Economist's View

'The Key Challenges Facing Central Bankers'

Narayana Kocherlakota on how he sees the balance between keeping interest rates low for an extended time period to help with the unemployment problem (the benefit) and potential financial instability that low rates bring (the cost). He doesn't give a precise statement about how he sees the tradeoff, but does seem to indicate that he sees the benefits as being much larger than the cost. He also explains how the increased demand for safe assets and the fall in supply translates into lowered aggregate demand and the need for stimulative policy from the Fed, and concludes that "Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described." I certainly agree. (This is from a Q&A at the 61st Annual Management Conference of the University of Chicago Booth School of Business.):

The Key Challenges Facing Central Bankers, by Narayana Kocherlakota, President Federal Reserve Bank of Minneapolis: Question: What are the key challenges facing central bankers around the world today?

Narayana Kocherlakota: Thanks for the question. Before answering, I should point out that my remarks today will reflect only my own views and not necessarily those of anyone else in the Federal Reserve System.

In my view, the biggest challenge for central banks—especially here in the United States—is changes in the nature of asset demand and asset supply since 2007. Those changes are shaping current monetary policy—and are likely to shape policy for some time to come.

Let me elaborate. The demand for safe financial assets has grown greatly since 2007. This increased demand stems from many sources, but I’ll mention what I see as the most obvious one. As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few people in the United States saw a severe macroeconomic shock as possible. However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk.

At the same time, the supply of the assets perceived to be safe has shrunk over the past six years. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. They no longer think that. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. They no longer think that either.

The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. It follows that the Federal Open Market Committee (FOMC) can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level. The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

The passage of time will ameliorate these changes in the asset market, but only gradually. Indeed, the low real yields on long-term TIPS bonds suggest to me that these changes are likely to persist over a considerable period of time—possibly the next five to 10 years. If this forecast proves true, the FOMC will only meet its congressionally mandated objectives over that long time frame by taking policy actions that ensure that the real interest rate remains unusually low.

One challenge with this kind of policy environment—and this is closely linked to the overarching theme of this panel—is that low real interest rates are often associated with financial market phenomena that signify instability. There are many examples of such phenomena, but let me focus on a particularly important one: increased asset price volatility. When the real interest rate is unusually low, investors don’t discount the future by as much. Hence, an asset’s price becomes sensitive to information about dividends or risk premiums in what might usually have seemed like the distant future. These new sources of relevant information can lead to increased volatility, in the form of unusually large upward or downward movements in asset prices.

These kinds of financial market phenomena could pose macroeconomic risks. These potentialities are best addressed, I believe, by using effective supervision and regulation of the financial sector. It is possible, though, that these tools may fail to mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence, the FOMC’s decision about how to react to signs of financial instability—now and in the years to come—will necessarily depend on a delicate probabilistic cost-benefit calculation.

Here’s an example of the kind of calculation that I have in mind. Last week, the Survey of Professional Forecasters reported that it saw less than one chance in 200 of the unemployment rate being higher than 9.5 percent in 2014, and an even smaller chance of the unemployment rate being that high in 2015.¹ One possible cause of this kind of a large upward movement in the unemployment rate is an untoward financial shock ultimately attributable to low real interest rates. Thus, the gain to tightening monetary policy is that the FOMC may—and I emphasize the word may—be able to reduce the already low probabilities of adverse unemployment outcomes.

Endnote

1 See the Survey of Professional Forecasters, page 14.

'Let's Get Real About the Stock Market'

One thing I learned from the recent crisis is that despite my indifference to the day to day gyrations in asset markets, I need to pay more attention to them. For example, is there presently a bubble in stock market prices?

Antonio Fatás argues that it's a difficult to find evidence for this:

Let's get real about the stock market: As reported by the financial press, the stock market continues to hit fresh record-high levels in many advanced economies. The Dow Jones passed the 15,000 mark, the Nikkei just went over 14,000, and the DAX just went above its previous record. It seems to be the time to talk about bubbles in asset prices - an important issue given how these bubbles have dominated the last business cycles in these economies.

Except that we are looking at the wrong numbers. It is remarkable that the discussion on the value that these indices are reaching ignores two fundamental issues:

1. These are nominal values and as we were told in the first economics lesson, we need to look at real variables and not nominal ones.
2. Asset prices are not supposed to stay constant (in real terms). In many cases its appreciation will reflect real growth in the economy, earnings and/or the expected return that these assets should provide in equilibrium.

