Getting to the Source of Systemic Risk

Recent articles on the US and world economic crisis have often been focused on the concept of ‘systemic risk’. For example, Robert Pozen, author of Too Big to Save?, argues in The Wall Street Journal (7/9/09) that the Federal Reserve ought to be given the job of monitoring systemic risk. What this refers to is certain kinds of financial ‘products’ and practices that have often graced the headlines of late: credit default swaps, collateralized debt obligations, and other kinds of credit derivatives.

The idea that the financial crisis has been caused by exotic new financial instruments—from credit derivatives to adjustable rate mortgages—has become part of the conventional wisdom. But is it true?

No doubt there is always a tendency to find fault in new practices that seem to be responsible for disasters, such as humbling the titans of finance with billions of dollars of losses, charmingly called ‘write-downs’. But how does that lead to systemic risk? If a large corporation (financial or otherwise) loses billions or even hundreds of billions, how does that threaten the system as a whole? Well, corporations often owe money to other corporations, and perhaps if a large lender goes under, other firms are placed at risk. That does indeed sound bad. But how is it different from the usual course of events? Companies rise and fall. Taking risks can lead to success or failure. When an idea leads to a failure, that strategy tends to be repeated less than those that are successful. A failure, even a large one, poses no threat to the system. Failures are an integral part of the system. Even the largest corporations are subject to market forces. And thank goodness for that. Big corporations must be exquisitely sensitive to quality and reputation, or else they are at risk of losing market share and potential takeover.

In the same way that nature rewards certain kinds of risks and penalizes others—successful strategies lead to greater propagation of a species—an evolutionary market-based process is the best enforcer of risk. The Fed or any regulator will always be 10 steps behind. Even if the government regulator happens to be on time, what should the penalty be? Will such penalties be subject to political forces—such as those that determined that Lehman should fail while Bear Stearns or AIG is rescued?

The nature of markets is the equalization of risk and return. Risky activities ought to have high returns, while less risky activities yield lower returns. Financial markets are filled with risky products that are hundreds of years old. Short-selling (the practice of borrowing shares in order to buy them back later, hopefully at a lower price) exposes the seller to potentially unlimited risk. Out of-the-money options that are close to expiration are also extremely risky. But these options are priced accordingly, not by government regulators, but by the market.

Yet even when markets are functioning well, it’s true there is a systemic risk lurking. At any moment, banks could collapse, for their reserves are only a tiny fraction of their deposits. Any threat to the banking sector sets off a damaging spiral: bank failure leads to bank runs, leading to loss of faith in banks, leading to further contraction in lending and paralyzing the conduit that runs from savings to investment.

This is why economists Kotlikoff and Leamer argue for a new financial architecture, one that does away with this source of systemic risk once and for all, while channelling society’s savings into investment, and providing prices for financial assets that correctly equalize risk and return. (See “A Banking System We Can Trust”, Forbes, 4/23/09). Their brilliant proposal would essentially to do away with the fractional reserve system. Unfortunately, this proposal has received little attention or discussion in the US. I get the sense we’re sick of the topic here. We’d rather believe in the green shoots that are supposedly sprouting. They say ‘less bad’ is the new ‘good’. My guess is that as the rally fades and new risks to the system are revealed, there will be an surge of interest in reforming the fractional reserve banking system, the source of systemic risk to the economy.

Great New Proposal by Kotlikoff and Leamer

Professors Kotlikoff and Leamer offer a bold yet simple way to reform the banking sector in their article in Forbes entitled A Banking System We Can Trust.

This is the most important proposal I have yet seen in the mainstream press to reform the financial system. Unlike the other plans I've seen, it would actually work, for it would end the fractional reserve banking system, while preserving the function of banks, which is to serve as a conduit for savings to flow to investment. Kotlikoff and Leamer call it "Limited Purpose Banking".

Everyone who is concerned about the financial crisis should read this article. I hope that policymakers and my fellow economists take heed.

There is one further step I'd suggest to protect the financial stability of the banking sector: tie the value of the dollar to a commodity. In an earlier post, I outlined a plan to do this. A commodity basis is necessary for the dollar to serve its function in the long term, which is to provide a stable store of value to facilitate trade and investment. Because the Federal government seems to run on deficit spending, it has tended to escape the discipline that commodity money imposes. But an escape from that discipline is only found in inflating the money supply, which cannot work in the long term.

"No reputable economic forecaster is predicting a depression"

Says Edward Leamer, Director of the UCLA Anderson Forecast, on Marketplace. He sees no depression in the near future:

We've frightened consumers to the point where they imagine there is a good prospect of a Great Depression. That certainly is not the prospect. No reputable forecaster is producing anything like a Great Depression. So it's still OK if you spend a little bit. You do not have to put all your money into a mattress.

Dr. Leamer also sees the economy in a "healing cycle" by the second half of 2009, without "significant growth", but with fewer of the "large negatives" we've seen so far.

We shall see. I do not think that the errors and excesses of the boom years will be corrected by then. My guess is that the inflationary recession will continue for a period of years rather than quarters, particularly since government policy seems driven to prevent markets from reaching equilibrium, and the Fed is producing monumental amounts of new money, much of it secretively, off its balance sheet. Estimates of Fed off-balance sheet money creation are in the trillions of dollars.

Here are a few analyses of the magnitude of these Fed activities: ritholtz.com/blog, nowandfutures.com (this site also has a reconstruction of M3, the broad monetary aggregate that was discontinued by the Fed in 2006.)