My first column argued that the global financial crisis is really a run on all explicit and implicit forms of insurance, which is showing up as a freezing of credit markets at all but the shortest maturity.
In this column I discuss the consequences of this and what to do about it. Specifically, I argue that an efficient solution involves the government taking over the role of the insurance markets ravaged by Knightian uncertainty.
A modern economy without financial insurance
An economy with no financial insurance operates very differently from the standard modern economies we are accustomed to in the developed world.
- there is limited uncollateralised or long-term credit (since such loans always have an insurance built in through the possibility of default),
- the risk premium sky-rockets,
- economic agents hoard massive amount of resources for self-insurance and real investment purposes.
During the last quarter of 2008, we witnessed the beginning of a transition from an economy with insurance to one without it. Ivashina and Scharfstein (2009) document that even healthy corporations began to draw down on their credit lines with otherwise solid banks, as they doubted their ability to do so at a later date.
In this environment, financially constrained agents obviously cannot go about their businesses with the flexibility they once enjoyed. However, the real hope for a recovery, as well as the concern for a meltdown, lies on the other side of the spectrum, on the unconstrained agents.
Mountains of investment-ready cash frozen by fear of the unknown
At this juncture of the crisis, there are mountains of investment-ready cash waiting for some indication that the time to enter the market has arrived. But investors are frozen staring at each other, and by so doing, they are further dragging the economy downward. The normal speculative forces that trigger a recovery are for everybody to want to arrive first, to “make a killing.” But with so much fear around us, investors have changed the paradigm and they are now content with letting somebody else try his or her luck first, so we are stuck.
Other cash-rich investors see great investment opportunities in the not-so-distant future, but, in the meantime, they do not unlock their resources for fear that the temporary investments may turn illiquid, a process which in itself contributes to widespread illiquidity, or because the lack of competition brought about by crisis almost ensures a better deal in the future. And yet others go one step further in profiting from illiquidity and panic itself – by shorting run-prone financial institutions, they close the circle of fear that fuels the runs.
We need to reverse this mechanism by restoring the appetite for arriving first.
Bringing the recession back to familiar turf
I do not mean to say that this recession is an imaginary one. On the contrary, I believe it is a very serious recession. My point is simply that good policy has an opportunity to bring the recession back to familiar turf, and when this happens, the recession will become a manageable one from which current asset prices, on average, will look like once-in-a-lifetime deals.
The silver lining to this diagnostic is that the core policy prescription becomes evident.
Facts framing the correct policy response
My sense is that, to a first order of approximation, the correct policy response should build on the following three observations:
- Many of the ex ante “imbalances” are more structural in nature than is implied in the consensus view, and hence will remain with us long after the crisis is over.
They stem from a global excess demand for financial assets and, especially, for AAA financial assets.
- The main policy mistakes took place during rather than prior to the crisis. The core aspect of the crisis is a collapse in all forms of (explicit and implicit) financial insurance due to a sharp rise in (Knightian) uncertainty. The policy response has been too slow in addressing this core issue. Until very recently, the Treasury’s response often exacerbated rather than reduced perceived uncertainty. The failure to prevent Lehman’s demise represents the worst of this dubious and ad hoc policy approach, but the “exemplary punishment” (of shareholders) policy during the Bear Stearns collapse also failed to recognise its uncertainty impact.
- Contrary to what investors thought at the peak of the boom, the (private) financial sector in the US is not able to satisfy the global demand for AAA assets when large negative aggregate events take place. The US government does, however, have the capacity to fill this gap, especially because it is the recipient of flight-to-quality capital.
These observations hint at a policy framework for the current crisis and for the medium run.
Medium-run and firefighting policy responses
As long as the government becomes the explicit insurer for generalised panic-risk, we can in the medium run go back to a world not too different from the one we had before the crisis (aside from real estate prices and the construction sector). That is, monolines and other financial institutions can leverage their capital for the purpose of insuring microeconomic risk and moderate aggregate shocks. They cannot, however, be the ones absorbing extreme, panic-driven, aggregate shocks.
This must be acknowledged in advance, and paid for by the insured institutions. Reasonable concerns about transparency, complexity, and incentives can be built into the insurance premia. Collective deleveraging, as currently being done, should not constitute the core response; macroeconomic insurance should.
Government generalised-panic risk instead of deleveraging
The structural policy framework for the medium run also carries over to the crisis-policy itself, i.e. the “firefighting policy”. The essence of a solid recovery should build not from deleveraging and a forced and brutal contraction of the financial sector. Rather it should be built on the explicit and systemic provision of insurance against further negative aggregate shocks to the financial sector’s balance sheet that might be caused by panic or predatory actions.
The recent government intervention with respect to Citi – with its mixture of (paid) insurance and capital – is a promising precedent. So too was the second government package for AIG.
These interventions need to be scaled up to the whole financial system (banks and beyond), and it is better to do it all at once, for in this case the likelihood of the government ever having to disburse funds for its insurance provision becomes remote.
The government must immediately replace the main insurance markets ravaged by uncertainty. The good news is that, unlike the situation in most other economies in the world, the US, as a whole, is perceived as a safe haven and hence rather than triggering capital outflows, its financial crisis has done the opposite. The main implication of this safe-haven status is that the cost of funding massive policy interventions is very low.
In formulating the list of insurance markets to be supported, it is important to look beyond the obvious. Surely one of the first worrisome symptoms during the crisis was a contraction in all forms of non-overnight uncollateralised lending among highly reputable financial institutions. Later on we saw the corporate sector losing trust in these financial institutions and hence drawing on their credit lines, by which they shifted from insurance arrangements to a much more inefficient (from a systemic point of view) form of self-insurance.
