Category Archive for: Financial System [Return to Main]

Monday, July 21, 2014

'Truth or Consequences: Ponzi Schemes and Other Frauds'

Cecchetti & Schoenholtz:

... A well-functioning financial system is based on trust. Widespread belief in honesty and integrity are essential for intermediation. That is, when we make a bank deposit, purchase a share of stock or a bond, we need to believe that terms of the agreement are being accurately represented. Yes, the value of the stock can go up and down, but when you think you buy an equity share, you really do own it. Fraud can undermine confidence, and the result will be less saving, less investment, less wealth and less income.
Unfortunately, in a complex financial system, the possibilities for fraud are numerous and the incidence frequent. Most cases are smaller and more mundane than Madoff or Ponzi. But they are remarkably common even today, despite enormous public efforts to prevent or expose them. One website devoted to tracking financial frauds in the United States lists 67 Ponzi schemes worth an estimated $3 billion in 2013 alone. ...

See also: Four years after passage, House keeps trying to kill Dodd-Frank.

Friday, July 18, 2014

'Did the Banks Have to Commit Fraud?'

Dean Baker:

Did the Banks Have to Commit Fraud?: Floyd Norris has an interesting piece discussing Citigroup's $7 billion settlement for misrepresenting the quality of the mortgages in the mortgage backed securities it marketed in the housing bubble. Norris notes that the bank had consultants who warned that many of the mortgages did not meet its standards and therefore should not have been included the securities.
Towards the end of the piece Norris comments:
"And it may well be true that actions like Citigroup’s were necessary for any bank that wanted to stay in what then appeared to be a highly profitable business. Imagine for a minute what would have happened in 2006 if Citigroup had listened to its consultants and canceled the offerings. To the mortgage companies making the loans, that might have simply marked Citigroup as uncooperative. The business would have gone to less scrupulous competitors."
This raises the question of what purpose is served by this sort of settlement. Undoubtedly Norris' statement is true. However, the market dynamic might be different if this settlement were different.
Based on the information Norris presents here, Citigroup's top management essentially knew that the bank was engaging in large-scale fraud by passing along billions of dollars worth of bad mortgages. If these people were now facing years of prison as a result of criminal prosecution then it may well affect how bank executives think about these situations in the future. While it will always be true that they do not want to turn away business, they would probably rather sacrifice some of their yearly bonus than risk spending a decade of their life behind bars. The fear of prision may even deter less scrupulous competitors. In that case, securitizing fraudulent mortgages might have been a marginal activity of little consequence for the economy.
Citigroup's settlement will not change the tradeoffs from what Citigroup's top management saw in 2006. As a result, in the future bankers are likely to make the same decisions that they did in 2006.

Thursday, July 17, 2014

'Debt, Great Recession and the Awful Recovery'

Cecchetti & Schoenholtz:

Debt, Great Recession and the Awful Recovery: ... In their new book, House of Debt, Atif Mian and Amir Sufi portray the income and wealth differences between borrowers and lenders as the key to the Great Recession and the Awful Recovery (our term). If, as they argue, the “debt overhang” story trumps the now-conventional narrative of a financial crisis-driven economic collapse, policymakers will also need to revise the tools they use to combat such deep slumps. ...
House of Debt is at its best in showing that: (1) a dramatic easing of credit conditions for low-quality borrowers fed the U.S. mortgage boom in the years before the Great Recession; (2) that boom was a major driver of the U.S. housing price bubble; and (3) leveraged housing losses diminished U.S. consumption and destroyed jobs.
The evidence for these propositions is carefully documented... The strong conclusion is that – as in many other asset bubbles across history and time – an extraordinary credit expansion stoked the boom and exacerbated the bust. Of that we can now be sure.
What is less clear is that these facts diminish the importance of the U.S. intermediation crisis as a trigger for both the Great Recession and the Awful Recovery..., while the U.S. recession started in the final quarter of 2007, it turned vicious only after the September 2008 failure of Lehman. ...
What about the remedy? Would greater debt forgiveness have limited the squeeze on households and reduced the pullback? Almost certainly. ...
The discussion about remedies to debt and leverage cycles is still in its infancy. House of Debt shows why that discussion is so important. Its contribution to understanding the Great Recession (and other big economic cycles) will influence analysts and policymakers for years, even those (like us) who give much greater weight to the role of banks and the financial crisis than the authors.

They also talk about the desirability of "new financial contracts that place the burden of bearing the risk of house price declines primarily on wealthy investors (rather than on borrowers) who can better afford it."

Sunday, July 13, 2014

'Why Macroeconomists, Not Bankers, Should Set Interest Rates'

Simon Wren-Lewis:

Why macroeconomists, not bankers, should set interest rates: More thoughts on the idea that interest rates ought to rise because of the possibility that the financial sector is taking excessive risks: what I called in this earlier post the BIS case, after the Bank of International Settlements, the international club for central bankers. I know Paul Krugman, Brad DeLong, Mark Thoma, Tony Yates and many others have already weighed in here, but - being macroeconomists - they were perhaps too modest to draw this lesson. ...

Saturday, July 12, 2014

'The Collapse of the French Assignat and Its Link to Virtual Currencies Today'

In case you missed this in links, I thought it was interesting:

Crisis Chronicles: The Collapse of the French Assignat and Its Link to Virtual Currencies Today, by James Narron and David Skeie, Liberty Street Economics: In the late 1700s, France ran a persistent deficit and by the late 1780s struggled with how to balance the budget and pay down the debt. After heated debate, the National Assembly elected to issue a paper currency bearing an attractive 3 percent interest rate, secured by the finest French real estate to be confiscated from the clergy. Assignats were first issued in December 1789 and initially were a boon to the economy. Yet while the first issues brought prosperity, subsequent issues led to stagnation and misery. In this edition of Crisis Chronicles, we review how fiat money inflation in France caused the collapse of the French assignat and describe some interesting parallels between the politics of French government finance in the late 1700s and more recent fiscal crises.

Remembering John Law and the Mississippi Bubble
It was not without grave reservation that the National Assembly elected to pursue a new issue of paper currency. Some who spoke out against issuing the assignat recalled the wretchedness and ruin to which their families were subjected during John Law’s tenure as head of French finance and the Mississippi Bubble of 1720. But there was also great political willpower against raising taxes of any sort and deficits were already high. So the only option was to turn to the printing press once again.
But this time, the National Assembly was convinced it would be different. The currency would be secured by confiscated church property...[continue reading]...

Wednesday, July 09, 2014

'Lifting the Veil on the U.S. Bilateral Repo Market'

Via the Liberty Street Economics blog at the NY Fed, should we worry as much about the bilateral repo market as we do about the tri-party market (which played a key role in the financial crisis and remains vulnerable to another "run on the shadow banking system")?:

Lifting the Veil on the U.S. Bilateral Repo Market, by Adam Copeland, Isaac Davis, Eric LeSueur, and Antoine Martin, Liberty Street Economics: The repurchase agreement (repo), a contract that closely resembles a collateralized loan, is widely used by financial institutions to lend to each other. The repo market is divided into trades that settle on the books of the two large clearing banks (that is, tri-party repo) and trades that do not (that is, bilateral repo). While there are public data about the tri-party repo segment, there is little to no information on the bilateral repo segment. In this post, we update a methodology we developed earlier to estimate the size and composition of collateral posted for bilateral repos, and find that U.S. Treasury securities are the dominant form of collateral for bilateral repos. This new finding implies that the collateral posted for bilateral repos is of higher quality than the collateral posted for tri-party repos. ...

Sunday, July 06, 2014

'Keynesian Yellen versus Wicksellian BIS'

Gavyn Davies:

Keynesian Yellen versus Wicksellian BIS, by Gavyn Davies: The Bank for International Settlements (BIS) caused a splash last weekend with an annual report that spelled out in detail why it disagrees with central elements of the strategy currently being adopted by its members, the major national central banks. On Wednesday, Fed Chair Janet Yellen mounted a strident defence of that strategy in her speech on “Monetary Policy and Financial Stability”. She could have been speaking for any of the major four central banks, all of which are adopting basically the same approach [1].
Rarely will followers of macro-economics have a better opportunity to compare and contrast the two distinct intellectual strands in the subject...
Paul Krugman correctly points out that the BIS has been wrong in the past about the threat of inflation. Furthermore, their supply-led analysis of the real economy probably underestimates the pervasive importance of demand shocks during most economic cycles (see Mark Thoma). But the risk of financial instability is another matter entirely. It is optimistic to believe that macro-prudential policy alone will be able to handle this threat. The contrasting needs of the real economy and the financial sector present a very real dilemma for monetary policy.
The BIS was right about the dangers of risky financial behaviour prior to the crash. That caused the greatest demand shock for a century. Keynesians, including the Chair of the Federal Reserve, should be more ready to recognise that the same could happen again.

Inadequate demand calls for low interest rates to try to stimulate spending, but does the threat of financial instability necessarily call for higher rates? If so, which should prevail? As I see it (1) lack of demand is the bigger threat right now, (2) if financial instability looks like the bigger problem at some point in the future, then macroprudential policy targeted at the specific problem should be the first line of defense, (3) and, if it is "optimistic to believe that macro-prudential policy alone will be able to handle this threat," that is, if macroprudential policy alone is not enough to eliminate the threat, then, and only then, should interest rates by raised beyond where they would be given the state of aggregate demand.

As I said a few days ago:

"I think the macroprudential approach is correct. Using interest rates to deal with pockets of financial instability is too blunt of an instrument, e.g. it hits all industries, not just the ones where the instability is suspected and it may not directly address the particular problem generating the instability. It's much better to target the sectors where the problems exist, and to shape the policies to directly address the underlying problem(s)."

But let me conceded one point. If we wait until we can be sure that a dangerous bubble exists, and to see if macroprudential policy will be sufficient, it may be too late to raise interest rates to try to pop the bubble -- it may be past the point of no return. But I still prefer pricking the bubble with targeted policy rather than raising interest rates and causing a slowdown in a wide variety of markets, almost all of which are not a threat to the economy.

Thursday, July 03, 2014

'The Financial Instability Argument for Raising Rates'

Simon Wren-Lewis responds to calls to raise interest rates to promote financial stability:

The financial instability argument for raising rates: ... Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. ...
I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. ...
However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused. ... So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery. ...
As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. ... Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.
So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.

Jane Yellen on how to deal with financial instability:

... Well, I think my main theme here today is that macroprudential policies should be the main line of defense, and I think the efforts that we’re engaged in in the United States but all countries coordinating through the — through Basel, through the Financial Stability Boards — the efforts that we are taking to globally strengthen the resilience of the financial system: more capital, higher quality capital, higher liquidity buffers, stronger and — arrangements for central clearing of derivatives that reduce interconnectedness among systemically important financial institutions, strengthening of the architecture of payments and clearing system dealing with risks we see in areas like tri-party repo. ...
I would also put resolution planning which we’re engaging in actively as among those measures. And, you know, as I mentioned, I think cyclical policies and sector-specific policies that we’re seeing many emerging markets take steps that can be used, particularly when we see problems developing in housing or a particular sector. These are really promising.
I don’t think we yet understand how they work. When they can be effective, how we should use them. I hope this will be an area for the IMF and for us of active research so we can better deploy those tools, capital — countercyclical capital charges.
But I think importantly, I’ve not taken monetary policy totally off the table as a measure to be used when financial excesses are developing because I think we have to recognize that macroprudential tools have their limitations. ... So to me, it’s not a first line of defense, but it is something that has to be actively in the mix. ...