No need to look for data that provides a better benchmark than just nominal indices. Robert Shiller provides all the necessary data in his web site. Adjusting for inflation is easy and below is a chart with the real price of the S&P500 index where the CPI has been used to convert nominal into real variables.

After adjusting for inflation we can see that the index is far from its peak in 2000 and it is even below the peak in 2007. No sign of a record level yet.

Adjusting for inflation is not enough as the fundamentals (earnings) also grow because of real growth. The price-to-earnings ratio takes care of this adjustment (it also takes care of inflation because earnings are measures in nominal terms). Making this adjustment is more difficult but I will reply on Shiller's numbers again (his book and writings provide a lot of detailed analysis on his data).

Once we adjust for nominal as well as real growth, the current levels look even less impressive. Very low compared to the bubble built in the 90s and significantly lower than the ratio observed in most of the years during the 2002-2007 expansion. We are very far from record-high levels if we use this indicator.

Of course, to do a proper analysis we need to bring a lot of other factors: expected earnings growth, interest rates, risk appetite,.... And there will be room there to debate whether the current valuation of the stock market is reasonable, too high or too low. But starting the analysis with a statement of record-high levels when measured in nominal terms and ignoring real growth in earnings is clearly the wrong place to start the debate.

For more on stock prices, see Fernando Duarte and Carlo Rosa of the NY Fed: Are Stocks Cheap? A Review of the Evidence:

We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years. But how do they reach this conclusion? Why is it that the equity premium is so high? And more importantly: Can we trust their models? ...

Why is the equity premium so high right now? And why is it high at all horizons? There are two possible reasons: low discount rates (that is, low Treasury yields) and/or high current or future expected dividends. ... We find that the equity risk premium is high mainly due to exceptionally low Treasury yields at all foreseeable horizons. In contrast, the current level of dividends is roughly at its historical average and future dividends are expected to grow only modestly above average in the coming years. ...

Sachs: Banking Abuses ‘Can’t Get More in Your Face’

Jeff Sachs is interviewed by Paul Vigna of the WSJ's MoneyBeat:

Jeffrey Sachs: Banking Abuses ‘Can’t Get More in Your Face’, by Paul Vigna: ....When I really started to ... keep track of the number of lawsuits, and the number of settlements, and it’s amazing actually how many there are, of course. Libor, Abacus, other financial fraud scandals, money laundering, insider trading. The list is actually extraordinary. The frequency of new cases, new settlements, new SEC charges, is stunning. ...

Why the lack of prosecution?

The legal defenses are very powerful, the lobbying is very powerful, the government in general is completely squeezed even if it would like to regulate. But we also have a revolving door of senior regulatory officials, congressional staff, congressmen and senators. Everyone’s in on this. ...

What will it take to change the system?

I think that the public is utterly disgusted, of course, and that is a major start. There’s going to be a massive backlash..., what one does feel is that the extent of abuse, the stench of it, is reaching such a high level that we’re not in an equilibrium, political or social, right now. This is explosive stuff (scandals like Abacus and insider trading). It’s unbelievable. So far it hasn’t stopped the practice, but it can’t get more in your face than this actually.

I think in the end the question will be ... whether a political movement not based on mega-donations can win political control. I believe that it can actually. Some movement like the populist movement or the progressive era of the past is going to rise and say ‘we don’t need contributions, we’re not taking them, and if you the American people want a way out of this that doesn’t involve politicians bought for big money, we’re the ones.”

But short of that I don’t see a way out. ...

Global Financial Regulation

In case this is of interest:

Global Financial Regulation

Speakers:

• James Barth, Senior Finance Fellow, Milken Institute; Lowder Eminent Scholar in Finance, Auburn University
• Bob Corker, U.S. Senator
• Carey Lathrop, Managing Director and Head of Global Credit Markets, Citi
• Kevin Lynch, Vice Chairman, BMO Financial Group
• Thomas Perrelli, Partner, Jenner & Block; Former Associate U.S. Attorney General

Moderator: Jaret Seiberg, Managing Director and Senior Policy Analyst, Guggenheim Partners

As countries implement new regulations in response to the global financial crisis, will safer and sounder markets be the result? Or just more burdens and costs? What impact can we expect on financial institutions, lending, the flow of capital around the world and, eventually, the global economy? Has the too-big-to-fail problem been solved, or should the giants simply be broken up? Is there a place for a global financial regulator? And what should be done about the shadow banking system - the institutions that wield influence but go largely unregulated? Our panel will delve into whether there are more effective ways to oversee financial markets than current methods.

Have Blog, Will Travel: Milken Global Conference

I am here today (Milken Global Conference 2013).

