Wednesday, May 20, 2009


In response to the Krugman and DeLong search for a model that explains bubbles and crashes, Arnold Kling suggests a focus on the financial system and its desire to provide households with risky liabilities (mortgages and corporate loans) and safe assets (deposits). As the financial system gets larger, the each side of the financial balance sheet expands. The burst comes when households start to doubt the safety of their assets.

1. Ordinary folks in the nonfinancial sector want to issue risky liabilities (shares of investments in fruit trees, mortgages on houses) and wants to hold riskless assets (demand deposits, money market fund shares).

2. The financial sector obliges by having a balance sheet with risky assets and supposedly riskless liabilities. The bigger the financial sector gets, the more euphoric the investment climate, because nonfinancial folks get to hold more riskless assets and issue more risky liabilities.

3. The financial sector's expansion is based in part on signaling. That is, banks signal that their liabilities are low risk. Signals include fancy buildings, the "FDIC insured" sticker, balance sheets filled with AAA-rated assets, and so on.

4. Financial expansions are gradual, because it takes a while to come up with new signaling mechanisms and to get the credibility of those mechanisms established with investors.

5. Financial crashes are sudden, because once investors lose a little bit of their confidence in financial institutions, their natural instinct is to ask for safer assets (they withdraw money from uninsured banks, or they ask AIG to post collateral). This behavior weakens the financial institutions further, leading to a rapid downward spiral. Today, we are seeing that all sorts of signals are discredited.

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