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Black Holes and Financial Crisis: a narrow escape?

Talk based on:‘Leverage and asset bubbles’

Marcus Miller and Joseph Stiglitz

CEPR DP September 2009

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Motivation

• Let firms use debt to buy assets at a time when asset prices are on an expanding bubble.

• When the bubble bursts, this unleashes strong contractionary forces: highly geared businesses can easily slide into insolvency (liabilities exceed assets) and end up being liquidated.

• Before looking at how these economic forces can trap small business, consider an analogous ‘trap’ – not in economics but in in cosmology.

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Cosmology: Black Holes

• When a supernova runs out of energy and begins to collapse, its density may become so great that it prevents light rays from escaping.

• So the dying star becomes a black hole: though invisible, it can be detected by how it distorts the space around it.

• [Stephen Hawking showed that, as black holes emit radiation, they should finally disappear. ]

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Beware! …there’s a black hole in there

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Light bends and spaceman disappears into black hole

Time

Space

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Man-made Black Holes?

• Economies seem to have black holes too!

• Richard Koo describes how - when the gigantic asset bubble burst in 1990 - many Japanese businesses were dragged into insolvency as their assets fell below the value of their debts.

• The efforts of firms to sell assets to pay down their debts only seemed to make things worse …

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Why should insolvency matter?• ‘If it becomes known that a borrower is

technically insolvent, loans extended to the company will become bad loans and the lender will be forced by government regulators to cut off credit, and try to collect on existing loans’. Koo (2008)

• A collusive strategy of concealment of true balance sheet position widespread in Japan.

• So the insolvency ‘black hole’ only detectable by the gross distortion to investment spending!

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Normal times – and hard times• In normal times, insolvency is an economic

form of natural selection – .it’s the way the capitalist system has evolved to shift resources from less to more productive uses.

• In aftermath of bursting bubble, insolvency may occur as a toxic by-product of debt collateralisation – threatening to swallow whole sectors of the economy and lead to gross misallocation of resources.

• Unlike the space traveller sliding into the black hole, however, firms can be rescued from this kind of insolvency - as we discuss.

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Iconic model to be used

• To illustrate the mechanism leading to mass insolvency, we look at a model with Small Business borrowers and Deep Pocket lenders who demand collateral, that of Kiyotaki and Moore (1997) published when they were at London School of Economics

• Need to look at normal times …. and abnormal times of bubble expansion followed by collapse

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Normal times: a step-by-step expansion of Small Business sector, SB

SB Productivity and User Cost

SB Productivity User Cost

βo/R ZXGD

kt-1 kt k*

α

XH

X'H'

A

A'

X

X'H'

E B

k SB Holdings

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Normal times; and pleasant shocks

• In normal times, as we have seen, small businesses expand (or contract) smoothly towards equilibrium.

• An unexpected macroeconomic shock can have a powerful ‘centrifugal’ effect. A temporary rise in productivity, for example, will raise a firm’s cash flow and increase borrowing power – and, if the productivity shock affects all firms across the sector, that will raise asset prices, further

increasing borrowing power.

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Asset Price jump

Small BusinessAsset Holdings

k*

S

θ

qt

Asset Price

1RR

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R X

E

S

q*

kt

Saddle-path

Q

Q

A

B

Initial condition

Adjustment in ‘normal times’ (green line) and

after positive productivity shock (blue line)

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What about abnormal times: bubbles and bad shocks

• Consider first the system in a fevered state with an asset bubble: firms borrow but that’s no problem as asset prices keep rising to match the debts.

• Then, unexpectedly, the music stops – the bubble bursts.

• System may recover, or it may collapse.

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Asset bubble and ‘black hole’

Insolvency Solvency

Small business asset holdings

N

Asset Price

BLACK HOLE

SC

E

Z

B

B

ASSET BUBBLE

T

Y

X

N

T

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The prospect of mass insolvency

• Need to look at the net worth of Small Business sector and how it evolves:

• First in normal times, with no unexpected macro shocks, but lots of small idiosyncratic shocks at micro level that cancel out on aggregate.

