From economists and politicians to our next-door neighbors, everyone seems to have a theory about what has driven our soaring economy into the ground. Solutions to the problem, however, seem harder to find than a loan on a three-bedroom condo. Simon Wilkie, professor and chair of economics in USC College, has a threefold explanation for how we got ourselves into this quandary — but most importantly he offers a way to help the country out of this mess (more on that later).
“One contributing factor is that we had a long period with very little economic growth in the ’70s and ’80s,” he said. “So what started to happen in the ’90s was that, all of a sudden, the gains from investment in information technology appeared and this growth came along.” According to Wilkie, who joined the College’s Department of Economics in 2008, people mistakenly thought this growth was sustainable and would continue unaided.
The second factor he believes led to the downturn is what popular media has dubbed the “moral hazard problem,” which resulted when the financial sector in the United States went through a period of reform and created new financial instruments such as mortgage-backed securities.
“Essentially, the bundling of loans into tradable assets meant that interest rates fell as loans became more liquid. But as a result, those writing the loans could pass the default risk on to someone else,” Wilkie said. “So we had an increase in the demand for housing because more people could afford it, but a decline in underwriting standards.”
And the third factor, Wilkie asserts, was the rapid growth of China. “In order to fuel their growth, China kept their currency low, and by doing this, they accumulated more than 1 trillion U.S. dollars,” he said. This money was then reinvested in U.S. Treasury Bills. The massive supply of funds kept American interest rates low but, in the long term, it was an unsustainable source of income.
“This is the general consensus,” he noted, regarding his version of events. “The disagreement is what to do about it.”
For his part, Wilkie has chosen to focus on toxic assets as one way to begin repairing the U.S. economy.
Given this nasty name for a reason, toxic assets are a collection of loans and securities for which borrowers have stopped making payments, and whose value has fallen to unknown amounts. Because their value is unclear, there is no market for these assets.
Until such a market is created, toxic assets will remain with the banks and continue to tie up funds and prevent other loans from being made. Although these assets are only one cause of the recession, their sale would allow banks to start lending again.
So how do you create value in an item such as a loan?
Pulling from his expertise in game theory as it applies to business strategy, Wilkie has formulated a toxic asset auction proposal that he will submit to Washington, D.C.’s economics experts. Game theory, an interdisciplinary type of applied mathematics, focuses on how the interaction of individuals influences the choices each person makes.
Auction design is just one example of game theory, and the most relevant to Wilkie’s plan. In an auction, the ultimate price paid for an item is a result of ascending bids, each of which is determined by previous bids. Bidders, therefore, create their own market and value for an item based on what other bidders are willing to pay. Wilkie’s plan utilizes applied game theory to create a market for toxic assets and to auction them off successfully.
Wilkie’s experience as chief economist at the Federal Communications Commission (FCC) proved to be essential in devising this proposal. In 1994, the FCC consulted game theorists such as Wilkie to design an auction for electromagnetic spectrum licenses — permits for the use of radio airwaves.
In this type of auction, the bidding is conducted online, and all available licenses are auctioned off in rounds to anonymous bidders. After each round is completed, the results are opened so that all bidders can see the prices, and therefore have a better idea of the value that other bidders place on the licenses. The bidders can then use this information to determine their future auction decisions and purchases.
“That was before eBay,” Wilkie said. “It was the first electronic, ascending-bids simultaneous auction, where lots of things were auctioned off at once. The idea of auction theory is that if each of us has a little piece of information, together we actually know quite a lot. So if we did all of the auctions at once, and they were open, then there would be a good deal of information about the prices in every market.”
Governments have since used this revolutionary auction design to sell over $100 billion in spectrum licenses worldwide.
In the case of toxic assets, their value is unknown because the initial trades were not observed by the public or by a third party. “Part of the reason that the market for these assets has fallen apart is that it was all done with bilateral trades. It was not an open market,” Wilkie said.
Value can be defined as the price someone is willing to pay for an item. But if one person bidding on an item doesn’t know the price other buyers have paid for similar items, it becomes difficult to determine worth. Since the assets changed hands between sellers and buyers with no observers, there is less information available to future buyers, and less information means a questionable value and more risk.
Wilkie’s toxic asset proposal utilizes a model similar to the FCC auction. His idea is to open the market and involve a third party — in this case, the government — so that the rate and price at which all assets are bought and sold can be seen by everyone involved.
