Nobel Laureates Predict Credit Crisis to Keep Hurting Growth

By Simon Kennedy

Aug. 21 (Bloomberg) -- Nobel Prize-winning economists Myron Scholes and Daniel McFadden predicted the yearlong credit squeeze will inflict more pain on the world economy and financial markets.

The crisis is ``not over and I'm not exactly sure when it's going to end,'' Scholes said today at a conference in Lindau, Germany, featuring 14 Nobel laureates in economics. McFadden said in an interview ``that as the crisis continues you will see a lot of business failures.''

A year since the U.S. housing slump sparked about $500 billion in credit-market losses for banks globally, the world's largest economies are all stumbling as rising borrowing costs combine with record commodity prices to sap growth. The U.S. is close to a recession and the euro-area and Japan contracted in the second quarter.

Economists at Goldman Sachs Group Inc. today said that countries that account for half of the world economy face recession, while those at JPMorgan Chase & Co. estimate a global expansion of 1 percent this quarter, the weakest in seven years.

Financial institutions still need to cut back lending and strengthen their balance sheets by raising additional capital and selling assets, said Scholes, chairman of Platinum Grove Asset Management LP, a hedge fund based in Rye Brook, New York. That will hurt companies that have borrowed short-term debt to finance long-term activities, said McFadden, a professor at the University of California.

Collapsing Banks

``There is still a tremendous amount of deleveraging still necessary,'' said Scholes, who was a partner in Long-Term Capital Management LP before it collapsed in 1998.

Lone Star Funds, the Dallas-based private equity firm, today agreed to buy IKB Deutsche Industriebank AG after the German bank was felled by the subprime mortgage crisis. Bear Stearns Cos., the fifth-largest U.S. securities firm has already collapsed, while the bonds of regional banks such as National City Corp. and Keycorp are under pressure on expectations of more fallout.

Speaking at the same event, Nobel laureate Joseph Stiglitz of Columbia University blamed U.S. and international regulators such as former Federal Reserve Chairman Alan Greenspan for failing to restrain an explosion in financial innovation and lending that led borrowers to rack up debt they couldn't repay. He criticized guidelines known as Basel II for encouraging too much self-regulation of banks.

'Massive Failure'

``It was a massive failure of the brains of the economy,'' said Stiglitz. ``There was a party going on and the regulator with the same mindset of those in the party didn't want to be a party pooper.''

McFadden suggested a financial equivalent of the U.S. Food and Drug Administration be established to monitor and certify new financial instruments. Scholes warned against a ``rush to regulation,'' arguing ``the cost of regulation may be far greater than its benefits.''

The economists spoke at a meeting of Nobel laureates attended by about 300 young researchers and held every two years. Scholes won the prize in 1997 for his work on derivatives, McFadden won three years later for studying how households make choices and Stiglitz won in 2001 for an analysis of how markets operate with uneven information.

To contact the reporters on this story: Simon Kennedy in Lindau, Germany, at skennedy4@bloomberg.net