Credit Questions

October 6, 2008

Though I do think traditional, boring classical economics is being unfairly neglected during this current crisis, I should avoid the other extreme. It may not be the case that everyone is behaving in a perfectly rational way right now. It seems to me that there are two important questions that we should try to answer. Namely,

1. Is credit really “frozen”? That is, are investors irrationally refusing to purchase debt at its true, risk-adjusted value?

2. If credit is frozen, can action on the part of the government cause a general improvement in the economic situation? That is, can the government do better than natural investors when the latter are behaving irrationally?

In this post, I’d just like to point out that the first question is a lot more difficult than most people assume. There’s no question that it’s more expensive for major institutions to borrow money now than it was two years ago. Ergo, some say, investors are irrationally fearful. But haven’t we established that two years ago, it was too easy to get loans because of systematic mis-pricing of risk? If money was “too cheap” back then, how can we be sure that the market has overshot, and money is “too expensive” right now?

As evidence that the credit markets are locked up, The New York Times reported on the difficulties California has had raising $7 billion though bond sales. Government bonds are generally considered pretty safe, so this is indeed a strange situation. But this is a state which, according to the same article, “adopted a $143 billion budget, 85 days overdue, after a protracted fight between Mr. Schwarzenegger and the Legislature over how to close a $15 billion gap.” Perhaps investors aren’t so irrational after all to have doubts about California’s ability to pay its debts.

On the other hand, investors are accepting ridiculously low rates of interest on short-term T-Bills, so that’s a piece of evidence in favor of the view that investor are overly fearful.

What I’d like to do to get a satisfying answer the question is to find the “money pump.” Where’s the obvious opportunity to make money by taking advantage of irrationally fearful investors? As one person describes this problem, if your preference set dictates that you’d rather be in Philadelphia than DC, rather be in New York than Philadelphia, and rather be in DC than New York, you’re going to spend a lot of money on cab fare (or Chinatown Bus fare). If we can establish that there’s a way to do that, we will have shown irrationality. Otherwise, we’re just looking at securities and saying, “Well, I think they should be worth more. Not that I want to spend my own money on them or anything. I’m just saying.”

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