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Gary B. Gorton and Andrew Metrick write,


If the growth of shadow banking was facilitated by regulatory changes, then why not just reverse all these changes? Would such reversals bring us back to a safer system dominated by traditional banks? We do not believe that such a radical course is possible even if it were desirable, which it is not in our view. The regulatory changes were, in many cases, an endogenous response to the demand for efficient bankruptcy-free collateral in large financial transactions: if repo had not been granted this status, then the private sector would have tried to create a less efficient substitute.

Tyler Cowen pulls more quotes from the paper. I am not as enthusiastic as Tyler about it, although I recommend it for the institutional color.

Where I differ from Gorton is on a matter of emphasis. I think that most of the growth of shadow banking came about because Wall Street captured Congress and regulators. With Congress, it was a matter of muscle. With the regulators, it was a matter of dazzle. The Wall Street guys seemed so smart, and of course, they made so much money. You just had to believe that they were doing great things for the financial system and for the economy.

The specific policies (see Not What They Had in Mind) that resulted from this capture tilted government support in the mortgage market away from traditional lending and instead toward Freddie, Fannie, and AAA-rated mortgage-backed securities. With a more neutral set of policies, I am not convinced that we would have seen anything like the growth in securitization that in fact took place.

At a deeper level, Gorton is expressing confidence in two sets of experts where I do not share his confidence. One is the financial wizards who built the shadow banking system. In my view, the wizards have not lived up to their billing, nor did the system.

The other set of experts is regulators. Even assuming that Gorton's fixes are sound theoretically, the experts have to implement them properly. Moreover, they have to be able to adapt to further innovation and, if my view is correct, they have to resist further efforts by Wall Street to create a regulatory environment that privatizes profits and socializes risk.

I am not saying that I have easy answers. As you know, my mantra is, "Don't focus on making the financial system hard to break. Focus on making it easy to fix." John Kay has some ideas on that score. I have various ideas as well, particularly reducing the tax advantage for debt relative to equity.


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COMMENTS (3 to date)
mick writes:

The debt was rated AAA because even the people at the top of the financial world believed the noble mythology that the "full faith and credit of the United States" behind Fannie Mae and Freddie Mac had divine veracity. The problem with such noble mythology is that when the ball drops Reality does whatever it pleases, regardless of expectations.

Reality dictates that the government can only pay back debts with taxation or money creation. Both of them have limited, very non-biblical properties. Taxation lowers growth and is reduced during recessions. Creating money generates inflation that ultimately defeats the ability of the government to tender currency value for debt.

Reality dictates that the United States is insolvent. Inflation is already rampant from money creation. Mainstream economists, of course, deny this by pointing to the CPI. They do not mention or do not comprehend that the purpose of the CPI is to deliberately understate inflation so that Reality will be fooled. Reality is not amused by the CPI and this is why the prices for goods and services has been rising about 10% a year.

Ultimately the United States must adopt a reality based debt policy. This can happen the easy way or the hard way. The easy way is to issue debt in accordance with real taxation potential and most importantly, real inflation data. The hard way is hyperinflation so savage that even the CPI won't be able to hide it.

The hard way is what is happening now. Mainstream economists face a very important choice. They can either continue to support the Noble Lie that leads to ruin or man up to the Truth that leads to real prosperity.

Tom Grey writes:

I believe that there was "AAA - inflation", too much AAA rated debt.
It was a limited form of money, but because it fed into the banking system via Tier 1 capital, it fueled the housing boom and over-investment / malinvestment.

There should be limits on the amount of debt rated AAA, and for each other investment grade, with the limits rising only with the size of the national economy.
Unfortunately, even if this is true, neither I nor anybody else knows what good limits are. I'd guess the prior year's total GDP.

Chris Koresko writes:

A couple of non-expert narratives, written mostly in the hope of provoking an educational response:

The fundamental problem is that by trying to reduce the intrinsic instability that would be present in a more-or-less free banking system, the Federal government set policies that created opportunities to make money by getting the government to subsidize risk, in effect breaking down the discipline of the market. The government tried to fix that through regulation, but the regulators weren't effective, and the result was disaster.

The bond ratings were inflated because the people doing the rating assumed that they were combining assets whose failures would be independent, so that the risk to the combined assets could be predicted using Gaussian statistics. They failed to account for the existence of a single-point failure mechanism, namely bad regulatory policy.

Anyone?

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