There´s an ‘unlearning’ process going on

Greg Ip has a post “When moderation is no virtue”. I was particularly interested in this exchange with someone with a very broad financial market experience, including a long stint at the Fed (my observations inside brackets):

I recently had an interesting exchange with Lewis Alexander. He’s  now chief U.S. economist for Nomura but spent much of the 1980s and 1990s at the Fed, before going to Citigroup and finally, during the crisis, to Treasury. He recalls:

In the spring of 2007 I was asked to give a presentation on the great moderation to Myron Scholes’ hedge fund.  I talked about the key themes … – inventories, consumer credit, and the stabilizing role of policy.  Just five minutes into my presentation Myron cut in and asked “But won’t people just take on more risk?”  That was the most prescient question I heard before the crisis.[Definitely NO. Portfolios are being rearranged or rebalanced because risk has fallen. In a sense they are taking less risk]

I have come to believe that the ultimate cause of the financial crisis in 2007-2009 was the great moderation.  The financial system responds to volatility.  When volatility declines the natural tendency is to use more leverage and to concentrate risk.  That was the essence of Myron’s question.[I´ll smoke, drink and eat junk food, all immoderately. Maybe I´ll live forever!]

It is natural, in some sense that the broad response of the financial system to the decline in macroeconomic volatility would play out in mortgage finance because mortgage finance is the biggest part of the system.  Of course policy mistakes in housing finance played a role and with better policies we probably could have avoided the particular problems that arose in that sector.[that´s right. See here]

I’ve come to believe, however, that had we gotten everything right in housing finance the tendency of the financial system to take on more leverage and to concentrate risk in response to lower macroeconomic volatility would have played out in some other part of the system.  The crisis would no doubt have been different, and possibly less severe and later.   But I think it would have come.  That’s what comes from studying financial history.[Keep on thinking, but having been at the Fed for many years you should know better]

2 thoughts on “There´s an ‘unlearning’ process going on

  1. Egads. Let me guess—this is another premise to the idea that the Fed should always be tight.

    I think Hyman Minsky came up with this idea that people take on more risk in sustained good times, back in the 1970s. So?

    If the Fed keeps growth on target, yes we will have some business and personal bankruptcies, but they will not matter in the big picture.

    There may be some sense in requiring banks to keep equity at a larger fraction of assets, such as 15 percent or 25 percent. Pushing home loans onto fragile borrowers is probably a bad idea too.

    What is most worrisome is the gathering strength of the idea that we should never have good times, as they lead to risk-taking and inflation, so it is better to stay in a perma-recession.

  2. “Portfolios are being rearranged or rebalanced because risk has fallen. In a sense they are taking less risk”

    This is a superb idea for the “elevator speech,” which in my line of work is referred to as the 30 seconds one has in the elevator with the VP or CEO to plant a seed of interest. When monetary policy assumes the role of neutrality, or is relied upon as a stabilizer, investment becomes less risky over all. This simply is not the case with asymmetrical IT, which by its very nature injects excess risk.

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