Archive for September 21st, 2007

Understanding financial crisis using information asymmetry framework

September 21, 2007

There are n (n as in many) number of papers on the subprime crisis .

Whichever way you look at it, the root cause lies in information asymmetry. By information asymmetry, I mean adverse selection, moral hazard and free riding. Mishkin has written a wonderful paper explaining each of these and how worsening info asymmetry leads to financial crisis. 

What distinguishes financial markets from general markets is that degree of info asymmetry is much more in former. And moreover, in a product/service market, once you get delivery of the product/service (which is usually immediate or after a few days), and in fin market your returns only come over a period of time. Hence, information problems continue and you are worried all the time about your investment/ loan.

I have expanded this analysis and have tried to understand the subprime crisis using the same. My paper can be found here.

Comments/Suggestions are welcome.

Roubini says tough times ahead

September 21, 2007

Nouriel Roubini (NR) has recently given a talk at IMF which is going to be talked about. The title itself would grab eyeballs: ‘The Risk of a U.S. Hard Landing and Implications for the Global Economy and Financial Markets’. He is quite a good economist and his views on global economy and financial markets are quite good.

The transcript of the talk is here and the summary is here. It is quite good, simply said and provides lots of food for thought. The moderator says NR made 3 predictions in his previous talk and 2 have come right:

1) Nouriel said that the U.S. housing correction would not go away quietly, but would go from bad to worse, and I think in this he has certainly been right on the nose.

2) He said that weakness in the U.S. subprime mortgage market would cause broader problems in the financial system, and here again Nouriel was certainly right, although for once perhaps not quite gloomy enough.

3) He put a high probability on the risk of a recession in the United States and a global hard landing. This has not happened yet.

As first 2 were bang-on target Roubini has many people wanting to hear what next. He says it simply that there would be a harder landing in US economy than what others might expect.

His analysis is house prices are going to decline much lower than expected, and as most consumption is funded via loans using  housing as collateral, this would lead to lower consumption. As US is a consumption driven economy (C=72% of GDP), there is an impact on the economy.

Further, as value of collateral falls there would be an impact on all those financial instruments created and there is an impact on the entire economy.

The broad analysis is the same as other analysis, his justifying the facts is quite good. For instance, his take on Fed

This is also the reason why I believe that actually while of course the Fed can ease and they are going to ease significantly, I am not sure that the Fed easing is going to resolve the problem the way they did in 1998 because there is an element of insolvency rather than illiquidity. I do not think what the Fed is going to do is going to be enough because it is going to be probably `too little, too late': too little because now they are worried still about inflation being on the upper limit of their comfort zone and because they are worried, rightly, about moral hazard issues. Therefore they are not going to aggressively ease the way they did in 2001.

And yes he assumed Fed is going to go for a 50 bps cut as 25 bps may not be enough.

 Highly recommended reading!

Assorted Links

September 21, 2007

1. Some articles are widely discussed from time to time (eg. Hip heterodoxy). MR points to a new one which asks why most research findings are false.

2. New economist pointsto a new paper on microcredit.

3. WSJ Blog points to a new paper by Fed that says:

The study examined how the U.S.’s trading partners adjust the prices of their exports when their currencies rise or fall against the dollar. The study, posted this week on the Fed’s Web site, found that increasingly, they tend to lower their prices when their currency rises against the dollar. That would tend to keep their prices constant in dollar terms in the U.S. market, minimizing their loss of market share. The reverse is usually also true — that is, they raise their prices when their currency falls against the dollar — with the exception of Canada.

 NY Fed had a similar paper which I mentioned here.

4. Mankiw tries to answer a fundamental question- Why do we need a Central Bank?

5. TTR on Bernanke put.

6. Rajrishi Singhal makes a case for the small investor, Only thing is he should have given the title – ‘The Reality of the small investor’.

7. In these times of transparency, our Central Bank still thinks Policy should spring surprises. I wonder what would SS Bhalla’s reactions be.

8. TCA summarises the research papers presented at Jackson Hole saying no whole answers were presented in the conference.  This is nothing new. Economics seldom offers whole answers.


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