When the Economics of Ignorance Cannot Model Politics

Moreover, when there is a serious enough shortage of collateral, the government will find it optimal to alleviate the situation by supplying collateral that is backed up by taxpayer money. This is more efficient than having the private sector invest in safe assets to cover exceptional severe shortages. The advantage of the government is that it can act ex post, when it is clear that such a shortage is at hand. No funds are tied up in advance....(22)

By now, the methods out of a crisis appear relatively well understood. Government funds need to be committed in force (Geithner (2014)). Recapitalisation [of banks] is the only sensible way out of a crisis. But it is much less clear how the banking system, and especially shadow banking, should be regulated to reduce the chance of crisis in the first place. The evidence from the past panic suggests that greater transparency may not be that helpful....Relying on market discipline and price discovery is unlikely to be effective in money markets generally. Letting the successful pricing of systemic risk in stock markets be a guide for money markets seems misguided. Bengt Holmstrom (2015) Understanding the role of debt in the financial system. (24)

There are five important points in these passages  just quoted; two are  (forgive my pun) transparent in the text and connected, the three others less so. Holmstrom is a recent Nobel laureate and Paul A. Samuelson Professor of Economics at MIT. The paper I quote from is very accessible -- surprisingly so given that he talking to professional bankers not the general public [his modeling and data are submerged in the footnoted papers] -- and does a nice job conveying the conceptual and policy relevant insights from what is otherwise rather technical and demanding modeling (as well as non-trivial data-driven inquiry). His writing is useful both to learn from and as a sociological proxy to find out and reflect on what the professional, technical economics elite thinks when they are talking in a policy-relevant environment (Bank of International Settlements is the place where central banks work together on standards and rules).

The core insight of the paper is that one should not model how to understand collateralized debt (which is information insensitive) -- and exists in order to provide liquidity and find a home for surplus savings -- on how one understands equity (which is information sensitive and pools risk)--in equity markets prize discovery is central; in debt markets providing  liquidity is. When one recognizes this, one can make sense, so Holmstrom argues, of non trivial differences between equity and debt markets (especially the shadow banking system) both in good times and during/after panics. (One very interesting consequence of the core insight is that debt becomes preferred collateral of debt leading to a kind of unstable, open-ended system of musical chairs.) Let me stipulate, for the sake of argument, that Holmstrom is right about this (I really find it fascinating, although it is notable that in his model equity markets are siblings of insurance markets--about that some other time).* Okay, let me now get to the five important points.

First, one consequence that Holmstrom hammers home is that attempts to make debt/money market instruments transparent reflects "a serious misunderstanding of the logic of debt and the operation of money markets" (2). If the collateral is generous enough you don't worry about repayment; if you don't have to worry about repayment you don't have to worry about the details of the collateral; (etc.) If you start making information readily available, you turn debt into equity because you start to have regular occasions to wonder about repayment and collateral, and you will start to make fine-grained distinctions among different debt repayment capacities and collateral values. So, you turn a low monitor, low volatile instrument into its opposite. Greater transparency may facilitate monitoring in good times, but it makes matters a lot worse in bad times (so his argument goes); and monitoring is expensive. (To be precise in times of panic he allows some transparency, but in ordinary times debt markets thrive on opacity.) So, Holmstrom deviates from the (liberal) consensus that more market transparency is desirable and efficient. He (and his co-authors) understand debt as a regime which involve "symmetrical ignorance," (see "Ignorance, Debt and Financial Crises.") This is an insight worth returning to in the future.

Second, he defends tax-funded bailouts. They are more "efficient" than trying to prepare to prevent panics. He also thinks that private firms are not capable of being the proper backstop. It is notable, however, that (i) silent about situations where the government lacks control over its own currency or (ii) finds itself confronted with seriously unwilling tax-payers. Because many governments are not in control over their own currency, the prescriptive force of his remarks is limited to a small number of policy environments. (He is also strikingly silent about bail-outs by supranational institutions [as several of my students noted].)

Third, he does not model the policy side. He simply assumes that (a) policy can ensure that collateral is ultimately "taxpayer backed." In addition, (b) he does not model the distributional effects of his policy prescriptions. Basically he seems to think that the benefits of keeping the system around seem to swamp whatever distributional side-effects. But, of course, electorates and politicians are less sanguine about this.+ (He is also uninterested in the moral evaluation of this, but that's less remarkable.) Basically if politicians were to appear to follow his advice they would probably not get re-elected.

Fourth, it is extremely notable that Holmstrom is modeling capital markets as they are, and have been, but that he does not really explore alternatives to the status quo. (He is very good at rejecting bad models of  the status quo, but he does not allow alternatives to the status quo.) Perhaps such status quo bias is to be expected when you are engaged to talk to Bank of International Settlements (is this an incentive free environment?), but it is odd to be making general efficiency claims about an institutional regime without having done comparative institutional analysis (and when the down-side risks onto those not at the table are not being modeled at all). More important. I am also a bit mystified what the evidence for the efficiency claim is supposed to be even within the status quo--the welfare loss of the financial crisis are still unfolding so, it's a bit odd to take the question as settled. (No source or data are cited, no back of the envelope model provided.)++

Finally, Holmstrom is pretty explicit that panics can't be eliminated. (As he says in the more technical paper, "A financial crisis is a manifestation of the “tail risk” that is endogenously created by agents in the economy in order to trade."(37) Although there is some ambiguity if a financial crisis is inevitable.) At one point he remarks that "Everything that adds to liquidity in good times pushes risk into the tail." It follows that if you can keep adding liquidity (at an even slow pace), you can try to keep pushing the probabilities of undoing of the system into the tail. (He never explains why you can't add liquidity indefinitely, but it's clear that he thinks that even low probability events will occur eventually.) What's striking about Holmstrom's point is that his argument here is not in terms of mechanism of debt markets, but entirely based on the nature of probability distributions. For Holmstrom uncertainty is a psychological state of investors/creditors; but it's not a feature of his model--that reality is composed of probability distributions in which there is no place for true uncertainty, even though the [onset of a] "crisis is a bad enough shock to cause information-insensitive debt to become information sensitive."** Here 'shock' stands for (exogenous) 'bad news.'  One other policy implication follows from his paper: some species of censorship would be good for debt markets.

 

*It is by no means obvious on Holmstrom's account why equity markets are still around; one wonders if he assumes that it has become a means to pay wages to firm insiders.

+One could imagine modeling regimes in which those that benefit most from the status quo are asked to contribute more of the share of the taxpayer money. One wonders if that impacts the efficiency claim.

++In this paragraph I am relying on my analytical egalitarian commitments.

**I thank my seminar students for helpful discussion.

Comments

[John Quiggin]

I am especially struck by Point 4, given that the current system is only a few dcades old and has performed poorly for most of that time.

[Eric Schliesser]

Yes, it is really quite amazing. But in fairness to Holmstrom, he thinks symmetrical ignorance and information insensitivity characterize debt since ancient times.

[Dan Davies]

Yes, the current system didn't replace one which was *more* transparent, or one in which market discipline worked.