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help me, obi-wan bernanke. you’re my only hope!

The depressing financial news to day is of a coordinated Fed/Bank of England/European Central Bank rate cut this morning, which occasioned a brief spike in stock prices, followed by a significant drop. Not so coincidentally, I read the following quote last night:

I am now somewhat sceptical of the success of a merely monetary policy directed toward the rate of interest.  I expect to see the State, which is in the position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking on ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principals I have described above, will be too great to be offset by any practicable changes in the rate of interest.

Any takers on guessing who wrote this? 

One irony in this quote is that in fact, this exercise in expanding the monetary supply actually comes after (or really, in the midst) of other measures that are closer to “taking over responsibility for organising investment.”  Essentially, Bernanke is trying any and all measures to restore stability.

Here is another irony, which is also not so encouraging:

I confess not knowing much about Bernanke’s  research, but something I read (can’t remember what) pointed out how his key contribution was to recognize that the Great Depression was made deeper and longer by non-monetary mechanisms that made banks unwilling to lend– in particular, their inability  to distinguish good from bad credit-risks, coupled with their need to preserve capital.  That local banks (obviously, the dominant form in that era) specialize in distinguishing the borrower wheat from chaff (i.e., limiting adverse selection; and also pressuring borrowers ex post, to limit moral hazard), and that strong, “embedded” relationships are key to this is now well-understood in both the finance (e.g. and e.g.) and economic sociology literatures (see Uzzi’s 1999 ASR paper; see also my favorite MBA teaching case, Mark Twain Bancshares).  Here is the cite to what seems to be Bernanke’s main paper on this:

Title: NON-MONETARY EFFECTS OF THE FINANCIAL CRISIS IN THE PROPAGATION OF THE GREAT-DEPRESSION
Author(s): BERNANKE BS
Source: AMERICAN ECONOMIC REVIEW   Volume: 73   Issue: 3   Pages: 257-276   Published: 1983
Times Cited: 311

Why do I say there is a painful irony?  Well, in arguing for the bank’s role in interpreting “soft” information, he argues that it is essentially wrong to assume the kind of financial market that is:

described by Eugene Fama (1980), .. which .. are complete and information/transactions costs can be neglected. In such a world, banks and other intermediaries are merely passive holders of portfolios. Banks’ choice of portfolios or the scale of the banking system can never make any difference in [such a market], since depositors can offset any action taken by banks through private portfolio decisions (p.263).

Rather, he says that instead, we should:

Assume… that banks specialize in making loans to small, idiosyncratic borrowers whose liabilities are too few in number to be publicly traded (such that) the real service performed by the banking system is the differentiation between good and bad borrowers….  (Such service) includes screening, monitoring, and accounting costs, as well as the expected losses inflicted by bad borrowers….  (The costs of providing this service are minimized) by developing expertise at evaluating potential borrowers; establishing long-term relationships with customers; and offering loan conditions that encourage potential borrowers to self-select in a favorable way.

He then goes on to argue that the Great Depression was longer and deeper than it otherwise might have been because these costs essentially skyrocketed as the value of people’s collateral deteriorated.

The irony of course is that the rise of debt (especially, mortgage) securitization was effectively based on the now-obviously faulty premise that you could build a (shadow) banking sector on Fama-like principles.  (So yeah, economists sometimes make markets; but they also break them). And effectively what this did was to lower the nominal cost (to, e.g., mortgage brokers) of providing financial intermediation without changing the realcost of such intermediation– where by this distinction, I mean to include the “screening, monitoring… and expected losses inflicted by bad borrowers” in real, but not in nominal.  Worse, by bundling both good and bad borrowers together into pools, it becomes that much harder to price the securities, and especially hard for speculators in such securities to figure out how one another will price them (which is key to the point I will develop in the promised follow-up post to my last one.)  And then much worse, the “badness” of these borrowers is something that is not fixed, but is endogenous to the economy (specifically, real estate prices), which is in turn driven down by the collapse of the financial system.  Ugh.

So, if there is any silver lining in this, it is that I’d much rather have someone like Bernanke than Greenspan at the Fed.  Not only does Greenspan deserve a lot of blame for this mess, but Bernanke seems sensitive to the key issues.  Here is how he ends this article:

Institutions which evolve and perform well in normal times may become counterproductive during periods when exogenous shocks or policy mistakes drive the economy off course. The malfunctioning of financial institutions during the early 1930′s exemplifies this point.

