savageinfidel

Was moral hazard, in the form of expectations of a bailout, responsible for the reckless behavior that led to the banking crisis? James Surowiecki argues , quite convincingly I think, that the moral hazard argument is overrated: In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that...

If there’s one idea that has achieved consensus over the past few months, it is that regulators were asleep at the switch as the credit bubble inflated. A better regulatory system would have preempted the bubble, precluded the need for bank bailouts, and saved the world much misery. If only it were that easy! Imagine that you are the regulator in charge of the banking industry. What are your aims? Well, on the one hand you want to prevent ‘unwarranted’ bank runs. An unwarranted bank run is one in which the bank did nothing wrong, and is actually well-capitalized, but due to ‘irrational’ investor panic faces a potentially life-threatening short-term funding gap. Preventing unwarranted bank runs is what lies behind well-known CB catchphrases such as “contagion”, “systemic risks”, “lender of last resort”, and “too big to fail”. On the other hand, you as the regulator are (moderately) in favor of ‘warranted’ bank runs. If a bank does something stupid, it should pay. Depositors shou...

A few weeks ago, Paul Krugman wrote a lengthy essay on the history of macroeconomic thought for the New York Times Magazine. His article prompted a flood of commentary both pro and con; I do not propose to add to this deluge. I do however want to take issue with one particular assumption that runs through both the original article, and through many of the responses to it (from both left and right). This assumption has to do with the relationship between rationality and bubbles. One group of economists argues that traders are rational and markets are efficient; hence bubbles (if they do arise) are likely to be short-lived and self-correcting. Since markets are largely self-regulating, the role of government is to intervene as little as possible 1 . Another group argues that traders are often irrational and markets are often inefficient; hence bubbles may last a long time before eventually (and painfully) bursting. Since markets cannot be trusted 100%, the role of government is to ...

When the histories of today’s very interesting times are finally written, I suspect that the phrase ‘regulatory arbitrage’ will feature prominently. One may point to the housing bubble or the bubble in finance as proximate causes; or to unsustainable global macro imbalances as a more distant cause. But the grease that lubricated the wheels of the runaway train was regulatory arbitrage. Why was regulatory arbitrage so prevalent during the boom? There are several reasons. First, regulatory arbitrage is easy . It’s certainly easier than trying to beat the market in ‘legitimate’ ways, as many retired traders can testify. What’s more, this state of affairs is likely to persist. Regulatory agencies in the USA are notoriously understaffed; their few workers are notoriously underpaid. Anyone competent enough to understand the complexities of modern financial instruments (which, incidentally, are often designed specifically to avoid or evade regulatory scrutiny) would waste little time i...