Wednesday 2018-06-13

This book frames the Great Recession as made much worse by policy error: deposit insurance has worked to prevent bank runs -- where is the deposit insurance for the repo market?

You can see the possibility of a panic; it could occur if the depositors in the repo market decide not to renew their deposits and withdraw instead. Once a panic occurs, things get complicated fast. Transactions (or “liquidity”) are best accomplished with information-insensitive securities, like demand deposits or repo with collateral. These markets are defined by the fact that individuals do not perform due diligence on the credit risk precisely because they have confidence in the value of the securities and because they are sure the other side does not know more than they do about the security’s value. Common knowledge that this is the case is called “confidence in the system.” No one needs to know the details of the securities precisely because they don’t matter.

It’s a bit like electricity. When you wake up in the morning, you put your lights on. And when you leave for work, you turn them off. Return from work, turn them on; go to sleep, turn them off. You don’t need to know anything about electricity for this system to work. In fact, the idea is that you shouldn’t have to know; you don’t need to be an electrician. But if it happens that there is a blackout in which the whole electrical grid breaks down (this came close to happening in August 2003), then there is a problem. No one saw what happened to the grid, and many people do not actually know what electricity is. For the consumers of electricity, thinking about electricity for the first time seems incredibly complicated. And it is. Of course, the solution is not for everyone to become an electrician, rather, it is to restore the credibility of the system so that no one has to think about electricity.

-- Introduction

Unmentioned in the book is that taxing the repo market requires international collaboration -- lest other stable-enough countries become the new home for the repo market.