Arnold Kling  

Let 'em Fail

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Peter Wallison writes,

it is my view that only the failure of a large commercial bank can create a systemic breakdown, and that nonbank financial firms--even large ones--are no more likely than GM to have this effect. For that reason, I would not designate any nonbank financial institution (other than a commercial bank) as systemically important, nor recommend safety and soundness supervision of any financial institutions other than those where market discipline has been impaired because they are backed by the government, explicitly or implicitly.

...As support for its proposal, the administration cites the "disorderly" bailout of AIG and the market's panicked reaction to the failure of Lehman Brothers. On examination, these examples turn out to be misplaced. Academic studies after both events show that the market's reaction to both was far more muted than the administration suggests. Moreover, the absence of any recognizable systemic fallout from the Lehman bankruptcy--with the exception of a single money market mutual fund, no other firm has reported or shown any serious adverse effects--provides strong evidence that in normal market conditions the reaction to Lehman's failure would not have been any different from the reaction to the failure of any large company. These facts do not support the notion that a special resolution mechanism is necessary for any financial institutions other than banks.

Read the whole thing. I would like to believe that Wallison is right (and I have no evidence that he is wrong). If he is right, then we can implement at least part of what I advocated yesterday, when I said that under my preferred regime, "As long as you're not a bank, you are free to fail any way you like."

Those who disagree with Wallison and me need to spell out their arguments.

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COMMENTS (15 to date)
JP writes:

Richard Posner's argument, which he presented in his book and revisited last night on his blog at the Atlantic, is essentially that GM and Chrysler needed to be kept alive for a few months because, given their size and high visibility, their failure in December would have been a debilitating (further) shock to consumer confidence -- leading to more cash hoarding, more price declines, & deflationary spiral. Now that the worst appears to be over, Judge Posner seems to be of the view that GM and Chrysler can be allowed to fail.

Methinks writes:

These facts do not support the notion that a special resolution mechanism is necessary for any financial institutions other than banks.

Well, who cares about that? Events provide an opportunity to fan the flames of fear and give government reason to expand its power. That's far more important to politicians than some puny and politically useless reality. Never let a good crisis go to waste - real or imagined.

Amiet writes:

Hm. I think he might be underestimating the significance of business financing at institutions other than commercial banks. It may be true that large non-commercial banks/pseudobanks are less systemically important than we think, but that's a much more complicated question than the paragraph Mr. Wallison devotes to it.

...Maybe we should try letting a big one collapse, just to see what happens. Lehman Brothers was set against such a background of turmoil it's hardly a data point at all.

cputter writes:

I'd like to read a convincing argument for not letting banks fail. Most arguments I've seen are based mostly on politics (surprise...)

What is the case for showing that the costs of a bailout (increased risk taking and moral hazards throughout the banking system) don't out way the benefits (can't think of any right now)?


Niccolo writes:

I'm still not exactly sure why ANY financial institution, bank or otherwise, should be saved.

But minus that portion, you're both correct.

JP writes:

What is the case for showing that the costs of a bailout (increased risk taking and moral hazards throughout the banking system) don't out way the benefits (can't think of any right now)?

It depends on how concerned (or not) you are about deflation. Some people (e.g., Bernanke and Posner) were extremely worried that bank failures would initiate a deflationary spiral. Others did not think deflation was so likely or would be so bad if it did happen.

Bill Woolsey writes:


Why not offset the consquences of "cash" hoarding by expanding the quantity of cash enough to meet the demand?


One theory is that firms with strong prospects of sales were unable to obtain credit necessary to finance production or trade. A firm needs money now to purchase inventory or buy resources, and so cannot produce or bring goods to market. This results in _shortages_ of goods and services. Is there any evidence that this is what really happened? There are customers beating down my doors, but I just can't them the product unless I get some financing.

While there were theories that fear resulted in trade credit drying up, when I asked firms about their situation, they said that suppliers with poor sales were willing to provide more trade credit. Yes, take the stuff and pay for it when you can. There was not "sorry, but we can't provide you with the products unless you pay cash because we don't trust you, or, we need the cash because we have to pay our bills because our suppliers no longer trust us." It is possible, but where is the evidence?

But there was some, "our customers quit paying their bills and so we had to quit providing them specific customers with new trade credit. We can only resume lending to them after they pay their existing balances." How does that work? They can't sell what they already have. Sales drop and then credit dries up.

