MONDAY, SEPTEMBER 17, 2012
Eugene Linden: In a World of Underpriced Risk, What Could Possibly Go Wrong?
Yves here. While I anticipate readers will enjoy Eugene Linden’s post, I do have a couple of quibbles. Linden comments in passing that the action of the Fed is understandable, if regrettable, given the options. I don’t believe in letting the officialdom off that easy. Japan warned the US early in the crisis not to repeat what was its biggest mistake: coddling the banks rather than forcing them to take losses. An IMF study of 124 banking crises concluded that regulatory forbearance, the term of art for letting impaired banks soldier on, found:
The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred…
And we’ve discussed long form that Obama blew the opportunity to get tough with financial services firms at the beginning of his term and instead threw his lot in with them.
In addition, it isn’t “profligate” to deficit spend when both the business sector and the household sector are net saving. But that raises the question of why more isn’t being done to get capitalists to act like capitalists. Andrew Haldane and Richard Davies have demonstrated that corporations are seeking overly high returns on investment, which leads to widespread underinvestment and also argues for a greater role for government investment given private sector mispricing. Thus the central bank efforts to force investors out the risk curve is partly in response to persistent corporate short-termism and unduly high return targets. But as the saying “you can bring a horse to water but you can’t make it drink” warns us, central bank efforts to lower risk pricing is not guaranteed to produce the behavior they want. Recent history has shown its impact on financial assets is much greater than on the real economy.
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