By Laurence Kotlikoff and Perry Mehrling
As we advocated two months back (Bagehot plus RFC: The Right Financial Fix), Uncle Sam is finally starting to sell systematic risk insurance on high-grade securities in exchange for preferred stock. This is a critical function for the US government; Uncle Sam is the only player capable of hedging systemic risk because he’s the only player capable of taking actions that keep the overall economic system on the right course. Read more
By Michael Spence
The crisis we are now in globally had its origins in an asset bubble fuelled by the interaction of excessive leverage and a widespread underestimation of the endogenously rising systemic risk – roughly the degree to which individual risks were becoming highly correlated via balance sheet linkages. The potential seriousness went unnoticed or not fully understood (by market participants, regulators and commentators) for several years. Read more
By Ricardo Caballero and Arvind Krishnamurthy
Financial institutions specialise in handling risk but are not nearly as efficient in dealing with uncertainty. To paraphrase a recent Secretary of Defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction is not only linguistically interesting but also has significant implications for economic behaviour and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner, makes the dreaded scenarios all the more likely. This mechanism has played an important role in the financial crisis. Read more
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