No, it looks like the problem was quite normal. The shadow banking system focused on securtization, which focused on consumer lending. When securitization broke down, poor credit risks couldn't get loans for conumption purposes (And, especially, for new home purchases,) and there was a reduction in demand. Sales fell, production fell, etc.

However, for every borrower is a lender. What were the people who would have purchased the asset backed securities doing with their money?

It gets back to the cash hoarding.

A break down in credit could reduce "supply" resulting in shortages, reduced production, and higher prices. Stagflation. But that isn't what happened.

A break down in credit could involve a shift in the pattern of demand between high risk and low risk projects or between consumption and investment generally. Because it is difficult to shift resources, there could be structural unemployment and reduced production for a time. This also involves shortages and inflation--at least in the markets into which the demand has shifted. Prices fall less and production falls more in the markets with less demand, while prices rise more and production rises less in the markets with added demand--at least for a time. And so, the aggregate result in stagflation.

But, as should be expected, a break down in credit markets can result in cash hoarding. The market process that corrects that is a general deflation of prices. The market signal for that is reduced sales across markets. The usual mistaken response is reduced production across the board. The solution is for the central bank to supply the "cash" that is being hoarded.

Central banks have failed to do what they needed to do. I think it is because they were too focused on trying to save securitization--to return the patterns of credit to where it was before the crisis. Let's figure out some way to get people to buy securities based upon loan pools.

By the way, the 10 or so largest money center financial institutions, all of which were involved in securitization, had to pay much higher interest rates than U.S. government. The U.S. government had to pay much less, and they had to pay somewhat more. And that LIBOR "spread" was taken to mean that credit had frozen.

If you assume that the large money center banks are, of course, the best credit risks in the private sector and that they are, of course, entitled to borrow at pretty much the same rate as the U.S. Treasury, then the TED spread showed crisis. Of course, everyone else must be paying even more that the 10 largest money center banks, right? In reality, those firms, because they owned lots of securitied loans, became exceptionally bad credit risks on the market. LIBOR was higher than the Federal Funds effective rate. AAA commerical paper rates were much lower than what Citibank was paying.

There was a flight to safety, to government bonds. The spread expanded. Market clearing would presumably require that other, less bad credit risk have lower interest rates. Evenutally that happened.

Focusing on TED _was_ a focus on the situation of a handful of political powerful financial institutions, that were very large compared to the market as a whole. However, saving them was also about returning credit to its previous paths--"jumpstarting" securitization.

Of course, there was another problem. The Fed had developed a tradition of targeting an overnight lending rate by trading government bonds. When the interest rate they targetting approached zero, they had to start using a new approach. They were unable to smoothly switch to making sure that there is as much "cash" as people want to hoard at an unchanged level of nominal income. In their efforts to restart the securitization markets, they went so far as to pay banks to hard cash.

JP writes:

Why not offset the consquences of "cash" hoarding by expanding the quantity of cash enough to meet the demand?

I'm not an economist, but Posner's response to that option is that the quantity of cash would have to be expanded so much that the risk of inflation, or of a second serious recession when the quantity is reduced in order to mitigate inflation, would be too great.

(Of course, this raises questions like How much is "too great"? How can we balance the risk of permanent government growth against the risk of inflation? Etc. Posner acknowledges that these questions are under-studied. That leads into one of his main contentions, that economists have tended to fall back on what he calls "preconceptions" to organize their thinking about the recession.)

Floccina writes:

1. Are we talking about a trade off of a deeper but shorter depression if we just let these financial institution fail or a longer but less bad depression if we bail them out? The politics could be frightening if unemployment gets over 15% but it looks to me that there might be great long term gains if the investment banks mostly failed. Their absence might allow much better systems to take that space.

2. Are there not methods to pump money into the system to replace the money created by the investment banks, E.g. the federal reserve buying up all the corporate bonds that it can get its hands on?

JP writes:

Floccina -- At the risk of turning this into the Posner thread ... Posner sees the trade off as one between a shorter & shallower depression and a deeper & longer one. Deeper & longer because a deflationary spiral would ultimately bottom out at a much lower level of aggregate economic activity, requiring a correspondingly longer period for us to return to pre-depression levels.

Regarding your second question, Posner points out that the purchase of corporate debt could have a more socialistic result than Keynesian stimulus spending, because such debt purchases would involve the government in "running" private non-bank enterprises. (I put "running" in quotes because debt holders aren't owners per se but, if they own enough debt, can have a significant influence on how the borrower-business is run.)