Paul Krugman says "It’s about sadomonetarism, not stability."

I think the macroprudential approach is correct. Using interest rates to deal with pockets of financial instability is too blunt of an instrument, e.g. it hits all industries, not just the ones where the instability is suspected and it may not directly address the particular problem generating the instability. It's much better to target the sectors where the problems exist, and to shape the policies to directly address the underlying problem(s).

Wednesday, July 02, 2014

'Monetary Policy and Financial Stability'

Janet Yellen:

... Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.

To that end, I will briefly lay out my current assessment of financial stability risks and their relevance, at this time, to the stance of monetary policy in the United States. In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector. Moreover, the improvements in household and business balance sheets have been accompanied by the increased safety of the financial sector associated with the macroprudential efforts I have outlined. Overall, nonfinancial credit growth remains moderate, while leverage in the financial system, on balance, is much reduced. Reliance on short-term wholesale funding is also significantly lower than immediately before the crisis, although important structural vulnerabilities remain in short-term funding markets.

Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach. For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward. In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a "reach for yield" in the face of persistently low interest rates. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued guidance regarding leveraged lending practices in early 2013 and followed up on this guidance late last year. To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures. But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate. It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.

Conclusion In closing, the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis. We have made considerable progress in implementing a macroprudential approach in the United States, and these changes have also had a significant effect on our monetary policy discussions. An important contributor to the progress made in the United States has been the lessons we learned from the experience gained by central banks and regulatory authorities all around the world. The IMF plays an important role in this evolving process as a forum for representatives from the world's economies and as an institution charged with promoting financial and economic stability globally. I expect to both contribute to and learn from ongoing discussions on these issues.

Monday, June 30, 2014

'How Securitization Really Works'

I didn't realize the share of the securitization market that is government-backed was so high. This is from Cecchetti & Schoenholtz:

How securitization really works: ... The success of U.S. securitization – as an alternative to bank finance – is a key factor behind the current push of euro-area authorities to increase securitization. ... Because finance is predominantly bank based in Europe – and banks faced heightened capital requirements – governments and potential borrowers are anxious to shift at least some financing into capital markets (including bonds and equities). ...
Yet, emulating American securitization ... probably means providing government guarantees at a scale that people currently do not envision. ...
To see what we mean, we can look at a few numbers regarding U.S. securitization. According to the Federal Reserve’s flow of funds statistics (the Z.1 release), total securitization stood at $9,360.4 billion as of end-March 2014... But government-backed securitizations – these are mortgages, student loans and the like – accounted for $7,721 billion of this total... That is, only 18% of U.S. securitization – primarily auto loans and credit card debt – are free from government guarantees! Even at the peak of private-sector securitization in mid-2007 ... the government-backed share exceeded 60%. ...
To put these numbers into perspective, we can look at another part of the U.S. financial system: insured bank deposits. You may be surprised to learn that ... only ... 61% of bank deposits are government backed ... versus 82% of securitizations. ...
We believe that U.S. government backing of securitizations can (and should) be scaled back... Nevertheless, it also seems difficult to jumpstart a large-scale securitization market in Europe without sizable public support. ...
The bottom line: If the euro area wishes to get securitization going in a big way, it will still need more of the mutual insurance among nations that has been so difficult to achieve. That doesn’t seem to be in the cards for now.

Friday, June 27, 2014

'How to Avoid the Next Crash'

From the editors at BloombergView:

How to Avoid the Next Crash: ... Many central banks, led by the U.S. Federal Reserve, have innovated boldly when it comes to monetary policy. They have pumped money into the financial system. They have provided banks with emergency loans. They have started providing "forward guidance" in an attempt to stabilize markets. Some even pay negative interest rates on reserves as a way to encourage private lending. Many countries have overhauled their financial regulatory systems as well.
There is a third category of innovation, however -- known as macroprudential policy -- that has lagged behind. It shouldn’t.
As the name suggests, macroprudential policies are a kind of hybrid: financial regulations attuned to the condition of the system as a whole, rather than the soundness of particular banks or other institutions. ...
Few deny the need for macroprudential policy. If speeches and conferences on the topic were a measure of progress, there'd be no cause for concern. Sadly, they aren't. Governments should develop a sense of urgency before it's too late.

For me, stopping the equivalent of bank runs within the shadow banking system -- a big problem during the financial crisis that has not yet been fully addressed -- is a top priority.

Thursday, June 26, 2014

'Are the Rating Agencies About to Get Their Comeuppance?'

Barry Ritholtz:

Are the Rating Agencies About to Get Their Comeuppance?: This week in encouraging news, we learn that the Securities and Exchange Commission may finally be pursuing one of the prime enablers of the financial crisis — the ratings companies. Previously, it was reported that disclosure violations were on the SEC’s radar, but truth be told, those are minor offenses.
The SEC’s Office of Credit Ratings, a division whose sole purpose is essentially to oversee Moody’s and Standard & Poor’s, seems to be stirring. ... Multiple cases have reportedly been referred to the SEC’s enforcement division, and new regulations are due.
And a welcome change it would be. Of all the players that helped cause the financial crisis, the ratings companies have gotten off scot-free. Banks have had massive fines while many mortgage and derivative underwriters have had their garbage securities put back to them at great cost. Since 2008, there have been 388 mortgage companies that have gone bankrupt. All of that junk paper found its way into AAA-rated securitized products and derivatives. The penalty for Moody’s and S&P has been essentially nil. ...[continue]...

It may be "encouraging news" but why has it taken so long?

Wednesday, June 25, 2014

'Speculation, Trading, and Bubbles'

For those who might be interested, an excerpt from a new book by José A. Scheinkman, Speculation, Trading, and Bubbles (with contributions by Sanford J. Grossman, Patrick Bolton, Kenneth J. Arrow, and Joseph E. Stiglitz):


Monday, June 23, 2014

Bank Failure, Relationship Lending, and Local Economic Performance

John Kandrac (a former Ph.D. student):

Bank Failure, Relationship Lending, and Local Economic Performance, by John Kandrac, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series: Abstract Whether bank failures have adverse effects on local economies is an important question for which there is conflicting and relatively scarce evidence. In this study, I use county-level data to examine the effect of bank failures and resolutions on local economies. Using quasi-experimental techniques as well as cross-sectional variation in bank failures, I show that recent bank failures lead to lower income and compensation growth, higher poverty rates, and lower employment. Additionally, I find that the structure of bank resolution appears to be important. Resolutions that include loss-sharing agreements tend to be less deleterious to local economies, supporting the notion that the importance of bank failure to local economies stems from banking and credit relationships. Finally, I show that markets with more inter-bank competition are more strongly affected by bank failure. [Download Full text]

Thursday, June 19, 2014

Did Timothy Geithner Pass the Test?

In case you missed this:

Does He Pass the Test?, by Paul Krugman: Midway through Timothy Geithner’s Stress Test, the former treasury secretary describes a late-2008 conversation with the then president-elect. Obama “wanted to discuss what he should try to accomplish.” Geithner’s reply was that his accomplishment would be “preventing a second Great Depression.” And Obama shot back that he didn’t want to be defined by what he had prevented.
It’s an ironic tale for Geithner to be telling, although it’s not clear whether he himself realizes just how ironic. For Stress Test is meant to be a story of successful policy—but that success is defined not by what happened but by what didn’t. America did indeed manage to avoid a full replay of the Great Depression—an achievement for which Geithner implicitly claims much of the credit, and with some justification. We did not, however, avoid economic disaster. By any plausible accounting, we’ve lost trillions of dollars’ worth of goods and services that we could and should have produced; millions of Americans have lost their jobs, their homes, and their dreams. Call it the Lesser Depression—not as bad as the 1930s, but still a terrible thing. Not to mention the disastrous consequences abroad.
Or to use one of the medical metaphors Geithner likes, we can think of the economy as a patient who was rushed to the emergency room with a life-threatening condition. Thanks to the urgent efforts of the doctors present, the patient’s life was saved. But while the doctors kept him alive, they failed to cure his underlying illness, so he emerged from the procedure partly crippled, and never fully recovered.
How should we think about the economic policy of these past seven or so years? ...

Saturday, May 31, 2014

Are Banks Too Large?

At Vox EU:

Are banks too large?, by Lev Ratnovski, Luc Laeven, and Hui Tong: Summary: Large banks have grown and become more involved in market-based activities since the late 1990s. This column presents evidence that large banks receive too-big-to-fail subsidies and create systemic risk, whereas economies of scale in banking are modest. Hence, some large banks may be ‘too large’ from a social perspective. Since the optimal bank size is unknown, the best policies are capital surcharges and better bank resolution and governance.

Thursday, May 22, 2014

'A Note on the Lender of Last Resort'

Cecchetti & Schoenholtz:

A note on the lender of last resort: ...In responding to queries about the Federal Reserve’s actions on the fateful Lehman weekend in mid-September 2008, various officials noted that the law does not allow the Federal Reserve to lend to an insolvent institution. As we reconsider the role of central bank lending, this is one principle, dating back to Walter Bagehot in the 19th century, that it is important to understand and maintain.
There are three big reasons that a central bank should not lend to a bankrupt institution. The first is that, by lending secured to an insolvent commercial bank, the central bank further subordinates bond holders. ... These actions pick winners and losers. In democracies, such choices are typically the prerogative of elected officials, not central bankers.
Second, lending to an insolvent institution by itself does not put an end to its fragility. Ultimately, the institution must be liquidated or re-capitalized. Postponing this resolution is usually costly. ...
Third, when people find out that the central bank is willing to lend to insolvent banks – and they will find out – then any bank that borrows will be suspected of being bankrupt. The resulting stigma will impair the useful function of the lender of last resort...
The real problem in 2008 was that there was no resolution regime in place that would allow ... big intermediaries to fail without disrupting the entire global financial system. ... Dodd-Frank ... created a new resolution mechanism... However, that regime ... remains untested...
Importantly, Dodd-Frank also narrowed the legal form of recipients eligible for Fed discount loans, contrary to the broad latitude suggested by Bagehot. ... Post Dodd-Frank, the discount window is for banks only. Others will have to seek liquidity elsewhere, even if they are solvent.

