limit the spread of the fire by putting some kind of fire wall between houses — that is the financial economy and the real economy.

Jaxon WHite

Unfortunately, he noted, the prevailing view in economics for too long was that everyone should have the right to smoke in bed.

“The view was, you don’t want to regulate, a man’s home is his castle,” he said.

Now, belatedly, the powers that be have taken some steps toward both preventing dangerous behaviors and limiting the damage that can be done by them, although they probably are not moving far enough, in his view.

Professor Solow, a Vineyard seasonal resident for some 48 summers, will outline those views in at a lecture at the Old Whaling Church in Edgartown on Monday. And yesterday at his Chilmark home, he gave a preview of what he would say.

The first thing he wanted to make clear was that an elaborate financial structure is vital to a modern economy. It does important things, like receiving the savings of people and allocating to others who are investing, and managing risk.

“If everyone who saved had to invest it himself or herself, like a peasant family, then very productive, efficient investments wouldn’t get made,” he said.

“If there were no way of shifting risks . . . the process of innovation would be limited. The guy who had the great idea in the garage or the workshop would have to bear all the risk.

“So the function of the financial system is to make the real economy more efficient. That is reflected in the statistical fact that middle income countries grow faster if they have a decent financial system.” He continued:

“However — there’s always a however — in rich countries and especially in the U.S., the financial system has proliferated to such an enormous extent that in a year like 2006, 40 per cent of all the corporate profits earned in the United States were earned by financial institutions.

“Less than half were earned by corporations producing goods and services other than financial services.

“I suspect, I think everyone now suspects, that the modern financial system in the U.S., this elaboration of complicated securities that are then sliced up and converted into other securities and sold to people who don’t know what’s in them — that has very little to do with the real economy.”

These huge amounts of money were not being invested in anything productive, the risks were taken not in pursuit of innovation, but were simple gambling.

“They made bets on outcomes other than what happens in production, in the everyday economy. They even bet on how other people’s bets will come out,” he said.

The gambling was all the more dangerous because many punters had little idea of the odds.

“Information was not symmetric,” Mr. Solow said. “Many in the market had no information, or false information.”

And the activity of “that crook” Bernard Madoff, with his multi-billion dollar Ponzi scheme was an example of what can happen in an environment of asymmetric information.

Not that most of the finance sector meltdown was due to criminality, he said, just excessive complication.

But not only were these people gambling, often with little idea of what exactly they were gambling on, they were doing it with huge amounts of borrowed money.

“A typical investment bank or private equity fund has debt equal to about 30 times its own capital. It leverages itself so much because it earns a teeny tiny profit. But it is earning that on 30 times its assets, so it can make vast profits.

“And if it loses a little bit, it can destroy all its own capital.”

Now, Professor Solow would not mind if it just involved what he calls rich people betting with one another.

“The problem is when you build this elaborate system and it breaks down, that has very real effects on the real economy. So we are right now in the middle of two events. One is a meltdown of the financial system and the other is a very deep recession,” he said.

According to the estimates of the Federal Reserve, in the past 18 months or so, households in the U.S. have seen their net wealth, at least on paper, diminish by somewhere between $15 and $20 trillion, or about one quarter.

Notwithstanding the fact that the real economy is capable of being just as productive as it was before — the labor force has grown, the stock of real capital has grown, no one has forgotten any technology, the education of the workforce has not deteriorated – it is not producing as much.

People feel poorer so they rein in spending.

“It’s a fairly well-established fact that the country as a whole spends on consumer goods roughly five cents of every dollar of wealth that it has,” Professor Solow said.

“So if the perceived wealth of the population falls by $13 trillion, consumer spending is likely to fall by something like $650 billion.”

Other way the financial meltdown spreads to the real economy is that financial institutions in trouble are less inclined to lend money.

“So there was, back last fall, an essential freeze that supports American business. The commercial paper market, in which businesses borrow for very short terms, absolutely froze.

“It would have been a very desperate situation except that the Federal Reserve stepped in and, instead of being a bank for banks, as originally intended, began to be a bank for business.

“The Fed has, with extraordinary ingenuity I think, started lending in all sorts of ways.

“And it’s lucky they did. Otherwise a lot of business would simply have come to a standstill,” he said.

But right up to the crash, and even to some extent now, some economic fundamentalists argued for an unregulated, or at least minimally-regulated market.

Competition, market forces, they said, would sort it out.

Professor Solow reached for another analogy.

“In the real, everyday economy in which, for example, the chairs in which we’re sitting are produced, it’s easy to understand why a competitive environment produces good results. Thus no one would think of telling the designers of chairs for summer houses how to design those chairs, because competition takes care of that.

“The almost fatal error was to believe the same thing was true of financial markets, and it’s not. And the reason it’s not true of financial markets is that the way they proliferate, based on debt.”

They borrow to buy assets. A leveraged financial system is unstable in a way canvas chairs is not unstable.

“Deep down, I think, economists knew that. But in the euphoria, the instant profits everyone was making in the boom, this got forgotten.

“Greenspan [former Federal Reserve chairman Alan Greenspan] has taken a lot of beating for having explicitly believed financial markets are self-correcting, the way the market for chairs is. He should have known better.”

So what to do?

Re-think regulation. Make sure the activities of the financial sector are more transparent. Limit the amount of leverage institutions can employ. Insulate, as best we can, the everyday economy from the occasional failures of the financial system, he said.

The Obama administration is moving in the right direction, but maybe not far enough, he added.

 

Robert Solow speaks on Monday at 7 p.m. at the Old Whaling Church. The cost is $20, with proceeds benefitting the Martha’s Vineyard Museum. He also will take part in a panel discussion on the economic crisis at 7:30 on Thursday at the Martha’s Vineyard Hebrew Center. The cost is $15.