One quick first impression based upon the schedule of sessions. In the last few years, two or three years ago more so than last year, there were quite a few "soul-searching" sessions from the financial industry. How did financial markets fail, how can they be fixed, etc. That's not to say that there wasn't a lot of resistance to regulation from the industry, but they were at least dealing with the main issues, there was an attempt at an honest appraisal from many, and there were quite a few sessions on the topic.

There are sessions on regulation this year -- I'm currently in one called "Global Financial Regulation" (usual TBTF discussion so far, just turning to leverage) -- but compared to previous years the main concern now appears to be where we are headed in the next few years, opportunities for investment, etc. I suppose that's good news for the economy, but for financial stability? There's still a lot of work to be done, and an eroding will to do it.

'Why Gold and Bitcoin Make Lousy Money'

David Andolfatto:

Why gold and bitcoin make lousy money: A desirable property of a monetary instrument is that it holds its value over short periods of time. Most assets do not have this property: their purchasing power fluctuates greatly at very high frequency. Imagine having gone to work for gold a few weeks ago, only to see the purchasing power of your wages drop by 10% in one day. Imagine having purchased something using Bitcoin, only to watch the purchasing power of your spent Bitcoin rise by 100% the next day. It would be frustrating. 

Is it important for a monetary instrument to hold its value over long periods of time? I used to think so. But now I'm not so sure. While I do not necessarily like the idea of inflation eating away at the value of fiat money, I don't think that a low and stable inflation rate is such a big deal. Money is not meant to be a long-term store of value, after all. Once you receive your wages, you are free to purchase gold, bitcoin, or any other asset you wish. (Inflation does hurt those on fixed nominal payments, but the remedy for that is simply to index those payments to inflation. No big deal.)

I find it interesting to compare the huge price movements in gold and Bitcoin recently, especially since the physical properties of the two objects are so different. That is, gold is a solid metal, while Bitcoin is just an abstract accounting unit (like fiat money). 

But despite these physical differences, the two objects do share two important characteristics:

[1] They are (or are perceived to be) in relatively fixed supply; and
[2] The demand for these objects can fluctuate violently.

The implication of [1] and [2] is that the purchasing power (or price) of these objects can fluctuate violently and at high frequency. Given [2], the property [1], which is the property that gold standard advocates like to emphasize, results in price-level instability. In principle, these wild fluctuations in purchasing power can be mitigated by having an "elastic" money supply, managed by some (private or public) monetary institution. This latter belief is what underlies the establishment of a central bank managing a fiat money system (though there are other ways to achieve the same result). ...

The key issue for any monetary system is credibility of the agencies responsible for managing the economy's money supply in a socially responsible manner. A popular design in many countries is a politically independent central bank, mandated to achieve some measure of price-level stability. And whatever faults one might ascribe to the U.S. Federal Reserve Bank,... since the early 1980s, the Fed has at least managed to keep inflation relatively low and relatively stable. 

'New Preface to Charles Kindleberger'

Brad DeLong and Barry Eichengreen in a new preface to Kindleberger's classic text argue that "We Need a Hegemon Who Won't Drive Us Crazy...":

New Preface to Charles Kindleberger, "The World in Depression 1929-1939": ... Three [of Charles Kindleberger's] lessons stand out, the first having to do with panic in financial markets, the second with the power of contagion, the third with the importance of hegemony. ...

Kindleberger’s third lesson ... has to do with the importance of hegemony, defined as a preponderance of influence and power over others, in this case over other nation states. Kindleberger argued that at the root of Europe’s and the world’s problems in the 1920s and 1930s was the absence of a benevolent hegemon: a dominant economic power able and willing to take the interests of smaller powers and the operation of the larger international system into account by stabilizing the flow of spending through the global or at least the North Atlantic economy, and doing so by acting as a lender and consumer of last resort. Great Britain, now but a middle power in relative economic decline, no longer possessed the resources commensurate with the job. The rising power, the US, did not yet realize that the maintenance of economic stability required it to assume this role. In contrast to the period before 1914, when Britain acted as hegemon, or after 1945, when the US did so, there was no one to stabilize the unstable economy. Europe, the world economy’s chokepoint, was rendered rudderless, unstable, and crisis- and depression-prone. ...

It might be hoped that something would have been learned from this considerable body of scholarship. Yet today, to our surprise, alarm and dismay, we find ourselves watching a rerun of Europe in 1931. Once more, panic and financial distress are widespread. And, once more, Europe lacks a hegemon – a dominant economic power capable of taking the interests of smaller powers and the operation of the larger international system into account by stabilizing flows of finance and spending through the European economy.