Monday, May 19, 2014

Paul Krugman: Springtime for Bankers

Heckuva job?:

Springtime for Bankers, by Paul Krugman, Commentary, NY Times: By any normal standard, economic policy since the onset of the financial crisis has been a dismal failure. It’s true that we avoided a full replay of the Great Depression. But employment has taken more than six years to claw its way back to pre-crisis levels...
Now Timothy Geithner, who was Treasury secretary for four of those six years, has published a book, “Stress Test,” about his experiences. And basically, he thinks he did a heckuva job. ...
Much of Mr. Geithner’s book is devoted to a defense of the U.S. financial bailout, which he sees as a huge success story — which it was, if financial confidence is viewed as an end in itself. ... But where is the rebound in the real economy? Where are the jobs? ...
One reason for sluggish recovery is that U.S. policy “pivoted,” far too early, from a focus on jobs to a focus on budget deficits. Mr. Geithner denies ... any responsibility for this... That doesn’t match independent reporting, which portrays Mr. Geithner ridiculing fiscal stimulus as “sugar” that would yield no long-term benefit.
But fiscal austerity wasn’t the only reason recovery has been so disappointing..., the burden of high household debt, a legacy of the housing bubble, has been a big drag on the economy. And there was, arguably, a lot the Obama administration could have done to reduce debt burdens without Congressional approval. But it didn’t... Why? According to many accounts, the biggest roadblock was Mr. Geithner’s consistent opposition to mortgage debt relief — he was, if you like, all for bailing out banks but against bailing out families.
“Stress Test” asserts that no conceivable amount of mortgage debt relief could have done much to boost the economy. But the leading experts on this subject are ... Atif Mian and Amir Sufi, whose just-published book “House of Debt” argues very much the contrary. ...
In the end, the story of economic policy since 2008 has been that of a remarkable double standard. Bad loans always involve mistakes on both sides — if borrowers were irresponsible, so were the people who lent them money. But when crisis came, bankers were held harmless for their errors while families paid full price.
And refusing to help families in debt, it turns out, wasn’t just unfair; it was bad economics. Wall Street is back, but America isn’t, and the double standard is the main reason.

Thursday, May 15, 2014

'Are Banks Too Large?'

I don't think this issue can be addressed without also considering the political power of large banks -- their ability to shape legislation in their favor in a way that increases the risk of financial meltdown:

Are Banks Too Large? Maybe, Maybe Not, by Luc Laeven, Lev Ratnovski, and Hui Tong, iMFdirect: Large banks were at the center of the recent financial crisis. The public dismay at costly but necessary bailouts of “too-big-to-fail” banks has triggered an active debate on the optimal size and range of activities of banks.
But this debate remains inconclusive, in part because the economics of an “optimal” bank size is far from clear. Our recent study tries to fill this gap by summarizing what we know about large banks using data for a large cross-section of banking firms in 52 countries.
We find that while large banks are riskier, and create most of the systemic risk in the financial system, it is difficult to determine an “optimal” bank size. In this setting, we find that the best policy option may not be outright restrictions on bank size, but capital—requiring  large banks to hold more capital—and better bank resolution and governance.
Large banks increase systemic, not individual bank risk
Large banks have significantly grown in size, and become more involved in market-based activities since the late 1990s..., the balance sheet size of the world’s largest banks increased two to four-fold in the 10 years prior to the crisis. ...
Also, large banks appear to have a distinct, seemingly risky business model. They tend to simultaneously have lower capital..., less stable funding..., more market-based activities..., and be more organizationally complex..., than smaller banks. ...
In addition, our study confirms that large banks create most of systemic risk in today’s financial system. ... Large banks create especially high systemic risk when they have insufficient capital or unstable funding. And, large banks create high systemic risk...
Too-big-to-fail and empire building
What drives the size and the business model of large banks? Our study suggests the following:
Implicit too-big-to-fail subsidies ... This predisposes large banks to use leverage and unstable funding, and to engage in risky market-based activities.
Possible empire building. ...
Economies of scale. While a good explanation for the size of large banks, recent studies suggest that they are modest. ...
Optimal bank size inconclusive
The evidence that large banks respond to too-big-to-fail and empire building incentives, and in process create systemic risk suggests that banks might become “too large” from a social welfare perspective. But there is an important caveat. We know too little about the value that large banks bring to their customers (e.g., large global corporations). The potential for economies of scale in large banks cannot be dismissed. As a result, we cannot draw conclusions as to the socially optimal bank size. And it also implies that outright restrictions on bank size or activities may be imprecise and hence costly. ...

Tuesday, April 29, 2014

'Narrow Banks Won't Stop Bank Runs'

This is from a new blog by Stephen Cecchetti and Kermit Schoenholtz:

Narrow Banks Won't Stop Bank Runs: Every financial crisis leads to a new call to restrict the activities of banks. One frequent response is to call for “narrow banks.” That is, change the legal and regulatory framework in a way that severely limits the assets that traditional deposit-taking banks can hold. One approach would require that all liabilities that are demandable at par be held in the form of deposits at the central bank. That is, accounts that can be withdrawn without notice and have fixed net asset value would face a 100% reserve requirement. The Depression-era “Chicago Plan” had this approach in mind.
In the aftermath of the financial crisis of 2007-09, Lawrence Kotlikoff, Jeremy Bulow and Paul Klemperer, John Kay, and, most recently, John Cochrane, and Martin Wolf have resurrected versions of narrow banking. All of these proposals, both the old and the new, have a common core: banks should be split into two parts, neither of which would supposedly be subject to runs. ...
Naturally, we share the objective of these reformers: preventing bank runs. The key issue is how to do so and at what cost. We suspect that narrow banking would be costly in terms of economic performance, yet unlikely to achieve this goal. ...
We know that a combination of transparency, high capital and liquidity requirements, deposit insurance and a central bank lender of last resort can make a financial system more resilient. We doubt that narrow banking would.

(The original post is much more detailed.)

Monday, April 28, 2014

New Research in Economics: Central Banking For All: A Modest Case for Radical Reform

Via Nicholas Gruen:

Central Banking For All: A modest Case for Radical Reform (Download): This paper offers a  radical option for banking reform: government should offer central banking services not just to commercial banks, but directly to citizens.
Key Findings
Nicholas Gruen argues the UK and other countries need radical banking reform This can be achieved by a simple change: giving ordinary people the same right to use central banks’ services as big commercial banks have. Though they enjoy high margins and/or fees, banks add little value to ‘commodity services’ like customer accounts and highly-collateralised mortgages like older ones that are partially paid off which are basically riskless.
There’s widespread agreement that the UK needs better banks and a better deal for bank customers. This report by Nicholas Gruen, economist and founding chairman of Kaggle and The Australian Centre for Social Innovation, proposes a simple but radical solution.
Gruen argues that in the age of the internet, the Bank of England can now extend the services it currently offers only to banks to everyone in the UK. In particular, it should offer (for instance through National Savings & Investments) simple, cheap deposit and savings accounts to all, paying interest at Bank Rate. Second, it should offer to guarantee any well-collateralised mortgage (for instance a residential mortgage for less than 60 per cent of the value of the collateral).
At the moment, commercial banks provide these services at a cost (both in terms of worse rates, fees with their margins inflated by their funder’s knowledge that they are implicitly government guaranteed).
By cutting out the middle-man in the form of the banks, Gruen argues customers would get a better deal, and private competitors providing finance could focus on the provision of finance where the efficient pricing of risk is essential – most particularly residential finance above 60 per cent of the value of collateral.
Policy Recommendations
The government should allow the Bank of England to provide central banking services directly to anyone who wants them, not just banks. The Bank should offer to fund or guarantee any well-collateralised mortgage (e.g. with less than 60 per cent of the property value outstanding) The Bank should, through National Savings and Investments, offer simple deposit and savings accounts to anyone who wants them with no upper limits, paying Bank Rate of interest.

Sunday, April 27, 2014

'Is the Stock Market Getting Bubbly?'

Dean Baker:

Is the Stock Market Getting Bubbly?: Washington Post columnist Steve Pearlstein argues it is, taking issue with fellow columnist Barry Ritholtz who says it isn't. I'm going to come down in the middle here.
The market is somewhat above its historic levels relative to trend earnings. Pearlstein cites Shiller who puts the price to earnings ratio at 25 to 1, compared to a historic average of 16. ... I would agree that stock prices are somewhat above trend, but not by quite as large a margin as Shiller.
To get some perspective, at the peak of the stock bubble in early 2000, the S&P peaked at just under 1530. The economy is almost than 70 percent larger today (in nominal dollars), which would mean that the S&P would be over 2600 today if it were as high relative to the economy. If we throw in that the economy is still operating at 5 percent below its potential then the S&P would have to be over 2700 now to be as high relative to the economy as it was at the peak of the stock bubble. With a Friday close of 1863, we can see the market is at a level that is a bit more than two thirds of its 2000 bubble peak, relative to the size of the economy.
It also is much lower relative to the economy than it was in 2007 when almost no one was talking about a stock bubble. The S&P peaked at just over 1560 in the fall of 2007. Taking into account the economy's 18 percent nominal growth over this period, and the fact that we are still 5 percent below potential GDP, the S&P would have to be over 1900 today to be as high relative to potential GDP as it was in 2007. Given recent patterns, it certainly doesn't make sense to talk about a bubble for the market as a whole.
However, there are some points worth noting. The social media craze has allowed many companies with no profits and few prospects for making profits to market valuations in the hundreds of millions or even billions of dollars. That sure looks like the Internet bubble. Some of these companies may end up being profitable and worth something like their current share price. The vast majority probably will not.
The other point is that the higher than trend price to earnings ratio means that we should expect to see lower than trend real returns going forward. This is an important qualification to Ritholtz's analysis. While there is no reason that people should fear that stocks in general will take a tumble, as they did in 2000-2002, they also would be nuts to expect the same real returns going forward as they saw in the past.
With a price to earnings ratio that is roughly one-third about the long-term trend, they should expect real returns that are roughly one-third lower than the historic average. This means that instead of expecting real returns on stock of 7.0 percent, they should expect something closer to 5.0 percent. That might still make stocks a good investment, especially in the low interest rate environment we see today, but probably not as good as many people are banking on.
In short, there is not much basis for Pearlstein's bubble story, but we should also expect that because of higher than trend PE ratios stocks will not provide the same returns in the future as they did in the past. Anyone who thinks we can better have their calculator checked.

'Is A Banking Ban The Answer?'

Paul Krugman:

Is A Banking Ban The Answer?: OK, a genuinely interesting debate on financial reform is taking place. I’m not even sure where I stand. But it’s certainly worth talking about.
Atif Mian and Amir Sufi draw our attention to proposals to either mandate or create strong incentives for 100-percent reserve banking, coming from Martin Wolf and, more surprisingly, John Cochrane. Equally surprising — at least to me — is that Cochrane seems more aware of the difficulties of the issue. ... So, three thoughts.
First, Wolf’s omission is a big one. If we impose 100% reserve requirements on depository institutions, but stop there, we’ll just drive even more finance into shadow banking, and make the system even riskier.
Second, Cochrane’s proposal calls for a remarkable amount of government intervention in finance; it makes liberal proposals for a transactions tax look like minor nuisances. Cochrane insists that we can easily run our economy without dangerous short-term private debt — that we can easily set things up so that the manager of your index fund sells a tiny piece of your stock portfolio every time you use a debit card at 7-11. Is this right?
Third, and on a quite different note: Are we really sure that banking problems are the whole story about what went wrong? I’ve made this point before, but look at any measure of financial stress: what you see is a huge peak in 2008 that quickly went down:
Yet ... we’re still depressed and many advanced countries are now on the edge of deflation, more than five years later. This strongly suggests that while bank runs may have brought things to a head, the problems ran deeper; in particular, I’m strongly of the view (based in part on Mian and Sufi’s work) that broader issues of excess leverage, and the resulting balance-sheet problems of many households, are key. And neither 100% reserves nor a repo tax would have addressed that kind of leverage. ...

