Roger Lowenstein Makes the Case Against Hedging

by Reihan Salam

At Bloomberg View, Roger Lowenstein uses JPMorgan’s recent losses as an object lesson in the dangers of hedging:

When JPMorgan hedges, it doesn’t get rid of the risk. That only happens when the customer repays the loan or, say, improves its balance sheet. JPMorgan’s hedges didn’t make the risk disappear; they merely transferred it to someone else.

Jamie had an escape hatch, but hedging doesn’t offer an escape for markets as a whole. To sum up, thanks to these instruments, banks take more risks than they otherwise would and thus more risky bets are collectively owned by society.

The plasticity of modern finance — the ease with which institutions can transfer risk — is a major cause of the heightened frequency of meltdowns and increased volatility. As with a saloon in which each gunslinger comes armed (and with the safety catch released), markets resemble a shooting gallery in which risk takers, each in the name of self-defense, put the group in peril.

Lowenstein’s discussion of systemic risk reminded me of the work of economist Robert Hetzel, who contrasts what he calls a market disorder view of the 2007-8 financial crisis and the monetary disorder view:

The spirit of this article is to use empirical generalizations deduced from historical experience and constrained by theory so that they are robust for predicting the consequences of monetary policy. The two contenders matched here are the credit-cycle view and the quantity-theory view of cyclical fluctuations. The credit-cycle view explains cyclical movements in output as a consequence of speculative booms leading to unsustainable levels of asset prices and leveraged levels of asset holdings followed by credit busts that depress economic activity through the impairment caused to the functioning of financial intermediation from insolvencies and deleveraging. The quantity-theory view explains significant cyclical movements in output as a consequence of monetary disorder deriving from the introduction by central banks of inertia in adjustment of the interest rate to shocks.

Those who favor the quantity-theory view are often somewhat less inclined to advocate the kind of interventions Lowenstein proposes. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.