Tail Risks

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by: Brad DeLong

Tail risks. Can we afford right now to think about tail risks? Probably not: Right now, what were our tail risks have become head risks, and given them and our day jobs, we are all fully absorbed. But if we are going to be spending even a little time thinking about tail risks, the big worry has to be that something happens to cause the Global North to stop investing, as it did in 2008-2009.

Cast your minds back to ten years and two months ago. Back then people were patting themselves on the back. The United States had wound down from its over-the-top over-commitment to housing construction and had done so without a recession. The Federal Reserve had handled the unpleasantness of mortgage-firm, structured-product, and Bear-Stearns bankruptcy. In doing so, the Federal Reserve had effectively guaranteed the unsecured debt of every systemically-important commercial and investment bank in and out of New York.

The forecast - at least among those who were not close students of Hyman Minsky, and who had not paid attention to Paul Krugman's The Return of Depression Economics - was for at most a small recession, with the balance of risks such that the major risk to the economy - at least in the minds of the Federal Reserve's Open Market Committee - was an increase in core inflation.

Then, somehow, Lehman Brothers arrived. And, somehow, the Federal Reserve claimed that it could not resolve the firm, could not put the firm into conservatorship, could not even manage the unwinding involved in the bankruptcy process. The Federal Reserve offered no explanation of why it had let a systemically-important financial institution become not just illiquid but catastrophically insolvent, and has watched this without devoting any time or energy to constructing an emergency action plan. And everything went to hell. And is still not fully back.

We still do not have a good enough understanding of why the Lehman shock was enough to send everything to hell. Suppose we get another shock of that magnitude? We are now in a much worse position than we were ten years and two months ago - much less fiscal space, much less monetary space, and what then appeared reasonable about the power of quantitative easing and other non-standard monetary policy tools have proven vain.

Thus, should we get another Lehman-sized shock, the only way to maintain anything like full employment will be aggressively expansionary fiscal policy. Given the lack of perceived fiscal space, the only way to manage the resulting debt increase will be substantial financial repression - things like those done in World Wars I and II to keep rates low.

Somebody in government needs to be thinking right now how to do this. The crisis response from 2008-2012 was distinctly subpar due to a failure of central banks to understand how to do the lender-of-last-resort thing right, due to optimistic false confidence that the private sector bounces back on its own, and due to a refusal beforehand to have outlined "shovel ready" projects and an unwillingness to grab for the "blood pressure meter ready" projects that could have been vehicles for lots of fiscal expansion.

It would be very nice if, right now, we had a full panoply of measures for fiscal expansion and financial repression on the back burner that we could quickly put on the table if, two years from now, we are blindsided by something that gets us back to 2009.

But we do not.