Monday, April 14, 2014

FRBSF Economic Letter: How Important Are Hedge Funds in a Crisis?

Another one that may be of interest:

How Important Are Hedge Funds in a Crisis?, by Reint Gropp, FRBSF Economic Letter: Before the 2007–09 crisis, standard risk measurement methods substantially underestimated the threat to the financial system. One reason was that these methods didn’t account for how closely commercial banks, investment banks, hedge funds, and insurance companies were linked. As financial conditions worsened in one type of institution, the effects spread to others. A new method that more accurately accounts for these spillover effects suggests that hedge funds may have been central in generating systemic risk during the crisis.

Paul Krugman: Three Expensive Milliseconds

 What is the "true cost of our bloated financial industry"?:

Three Expensive Milliseconds, by Paul Krugman, Commentary, NY Times: Four years ago ... Spread Networks finished boring its way through the Allegheny Mountains of Pennsylvania. Spread’s tunnel was ... a fiber-optic cable that would shave three milliseconds — three-thousandths of a second — off communication time between the futures markets of Chicago and the stock markets of New York. ...
Who cares about three milliseconds? The answer is, high-frequency traders, who make money by buying or selling stock a tiny fraction of a second faster than other players. ...
Think about it..., spending hundreds of millions of dollars to save three milliseconds looks like a huge waste. And that’s part of a much broader picture, in which society is devoting an ever-growing share of its resources to financial wheeling and dealing, while getting little or nothing in return.
How much waste are we talking about? A paper by Thomas Philippon of New York University puts it at several hundred billion dollars a year. ...
What are we getting in return for all that money? Not much, as far as anyone can tell. ...
But if our supersized financial sector isn’t making us either safer or more productive, what is it doing? One answer is that it’s playing small investors for suckers, causing them to waste huge sums in a vain effort to beat the market. Don’t take my word for it — that’s what the president of the American Finance Association declared in 2008. Another answer is that a lot of money is going to speculative activities that are privately profitable but socially unproductive. ...
 It’s ... hard ... to see how the three-millisecond advantage conveyed by the Spread Networks tunnel makes modern America richer; yet that advantage was clearly worth it to the speculators.
In short, we’re giving huge sums to the financial industry while receiving little or nothing — maybe less than nothing — in return. Mr. Philippon puts the waste at 2 percent of G.D.P. Yet even that figure, I’d argue, understates the true cost of our bloated financial industry. For there is a clear correlation between the rise of modern finance and America’s return to Gilded Age levels of inequality.
So never mind the debate about exactly how much damage high-frequency trading does. It’s the whole financial industry, not just that piece, that’s undermining our economy and our society.

Saturday, April 12, 2014

Have We Repaired Financial Regulations Since Lehman?

"The 2008 financial crisis led to the worst recession in the developed world since the Great Depression. Governments had to respond decisively on a large scale to contain the destructive impact of massive debt deflation. Still, several large financial institutions and thousands of small-to-medium-sized institutions collapsed or had to be rescued, numerous non-financial businesses closed, and millions of households lost their savings, jobs, and homes. Five years later, we are still feeling these effects. Will the financial reforms introduced since the onset of the crisis prevent another catastrophe? This keynote panel titled 'Have We Repaired Financial Regulation Since Lehman' at the Institute for New Economic Thinking's "Human After All" conference in Toronto."

Featured speakers: Anat Admati, Richard Bookstaber, Andy Haldane, and Edward Kane, moderated by Martin Wolf.

Thursday, April 10, 2014

'Pseudo-Mathematics and Financial Charlatanism'

"Past performance is not an indicator of future results":

Pseudo-mathematics and financial charlatanism, EurekAlert: Your financial advisor calls you up to suggest a new investment scheme. Drawing on 20 years of data, he has set his computer to work on this question: If you had invested according to this scheme in the past, which portfolio would have been the best? His computer assembled thousands of such simulated portfolios and calculated for each one an industry-standard measure of return on risk. Out of this gargantuan calculation, your advisor has chosen the optimal portfolio. After briefly reminding you of the oft-repeated slogan that "past performance is not an indicator of future results", the advisor enthusiastically recommends the portfolio, noting that it is based on sound mathematical methods. Should you invest?
The somewhat surprising answer is, probably not. Examining a huge number of sample past portfolios---known as "backtesting"---might seem like a good way to zero in on the best future portfolio. But if the number of portfolios in the backtest is so large as to be out of balance with the number of years of data in the backtest, the portfolios that look best are actually just those that target extremes in the dataset. When an investment strategy "overfits" a backtest in this way, the strategy is not capitalizing on any general financial structure but is simply highlighting vagaries in the data. ...
Unfortunately, the overfitting of backtests is commonplace not only in the offerings of financial advisors but also in research papers in mathematical finance. One way to lessen the problems of backtest overfitting is to test how well the investment strategy performs on data outside of the original dataset on which the strategy is based; this is called "out-of-sample" testing. However, few investment companies and researchers do out-of-sample testing. ...

Sunday, April 06, 2014

'Superfluous Financial Intermediation'

Rajiv Sethi:

Superfluous Financial Intermediation: I'm only about halfway through Flash Boys but have already come across a couple of striking examples of what might charitably be called superfluous financial intermediation. This is the practice of inserting oneself between a buyer and a seller of an asset, when both parties have already communicated to the market a willingness to trade at a mutually acceptable price. If the intermediary were simply absent from the marketplace, a trade would occur between the parties virtually instantaneously at a single price that is acceptable to both. Instead, both parties trade against the intermediary, at different prices. The intermediary captures the spread at the expense of the parties who wish to transact, adds nothing to liquidity in the market for the asset, and doubles the notional volume of trade. ... [gives two examples] ....

Michael Lewis has focused on practices such as these because their social wastefulness and fundamental unfairness is so transparent. But it's important to recognize that most of the strategies implemented by high frequency trading firms may not be quite so easy to classify or condemn. For instance, how is one to evaluate trading based on short term price forecasts based on genuinely public information? I have tried to argue in earlier posts that the proliferation of such information extracting strategies can give rise to greater price volatility. Furthermore, an arms race among intermediaries willing to sink significant resources into securing the slightest of speed advantages must ultimately be paid for by investors. ...

I hope that the minor factual errors in Flash Boys won't detract from the book's main message, or derail the important and overdue debate that it has predictably stirred. By focusing on the most egregious practices Lewis has already picked the low-hanging fruit. What remains to be figured out is how typical such practices really are. Taking full account of the range of strategies used by high frequency traders, to what extent are our asset markets characterized by superfluous financial intermediation?

Friday, April 04, 2014

'The Legitimacy of High Frequency Trading'

Tim Johnson on high frequency trading:

The Legitimacy of High Frequency Trading: Mark Thoma brought my attention to a post by Dean Baker, High Speed Trading and Slow-Witted Economic Policy. High Frequency Trading, or more generically Computer Based Trading, is proving problematic because it is a general term involving a variety of different techniques, some of which appear uncontroversial, others appear very dubious.

For example, a technique I would consider legitimate derives from Robert Almgren and Neil Chriss' work on optimal order execution: how do you structure a large trade such that it has minimal negative price impact and low transaction costs. There are firms that now specialise in performing these trades on behalf of institutions and I don't think there is an issue with how they innovate in order to generate profits.

The technique that is most widely regarded as illegitimate is order, or quote, stuffing. The technique involves placing orders and within a tenth of a second or less, cancelling them if they are not executed. I suspect this is the process that Baker refers to that enables HFTs to 'front run' the market. Baker regards the process as illegitimate...

The problem I have with Baker's argument is that I do not think it is robust. ... [explains why] ...

The substantive question is whether I can come up with a more robust argument than Baker's, and I offer an argument at the bottom of this piece. ...

Tuesday, April 01, 2014

'High Speed Trading and Slow-Witted Economic Policy'

Busy morning, so I will take advantage of the Creative Commons license and do a quick post. This is from Dean Baker:

High Speed Trading and Slow-Witted Economic Policy, by Dean Baker: Michael Lewis' new book, Flash Boys, is leading to large amounts of discussion both on and off the business pages. The basic story is that a new breed of traders can use sophisticated algorithms and super fast computers to effectively front-run trades. This allows them to make large amounts of money by essentially skimming off the margins. By selling ahead of a big trade, they will push down the price that trader receives for their stock by a fraction of a percent. Similarly, by buying ahead of a big trade, they will also raise the price paid for that trade by a fraction of a percent. Since these trades are essentially a sure bet (they know that a big sell order or a big buy order is coming), the profits can be enormous.
This book is seeming to prompt outrage, although it is not clear exactly why. The basic story of high frequency trading is not new. It has been reported in most major news outlets over the last few years. It would be nice if we could move beyond the outrage to a serious discussion of the policy issues and ideally some simple and reasonable policy to address the issue. (Yes, simple should be front and center. If it's complicated we will be employing people in pointless exercises -- perhaps a good job program, but bad from the standpoint of effective policy.)
The issue here is that people are earning large amounts of money by using sophisticated computers to beat the market. This is effectively a form of insider trading. Pure insider trading, for example trading based on the CEO giving advance knowledge of better than expected profits, is illegal. The reason is that it rewards people for doing nothing productive at the expense of honest investors.
On the other hand, there are people who make large amounts of money by doing good research to get ahead of the market. For example, many analysts may carefully study weather patterns to get an estimate of the size of the wheat crop and then either buy or sell wheat based on what they have learned about the about this year's crop relative to the generally held view. In principle, we can view the rewards for this activity as being warranted since they are effectively providing information to the market with the their trades. If they recognize an abundant wheat crop will lead to lower prices, their sales of wheat will cause the price to fall before it would otherwise, thereby allowing the markets to adjust more quickly. The gains to the economy may not in all cases be equal to the private gains to these traders, but at least they are providing some service.
By contrast, the front-running high speed trader, like the inside trader, is providing no information to the market. They are causing the price of stocks to adjust milliseconds more quickly than would otherwise be the case. It is implausible that this can provide any benefit to the economy. This is simply siphoning off money at the expense of other actors in the market.
There are many complicated ways to try to address this problem, but there is one simple method that would virtually destroy the practice. A modest tax on financial transactions would make this sort of rapid trading unprofitable since it depends on extremely small margins. A bill proposed by Senator Tom Harkin and Representative Peter DeFazio would impose a 0.03 percent tax on all trades of stocks, bonds, and derivatives. This would quickly wipe out the high-frequency trading industry while having a trivial impact on normal investors. (Most research indicates that other investors will reduce their trading roughly in proportion to the increase in the cost per trade, leaving their total trading costs unchanged.)The Joint Tax Committee projected that this tax would raise roughly $400 billion over a decade.
A scaled tax that imposed a somewhat higher fee on stock trades and lower fee on short-term assets like options could be even more effective. Japan had a such tax in place in the 1980s and early 1990s. It raised more than 1 percent of GDP ($170 billion a year in the United States). Representative Keith Ellison has proposed this sort of tax for the United States.
If the political system were not so corrupt, such taxes would be near the top of the policy agenda. Even the International Monetary Fund has complained that the financial sector is under-taxed. However, because of the money and power of the industry the leadership of both political parties will run away from imposing any tax on the financial industry. In fact Treasury Secretary Jack Lew has been working to torpedo the imposition of such a tax in Europe. So look for lots of handwringing and outrage in response to Lewis' book. And look also for nothing real to be done. 

