Saturday, April 25, 2009

New Research from the St. Louis Fed Appears to Add Academic Credibility to the Battle Against PPIP

The St. Louis Fed has just released a working paper that joins its neighbor, the K. C. Fed, in pushing back against Fed and Administration policies. First, let us recall that the K. C. Fed's chief, Thomas Hoenig, pulled no punches in joining much of the blogosphere when he testified before Congress that policy toward financial institutions was tilted far too much in favor of the companies rather than the taxpayer, as well as that there had been far too much of the Japan rather than the Stockholm syndrome in creating and then nurturing zombie banks.

Now the St. Louis Fed has come out with "A Simple Model of Trading and Pricing Risky Assets Under Ambiguity: Any Lessons for Policy-Makers?"

The abstract almost says it all from a policy standpoint:

The 2007-2008 financial crises (sic) has (or, "sic" the verb) made it painfully obvious that markets may quickly turn illiquid. Moreover, recent experience has taught us that distress and lack of active trading can jump “around” between seemingly unconnected parts of the financial system contributing to transforming isolated shocks into systemic panic attacks. We develop a simple two-period model populated by both standard expected utility maximizers and by ambiguity-averse investors that trade in the market for a risky asset. We show that, provided there is a sufficient amount of ambiguity, market break-downs where large portions of traders withdraw from trading are endogeneous and may be triggered by modest re-assessments of the range of possible scenarios on the performance of individual securities. Risk premia (spreads) increase with the proportion of traders in the market who are averse to ambiguity. When we analyze the effect of policy actions, we find that when a market has fallen into a state of impaired liquidity, bringing the market back to orderly functioning through a reduction in the amount of perceived ambiguity may cause further reductions in equilibrium prices. Finally, our model provides stark indications against the idea that policy makers may be able to “inflate” their way out of a financial crisis. (emphasis added)

Your humble blogger has slogged through the lengthy paper, skipping the equations that a non-economist finds more than a mite obscure. It would appear that the St. Louis Fed has two policy objectives, the more topical one taking dead aim at PPIP.

One of the most important set-ups in the paper involves the situation in which SEUs (subjective expected utility) maximizers own securities which become illiquid due to a financial crisis. AA's (ambiguity averse) then enter the market with government assurance against a worst-case scenario. The authors state (pp. 36-37) for example that:

The implication is that starting from situations of SEU-only participation, it will take large jumps in "mu"-min (=minimum projected return, I believe-though never specifically defined) for the equilibrium to be significantly affected; however, when this happens, one can also expect a detrimental effect on risky asset prices. Interestingly and realistically, as the fraction of AA investors "alpha" increases, the threshold level mu-min required for inducing participation reduces, since now each AA agent has to bear a lower amount of risk. This is relatively surprising; even though the policy action consists of ruling out the worst possible scenarios increasing mu-min, for an action of sufficient magnitude its eventual effect on equilibrium prices will be negative and the cost of enforcing a participation equilibrium will consist of a higher risk premium. This means that when a market has fallen into a state of disruption (a SEU-only equilibrium), bringing the market back to higher liquidity and orderly functioning through a reduction in the amount of perceived ambiguity may actually go through further reductions in equilibrium prices. (emphasis added)

Later on p. 37, the authors summarize the above:

As we have seen, when a market has already broken down in terms of participation, trying to affect the perceived uncertainty by increasing mu-min may actually depress prices and inflate risk premia, although this policy can eventually raise liquidity and induce full participation. (emphasis added)

The above appears to describe the current situation in which the largest holders of CDOs and the like are faced with an auction to sell to risk-averse buyers, with government intermediation. Lower prices for the securities are projected. That would appear to describe the Public-Private Investment Program to a PPIP!

Regarding the different problem of the Fed's expanded balance sheet and inflation risks, in addition to the strong language in the abstract, the paper specifically addresses inflation in section 5.5.3., which contains the following (page 40):

Once more, inflation as a policy tool seems ineffective or perverse because it may induce limited participation and depress equilibrium real asset prices. . .

Therefore low inflation has only virtues, leading to steady, widespread participation, steady liquidity, and (with high probability) even to higher risky asset prices in real terms. Therefore, it seems that a sensible policy-maker interested in supporting a well-functioning, non-segmented asset market ought to reduce inflation.

The heartland is making itself heard. Let us hope that being "from Missouri" means something to Team O and Gentle Ben.

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