Introducing Economist Anton Korinek – Capturing the Complexity of Crises

bridges vol. 34, July 2012 / News from the Network: Austrian Researchers Abroad

By Bernhard Mayr

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Korinek Anton"Being an economist with focus on international financial markets keeps you busy these days," says Anton Korinek, assistant professor at the Center for International Economics at the University of Maryland. We sit in his office on the College Park campus, which seems unusually deserted and quiet on this afternoon in late June. It is the time after graduation but before summer classes start. However, this is not a quiet time for Korinek, who just returned the night before from Basel, Switzerland, where he participated in discussions on macroprudential regulations at the Bank for International Settlements.

Ever since the global financial crisis began some five years ago with the 2007 bursting of the US housing bubble, one wonders how much longer the bailouts of banks, downturns in stock markets, and stubbornly high unemployment numbers will continue. Having prepared several pages of questions, I was ready to absorb Korinek's knowledge on these topics.


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Korinek came to the US after finishing his master's degree in economics with distinction in 2000 at the University of Vienna. He began working on his Ph.D. with a full scholarship from Columbia University, and was also supported by a postgraduate fellowship from the Austrian Ministry of Science and Research. His dissertation focused on the role of dollar borrowing in emerging markets and was sponsored by Nobel Laureate Joseph. E. Stiglitz.

Bridging the gap between theory and practice

"I find it very appealing how economics captures complex social interactions in mathematical relations that resemble the laws of nature," Korinek replies, when asked why he chose to become an economist. His research focuses on how financial market problems affect the macroeconomy. Korinek stresses the importance of connecting economic theory and the real world. "I try to make economics as practical as possible. For example, in one of my undergraduate courses, I introduced a stock market game - the students learned very fast, and you'd be surprised how well many of them did. Keeping economic theory close to real-world issues is something essential that is often forgotten in modern economics."

During our interview of almost two hours, I came to truly appreciate Korinek's approach to teaching and communicating economic concepts. Our interview turned into one of the most enjoyable economics lessons I have ever received.

According to the standard economics textbook description of a financial market: "its basic function is to allow funds to flow from savers/lenders (those who have money) to borrowers (those who need money). Through providing this service, financial markets promote economic efficiency and growth." Simple enough, one would think. So how come we ended up with today's mess in international financial markets? As Korinek explains it, the answer lies in the imperfections of financial markets. "One of the most significant imperfections in financial markets is that people cannot commit to repay. In a normal market when we exchange apples for oranges, you give me the apples and I give you the oranges at the same time and that means that the contract is easily enforceable. In financial markets, I give you oranges today and you promise to repay me with interest in a year, or in thirty years from now. That means that I rely on a promise, and as we know, especially after the latest mortgage default crisis, this promise isn't always kept. This is the main problem of financial markets – that people do not or cannot always honor their promises. Thus, the entire financial industry revolves around screening and monitoring people who want access to financial markets, to make sure that we give money to those who will repay us and not to those who will not."

So-called externalities are another problem that contributed to the crisis. Well known with regard to environmental pollution, externalities exist when prices in a competitive market do not reflect the full costs or benefits of producing or consuming a product or service. Externalities also exist in financial markets, as Korinek explains: "When we speak about financial crises, one of the most fundamental externalities is what some people have called fire sales. In almost all financial crises the reason why prices fall so severely and typically overshoot, is that an initial decline in the price of an asset leads to subsequent rounds of fire sales and defaults, causing prices to fall further and resulting in negative feedback loops. In this whole process, individuals take actions that may be rational from their point of view. But they don't allow for the fact that their own behavior negatively impacts other players in the market, in terms of increased system risk. For example, let's imagine that I default on my mortgage; the bank repossesses my house and sells it in a foreclosure at a loss. That sale pushes down home prices and hurts all the other home owners in the area. As they see home prices falling, they have less incentive to repay and may walk away from their mortgages, causing even more foreclosures and leading to further collapses in housing prices. We have seen that type of negative feedback loop played out in the mortgage default crisis in the US, and similar feedback loops play out all the time in financial markets. When asset prices fall, people who borrowed against these assets have to either inject more money or sell them, which reinforces a decline in asset prices."

Fair enough, I think. But are market imperfections and negative feedback loops the only villains in such a wide-reaching crisis? "No," Korinek says, "a financial crisis as big as this one can be compared to the outbreak of a major war, which also has multiple causes, taking a confluence of a large number of factors to happen. Excessive risk taking combined with financial innovation like subprime mortgages or credit default swaps played a major role in the buildup of the financial crisis. Another factor was irrational exuberance across a large part of society, not only in the financial sector but also in society at large, when people thought housing prices could only go up."

On a deeper level, Korinek sees some societal developments as contributing to the crisis: "I personally believe that increasing inequality leads to more financial instability. The point is that people who are rich want to store their wealth in financial assets. However, in order for one person to save, another person needs to borrow – otherwise we are not in macroeconomic equilibrium. Thus, if some people accumulate more and more wealth, somebody else has to accumulate more and more debt, and that automatically makes the system more fragile and vulnerable to any shocks."

