Thursday, October 09, 2008

Why Didn't Passage of the $700 Billion Bailout Stabilize The Financial Markets?

Manuel Hinds, writing in the Wall Street Journal may just have the right answer, illustrating his point with a poker analogy. Read the whole thing of course but here's the meat of the article.

"What we are witnessing is what economists call a rise in the liquidity preference, which was the main factor leading to the Great Depression. By a rise in the liquidity preference we mean that investors aim to increase the share of liquid instruments in their total assets. For the banks it means they want to liquidate loans and transfer the proceeds to very liquid instruments, such as Treasury Bills.
This migration depresses the economy by reducing credit. In these circumstances, the solution is not to keep on throwing money at the banks, which are inclined to hoard it not lend it. Rather, what is needed is stopping the skyrocketing increase in their liquidity
preference and then lowering it. Doing that requires writing off the losses now lodged in the financial system as soon as possible.

A simple analogy will help illustrate this point. Imagine that you are playing poker with 10 people and that you learn that a minority of them is broke and would not pay you if
they lose. You don't know, however, who the ones are who won't pay. In this environment, the risk of losing would be too high even if you know that most of the players are perfectly sound financially and would pay up if they lose.

In this environment, any rational card player would stop making bets until the true solvency position of each player is revealed and the bankrupt ones are expelled from the game. Having insolvent players sitting at the table spoils the game.

This is what is happening in the banking system -- only worse, because in poker you would only fail to collect the pot if you played with an insolvent player, while in the banking system you would lose your bets if you lend to an insolvent bank. Liquidity preference will not subside until the losses are made explicit, written off and absorbed."

This sounds about right to me. I've quipped to more than one person in the last few days that it seems like every time the government tries to "do something" the market swoons again and maybe they should just stop. I may have been coincidentally closer to the mark than I thought.
Update: The day afer the first bailout bill was rejected by the House, i.e., the government failed to "do something," the dow rallied by 485 points. Yes, it dropped the day of the vote but could that be more due to the expectation of passage by some who expected the companies they invested in to benefit from the bailout and that was priced into the stocks? When the expectation didn't materialize, the market fell.
Share |

No comments: