Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [89]
The second view focuses on levered financial institutions and their role in morphing what was otherwise a garden-variety macroeconomic adjustment into an all-out crisis. This view holds that a relatively small perturbation—the excessive real estate borrowing of a small group of homeowners—negatively affected financial intermediaries’ balance sheets. These intermediaries—banks and “shadow” banks that jointly fulfilled the function of credit extension to a wide universe of companies and investors—essentially cut back on lending to investors and to their market-making desks. Investors who depended on credit to hold securities had to sell them. And the lack of dealer market-making funding made the situation worse, substantially undermining the liquidity of many dealer-centric markets.1 So the de-leveraging process, which by itself is the mechanical result of an initial reduction in asset values, had to take place in the context of increasingly illiquid and nonfunctioning dealer-centric markets. With liquidity low and falling, additional selling brought falling prices down even more dramatically than would otherwise have been the case. As a result, prices fell further than the current fundamentals might have justified and credit became expensive and scarce. Unfortunately, the fear and concern around these declining markets led to runs—not only on markets and institutions, such as money market funds, but also on consumption. This resulted in dramatic and precipitous declines in economic activity that ultimately, though unnecessarily, validated the low levels of asset prices. This financial-intermediaries view emphasizes what I refer to as a “supply shock”—a collapse of internal capital in financial intermediaries that greatly magnifies a small price change and turns it into a crisis in the macroeconomy.
These two versions of the current financial crisis are clearly illustrated in Figure 20.1. It shows an equilibrium in the pricing and availability of intermediary-provided capital. This capital is used by households to gain access to mortgages and other forms of credit (such as automobile-purchase credits or credit-card receivables), by corporations for borrowing from financial institutions, and by investors and traders who rely on dealers to help provide liquidity and who obtain financing in order to buy securities or other investments.
The bubble-has-burst hypothesis describes a leftward shock to the demand curve. A reduction in customers’ demand for credit is equivalent to a leftward shift in the demand curve. As expected, the quantity of intermediary-provided credit falls. So, too, does the cost of credit. At the original rates charged by intermediaries, there is excess supply of credit, so the shadow return on intermediary capital must decline.
FIGURE 20.1 Equilibrium in the Market for Intermediary-Supplied Capital
Source: Copyright © Ken Froot.
FIGURE 20.2 A Negative Shock to the Demand for Intermediary Capital
Source: Copyright © Ken Froot.
FIGURE 20.3 A Negative Shock to the Supply of Intermediary Capital
Source: Copyright © Ken Froot.
The levered-intermediary view describes a supply shock—the leftward move in the supply curve shown in Figure 20.3. Here, too, the amount of credit supplied in equilibrium falls. However, because the cause is a reduction in the capacity of intermediaries to lend, the shadow cost of intermediary capital rises.
There seems to be little controversy about what has happened in this financial crisis to the quantity of credit extended by intermediaries: It has fallen considerably. The critical, and