Stochastic Optimal Control and the U.S. Financial Debt Crisis.

• Author: Clark, Peter
• Position: Book review

Stochastic Optimal Control and the U.S. Financial Debt Crisis

Jerome L. Stein

New York: Springer-Verlag, 2012, 180 pp.

At one point during the recent financial crisis the queen of England reportedly asked economists at the London School of Economies a seemingly straightforward question: "Why did academic economists fail to foresee the crisis?" This question earl be broadened to include central banks, the International Monetary Fund, and technical specialists on Wall Street ("quants"). Jerome L. Stein, professor of economies (emeritus) and research professor in the Department of Applied Mathematics at Brown University, has written a timely book that provides a cogent and convincing answer to this question.

He devotes one chapter to why the Federal Reserve and the Fund failed to anticipate the crisis, and another chapter to the failure of the quants and their mathematical models to properly measure the risks associated with the new financial instruments that they had invented. Unlike the burgeoning literature on the debt crisis, this book develops a theoretically well-based measure of optimal debt that provides a yardstick against which to compare the actual debt level. As the latter rises significantly above the benchmark, there is a growing risk that the debt has become unsustainable--a financial bubble has been generated that is increasingly likely to collapse. Stein applies this approach to show that asset values became vastly out of line with the fundamentals of the U.S housing market and with the balance sheet of the American International Group (AIG), the insurance and financial firm. Stein's approach generates an early warning signal of impending financial collapse that he also applies to the bubble in agricultural land prices in the 1980s. In addition, he provides a timely analysis of the financial crisis in Europe and makes a strong case that it reflects just as much excessive private debt as an overindebted government sector.

In chapter 2, Stein discusses why the Fed and the Fund were oblivious to the signs of an emerging bubble in the U.S. housing market and the risk this posed to the wider financial system. One reason for this failure was the lack of adequate economic models, but he does not describe the models then in use or explain their failure. The core of Stein's argument is that file Fed was not predisposed to attempt to identify financial bubbles because it believed there was no reliable way to do so; pricking such a bubble prematurely could involve unnecessary costs, and the preferred strategy was to use monetary policy to "mop up" after a bubble had burst of its own accord to deal with any adverse macroeconomic fallout. This hands-off approach for dealing with financial bubbles became known as the "Jackson Hole Consensus," named after Jackson Hole, Wyoming, where this view was first enunciated at one of the annual summer conferences on monetary economics and policy sponsored by the Federal Reserve Bank of Kansas City. Stein notes that the Fed was lulled into a false sense of security because this strategy was viewed as successful in dealing with previous bubbles; the macroeconomic situation at the time of low inflation and sustained growth--dubbed "the Great Moderation"--was quite benign; and because it was felt that a...