The ECB does not believe it has the authority: its mandate, the argument goes, requires it to mechanically pursue an inflation target – which it defines in practice as an inflation ceiling. It is not empowered, it argues, to act as a lender of the last resort to distressed financial markets... The EU, a diverse collection of more than two dozen states, has found it difficult to reach a consensus on how to react. And even on those rare occasions where it does achieve something approaching a consensus, the wheels turn slowly, too slowly compared to the crisis, which turns very fast.

The German federal government, the political incarnation of the single most consequential economic power in Europe, is one potential hegemon. It has room for countercyclical fiscal policy. It could encourage the European Central Bank to make more active use of monetary policy. It could fund a Marshall Plan for Greece and signal a willingness to assume joint responsibility, along with its EU partners, for some fraction of their collective debt. But Germany still thinks of itself as the steward is a small open economy. It repeats at every turn that it is beyond its capacity to stabilize the European system: “German taxpayers can only bear so much after all”. Unilaterally taking action to stabilize the European economy is not, in any case, its responsibility, as the matter is perceived. The EU is not a union where big countries lead and smaller countries follow docilely but, at least ostensibly, a collection of equals. Germany’s own difficult history in any case makes it difficult for the country to assert its influence and authority and equally difficult for its EU partners, even those who most desperately require it, to accept such an assertion.[6] Europe, everyone agrees, needs to strengthen its collective will and ability to take collective action. But in the absence of a hegemon at the European level, this is easier said than done.

The International Monetary Fund, meanwhile, is not sufficiently well capitalized to do the job even were its non-European members to permit it to do so, which remains doubtful. Viewed from Asia or, for that matter, from Capitol Hill, Europe’s problems are properly solved in Europe. More concretely, the view is that the money needed to resolve Europe’s economic and financial crisis should come from Europe. The US government and Federal Reserve System, for their part, have no choice but to view Europe’s problems from the sidelines. A cash-strapped US government lacks the resources to intervene big-time in Europe’s affairs in 1948; there will be no 21st century analogue of the Marshall Plan... Today,... the Congress is not about to permit Greece, Ireland, Portugal, Italy, and Spain to incorporate in Delaware as bank holding companies and join the Federal Reserve System.[7]

In a sense, Kindleberger predicted all this in 1973. ... It was fear of this future that led Kindleberger to end The World in Depression with the observation: “In these circumstances, the ... alternative of international institutions with real authority and sovereignty is pressing.”

Indeed it is, more so now than ever. ...

Low Real Interest Rates and Financial Market Instability

Here's the executive summary of a speech from Minneapolis Fed president Narayana Kocherlakota. He argues that "the FOMC will only be able to meet its congressionally mandated objectives ... by taking policy actions that ensure that the real interest rate remains unusually low," and that these policies will "necessarily give rise to signs of financial market instability":

Low Real Interest Rates - Executive Summary, by Narayana Kocherlakota - President Federal Reserve Bank of Minneapolis: My talk is about the decline in real—that is, net of inflation—interest rates since 2007. I begin by describing how, over the past six years, the demand for safe assets has grown, while the supply of those assets has shrunk. These changes in asset demand and asset supply imply that households and firms spend less at any level of real interest rates. It follows that the Federal Open Market Committee can only meet its congressionally mandated objectives for employment and prices by taking actions that greatly lower the real interest rate relative to its 2007 level. This is my first of three main messages: The FOMC should be thought of as having been forced to lower the real interest rate in order to respond appropriately to dramatic changes in asset market demand and supply.

I suggest that these dramatic changes in asset demand and asset supply are likely to persist over a considerable period of time—possibly the next five to 10 years. If that forecast holds true, it follows that the FOMC will only be able to meet its congressionally mandated objectives over that time frame by taking policy actions that ensure that the real interest rate remains unusually low. I point out that low real interest rates can be expected to be associated with financial market phenomena—like high asset price volatility—that are seen as signifying instability. This is my second main message: For many years to come, the FOMC will only be able to achieve its objectives by following policies that necessarily give rise to signs of financial market instability.

These financial market phenomena could pose macroeconomic risks. In my view, these potentialities are best addressed using effective supervision and regulation of the financial sector. It is possible, though, that these tools may only partly mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence—and this is my third main message—the FOMC’s decision about how to react to signs of financial instability will necessarily depend on a delicate probabilistic cost-benefit calculation. The Committee is in a better position to make that calculation now than it was in 2007, and continues to make progress on this dimension.

