Notes on McArdle's Law
By Arnold Kling
The theory that in a financial panic people demand too much risk protection is one possible explanation of what I like to call McArdle’s Law, namely “Money is weird. Finance is weird.”
In contrast, I quoted Hall and Woodward to the effect that mortgage securitization does not create supply chain problems that are any different from the supply chain problems faced by Toyota. Thus, they deny the validity of McArdle’s Law.
This is an issue worth discussing at length.One (minor) difference between Freddie Mac and Toyota is that Toyota’s suppliers can’t run and hide. If you manufacture paint or steel or electrical components, you have a fixed address and a lot of capital invested, so that if you fail to perform Toyota can hurt you. If you’re a fly-by-night mortgage broker, you can dump a lot of bad loans into the system, take your profits, and by the time the loans default you could be in Tahiti.
Freddie Mac can manage the problem, but I think it’s more costly to manage a supply chain where the bottom layer is a bunch of small mortgage brokers than to manage a manufacturing supply chain. If Toyota’s paint supplier in turn is supplied by a firm that messes things up, presumably the problem with the paint will be pretty obvious to Toyota right away. If Countrywide Funding starts delivering loans to Freddie Mac from sleazebag mortgage brokers, it could be a year or more before Freddie Mac figures out that they have a problem. The process of identifying a sleazebag and fixing the problem can be quite expensive relative to the volume of loans involved. In the Coaseian model of the firm, I think that the case for vertical integration may be stronger with mortgage origination than it is with automobile manufacturing.
More importantly, with manufacturing, when the supplier delivers a component you can tell right then and there whether the component meets specifications. Once you accept delivery, you have no further need to require that your supplier have capital or put up collateral. If the seller goes out of business, you may lose a valued supplier, but the stuff you bought can still be used to make your widgets.
With financial contracts, such as bank deposits, mortgages, bonds, bond insurance, or swaps, you care about the other party’s long term ability to meet its obligations. When you buy a bond, you can’t inspect it, find that it meets specs, and say, “Phew! Now I don’t care whether the company I bought it from goes down the tubes. ” Quite the contrary.
What I am suggesting is that there is a fundamental difference between finance and manufacturing in terms of the role played by trust. In manufacturing, the length of time that a purchaser is exposed to risk from nonperformance by a supplier is relatively short. (When the length of time is longer than a few months, we often see warranties or performance bonds. For example, if company A relies on proprietary software from company B, company A may require that company B provide a copy of its source code in escrow, so that if company B goes bankrupt company A can take over the maintenance.)
With finance, trust is fundamental. Trust is based largely on financial practices that evolve over time. However, there is also a psychological component. When psychology changes, risk premiums change. Hence, McArdle’s Law.