Wednesday, October 31, 2012

Misunderstanding the Financial Crises

I forget where I found this link, I think it was on an MMT blog and it was supportive towards the article. Having good MMT info on the Financial Times would be great, and I had not heard of Gary Gorton, so I was interested in reading what it said. Unfortunately, I don't agree with Gary.

The specifics. Gary has some interesting points about the role collateral plays in repo and other overnight interbank lending markets. Essentially, Gary says, these are not credit decisions most of the time. I agree. I would go farther and say these should never be credit decisions because when the credit of the institution comes under question, it generates a negative feedback expectations loop and the bank finds itself cut off from the rest of the financial system, and needs to go to the Fed (with the stigma attached to that). More robust, then, to have everyone always go to the Fed directly. The Government is the best source of "secret-less and information-insensitive collateral" to use Gary's phrase.

He adds a second good point:
As I mentioned above, the private sector cannot create riskless collateral. This is because the backing assets are longer-term than the bank money; the backing assets are claims on real output. An inherent feature of a market economy is that private money is useful over shorter time intervals than the backing collateral. This “maturity transformation” is not a choice, but inherent in the economy.
Also interesting. This is the first time I've heard this argument to support maturity transformation as an inherent element in the economy. But then he seems to contradict himself:
Privately-produced safe debt can be created without being vulnerable to bank runs with the right regulation. It would be better for the government to oversee the creation of privately-produced safe debt than to try to create enough government debt to meet the demand.
 Why? It's easy for the US to create enough government debt to meet demand by simply taxing less. Having the Government work with the private sector to create safe debt through implicitly backing private actors seems needlessly complicated and more open to corruption. It gets worse.
Yes, there are limits to a government’s ability to create safe debt. We have seen this recently in Europe where the debt of some governments has become information-sensitive – it is no longer viewed as safe.
Individual Euro nations are closer to currency users than issuers, and therefore are more similar to private actors than monetary sovereigns. So, "Governments" are not the same, and a currency sovereign that maintains its ability to tax also has no limit to its ability to create safe debt -- aside from inflation risk if it exceeds the private sector's demand. But, the misunderstanding's continue:
This history has been lost because financial crises are misunderstood. Crises are now attributed to government actions rather than to the inherent features of bank money. The government tries to prevent bank runs, but then—when the bank run is not observed—the government is blamed for the crisis. The run on repo was not observed by regulators, academics, journalists, or the public. So instead of the Livingston and Blaisdell logic of saving the banking system and providing mortgage relief, there have been proposals to efficiently liquidate banks during crises. Realistically, this would mean liquidating the banking system.
I don't believe this is true. Depositors could be protected while actual bank investors (equity and bond) could be wiped out. So long as the Fed continues to provide liquidity, a bank in any degree of capital insolvency can continue to operate, regardless of how that capital insolvency impacts the bank's investors.
It seems like mandating more prudential lending standards would help — if not prevent future bank runs, then make them less frequent or less severe.
I don’t think that will help. It is an inherent feature of private economies that they cannot create riskless debt. What is the proposed lending standard, that banks are only allowed to make riskless loans?
How about keeping banks on the hook for the credit quality of the loans they make, by requiring them to keep all loans on their books?

And finally, a non-solution to a non-problem:
These new banks would essentially create private safe assets and short-term bank debt subject to regulatory oversight. Essentially, these banks would hold asset-backed securities and finance their portfolios with short-term debt, repo. We want to avoid another run so we want to address the problem head-on. Furthermore, we recognize that this new banking system—shadow banking– is real banking. The economy needs this banking system. Prior to the crisis the issuance of non-mortgage asset-backed securities was larger than the issuance of U.S. corporate bonds.
I don't think we need narrow banking, I think we need unlimited FDIC coverage. I also think we need to question whether we need that Gary calls "real banking". Prior to 1970s, there was no housing shortage in the US. Mortgage backed securities appeared in 1970. Why real benefit did this generate?


Blogger NeilW said...

"How about keeping banks on the hook for the credit quality of the loans they make, by requiring them to keep all loans on their books?"

Make loans unsecured.

Which has the added advantage of breaking the asset/loan value spiral that so benefit those who charge interest.

12:42 PM  
Blogger winterspeak said...

I don't think this breaks the asset/loan value spiral.

You can think of venture capital as an unsecured loan in that it's just an equity stake, and you certainly see valuations rising in bubbles.

Why isn't just keeping the loan on the books enough?

2:10 PM  
Blogger Ralph Musgrave said...

My initial and off the cuff reaction is that that run on shadow banks prior to the crisis was the same in nature as the flight from lower quality bills of exchange the preceeded every crash in the 1800s described by Walter Bagehot. And that flight from low quality bills, then calls into question better bills, till virtually no one trusts anything except gold, or central bank gold backed money.

Then the whole process starts again: people start using home made money (i.e. private bills of exchange) instead of gold backed money. It starts again because the private sector can create and lend out money at a zero rate of interest (it costs nothing to print money).

The process whereby privately produced money displaces central bank money is described by George Selgin here:

10:06 PM  
Blogger NeilW said...

"Why isn't just keeping the loan on the books enough?"

Misprices and misalloactes money. The loan doesn't represent the fundamentals of the investment made.

In a collateralised system like ours the banks are not really lending institutions. They are glorified pawnbrokers.

12:46 AM  

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