Note

* I thank Ron Feldman, David Fettig, Terry Fitzgerald and Kei-Mu Yi for many valuable comments.

Full speech: Low Real Interest Rates.

'Financial Stability Monitoring'

In order to stabilize the financial system, there are two recommendations that I would definitely make. One is to reduce the chance of runs in the shadow banking system -- a key factor behind the financial crisis. As noted below, the Dodd-Frank Act "does not address structural problems in wholesale short-term funding markets, such as the susceptibility of money market funds to investor runs or the inherent fragility of repo markets." Regulators have been working on fixes for this problem, but it's not fixed yet and that should be a bit more alarming than it seems to be.

The other change is to develop a better early warning system for financial crises. Dean Baker would say just call me, but I'd like to go beyond that and develop new tools, statistics, etc. that can help us do a better job of identifying risks before they become destructively large. I won't be satisfied with the excuse that we can't predict bubbles reliably until we have done the work of trying to find better leading indicators for problems.

Those two changes are far from exhaustive, reducing leverage, for example, should be on the list as well. But they are key issues that need to be addressed and it's nice to see that the Fed recognizes this and is trying to develop a "broad and forward-looking monitoring program" (the problem of bank runs in the shadow banking system isn't directly addressed, the idea is to prevent problems through early detection coupled with a policy response to relieve the pressure in the market).

Before moving on to the paper, given recent developments surrounding the work of Reinhart and Rogoff, I should probably remind people of this:

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors.

Here's the abstract and introduction (on the continuation page) to the preliminary paper:

Financial Stability Monitoring, by Tobias Adrian, Daniel Covitz, and Nellie Liang, FRB Working Paper: Abstract While the Dodd Frank Act (DFA) broadens the regulatory reach to reduce systemic risks to the U.S. financial system, it does not address some important risks that could migrate to or emanate from entities outside the federal safety net. At the same time, it limits the types of interventions by financial authorities to address systemic events when they occur. As a result, a broad and forward-looking monitoring program, which seeks to identify financial vulnerabilities and guide the development of pre-emptive policies to help mitigate them, is essential. Systemic vulnerabilities arise from market failures that can lead to excessive leverage, maturity transformation, interconnectedness, and complexity. These vulnerabilities, when hit by adverse shocks, can lead to fire sale dynamics, negative feedback loops, and inefficient contractions in the supply of credit. We present a framework that centers on the vulnerabilities that propagate adverse shocks, rather than shocks themselves, which are difficult to predict. Vulnerabilities can emerge in four areas: (1) systemically important financial institutions (SIFIs), (2) shadow banking, (3) asset markets, and (4) the nonfinancial sector. This framework also highlights how policies that reduce the likelihood of systemic crises may do so only by raising the cost of financial intermediation in non-crisis periods.

Did the Fed Cause the housing Bubble?

According to research by Ambrogio Cesa-Bianchi and Alessandro Rebucci, the housing bubble was caused by "regulatory rather than monetary-policy failures":

Is the Federal Reserve breeding the next financial crisis?, by Ambrogio Cesa-Bianchi and Alessandro Rebucci: Many economists think that the US Federal Reserve’s loose monetary stance in the 2000s fuelled the US housing bubble. Is the Fed thus responsible for the Global Crisis? This column discusses evidence suggesting that monetary policy was, in fact, not to blame. Rather, it was the absence of an effective regulatory function that created the mess we’re in now. It is not fair to blame the Great Recession only on the Fed’s monetary-policy stance nor is the Fed now breeding the next US financial crisis. ...

In the context of our model and according to this evidence, regulatory rather than monetary-policy failures are largely to blame for the occurrence and the severity of the Great Recession. Only by assuming that the Fed was the sole institutional guardian of financial stability, or at least the main one, is it possible to contend that monetary policy is to blame for the 2007-09 financial crisis and the ensuing Great Recession. ...

Solow: Has Financialization Gone Too Far?

Robert Solow has an essay that begins with lots of praise for Ben Bernanke:

How to Save American Finance from Itself: Has financialization gone too far?, by Robert Solow, TNR: Central banking is not rocket science, but neither is it a trivial pursuit. ... Running a central bank is in one way a little bit like flying a plane or sailing a boat: much of the time standard responses and small adjustments will do just fine, but every so often a situation arises in which fundamental understanding, knowledge of history, and good judgment can make the difference between riding out the storm and crashing. There was no such person in charge in 1929, and the result was disaster. There was one in 2008.

