Should the Market Monetarists and Gary Gorton be friends? (speculative)
This Timothy Taylor post from last week on Gary Gorton’s very important and fascinating work on the financial crisis reminded me to get back to pursuing a line of thought I started a while ago, about a potentially fruitful analogy between what structured finance products accomplish on the micro level and what the financial sector does at the macro level*. I haven’t come close to thinking this all the way through yet, but I find thinking out loud very helpful sometimes. So please take this in the open spirit of inquiry in which it is offered.
First, Gorton. He has a theory of financial crises that relies on the distinction between information-sensitive and information-insensitive debt. His thought (in its barest form) is that people often have a need for financial assets that they don’t need to worry about how new information affects the possibility of a loss. Then something happens to make those assets information-sensitive, and people sell those assets in droves to reacquire information-insensitive assets. This then wreaks havoc in the repo market, with haircuts on short term secured lending increasing dramatically due to the uncertainty over the pricing of those assets – effectively leading to a net withdrawal from the banking system:
But how do we create safe assets in the first place? The economy is mostly made up of people doing risky things: starting businesses, investing in new factories, opening new divisions or product lines etc. There’s two basic ways you can turn risky things into safe things: diversify, and structure the cashflow pooled through said diversification. In my mind, I have the whole economy as looking like a giant securitisation vehicle, spitting out bank deposits / money market funds at the top and good ol’ equity at the bottom.
Now, how much information-insensitive debt can be produced from a given set of underlying assets is a basically a function of a) the individual riskiness of the assets and b) the correlation of the risks between those assets. (I intend at some point to build a toy model to explain and show this better, but just accept this on epistemological credit for now). If the underlying assets become more risky, or if the correlation between them increases, then that means a reduction in the amount of super-safe, information-insensitive assets that can be spit out the other end.
Now, I wonder what could possibly cause both a) an introduction of risk across the entire economy and b) correlation in those risks. Well, how about a fall in aggregate demand caused by an increase in the demand for money not offset by an increase in the supply of money by the central bank? That (if the Market Monetarists are right) introduces new risks to businesses all over the place, and the risk is highly correlated across the economy. The existing structure of the economy’s cash flows can no longer sustain the same level of super-safe assets, so therefore some previously information-insensitive assets have to become sensitive and you get your crisis a la Gorton.
So when people are talking about a ‘shortage of safe assets’, you either need to restructure the cashflows of the economy to have more loss-absorbency at the bottom to support more quality at the top, or solve the problem of the underlying increase in correlated risk. If this is right, then this seems to me a pretty powerful (but embryotic) theory of how an AD shortfall could cause (or seriously exacerbate) a financial crisis like the one we experienced.
Other assorted thoughts:
- I think this highlights a key problem with Gorton’s solution to the problem (massive extensions of deposit insurance), which is that it doesn’t in any way do anything to change the amount of super-safe assets the underlying economy can *actually* sustain
- All the above is not to invalidate all the other potential factors that led to the crisis, (and the chart above seems to show that the run on the repo market was already beginning by early 2008) but to identify the mechanism whereby it suddenly got a whole lot worse when NGDP (and expectations thereof) fell in mid-summer 2008, and why people are currently saying ‘we still have a shortage of safe assets’
- Felix Salmon’s question ‘Is information-insensitive debt a good thing‘, is one worth considering very seriously
* I’m very indebted to Arnold Kling, whose mantra “The nonfinancial sector wants to issue risky long-term liabilities and to hold safe short-term assets. The financial sector accommodates this by doing the opposite” first got me thinking down this line