Finance is Weird
By Arnold Kling
James Kwak of Baseline Scenario wrote,
The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis…
without any fundamental changes, the markets decided that AIG might be at risk, and the fear became self-fulfilling. As with Lehman, the Fed chose not to protect creditors; because the $85 billion loan was senior to existing creditors, senior debt was left trading at a 40% loss…
This decisive change in policy reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. In any case, though, the implications for creditors and bond investors were clear: RUN from all entities that might fail, even if they appear solvent. As in the emerging markets crisis of a decade ago, anyone who needed access to the credit markets to survive might lose access at any time.
The implication is that there is a public policy imperative to stop runs on nonbank institutions that is as strong as the need to stop runs on banks. Is that true?
My Instinct is to say no. In some sense, every firm in the world is a financial intermediary. It has obligations and revenues. How does one draw the line between a firm that is too ___ to fail and one that is not? Is the blank “big” or “interconnected” or “financial” or what?
I think this is one of the biggest questions of the financial crisis.
Here’s a silly idea: use macroeconomic theory to answer the question. It’s not obvious to me how to do so, but perhaps I’m missing something. But in future lectures in macro, I will attempt to tackle this question. I am reasonably happy about how my lectures on the labor market issues in macro turned out. I am not so confident that the financial market issues will come out as neatly.