Liquidity, Default, Risk

J. Bradford DeLong

University of California at Berkeley and NBERbrad.delong@gmail.com; http://delong.typepad.com; 925-708-0467December 6, 2008

Larry White is the Best of the Austrians—the most persuasive, the mostthoughtful, and the most knowledgeable of the economists working in theAustrian monetary theory tradition, which is an essential part of ourcollective diversified intellectual portfolio in our age in which economictheory is so underdeveloped that, as John Maynard Keynes wrote in anearlier and somewhat similar episode, “[w]e lack more than usual acoherent scheme…. All the political parties alike have their origins in pastideas and not in new ideas…. It is not necessary to debate the subtleties of what justifies a man in promoting his gospel by force; for no one has agospel…”Nevertheless, I think that what Larry White has written misses the bigpoint about what really has happened. So let me try to lay out what thesituation looks like to me:Think of it this way: two years ago we lived in a world in which thewealth of global owners of capital was some $80 trillion—that was themarket value of all of their property rights to dividends and contract rightsto interest, rent, royalties, options, and bonuses. Now over time the wealthof global capital fluctuates, and it fluctuates for five reasons:1.

Savings and Investment:

Savings that are transformed to theinvestment add to the productive physical—and organizational,and technological, and intellectual—capital stock of the world.

2This is the first and in the long run the most important source of fluctuations—in this case, growth—in global capital wealth.2.

News:

Good and bad news about resource constraints,technological opportunities, and political arrangements raise orlower expectations of the cash that is going to flow to those withproperty and contract rights to the fruits of capital in the future.Such news drives changes in expectations that are a second sourceof fluctuations in global capital wealth.3.

Liquidity Discount:

The cash flowing to capital arrives in thepresent rather than the future, and people prefer—to varyingdegrees at different times—the bird in the hand to the one in thebush that will arrive in hand next year. Fluctuations in this liquiditydiscount are a third source of fluctuations in global capital wealth.4.

Default Discount:

Not all the deeds and contracts will turn out tobe worth what they promise or indeed even the paper that they arewritten on. Fluctuations in the degree to which future paymentswill fall short of present commitments are yet a fourth source of fluctuations in global capital wealth.5.

Risk Discount:

Even holding constant the expected value and thedate at which the cash will arrive, people prefer certainty touncertainty. A risky cash flow with both upside and downside isworth less than a certain one by an amount that depends on globalrisk tolerance. Fluctuations in global risk tolerance are the fifth andfinal source of fluctuations in global capital wealth.In the past two years the wealth that is the global capital stock has fallen invalue from $80 trillion to $60 trillion. Savings has not fallen through thefloor. We have had no little or no bad news about resource constraints,technological opportunities, or political arrangements. Thus (1) and (2)have not been operating. The action has all been in (3), (4), and (5).

3As far as (3) is concerned, the recognition that a lot of people are notgoing to pay their mortgages and thus that a lot of holders of CDOs,MBSs, and counterparties, creditors, and shareholders of financialinstitutions with mortgage-related assets has increased the default discountby $2 trillion. And the fact that the financial crisis has brought on arecession has further increased the default discount—bond coupons thatwon’t be paid and stock dividends that won’t live up to firm promises—bya further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion declinein market values.The problem is made bigger by the fact that for (4), the Federal Reserve,the European Central Bank, and the Bank of England have flooded themarket with massive amounts of high-quality liquid claims ongovernments’ treasuries, and so have

reduced

the liquidity discount—notincreased it—by an amount that I estimate to be roughly $3 trillion. Thus(3) and (4) together can only account for a $3 trillion decrease in marketvalue. The rest of that decline in the value of global capital—all $17trillion of it—thus comes by arithmetic from (5): a rise in the riskdiscount. There has been an increase in the perceived riskiness (not a fallin the expected value, an increase in the spread holding the expected valueconstant) of income from capital. And there has been a massive crash inthe risk tolerance of the globe’s investors.Thus we have an impulse—a $2 trillion increase in the default discountfrom the problems in the mortgage market—but the thing deservingattention is the extraordinary financial accelerator that amplified $2 trillionin actual on-the-ground losses in terms of mortgage payments that will notbe made into an extra $17 trillion of lost value because global investorsnow want to hold less risky portfolios than they wanted two years ago.From my standpoint, the puzzle is multiplied by the fact that weeconomists have what we regard as pretty good theories about (4) and (5),and yet those theories do not seem to work at all. As far as the liquiditydiscount (4) is concerned as long as we love our children as ourselves (andmost of us do) and as long as we have access to and can credibly pledge