In my opinion, it doesn't make a difference for policymakers whether the recent developments were triggered by fundamentals or by irrational and self-fulifilling market behaviour or - most likely - a mix of both. We are in a very serious situation now - regardless of the cause. And in a first step, all should be done to avoid panics and contagion. But of course making the second step afterwards is crucial. Adressing moral hazard issues on the level of market participiants and aiming for sound fiscal policy in the member states is absolutely necessary.He assumes that there are no frictions and dependencies in the political process itself. The policy approach to long-run or institutional problems ls wants to see addressed in a "second step afterwards" depends
(1) on the public perception of the causes of the crisis: I guess in a democracy like ours no policy-maker can sell Shiller's correct argument in favor of more markets for derivatives to people who blame speculation and market insanity as prime causes of the crisis,
and (2) on the short-run policy response to the crisis: policy is path dependent in the sense that a shift to a transfer union reduces the probability to reach a long-run solution based on bankcruptcy.
So I think ls's monetary policy views need a public choice update. Yet, even if it is important to get the causes of the crisis right from the outset ... such thing it very, very unlikely to happen, especially if economists argue that it doesn't matter. Further, I never argued that policy shouldn't react to such a crisis. The difficult thing is to find the best possible response given the incentive system of the political process. Again, it is unhelpful that economists start blaming market mentality as the public does, obviously untouched by the subject they have studied and what they actually teach.
Next, ls writes
Amv's arbitrage argument is not convincing to me. In fact, there were institutional incentives which avoided arbitrage. Just take the ECB's collateral framework treating Greek bonds equal to German ones. I suppose that the "missing markets argument" might be applicable, too. This argument was brought up in the light of the subprime crisis. It basically states that there was no market to bet on the bust of the housing market. The major share of the innovations in mortgage finance focused on participating from the boom. This led Bob Shiller to the conclusion that we need even more deriviatives to cover every possible future state, which is a quite remarkable statement given the current political pressure on the financial sector. And CDS markets for EMU government debt don't seem to have been very liquid in the years on from 2004. This is at least what a quick look on the pricing data suggests. So buying protection and betting on a Euro debt crisis might have been very difficult.Well, I don't see his point. I agreed with everything he writes here. My point was not that arbitrage was easily possible and thus irrationality has been crowded out (so that it couldn't explain market movements). I rather asked about the institutions that prevented arbitrage in the first place, allowing irrationality (however defined) to remain within the market. I asked (in italics as blockquote):
What kind of rules of the game and what kind of policy commitments leave expectations unanchored and fundamentals ineffective in the selection process called 'competition'? Why do agents generate sunspot equilibria, and much more importantly, why does the institutional setting not rule them out over time?
