Epsilon is really small
2008-10-30 · Original WordPress address
Essential reading from NotSneaky.
My sense is that epsilon (the effect contraction in the financial sector will have on the non-financial sector) is small in the short run and zero in the long run. There are some transaction costs in finding a new bank for "real" economy businesses if their old ones stop providing credit, but in the end we're talking about a couple strokes on a keyboard and maybe a walk further down the block.
Is there any "micro evidence" that can help us pin down this parameter?
Also, the large dip in financial paper with no corresponding dip in the non-financial sector on the first chart here is evidence of a small epsilon.
As long as there's at least one bank standing at the end of all this, I don't think epsilon can get that big. So maybe the bailout is attempting to throw money at this problem hoping to avoid this non-linearity.
In the long run, epsilon is zero as everyone in the non-financial sector has found alternative sources of credit. The fact that a bunch of smart ex-bankers will become smart middle managers in the real sector is gravy. But because someone was stupid-efficient at moving electronic bits shaped as dollars around doesn't mean they'll be good at moving electronic bits shaped as goods and services and it probably means they're just plain bad at moving atoms around (although, Bankers tend to work out a lot).
Using NotSneaky's handy chart, I predict a recession of about 2% peak to trough.
UPDATE: We're on our way. GDP down 0.3% last quarter.