Saturday, November 29, 2008

Financial Crisis '08: attack of the parasites

How did this happen?

In a nutshell, consumption, especially in the US, of housing was at an unsustainable level, driven as it was by mispriced credit (too cheap). Government policies such as the deductiblity of interest on money borrowed to purchase a home aggravated the mispricing.

In general you support laissez faire policy on the grounds that government interventions, however well intentioned, typically create mispricings that undermine their objectives. But when you suggest here that government policy "aggravated" the mispricing, are you suggesting that the free market mispriced?

Yes. To begin with, free markets are subject to panics, manias, and bubbles, and these are mispricings. The "bubble" in US mortgage lending has been followed by a global credit panic.

It is important to understand here that panics and bubbles are symptoms of a problem, however, as opposed to the problem themselves. The problem is a lack of transparency. If it is clear to everyone what the "true" price should be, prices wouldn't soar far beyond that or crash far below.

Financial intermediation is critical to economic development. It puts people with ideas about how to produce more for less together with people with the capital to enable that idea. Unfortunately for capital suppliers, they have less information about the value of potential investment opportunities than the capital seeking entrepreneurs. Economists call this "information asymmetry", a concept at the core of financial market theory.

There are various things governments and regulators can do to try to address this problem, such as mandating disclosure and prohibiting trading on non-public information (lest the pool of willing capital suppliers shrink to insiders). Especially important is creating an investor friendly tax and legal system in the background. One of the lessons of this crisis, however, is that there was, in the end, still a significant shortage of information, or, more precisely a shortage of meaningful information in a sea of complex data.

So price discovery cannot be left to the private sector?

The wrong lesson from this crisis is that government should discover prices (i.e. determine how much of any given good or service should be produced). The right lesson is that private actors discover prices best and what happened is that these actors were overwhelmed by other private actors who obscured prices.

Who obscured prices here?

The guilty parties are legion, ranging from mortgage applicants who misrepresented their incomes to uninformed retail traders who exacerbated any mania or panic, but the prime culprits here are investment bankers. Investment bankers are financial innovators. And for a long time this financial innovation was economically useful. For example, whoever invented the common share made a very useful contribution by creating a product that represents a residual claim on a firm's assets instead of a fixed claim (like a bond or a bank loan). But with the explosion of progressively more complex derivatives, the generally useful process of spreading risk by slicing and splicing various payoffs and exposures became dominated by the harmful process of of obscuring just what the risks were.

Is there an example of when spreading risk is not useful?

Yes. Consider a bank originating a mortgage. It knows the borrower if it has a first hand relationship and has every incentive to monitor that borrower. If the default risk is spread, the bank will lend more and monitor less. Indeed, this financial crisis brings us back to the typically ignored policy fact which is that overinvestment is as much a problem as underinvestment per se, overinvestment in a particular sector implying mispriced investment (which in turn implies underinvestment in some other area). When investment bankers step in to slice and dice the risk across a chain of parties, they create another chain of information asymmetries and the duty to monitor suffers from a "tragedy of the commons".

How does it serve these investment bankers to obscure?

The more complex the valuation process is, the more these people leverage their comparative advantage. Markets move money from the uninformed to the informed. To a large extent, this is what policy makers want, because it is central to the idea of efficient price discovery. But in this case, "informed" people were making money who were not, in fact, more informed about the fundamental economic (as opposed to financial) values, they were rather more informed about the operations of things like derivatives, which do not further price discovery.

Why do you call derivatives parasites?

Because the value of a derivative is entirely derived from the value of the underlying. Resources diverted to pricing derivatives are resources diverted away from price discovery of the underlying.

Had the investment bankers really understood the nature of the beast they created, they would have kept the host alive. But in the end the beast was so big it completely obscured any view of the host.

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