Wednesday, March 26, 2014

Video: Robert Shiller on Market Bubbles – And Busts

Sunday, March 23, 2014

'Secular Stagnation and Wealth Inequality'

Atif Mian and Amir Sufi:

Secular Stagnation and Wealth Inequality, by Atif Mian and Amir Sufi: Alvin Hansen introduced the notion of “secular stagnation” in the 1930s. Hansen’s hypothesis has been brought back to life by Larry Summers...
A brief summary of the hypothesis goes something like this: A normally functioning economy would lower interest rates in the face of low current demand for goods and services... A lower interest rate helps boost demand.
But what if ... real interest rates need to be very negative to boost demand, but prevailing interest rates are around zero, then we will have too much savings in risk-free assets — what Paul Krugman has called the liquidity trap. In such a situation, the economy becomes demand-constrained.
The liquidity trap helps explain why recessions can be so severe. But the Summers argument goes further. He is arguing that we may be stuck in a long-run equilibrium where real interest rates need to be negative to generate adequate demand. Without negative real interest rates, we are doomed to economic stagnation. ...
In our view, what is missing from the secular stagnation story is the crucial role of the highly unequal wealth distribution. Who exactly is saving too much? It certainly isn’t the bottom 80% of the wealth distribution! We have already shown that the bottom 80% of the wealth distribution holds almost no financial assets.
Further, when the wealthy save in the financial system, some of that saving ends up in the hands of lower wealth households when they get a mortgage or auto loan. But when lower wealth households get financing, it is almost always done through debt contracts. This introduces some potential problems. Debt fuels asset booms when the economy is expanding, and debt contracts force the borrower to bear the losses of a decline in economic activity.
Both of these features of debt have important implications for the secular stagnation hypothesis. We will continue on this theme in future posts.

Thursday, March 13, 2014

'The Free Market’s Weak Hand'

James Kwak:

The Free Market’s Weak Hand, by James Kwak:

“Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.”

That was Alan Greenspan back in 2003. This is little different from another of his famous maxims, that anti-fraud regulation was unnecessary because the market would not tolerate fraudsters. It is also a key premise of the blame-the-government crowd (Wallison, Pinto, and most of the current Republican Party), which claims that the financial crisis was caused by excessive government intervention in financial markets.

Market discipline clearly failed in the lead-up to the financial crisis. ... However, one thrust of post-crisis regulation has been to attempt to strengthen market discipline. This is consistent with the overall Geithner-Summers doctrine that markets generally work close to perfectly, and that regulation should mainly attempt to nudge markets in the right direction.

David Min (the lead rebutter of Wallison and Pinto’s theory of subprime mortgages, which relied on a made-up definition of “subprime”) has a new paper explaining why this is likely to fail. ...

Ultimately, one of Min’s suggestions is that we simply cannot rely heavily on market discipline as a means of constraining risk-taking by financial institutions. This leaves us with relatively unfashionable tools like higher capital requirements and structural reforms (size and complexity limits). But that’s not nearly sophisticated enough for the Geithner-Summers-Bernanke crew.

Sunday, March 02, 2014

'In Search of a Stable Electronic Currency'

Robert Shiller:

In Search of a Stable Electronic Currency, by Robert Shiller, Commentary, NY Times: ... Bitcoin’s future is very much in doubt. Yet whatever becomes of it, something good can arise from its innovations... I believe that electronic forms of money could give us better pricing, contracting and risk management. ...
Bitcoin has been focused on the wrong classical functions of money, as a medium of exchange and a store of value. ... It would be much better to focus on another classical function: money as a unit of account...
This has already begun to happen. ... For example, since 1967 in Chile, an inflation-indexed unit of account called the unidad de fomento (U.F.), meaning unit of development, has been widely used. Financial exchanges are made in pesos, according to a U.F.-peso rate posted on the website One multiplies the U.F. price by the exchange rate to arrive at the amount owed today in pesos. In this way, it is natural and easy to set inflation-indexed prices, and Chile is much more effectively inflation-indexed than other countries are. ...
With electronic software in the background, we can ... move beyond just one new unit of account to a whole system of them...
Bitcoin has been a bubble. But the legacy of the Bitcoin experience should be that we move toward a system of stable economic units of measurement — a system empowered by sophisticated mechanisms of electronic payment.

Thursday, February 20, 2014

'Random Variation'

James Kwak:

... I used to believe that no one could beat the market: in other words, that anyone who did beat the market was solely the beneficiary of random variation (a winner in Burton Malkiel’s coin-tossing tournament). I no longer believe this. I’ve seen too many studies that indicate that the distribution of risk-adjusted returns cannot be explained by dumb luck alone; most of the unexplained outcomes are at the negative end of the distribution, but there are also too many at the positive end. Besides, it makes sense: the idea that markets perfectly incorporate all available information sounds too much like magic to be true. ...

Sunday, January 19, 2014

'Rational Agents: Irrational Markets'

Roger Farmer:

Rational Agents: Irrational Markets: Bob Shiller wrote an interesting piece in today's NY Times on the irrationality of human action. Shiller argues that the economist's conception of human beings as rational is hard to square with the behavior of asset markets.
Although I agree with Shiller, that human action is inadequately captured by the assumptions that most economists make about behavior, I am not convinced that we need to go much beyond the rationality assumption, to understand what causes financial crises or why they are so devastatingly painful for large numbers of people. The assumption that agents maximize utility can get us a very very long way. ...
In my own work, I have shown that the labor market can go very badly wrong even when everybody is rational.  My coauthors and I showed in a recent paper, that the same idea holds in financial markets. Even when individuals are assumed to be rational; the financial markets may function very badly. ...
Miles Kimball and I have both been arguing that stock market fluctuations are inefficient and we both think that government should act to stabilize the asset markets. Miles' position is much closer to that of Bob Shiller; he thinks that agents are not always rational in the sense of Edgeworth. Miles and Bob may well be right. But in my view, the argument for stabilizing asset markets is much stronger. Even if we accept that agents are rational, it does not follow that swings in asset prices are Pareto efficient. But whether the motive arises from irrational people, or irrational markets; Miles and I agree: We can, and should, design an institution that takes advantage of the government's ability to trade on behalf of the unborn. More on that in a future post. ...

Tuesday, January 14, 2014

'Capital Markets Balkanization Should Not Prevent Regulation'

Adair Turner:

Adair Turner: Capital Markets Balkanization Should Not Prevent Regulation, by The Institute for New Economic Thinking: “Don’t worry about the balkanisation of global capital markets” – Adair Turner
Fears that bank regulation or capital controls could lead to a “balkanisation” of global capital markets are overstated and should not constrain policy action to address the problems created by volatile short term capital flows and excessive credit creation, says Adair Turner, Senior Fellow at the Institute for New Economic Thinking and former chairman of the United Kingdom Financial Services Authority.
Speaking at a conference in Delhi sponsored by the Reserve Bank of India, Turner focused on the links between the international monetary system and domestic financial stability. [For the text of the speech and presentation please see below.] ...
Ultimately, Turner rejected the idea that this would lead to a harmful fragmentation of global capital markets.
“Talk of such policies is often met by objections that this will lead to a dangerous ‘balkanisation’ of global capital markets, preventing the free flow of capital and stymieing its allocative efficiency benefits,” he said. “But since the evidence for the benefits of financial integration is at best elusive and ambiguous, some ‘balkanisation’ of short term international debt markets could be a good thing”.

Tuesday, December 17, 2013

'The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?'

Could it really be that no fraud was committed prior to the Great Recession? It's unlikely:

The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?, by Jed S. Rakoff, NYRB: Five years have passed since the onset of what is sometimes called the Great Recession. While the economy has slowly improved, there are still millions of Americans leading lives of quiet desperation: without jobs, without resources, without hope.
Who was to blame? Was it simply a result of negligence, of the kind of inordinate risk-taking commonly called a “bubble,” of an imprudent but innocent failure to maintain adequate reserves for a rainy day? Or was it the result, at least in part, of fraudulent practices, of dubious mortgages portrayed as sound risks and packaged into ever more esoteric financial instruments, the fundamental weaknesses of which were intentionally obscured?
If it was the former—if the recession was due, at worst, to a lack of caution—then the criminal law has no role to play in the aftermath. ... If the Great Recession was in no part the handiwork of intentionally fraudulent practices by high-level executives, then to prosecute such executives criminally would be “scapegoating” of the most shallow and despicable kind.
But if, by contrast, the Great Recession was in material part the product of intentional fraud, the failure to prosecute those responsible must be judged one of the more egregious failures of the criminal justice system in many years. Indeed, it would stand in striking contrast to the increased success that federal prosecutors have had over the past fifty years..., Michael Milken..., the so-called savings-and-loan crisis, which again had some eerie parallels to more recent events, resulted in the successful criminal prosecution of more than eight hundred individuals, right up to Charles Keating. And again, the widespread accounting frauds of the 1990s, most vividly represented by Enron and WorldCom, led directly to the successful prosecution of such previously respected CEOs as Jeffrey Skilling and Bernie Ebbers.
In striking contrast with these past prosecutions, not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis, and given the fact that most of the relevant criminal provisions are governed by a five-year statute of limitations, it appears likely that none will be. It may not be too soon, therefore, to ask why.
One possibility, already mentioned, is that no fraud was committed. This possibility should not be discounted. ... For example, the Financial Crisis Inquiry Commission, in its final report, uses variants of the word “fraud” no fewer than 157 times in describing what led to the crisis, concluding that there was a “systemic breakdown,” not just in accountability, but also in ethical behavior. ...[continue]...

Tuesday, December 03, 2013

'Five Years Later'

David Warsh on the "nature of what happened in September five years ago":

...George W. Bush was one of the heroes of the crisis. Despite the cavalier behavior of the first six years of his presidency, his last two years in office were pretty good – especially the appointment of Bernanke and Treasury Secretary Henry Paulson. Bush clearly shares credit with Obama for a splendid instance of cooperation in the autumn of 2008. (Bush, Obama and John McCain met in the White House on September 25, at the insistence of Sen. McCain, in the interval before the House of Representatives relented and agreed to pass the TARP bill. Obama dominated the conversation, Bush was impressed, and, by most accounts, McCain made a fool of himself.) ...

