This interview with Gary Gorton
is excellent reading. Gary knows a lot about banking history, banking regulation, financial innovation, and securitization, and puts this all together to give us some interesting insights. Here is a good quote regarding mainstream macroeconomics and how it deals with financial factors:
The way standard models deal with [financial instability] is, I think, incorrect. A lot of macroeconomists think in terms of an amplification mechanism. So you imagine that a shock hits the economy. The question is: What magnifies that shock and makes it have a bigger effect than it would otherwise have? That way of thinking would suggest that we live in an economy where shocks hit regularly and they’re always amplified, but every once in a while, there’s a big enough shock … So, in this way of thinking, it’s the size of the shock that’s important. A “crisis” is a “big shock.”
I don’t think that’s what we observe in the world. We don’t see lots and lots of shocks being amplified. We see a few really big events in history: the recent crisis, the Great Depression, the panics of the 19th century. Those are more than a shock being amplified. There’s something else going on. I’d say it’s a regime switch—a dramatic change in the way the financial system is operating.
This notion of a kind of regime switch, which happens when you go from debt that is information-insensitive to information-sensitive is different conceptually than an amplification mechanism. So there’s a problem. Conceptually, the notion of adding things to existing models—a friction or an amplification mechanism—retains this overall paradigm in which financial intermediation generally has no role. I don’t think that is going to work.
This one, on how some people "understand" the financial crisis, is good:
After the fact, things always look clearer, don’t they? Monday morning. People make statements like, “Obviously, there was too much leverage.” That’s like saying the patient died because his heart stopped beating or inflation is caused by prices going up. Obviously, there was leverage. That’s why I said before that you need a theory of debt; you need to explain why there’s this debt and what is the purpose of having this debt. Does that security, which is optimal, have consequences that are socially suboptimal or not? What’s the problem? To make progress, we need to say more rather than just repeating these things.
The interview is a nice summary of Gary's work, and you can read more about it if you follow the references. His regulatory reform proposal for "narrow-funding banks," is particularly interesting.
GG: "This notion of a kind of regime switch, which happens when you go from debt that is information-insensitive to information-sensitive is different conceptually than an amplification mechanism."ReplyDelete
A sketch of a model:
Some fraction of the assets are lemons. It is costly to test which one is or is not a lemon. Your incentive to test depends on whether the person selling you the asset tested, and whether the person to whom you will sell it will test. (You don't want to get stuck buying a lemon at the average price and having to sell it at the lemon price).
So you get two equilibria: in the first equilibrium nobody tests; in the second equilibrium everybody tests. A big enough shock, even if temporary, could flip the economy from one equilibrium to the other. And the asset is much less liquid in the second equilibrium (since there's a fixed cost of testing before you buy).
I think that's an amplification mechanism, because of the strategic complementarity in testing.
GG: "That’s why I said before that you need a theory of debt; you need to explain why there’s this debt and what is the purpose of having this debt."ReplyDelete
That's what's so hard. Why would two people agree to a loan which isn't indexed to anything? Not even the CPI.
And simply assuming there's a "cost to indexation" just doesn't cut it for me. But I can't think of anything better.
It's easier to talk about the externalities of debt than to explain why debt exists.
1. Gary seems to think he is talking about something out of the realm of conventional theory, but it certainly sounds like a sunspot equilibrium, which we know a lot about. I think that is what you are sketching out as well.
2. We do have models of debt, based on Townsend's (1979) costly state verification setup. What that gives you, given some assumptions about commitment and pure strategies, is non-contingent debt. The fixed payments are real, though (i.e. think of them as indexed). No one has a model of nominal debt contracts, but Townsend's idea is quite simple and compelling. Non-contingent payments allow you to efficiently economize on verification costs, which can be broadly interpreted as costs of extracting payment.
Nick Rowe argues that "a big enough shock" can cause the "testing" equilibrium to occur. This overlooks a point Gorton makes in the interview: it was not a big shock at all, but the flattening out of home prices, that resulted in shadow bank liabilities becoming information-sensitive. IMO, Gorton is saying that the "amplification" construct is not useful when one is talking about a very small shock resulting in a large liquidity event.ReplyDelete
Reading Gorton's work, it is clear he focuses on the structure of shadow bank liabilities: it was the dominance of AAA-rated ABS collateral backing shadow bank "deposits" (ABCP and repo's) that ultimately led to a run on those deposits. This unique initial condition is what made the system vulnerable to a system-wide run, not an "amplification" mechanism ("testing") potentially generic to any recession.
One implication of Gorton's work is that Fed AD stabilization can result in lower and lower requirements for collateral backing liquid deposits. The more aggressively stabilized the system, the less liquidity insurance taken out by actors (margin in the form of collateral haircuts), and the more vulnerable the system ultimately becomes to even a small shock.
Thanks. The point from your last paragraph is particularly interesting.