Paul Krugman has given us a first stab at a leverage-constrained intermediary-driven model of financial contagion. Its point is well-taken, but in my view it misses a very large piece.
I won’t reproduce the math (all basic algebra), but will make the argument verbally: Krugman’s model captures the effect that a falling asset price has on intermediaries’ portfolio capacity for this asset, assuming a fixed capital requirement: the price goes down, so holdings have to decline too in response to diminished equity. This assumes that the extent of leverage is externally imposed, for instance by a responsible regulator.
As we know, however, such regulators have been in short supply. Rather, desired leverage can be viewed as endogenous, a function of perceived risk. A falling asset price can therefore generate a potential double-whammy: for any given degree of leverage it reduces holdings, and it can also increase perceived risk exposure, reducing desired leverage still more.
If this is correct, one potential irony in renewed regulatory vigor (such as demanding more prudent policies on the part of institutions the government acquires an equity stake in) is that it intensifies deleveraging and puts further downward pressure on assets. Such an effect would not arise in interventions that touched a small corner of the global financial system, like Sweden’s in the early 90s, but it would have to be taken into account in the emerging global rescue. This would be an argument for public banking, as I’ve advocated here before, since such a system could be scaled up to whatever level of finance is deemed necessary, rather than relying on private sector willingness to lend and take positions.
"This would be an argument for public banking, as I’ve advocated here before, since such a system could be scaled up to whatever level of finance is deemed necessary, rather than relying on private sector willingness to lend and take positions."
What might be the model for such public banking? Might staffing have political biases? The Fed was established to be independent with its expertise. But Greenspan made the Fed political to a great extent. So there would, in my mind, be great concern that public banking might go the way of the Fed. Then of course there is the matter of accountability, especially if the public bankers serve long terms. (Consider the political implications of renewed terms of such as Greenspan that just might have included political motives.) Is there a model of public banking in other nations that might give some clues as to whether such would work here?
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