## Liquidity, Default, Risk

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### Liquidity, Default, Risk

University of California at Berkeley and NBER

December 6, 2008

Larry White is the Best of the Austrians—the most persuasive, the most thoughtful, and the most knowledgeable of the economists working in the Austrian monetary theory tradition, which is an essential part of our collective diversified intellectual portfolio in our age in which economic theory is so underdeveloped that, as John Maynard Keynes wrote in an earlier and somewhat similar episode, “[w]e lack more than usual a coherent scheme…. All the political parties alike have their origins in past ideas and not in new ideas…. It is not necessary to debate the subtleties of what justifies a man in promoting his gospel by force; for no one has a gospel…”

Nevertheless, I think that what Larry White has written misses the big point about what really has happened. So let me try to lay out what the situation looks like to me:

Think of it this way: two years ago we lived in a world in which the wealth of global owners of capital was some $80 trillion—that was the market value of all of their property rights to dividends and contract rights to interest, rent, royalties, options, and bonuses. Now over time the wealth of global capital fluctuates, and it fluctuates for five reasons: 1. Savings and Investment: Savings that are transformed to the investment add to the productive physical—and organizational, and technological, and intellectual—capital stock of the world. This is the first and in the long run the most important source of fluctuations—in this case, growth—in global capital wealth. 2. News: Good and bad news about resource constraints, technological opportunities, and political arrangements raise or lower expectations of the cash that is going to flow to those with property and contract rights to the fruits of capital in the future. Such news drives changes in expectations that are a second source of fluctuations in global capital wealth. 3. Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer—to varying degrees at different times—the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are a third source of fluctuations in global capital wealth. 4. Default Discount: Not all the deeds and contracts will turn out to be worth what they promise or indeed even the paper that they are written on. Fluctuations in the degree to which future payments will fall short of present commitments are yet a fourth source of fluctuations in global capital wealth. 5. Risk Discount: Even holding constant the expected value and the date at which the cash will arrive, people prefer certainty to uncertainty. A risky cash flow with both upside and downside is worth less than a certain one by an amount that depends on global risk tolerance. Fluctuations in global risk tolerance are the fifth and final source of fluctuations in global capital wealth. In the past two years the wealth that is the global capital stock has fallen in value from$80 trillion to $60 trillion. Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5). As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by$2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount—bond coupons that won’t be paid and stock dividends that won’t live up to firm promises—by a further $4 trillion. So we have a$6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values. The problem is made bigger by the fact that for (4), the Federal Reserve, the European Central Bank, and the Bank of England have flooded the market with massive amounts of high-quality liquid claims on governments’ treasuries, and so have reduced the liquidity discount—not increased it—by an amount that I estimate to be roughly$3 trillion. Thus (3) and (4) together can only account for a $3 trillion decrease in market value. The rest of that decline in the value of global capital—all$17 trillion of it—thus comes by arithmetic from (5): a rise in the risk discount. There has been an increase in the perceived riskiness (not a fall in the expected value, an increase in the spread holding the expected value constant) of income from capital. And there has been a massive crash in the risk tolerance of the globe’s investors.

Thus we have an impulse—a $2 trillion increase in the default discount from the problems in the mortgage market—but the thing deserving attention is the extraordinary financial accelerator that amplified$2 trillion in actual on-the-ground losses in terms of mortgage payments that will not be made into an extra $17 trillion of lost value because global investors now want to hold less risky portfolios than they wanted two years ago. From my standpoint, the puzzle is multiplied by the fact that we economists have what we regard as pretty good theories about (4) and (5), and yet those theories do not seem to work at all. As far as the liquidity discount (4) is concerned as long as we love our children as ourselves (and most of us do) and as long as we have access to and can credibly pledge collateral for financial transactions (and we can) the magnitude of the liquidity discount should be roughly equal to the technologically- and organizationally-driven rate of labor productivity growth divided by the intertemporal elasticity of substitution. The technologically- and organizationally-driven rate of labor productivity growth is a fairly steady 2 percent per year. The intertemporal elasticity of substitution is in the range from 1/2 to 1. The liquidity premium should be in the range of 2% to 4% per year in real terms—and no central bank should be able to drop it to –2% per year by a few open-market operations: big moves in the liquidity premium should require big moves in expected future growth rates of consumption. Perhaps in the old days—back when banknotes and demand deposits backed fractionally by gold or central-bank reserves were the only liquid stores of value, the only means of payment, the only mediums of exchange, or the even older days when the king’s picture on a disc of gold was it and when the torturers of the Mint and the Tower were standing by—things were different and credit expansion via the use of the seignorage power could have greater effects. But today the ability of central banks to swing the liquidity discount as they have in the past year and a half is a mystery. Things are even worse as far as the risk discount is concerned. In normal times, our models predict, with the ability to diversify portfolios that exists today the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times—it is more like 10% per year today. And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a$2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.

