In his book “Unintended Consequences” Edward Conard1 not only supports the benefits of income and wealth inequality (as described in a previous post (August 7, 2012)), both as an indicator of past successful ventures and as an inducement to future ventures, but he also provides a diagnosis and remedy for financial crises.

He denigrates the conventional explanations for the crisis from both the left and the right.  The cause was not predatory lending (the left argument), nor was it government housing policies (the right argument).  Fundamentally what occurred was a bank run, much like the event that triggered the Great Depression in 1929. 

Conard argues that the consequence of predatory lending is to shift risk from lenders to borrowers, by charging high interest rates and fees.  What happened in the years leading up to the crisis was the opposite:  lower required down payments, lower credit scores and lesser documentation shifted risk from the borrower to the lender/investor.  That is, if you can buy a home with no money down then you effectively have a call option on the value of the home.  If the value falls your option has no value, but it did not cost you much.  The major loser in that deal is not the borrower, but rather the owner of the mortgage loan. 

Government housing policy pushed underwriting standards lower in order to increase the home ownership rate.  The effect was to increase the effective demand for housing and drive housing prices higher.  The process was enabled by strong investor demand for mortgage backed securities (MBS).  In retrospect, we can see that there was judgment error on the part of investors and guarantors of MBS.  The error was compounded by investor willingness to hold MBS in levered portfolios funded with short-term financing.  In effect, the error was to assume, at least implicitly, that housing prices would not fall.  

Conard defends financial markets and institutions against the charge that unfettered capitalism caused the financial crisis and ongoing economic doldrums.  In his view, a primary role of financial institutions is to create liquid, safe and short-term investment vehicles for risk-averse savers, and to translate those short-term funds into risky long-term assets that support consumption and investment.  Given the mismatch between short-term liabilities and long-term assets, financial institutions (e.g., banks) are susceptible to “runs on the bank.”  This is what happened in 1929 and it is what happened again in 2008 (I would say the run actually began in 2007, in particular the first week of August, 2007).  Whereas in 1929 the run was bank depositors attempting to get their money back, in 2008 it was institutional investors that withdrew funding for levered investments in mortgage backed securities (MBS).  The impact of this withdrawal of funding was termination of the market for non-agency mortgage loans, collapse of the value of MBS and huge liquidity and solvency problems for major financial intermediaries (FI).

According to Conard, there are two ways to prevent the risks of bank runs.  First, we can insist that banks (and other FI) hold huge reserves of cash and/or equity against loans and investments.  Or second, we can implement government guarantees on short-term funding.

Conard strongly favors option #2 over option #1.  In his argument, the problem with option #1 is that it would short circuit the process of financial intermediation.  Most savers want low risk highly liquid instruments for their savings.  Meanwhile, investors need long-term financing.  The role of FI is to intermediate these desires.  If onerous reserve and/or capital requirements are imposed, FI will not be able to perform their economic function.  The cost of this would be huge in terms of lower long-run economic growth.  Meanwhile, the cost of government guarantees of short-term liabilities is relatively small. 

At first glance, it seems incongruous that a free-market thinker would support government guarantees of private contracts.  Conard does recognize the moral hazard risks of his proposal.  To combat this, he proposes that insurance premiums be charged for government guarantees and that these premiums be set proportional to risk. 

I think in the case of a liquidity crisis (e.g., a bank run) it is appropriate for the monetary authority to follow the dictum of Bagehot2 to lend freely against good collateral at a penalty rate.  But this is different from guaranteeing short-term funds.  The effect of a guarantee would be to promote higher leverage and riskier investments.  The purpose of financial institutions is to intermediate between low-risk short-term liabilities and higher risk longer term loans and securities.  It is appropriate that they monitor and manage the interest rate and credit risks inherent in this activity, and hold sufficient capital and liquidity.  I don’t believe the intermediation function would be made more efficient by the government assuming the liquidity risk.  

1Edward Conard, “Unintended Consequences:  Why Everything You Were Taught about the Economy is Wrong,” 2012.

 2Walter Bagehot, Lombard Street:  A History of the Money Market, 1900.