sabato 13 marzo 2010


Uh, this morning I've understood another small element of the edifice of economic theory.

Here's my comment (on this post by Prof. Rizzo) which shows the intuition:

Moral hazard is not only relevant because of deposit insurance: it is relevant whenever costs are socialized.

If I invest too much now, together with everybody else, in a private-costs world I would expect high interest rates in the future, when there will be a scramble for credit, i.e., investment that raises the demand for capital, as Hayek put it.

When there is the central bank following a countercyclical monetary policy, during the scramble for capital, normally, interest rates don't rise in the short run, and probably also in the long run (the policy intervention will be at least as persistent as the crisis, i.e., the scramble for credit).

Counterfactually, an interest rate that in a private-costs world would have risen to 7-8% at the onset of the crisis, becomes a 0% interest rate because of the central bank. This may be imply great cost socialization… as the counterfactual market interest rate is not observable, however, it is difficult to evaluate if the phenomeon is relevant.

When costs are socialized, the market system is uncapable of retrieving and spreading correct information and forcing correct incentives. All the coordination process goes astray.

Competitive market agents will take moral hazard into account and “optimize” taking the cost socialization technology into account, i.e., they won’t “optimize” to find a “social optimum”, whatever it means.

Systemic risk cannot be avoided because noone has private incentives to avoid it. Only monetary authorities can stop socializing risks, but countercyclical policies work on the opposite principle.

7 commenti:

  1. A friend of mine says that it is not possible to comment this blog.

  2. It would have been nice if this article exposed also how a 0% interest rate involves cost socialization whereas 8% does not.

  3. I started on the assumption that monetary injections by central banks shift costs from investors to others (in which "others" may mean tax-payers, money-holders, financial markets as a whole...).

    So interest rate cuts are tantamount to a "don't worry about capital costs and risk premia, as someone else will foot the bill".

    8% was the counterfactual spike in interest rates (the new natural rate at the onset of the recession), and although noone can know its value, it must be higher than the standard natural rate because of the dearth in savings at the onset of the depression.

    So, if 3% is the standard "free market" interest rate and 8% is the free market spike at the beginning of the recession, cutting interest rates to 0% is not a 3% gift but a 8% gift to investors.

    The market, left alone, would have got a 8% price for credit, so whatever the central bank does to lower this cost is cost socialization.

  4. I meant about expliciting the mechanism (not the measure) of this 8% gift spreading into everybody's pocket as a subtle withdrawal of wealth (cost socialization).
    I can imagine it involves consumption of capital, for instance, but I would like your personal insight on the subject.


  5. I can try.

    Step 0: the central bank promises countercyclical interventions.

    Step 1: everybody acknowledges this policy and starts investing too much. In this phase, I expect a fall in risk spreads because of moral hazard, an increase in investment, employment and production, a lowering of return rates (a relative overvaluation of capital goods against consumption goods). Bondholders fund investments becasue they can only obtain lower interest rates. This is the first transfer of resources.

    Step 2: at some point a rush for credit occurs because excessive investments demand excessive circulating capital to be continued. This causes a spike in interest rates.

    Step 3: the central bank starts monetizing everything at hand to lower interest rates. Bondholders (savers) pay because there's no real increase in interest rates.

    Step 4: new money flows in consumer markets and reduces the purchasing power of fixed-income receipients and money-holders. This, too, is cost socialization, although it can't be measured in terms of interest rate differentials.

    The difference between actual and counterfactual rates explains the variation in private costs of the investors. The reduction in private costs comes at the expense of money- and bond-holders.

    Besides, cost socialization doesn't require that the exploiter and the exploited are separated: also with identical investors, cost socialization creates inefficiency because every single investor pays for the risk taking of others. And although everybody pays the same, at the margin no-one pays.

    For what concerns real resources, an increase in investment can be obtained by capital consumption, more risky attitude toward investments, the use of submarginal capital goods, the introduction of submarginal technological innovations, the increase in labor supply when real wages rise during the boom... so I would summarize everything under the label "capital consumption", although this concept is severely underspecified in the literature, and it is not always clear how it looks like in real (other than accounting) terms...

    That's something probably worth researching on.

  6. I do like this resume.
    We could even say that higher interest rates, during the credit rush, partly compensate an increase of the perceived risk of the entrepreneurial activity; if the CB keeps rates low, this means an undercompensation of the risk. As I think that lending can be considered as a "service" offered to the borrower, this service is now under-priced, which means a net transfer of wealth or, we better say, the transfer of risk onto the fund lender i.e. cost socialization.

    Well done Pietro. Thanks.