Thus my dissatisfaction with Larry White’s piece: he talks only about the impulse, while it is the propagation mechanism—the financial accelerator—that is the important part of the story. $2 trillion shocks to global wealth do, after all, happen every several years, everytime there is a recession or a big rise in the prices of natural resources. But financial distress of the magnitude we see today happens once a century. Since the Bank of England developed its lender of last resort doctrine in the 1830s, we have only had two episodes this bad: the Great Depression and today. Moreover, I do not think that Larry White has gotten the part of the story that he does cover right. I am not convinced of his account of the origins of the trouble in the housing finance market. Larry White blames government subsidies: the implicit government guarantee offered to FNMA and FHLMC, the explicit guarantee to the FHA, the requirements of the CRA, and the subsidy to borrowers provided by the Federal Reserve’s credit expansion—i.e., its open-market operations that bought Treasury bills for cash. From the start of 2002 to the start of 2006 the Federal Reserve bought$200 billion in Treasury bills for cash. This $200 billion reduction in ourstanding bonds and increase in cash surely did lead to an increase in demand for private bonds. but recall the magnitudes here. We have$2 trillion of losses on $8 trillion in face value of mortgages that ex post should not have been made. Are we supposed to believe that$200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately-unprofitable loans? Not likely. I can see how monetary contraction can make previously profitable loans unprofitable. But I see no way that this amount of monetary expansion can force private agents to make that amount of unprofitable loans. The magnitudes just do not match. The requirements of the CRA also appear to me to be a red herring. Larry White writes that those who blame the crisis on greed are wrong because “greed… is always around” and you cannot explain a variable result by a constant cause “just as one can’t explain a cluster of airplane crashes by citing gravity.” I say that the same is true of the CRA. It has been around in more-or-less its current form for a generation. FHA and FNMA and FHLMC make up the last of the actors to whom Larry White attributes the impulse—the$8 trillion in unwise mortgage loans made over the past five years. Once again the problem is that they have been around for a while. White tried to deal with this by saying that the GSEs changed their policies by cutting severely on down payment requirements—and that the private-sector mortgage lenders had no choice but to match them.

This claim provokes two immediate reactions. First, as your mother says: "If Freddie jumps off a cliff is that a good reason for you to follow him?" The answer to your mother's question is: "No." Just because GSEs are leading the market in making stupid money-losing loans did not force private financial companies to follow them and so lose their money too.

Second, Freddie and Fannie and FHA were not the first to jump off the cliff. They lost huge amounts of market share in the mid 2000s. We don't have a crisis which started when private mortgage lenders losing market share cut back on the quality of the loans they were willing to make. We have a crisis which started when private mortgage lenders cut back on the quality of the loans they were willing to make and so gained market share. The sequence is the opposite of what would have happened if White were correct.

Moreover, if ill-judged loans by the GSEs were the problem, we would expect to see a crisis in which FNMA and FHLMC failed first—which they did not, their troubles coming back in the line well after the Countrywides and the Bears Stern. And we would expect the failure of FNMA and FHLMC to take the form of them leaking cash as the number of mortgage payments they received crashed with defaults and consequent foreclosures. Instead Fannie and Freddie are still cash-flow positive—as long as they can borrow at nearly the Treasury rate. Fannie and Freddie crashed not because their revenues collapsed but because their borrowing costs ballooned. At it looks right now as though government ownership of 80 percent of Fannie and Freddie will bring money into the Treasury over the next five years.

So why does Larry White’s diagnosis of what is going on differ so much from mine? I think that what is going on is a characteristic weakness of the Austrian tradition: the baseline assumption that all evils must have their origin in some form of government misregulation. If government could be drowned in the bathtub, then an Eden in which people indulged in their natural propensity to truck, barter, and exchange would emerge. And this automatically rules out what I regard as the most likely and fruitful road to walk down to understand this financial crisis: the road that starts from investigating how human psychological limits lead to bad private-sector contract design that then magnifies psychological biases.

I am not happy with the state of such explanations—they seem to involve, at the moment, a great deal of handwaving. But in my judgment it is less handwaving than required to make the case that our current financial crisis is the result of our abandonment of a proper gold standard and our embrace of fractional-reserve banking and government-sponsored mortgage lending enterprises.

References

Lawrence White (2008), “What Really Happened?” Cato Unbound (December 2) http://www.cato-unbound.org/2008/12/02/lawrence-h-white/what-really-happened/