Marginal Revolution

Bad news, but good news too

Banks are hoarding cash in expectation of pay-outs on up to $400bn of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and ­dealers.

This added pressure on the frozen financial system comes as authorities prepare to meet participants in the so-far unregulated $54,000bn credit derivatives market to speed up plans for the creation of a central clearing house.

Here is the story.  Here is my earlier post on derivatives and clearinghouses.

How to tell if things are going very badly

If the Fed ends up guaranteeing commercial paper and/or interbank loans.  Too many people are listening to Polonius.

Assorted links

1. The ten highest earning authors; I like only one of them.

2. Chris Blattman and Michael Clemens on the long run.

3.The worst academic jobs around the world?

4. The difference between country music and rap music

5. Is there a need for "speed bankruptcy"? -- an analysis of the major plans

Does the free market erode moral character?

I am honored to share a symposium with Garry Kasparov, among other notables, including Robert Reich, Jagdish Bhagwati, Bernard Henri-Levy, Michael Novak, and others.  My answer to the question is "No, on balance" and here is my opening bit:

In matters of morality, the free market functions like an amplifier. By placing more wealth and resources at our disposal, it tends to boost and accentuate whatever character tendencies we already possess. The net result is usually favorable. Most people want a good life for themselves and for their families and friends, and such desires form a part of positive moral character. Markets make it possible for vast numbers of people, at every level of society, to strive for and achieve these common human ends.

There is much more at the links.

Why is the Fed Paying Interest on Excess Reserves?

Today the Fed starts to pay interest on reserves.  The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax.  Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed.  Overall, however, this is small potatoes.

More interesting is why the Fed. will pay interest on excess reserves.  In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets?  My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong's terms this gives them an additional tool to do it on the Pan-Galactic scale.  In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize.  Although paying interest on excess reserves brings this whole operation under the Fed house it's unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.

What caused the financial crisis?

Forget about particular details for a moment, in conceptual terms what led so many financial institutions to take so much excess risk?  Bob Frank addresses that question and here is my list of major factors:

1. Collective stupidity: A lot of Greeks believed in Zeus and a lot of people in 1938 thought Hitler would be good for Germany.  They were just plain, flat out wrong.  I'll also put "model error" under this heading.  The relevant stupidity concerned both the fate of home prices and the degree of acceptable leverage.

2. Writing the naked put: This is Bob Frank's main explanation, noting that he uses different terminology and adds a relative status dash to the argument.  If you don't know options theory, just imagine betting against the Washington Wizards to win the NBA title every year.  For a lot of years you'll earn super-normal returns, but one year (not anytime soon, I can assure you) you'll be wiped out.  That is essentially the strategy the banks were playing.  They were going "short on volatility," so to speak.  In the meantime they reaped high returns and some amazing perks for private life.  It's hard to just call the party to an end, even if you have a relatively long time horizon.

3. The neutering of debtors. This is the sophisticated form of the moral hazard argument.  Bailouts mean that debtors and depositors don't have enough incentive to keep safe the firms they give their money to.  Note that #3, as a corollary, suggests that equity holders do not on their provide adequate safeguards against a crash.

Evaluation: You can pin most of the blame on #3 provided you think that a) our government really could let these firms default on their debts ex post and b) society is willing to live with significantly less liquidity transformation up front and also lower returns for depositors.  I reject this mix for reasons of time inconsistency, namely that ex post the bailout is always on its way so this is simply something we have to live with. 

You're left with #1 and #2 but it is hard to assign relative weights because they work together.  The people earning money under #2 won't work terribly hard to disillusion the fools and frauds operating under #1.

At times I am tempted to add #4 to the mix:

4. The increasing value of human capital: Bankruptcy is no longer so painful for the wealthy.  You can always get another high-paying job plus you have $10 million squirreled away somewhere in Switzerland.  You could end up working for the guv'ment for $130K a year and your life still is pretty good once you get over the shock of adjustment.  So why not take lots of risk and try to get ahead of the other guy?

The full story then involves additional resources being put on the table -- for possible risky investment -- as a result of easy monetary policy, pro-housing government policies, the global savings glut, and simple bad luck.  I'll cover those factors in more detail soon.  And I'll also have more to say about some of the details of mortgage-backed securities and accounting practices and regulation; those were factors too, although not at the level of generality I am covering here.

Addendum: Here's Mark Thoma and Barry Ritzholz.  In the comments Robert Feinman is square on, read him.

Second addendum: Megan McArdle adds quite a bit.