their major asset -- would certainly have sharply reduced consumption anyway, due to the negative wealth effects. Indeed, based on earlier estimates of wealth effects, Baker (2006) predicted that consumption would fall by 2 percent of GDP as the housing bubble deflated. But the unexpected disruption that the home-price collapse caused in the financial sector greatly compounded the damage. Mortgage-backed securities in the portfolios of banks and other financial institutions turned out to be worth far less than their assumed value, dragging down the asset side of the ledger and threatening the solvency of many institutions. Uncertainty and asymmetric information regarding the actual value of mortgage backed securities (MBSs) exacerbated the problem. The market for securities became subject to the “lemons” problem of asymmetric information in which potential buyers, unable to discern which securities were affected by default risk, and obliged to rely on expectations, bias the valuation downwards – since any given price will be more attractive to sellers of risky assets (as in Akerlof 1970). As buyers offer a lower price, sellers are willing only to part with their riskier assets and buyers lower their valuation still further – since it is now the expectation formed on the basis of a riskier pool. This process is iterated until the market collapses. In this case, liquidity dried up and little or no trading of the MBSs could take place. (For a theoretical model that develops this idea in connection with the crisis, see Chari, Shourideh, and Zetlin-Jones (2009).) Like the housing bubble itself, the extent of the damage to the financial sector was inconsistent with at least a naive version of neoclassical theory. Fundamentally, this stage of the crisis stemmed from financial actors’ systematic misperception of the risk in the mortgage-backed securities that they held. The economics of information – the branch of economics that emphasizes the importance of information asymmetries – had long shown that with imperfect or incomplete information, there should be no presumption that market equilibria are optimal from a social standpoint (Akerlof 1970; Spence 1973; Stiglitz 1979). Of course, participants in financial markets had a strong incentive to gather information about the quality of investments, and the market had devised a solution to the problem of gathering information about risks: the bond rating agencies. But Moody’s, S&P, and Fitches had consistently given strong investment-grade ratings to the MBSs, paving the way for financial institutions to load up on those investments.<sup>2</sup> As the _Economist_ magazine has wryly noted, “[i]f the past decade’s financial overengineering was a crime, rating agencies were the getaway driver” (The Economist 2009a). Their failure – and that of the many financial analysts who were supposed to spot problems – means that information problems may deal a more severe blow to the standard model than previously thought.<sup>3</sup>

> 2  In the case of S&P, this is somewhat ironic, given that since early 2006 the firm has published the Case-Shiller housing price series that provided the most graphic evidence in favor of the “bubble” view.

> 3 A quote from Nobel prize winner Robert Lucas indicates the information problem extended well beyond the rating agencies:  while defending the overall Chicago approach, he notes that “You had a bunch of guys who thought they knew a lot.  It turned out we didn’t know a damn thing about the stability of the banking system, so it’s back to the drawing board and we’ll see what comes out of it” (Islam 2009).

5