2009 Jackson Hole Symposium

The Kansas City Fed has released the proceedings of the 2009 Jackson Hole Symposium on Financial Stability and Macroeconomic Policy.

Ricardo J. Caballero, last mentioned on PrefBlog in connection with tail-risk insurance, presented a paper titled The “Surprising” Origin of Financial Crises: A Macroeconomic Policy Proposal, which, rather oddly, has been encrypted. He argues that three elements are necessary to produce a financial crisis:

  • Negative Surprise (not that sub-prime blew up, but that linkages were so strong and that transmission was so virulent)
  • Excessive Aggregation of Risk in systemically important leveraged institutions
  • Slow Policy Response

Dr. Caballero proposes the establishment of Tradable Insurance Credits, issued and backed by the Central Bank. In normal times, these would carry no pay-off; in times of crisis, the Central Bank would make them convertible and holders would have the option of, essentially, converting them into Credit Default Swaps. This addresses the risk of Knightian uncertainty that was addressed in Dr. Caballero’s prior proposals.

Stephen Cecchetti, Marion Kohler & Christian Upper presented a paper titled Financial Crises and Economic Activity, also encrypted. Pretty gloomy stuff – he suggests that even in a best-case scenario, it will take years to make up for the current loss of output. Dr. Cecchetti was last mentioned on PrefBlog on April 10, 2008.

Carl Walsh presented a paper titled Using Monetary Policy to Stabilize Economic Activity, in which he suggests that, overall, Price Level Targetting is superior to Inflation Targetting, due to its automatic stabilizing influence. He cautions, however, that changing horses in mid-stream (mid-raging-torrent might be a better metaphor in this economy) is not advisable. Price Level Targetting was the subject of the BoC Spring 2009 Review and the paper’s respondant was BoC Governor Mark Carney.

Auerbach & Gale presented Activist Fiscal Policy to Stabilize Economic Activity. They explicity exclude “automatic stabilizers” (e.g., Unemployment Insurance, Welfare) from the discussion, focussing more on discretionary fiscal stimulus.

Update, 2009-8-26: Mark Carney’s response to the Walsh paper have been published by BIS.

A kind soul has sent me an unencrypted version of the Caballero paper:

Coval et. al. (2008) argue that the correlation between economic catastrophe and default by highly rated structured products went largely unappreciated by investors, who seemed to treat ratings as a sufficient statistic for pricing. Highly rated single–name CDSs and structured product tranches traded at very similar spreads (their data is for September 2004 to September 20 2007), despite the fact that on average the structured product tranche would likely default in a much worse macroeconomic state.

Regardless of whether this correlation was underappreciated or not, the systemic consequence of this risk was that highly leveraged institutions were bearing more aggregate risk than would have been thought from simply observing the ratings of their assets. Having the highly leveraged financial sector of the economy holding the risk with respect to an aggregate surprise proved to be a recipe for disaster.

A standard advice stemming from the moral hazard camp is to subject shareholders to exemplary punishment (the words used by Secretary Paulson during the Bear Stearns intervention). This is sound advice in the absence of a time dimension within crises. With no time dimension, all shareholders were part of the boom that preceded the crisis and as soon as the bailout takes place the crisis is over; the next concern is not to repeat the excesses that led to the crisis. Punishing shareholders means punishing those that led to the current crisis, and it is better that they learn the lesson sooner rather than later, the righteous speech goes.

However, this advice can backfire when we add back the time dimension. Now, the expectation that shareholders will be exemplarily punished if the crisis worsens delays investors’ decision to inject much needed capital. As a concrete example, sovereign wealth funds were much less eager to inject equity into the U.S. financial system after the Bear Stearns exemplary punishment policy (March 2008) than they were before the policy, as illustrated in Figure 6. Some of the capital injections that did take place after this, such as UFJ Mitsubishi’s $9 billion investment in Morgan Stanley in October 2008, only took place after the U.S. Treasury assured them that the investment would not be wiped out in a future government intervention. Conversely, destabilizing speculators and shortsellers saw the value of their strategy reinforced by the policy of exemplary punishment.23 Moreover, from the point of view of future crises, memories of this intervention may also hamper any chance of a private sector resolution as new equity will be less likely to attempt to arbitrage the initial fire sales. In other words, once the within-crisis time dimension is considered, the anti-moral hazard strategy may morph into a current and future crisis enzyme.

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