Monday, April 20, 2020

Kocherlakota on moral hazard

I found a kindred spirit. Narayana Kocherlakota, ex president of the Minneapolis Fed, shares my concerns over the current lending and bailout spree, in particular propping up the prices of corporate bonds.
In its last financial stability report of 2019, the Fed highlighted how many nonfinancial corporations were making use of highly risky debt. The report pointed out that “a number of contacts expressed concern that a U.S. recession would expose highly leveraged sectors … concerns related to nonfinancial corporate debt were cited most frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds.” 
The financial stability report, of course, made no mention of pandemics or social distancing. It didn't need to — the risk to the financial system and the economy is posed by any recessionary shock. The coronavirus just happened to be the first one that come along.

 Narayana hits on a good point here. I think there is a lot of sympathy for corporations, like airlines, because "this wasn't their fault." But a recession is never an individual company's fault. And the premium you get -- the higher interest rate -- for holding corporate debt comes entirely from the fact that corporate bonds lose value in recessions -- in aggregate "bad times." The Fed is willing to let us hold idiosyncratic risk. But idiosyncratic risk is not priced.

Or perhaps the market is allowed to absorb risk for little recessions but "this shock was too big." Well, it's also taking the left tail that generates the premium.
In the 2007-09 financial crisis, governments around the world engaged in large amounts of subsidized lending to financial institutions. These interventions were rightly seen by many as a subsidy to future risk-taking by those institutions — risk-taking that can deepen any recessionary shock. To prevent this moral hazard, financial institutions are now required hold a lot more capital — that is, be much less leveraged, thus lowering the need for future bailouts.  
We shouldn't let the novel source of the 2020 downturn fool us: The interventions by the Fed and Treasury are creating the same sort of subsidy for risk-taking by nonfinancial corporations. We will need the same kind of post-recession policy response: Congress should use its power to tax or regulate to discourage or even bar the country's large corporations from being too highly leveraged or using risky financing instruments. Otherwise, corporation will be further incentivized to take on too much risk and force another, possibly larger, bailout when another recession hits. 


  1. One important difference is that now what we have is not actually a "recession", it is essentially a natural calamity that is hitting business in specific sectors (mainly travel, restaurants, hotels). These businesses never insured themselves against this sort of risk because nobody was aware of the possibility of a pandemic induced global lockdown before 2 months ago: it is a novel kind of event in world history. In fact, a few decades ago the technology to shift to implement a lockdown and shift to remote work for hundreds of millions didn't even exist.

    The Pareto efficient thing would be to insure against pandemic knockdown but nobody did that because nobody was aware of this possibility. It revealed itself now as it occurs. The government is acting as an insurance agaisnt a novel natural calamity. Yes, it is using it's power of coercion to replace the function of a market for pandemic induced lockdown insurance that couldn't exist because nobody was aware of such possibility. I call it revelation of incomplete markets by backward induction.

    So I think this bailout might be justified as a form of insurance.

  2. We need minimum capital ratios for all corporations don't we - not just for banks? Of course any such move would be strongly resisted by Wall Street, which would make a dash (armed with wads of $100 bills) for politicians, with a view to stuffing the wads of money into politicians' back pockets.


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