Monday, April 23, 2007

Ruination and Despair

Inspired by the two articles below I have been thinking about the link between Monetary Policy and risk. In particular there is this pop concept that one can be ruined.

That is, there are realizations of stochastic events whose effects cannot be smoothed out by access to credit. In plain English, if a lot of bad things happen to you at once the result can be much worse than if those same bad things happened to you over a longer period of time. Is this true? And if so, what are the causes? Why can't you borrow to get out of the situation?

Does being put in a bad situation make you more vulnerable to other bad things? When it rains does it pour?

This is important because it could mean that short term fluctuations in terms of credit could have long term repercussions. If suddenly everyone finds it more difficult to borrow to cover an emergency does this make the whole system more vulnerable?

13 comments:

Joana and Nick said...

Hi Carl,
I was reading Greg Mankiw's Blog and just read you. Small world... I looked, but no email contact. Send us news!

Gabriel Mihalache said...

Well, I don't think that credit and risk can be taken together like that.

Even with perfect capital markets you're still bound by the no-Ponzi-scheme constraint, i.e. that in expectations, at the end of you life you should have 0 credit.

So even if the market could supply a lot of credit, it wouldn't supply it to me beyond what I'm reasonably expected to be able to pay back with interest.

As for risk, again, with perfect markets, you get individual risk vs. social risk. People on markets can pool risk and cancel-out opposing loses (i.e. diversify: buy stock in an umbrella factory and in an ice cream factory and regardless of whether the Spring is rainy or sunny you don't lose out). But social/market risk can't be diversified like that (the risk that a meteorite destroys the planet).

So yes, even in a RBC models where everything is perfect and changes in productivity induce business cycle like fluctuations... even there people can be miserable.

Karl Smith said...

^

True but the question is whether or not a concentration of bad events at a single point can overwhelm your ability to smooth themout.

For example, suppose that there are three periods. I know going in that I have an expected loss of X in each period.

Under one scenario I experience a loss of 3x in period 2.

Under another I experience a loss of x in all three periods.

Under what circumstances would these have different results.

Well, one easily constructable one is if I have a credit constraint. So that my optimal savings plus maximum credit is less than 3x.

Sometimes people speak as if this is the case. Is this real? Are credit constraints important? Is there something similiar.

If there was then a channel through which monetary policy could act is by changing cost of short term credit, bankruptcies became less likely.

This in turn eases credit along the entire yeild curve, which both expands residential investment and explains the change in conditional variance between currencies.

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