Arnold Kling  

Finance is Weird

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The Lorelai Paradox... Quoting Will...

James Kwak of Baseline Scenario wrote,


The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis...

without any fundamental changes, the markets decided that AIG might be at risk, and the fear became self-fulfilling. As with Lehman, the Fed chose not to protect creditors; because the $85 billion loan was senior to existing creditors, senior debt was left trading at a 40% loss...

This decisive change in policy reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. In any case, though, the implications for creditors and bond investors were clear: RUN from all entities that might fail, even if they appear solvent. As in the emerging markets crisis of a decade ago, anyone who needed access to the credit markets to survive might lose access at any time.

The implication is that there is a public policy imperative to stop runs on nonbank institutions that is as strong as the need to stop runs on banks. Is that true?

My Instinct is to say no. In some sense, every firm in the world is a financial intermediary. It has obligations and revenues. How does one draw the line between a firm that is too ___ to fail and one that is not? Is the blank "big" or "interconnected" or "financial" or what?

I think this is one of the biggest questions of the financial crisis.

Here's a silly idea: use macroeconomic theory to answer the question. It's not obvious to me how to do so, but perhaps I'm missing something. But in future lectures in macro, I will attempt to tackle this question. I am reasonably happy about how my lectures on the labor market issues in macro turned out. I am not so confident that the financial market issues will come out as neatly.


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MattYoung writes:

James Kwak is wrong about no fundamental changes. Fundamentally the consumer reached his limit, and the global imbalance started to reconcile.

Why did the consumer reach his limit? Because the consumer has much better information today than he had ten years ago, due to an underlying technology shock.

The technology shock increases the speed and accuracy of inventory information, and the new more accurate accounting begins to show errors in capital accounting. So, consumers move to a new operating point to reconcile capital accounts.

We saw the consumer move by watching the oil prices. For consumers to continue at the old operating point, he would be looking at $150/ barrel. Operating from the new point, the consumer is looking at $60/barrel. That is what happened.

The technology shock is the same one we always have seen for 275 years, namely market and price information between producer and consumer shortens. Each major innovation in price transmission results first) A more accurate measurement of aggregate capital, and Second) A reorganization of labor and consumer.

I can list the major technology shocks; the clipper ship, the railroad, the telegraph, the international telegraph, the radio, the internet, and now, low cost digital.

We have reach the point which the current, up to date position of a useful good can be known to the second in time and to the meter in space; using a few dollars of a low cost digital pager technology.

As consumers, we can collectively log right onto the Chinese factory floor, look at the product being built, talk to inside sales, order a group of items using web software for collective buying, and finally track the objects on their route, in real time, timing my payment to the exact point of arrival of the good.

This capability happened in the last ten years. Prior to that, we have the quantum jump by commercial radio, shortening market information from weeks to hours. Prior to that, the telegraph got us down from months to weeks, and the clipper knocked is down by half. These are quantum jumps when we remember that for 15,000 years, the standard inventory information travel time across the globe was about a year.

Economic theory is having some problem with such a generational quantum changes in price transmission, and no wonder!


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