In his earlier scholarly life, Ben Bernanke, the chairman of the Federal Reserve Board, had been a careful student of the general interaction between the financial system and the real economy and especially of its working out in the Great Depression of the 1930s. So he had done his homework. His decisive and innovative actions at the Fed saved our economy from free fall with a possibly catastrophic end. ...

He goes on to review a book of four lectures Ben Bernanke gave on the role of the Fed:

In March 2012, George Washington University invited Bernanke to give four lectures as part of a course devoted to the role of the Federal Reserve in the economy. The lectures are now reproduced in book form, apparently from lightly edited transcripts. Each lecture ends with half a dozen questions from anonymous “students” and Bernanke’s answers. Some of the questions are smart, some less so, in which case Bernanke exhibits the professorial skill of seamlessly answering a slightly different question. ...

The lectures are consistently lucid and informal—maybe a little too anecdotal, but illustrated with many clear and informative slides—and above all intelligent and interesting. There are no revelations or recantations; even if Bernanke had any in mind, this would not be the place for them. A short book such as this has no room for a play-by-play account of the crisis. But it would be difficult to find a better short and not very technical account of what went wrong, and of how the Fed (and the Treasury) managed to keep it from getting much worse. ...

He then goes through a long, detailed discussion of the issues Bernanke addresses in these lectures, but I want to pick it up again near the end:

Bernanke's ... preferred answer is better and more system-oriented regulation. One has to ask then why regulation failed to see the crisis of 2007–2008 coming and take action to head it off. Bernanke suggests that regulators were lulled into inattention by the so-called Great Moderation...

For safeguarding financial stability in the future, Bernanke seems to count heavily on the provision in Dodd-Frank that establishes a committee of regulators charged with keeping an eye on “systemically important” financial institutions, whatever they look like, in order to warn them away from dangerously risky behavior and/or impose extra capital requirements. We will have to see how that works out...

He touches on it only obliquely in these lectures, but Bernanke has lingering worries that the size, the complexity, and the interconnectedness of today’s financial system strain the capacity of even improved risk-management techniques to protect the system against its inherent vulnerabilities. ...

All of which leads to a broader issue... Any complicated economy needs a complicated financial system: to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects. If these functions are not performed adequately, the economy cannot produce and grow with anything like efficiency. Granted all that, however, the suspicion persists that financialization has gone too far.

What would that mean? It would mean that the last x percent of financial activity absorbs more resources (especially intellectual resources) and creates more potential instability than its additional efficiency-benefits can justify. This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate. Yes, it is hard to imagine that the Hedge Fund Operator of the Year does anything that is remotely socially useful enough to justify the enormous (and lightly taxed) compensation that results; but that is not really an argument. Much more significant is the fact that the bulk of incremental financial activity is trading, and trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of. This is, you might say, the $64 trillion question. Maybe I shouldn’t wish it on Ben Bernanke. 

Given his worries about financial stability, I have to wonder if the praise for Bernanke shouldn't be a bit more qualified. I agree that the Fed did a pretty good job responding the the recession. It could have done better -- it was frequently too late and too timid, especially during the first few years -- but it also could have done a whole lot worse. But what we don't yet know is how well we have been insulated from future shocks. Is Bernanke's view correct about what is needed on the regulatory front, and has it been implemented? In my view, significant vulnerabilities remain within the shadow banking system (and I'm far from alone). If that's true and we do have another crisis down the road, then the effusive praise for Bernanke will diminish much as happened with Greenspan (anointed as the best Fed Chair ever only to have housing bubble crash dramatically change the view of his record). As Robert Solow says about Bernanke's views on safeguarding financial stability in the future, "We will have to see how that works out.

Thinking Straight About Debt

Paul Krugman on something I emphasized in a recent post, the danger of "excessive leverage":

Thinking Straight About Debt: A heads-up: I’m doing This Week this week. Also on the panel: David Stockman. This should be, um, interesting.

So, a few more thoughts on debt and what it does and doesn’t signify. ...

This is how you want to think about debt: it’s not a burden on the nation’s resources, because it’s mainly money we owe to ourselves, and it’s a problem not because we have to tighten our belt but because debt is currently leading to spending that’s less than we need to maintain full employment.

I would add that ... the ... debt of financial intermediaries ... is a big part of the real story and if anything bears even less resemblance to the notion of debt as a consequence of national overspending; to a large extent it’s just an accounting issue, because old-fashioned deposits aren’t counted as debt even though they are.

Maybe a short way to put all this is to say that we have a real problem with excessive leverage; that’s not at all the same thing as the nation being deeply in hock to some external player or players. And failing to understand that difference is a way to get both the nature of our crisis and the shape of appropriate policies totally wrong.

