Vernon L. Smith (Wichita, KS – 1927)

Vernon L. Smith, Ph.D. was awarded the Nobel Prize in Economics in 2002 for his groundbreaking work in experimental economics. He is a professor in Chapman University’s Argyros School of Business and Economics and School of Law and is a member of the Economic Science Institute at Chapman. Dr. Smith is a Senior Fellow at the Cato Institute and a Fellow of the Mercatus Center. He is the president of the International Foundation for Research in Experimental Economics, which he founded in 1997.

Born in Kansas in 1927, Dr. Smith completed his undergraduate degree in electrical engineering at the California Institute of Technology, his master’s degree in economics at the University of Kansas, and his Ph.D. in economics at Harvard University.

The euro is facing some critical challenges these days.

I was asked in Prague two years ago what was the outlook for the dollar, and I said that we [the United States] would certainly not manage it well, but that the Europeans would do even worse, and so the dollar would fare pretty well as a world currency. All the problems then have now come to a head.

Some euro zone members are on verge of default and Germany opposes any bold move towards dispensing more cash unless further fiscal integration is embraced and stern austerity measures are adopted. How do we move forward?

The strong countries of Europe are being asked to foot the bill for the profligate countries and that is not a sustainable policy. The weak countries are de facto bankrupt, should face that fact, and default, if necessary, on their debt. This will force them into balancing their budgets, becoming more disciplined, and to live within their means. Investors will return if these actions are credible, as investors are remarkably forgiving, buoyed by hope that stability and growth will return. Default is not the end of the world but a means to restore government balance sheets that are in effective negative equity. And the US is by no means immune to the consequences of having engaged in unsustainable excesses both public and private.

Spain’s incoming government has said that it will seek a balanced budget through austerity and engage structural reforms (mainly in the labor and financial sectors). With unemployment at 22.6% and debt costs soaring, couldn’t these policies lead to further economic contraction?

You are already in a growth recession, and soaring debt cost means that you have exhausted your capacity to borrow. Spain has borrowed more from its future growth prospects than it can now deliver. As in all these situations there are no good options left; my view is that if Spain is bailed out that policy runs the risk that it will just kick the can down the road, and could easily end up making it far worse for you than if you bite the bullet now. The lasting lesson for the future is for Spain not to paint itself into this corner in the first place. The open question is whether the Spanish political process can credibly put its house in order if they are being protected from default. That is an umbrella fraught with incentive leaks and hence may not even be in Spain’s interest. I see no way to avoid facing the necessity of the structural reforms you mention. The question is how best to further that process.

What do you make of last week’s central banks’ interventions to save the day?

These policies simply confirm the central banks’ utter desperation; the policies temporarily stretch out and delay the problems of economies that are in severe disequilibrium; that is, they have opted for an attempt at slow deleveraging. Liquidity enhancement is being used to delay the consequences of a household/bank insolvency problem in the hope that things will turn around. But we have precious little experience with these severe disequilibria and no one can be assured that if you maintain episodes of temporary liquidity long enough that it will allow insolvency in private and public balance sheets to disappear. Even if it works, how much will it cost in terms of low protracted growth? No one knows; those who profess otherwise are flying blind.

How did the disequilibrium come about?

The disequilibrium arose because the prices of homes escalated beyond reasonable expectations of income growth and were financed by mortgage credit growth. The demand for homes soared relative to income growth, and their prices grew unsustainably faster than the prices of all other goods. The inevitable collapse of home prices created negative mortgage equity in many households and many more are on the edge; this means that their banks also have negative equity problems. Until that equilibrium is restored to normal levels households will be reluctant to spend and their banks reluctant to lend. The combination of lower home prices and modest inflation in other prices is working in the right direction, but it is a painful and protracted process.

And nobody saw it coming?

There is more than enough blame to go around, including my own economics profession: the experts and policy makers were almost all blind sighted; those that feared the worst and said something were ignored. During prosperity no one wants to hear that everyone is borrowing from their own future and need to correct their ways.

What is the lesson to be learned?

I was born in 1927, so I have seen two of these calamities in 85 years. The long term lesson seems to be that the old fashioned virtues of working, saving and living within your means are precious beyond gold and diamonds, and worthy of honoring because they were born out of human experience.

The ‘new finance’ has done nothing to repeal those enduring hard-won principles of human conduct.

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