In praise of things that are always what you think they are January 8, 2012 at 7:26 am

A major cause of systemic risk in the financial system is things that are mostly one thing, but occasionally another. Unlike Gremlins – where you are safe provided you don’t get them wet* – these things change without your intervention. Euro-periphery government bonds are one example; AAA RMBS during the crisis are another.

These things are dangerous precisely because you are lulled into thinking that they are always safe, when in fact they mostly are. A shortage of things that are always safe, plus perhaps a touch of greed, causes folks to buy the almost-safes. And we all know how that ends: a flight to (genuine) quality and contagion as investors exit all assets that might even possibly be risky.

There are two reactions to this. FT alphaville nicely sets out the positions in relation to uninsured bank deposits. You can say folks should grow up, and understand the risk; or you can say the risk ought to be removed. For me, the ‘grow up’ position is naïve. Just saying people should not be mistaken solves nothing. At least the ‘do something’ school (represented by Amar Bhidé) recognises the risk that investors will fail to recognise the risk, then flee when bad things happen. If those same investors are forced to pay now for the protection they will need later, maybe stability is enhanced.

Now, of course, there are lots of issues with this, and lots of potential to get the design of the solution wrong. But just throwing your hands up in the air and saying people should be smarter – well, that’s as dumb as a fish trying to swim up Kingston Falls.

(For a further discussion of the importance of genuinely safe assets, see here.)

* Or feed them after midnight, or expose them to sunlight.

2 Responses to “In praise of things that are always what you think they are”

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