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September 18, 2007

Patrick Minford on The Rock

Excellent. So. to peple who are complaining about the way in which the risks of default are now spread throughout the financial system, Patrick Minford says:

The answer is No. In fact the spread of credit outwards from the well-heeled is one of the great triumphs of modern competitive finance.

By spreading the consequent risks around many well-capitalised holders they can be absorbed by the magic of 'diversification': by holding a wide spread of assets whose risks are 'not correlated', the average risk is reduced as in 'swings and roundabouts'.

It was this principle at work three decades ago that transformed company finance and governance through making possible the 'junk bond'; business has never looked back as entrepreneurs could use 'junk' debt to take over large sleepy companies.

So with the extension of credit to people; of course it is well-known that there will be default at a higher rate on this debt. But by opening up a market in it and spreading it around this risk can be priced reasonably.

This process is known as the 'completing' of financial markets. In 'complete' financial markets all risks that are not in principle uninsurable can actually be insured either directly or indirectly through the financial system.

This isn't a fault in the system, it's actually the whole damn point. That's not to say that there isn't a problem:

In fact what seems to have gone wrong is a failure of information in a rapidly developing financial environment.

It seems not to have occurred to anyone that there would be a need to know exactly what was in each securitised package - after all, the whole idea was to spread risk around so that it became relatively innocuous.

So when the worries about sub-prime mortgages surfaced no-one did know; and then of course there was general panic.

However the scale of any possible losses on sub-prime mortgages, even at its very worst, is not very large on the scale of the total balance sheets of the world's banks.

Therefore had all parties known what percentage they actually had on each particular balance sheet this could easily have been priced; the bank's share prices would have been adjusted for the prospective loss of profits and normal banking business would have gone on being done.

So the remedy for the systemic problem seems rather simple and will undoubtedly be adopted in future anyway: any CDO must have its contents on the jar, so to speak.

While we do actually want the risk to be spread around we'd actually really like to know where it is spread around. And given the results of our not knowing this time, anyone issuing in the future is going to have to tell. So, we'll end up with the system that we actually want. Widely dispersed risk with full information disclosure.

It might be that we don't actually need any new regulation after all. Markets do indeed make mistakes, but they also tend to learn from them.

September 18, 2007 in Economics | Permalink

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Comments

It's not going that way though at the moment, is it? If we're going to have 100% deposit insurance then I imagine regulation is going to become so stringent it'll be pretty much like de facto nationalisation.

Posted by: Matthew | Sep 18, 2007 10:49:38 AM

I'm moving my liquidity from Alliance and Leicester to Northern Rock - it's the latter that's got the 100% deposit insurance. Or perhaps I should wait a day until the former has too?

Posted by: dearieme | Sep 18, 2007 11:55:18 AM

Which is a Govt failure, not a market failure.

Posted by: Cleanthes | Sep 18, 2007 11:55:53 AM

On reflection, there're two objections to moving cash to Northern Rock. (1) I probably would have to queue for hours. (2) Then I'd have to spend 45 minutes opening an account, including proving who I am, explaining the source of the cash and purpose of the saving (Pure funk, madam) and so on. Perhaps I should just take the cash round to Majestic and stock up for winter: Aussie reds, Belgian beers and Normandy cider should keep the winter cold out. Or act as an alternative currency.

Posted by: dearieme | Sep 18, 2007 12:01:43 PM

The trouble is, with no respect to Patrick Minford, that economists have no clue at all as to how economics works. Just say to them "non-closed macro economic systems" and watch their eyes glaze over. Let all of us with an IQ of more than 3 digest that phrase "complete" a financial market. Assuming that were possible, which it isn't, then given a logistical loop, every process within that loop would be predictable - which it isn't which is why almost no economists are multi billionaires

Posted by: John Miller | Sep 19, 2007 11:13:17 PM

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