Arnold Kling  

With All Due Respect, 2

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My views have been influenced by Gary Gorton, well before his latest paper, but I nonetheless disagree with him on important matters.

I view the financial crisis as having four components:

Bad Bets
Excessive leverage
Domino effects
21st-century bank runs

For explanations of those terms, see Not What They Had in Mind.

Gorton's contribution has been to describe the mechanism of 21st-century bank runs and point out how widespread they were. By the same token, he downplays the significance of bad bets and excessive leverage. If he is correct, then Ben Bernanke knows what he is doing. Treating the financial crisis primarily as a liquidity crisis, the central bank is preventing otherwise sound institutions from being driven under by a short-term panic.

I disagree on that. I think that the runs are the last stage in the process. The mechanisms that Gorton describes account for the rapidity of the collapse of financial institutions. However, those institutions were, in my view, unsound, due to bad bets and excessive leverage.

This relates to an age-old and possibly false dichotomy between liquidity crises and solvency crises. The Bernanke-Gorton view is that the financial crisis was a mild solvency problem that, because of panic, became a severe liquidity problem. My view is that there was a genuine solvency problem, due to bad bets and excessive leverage. Freddie, Fannie, and some other large financial institutions deserved to go out of business. Keeping them alive does not end the crisis, but instead stretches it out. By treating the crisis as a liquidity problem we are maintaining a system with too many banks, too much government-provided mortgage lending (the combined FHA-Freddie-Fannie share is 95 percent), and the conversion of the Fed from a central bank to a piggy bank. (James Hamilton's has another new post that raisespiggy bank concerns.)


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COMMENTS (3 to date)
TA writes:

My guesses go as follows:

1) There was a liquidity problem. That's why the Fed lent to broker/dealers, to the commercial paper market, etc. The liquidity problem was resolved in fairly short order. That's why the Fed is no longer lending much to these entities.

2) There was and is a solvency problem. A minor part of it had to do with losses taken on securities by commercial banks but mostly by investment banks -- partly in firesales, as Gorton would say.

3) The major solvency problem is with commercial banks (and with S&Ls and finance companies) and emanates from losses on loans on their books.

I think the shadow bank/repo market phenomenon described by Gorton existed, but his view vastly exaggerates it.


Noah Yetter writes:

The solvency problem is endemic to the system. Under fractional reserve no bank is ever solvent, thus crises are inevitable.

Chris Koresko writes:

Here's my story:

* Way too much investment in real estate, due to a combination of low interest rates and bad government policy. By design, the policy caused a significant fraction of this investment to be financed through borrowing by people who would not repay the loans in the absence of the bubble. The real loss of wealth occurred due to this mal-investment. But the damage to the real economy was masked by inflated housing prices.

* Housing prices finally reached the point of implausibility, at least in some large zoned markets. Buyers lost confidence that prices would go on rising long enough to allow them to cash out at a profit.

* People who had bought real estate expecting to make easy money decided they'd better get out ASAP. Dumping that excess housing on the market precipitated a drop in the price. Some of this was 2nd or 3rd houses bought as investments, but a lot was people who owed more than the new value of their houses and simply walked away from their mortgages rather than realize the loss. That meant the lenders, or more precisely the loan guarantors, took the losses.

* Approximately $1T of this debt was exposed as 'toxic'.

* Never mind credit default swaps, leveraging, and all that. You can't inject $1T of bad debt into the economy and expect nothing bad to happen.

* Some people argue that leveraging amplified the shock. Maybe they're right. But I suspect that a lot of that talk is politically motivated: it tends to transfer blame for the crisis from Washington to Wall Street.

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