Views I toy with but do not (yet?) hold

Financial panics and economic crises are nearly inevitable, for at least two reasons.  The first is that policymakers are ill-informed and have poor incentives.  The second is that bank managers, periodically, like to take risk and we are unwilling to shoot or otherwise severely punish the failed ones.  Instituitions which transform liquidity can, sooner or later, find a way to take such precarious risks, no matter what the regulators do (it still may be worth trying regulatory restraint, however).  There's simply not enough downside risk in a wealthy, humane society.

The nineteenth century financial panic will prove the "norm" for human history.  The research question is how we avoided such panics for 1950-S&L crisis, or whatever you take the cut-off points to be.  The capital controls of Bretton Woods may be part of the answer (plus that is a strange economic period in a number of ways), although it is not obvious such controls could be made to work today.

More and more, people will turn to the wisdom of the great 19th century economists on financial panics, bank runs, and the like.  It was an intellectual mistake to think we had ever left that world for good.

I thank Benjamin Chabot and Mario Rizzo for useful conversations on this topic.  Bill Easterly offers related remarks, as does Paul Krugman.


"On the other hand, there were no systemic crises from 1934 to 2007."

Do economists laugh when they read things like this from Krugman?

Every Hundred Years or So: "it was the bankers themselves, led by Paul Warburg, of the merchant banking firm of Kuhn, Loeb, who laid out the basic design of the Fed"

Republic of the Central Banker: "All this evolved not by design but by accident. The Bank of England did not start out thinking its job was to rescue the banking sector in crisis; it just found there was a crisis and thought it could do some good. Robert Peel did not set out to create a central bank, but prosecuting the Bank of England for charter violations seemed a mistake at the time. The Bank of England did not set out to supplant the market and turn the interest rate into a centrally planned and administered price, but monetary management in extraordinary times led to monetary management in unusual and then in ordinary times."

Dog carcass in alley this morning, tire tread on burst stomach. This city is afraid of me. I have seen its true face. The streets are extended gutters and the gutters are full of blood and when the drains finally scab over, all the vermin will drown. The accumulated filth of all their sex and murder will foam up about their waists and all the whores and politicians will look up and shout "Save us!"... and I'll whisper "no." --Rorschach :P

I have a simple mental model of the economy as a system with positive feedback. Growth spurs more growth; contraction causes more contraction. All you need is a good positive or negative impulse into the system to throw it away from its stable growth rate. Therefore booms and busts are inevitable.

I suppose the post is more about how we are unable and/or unwilling to reduce the magnitude of that feedback. A negative impulse into an economy with low leverage will look a lot different from that into a levered economy.

I believe our inability to stop panics has more to do with us being politically unwilling to halt booms. Most of the panics I can think of follow unsustainable run-ups in prices; it's rare to see a bust out of nowhere (maybe oil shocks in the 1970s?). Plus, the booms often encourage the same leverage that magnifies the following panic. During booms do levered companies swallow up the less profitable un-levered ones, increasing the feedback even more?

A related side point: Is a widely held belief in the "great moderation" fundamentally incompatible with reality? If many believe risk is gone, they'll lever up more thereby bringing back risk again.

Brian, it was never reality. I always liked the term 'great moderation' because it created a different question-- is 'great' a wide moderation (many market organizations and sectors) or a deep moderation (money supply or institutional credit instruments only)?

The difficulties in explaining massive complexity in economic systems never go away, they are defined away.

The more liquid a market is, the more likely it is to bubbles and crashes. Cheaper trading costs means that holding times are shorter. It's like moving all the trees in a forest closer together, increases the likelihood of a fire.


Bubbles exist in both liquid and illiquid markets. Housing is about as illiquid as it gets with 6% transaction costs and no fungibility, yet we had a bubble there. So did Japan, Ireland, Spain, ...

Wasn't the bubble in the housing market really a function of the liquidity in the secondary mortgage market? The faster money moves around, the faster bubbles blow and burst.


Maybe we're thinking about liquidity differently. I think of liquidity as the ability to trade lots of volume with little impact on price.

Just because lots of people are trading (liquidity) doesn't mean prices will be inefficient (booms and busts), in fact the opposite is more likely true. Take SPY for instance, 187 million shares trade per day but it's hard to argue the prices are inefficient there.

I think for boom and busts you need a way to get positive feedback in a system, so the an increase in price will cause more increases. Say, tech stocks perform well and you see your neighbor making lots of money in them, so you buy too. That'll continue until everyone holds tech stocks and then the bust comes. Or the same thing in housing.

Just because people are trading isn't bad. You need a mechanism other than liquidity to fuel a boom.

The more liquid the market, the more it acts like a casino. See forex trading, the most liquid market in the world. If trading costs or slippage were higher, traders wouldn't speculate. Housing is a bad example because it has an embedded put, it encourages speculation.

"Statutory directors, board members, and controlling shareholders of Brazilian banks have their entire net worth at stake if their banks fail. All their personal assets are frozen for the duration of the liquidation process and may be used to cover any shortfall."

bank managers, periodically, like to take risk and we are unwilling to shoot ... the failed ones.

Speak for yourself!

Tyler, assuming that you're familiar with the conclusions of the huge economic research on financial systems of the past 30 years and that you don't find them good enough to design a new regulatory system for its stability, I recommend you to start with the simple question of why everywhere legal systems cannot protect investors from managers that take "excessive" risks, from managers that want to defraud them, and from governments that want to abuse their power. To complement legal systems one may argue for a regulatory system to PREVENT excessive risk taking, fraud, and abuse of power. Unfortunately it seems that the same factors that weaken legal systems also weaken regulatory systems. To some extent Andrei Shleifer and his associates have been addressing these issues but their research is at best a starting point.

tyler, exactly what economists are you talking about when you say ..."wisdom of the great 19th century economists on financial panics"
and which books?

chris wrote: "Mistakes can't be modeled in classical economics: it predicts that nobody would ever make any because it isn't in their interest to do so."

Remind me again why universities have a separate economics department, instead of bundling it under, oh, philosophy. Or perhaps theology.

Whoever said we were unwilling to shoot them?

"Finance has become more international and bigger"

I knew that was coming. That's the only rationale left to explain away how their best efforts have screwed the pooch so far. Krugman et. al. would have us believe that there is either less regulation now than in 1934 or that the regulation must be proportional in size to that which is regulated. Nonsense of course. Macro regulation without regard to quality. Rubbish.

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