Thursday, October 16, 2008

Zeno's paradox

In Zeno's paradox, Achilles keeps gaining on the Tortoise but never actually reaches it. Similarly, economists keep coming closer to the core problem behind this (and all) credit crises, but can never bring themselves 100% there. In this NYTimes piece, Diamond and Kashyap (and Diamond in particular is closest to understanding the problem here) say:
If the remaining investment banks, Goldman Sachs and Morgan Stanley, do not get more secure funding in place, they may be acquired or subject to a run too. In the current environment, relying almost exclusively on short-term debt is hazardous, even if a firm or bank has nothing wrong with it.
The very next paragraph reads:
The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.
Perhaps Diamond and Kashyap could explain in what kind of environment relying almost exclusively on short-term debt is not hazardous, and while they are at it, perhaps they want to explain FDIC, and how sounds the retail banking system would be if FDIC did not exist. And while in this article the say that the inability to secure short-term funding comes from having insufficient capital, perhaps they could explain why the crises happened when it did, and not a year ago (where housing financials were as dubious as they are now)? As Diamond's own freakin' model demonstrates, relying almost exclusively on short-term debt is never a good idea because you can have a bank run at any time, for any reason. The bank run reduces capital, which exacerbates the bank run.

Megan makes a similar error when she talks about the timing of the recession, who called it, and who did not. The only honest article I've seen on this is from the overweight and overwrought Brad DeLong: The Wrong Financial Crises. He straightforwardly admits that academic macroeconomists were focused on trade and current account deficits, particularly between the US and China, and not on the potential for a bank run on the shadow financial system (which is what's happening now). Bank runs happen spontaneously and for no reason -- they cannot be timed or predicted. If you don't see this credit crises as a bank run, then you can make claims about who should or should not have predicted it. Bank runs are unpredictable -- everything works fine until it doesn't. It's a lousy way to run a financial system.

Finally, I would add, that there is still an entity out there who relies almost entirely on rolling over short term debt, and has not yet seen demand for that debt dry up


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