Chicago Fire, 1871

One of the fundamental problems in macroeconomics is understanding and modeling the financial externality.  I would argue that on some level most, if not all, macroeconomists accept that there is some kind of fundamental externality in financial markets and it is this externality that makes Central Banking, ie the Federal Reserve, useful.  What we haven’t been able to do is model that externality completely and successfully.

Mike Rorty provides a narrative in his discussion of the shadow banking system

AIGFP created systemic risk out of nothing by mispricing CDS contracts over a few year period. Systemic risk is the risk that effects us all, the risk we can’t diversify or innovate our investments away. It’s the risk that hits my boring index fund of stocks that I want to use to retire.

How do they do that? By underpricing CDS contracts – charge 2 or 15 bp on some accounts – they encourage people on the other end to take on more risk thinking they are insured, when they are not. This chains through the system to the point where it hits my boring index fund.

This point is really important, so I’m going to harp on it. Think if you got fire insurance on your home cheap, really cheap, but the fire insurance firm has no intention of paying it out. Since you feel more secure, you smoke in bed and leave oily rags around the furnace and use the smoke alarm batteries for the remote, and sure enough your house catches on fire. You aren’t going to get paid, but that’s a your problem at that point – however now your house is on fire, and your neighbors houses are catching on fire. Other fire insurance companies, not capitalized to handle this sudden wave of fires, start going bankrupt. This metaphor may seem a bit much, but that’s what happens in financial firms.

AIGFP entered into a contract and because of that contract you and I face more risk. This is the essence of the big externality. I’d change the fire analogy a bit to say that the problem was that people sold cheap private fire department services. AIGFP told investment banks not to worry. If their house caught on fire AIGFP would come put it out. So, the banks start to feel comfortable taking more risks, smoking in bed etc.

Now the house catches fire but AIGFP doesn’t show up. Perhaps, they’ve sold fire department services to the whole town but they only have one truck. Two or three houses catch on fire and now there is nothing they can do to put out all of them. One or two of the houses have to burn and those houses catch more houses on fire until eventually the whole town is in an uncontrollable blaze.

The mistake a lot of economists made in the run-up to this crisis is in thinking the financial externality only applied to traditional banks and their relationships with depositors.

In some sense this is like believing that the problem with a private fire department is that those who smoke in bed might not get rescued. That’s not the problem. The problem is that if the smokers have poor fire service the whole town will go up.

To wit, it doesn’t matter what mechanism it works through, if someone is taking on liquidity risk and solvency risks then the whole town is taking on risks.

The deep question is why does this process have to work through the chain? Our basic intuition about markets would say ok, “I know that you are taking on this risks. I know that you have cheap CDS so I am going to limit my exposure to you.”

Perhaps there is an information problem. I might not know exactly what risks my counterparties are taking on. Why then don’t I say “Unless I can understand your risks I am going to assume that they are high and limit my exposure to you” Why doesn’t that mechanism work?

Somehow the risks or false senses of security have to amplify one another so that this kind of hedging doesn’t take place or doesn’t take place effectively. I have some theories on how that might happen but I don’t really know for sure.