The key concept is the distinction between informationally-sensitive financial assets — assets which change in price when new information emerges — and informationally-insensitive financial assets — assets which don’t change in price when new information emerges. In the latter bucket we can include insured bank deposits, but bank deposits are insured only up to $250,000, and there are a lot of companies and other institutional investors who just want a safe place to park their cash and are also on the hunt for informationally-insensitive assets.
They found them — or thought they found them — in things like asset-backed commercial paper: they would hand over cash, and receive the senior tranches of securitized loans as collateral. When that happens, writes Gorton,
A ‘banking panic’ occurs when ‘informationally-insensitive’ debt becomes ‘informationally-sensitive’ due to a shock, in this case the shock to subprime mortgage values due to house prices falling.
Gorton’s solution to this problem is to involve the government in all manner of regulation — and insurance — of the securitization market, thereby making ABCP behave much like federally-insured bank deposits. I don’t like this solution at all, since it would send the contingent liabilities of the government into the stratosphere, and more importantly would ratify the demand for informationally-insensitive assets by creating trillions of dollars of new ones.In my view of the crisis, it’s precisely the demand for informationally-insensitive assets which is the problem. And we need to get individuals, companies, and institutional investors out of the mindset that they can do an elegant little two-step around the inescapable fact that anybody with money to invest perforce must take a certain amount of risk. If you have a world where people are all looking for risk-free assets, you end up shunting all that risk into the tails. And the way to reduce tail risk is to get everybody to accept a small amount of risk on an everyday basis. We don’t need more informationally-insensitive assets, we need less of them."
I disagree. I did agree with almost all of Gorton’s views. For one thing, he agrees that we had, what I, in my sophisticated way, have been calling since September, a Calling Run, meant to connote a bank run like occurrence of getting to cash or safe investments. It’s been followed by a Proactivity Run and Savings Spree, thereby showing that my sophistication hasn’t increased.
The problem was Debt-Deflation or a Debt-Deflationary Spiral. I derived this view from Irving Fisher, assuming that, if he were alive, he’d acknowledge the parentage of my views. In any case, there are two solutions:
1) Bagehot’s Principles, meaning issuing a full government guarantee that necessitates, in order to work, an FDIC like agency that shuts down insolvent businesses without caring about their power or connections. This was my original view, and it’s like Gorton’s, and Felix dislikes it because of the guarantees.
A: If you have a Lender of Last Resort, these guarantees might well be ineradicably implicit.
B: The point isn’t to have to spend the money, but simply allow enough confidence for a reasonable unwinding. Only a government has the resources for this, sad to say.
2) The other alternative is a split between Narrow/Limited Banking and Investment Concerns, which would be self-insured, while the Banks are government guaranteed, to the extent that they need to be.
Both are meant to stop major events like Calling Runs, not investors losing money. It seems to me that worrying about the particular investments verges on worrying about people losing money or trying to avoid recessions, which I consider impossible. We should focus on major events, not creating a perpetually spooked market.
I switched to Narrow Banking merely because I’ve experienced a crisis of faith in regulators as a class, although I agree that there are better and worse. I’m willing to become a believer again given a compelling scripture.- Posted by Don the libertarian Democrat