Random statement of the day
This from the Minneapolis Fed:
Thus, roughly 80 percent of such business borrowing is done outside of the banking system. The claim that disruptions to the banking system necessarily destroy the ability of nonfinancial businesses to borrow from households is highly questionable
There are two ways I can read this quote, one that I agree with and one that I dispute. The first way is that “this isn’t the end of the world” – I agree with this, and I still think that people too closely linked to the financial markets are expecting worse outcomes for the global economy than will actually occur.
However, I think the Minneapolis Fed’s paper overplays it a little and suggests that there is no credit rationing element – only a risk-price element.
If this was the case, then risk has been re-priced, maybe even more appropriately, and industries that have an expected rate of return high enough will still be able to borrow. Although this will lead to a slowdown in economic growth this is not a market failure – and as a result no intervention in financial institutions is really necessary.
However, it is likely that this isn’t the case – according to the numbers in the above quote, a freezing up in the financial sector reduces the credit available to firms by 20%. If firms are liquidity constrained you can bet that this will be a big deal 😛
The “evidence” the paper shows to illustrate no credit rationing is decidedly useful – as any decline in non-financial credit will occur with a lag. The concern in a country like New Zealand is that credit will tighten at the start of 2009 – once banks have run through reserves and called in all there favours. As a result, the possibility of credit rationing does exist.
The difficulty we have in the data at the moment is that we can see the price of futures contracts, but we can’t tell how much of the increase is the result of a change in justifiable expected risk from lending (given new information that has been revealed), and how much is the result of an asymmetric information issue which leads to credit rationing. In six months, once we have the data, we will know – and we can say what central banks did wrong and what they should have done. However, at the moment any such statements are simply conjecture.
Update: Noted a lot more discussion for the Fed paper here, and against it here, here, here, here, and here.
Thought provoking.
From a bank’s perspective, the concern is that you do not know how exposed your counterparties are to the “toxic assets”. There is the direct element (“how much MBS, CDS, CDO is the counterparty a transactional party to”) and an indirect element (“does your counterparty have exposures to other institutes that are heavily exposed”).
The asymmetry in information (you do not know what your counterparty knows) means that assessing the actual risk (and hence the appropriate risk premium) is difficult. Under such a situation everyone plays it cautious and hoards cash.
I’ld be interested in you exapnding on the last couple of sentences of your post. What will the data in 6 months’ time tell us in regard to what should have been done? If we are talking about the current type of data collected, then I suspect precious little. The exposures may well be off balance sheet and therefore less easy to collect.
“I’ld be interested in you exapnding on the last couple of sentences of your post. What will the data in 6 months’ time tell us in regard to what should have been done? If we are talking about the current type of data collected, then I suspect precious little. The exposures may well be off balance sheet and therefore less easy to collect.”
My feeling is that in six months time we will have a better handle on how much “good” lending was not approved through the shift in real economy variables – such as non-residential investment and residential investment. At least in New Zealand.
New Zealand hasn’t built up an oversupply of “building” in the same way as other countries – so any deviation from current levels is concerning. If we see the net capital declines in residential building (which is on the cards) then we have definitely seen credit rationing!
For New Zealand I think private investment will provide a pretty transparent signal – but we shall see.
Yes – the impact on the real economy will be clearer but will the extent of the informational problems be clearer?
The informational problems were/are concentrated within the financial sector. I think at the individual mortgage level, the information is pretty much all there – the one thing that was wrong (in the US) was the risk of house prices dropping and thus the risk of default.
“Yes – the impact on the real economy will be clearer but will the extent of the informational problems be clearer?”
It involves decomposing between what would have happened if it was solely a risk issue and what did happen. In the New Zealand context this should be a touch easier – given that we know that the long-run payoff of building activity is unchanged. As a result, any dip in building below, say 2006 levels would tell me that there was credit rationing in the building industry.
Looking at the more general firm level is difficult – as we can’t clearly separate what is going on in the real economy. Furthermore, if we try to look at the flow of credit we get stuck between the slowdown that should be the result of weakening fundamentals and a reduction in activity because of a lack of ability to source credit.
I think something else which we can look at, and which they will probably look at in the US, is the distribution of where credit is going. It is all well and good to find that aggregate business lending is unchanged – but a sudden shift in that lending without a sudden, fundamental shift, in the marginal product of capital in the associated industries would imply that something is amiss.
“I think at the individual mortgage level, the information is pretty much all there – the one thing that was wrong (in the US) was the risk of house prices dropping and thus the risk of default”
Agents misappropriated the risk for some reason – no doubt there were information asymmetries and the agents that were meant to solve them didn’t as the result of some agency problem. We did not have those same issues in New Zealand