Let’s try to get along February 16, 2012 at 7:16 am
A minor spat in the finance blogosphere – no one died. This is hardly news I know. But for me this fight is unnecessary; both parties have some of the truth. John Cochrane first – his tagline is
As long as some firms are considered too big to fail, those firms will take outsized risks.
That seems pretty reasonable. His account of the mechanism at work around the Lehman failure has a measure of truth about it too:
After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman, and
in fact said it lacked the legal authority to do so, everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad…
Buttressing this story, let us ask how—by what mechanism — did Federal Reserve and Treasury equity injections and debt guarantees in October eventually stop the panic? An increasingly common interpretation is that, by stepping in, the government signaled its determination and legal ability to keep the large banks from failing. That too makes sense in a way that most other stories do not. But again, it means that the central financial problem revolves around the expectation that banks will be bailed out.
I might quibble with that ‘central’, but certainly too-big-to-fail is a problem, and certainly it needs to be resolved.
Next, Economics of Contempt, who lays into Cochrane. They choose instead to emphasise the liquidity aspects of Lehman’s failure:
…the end result is that LBIE’s [Lehman’s main London entity’s] failure caused hundreds of billions in liquidity to suddenly vanish from the markets. It also caused other hedge funds to pull their money out of their prime brokerage accounts at Morgan Stanley and Goldman (the two biggest prime brokers), since they were now scared that they wouldn’t be able to access their funds if either of the prime brokers failed…
And there was absolutely nothing minor about the run on the money markets. One of the biggest money market mutual funds, the Reserve Primary Fund, “broke the buck” because of losses on Lehman commercial paper. This caused a massive run on money market mutual funds, with redemptions totaling over $100bn.
This is perfectly fair, and indeed the liquidity aspects of the crisis are rather less well understood than the solvency ones, so EoC is right to discuss them. Having another angle does not justify calling Cochrane’s piece ‘mind-boggling nonsense’ though.
Now, I do think that Cochrane goes astray in his account of the TARP, but I don’t think he is being duplictious, and he does show some sympathy for the complexity of the policy choices the authorities faced after Lehman. He’s good on the fragility of some of the structures such as ABCP conduits used to fund mortgages, and on the ‘huge initiative of mostly pointless regulation that would move derivatives and cds onto exchanges, regulate hedge funds, force loan originators to hold back some credit risk, and so forth’.
Give both of them a read, Cochrane and EoC. They both have worthwhile things to say. There’s plenty of crisis to go around, with no need for a fight.