Wednesday, December 10, 2008

The Capital Crunch: What Happened, and Why

A very interesting macro-economics summary from Brad DeLong, econ prof at UC-Berkley, responding to another Cato essay blaming the GSE's, CRA, (etc).

...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; 2) News; 3) Default Discount; 4) Liquidity Discount; 5) Risk Discount.

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 little or no bad news about resource constraints, technological opportunities, or political arrangements.

That's a 25% deflation--large by any definition.

Pertaining to "default discount":

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...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

Which accounts for $6 trillion...

...The problem is made bigger by the fact that for [the liquidity discount], 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 a massive crash in the risk tolerance of the globe’s investors.

OK?

Well, not so OK.

...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. ...Things are even worse as far as the risk discount is concerned. Our models predict that in normal times, 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 — and 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 but that has led to ten times the total losses in financial wealth of the impulse

To cut to the chase:

...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

I only wish that Prof. DeLong had invoked the operative actuality: Original Sin. Profit is not evil, nor is regulation. But the abuse of either (or both) will have bad consequences.

And the direct cause of abuse is sin.

HT: Just One Minute

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