The Role of Incentives in the World Financial Crisis Bob Aumann Center for the Study of Rationality The Hebrew University of Jerusalem Astana, Kazakhstan 4 May 2011

Causes –Immediate –Underlying Remedies - Good and Bad –For Governments –For Firms –For Individual Investors Outlook for the Future –Specific –General

The Key to Economic Analysis Incentives

Immediate Cause: Subprime Lending Easy borrowing created high demand for housing This demand was met by a lot of new construction Then defaults created a housing glut, so prices dropped Low down payments gave incentives to default This drove prices even further down The process continues …

Underlying Causes: Overleveraging Entanglement (insurance – credit default swaps) Correlation (everyone doing the same kind of loans) Incentives for Bank Managers Negative Bubbles

Bad Remedies For Governments: –Abandon Market Economy –Bailouts For Firms: –Across-the-Board Lowering of Executive Pay For Individual Investors: –Panic Selling

Good Remedies: For Governments: –Regulate to avoid entanglement For Financial Institutions: –Avoid overleveraging –Use correct incentives for managers For Individual Investors: –(November 08): Sit tight –(July 10: perhaps now is the time to buy)

Outlook for the Future: (Nov 08): World Economy basics look good (July 10): The recovery is well on its way BUT Economic forecasting has never been very reliable

Rahmet!