'Don’t Panic – Financial Reform is Coming'

Barney Frank is confident that new financial regulation "will be completed in time to prevent the type of crises that they are intended to prevent":

Don’t panic – financial reform is coming to America, by Barney Frank, Commentary, Financial Times: We are going to sort out the US financial system. This might seem a bold statement when, two and a half years after the Dodd-Frank Act was signed into law, much necessary regulation is still not on the books. But with the re-election of Barack Obama, I have no doubt that the necessary new rules will be in place in good time. ... Some of the factors responsible for the pace were inherent in the task. ...

This brings us to the set of obstacles to filling out the rule book... First, the SEC and the CFTC receive vast amounts of comments for each proposed rule, which they must process. Meanwhile, the Republican House appropriations committee starves them of money. ...

This is where the DC courts come in. Not only do these agencies have to go through comments, the court then grades their work... On several occasions, DC courts have struck down SEC and CFTC rules, not because of any constitutional problem, but because the conservative judges think the agencies have given too little deference to the financial industry’s arguments.

Documenting decisions to the degree that the court requires would be difficult in any circumstance. Doing so with ... Republican underfunding is impossible. This was, in part, what was at stake when the Republican Senate minority filibustered to death an Obama appointee to the DC circuit. ...

The rules will be completed in time to prevent the type of crises that they are intended to prevent, but later than they should be. But the fault for that will rest with Republican appropriators withholding adequate funding and Republican senators filibustering to maintain the DC circuit as a rightwing bastion.

I am not as confident as he is that we will get the rules we need. In addition, notice that he talks about preventing financial crisis. However, we can never fully prevent a financial collapse, only make it less likely. Thus, there is another aspect of regulation that is just as important as trying to prevent problems from occurring, building systems that are robust to shocks. Leverage is a good example. Limiting leverage can limit the "unwind" that occurs with large negative financial shocks and thus limit the downside risk.

The recent financial collapse surely illustrated that we need better regulation to reduce the chances of financial collapse, but it also illustrated -- starkly -- that the sorts of shock absorbers we should have in place are missing. Yes, things like limiting leverage will be resisted mightily by the industry and the politicians in the financial industry's pocket, but this type of protection for the system is just as important as trying to prevent problems in the first place.

'Dark Pool Trading'

Hmmm: -- anyone want to convince me this is not something regulators should worry about?:

... The portion of all stock trading taking place away from the public exchanges hit new highs over the last few weeks, amounting to close to 40 percent on several days, up from an average of 16 percent in 2008 ...

'Olivier Blanchard’s Five Lessons for Economists From the Financial Crisis'

Long, long travel day today (and not sure if I'll have an internet connection), so -- for now -- a few quick ones (between here and today's links). First, Brad Delong sends us to David Wessel, who sends us to Olivier Blanchard (I've shortened the five points):

Olivier Blanchard’s Five Lessons for Economists From the Financial Crisis: ...Here are Mr. Blanchard's five lessons in his own words, lightly edited by The Wall Street Journal’s David Wessel:

1. Humility is in order: The Great Moderation ... convinced too many of us that the large-economy crisis -­ a financial crisis, a banking crisis ­- was a thing of the past. It wasn’t going to happen again... My generation ... knew how to do things better, not only in economics but in other fields as well. What we have learned is that's not true. History repeats itself. We should have known.

2. The financial system matters — a lot: It’s not the first time that we¹re confronted with ... “unknown unknowns”... There is another example in macro-economics: The oil shocks of the 1970s... It took a few years, more than a few years, for economists to understand what was going on. After a few years, we concluded that we could think of the oil shock as yet another macroeconomic shock. We did not need to understand the plumbing. We didn’t need to understand the details of the oil market. ...

This is different. What we have learned about the financial system is that the problem is in the plumbing and that we have to understand the plumbing..., it's very clear that the details of the plumbing matter.

3. Interconnectedness matters: This crisis started in the U.S. and across the ocean in a matter of days and weeks. Each crisis, even in small islands, potentially has effects on the rest of the world. The complexity of the cross border claims by creditors and by debtors clearly is something that many of us had not fully realized..., which countries are safe havens, and when and why? Understanding this has become absolutely essential. What happens in one part of the world cannot be ignored by the rest of the world. ...

It’s also true on the trade side. ... One absolutely striking fact of the crisis is the collapse of trade in 2009. Output went down. Trade collapsed. Countries which felt they were not terribly exposed through trade turned out to be enormously exposed.