Much more here.

Friday, November 15, 2013

'Actually, Economists Can Predict Financial Crises'

I've argued for some time that we need new measures of systemic risk in financial markets -- we won't know if we can find reliable measures or not until we try -- so as it says below, recent "efforts to develop measures of systemic risk are encouraging":

Actually, Economists Can Predict Financial Crises, by Mark Buchanan, Commentary, Bloomberg: ... In recent years, an inconsistency has emerged in the economics profession. Many, including some Nobel Prize winners, maintain that crises are by their very nature unpredictable. At the same time, others -- aided by engineers, physicists, ecologists and computer scientists -- are developing ways to detect and quantify systemic risks, including measures that regulators could use to identify imbalances or vulnerabilities that might result in a crisis. ...
The challenge for economists is to find those indicators that can provide regulators with reliable early warnings of trouble. ...
Work is racing ahead. In the U.S., the newly formed Office of Financial Research has published various papers on topics such as stress tests and data gaps -- including one that reviews a list of some 31 proposed systemic-risk measures. The economists John Geanakoplos and Lasse Pedersen have offered specific proposals on measuring the extent to which markets are driven by leverage, which tends to make the whole system more fragile.
One problem has been “physics envy” -- a longing for certainty and for beautiful, timeless equations that can wrap up economic reality in some final way. Economics is actually more like biology, with perpetual change and evolution at its core. This means we’ll have to go on discovering new ways to identify useful clues about emerging problems as finance changes and investors jump into new products and strategies. Perpetual adaptation is part of living in a complex world.
The efforts to develop measures of systemic risk are encouraging. ...

Saturday, November 09, 2013

'The Crisis as a Classic Financial Panic'

Ben Bernanke on how the bank panic of 2007 is similar to the panic of 1907:

The Crisis as a Classic Financial Panic, by Chairman Ben S. Bernanke: I am very pleased to participate in this event in honor of Stanley Fischer. Stan was my teacher in graduate school, and he has been both a role model and a frequent adviser ever since. An expert on financial crises, Stan has written prolifically on the subject and has also served on the front lines, so to speak--notably, in his role as the first deputy managing director of the International Monetary Fund during the emerging market crises of the 1990s. Stan also helped to fight hyperinflation in Israel in the 1980s and, as the governor of that nation's central bank, deftly managed monetary policy to mitigate the effects of the recent crisis on the Israeli economy. Subsequently, as Israeli housing prices ran upward, Stan became an advocate and early adopter of macroprudential policies to preserve financial stability.
Stan frequently counseled his students to take a historical perspective, which is good advice in general, but particularly helpful for understanding financial crises, which have been around a very long time. Indeed, as I have noted elsewhere, I think the recent global crisis is best understood as a classic financial panic transposed into the novel institutional context of the 21st century financial system.1 An appreciation of the parallels between recent and historical events greatly influenced how I and many of my colleagues around the world responded to the crisis.
Besides being the fifth anniversary of the most intense phase of the recent crisis, this year also marks the centennial of the founding of the Federal Reserve.2 It's particularly appropriate to recall, therefore, that the Federal Reserve was itself created in response to a severe financial panic, the Panic of 1907. This panic led to the creation of the National Monetary Commission, whose 1911 report was a major impetus to the Federal Reserve Act, signed into law by President Woodrow Wilson on December 23, 1913. Because the Panic of 1907 fit the archetype of a classic financial panic in many ways, it's worth discussing its similarities and differences with the recent crisis.3 
Like many other financial panics, including the most recent one, the Panic of 1907 took place while the economy was weakening; according to the National Bureau of Economic Research, a recession had begun in May 1907.4 Also, as was characteristic of pre-Federal Reserve panics, money markets were tight when the panic struck in October, reflecting the strong seasonal demand for credit associated with the harvesting and shipment of crops. The immediate trigger of the panic was a failed effort by a group of speculators to corner the stock of the United Copper Company. The main perpetrators of the failed scheme, F. Augustus Heinze and C.F. Morse, had extensive connections with a number of leading financial institutions in New York City. When the news of the failed speculation broke, depositor fears about the health of those institutions led to a series of runs on banks, including a bank at which Heinze served as president. To try to restore confidence, the New York Clearinghouse, a private consortium of banks, reviewed the books of the banks under pressure, declared them solvent, and offered conditional support--one of the conditions being that Heinze and his board step down. These steps were largely successful in stopping runs on the New York banks.
But even as the banks stabilized, concerns intensified about the financial health of a number of so-called trust companies--financial institutions that were less heavily regulated than national or state banks and which were not members of the Clearinghouse. As the runs on the trust companies worsened, the companies needed cash to meet the demand for withdrawals. In the absence of a central bank, New York's leading financiers, led by J.P. Morgan, considered providing liquidity. However, Morgan and his colleagues decided that they did not have sufficient information to judge the solvency of the affected institutions, so they declined to lend. Overwhelmed by a run, the Knickerbocker Trust Company failed on October 22, undermining public confidence in the remaining trust companies.
To satisfy their depositors' demands for cash, the trust companies began to sell or liquidate assets, including loans made to finance stock purchases. The selloff of shares and other assets, in what today we would call a fire sale, precipitated a sharp decline in the stock market and widespread disruptions in other financial markets. Increasingly concerned, Morgan and other financiers (including the future governor of the Federal Reserve Bank of New York, Benjamin Strong) led a coordinated response that included the provision of liquidity through the Clearinghouse and the imposition of temporary limits on depositor withdrawals, including withdrawals by correspondent banks in the interior of the country. These efforts eventually calmed the panic. By then, however, the U.S. financial system had been severely disrupted, and the economy contracted through the middle of 1908.
The recent crisis echoed many aspects of the 1907 panic. Like most crises, the recent episode had an identifiable trigger--in this case, the growing realization by market participants that subprime mortgages and certain other credits were seriously deficient in their underwriting and disclosures. As the economy slowed and housing prices declined, diverse financial institutions, including many of the largest and most internationally active firms, suffered credit losses that were clearly large but also hard for outsiders to assess. Pervasive uncertainty about the size and incidence of losses in turn led to sharp withdrawals of short-term funding from a wide range of institutions; these funding pressures precipitated fire sales, which contributed to sharp declines in asset prices and further losses. Institutional changes over the past century were reflected in differences in the types of funding that ran: In 1907, in the absence of deposit insurance, retail deposits were much more prone to run, whereas in 2008, most withdrawals were of uninsured wholesale funding, in the form of commercial paper, repurchase agreements, and securities lending. Interestingly, a steep decline in interbank lending, a form of wholesale funding, was important in both episodes. Also interesting is that the 1907 panic involved institutions--the trust companies--that faced relatively less regulation, which probably contributed to their rapid growth in the years leading up to the panic. In analogous fashion, in the recent crisis, much of the panic occurred outside the perimeter of traditional bank regulation, in the so-called shadow banking sector.5 
The responses to the panics of 1907 and 2008 also provide instructive comparisons. In both cases, the provision of liquidity in the early stages was crucial. In 1907 the United States had no central bank, so the availability of liquidity depended on the discretion of firms and private individuals, like Morgan. In the more recent crisis, the Federal Reserve fulfilled the role of liquidity provider, consistent with the classic prescriptions of Walter Bagehot.6 The Fed lent not only to banks, but, seeking to stem the panic in wholesale funding markets, it also extended its lender-of-last-resort facilities to support nonbank institutions, such as investment banks and money market funds, and key financial markets, such as those for commercial paper and asset-backed securities.
In both episodes, though, liquidity provision was only the first step. Full stabilization requires the restoration of public confidence. Three basic tools for restoring confidence are temporary public or private guarantees, measures to strengthen financial institutions' balance sheets, and public disclosure of the conditions of financial firms. At least to some extent, Morgan and the New York Clearinghouse used these tools in 1907, giving assistance to troubled firms and providing assurances to the public about the conditions of individual banks. All three tools were used extensively in the recent crisis: In the United States, guarantees included the Federal Deposit Insurance Corporation's (FDIC) guarantees of bank debt, the Treasury Department's guarantee of money market funds, and the private guarantees offered by stronger firms that acquired weaker ones. Public and private capital injections strengthened bank balance sheets. Finally, the bank stress tests that the Federal Reserve led in the spring of 2009 and the publication of the stress-test findings helped restore confidence in the U.S. banking system. Collectively, these measures helped end the acute phase of the financial crisis, although, five years later, the economic consequences are still with us.
Once the fire is out, public attention turns to the question of how to better fireproof the system. Here, the context and the responses differed between 1907 and the recent crisis. As I mentioned, following the 1907 crisis, reform efforts led to the founding of the Federal Reserve, which was charged both with helping to prevent panics and, by providing an "elastic currency," with smoothing seasonal interest rate fluctuations. In contrast, reforms since 2008 have focused on critical regulatory gaps revealed by the crisis. Notably, oversight of the shadow banking system is being strengthened through the designation, by the new Financial Stability Oversight Council, of nonbank systemically important financial institutions (SIFIs) for consolidated supervision by the Federal Reserve, and measures are being undertaken to address the potential instability of wholesale funding, including reforms to money market funds and the triparty repo market.7 
As we try to make the financial system safer, we must inevitably confront the problem of moral hazard. The actions taken by central banks and other authorities to stabilize a panic in the short run can work against stability in the long run, if investors and firms infer from those actions that they will never bear the full consequences of excessive risk-taking. As Stan Fischer reminded us following the international crises of the late 1990s, the problem of moral hazard has no perfect solution, but steps can be taken to limit it.8 First, regulatory and supervisory reforms, such as higher capital and liquidity standards or restriction on certain activities, can directly limit risk-taking. Second, through the use of appropriate carrots and sticks, regulators can enlist the private sector in monitoring risk-taking. For example, the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) process, the descendant of the bank stress tests of 2009, requires not only that large financial institutions have sufficient capital to weather extreme shocks, but also that they demonstrate that their internal risk-management systems are effective.9 In addition, the results of the stress-test portion of CCAR are publicly disclosed, providing investors and analysts information they need to assess banks' financial strength.
Of course, market discipline can only limit moral hazard to the extent that debt and equity holders believe that, in the event of distress, they will bear costs. In the crisis, the absence of an adequate resolution process for dealing with a failing SIFI left policymakers with only the terrible choices of a bailout or allowing a potentially destabilizing collapse. The Dodd-Frank Act, under the orderly liquidation authority in Title II, created an alternative resolution mechanism for SIFIs that takes into account both the need, for moral hazard reasons, to impose costs on the creditors of failing firms and the need to protect financial stability; the FDIC, with the cooperation of the Federal Reserve, has been hard at work fleshing out this authority.10 A credible resolution mechanism for systemically important firms will be important for reducing uncertainty, enhancing market discipline, and reducing moral hazard.
Our continuing challenge is to make financial crises far less likely and, if they happen, far less costly. The task is complicated by the reality that every financial panic has its own unique features that depend on a particular historical context and the details of the institutional setting. But, as Stan Fischer has done with unusual skill throughout his career, one can, by stripping away the idiosyncratic aspects of individual crises, hope to reveal the common elements. In 1907, no one had ever heard of an asset-backed security, and a single private individual could command the resources needed to bail out the banking system; and yet, fundamentally, the Panic of 1907 and the Panic of 2008 were instances of the same phenomenon, as I have discussed today. The challenge for policymakers is to identify and isolate the common factors of crises, thereby allowing us to prevent crises when possible and to respond effectively when not.