I think we now have another case to exemplify his point.

A final note: besides placing hope in Bernanke, I also greatly sympathize with him.  Besides having to deal with a momentous mess that is not of his own making, I’m sure he is working non-stop these days and will have to work over Yom Kippur.  More generally, I’m sure he has no time to assume any identity other than the Chairman of the Fed.  And that’s sad.  For myself, I will be signing off for a few days for the observance of YK (exciting year for us– our oldest son [12 yrs] is fasting for the first time; definitely a major stage as a parent when you encourage your child to not drink or eat for 25 hours!).  I pray that we are all in a better state when I am next online.

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Written by ezrazuckerman

October 8, 2008 at 4:54 pm

Posted in uncategorized

7 Responses

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  1. Any takers on guessing who wrote this?

    If I — or anyone — had any, I would lay good money that this is almost certainly Keynes.

    Kieran

    October 8, 2008 at 6:07 pm

  2. Keynes it is. Nicely done. (Though I telegraphed it a bit with the British spellings)

    From P.164 of the General Theory, which is the end of chapter 12– which, for my money (!), is the best piece of work ever written on financial markets. I’ll discuss it in my next post.

    ezrazuckerman

    October 8, 2008 at 6:12 pm

  3. First of all, Shana Tova and Hatima Tova Ezra. I hope your son had a good experience in his first observance of the holidays as a “grown up”.

    A tiny comment I would make to your post is that there is are a couple of additional mechanisms operating that are worth mentioning. The first is that, as you say, part of the problem is that both the responsibility *and* the incentives were removed away from banks to develop closer relationships with borrowers and do a better job at screening. Given the way incentives were broken up in the value chain (between originators, banks, aggregators, investment banks, etc.) there was basically no incentive for anyone along the value chain to create a closer working relationship with borrowers and to maintain a tight oversight on screening processes.

    That said, I do not believe that this is all because there is a large proportion of “bad” borrowers out there whose quality was not properly ascertained before being granted loans. What I do believe, however, is that as inflation soared up, house prices declined, and interest rates rose many borrowers found themselves in a much tighter spot than they expected, especially given what the loan originators sold them on. A person in that situation, however, would have few options available to her. That is, in previous times and in “traditional” mortgage loans, when things get rough you always have the option to talk to your banker and try to figure a solution out. Most of the time, especially when there is a systemic problem, it is in the bank’s best interest to renegotiate a loan rather than seek foreclosure. Banks are (were) good at placing and managing loans, they are not good at selling real estate. The problem today is that individual borrowers don’t even know who truly “owns” their loan. Worse still, lenders don’t really know whose loans they own! Accordingly, the only option available for borrowers is foreclosure (which, incidentally, only accelerates the systemic spiral).

    In such a world, and for financial sector actors who are used to interpret the signal of default only as a signal of underlying borrower quality, default rate statistics would show that many more borrowers than expected were of a “bad” quality. This coupled with the complexity of the instruments and the lack of clarity on who owns what would make these instruments extremely hard to value. The important clarification is that it is at least possible that many of these borrowers are actually not inherently bad, they were *turned into* bad borrowers by the structural set up.

    In summary, I agree with you that a big problem was to not consider the real costs of lending (screening, monitoring, and expected losses) and to remove the banks one step further from their clients, thus limiting their capability to do proper screening and loan valuation. An additional mechanism, however, has to do with the ties that such a removal broke (or rather prevented from forming).

    Rodrigo Canales

    October 9, 2008 at 9:08 pm

  4. Thanks for the holiday wishes, Rodrigo. And thanks– my son’s fast went well; I think even better than his old man’s!

    Thanks also for the very insightful and important points about how borrower badness is not only endegenous to housing prices, but to the opaque structure that emerged. Seems right to me. And you know already that I agree with you about the critical importance of close lender-borrower relationships for making effective loan resturing work, both for borrower and lender. I believe I read something about that in a great paper by Canales!

    ezrazuckerman

    October 12, 2008 at 5:51 pm

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