Unfair to Brazil

Paul Krugman writes that the crisis shows how "we are all Brazilians now."  I thought that was quite unfair to Brazilians, who after all became investment-grade in April.  Oh wait. Who upgraded Brazil's sovereign debt?  Standard & Poor's, the same firm that was the leading credit rating agency in the subprime mortgage market?  Never mind...

Seriously, Krugman presents a characteristically insightful model of contagion, which has helped me think through the issues.  The basic story is that highly-leveraged institution are bumping against a maximum-leverage ceiling, and when their balance sheets take a hit they have to respond by dumping some of their assets, which only exacerbates the downward price spiral. 

There is an interesting paradox buried in the Krugman model.  On the one hand, the more leveraged you are, the larger is the sell-off you need to engage in to restore your original leverage ratio following any initial reduction in asset prices.  That makes high leverage the prime culprit of the present crisis, and rationalizes Krugman's (and many others') view that liquidity is of no help; only recapitalization will work.  On the other hand, if the leverage constraint were not binding (as Krugman forces it to be in his model)--i.e, if you were able to ramp up debt--then you would not have had to dump any assets in the first place.  In this second view, the problem is liquidity.  Is this a possible justification of the Paulson plan? 

Comments

[Per Kurowski]

And while the ratings are going up this, for the banks, also means that they need less capital, which is something that also comes back with vengeance, when the ratings are going down. All in all we have managed to leverage pro- cyclicality. Great job regulators!

[bunbury]

Liquidity is the problem the way it is for a Ponzi scheme.

[chris]

But if Krugman's model isn't correct, if the problem wasn't too much leverage, then where does the crisis come from? What type of crisis would lead one to believe that injecting liquidity is the optimal solution? Is there another explanation that's nearly as plausible as Krugman's?

[Dan]

Brazilians were not offended by Krugman's post. They remember vividly that contagion in 1998-99 was hardly a matter of lack of financial virtue. Investors sold Brazilian assets because of a Russian default, a non sequitur that Krugman now tries to model. The sin of Brazil was to be vulnerable to leveraged investors and volatile capital flows and, in that respect, we truly are all Brazilians now.