1. See Ben S. Bernanke (2012), "Some Reflections on the Crisis and the Policy Response," speech delivered at "Rethinking Finance," a conference sponsored by the Russell Sage Foundation and Century Foundation, New York, April 13. For the classic discussion of financial panics and the appropriate central bank response, see Walter Bagehot ([1873] 1897), Lombard Street: A Description of the Money Market (New York: Charles Scribner's Sons).
2. Information on the centennial of the Federal Reserve System is available at
3. The Panic of 1907 is discussed in a number of sources, including O.M.W. Sprague (1910), A History of Crises under the National Banking System (PDF), National Monetary Commission (Washington: U.S. Government Printing Office), and, with a focus on its monetary consequences, Milton Friedman and Anna Jacobson Schwartz (1963), A Monetary History of the United States, 1867-1960 (Princeton, N.J.: Princeton University Press). An accessible discussion of the episode, from which this speech draws heavily, can be found in Jon R. Moen and Ellis W. Tallman (1990), "Lessons from the Panic of 1907 (PDF)," Leaving the Board Federal Reserve Bank of Atlanta, Economic Review, May/June, pp. 2-13.
4. See Charles W. Calomiris and Gary Gorton (1991), "The Origins of Banking Panics: Models, Facts, and Bank Regulation," in R. Glenn Hubbard, ed., Financial Markets and Financial Crises (Chicago: University of Chicago Press), pp. 109-74.
5. As discussed in Bernanke, "Some Reflections on the Crisis" (see note 1), shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions--but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies.
6. See Bagehot, Lombard Street, in note 1.
7. For a more comprehensive discussion of recent changes in the regulatory framework, see Daniel K. Tarullo (2013), " Evaluating Progress in Regulatory Reforms to Promote Financial Stability," speech delivered at the Peterson Institute for International Economics, Washington, May 3.
8. See Stanley Fischer (1999), "On the Need for an International Lender of Last Resort," Leaving the Board Journal of Economic Perspectives, vol. 13 (Fall), pp. 85-104.
9. For example, see Board of Governors of the Federal Reserve System (2013), Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice (PDF) (Washington: Board of Governors, August).
10. For a more detailed discussion, see Daniel K. Tarullo (2013), "Toward Building a More Effective Resolution Regime: Progress and Challenges," speech delivered at "Planning for the Orderly Resolution of a Global Systemically Important Bank," a conference sponsored by the Federal Reserve Board and the Federal Reserve Bank of Richmond, Washington, October 18.

Wednesday, November 06, 2013

(Unmet) Credit Demand of American Households

From Liberty Street Economics at the NY Fed:

(Unmet) Credit Demand of American Households, by Basit Zafar, Max Livingston, and Wilbert van der Klaauw, NY Fed: One of the direct effects of the 2008 financial crisis on U.S. households was a sharp tightening of credit. Households that had previously been able to borrow relatively freely through credit cards, home equity loans, or personal loans suddenly found those lines closed off—just when they needed them the most. In recent months, aggregate statistics such as the Federal Reserve’s Consumer Credit series and the Senior Loan Officer Opinion Survey have shown a gradual improvement in consumer credit. The former series is an indicator of interaction of credit supply and demand, while the latter shows only short-term changes in demand and supply (as reported by lenders) separately. It is, therefore, not entirely clear whether the observed trends are a result of fluctuations in demand or supply. Are those demanding credit getting it? What differences are there among U.S. consumers in their demand for and access to credit?
To answer these questions, we designed and included a set of questions on credit access and demand as part of an internet-based survey... Using our survey, we have been able to determine that currently there is a large amount of unmet demand for credit. In the future, we intend to follow-up on respondents’ ability to obtain credit to see how their actions and perceptions with regard to credit change over time.

Tuesday, November 05, 2013

Do People Have Rational Expectations?

New column:

Do People Have Rational Expectations?, by Mark Thoma

Not always, and economic models need to take this into account.

DeLong on Blinder's 'After the Music Stopped'

Brad DeLong reviews Alan Blinder's new book:

You Got Me Feelin Hella Good So I'm Gonna Keep on Dancing: Alan Blinder: "After the Music Stopped": Tuesday Book Reviews Extended Version Weblogging: A Review of Alan Blinder's After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: Penguin Press), J. BRADFORD DELONG is Professor of Economics at the University of California at Berkeley

Properly edited shorter version in Foreign Affairs, July/August 2013

Alan Blinder is the latest economist out of the gate with an analytical account of the recent economic downturn. His 2013 After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: Penguin) is, I think, the best of accounts--at least the best for those without the substantial background and experience in finance needed to successfully crack the works of Gary Gorton. It is the best for four reasons:

  1. The narrative is very good--it is, from my perspective at least, clear and correct.
  2. Alan Blinder has a deep understanding of macroeconomics--thus he can place the events in context, and explain just how it was that the housing boom and its crash had such catastrophic effects on the American economy while, say, the dot-com boom and its crash did not (and was in fact a net plus for the U.S. economy as a whole: a lot of research and development got done, a lot of useful business-model experimentation took place, and a lot of very valuable twenty-first century virtual infrastructure got built--the housing boom brought us no analogous benefits).
  3. Alan Blinder has a very clear sense of the policy options, both in the past and now: what did work, what would have worked, what might have worked, and what would still work were we to try it to get us out of the current fix we are in.
  4. As noted, the book is very readable, even for those who have not been marinated in finance enough to grasp the technicalities and even for those who find topics like "the fall of the rupee" sensational and interesting. For those who do and have worked in or near Wall Street or it equivalent, I recommend Gary Gorton. For everybody else, I recommend Alan Blinder.The topic is certainly enormously important. The economy is today, still, four and a half years after the crash of 2008, six years after the emergence of the first signs of significant trouble in Wall Street, and seven years after the peak of the housing boom, deeply depressed.

Blinder writes that "policy makers are still nursing a frail economy back to health". I am not so sure that is right. It does not look, to me at least, "frail" and "being nursed back to health". To me, it still looks very sick. Blinder writes: "having the national unemployment rate near 8 percent is a lot better than having it near 10 percent, but it is far from good". Blinder is thinking in terms of an economy in which acceptable (although far from ideal or attainable) employment performance has an unemployment rate of 6 percent, and thus that we are halfway back to economic health.

I see an economy in which the share of American adults who were employed was 63% in the mid-2000s, fell to 58.5% in 2009, and is still 58.5% today. We would have expected the natural aging of America's population to have carried the share of adults at work from 63% down to 62% over the past seven years or so--not to 58.5%. And we would have expected the collapse of people's retirement savings either in housing or in stocks in 2008 to have led many Americans to postpone retirement. Given the collapse in the value of retirement savings and their impact on desired retirements, I see a healthy American economy today as one that would still have the same adult employment-to-population ratio of 63% as the economy of the mid-2000s.

From that perspective, we are not halfway back to health. We had a gap of 4.5% points between actual employment and full employment at the end of 2009. We have a gap of 4.5% points between actual employment and full employment today. We are flatlining. It is true that in late 2009 there were still real and rational fears that things might become worse very quickly, and that that possibility is no longer on the menu. But in my view our "recovery" has taken the form not of things getting better but of having successfully guarded against the possibility that things would get even worse. And that is a very feeble recovery indeed. And, in Europe, things are getting worse right now.

Most economists would say that there is a silver lining, in that this is not a Great Depression. I have been calling the current episode the "Lesser Depression". I now think that most economists are--and that I was--wrong in claiming this silver lining. ...[continue to much, much, much more]...

Thursday, October 31, 2013

'Why Bankers Still Aren't Chastened'

From Spiegel:

Why Bankers Still Aren't Chastened, by Martin Hesse and Anne Seith, Spiegel: ... At 1:45 on the morning of Oct. 19, Italian police arrested the 53-year-old [Raoul Weil, once one of the most influential executives at Swiss bank UBS] ... and brought him to ... Dozza prison. The reason: US authorities had indicted Weil, the former head of wealth management at UBS, for allegedly helping American clients hide their assets from US tax authorities on Swiss bank accounts.
Weil's arrest was only one of a series of reminders last week that bankers around the globe are no longer the admired elite of the business world. Public prosecutors, financial regulators and politicians everywhere now suddenly seem to be striving to condemn all of the industry's excesses in fast forward.
British authorities recently hit the financial sector with record penalties. Last week, on the other side of the Atlantic, a US court found Bank of America and a former manager guilty of fraud because of a scheme involving shoddy home loans. Shortly before that, Jamie Dimon, CEO of JPMorgan,reluctantly negotiated a record settlement of $13 billion (€9.45 billion) to at least put a stop to civil claims that his bank knowingly sold toxic US mortgage-backed securities. ...
The truth is, spectacular coups like Weil's arrest are little more than symbolic gestures. The fines and settlements paid by many financial institutions are akin to the indulgences sold by the medieval Catholic Church. The sins of the past may now be forgiven -- but there are no guarantees of improvement in the future.
Regulatory agencies and politicians have not set effective controls on banks and bankers, and although their reputation may be tarnished, their power remains unbroken. ...

Monday, October 21, 2013

Predatory Lending and the Subprime Crisis

From the NBER:

Predatory Lending and the Subprime Crisis, by Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet, Douglas D. Evanoff, NBER Working Paper No. 19550 Issued in October 2013: We measure the effect of an anti-predatory pilot program (Chicago, 2006) on mortgage default rates to test whether predatory lending was a key element in fueling the subprime crisis. Under the program, risky borrowers and/or risky mortgage contracts triggered review sessions by housing counselors who shared their findings with the state regulator. The pilot cut market activity in half, largely through the exit of lenders specializing in risky loans and through decline in the share of subprime borrowers. Our results suggest that predatory lending practices contributed to high mortgage default rates among subprime borrowers, raising them by about a third.

Saturday, October 19, 2013

Sovereigns versus Banks: Crises, Causes and Consequences'

Here's the conclusion from a Vox EU piece by Òscar Jordà, Moritz Schularick, Alan Taylor:

... Conclusion

The long-run historical record underscores the central role played by private-sector borrowing behavior for the buildup of financial instability.

  • The idea that financial crises typically have their roots in fiscal problems is not supported by history.
  • We find evidence, however, that high levels of public debt can matter for the path of the recovery, confirming the results of Reinhart et al. (2012).

However, this effect is related to recoveries from financial crises rather than typical recessions.

  • While high levels of public debt make little difference in normal times, entering a financial crisis recession with an elevated level of public debt exacerbates the effects of private-sector deleveraging, and typically leads to a prolonged period of sub-par economic performance.

