Richard Clarida's retrospective on the financial crisis

October 24, 2010

I earlier discussed several of the presentations at the monetary policy conference at the Federal Reserve Bank of Boston last week. But missed in the popular coverage of the conference was an insightful discussion by Columbia Professor Richard Clarida that expressed very nicely the conclusions that I have come to as well on the events that led us into these problems.

Clarida wrote:

The subtitle of this paper is not 'I Told You So' and for a good reason. I didn't, and it wasn't because I was shy. Rather, as will be discussed later, I, like the vast majority of economists and policymakers, suffered-- in retrospect-- from Warren Buffet's 'lifeguard at the beach' problem: "you don't know who is swimming naked until the tide goes out"....
The efficient markets paradigm was seen as a working approximation to the functioning of real world equity and especially credit markets. The growing role of securitization in credit markets, especially in the US, was seen as a stabilizing innovation that reduced systemic risk by distributing and dispersing credit risk away from bank balance sheets and toward a global pool of sophisticated investors. While asset prices might well drift away from fundamental value and for long periods of time, 'bubbles' were difficult enough to identify ex ante so that the role for monetary policy was to limit collateral damage to inflation and economic activity when they burst....
It is startling to note in the US the chasm that emerged during the 'great moderation' between credit extended to the household and non-financial business sectors-- much of it through the 'shadow banking' system to be discussed below-- as compared against nominal GDP. This was the 'great leveraging' that accompanied the 'great moderation'....

Source: Clarida (2010; presentation slides)

Shadow bank liabilities versus traditional bank liabilities, in trillions of dollars. Source: Clarida (2010)

Clarida continued:

...greater and greater use of leverage which in turn supports asset prices which in turn support more leverage. And importantly, this channel is missing in the justly celebrated and influential Bernanke-Gertler model (1999) presented at Jackson Hole in 1999. In that model, the bubble affects real activity in two ways. First, there is a wealth effect on consumption, although that effect is presumed to be rather modest. Second, because the quality [of] firms' balance sheets depends on the market values of their assets rather than the fundamental values, a bubble in asset prices affects firms' financial positions and, thus, the premium for external finance. Although bubbles in valuations affect balance sheets and, thus, the cost of capital, B and G assume that—conditional on the cost of capital—firms make investments based on fundamental considerations, such as net present value, rather than on valuations of capital including the bubble. This assumption rules out the arbitrage of building new capital and selling it at the market price cum bubble-- the Ponzi finance stage of a bubble in the Minsky nomenclature.... "This time it was supposed to be different" because securitization and the expertise of the ratings agencies in assessing default risk correlations across various tranches of structured products was in theory supposed to make the financial system more stable and reduce systemic risk....
With the benefit of hindsight ... it seems clear-- at least to this author-- that the financial crisis and the credit and securitization bubble that preceded it resulted not only from spectacular failures in securities markets-- to allocate capital and price default risk-- but serious failures also as well by policymakers to adequately understand, regulate, and supervise these markets. Policymakers, academics, and market participants simply didn't know what they didn't know. They assumed that either it couldn't happen (after all, AAA securities 'never' default), or if it did, it would be systemically unimportant. Until the tide went out. But by then it was too late.

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