Monday, October 06, 2008

E ainda mais outro...

Nick Rowe provides us with some talking points on how we all got into this mess:


Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis. No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed.

Politics: The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong. The housing bubble is global; the financial crisis is global. Russia has a financial crisis, but the Republicans do not regulate Russian financial markets. England had a housing bubble, but does not have a CRA. The US bubble burst first, but other countries are following closely. Canadians watch too much US news. This is a global phenomenon, and needs a global explanation.


So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high. And world savings were high because the world’s population is getting older, and when people get older they save more for their retirement (note China). And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too. (...). Which made it easier for bubbles to form, in many countries.

So why did bursting bubbles cause a global financial crisis? Why are financial markets so fragile? Because financial markets try to do the impossible. Ultimate savers/lenders want financial assets to be Short, Safe, and Simple. Ultimate investors/borrowers have projects which are Long, Risky, and Complex. Financial markets and financial institutions try to give both sides what they want. In normal times the magic works. Without that magic, people would only save gold or canned food, and there would be no investment, and we would still be in the Stone Age. But the price of that magic is an inherent instability. Each individual can liquidate his savings at any time, but we can’t all liquidate at once. Beliefs become self-fulfilling, and we can also get a second, bad equilibrium, with a bank run or stock market crash. Most people can hold safe assets, if uncorrelated risks are pooled, but some people must always hold the remaining, correlated risks. And if those people go bankrupt, the safe assets too become risky. Many people can hold simple assets, provided some other people do the complicated research. But if their research turns out to be wrong, the simple assets become complicated too.

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