The housing stock’s insurance function
Yet another, perhaps more subtle, insurance collapse came from the housing market crash itself, as households lost the buffer offered by Home Equity Lines of Credit (HELCs) against any shock they may face. This loss of insurance became all the more significant after Lehman’s demise, when the collapse in equity markets erased another buffer and overall economic uncertainty spiked. The sharp rise in margin requirements has played a similar role for leveraged investors.
Trimming tail-risk is more efficient than bank capital injections
In all these contexts, trimming the (lower) tail-risk offers the biggest bang-for-the-buck. In this sense, capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, certainly much more than the current TARP. The reason is that Knightian uncertainty generates a sort of double-(or more)-counting problem, where scarce capital is wasted insuring against impossible events (Caballero and Krishnamurthy 2008b).
A simple example can reinforce this point. Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays one dollar to agent A, and the opposite happens in state Y. Thus, only one dollar is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only one dollar is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than one dollar. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.
Of course real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.
But there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.
The Knightian uncertainty perspective and asset-purchase programmes
The Knightian uncertainty perspective also sheds light on some of the virtues of the asset-purchase program of the original TARP. In practice, financial institutions face a constraint such that value-at-risk must be less than some multiple of equity. In normal times, this structure speaks to the power of equity injections, since these are “multiplied” many times when relaxing the value-at-risk constraint. In contrast, buying assets reduces value-at-risk by reducing risk directly, which typically does not involve a multiplier. However, when uncertainty is rampant, some illiquid and complex assets, such as CDOs and CDO-squared, can reverse this calculation. In such cases, removing the uncertainty-creating assets from the balance sheet of the financial institution reduces risk by multiples, and frees capital more effectively than directly injecting equity capital.
Does this mean that there is no role for capital injections? Certainly not. Knightian uncertainty is not the only problem in financial markets, and capital injections are needed for conventional reasons as well. The point is simply that these injections need to be supplemented by insurance contracts, unless the government is willing to increase the TARP by an order of magnitude (i.e. measure it in trillions).
Before concluding, I wish to clarify that I am not arguing that the world was perfect before the crisis and that the aspects mentioned in the consensus view should be ignored.
Of course, we should continue to work to produce the right regulatory environment where the silver lining of crises is that problems become more apparent. But we should also acknowledge that this is a dynamic process which is likely to lead to new and different problems in the future, and therefore it is never ending. Instead, the questions that have concerned me here are twofold. Given this constant flow of microeconomic incentive problems, what is the role played by the global macroeconomic environment in causing fragility? And, how can we deal with it without “throwing out the baby with the bath water”?
In a nutshell, I have argued that, by now, fear has distorted the price of risk and its insurance to an extreme. In this context, it makes little sense to apply the ordinary recipe of restructuring and liquidation that works during normal times. The main role of the government should be to provide insurance against systemic events at non-Knightian prices. This recipe applies as much during as after the crisis.
US crisis as an emerging-market-like crisis
Paradoxically, the weakness that has plagued emerging market economies for decades has now stricken the financial systems of developed economies and that of the US in particular. The weakness is the sudden loss of investors’ confidence which has ravaged credit markets and the stability of previously sound financial institutions. The conventional advice to emerging markets has been to accumulate international reserves and reduce short term liabilities. Consistently, the message now for financial institutions in developed economies is to accumulate capital and deleverage. I have, over the years, repeatedly argued that this policy prescription for emerging markets is a highly inefficient mechanism to solve their external vulnerability problem. For similar reasons, I view the capital accumulation and deleveraging mechanism as a highly inefficient solution to the financial vulnerability problem behind the current crisis.
Essentially, the US (and other) financial markets are experiencing the modern version of a systemic run as we had not seen since the Great Depression. It used to be that depositors ran from banks. Some of this still happens, but runs in modern financial markets, to be systemic, have to involve a larger class of assets. A run against explicit and implicit financial insurance is essentially a run against virtually all private sector financial transactions but for those with the shortest maturities. Thus, the modern lender-of-last resort facility has to be a provider of broad insurance, not just deposit insurance. This is what it will take to get us back into a reasonable equilibrium where we can initiate a recovery from a (more) “normal” recession.
On the day before I gave these remarks in New York City, the UK began the day well by announcing a mega-insurance policy for its financial markets. The good news was turned into yet another run on banks’ equity once it became apparent that the spectre of shareholders dilution is still present.
While it is reasonable for the government to protect taxpayers, it is unreasonable for it to inject equity into banks at fire-sale prices, as this is the equivalent of (or the other side of) selling insurance at Knightian prices. The logic of my argument above suggests that if public injections of equity are to happen, these should not take place at fire-sale/Knightian prices but at some reasonable long-run price. Convertible debt aid that is converted at fire-sale prices has a payoff structure which is just the opposite of the put option payoff that is needed from this aid, and hence it is likely to exacerbate rather than dampen the problem.
Normalcy is Just a Few Bold Policy Steps Away
Ricardo J. Caballero
December 17, 2008
Moral Hazard Misconception
Financial Times, 16 July 2008
The Future of the IMF
Ricardo J. Caballero
May 2003, American Economic Review, Papers and Proceedings, 93(2), 31-38.
Bubbles and Capital Flow Volatility: Causes and Risk Management
Ricardo J. Caballero and Arvind Krishnamurthy
January 2006, Journal Monetary of Economics, 53(1), pp. 35-53.
Government’s role as credit insurer of last resort and how it can be fulfilled, by Perry Mehrling and Alistair Milne, October 2008