Put differently, the long-run data suggest that without enough fiscal space, a country’s capacity to perform macroeconomic stabilisation and resume growth may be impaired.

Friday, October 18, 2013

Are Market Bubbles Predictable, Controllable?

"The limitation of our paper is that we haven't shown that our circuit has relevance to the stock market":

Market bubbles may be predictable, controllable, EurekAlert: It's an idea financial regulators have dreamed of. Experiments on a simple model of chaos have found that it may be possible not only to predict an extreme event, like a stock market collapse, but to intervene and prevent it from happening.
In a paper appearing October 21 in the journal Physical Review Letters, an international team of chaos researchers say that these extreme events, which they call "dragon kings," are less random than had been thought and that, in a simple experiment at least, they can be anticipated and controlled.
"These dragon kings are predictable, if we knew what to measure," said co-author Dan Gauthier, the Robert C. Richardson professor of physics at Duke University.
The latest finding is an outgrowth of experimental work Gauthier has been doing since the 1990s with simple electrical circuits he calls "chaos generators." ...
During a long run of the experiment, the data reveal that the chaotic behavior visits "hot spots" in which an extreme event, "a bubble," might occur. This is an event in which the circuits suddenly and temporarily loose synch. Sometimes the size of the event is small, like a small change in a financial market, and other times it is gigantic, like a market crash. And the size of most of these disturbances follows a power law distribution, in which one variable changes as a power of the other. The most extreme events, the "dragon kings," are responsible for significant deviations from the curve of the power law.
Extreme events that may be governed by these laws would include sudden population crashes in species or freak waves in the ocean, Gauthier said. Other examples might be epileptic storms of activity in the brain and rolling power outages caused by an initial small disturbance, like a squirrel shorting out one substation on a large grid. Other examples could be found in the occurrence of incipient failure of materials and of engineering structures, in the synchronized behavior of kidney and heart cells in the body, in meteorological front dynamics and in climate change, among many others.
In a series of experiments performed with the coupled chaos circuits by Gauthier's colleague and former post-doctoral research associate, Hugo Cavalcante, who is now at the Federal University of Paraiba in Brazil, it was found that the introduction of a tiny amount of current injected into one of the circuits at just the right time prevented a predicted dragon king from happening. "Maybe tiny nudges can make a big difference," Gauthier said. ...
"The limitation of our paper is that we haven't shown that our circuit has relevance to the stock market," which has many more variables, Gauthier said. "We aren't yet sure where to look, but for this one simple system, we figured out how to find it."
Gauthier said the five-page paper faced a difficult gauntlet of reviewers before being accepted in PRL. ...

Sunday, September 29, 2013

'Information, Beliefs, and Trading'

Under the weather today, so I'll hand the microphone over to Rajiv Sethi:

Information, Beliefs, and Trading: Even the most casual observer of financial markets cannot fail to be impressed by the speed with which prices respond to new information. Markets may overreact at times but they seldom fail to react at all, and the time lag between the emergence of information and an adjustment in price is extremely short in the case of liquid securities such as common stock.
Since all price movements arise from orders placed and executed, prices can respond to news only if there exist individuals in the economy who are alert to the arrival of new information and are willing to adjust positions on this basis. But this raises the question of how such "information traders" are able to find willing counterparties. After all, who in their right mind wants to trade with an individual having superior information?
This kind of reasoning, when pushed to its logical limits, leads to some paradoxical conclusions. As shown by Aumann, two individuals who are commonly known to be rational, and who share a common prior belief about the likelihood of an event, cannot agree to disagree no matter how different their private information might be. That is, they can disagree only if this disagreement is itself not common knowledge. But the willingness of two risk-averse parties to enter opposite sides of a bet requires them to agree to disagree, and hence trade between risk-averse individuals with common priors is impossible if they are commonly known to be rational.
This may sound like an obscure and irrelevant result, since we see an enormous amount of trading in asset markets, but I find it immensely clarifying. It means that in thinking about trading we have to allow for either departures from (common knowledge of) rationality, or we have to drop the common prior hypothesis. And these two directions lead to different models of trading, with different and testable empirical predictions.
The first approach, which maintains the common prior assumption but allows for traders with information-insensitive asset demands, was developed in a hugely influential paper by Albert Kyle. Such "noise traders" need not be viewed as entirely irrational; they may simply have urgent liquidity needs that require them to enter or exit positions regardless of price. Kyle showed that the presence of such traders induces market makers operating under competitive conditions to post bid and ask prices that could be accepted by any counterparty, including information traders. From this perspective, prices come to reflect information because informed parties trade with uninformed market makers, who compensate for losses on these trades with profits made in transactions with noise traders.
An alternative approach, which does not require the presence of noise traders at all but drops the common prior assumption, can be traced to a wonderful (and even earlier) paper by Harrison and Kreps. Here all traders have the same information at each point in time, but disagree about its implications for the value of securities. Trade occurs as new information arrives because individuals interpret this information differently. (Formally, they have heterogeneous priors and can therefore disagree even if their posterior beliefs are commonly known.) From this perspective prices respond to news because of heterogeneous interpretations of public information.
Since these two approaches imply very different distributions of trading strategies, they are empirically distinguishable in principle. But identifying strategies from a sequence of trades is not an easy task. At a minimum, one needs transaction level data in which each trade is linked to a buyer and seller account, so that the evolution of individual portfolios can be tracked over time. From these portfolio adjustments one might hope to deduce the distribution of strategies in the trading population.
In a paper that I have discussed previously on this blog, Kirilenko, Kyle, Samadi and Tuzun have used transaction level data from the S&P 500 E-Mini futures market to partition accounts into a small set of groups, thus mapping out an "ecosystem'' in which different categories of traders "occupy quite distinct, albeit overlapping, positions.'' Their concern was primarily with the behavior of high frequency traders both before and during the flash crash of May 6, 2010, especially in relation to liquidity provision. They do not explore the question of how prices come to reflect information, but in principle their data would allow them to do so.
I have recently posted the first draft a paper, written jointly with David Rothschild, that looks at transaction level data from a very different source: Intrade's prediction market for the 2012 US presidential election. Anyone who followed this market over the course of the election cycle will know that prices were highly responsive to information, adjusting almost instantaneously to news. Our main goal in the paper was to map out an ecology of trading strategies and thereby gain some understanding of the process by means of which information comes to be reflected in prices. (We also wanted to evaluate claims made at the time of the election that a large trader was attempting to manipulate prices, but that's a topic for another post.)
The data are extremely rich: for each transaction over the two week period immediately preceding the election, we know the price, quantity, time of trade, and aggressor side. Most importantly, we have unique identifiers for the buyer and seller accounts, which allows us to trace the evolution of trader portfolios and profits. No identities can be deduced from this data, but it is possible to make inferences about strategies from the pattern of trades.
We focus on contracts referencing the two major party candidates, Obama and Romney. These contracts are structured as binary options, paying $10 if the referenced candidate wins the election and nothing otherwise. The data allows us to compute volume, transactions, aggression, holding duration, directional exposure, margin, and profit for each account. Using this, we are able to group traders into five categories, each associated with a distinct trading strategy.
During our observational window there were about 84,000 separate transactions involving 3.5 million contracts and over 3,200 unique accounts. The single largest trader accumulated a net long Romney position of 1.2 million contracts (in part by shorting Obama contracts) and did this by engaging in about 13,000 distinct trades for a total loss in two weeks of about 4 million dollars. But this was not the most frequent trader: a different account was responsible for almost 34,000 transactions, which were clearly implemented algorithmically.
One of our most striking findings is that 86% of traders, accounting for 52% of volume, never change the direction of their exposure even once. A further 25% of volume comes from 8% of traders who are strongly biased in one direction or the other. A handful of arbitrageurs account for another 14% of volume, leaving just 6% of accounts and 8% of volume associated with individuals who are unbiased in the sense that they are willing to take directional positions on either side of the market. This suggests to us that information finds its way into prices largely through the activities of traders who are biased in one direction or another, and differ with respect to their interpretations of public information rather than their differential access to private information.
Prediction markets have historically generated forecasts that compete very effectively with those of the best pollsters.  But if most traders never change the direction of their exposure, how does information come to be reflected in prices? We argue that this occurs through something resembling the following process. Imagine a population of traders partitioned into two groups, one of which is predisposed to believe in an Obama victory while the other is predisposed to believe the opposite. Suppose that the first group has a net long position in the Obama contract while the second is short, and news arrives that suggests a decline in Obama's odds of victory (think of the first debate). Both groups revise their beliefs in response to the new information, but to different degrees. The latter group considers the news to be seriously damaging while the former thinks it isn't quite so bad. Initially both groups wish to sell, so the price drops quickly with very little trade since there are few buyers. But once the price falls far enough, the former group is now willing to buy, thus expanding their long position, while the latter group increases their short exposure. The result is that one group of traders ends up as net buyers of the Obama contract even when the news is bad for the incumbent, while the other ends up increasing short exposure even when the news is good. Prices respond to information, and move in the manner that one would predict, without any individual trader switching direction.
This is a very special market, to be sure, more closely related to sports betting than to stock trading. But it does not seem implausible to us that similar patterns of directional exposure may also be found in more traditional and economically important asset markets. Especially in the case of consumer durables, attachment to products and the companies that make them is widespread. It would not be surprising if one were to find Apple or Samsung partisans among investors, just as one finds them among consumers. In this case one would expect to find a set of traders who increase their long positions in Apple even in the face of bad news for the company because they believe that the price has declined more than is warranted by the news. Whether or not such patterns exist is an empirical question that can only be settled with a transaction level analysis of trading data.
If there's a message in all this, it is that markets aggregate not just information, but also fundamentally irreconcilable perspectives. Prices, as John Kay puts it, "are the product of a clash between competing narratives about the world." Some of the volatility that one observes in asset markets arises from changes in perspectives, which can happen independently of the arrival of information. This is why substantial "corrections" can occur even in the absence of significant news, and why stock prices appear to "move too much to be justified by subsequent changes in dividends." What makes markets appear invincible is not the perfect aggregation of information that is sometimes attributed to them, but the sheer unpredictability of persuasion, exhortation, and social influence that can give rise to major shifts in the distribution of narratives. 

Saturday, September 28, 2013

'Housing Market Is Heating Up, if Not Yet Bubbling'

Robert Shiller:

Housing Market Is Heating Up, if Not Yet Bubbling, by Robert Shiller, Commentary, NY Times: Home prices have been rising rapidly, so much so that there is talk that we are entering another national bubble. ...
Is it possible that we are lapsing into what I call a bubble mentality — a self-reinforcing cycle of popular belief that prices can only go higher? ...
People who are now inclined to buy a home are most often just thinking that we are gradually recovering from a recession and that this is a good time to buy. The mental framing still seems to be about economic recovery and the likelihood that interest rates will rise. People mostly don’t seem to be prompted by the anticipation of another housing boom.
That’s the thinking at the moment. But whether these attitudes mutate into a national epidemic of bubble thinking — one big enough to outweigh higher mortgage rates, fiscal austerity in Congress and other factors — remains to be seen.