Arnold Kling  

Is This the Cure or the Disease?

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From an article on Ricardo Caballero.


Because this "insatiable demand for safe debt instruments," as Caballero has called it, was not wholly absorbed by the traditional safe haven of U.S. Treasury notes, it helped spur the growth of the mortgage-backed bond market. But these bonds, backed by subprime loans, turned out to be unsafe despite their AAA ratings, exploding en masse. Financial markets are still feeling the aftereffects.

As a solution to this imbalance, Caballero -- an expert on global capital markets, financial panics and risk who is among the 100 most-cited economists worldwide -- has proposed the idea of government-issued investment insurance meant to help spur financial activity. Without such policies, he has warned, we could see the "recurrent emergence of bubbles," as capital chases emerging investment areas.

Pointer from Mark Thoma.

Remember my aphorism about finance. The nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets. The financial sector accomodates this by doing the reverse.

One question is, how much of this financial intermediation is optimal? Up to a point, financial institutions can use specialized knowledge, monitoring arrangements, and diversification to perform their function relatively safely. However, beyond that point, they are relying more and more on signaling and confidence. This is true for governments as well as for financial intermediaries.

Since 2008, my reading has been that the amount of financial intermediation needs to decrease, with whatever painful consequences that follow. This includes a reduction in government-backed intermediation, rather than a new form of government backing of the sort that Caballero is suggesting.

The Austrian perspective would be that government support for financial intermediation is the disease, not the cure. In this case, I believe that is correct.


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COMMENTS (8 to date)
Seth writes:

Yep.

Having to exercise prudence is such a drag.

Ashwin writes:

Maturity transformation by financial firms clearly needs to decrease. But the reason is that even your aphorism doesn't hold true anymore. The non-financial sector has a very significant demand for diversified risky long-term assets - through the household sector's demand for retirement savings avenues. In the United States, households' long-term savings are a cumulative 186% of GDP which should be more than enough for long-term risky investments.

If maturity transformation doesn't even have an efficiency gain to compensate for its fragility loss, then the whole rationale for our current financial system - Diamond-Dybvig, Fed backstop etc, falls apart http://www.macroresilience.com/2011/10/10/the-case-for-allowing-banks-to-fail/

Jack writes:

I find it odd to read a leading economist talk about the "insatiable demand for safe debt instruments." Markets clear, don't they? Then the sentence strikes me as nonsensical. Rather, there was a demand for AAA-rated instruments yielding more than the normal AAA interest rate. (Having your cake and eating it too.) Hence MBS to the rescue!

Charles R. Williams writes:

Maturity transformation is underpriced. Yes there is a huge demand for short term investments but this demand is subsidized by the govt through the "too big to fail" approach to regulating banks.

Tom Castro writes:

"The Austrian perspective would be that government support for financial intermediation is the disease, not the cure. In this case, I believe that is correct."

Yes, it is correct.

The banks are willing put all of your money (with the full backing of the government) at risk to make my numbers and get their bonus.

Some economic variable is missing...?

Tc.
P.S. Government is willing to tax you to continue to let the bonus be paid.

[broken url removed--Econlib Ed.]

Hasdrubal writes:
But these bonds, backed by subprime loans, turned out to be unsafe despite their AAA ratings, exploding en masse.

Something I've wondered for a while now is how many MBSs actually defaulted, how much contagion has really reached the top tranches? Sure, more of the lower tranches defaulted than expected, and the prices of MBSs plummeted because of fire sales, but how many actually defaulted? Will they still be trading at a huge haircut 5 years from now?

Arthur_500 writes:

What is wrong with MBS? Why is this not AAA rated?

These questions, and others, are often not answerable with the available information. People will always pay their mortgages first, was the common belief. Therefore, MBS are certainly stable and secure.

We have been fed the mantra of "diversify" and MBS and similar securities seemed to meet both the mantra and the needs. Who was to know that this was all a house of cards?

As the system devolved there were those who felt that getting the fees were all that was necessary and any junk could be passed on. Remember that ENRON used to have very good SPE's but those began to devolve into pure junk. Many of the purchasers of those notes never knew they were buying junk. The lack of knowledge, I believe, was more pervasive than those who were actively gaming the system.

Our system has been based on opportunity to gain a reward combined with the opportunity to fail. The more our system is rigged to prevent failures the more it becomes incumbent upon the regulators to bail out those who have failed. After all, they designed the regulations that would prevent collapse!

We really need to decrease regulation and allow institutions to fail. Until we do, the American public (as well as the rest of the world) will continue to believe that everything always goes up. Even a 3-year old can tell you that simply isn't true.

Matthew C. writes:

everything always goes up.

But when you print the reserve currency into the dust, everything DOES go up in nominal terms. Which is great if you are a TBTF bank holding a bunch of garbage MBS on your balance sheet. Enough inflation, and you can turn busted loans good.

Of course for those in the bottom 90% whose primary assets are in their earnings potential and fixed-income retirement savings, it's a complete disaster as wages go up more slowly than inflation, especially in food / energy costs.

But the Fed and Federal government are run for the benefit of the 1%, not everyone else. That should be beyond obvious at this point.

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