• Then, after a macro shock – a synchronised shock, when all Small Businesses might become insolvent

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Evolving net worth of Small Businesses in ‘normal times’…

Initial Shortfall

Net worth

kt k*

Opportunity Cost

*kE

A

N

N

F

B

C

k0

OU

O

I

Evolution of Small Business net worth

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… and after a bad shock

Small Bubble

Effect of 'Fire-sales'

Net worth

Mass Insolvency Solvency

kt k*

Opportunity Cost

B

E

SC

N

N

F

F

Recovery

kc

OU

O

I

BLACK HOLE

BIGGER BUBBLE

B'

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Help may be at hand

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Rescue Operations

• Collusive concealment as in Japan: CEO and bank manager hide the truth

• Asset purchase as in US Paulson Plan

• Capital Injection as in UK Treasury Plan

• Quantitative easing CB lends against frozen assets

• All being well, these can stop the slide into the Black Hole

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Capital injection

Net worth

kt k*

U

θ

E

A

W

N

D'

D A' C RC

U

kc

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Asset bubble and ‘black hole’

Insolvency Solvency Small Business Asset Holdings

k *

S

θ

qt Asset Price

1 R R

1 0 R

G

SC

E

S

q *

kt

D

D

B

B' D'

D'

kc

X qx

Black hole

Bubble

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Help from Central Banks - since Aug ‘07

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Plus support from Government =3/4 GDP!

• United Kingdom United States • Jan. 2007 Latest Jan.207 Latest• Government support

£ trillions $ trillions• Guarantees of financial• institutions’ liabilities – 0.37 – 2.08

• Insurance of financial assets – 0.46 – 3.74 •

Capital injections to banks and• special purpose vehicles – 0.06 – 0.70 •

Increase in public sector support 1.26 – 10.44

(including CB assistance)

• Percentage of GDP – 88% – 73%

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Financial Externalities exist in economy with financial constraints

• Market economies with constraints that depend on market prices (such as V@R, collateral requirements) are not constrained efficient.

• Rational atomistic agents take asset prices as given and do not internalize the fact that their fire-sale disposals give rise to amplification effects when financing constraints are binding.

• Korinek (2009)

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This leads to over-borrowing and over investing by banks

• Value of liquidity in a crisis is undervalued and this leads to distortoted decisions

• Bankers take on too much risk - over borrow and over-invest

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What if expectations are incorrect?

• Korinek goes on to point out that

• amplification effects magnify the impact of any unexpected change to liquidity position

• In crisis times when constraints are binding, welfare costs of asset price corrections are much larger than in normal times

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Moral: tax the HLI*s who generate externalities

• Relaxing financial constraints (forbearance) leads to Moral Hazard

• So does providing price guarantees • So Korinek(2009) advocates Pigovian taxation

of externalities associated with HLIs – e.g. by capital adequacy ratios and presumably liquidity ratios

• *inc any player who might get involved in ‘fire-sales’, banks, shadow banks and hedge funds.

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The current challenge: implementation

• “Academic economists analyse financial regulations, what we must do is change them” (with apologies to V. I Lenin)

• Will this crisis prompt the necessary change?

• What are the obstacles? Political economy? Academic paradigm that denies existence of crisis?

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The economics of denial?

RB C: no Black Holes

Representative Agent

Rational Expectations

‘every financial system has a black hole: except RBC’

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Conclusion

• US and UK banks are borrowing at low rates and posting great profits and not lending much.

• So it seems that the solution being followed is to fatten the fat cats so they won’t risk their wealth!

• Reminds one of pre FDR USA with big steel, big oil and JP Morgan.

• Is that the future? Why not update the regulatory structure that FDR created taking account of the externalities and oioncentive issues.

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The choice

• Earlier the world was warned that BASEL II was not addressing the issue of systemic stability: but BASEL II has been chosen.

• This time we face the choice again. Which path will be taken.

• Robert Frost • Two roads diverged in a wood, and I-- • I took the one less traveled by, • And that has made all the difference.

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The Holy Grail of theoretical physics…

to unify gravity and quantum mechanics into a single theory!

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What about economics?

• Some economists like to think of economics as a science: and they seek to unify macro and micro

• Real Business Cycle theorists, for example, assume a Representative Agent with Rational Expectations: but RBC(RA & RE) no BH!

• So, as Krugman says, they may have mistaken beauty for truth.

• Alas! One rejection is enough to discredit a scientific theory.

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Two approaches to macroeconomics

Current paradigm: the postulate of perfection

Alternative: look to see how things really function - and may fail

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The Economic Universe ?

RBS: no BH

Representative Agent

Rational Expectations

‘every financial system has a black hole’ Fed economist

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What are the alternatives?

• If one is to unify micro and macro, should it not be along lines of Kiyotaki and Moore with Heterogeneous Agents (Borrowers and Lenders), and possibility of a Bubble? Note that KM( noRA & noRE) BH.

• Personally, I think John Hicks was right to say that economics is a discipline but not a science: but that’s another story.

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A sting in the tail

• From cosmological black holes there is no escape: from financial black holes there is.

• Where the problem stems from the existence of externalities and distorted incentives in the economy itself, rescues can increase moral hazard.

• Unless sufficient energy is dedicated to countering the externalities and distorted incentives, these rescues could increase the probability of future crises.

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The End