As the topic of financial stability becomes increasingly important in the Australian political landscape I have increasingly found myself confronted by 2 indubitably populist arguments that claim to undermine the consensus in financial economics. The 2 claims that I have been confronted with go as follows:
- The crash of September 15, 2008 is a perfect counterexample to the efficient market hypothesis. Clearly, innovation creates an information asymmetry in finance since sellers can deceive buyers via the ‘complexification’ of products.
- Bailouts provide an implicit subsidy to institutions that desire to take on excessive risk.
First off, it is probably helpful to recognise that there is a vast amount of misinformation circulating with respect to TARP and the Federal Reserve’s emergency liquidity facilities. In many political circles I hear the claim that the response of the Fed in 2008 was an implicit subsidy to the financial sector at the expense of the taxpayer. This claim however, is dubious at best.
In fact, if one looks at the actual cash flows from the emergency loan facilities it is clear that the Fed has ostensibly profited off of the crisis. From October 2008 onwards Bernanke made it clear that the Fed would constrain credit support to illiquid institutions only, and would not fund insolvent corporations. I would also claim that the Treasury department’s TARP has delivered a substantial profit. Thus, the position that bailouts are everywhere and anywhere a phenomenon of corporatist greed is not tenable in my view.
Interestingly enough though, the conservatorship of Fannie Mae and Freddie Mac (prior to TARP), did indeed involve substantial transfers of losses from the private to the public sector. These losses on the whole could amount to over $300 billion if the worst forecasts are to be believed.
This opens the argument, is there an actual case for central bank and treasury intervention on behalf of insolvent institutions? On the surface, it appears difficult to justify such an action given that it would involve the creation of moral hazard to some extent.
But how does this moral hazard actually manifest? Moral hazard undoubtedly develops from the class of agents that are shielded from risk by public policy. In the vast majority of conservatorship arrangements these agents are the senior creditors. Equity holders and the managerial class classically get wiped out and as such, those who are directly insured are not those who are direct risk takers. Instead the implicit subsidy takes an ancillary form, where creditors will generally be inclined to lend to risky institutions at lower rates. The insensitivity of interest to risk thence creates a profit spread that is conducive to leverage and risky investments.
But notice the implicit assumptions here. In the real world it is not the sellers of derivatives that are insured, but rather a distant group of savers. To assume that these saver understand their government insurance policy we assume a kind of hyper-rationality. These creditors can not only perceive the levels of risk embedded in investment bank assets, but can also foresee the chance that the public will insure against any possible downside. Here, the level of moral hazard emanating from public policy is directly proportional to the informational efficiency of financial markets. In other words, a world in which the odd bailout can create huge moral hazard problems is also the world in which markets have high informational efficiency.
Hence, argument (1) is completely inconsistent with argument (2) unless one can make the claim that the makeup of CDOesque consumers is less sophisticated than the makeup of creditors. I am not going to come out in favour of any position on financial regulation here, but I encourage those who take issue with the whole paradigm of financial economics to reconsider their dogma.