via Tyler Cowen we are sent to FT Alphaville for a some serious brain damage. I have training in both bond markets and monetary macroeconomics but have no real practical experience in either, so I know only enough to be dangerous here. Beware.
With that, let’s of course talk about how bond markets affect monetary policy.
Banks borrow money. In the olden days, they’d borrow it from you and me (deposits) and lend it out for profit. Sometimes the banks would make enough bad loans that borrowers would all simultaneously freak out and try to withdraw all their money. Loans can’t be called that fast. Bank run… Bust.
A big part of Bernanke’s academic legacy is describing the nasty things that happen when an economy is starved of credit after an epidemic of bank runs.
Deposit insurance stops this problem because the olden days creditors (us) never have to worry about getting their money back. But these days there’s a new channel for bank runs: shadow banking.
Here’s how a shadow bank works: you have a treasury bond or some highly rated corporate debt but you WANT cash. So you borrow money overnight and pledge that bond as collateral then go make some money with that cash. That’s shadow banking.
The point of the FT post is that shadow banking is huge and absolutely TANKED during the crisis. There’s lots of interesting discussion in that piece on this point. Here’s a graph (there are may more)
This had the effect of sucking money out of the economy, perhaps not quite like what happened in the Great Depression but certainly more than the experts thought they saw in 08-09.
I really liked this quote:
6) How does this understanding of the crisis jive with Gary Gorton’s theory of what happened? Recall that Gorton’s story wasn’t just about collateral values plunging and haircuts rising in repo markets. It was that certain types of debt used as collateral flipped from being information-insensitive to information-sensitive. And this flip wasn’t limited to subprime MBS, which would have caused only minor stresses.
His argument wasn’t about the relative safety of the collateral as its value fell. It was about the collateral going from safe to unsafe just because lenders in repo markets realised that it could potentially fall. So they pulled out en masse and hiked haircuts even when the collateral wasn’t subprime-related, and voila you’ve got a crisis. This was partly an issue of repo market transparency, but it also reflects a different, more binary understanding of what triggered the crisis.
Summary: on a one-day time horizon, highly rated corporate paper wasn’t risky until it was. And if that stuff was used for repo loans then the repo system stops working.
What nobody really understands, even now, is how important the repo system is. Even though Scott Sumner thinks it doesn’t matter.