Arnold Kling  

Engineering the Financial Crisis

David on 2nd-Best Immigration ... Bryan's Question and Stagnatio...

That is the title of the new book by Jeffrey Friedman and Wladimir Klaus. I have just started to read it.

Their view is very close to mine in several ways. First, they emphasize the role of capital regulations in steering banks toward holding mortgage securities blessed with high ratings from rating agencies. Second, they emphasize that the financial system is beyond the capacity for even an expert to understand well enough to control. Third, they are skeptical of narratives of the crisis that fit political agendas. This includes the narrative that emphasizes greed and deregulation as well as the narrative that emphasizes government promotion of high-risk mortgages and the buildup of moral hazard at banks due to a track record of bailouts.

I will say more about the book when I have read more of it. I wanted to post now, because some of you in the DC area may want to attend a session that will feature the book. Two options:

1. Monday afternoon, October 24, at the American Enterprise Institute.

2. Thursday afternoon, October 27, at the Cato Institute (actually, down the street from Cato, because of construction)

COMMENTS (1 to date)
David Beckworth writes:

These distortions were important, but why did they emerge when they did? Does the book address the timing?

My own view is that the Fed's low interest rate policies created the incentives that made these distortion's full potential come to fruition.

From an earlier post, I wrote this:

Didn't the Fed itself create some of the increased demand for safe assets by pushing short-term interest rates super low and promising to hold them there for a "considerable period?"

When the Fed pushed interest rates low, held them there, and promised to keep them there for a "considerable period" it created new incentives for the financial system. First, via the expectations hypothesis (which says long-term interest rates are simply an average of short-term interest rates over the same period plus a term premium) these developments pushed down medium to longer yields as well.

As Barry Ritholtz notes, this drop in yields caused big problems for fixed income fund managers who were expected to deliver a certain return. Consequently, there was a "search for yield" or as Ritholtz says these managers of pension funds, large trusts, and foundations had to "scramble for yield." They needed a higher but relatively safe yield in order to meet their expected return. The U.S. financial system meet this rise in demand by transforming risky assets into safe, AAA-rated assets.

The Fed's low interest rate policies also increased the demand for safe assets for hedge fund managers. For them the promise of low short-term interest rates for a "considerable period" screamed opportunity. As Diego Espinosa shows in a forthcoming paper, these investors saw a predictable spread between low funding costs created by the Fed and the return on higher yielding but safe assets. They too wanted more AAA-rated assets to invest in so that they could take advantage of this spread that would be around for a "considerable period." Here too, the U.S. financial system responds by transforming risky assets into safe assets.

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