Three big questions on the financial disturbance of 2007 and 2008
Business Standard, 16 April 2008
The financial disturbances of 2007 and 2008 have prompted an immense outpouring of analysis. Three questions now stand out. First, why was there pronounced demand for high yielding financial products? Second, why did dodgy practices flourish in the US home loan and securitisation markets? Third, why did liquidity collapse in key markets? Achieving clarity on these questions might lead to policy proposals about governments could do different.
It is easy to blame some of the players, such as credit rating agencies or financial firms that originated bad home loans. But a deeper economic analysis requires understanding the environment of prices which shaped the behaviour of these players (see this page).
A rough narrative of 2007-2008 runs like this. The giant reserves accumulation by governments, coupled with monetary policy decisions in the US, gave very low interest rates on traditional fixed income portfolios worldwide which were heavy on US government bonds. This gave many investors a powerful urge to find higher yields. This led to unusual demand for illiquid and risky products, including a push to giving out dubious home loans in the US.
Then interest rates rose, and difficulties of credit ratings of securitisation paper became visible. This led to a flight to quality. Some critical financial markets had a dramatic decline in liquidity. Financial firms which had leveraged bets on this paper, or depended on liquid bond markets, ran into trouble and some of them went bust. Losses by hedge funds and private equity funds worked out fine, but real trouble emerged in two cases: Northern Rock (which had retail deposits) and Bear Sterns (which was too systemically important to fail).
Q1: Why was there such a surge in demand for a yield pickup? The currency trading of many central banks, which gave massive purchases of US government bonds. It led to a lack of market discipline from the bond market upon the expenditure patterns of the US government and US households. Strong expectations of high global growth encouraged purchases of risky assets. Where there mistakes in monetary policy making, where rates were kept too low?
Some think that the flaw lies in the inflation targeting that is now found in most mature market economies. They argue that central banks need to worry more about asset prices. However, asset markets are very flexible - as recent events have demonstrated. Monetary policy needs to stay focused on the real economy because that is where inflexibilities like wage rigidity or sticky prices are found. In addition, it is very difficult for government economists to make calls on asset prices.
Working within the approach of inflation targeting, John Taylor has pointed out that Greenspan kept rates too low for too long in the aftermath of the 9/11 attacks when compared with the rate setting that would come out from rules-based monetary policy. This is a case for more rules and less discretion in monetary policy formulation.
Raghuram Rajan did a speech in June 2006, showing how low interest rates to risk taking in finance. Low interest rates lead to demand for a yield pickup, which can only be met in three ways: buying more risky products, buying more illiquid products, or selling options (i.e. giving insurance). This links up to the heightened demand for securitised home loans, which looked like bonds but offered higher yields.
Q2: Why did dodgy practices flourish in the US? One element is the conflicts of interest where a credit rating agency is paid by the issuer. Another line of attack emphasises problems of compensation. Writing in FT, Raghuram Rajan emphasised problems of compensation of banks, where immediate profits are rewarded with bonuses but deeper difficulties are not penalised. But as Gary Becker pointed out in his blog, hedge funds and private equity funds - where there are no difficulties on compensation - have also had their fair share of losses in recent events. Hence, it is not easy to ascribe a major role to compensation practices.
Compensation practices, which are similar across most countries, also do not explain how the US got the brunt of it. One useful line of attack is the messy financial regulatory architecture of the US. The US treasury has come up with a elaborate reforms proposal to address these problems. Their documents on this subject look remarkably like the Mistry and Rajan committee reports in India in many respects. In the UK, the Northern Rock experience is seen to reflect human errors and weaknesses of deposit insurance.
Q3: Why did liquidity collapse in key markets? This is the most difficult question of the lot. As with the LTCM crisis in 1998, we seem to have run into a `liquidity black hole', where transactions costs suddenly spike dramatically, bankrupting business strategies that rely on low transactions costs.
Financial market liquidity requires diversity of viewpoints where a speculative buyer and a speculative seller enter into a trade while each believes he has got a good deal. Avinash Persaud reminds us that his diagnosis the events of 1998 works pretty well this time also. His story is one where too many people armed with correlated intellectual infrastructure are studying the same datasets and coming up with correlated trading strategies. This leads to herding of trading strategies, where too many people try to buy or sell at once.
Jayanth Varma has remarked on the amazing speed with which the academic community has plunged into doing `research in real time' on these events. As an example, the US Fed announced a new `Term Auction Facility' in December 2007. In April 2008, Taylor and Williams had a paper out measuring its impact. Another fascinating aspect that Prof. Varma emphasises is the interplay between finance and business cycle stabilisation: finance has done well by being the canary in the coal mine that has led to a more rapid application of fiscal and monetary policy towards stabilisation.
For us in India, while these discussions are intellectually interesting, there is little by way of implications for domestic policy debates. We in India are still at the level of being tribesmen in the Kalahari desert reading stories about plane crashes in faraway continents. The first order issues that need to be addressed in India remain those of breaking down a repressive license-permit raj, and setting up a consistent monetary policy framework.
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