Federal Reserve Inter-Meeting Statement
Objects in Your Calendar Are Closer than They Appear

Notes for KCBS Interview: Rebecca Corral: 1:20 PM Friday August 17, 2007

It's time to start documenting these. Needless to say, what I said had nothing to do do with my notes. But here they are:

Notes for KCBS Interview: Rebecca Corral: 1:20 PM Friday August 17, 2007:

  • Back at the turn of the twentieth century, governments became convinced that bank regulation was a good idea. Banks--institutions that leveraged themselves up and provided capital to governments, real estate, industry, and agriculture--needed to have the government impose on them (1) capital requirements (so that counterparties could be confident they would be repaid), (2) reserve requirements (so that creditors and investors could be confident of liquidity--that they could get their money out quickly even in an emergency), and (possibly) deposit insurance (so that creditors could sleep easy even in a really big emergency. Deposit insurance, of course, then creates the possibility of moral hazard: bank executives can gamble with the government's money. And so it requires an even tighter regulatory regime, rating, assessing, and limiting the kinds of investments that banks can make in order to safeguard the government's money that they might be risking.

  • Now we understand once again why our predecessors went down this institutional road. For a financial system to have rotten-apple institutions can cause pieces of the system through which savings flow to agriculture, industry, and construction to freeze up. And that is very bad: it might be worth imposing somewhat of a straitjacket on firms to limit the trouble they can get into. What kind of straitjacket would do the most good and the least harm? Now that is a very hard problem. It is made harder by the fact that (a) nobody expected the big losers from subprime mortgages to be quantitatively-sophisticated hedge funds, (b) quantitatively-sophisticated hedge funds don't really know why they are the big losers, and (c) quantitatively-sophisticated hedge funds don't know how big losers they will be--of if they will be losers at all, for many think (and I agree) that organizations that survive will look back on the next month as a time of opportunity to make $$$$$.

  • Our current situation is strange in a number of ways. First, usually you need to have something happen to the real economy--a gold drain, a flight of foreign capital, a recession, something--in order to trigger the scramble for liquidity that causes the crisis. Now we don't: no recession, no capital flight, no reserve problems, no massive waves of foreclosures in Riverside and Solano counties. Just the fact that we can no envision states of the world in which there might be waves of foreclosures has sent the high-risk end of the money market into a remarkable state of panic.

My side of what I actually said: Interview on KCBS about the Federal Reserve: