Arnold Kling  

The Financial Invasion Continues

A Deleted Scene from MRV Two Aphorisms...

The next redoubt to fall is Lehman. Steven Pearlstein writes,

the government now finds itself hip-deep in the direct management of the financial system, rescuing four of the country's biggest financial institutions -- Bear Stearns, Fannie Mae, Freddie Mac and now Lehman Brothers -- from the harsh discipline of markets and the consequences of their own misjudgments.

Let's step back a bit and think about what has been going on.

1. We had a liquidity bubble or a credit-spread bubble. By that, I mean that some financial institutions--hedge funds, investment banks, Fannie and Freddie--were able to pay a very low risk premium to investors. This meant that they could earn a profitable spread on risky investments.

2. However, credits spreads can move in two directions. When investors change their minds about the riskiness of, say, Fannie Mae, the cost of funds to Fannie goes up and the business becomes unprofitable all of a sudden. See my earlier illustration.

3. When one firm goes down, it threatens to take down other firms, because the financial sector is highly inter-connected.

4. When a really big firm gets in trouble, its sheer size makes it awkward to merge with other firms. In the case of Freddie and Fannie, change "awkward" to "impossible."

5. Government officials try bailouts for two defensible reasons. First, they believe that the firms' assets are more valuable than they will appear to be if they have to be sold quickly. Thus, the government may lose little or nothing if it arranges to hold those assets for a while. Second, the officials are hoping to avoid a domino effect in which the failure of shaky firms causes good firms to fall also.

6. However, government officials also have a "not on my watch" attitude. That means, it always makes sense to engage in short run behavior that props up the system, even if in the long run it makes the system more fragile. In the long run, it might be better to have Bryan as Treasury Secretary. In the short run, it is unthinkable.

7. The bailouts serve to demonstrate that there is a sort of de facto insurance for large financial firms that is analogous to the deposit insurance for banks. However, this insurance is ad hoc and unmanaged. With deposit insurance, there is an insurance fund, there are capital regulations, there is risk-based pricing, and there are routine procedures for monitoring and closing troubled banks. None of this is in place for the rest of the financial sector.

8. Above all, in the banking sector, you don't have any one institution that is too large to merge. The Freddie-Fannie duopoly is an entirely artificial creation, as I argued in my exit strategy paper for Cato. The reasons for the consolidation of investment banking are less clear. But if I were designing an insurance and regulatory structure for investment banking, one of the things I would want to encourage is a decrease in industry concentration.

9. Even with a less consolidated industry, there is still systemic risk. Remember the S&L's.

10. I don't see partisan politics coming up with a good solution. My guess is that financial reform has to start with a non-partisan commission of some sort.

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COMMENTS (3 to date)
E. Barandiaran writes:

Arnold, there is one point missing from excelent summary. It is in a post by Donald Luskin:

Friday, September 12, 2008

THE SECRET PLAN My DC-insider friend "Mick Danger" imagines four Democratic senators huddled in a smoky room somewhere having a conversation something like this...
Dem One: "The contagion isn't strong enough. It's all playing out too slowly. You call this a credit crunch? It's been over a year and we've only brought down a few Wall Street firms and..."
Dem Two: "Fannie and Freddie."

Dem Three: "Yeah, and what do we get from that? Some say the markets will recover and Fan and Fred can't give us political money anymore."

Dem Four: "Wait, guys, we can use Fannie and Freddie to our advantage on a far bigger scale, now that the Feds control 'em. You guys are thinking too small. We have to do this carefully, so no one can see our secret plan. The next step..."

And the next step links to this

Carter writes:

Dr. Kling,

I was wondering if you could elaborate on point #6:

"6. However, government officials also have a "not on my watch" attitude. That means, it always makes sense to engage in short run behavior that props up the system, even if in the long run it makes the system more fragile. In the long run, it might be better to have Bryan as Treasury Secretary. In the short run, it is unthinkable."

I hope I am correct in assuming that Bryan is a proponent of the no-bailout option.

If, in the long run, it would be better to have Bryan as the Treasury Secretary, it is because of the sum effects of his short term decisions. It seems to me to be logically inconsistent to state that the short-term effects of his actions would be, "unthinkable." If the short-term effects of the no-bailout option are always worse, but the long-run effects better, shouldn't we choose the no-bailout option anyhow despite the short-term pain?

I will anticipate one possible response to this: in some cases, the short-term risks are so great that the no-bailout solution would cause a worse long-term outcome. Therefore it must be decided on a case-by case basis whether or not to intervene.

However in order for this to be true, we must assume that the government will make the correct decision regarding when and when not to intervene. Given your assertion that politicians usually act with a "not on my watch" attitude (not to mention Bryan's MRV hypothesis), this seems like a poor assumption to make. Shouldn't we then support a strategy of always taking the no-bailout option and let the market sort it out?



Arnold Kling writes:

That is a good question. I am working on a longer article on the topic. The short answer is to look at what has worked and failed in the past. A total hands-off approach has failed, because financial markets are inherently unstable. Government backing without risk-based pricing and capital has failed, because of moral hazard. It seems as though a combination of government backing, with an independent regulator setting capital requirements and insurance-fund prices based on risk works best.

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