Korinek also blames the financial sector's rent extraction behavior for the crisis. When economists speak of "rent extraction," they mean that somebody can extract more than their fair share of profits from a transaction by distorting the market, for example by colluding, by taking advantage of superior information, or by changing the rules of the game via political lobbying. Korinek points out that "financial institutions extract rents from taxpayers, as we have seen with all the bailouts in recent years. They extract rents from common savers like you and me, who put money into pension funds that charge exorbitant management fees; and they extract rents from the productive sector of the economy by making financial transactions more expensive than they need to be. Ultimately, many of these rents arise because the financial sector manages to take advantage of market imperfections. Many behaviors that yield these large profits are not actually adding economic value. They distort the market and make the economy less efficient in order to redistribute money from the rest of society towards the financial sector.

To bail or not to bail – is that the question?

While sitting in Korinek's office, I notice a cartoon hanging on his door.

© David Fitzsimmons / Arizona Star

So I ask his opinion on government bailouts for banks. Korinek urges caution: "When we think about how desirable bailouts are, we should be aware that a major trade-off is always involved. On the one hand, once a financial system is in free fall, we can limit the damage for the real economy by saving banks. On the other hand, when we do that we also change the incentives – and financial institutions have much greater incentives for risk taking if they can expect bailouts. An important issue is that financial innovations like credit default swaps or subprime mortgages really change the trade-off, as they allow the financial sector to take on more concentrated risk and, consequently, to extract larger bailouts than would otherwise have been possible. If things go wrong, this makes it so much more expensive for the taxpayer."

Instead of fixing broken banks, Korinek would rather see the prevention of such a situation altogether. How to achieve this? Additional regulation for financial markets might be a good place to start. Korinek is currently writing a paper on what such regulation could look like, investigating the pros and cons of financial regulation on a global level, versus leaving regulation to individual countries. He thinks the regulatory reaction to the recent US crisis "was far too weak. The regulations that were passed in the US financial reform bill went in the right direction, just not far enough. For example, capital levels among banks still need to be raised a lot, to limit the extent to which the financial sector can gamble at taxpayers' expense. Given the small change in regulations, I wouldn't be too surprised if we experience another financial crisis soon after we recover from this one."

The transatlantic "Slow-Motion Depression"

As a consequence of the financial crisis, Korinek sees both the US and Europe as suffering from stagnation or, as he puts it, a "slow-motion depression." In the US, as well as a number of European countries, households still have too much debt, which holds back aggregate demand. However, a problem specific to Europe is the euro, its common currency. "We all know the beginning of the story," he says. "There were all those countries with different economic histories coming under the umbrella of a common currency and a low interest rate. That led to lending booms in some of the peripheral countries, causing huge amounts of private and public debt. The problem could have been solved easily if every country still had an individual currency. For example, Greece could devalue its currency, which would both lower the value of its debt and make it more competitive – and the problem would be solved. Now, with one common currency, they no longer have this option. The same is true for Spain, Ireland, and some other countries. It is really a design error of the euro that such situations can arise, and we have no policy measures for how to deal with them."

Faced with these facts of the past, what is the outlook for the future of the euro zone?

"To be honest, I am not very optimistic," Korinek replies. "There are two issues, but policy makers are dealing with only one of them: Given that markets have doubts about the euro's survival, borrowers are no longer willing to hold euro-denominated debts of countries like Greece, Spain, and Italy. Thus, these countries are charged ever higher interest rates -– making their debt problems even worse. If they all had German interest rates, they would probably have no problems; but with higher interest rates, their debt problems are severe. All the policy solutions that European summits have focused on over the past year are how to deal with that debt problem. But the bailout packages, all the checks that the EU is writing for Greece and Spain and whomever else, do not really address the second, deeper issue: Peripheral countries have a dramatically overvalued real exchange rate. During the boom of the 2000s, prices in Greece, Spain, Portugal, and Italy rose faster than in Germany. As long as these countries had lots of credit flowing in from Germany, they could afford to live with those high prices. Now that credit flows have stopped, they have a huge competitiveness problem and somehow need to get their prices back in line again. However, economic history tells us that it is almost impossible to have a serious amount of deflation, as prices are very sticky when it comes to downwards movements. In my view, that means the only way for the euro zone to survive in its existing form is for Germany to allow more inflation. Or another option could be that single countries, like Greece, drop out of the euro, which would cause their exchange rate to drop by half or two-thirds, making them competitive again. Yet another scenario is to have two euro zones, a "strong" and "weak" one. That sounds attractive in theory, but politically there would be an adverse selection problem. Would France, for example, accept being a member of a "weak" euro zone? Would a "weak" euro zone consist only of Spain and Greece? Where would we make the cutoff? That is where the implementation gets very tricky and why I think that, if the euro zone breaks apart, there may be a core (zone) remaining, but most other countries would reintroduce their own currencies."

But, ending our conversation on a lighter note, Korinek quickly points out that for the US, the latest economic data suggest that the worst is probably already behind us. And there is also good that can come from the bad. "You know," Korinek says, "the positive thing about the recent crisis is that it has made a new generation of talented students interested in studying financial markets –- they will become experts who will hopefully figure out how to prevent such crises in the future."

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This article is based on an interview conducted by the author, Bernhard Mayr, with Assistant Professor of Economics Anton Korinek at the Center for International Economics at the University of Maryland.

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