Mike Rulle writes:

I agree and disagree. I believe the Lehman and AIG situations were poorly handled. Lehman should have been permitted to fail, but the Government had been signaling the opposite. AIG should have also been put in bankruptcy---but the Government was bailing out other Investment Banks by bailing out AIG. So a correct perception of chaos and confusion prevailed. Treasury/Fed tried to justify the AIG action by somehow making AIG appear as if were some lynchpin to the global insurance industry--when of course the CDS was walled off from insurance.

What we do know, is as soon as this happened, it was followed up by the absurd TARP proposal. Money Market and TED spreads spiked 300 plus bps or so, CDS spreads spiked, and the equity markets crashed. I am not sure what study the authors could have been talking about. I think the mishandling of Leh and AIG contributed to the crisis---but what "muted reactions" are the authors referring to?

cputter writes:

@JP: Thanks for the clarification.

What's wrong with moderate deflation? Don't the laws of supply and demand do a much better job at setting prices than central planners? Don't we want prices in sectors with over supply (I'm thinking housing and related industries) to fall so that the market can clear as fast as possible? I remember reading that there's more than a years worth (+- 18 months) of surplus housing at current buying rates. Is it stupid to think that allowing the market to clear would be good for the construction industry?

Though I think the best argument for deflation is that it's controlled by market processes, not the ham fisted policies of the Fed (both the bank and the guys in DC). They can't possibly target only specific sectors and end up 'stimulating' arbitrary sectors (think 20 passenger per day airports named after certain congressman). Whereas price deflation through the market is specific to the supply and demand of individual goods and services.

Besides, what do mainstream economists have against poor people? Aren't they the ones hurt the most by preventing deflation (or more likely after doubling the money supply, massive inflation)?


JP writes:

cputter -- You're right that we do want prices for some things to come down. What's worrisome (according to Posner) is deflation strictly defined, i.e., a sustained decrease in the general price level. This worries (some? most?) economists because when people see that prices overall are dropping and will continue to do so, their incentive is not to spend or invest (the opposite of what we want people to do in a recession). Even if they just stuff their money in a mattress, its purchasing power will grow as time passes. This leads to the dreaded "deflationary spiral," where people spend less, prices drop, people spend even less, prices drop even more, and so on. That supposedly happened in the Great Depression and in Japan in the 1990s. That fear is underlying Posner's arguments.

cputter writes:


Is the "deflationary spiral" argument specific to certain industries? Technology becomes cheaper every few months yet people keep on buying computers and gadgets. If you wait just 3 months before buying a pc you could probably buy it for 2/3 the price.

People aren't going to Starbucks any more because they think the Moccachinos there will be cheaper in a month. They stop going because they're broke and McDonalds makes a rather ok coffee too.

Sure, now that the credit bubble has burst, people are scaling down on their spending. It's absurd for Posner or Bernanke to think that price levels attained during the boom need to be re-inflated again, or that the spending that was taking place was sustainable.

If prices are allowed to fall to levels where people can afford to buy things without taking out a loan or mortgaging their house they'll start spending again. People still have the same wants they had before the bust and will satisfy those wants if they can afford it. Preventing price deflation will only delay that from happening. I don't see how government projects help satisfy individuals' wants in any case.

Japan's government had 8 'stimulus' packages since 1990 totalling more then 6 trillion dollars, bailouts all round and massive government works projects. That clearly didn't work for them (ditto for the New Deal), yet Bush/Obama are going down the exact same path. Why would they think the result will be any different this time round?

Besides, the money people save becomes available to investors, unless they really stick it in their mattresses (which I wouldn't blame them for at these ridiculously low interest rates). The only 'paradox' of thrift is that people still listen to Keynesians when they repeat it.

The way I see it is that all the mistakes were made during the past 7 years, right now the market is trying to correct that. Unless Posner or Bernanke have time machines the actual mistakes can't be fixed. Everything they attempt now is just prolonging the required correction. Which is simply a reallocation of resources and restructuring of capital now that we've realised the previous capital structure was unsustainable.

Until we can think of something better the free market is the most efficient (and least painful) way to do that.

ps. I thought deflation / inflation was a decrease / increase in the supply of money. Which tends to influence prices at some point.

Phokat writes:

You wrote
"Those who disagree with Wallison and me need to spell out their arguments."

This was already done two moths ago by the FT:

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