Mechanism Design and Financial Panics

Jeffrey Lacker, president of the Richmond Fed, uses mechanism design theory to analyze and explain the recent financial panic. This is from the WSJ Economics blog:

Nobel Theory Offers Insights Into Turmoil, Fed’s Lacker Says: Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said mechanism design theory, which won its architects a Nobel prize today, offers insight into what happened in financial markets this summer.

Mechanism design theory, basically, is about the use of incentives and rules to create efficient methods for allocating resources, essentially setting rules for markets or alternatives to markets. “It takes very seriously the informational constraints that people operate under,” Mr. Lacker said... It “looks for the optimal allocation without taking a stand on what institutions exist or arise… Often markets can achieve an optimal allocation, but sometimes government intervention is required, and sometimes institutional arrangements like financial intermediaries or clearing houses are capable of achieving good allocations.”

Mr. Lacker says mechanism design theory suggests “it’s not clear that liquidity was an important constraint” in causing the recent turmoil in financial markets. Rather, it suggests that the problem was more a shortage of information, a conclusion he deemed “consistent with the lack of use we’ve seen in the discount window,” ... “I supported the discount rate reduction and I think it was the right thing to do,” he said. However, “if liquidity was the problem we would have seen more use of the discount window… It just didn’t turn out to be crucial.”

“If liquidity wasn’t the problem, I think it makes sense in that situation to keep interest rate policy focused on growth and inflation rather than the functioning of the financial market per se,” said Mr. Lacker, discussing the Fed’s decision to wait until September to cut interest rates. The Federal Open Market Committee “waited until more information was available about the implications for growth and inflation.”

“I want to make sure people understand how deep and important this field is,” Mr. Lacker concluded. “...It’s the only coherent approach to figuring out what the economic role of banks or other financial intermediaries is.”...

[For more from the WSJ Economics Blog on financial panics, see Bernanke’s Insight on Why Crashes Happen in October by Phil Izzo.]