Friday, September 26, 2008

Micro is from Earth, Marco is from Cuckoo land

I attribute Steve Landsburg's complete failure to understand the credit crises to the fact that he's well versed in microeconomics (which is sane) and therefore feels that macroeconomics is too (which it is not -- it is fundamentally nonsensical)
That's one reason I feel squeamish about the official pronouncements we've been getting. They tell us bank failures will make it hard to borrow but never that bank failures will make it hard to lend. But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically. This makes me suspect that the official pronouncers have not entirely thought this thing through.

In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent. Second, as any user of match.com can tell you, the technology for finding partners has improved since then. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad?

Steven, in our fractional reserve system, every borrower is NOT matched to a lender. A borrower who wants a long term loan is NOT matched to a lender who wants some place to stash their money for 30 years. Instead, short term lenders (who aren't really lenders at all -- they think their money is in cash) are, through the magic of term transformation, converted to nine times that number of long term lenders. This is an inherently unstable state of affairs and will end in a bank run, which is what we are seeing in the shadow financial system. When these banks vanish, we will see a world where every borrower IS matched to a lender, and it will be very different from this world. Key differences:
1. Long term rates will be MUCH higher, as the current supply of long term money is created almost entirely through term transformation. And only banks can term transform.
2. A much smaller money supply, as this 9x multiplier (which, if it flows through another bank, gets an additional 9x boost, ad infinitum) vanishes. This will be true even if the Government steps in and keeps M0 whole. At this point, the US Government can always run the printing press to create M2 etc., but banks failing are inherently deflationary because banks are inherently inflationary.

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