Blame the current economic crisis on too much debt taken on with too little research.

Nobel Prize winning economist Myron Scholes lectured at the University of Western Ontario’s Faculty of Law on March 19, packing the faculty’s largest classroom to overflowing with students, professors and businesspersons curious to know what the Professor (Emeritus) of Finance from Stanford University had to say about today’s financial doldrums.

Scholes, who won the Nobel Prize in 1997 for work on the Black-Scholes Options Pricing Theory, was speaking as part of the Torys LLP Business and Law Pre-Eminent Scholars Series.

When financing operations, business organizations can choose between raising equity by selling shares, or taking on debt. Often they prefer debt financing because interest on debt is tax deductible.

Leading up to the crisis, financial institutions leveraged debt heavily, which means the outcomes, whether positive or negative, would be magnified.

One of the main problems with the current debt market, Scholes suggested, is the debt rating system. Under the current regime, debt that is considered high quality is low risk for investors. By comparison, debt that is rated lower is considered more risky — and with that weighting comes a greater promised rate of return.

Scholes offered several criticisms of the rating system.

First, he suggested that rating agencies use too little data in making their assumptions. The agencies used data from only the last few years and assumed – incorrectly, as it turned out – that housing prices wouldn’t fall. Had agencies used older data, they would have seen different long-term trends.

Secondly, rating agencies assumed that any losses on housing prices would occur idiosyncratically. In other words, their models did not have a built-in contagion or domino effect.

Thirdly, the current rating system suffers from a “cheapest to deliver” problem. Scholes compared the problem to buying wheat. If wheat vendors are only allowed to put up to X amount of sawdust in their wheat, then those vendors will put exactly X amount of sawdust in their wheat. Likewise, when rating agencies specify precisely what criteria will achieve a high rating of, say, AAA, then companies will do just enough to pass that test and no more. Indeed, they will keep pushing the envelope to get away with doing less.

In the future, Scholes said our economies will need a design with more flexibility. Flexibility refers to the ability to protect oneself with financial reserves.

During prosperous times, keeping reserves, such as money in the bank, instead of investing is seen as costly. However, a policy based on the preservation of some flexibility will signal to people that having options is a part of life. By example, carrying an umbrella when it does not rain is burdensome; not carrying an umbrella when it starts to rain is more burdensome. As people become afraid, they build up excess amounts of reserves and money stops flowing through the economy.

Ultimately, Scholes argued that the cost of being reactive is gigantic. Financial and political leaders should think about developing proactive solutions that build flexibility into our economy.

The Torys LLP Business and Law Pre-Eminent Scholars series is one of Western Law’s most popular courses. Each month one of the world’s top legal and business scholars presents a paper in his or her area of expertise to Western law students.

Cross-posted from the Financial Post Executive Blog and the UWO Law site.