Arnold Kling  

Re-Leveraging, Not De-Leveraging

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Tracy Alloway writes,


The turmoil of 2008 shunted some investors from ABS into safer sovereign debt, it's true. But you also had a plethora of incoming bank regulation to purposefully herd investors towards holding more government bonds, plus a glut of central bank liquidity facilities accepting government IOUs as collateral. Where ABS dissipated, sovereign debt stood in to fill the gap. And more.

You should go to the post and read the graph. Pointer from Tyler Cowen.

The nonfinancial sector wants to issue risky long-term liabilities and to hold safe short-term assets. The financial sector accommodates this by doing the opposite. But sometimes the financial sector gets too big. The financial crisis was a signal that the financial sector needed to shrink.

It didn't. Have a nice weekend.


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Dale writes:

I am having trouble understanding what you are saying here given the context that I assume you are coming from (a PSST construction). I am quite certain it doesn't mesh with what Cowen is saying though.

Cowen seems to be saying that there is now a large amount of "safe" assets. And that since there are a large amount of "Safe" assets and since they tend to be sovereign debt, a sovereign debt crisis would be terrible.

But this seems to be a fairly standard Keynesian/New-Keynesian construction. There is excess demand for safe assets implying excess supply for in the rest of the economy. If there were a sovereign debt crisis, the movement of sovereign debt from the "safe asset" category to the "unsafe asset" category would cause an even larger excess of demand for safe assets and an even large excess in supply for the rest of the economy(though we might expect the opposite of the standard falling interest rate expectations since instead of having an excess of demand for the interest rates we are looking at we have an excess of supply)

This also mesh's with the data we have. Interest rates and inflation are both very low.

But you seem to be saying that this indicates that we have an imbalance in the sectors of the economy and that the financial sector is too big, causing other sectors of course to be too small.

Lets examine that in a little bit more detail. If we had the size of the financial sector before the drop from full employment then we expect demand and supply to be in equality. Then the crisis hits and the financial sector which is supposed to shrink, does not. Do we have an excess supply or excess demand for these products?

If we assume that it was demand rather than supply that changed then if we have an excess supply then we expect prices will be too high and falling. And if we have an excess demand we expect prices will be too low and rising. Or, excess supply implies rising interest rates and excess demand implies falling interest rates.

Let us assume that we have excess supply for a second. This implies excess demand in the rest of the economy. Excess demand in the rest of the economy implies rising prices and rising employment in those sectors.

In short, your PSST should predict rising interest rates(in the financial sector) and rising prices. At the very least we can see that prices are not rising, which either means we have excess demand in some other area that entirely offsets the excess supply that we see in the financial sector or your story is wrong.

Lets say that we have excess demand in some other area? What is the one area we see rising prices? A: Govt securities.

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I actually think we can reconcile these stories for a second, and i think we do have excess supply in the financial sector.

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Let us say that before the crisis we are in general equilibrium and then suddenly the debt issued by the financial sector is no longer considered "safe". We would then have an excess supply in the financial sector, but it was because they were no longer supplying safe assets.

This is how we can reconcile what we consider a normal flight to safety with a failing financial sector that should shrink.

The problem for PSST is that this implies there is excess demand for safe securities because there was a flight to safety and that there was a reduction in supply of safe securities. We then have excess supply for goods/services/unsafe securities and such, unemployment, falling interest rates for the government(now essentially the sole provider of safe securities), and falling prices.

Normally we don't have to worry about correcting this. Interest rates fall and that corrects the entire system. But interest rates can't fall, they are at a zero nominal bound.

Thus we have the obvious answer of "issue more securities until the market is satisfied"

Now this story can imply that we should not have rescued the financial sector. But it only does that on the corresponding implication that we should have a massive govt stimulus in other areas to fill the difference or a massive govt infusion of liquidity in order to move interest rates low enough to correct the imbalance. At which point I am not sure how a PSST construction is any different than a Keynesian construction.

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The FT piece/cowen seem to imply that if we do that issuing we might risk kicking the govt securities off of the "safe asset" designation, triggering another crisis similar to the one we have now, except with no way to issue safe securities and fix the problem.

At least that is how I read it. Partially because the other answer that we have a bubble in terms of quantity doesn't make any sense unless you are positing that demand and supply are in equilibrium for that good and you're just suggesting that demand is "too high" for that good or actual supply is "too high". This begs the question of how you define "too high" (and note that we are talking about demand in this case due to high prices/low interest rates for govt securities.)

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