Before the start of the recession, “there were trillions of dollars of these trades being done privately,” Wilkie said. “If we made this an open, transparent market, we would get better price discovery and then the market might start working again. The financial system would recover.”
What separates Wilkie’s plan from the FCC auction is his goal to ensure that the buyer can purchase assets at an informed price, and that both the seller and the government will make money from the sale.
To do this, he proposes to set the market so that buyers pay a competitive price in the way they would at a standard auction. With the information open to all buyers, they will find it easier to assign a value to the assets. This method also ensures that the assets are purchased by the buyers who value them the most.
In addition to buyer competition, the price the sellers receive would also be set by competition among the sellers.
“Then we run a double auction, raising the price for sellers from a low start and lowering the price for buyers from a high start,” he said. “When demand just falls short of supply, we stop.” This way, the price buyers pay is slightly higher than the price the sellers receive. The market maker, in this case the government, will be paid the difference.
In spring 2009, the U.S. Treasury Department unveiled their own proposed market design — the Public-Private Investment Program. Wilkie sees snags in this proposal. In particular, he considers, it is reminiscent of the FCC’s failed 1996 C-Block spectrum auction in which the government gave bidders credit so that they could pay for their purchases over time.
“These auctions are plagued by the winner’s curse,” Wilkie said. “A winning bidder needs to account for the fact that he or she has bid the most and so may have an overly optimistic estimate of the value.”
Suppose, Wilkie theorizes, a person can purchase an item on credit and default later. If it turns out the buyer bid too much, and cannot pay, he or she can declare bankruptcy and walk away. This diminishes any incentive to account for the winner’s curse and results in overbidding.
In the case of the ’96 FCC C-Block auction, Wilkie notes that he cautioned the FCC about this problem two years prior, but unfortunately the advice went unheeded. As a result, auction participants overbid by 100 percent, and most went bankrupt. “It was a $10 billion debacle then — unfortunately this time, there are a few more zeros at stake,” he said.
Even if the government adopts various economic solutions such as Wilkie’s toxic asset relief proposal, he concurs with many economists’ views on a timeline for recovery. “It’s probably going to be two to three years,” he said.
An improved housing market will be one benefit of resolving the toxic asset predicament. Once housing prices stabilize, Wilkie notes, it will be a good sign that we’re digging our way out.
He adds that the relationship between median income and the median price of a home is an indication of the state of the economy. “If the average person can’t afford the average mortgage, then the housing market is in trouble, and the prices are going to come down. It turns out this is a really good rule of thumb,” he said.
Although no one will admit it, Wilkie stated, a large portion of the stimulus package will be inflationary. “One way to get people out from being under water on their houses is to inflate the value of houses back up.” A massive program of inflation would solve the foreclosure problem, but the fix would only be temporary.
“Ultimately, we just have to realize the losses and move on,” he said.
In his field, at least, there could be some long-term benefits to the current economic crisis and the steps that are being taken to fix it. “We’re starting to see an increase in the importance of behavioral economics research,” Wilkie said.
He expects that the government will shift from using traditional economics to using types of behavioral economics, like behavioral game theory, to form policies and anti-trust rules. While standard economics assumes rationally functioning markets, behavioral economics takes into consideration personal biases and “small departures from perfect rationality”.
Wilkie also expects to see more doctoral students doing research in the field, and more openings in the academic job market.
His proposed toxic asset auction is not the only practical application of game theory — it is already being used outside academic spheres. Public school districts and hospitals use game theory to account for parents’ strategies for placing their children in specific schools and interns’ strategies for being accepted at the hospitals of their choosing. Game theory has also been applied to designing arbitration mechanisms in company mergers.
When he’s finished with his toxic asset relief proposal, Wilkie will present it to the Treasury Department and the National Economic Council with the hope that his ideas will help balance the economy.
Wilkie is not the only one pitching a proposal to Washington, so he will encounter quite a bit of friendly competition along the way. He could use game theory to create a formula that would ensure that his proposal landed on the right desk and was read by the right person. After all, it could be argued that game theory could be applied to an overworked group of politicians desperate for a solution. But there’s no need to play games. His work will speak for itself.
Our Experts Weigh In
Economists Caroline Betts and Robert Dekle share their insights into the nuances of the economy.