Monday, September 1, 2008

Charles Calomiris: The Perfect Finanical Storm

Charles Calomiris gave a paper at the Jackson Hole meetings on the current housing boom-bust cycle. Calomiris argues in the paper that the simultaneous occurrence of two "longstanding incentive problems" and two "unusual historical circumstances" gave rise to the perfect financial storm we now know so well.

From the paper:
The longstanding problems were (1) asset management agency problems of institutional investors and (2) government distortions in real estate finance that encouraged borrowers to accept high leverage when it was offered. But these problems by themselves do not explain the timing or severity of the subprime debacle. The specific historical circumstances of (1) loose monetary policy, which generated a global savings glut, and (2) the historical accident of a very low loss rate during the early history of subprime mortgage foreclosures in 2001-2002 were crucial in triggering extreme excessive risk taking by institutional investors. The savings glut provided an influx of investable funds, and the historically low loss rate gave incentive-conflicted asset managers, rating agencies, and securitisation sponsors a basis of “plausible deniability” on which to base unreasonably low projections of default risk.
I find myself in agreement with Calormiris' take on the origins. I especially like his argument that loose monetary policy created the global saving glut, not the other way around as argued by many observers. Calomiris also discusses the Fed's response to the crisis. He argues the Fed's "surgical" strikes (e.g. Bear Sterns) prevented a meltdown of the financial system, but its low fed funds rate policy has been eroding the Fed's inflation-fighting credibility. He also discusses some reforms going forward. Finally, the paper has a lot of interesting financial history in it. Collectively, these various parts make the paper a good supplement to a money and banking class. I plan to use it this fall in my classes.

You can the entire paper here or view a summary of it here.

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