Financial Institutions, Again
By Arnold Kling
Continuing this thread, which had some very interesting comments. The reason that this is important is that when this financial crisis is over, we want to know what might work to prevent another one. We know how to prevent another mortgage securities crisis, of course. But we do not know how the next bubble might emerge. If there are institutional reforms that would make the economy less vulnerable to speculative bubbles and bank runs, such reforms would be worth considering.
In some sense, Mencius Moldbug is asking “What would Mises think?” I think of myself as asking, “What would Fischer Black think?” Unfortunately, neither gentleman is alive to enlighten us.
UPDATE: for a view that runs counter to my own instincts, see John Steele Gordon. His bottom line:
the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.
It seems to me that European countries have banking systems with all these features, and they are even more fragile than ours.Let us think in terms of many different fruit trees. They could be different because one is pear, one is apple, etc., or they could be different because one is in Kentucky, one is in New Jersey, etc. The point is that they are different, their values change over time, and the changes in value are not perfectly correlated.
In a simple financial market, the only securities are equity interests in each fruit tree. Each period, the value of a share in any given fruit tree changes, based on new information. How well is the tree growing? What is the weather forecast in the tree’s location? What are supply and demand conditions like in the market for the tree’s fruit?
The challenge for this economy is to fund the investment in fruit trees. Some people have superior expertise in the fruit tree business, but they don’t have the resources to plant lots of trees. Other people have excess savings, but not much expertise. We need to get them together.
If the fruit experts issue equity shares, then the savers will not know a good investment from a bad one. I can pretend to be a fruit expert (or imagine that I am a fruit expert) and sell you worthless shares.
As a saver, you might prefer to have a debt instrument from a fruit entrepreneur, who retains the upside from the equity in the tree. This has two advantages for the saver. First, the entrepreneur’s willingness to issue debt in exchange for equity is a nice signal that the entrepreneur genuinely believes in her tree. Second, it reduces the impact of the saver’s lack of expertise on the saver’s outcome. The debtholder gets a fixed return for a variety of possible tree circumstances, so the debtholder can rely on a relatively crude assessment of the tree’s prospects.
To take another example, suppose you as an entrepreneur are going to buy an old house for $100 K, fix it up, and flip it. I as a saver don’t know how well you will do, but I am willing to supply $80 K of the funds to buy the house. I am better off taking an $80 K debt instrument and letting you hold all the equity for your $20 K. If the project works out badly, and you only sell the house for $95 K, that is your problem, not mine. You’re the one who needs to make a really sharp-penciled assessment of the possible outcomes of the project, not me.
Next, we can add intermediaries. One intermediary can give me shares in a diversified portfolio of equity shares in fruit trees. Another intermediary can invest in debt issued by fruit tree entrepreneurs and then offer me its own debt instruments.
Suppose that an intermediary acts like a bank. It offers me a deposit that I can withdraw at any time, but it invests in long-term debt from fruit tree entrepreneurs. The long-term debt emerges only to save transaction costs–it’s a pain re-evaluating the fruit tree each time you want to renew short-term debt. The bank is counting on (a) not all depositors wanting to withdraw at once and/or (b) being able to sell its assets (the fruit-tree loans) in a liquid market.
This banking institution tends to be really unstable. Do we want it, anyway? Is there a way to stabilize it if we do have it? Those are the questions that give me a headache.