Economics Nobel laureate skeptical about U.S. financial reform
Thursday, September 09, 2021 4:01 PM

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STANFORD, Sep. 9, 2010 (Kyodo News International) -- Nobel Prize-winning economist Myron Scholes has expressed skepticism over the effectiveness of the recent overhaul of U.S. financial regulations in preventing future financial crises, saying it is like ''having a band-aid without knowing where the cut is.''

Scholes, the co-creator of the 1973 Black-Scholes model that revolutionized the financial industry through its valuation of derivatives, expressed his view in a recent interview with Kyodo News conducted on the eve of the second anniversary of the Sept. 15, 2008 collapse of Lehman Brothers Holdings Inc. (OOTC:LEHMQ)

He said the new regulations fail to address the root cause of the financial crisis -- policies that encouraged people and corporations to take excessive risk -- and that creating new restrictions on investment without touching the core problem will only create additional obstacles for much needed economic recovery.

Acting in the wake of the global financial crisis, U.S. President Barack Obama in July signed into law a bill for financial regulatory reforms that restricts banks' speculative proprietary trading activities and investment in hedge funds.

''But derivatives really didn't cause much of the crisis,'' Scholes said. ''I think that a lot of the difficulties arose because of excess risk-taking of consumers -- the same way as in Japan in 1989 -- too much risk in housing and in real estate.''

Scholes said the financial crisis stemmed from the U.S. housing market and spread around the world, backed by the widespread assumption among individuals as well as within the financial circles that they had ''tamed the risk.''

''When they thought that they have tamed the risk, people took on more debt, people had less operating flexibility, less financing flexibility, so we have consumer loans increased, we have people didn't save for the future, they bought homes based on the idea of just price appreciation of homes.''

He also criticized the U.S. government for encouraging people to buy high-yielding securities through keeping interest rates low and continuing to back subprime lending through government-sponsored mortgage giants Fannie Mae and Freddie Mac.

Scholes said the housing bubbles in the 2000s went unheeded in the United States largely because the government was too focused on keeping inflation in goods and services in check and failed to pay due attention to asset prices.

With a recent series of troubling economic reports -- from the sharp slowdown of the gross domestic product growth rate to tumbling home sales -- talk of a looming double-dip recession is rife, prompting the government to take additional monetary easing and economic stimulus policies.

But Scholes doubted their appropriateness, saying, ''Right now, people realize they took too much risk -- they are trying to get their balance sheets back in shape. The natural tendency for them is to save, not consume. So the policy to encourage consumption is wrong.''

''The policies the government should have undertaken, in my view, are ones that stimulate investment. Take projects that have value to society, encourage investment by the corporate sector, not create so much uncertainty in the economy through new laws.''

Scholes, however, added that he would like to see a change in U.S. bankruptcy law by making dealer-to-dealer transactions exempt from its special protection so that banks involved in a risky derivatives contract would act more responsibly, paying closer attention to the other party's ability to pay.

Scholes was referring to the U.S. bailout of American International Group Inc. in the fall of 2008, when the insurer collapsed under the weight of demands for collateral payment from Goldman Sachs Group Inc. and other trading partners after the mortgage market began to deteriorate in 2007.

Regarding the U.S. dollar's recent drop to a 15-year low against the yen, Scholes said that the yen is the only currency bearing the brunt of other economies' devaluation race to boost exports, with the Chinese yuan still effectively pegged and the euro staying weak.

Under the circumstances, pressure has mounted for Japan's monetary authorities to intervene in the currency market to stem the yen's appreciation.

But Scholes said, ''I don't know it's going to work. It didn't work very well in the past...I worry the most that there will be a trade war, that there will be a currency war with restrictions and tariffs,'' he said.

Scholes said Japan may be turning into a steady deflationary state and that its citizens should try to get the most of the stronger yen.

''We have to allow having ups and downs in the economy, I think that's important. I think Japan is so well-positioned in Asia with the high-tech and with the infrastructure that Japan has,'' he said.

''If you always want a weak yen policy to encourage exports, how much will that cost? Now is the time for the Japanese to buy condos overseas, travel and enjoy life.''



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