Dealing with debt, financial regulation, and the lender of last resort

By Matt Nolan 03/10/2012

Previously we’ve talked a lot here about the lender of last resort function of a central bank.  In discussions a trade-off is often discussed, whereby having a lender of last resort can help to prevent financial crises when financial intermediaries are suffering from issues of “illiquidity”, but are not “insolvent” – however, the existence of a LOLR can in turn lead to moral hazard … where financial intermediaries and lenders are willing to take on “too much risk” and charger borrowers “too little”.

Although the discussion of these issues has a long history in economics, Thomas Sargent’s article (REPEC) on the issue – and the solution mentioned – are worth reading.

Now we live in a history dependent world.  Yes, we have had a global banking system willing to take on too much risk – due in a large part to issues of asymmetric information and an implicit solution subsidy of risk.  Yes, in this environment debt accumulated, and the existence of debt and the following credit constraints on people with “useful projects” that they could invest in is having a big negative impact – likely much bigger than any “social boost” that may have existed from the additional marginal projects that took place with easy credit.

We have an environment where people think there is a real risk of the failure of financial intermediaries.  Now if we understood “why” we could ask if there is a solution.  What are some reasons:

  1. There is too much debt.  If we saw this as an issue, we could convert bondholders into equity holders in banks.  After all, isn’t a government bailout really just a transfer from non-depositors to depositors in the bank?
  2. There is no trust.  There was a “capital stock” of trust that was built up between financial institutions, a stock that was destroyed and will have to be rebuilt.  This can be expected to keep hurting the efficiency of financial markets for a long time.
  3. Central banks/governments have lost credibility as lenders of last resort.  I think this is compelling – everyone talks about “too big to fail”, but exactly what that means, exactly what the “insurance” is, and exactly how the “insurance” is paid for are questions that are still up in the air.
For me the key issue is the last one – as the negative impact of the first two is “endogenously determined” by the credibility of the financial system stemming from regulation.  The fact we have a government monopoly for fiat money, and direct management, combined with a LOLR function, ensures this.

Note:  Anyone reading here since the crisis has been in full swing will think I lean strongly on the side of constant bailouts.  However, this is far from the case – I only started writing in favour of them once we already had a crisis where this needed to be the case.  In 2007, once the crisis had begun but a few months before Bear Sterns, I was writing like some sort of “purging our evils” Austrian economist.  After Lehman Brother’s collapse, even a half pint analyst like myself saw the issue of a lack of trust even when it was unclear whether there was a bailout or not :P (it was interesting reading these old posts, the lack of clarity around what was going on was even worse than I remember!).   By the time what happened was clear, we had switched our tune in favour of bailouts for that period of time – and even I found the ECB’s call to attack moral hazard in the middle of the crisis strange, even though I saw that as a big issue.

This was seen as a major issue coming into the crisis, it was viewed as a key issue during the crisis (I would argue that the efficiency of NGDP targeting would still depend on a banking system without bank runs), and now during these later stages of the crisis it is an issue receiving a lot of research and taken into account for regulation.  Mainstream economics has the tools to understand what has happened, and hopefully policies can be developed that ensure that the next economic crisis is something completely different.