Interest rates, regulation, trust, and finance's intermediary role

This post adds points to Mark Thoma’s post, where he said that both low interest rates and regulatory failure were responsible to the credit crisis. In response to the question of whether the Fed's low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernanke has also made this argument. However, I don't think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.

….Once the fuel was present, something had to allow the bubble to inflate and then do widespread damage, and that's where the regulatory failure comes in. But I don't think the regulatory failure matters much without a large amount of liquidity within the system, and I don't think the large amount of cash in the system is problematic without the regulatory failures.

I agree with Mark that Ben Bernanke cannot deny the low interest environment’s role in creating the crisis. In fact, in my view, interest rate’s role is even more emphasized than lax regulation (though I’m certainly not excusing lax regulation either).

To explain this point, let me start with Nick Rowe’s musings on finance. I can't get over the feeling that Finance is magic….By "Finance" I mean the whole industry that intermediates between ultimate borrowers and ultimate lenders. And that means not just banks, insurance companies and mutual funds, but also financial markets for stocks and bonds.

Like any other industry, Finance converts inputs into outputs. Ultimate borrowers want to borrow to finance assets that are: long, illiquid, risky, and complicated. Ultimate lenders want to hold assets that are: short, liquid, safe, and simple. Finance is an industry that coverts the raw materials of the former into the finished output of the latter. And it just can't be done. It's an illusion, a confidence trick; it's magic.

..... what surprises me is how far it has come along that road. It's surprising that Finance exists at all. Theoretically, Finance doesn't seem possible. It's just too far-fetched to expect it to work in practice. It's just a confidence trick; it all depends on trust.

Leading from Nick’s thoughts, here’s a summary of my thoughts on finance’s role and importance to society. Finance exists because its practitioners know who, in a given population, are willing to exchange liquidity for yield. They also know, on average, how much that yield should be, given how much everybody is willing to part with his liquidity. This is true for all kinds of intermediaries - bankers, insurance people, and fund managers.

Finance does the job mostly successfully because, in a given population, people have varying preferences for liquidity. They have different durations whereby they sacrifice liquidity. Finance, if it deals with a large enough segment of the population, manages its liquidity by matching funds with uses that have the same duration. Anytime that one person (or entity) decides he needs his liquidity back, he trusts that he will get it, because finance can replace that lost fund with funds from another person (or entity) who doesn’t need his liquidity at that moment.

For as long as the market’s preference for liquidity is the determinant of yield in constructing finance’s output, everything is okay. However, we occasionally see cases when people are chasing after yield, while maintaining the façade that liquidity is not being sacrificed. (This is what happened in the run-up to the crisis.)

Now this gets to the point I want to make. The biggest reason the market was chasing after yield was because the prevailing interest rates were too low. The need for yield is more acute the more the market consists of money market funds and insurance funds, who have an obligation toward their investors to consistently provide positive returns.

This need for yield necessitated that they go after what would normally be considered riskier investments, or investments that sacrificed more of liquidity. Without the impetus coming from low interest rates, finance would not have found the need to chase after yield at the expense of liquidity.

Now this also came at a time when regulations were also getting lax. In this environment, it became easier for investment bankers, the ultimate intermediary to other intermediaries, to come up with products and structures that effectively clouded the true extent to which liquidity was being sacrificed for yield. In this way, finance (investment bankers) compromised much of the trust from the market (the fund providers) that enabled it to do its job.

Finance is an activity that needs pro-active regulation because it is so easy for its emphasis to shift from using the market’s preference for liquidity as the determinant of yield, to using the market’s demand for yield as the basis for creating its outputs, without full consideration to high yield’s ramifications for liquidity. When people realize that liquidity has been compromised in way that they never anticipated, it will be a mad scramble for the exits as people demand more liquidity, even at the cost of negative yield. (This is where we found ourselves in the fall of 2008).

Now, whether we have lax regulations or not, low interest rates will always lead to markets chasing after yield. Because we had lax regulations, more people were victimized by Wall Street’s unscrupulous practices that fudged the real extent that the artificially high yield was being achieved at the cost of liquidity. Going forward, the Fed should be more sensitive at the adverse effects created by low rates and lax regulations.