For each dollar they have in deposits/capital, they are making 10+ different loans on your initial deposit. (It’s a bit more complicated than that.) Banks make their money by… well… creating money. Literally.

The challenge is we are now dependent on banks to create the money we have in circulation. This crisis has forced enough interest from the public that a few are pulling back the curtain. And they don’t like what they see.

Anyone care to respond?

The author introduces a new variable (risk premium) as an exogenous entity. Likewise, the _wealth_ loss caused by the housing price plummet (and stock market collapse) is treated as an _exogenous_ shock to the system, specifically to demand.

I have two critiques about introducing these as _exogenous_ variables:

1) The Wealth Shock. The LM curve is supposed to embody the equillibrium between the willingness to hold cash and to hold assets – specifically transaction demand as well as speculative demand. It is quite clear that LM has a direct impact on (perceived) household wealth, since the dramatic loss in household wealth is a largely _result_ of the flight from assets to cash.

Let me rephrase this: Many people agree that the loss in household wealth (fall in home/401k values) is a _direct_ result of a change in liquidity preference (which is supposed to be represented by the LM curve), but in this model it’s represented as an independent and external shock to the system.

Makes no sense. Moreover, by asserting this, the model essentially says “it’s exogenous, there’s nothing we can do about it… it’s an act of nature”.

2) The risk premium, likewise, is seen as an exogenous parameter.

Aversion to risk “just happened”. There’s no internal explanation for it within the model.

It has nothing to do with legal rules (like the cap asset ratio) that enforce extreme reductions in outstanding assets whenever capital base shrinks due to a modest loss on a highly leveraged balance sheet.

It has nothing to do with imposing a mark-to-market rule at the height of the bubble, which front-loads implied losses before those losses actually happen, and thereby creates an immediate credit crunch as forward-looking markets translate future losses into the present (and thereby create immediate massive constraints on lending).

Seriously, isn’t LM supposed to be the “Liquidity/Money Equillibrium”? Modeling risk premium as an external shock is a slight-of-hand to get the model to fit the data by adding a “free parameter”.

However, that new parameter explains nothing. It doesn’t tell us how we got into this mess, or how to get out of it. It’s basically saying “bad stuff happened – it was an act of nature”.

It also has no predictive value, since we don’t know whether that risk premium will stay the same or change. And if the risk premium can change, then the LM curve is no longer a line – it’s more like a wide band that is now contingent of “risk premium”.

It reminds me of Keynes’ “animal spirits”.

Reading this chapter vaguely reminded me of Ptolemaic Astronomy – full of cycles and epicycles and other contortions trying to explain observed facts while still keeping the sun at the center of the universe.

Perhaps economics needs to confront the fact that the sun is not at the center of the universe.

This counterfactual has an N-size of exactly 1.

Let’s ask this question: What would the GDP have looked like if WWII (and the massive technological and industrial investments to drive it) had not followed immediately after? If the US had lost WWII (which very nearly happened)? If the US had not rebuilt Europe with the Martial Plan? If the US had not invested in domestic infrastructure in order to build a manufacturing base capable of opposing the Soviet Union?

Nor can we look across countries and say the N-size = the number of countries in the world. If CDO traunching has taught the quants anything, it’s not to underrate the impact of cross-unit correlation.

I’m not sure about the motivation behind the statement, but in reading the chapter I too immediately thought it very odd and out of place. Certainly it does not add to the credibility of the author.

“…you totally miss the failure by the bureaucrats/regulators that caused all this (“The consequence of bad economics”, editorial, March 10)…you seem not to understand that the problem is that the central banks and governments refused to let the market work for 15-20 years or so. Had they done so, we would not have these problems today…. Had [Greenspan] let Long-Term Capital Management collapse in 1998, Lehman, Bear et al would still be in business…” http://www.ft.com/cms/s/0/a1c18156-0ddc-11de-8ea3-0000779fd2ac.html

long-run GDP is of little (and ultimately negative) worth when it is achieved by generating negative externalities. for the roots of today’s problems, perhaps it would be more instructive to start as far back as the first and second world wars.