The essence of the de-leveraging crisis
Tony Curzon Price
October 7th 2008
Paul Krugman has a simple model of the crisis that is a pretty useful tool to think about what is happening and what should be done immediately. It is not a model of why we got here, but a diagnostic tool for short term action.
First, Krugman's conclusions from the model are a) that taxpayers becoming shareholders in banks is a good next move and b) that international coordination of rescue plans is particularly important. Quoting him directly:
First, it suggests that the core problem is capital, not liquidity - or at least that you can explain much of what's going on without appealing to a breakdown of buying and selling per se. To the extent that this is true, rescue plans centered on making troubled assets liquid, like the Paulson plan passed last week, won't do the trick. Instead, what's needed is an injection of capital, which can't reverse the original shock, but can undo the financial multiplier effect of that shock.
Second, the international implications: to the extent that we regard falling asset prices and their consequences as a bad thing, which we obviously do right now, this analysis suggests that there are large cross-border externalities in financial rescues. Macroeconomic policy coordination never got much traction, largely because economists never could make the case that it was terribly important. Financial policy coordination, however, looks on the face of it much more important. Capital injections by U.S. fiscal authorities would help alleviate the European financial crisis, capital injections by European fiscal authorities help alleviate the U.S. financial crisis. Multilateral Man, come home - we need you!
On the specifics of how to re-capitalise the banks, I have to agree 100% with the basic framework proposed by Willem Buiter.
The model makes it clear why we might want to re-capitalise the banks rather than allow the de-leveraging to run its course. Ordinary savers are quite right to be wanting to reduce their holdings of risky assets--they have understood that the investments they held were much less good quality than they previously thought. The price of houses, art works and all the bubble assets must still fall a great deal. But this adjustment, which is just a welcome return to reality, is creating massive knock-on effects as the ``Highly Leveraged Institutions'' of the financial sector have to reduce their lending because the price of the assets they were using as security for the lending is (rightly) falling. This forces the financial institutions to sell assets, making the problem worse. As Krugman points out, this is exactly the way that contagion spread from the Russian to the Asia to the Brazilian crisis in 1998.
Worryingly, the model leaves open the possibility of instability. In particular, if we --- we the ordinary savers --- become extremely unwilling to hold assets with any risk at all, then the model predicts that we spiral into a very nasty loop indeed. I do not think we are there yet, but the model underlines the importance of investor psychology at this point.
A financial system based on such highly leveraged institutions is not right. But we need to wean the system from that leverage slowly, giving the real economy time to adjust, while the logic of Krugman's de-leverage model is that this is being forced on banks at lightning speed. Re-capitalising the banks is a way of breaking the cycle of de-leveraging. Krugman's international conclusion comes form the fact that the banks all hold assets from all countries, so that asset price shocks ripple through the leverage multiplier much faster than would be suggested by the extent of movements of goods and services around the world. Krugman illustrates this with a nice graph.
So the way forward is becoming clear. Put capital into the banks following the Special Resolution Regime proposal of Buiter's to stabilise the system. Once the real economy has access to the credit it needs to operate, nationalise or hyper-regulate the banks and let the real economy slowly - over five years - reduce its dependence on bank credit.
The chart shows rest-of-world assets in the United States (red) and US assets abroad (blue) as a percentage of non-US GDP. What this shows is that when US asset prices fall, foreign financial firms feel the de-leveraging squeeze; and when foreign asset prices fall, so will US financial firms.