4. We don’t know if macro-prudential tools work: It’s very clear that the traditional monetary and fiscal tools are just not good enough to deal with the very specific problems in the financial system. This has led to the development of macro-prudential tools... [Macroprudential tools allow a central bank to restrain lending in specific sectors without raising interest rates for the whole economy, such as increasing the minimum down payment required to get a mortgage, which reduces the loan-to-value ratio.] ... If there is a problem somewhere you can target the tool at the problem and not use the policy interest rate, which basically is kind of an atomic bomb without any precision.

The big question here is: How reliable are these tools? How much can they be used? The answer ... is this: They work but they don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere.

5. Central bank independence wasn’t designed for what central banks are now asked to do: ... One of the major achievements of the last 20 years is that most central banks have become independent of elected governments. Independence was given because the mandate and the tools were very clear. The mandate was primarily inflation... The tool was some short-term interest rate that could be used by the central bank to try to achieve the inflation target. In this case, you can give some independence to the institution in charge of this because the objective is perfectly well defined, and everybody can basically observe how well the central bank does.

If you think now of central banks as having a much larger set of responsibilities and a much larger set of tools, then the issue of central bank independence becomes much more difficult. Do you actually want to give the central bank the independence to choose loan-to-value ratios without any supervision from the political process. Isn’t this going to lead to a democratic deficit in a way in which the central bank becomes too powerful? I'm sure there are ways out. Perhaps there could be independence with respect to some dimensions of monetary policy -­ the traditional ones — and some supervision for the rest or some interaction with a political process.

Why Does Marty Feldstein Wants Higher Interest Rates???

Today's what were you thinking when you wrote that award goes to Martin Feldstein:

Department of "Huh?!": I Don't Understand Why Marty Feldstein Wants Higher Interest Rates Right Now Weblogging, by Brad DeLong: I confess that I am having a hard time understanding Marty Feldstein's latest column…

Bond Bubble Brouhaha, by Paul Krugman: Brad DeLong is puzzled by Martin Feldstein’s mental contortions as he tries to come up with a reason to raise interest rates in a depressed economy. So am I. But I’m also puzzled by Feldstein’s underlying economic analysis, in which he treats it as totally obvious that we have a massive bond bubble.

Now, maybe we do have a bond bubble. But the arguments Feldstein uses are one that I thought every sensible economist — a group I thought included Feldstein — had dismissed as bogus years ago. ...

Financing the Deficit (More Feldstein), by Paul Krugman: OK, a bit more on the puzzle of people who think there’s an interest rate puzzle. Here’s the picture of what has happened to saving and investment in America in recent years...

So there isn’t any puzzle here, except the puzzle of people who are puzzled. I really don’t understand how Marty Feldstein can look at these facts and conclude that the only way to explain low interest rates is to imagine that the Fed is imposing massive market distortions. ...

'Did the Iraq War Cause the Great Recession?'

Via Henry Farrell:

Did the Iraq War Cause the Great Recession?, Henry Farrell: Thomas Oatley thinks that it very plausibly did. His argument draws upon an interesting article (should be ungated) in the new issue of Perspectives on Politics, where he, Kindred Winecoff, Andrew Pennock and Sarah Bauerle Danzman argue that international political economy scholars pay too little attention to the structural characteristics of international politics. By concentrating too much on states as unitary actors, they fail to recognize the importance of the network connections between them. The network topology – the shape of the network – can have consequences – networks where no node gets very much more links than any other node are quite different in their consequences from networks where one or a couple of nodes receive a lot more links than others. This has implications for financial contagion – if contagion spreads across links, network topology will have important consequences for the likelihood of spread. As it turns out, there is strong reason to believe that the international financial system is one of the latter kinds of networks rather than one of the former. On two measures of financial ties, most countries on the periphery of the network have few links to other peripheral countries, but pretty well everyone has links to the US, and many have links to the UK too. ...[more]...

I'm not fully convinced by this theory that the Iraq war caused the recession, but it does bring up some important issue about network connectivity. Are highly interconnected networks better at dispersing risk? It depends upon the type of risk. Suppose a toxin hits a network. If diluting the toxin across the network also dilutes its effects to practically nothing, then we want the network to be as large and interconnected as possible. When shocks hit they will be quickly diluted and rendered relatively harmless. But for toxins that are deadly in minute doses, toxins that kill whatever they touch even when they are highly diluted, we want the infected node on the network to be isolated as much as possible.

Optimally, then, assuming that most shocks are not toxic if they are dispersed across a large network, we want the network to be large and highly interconnected so that risks can be diversified across the network to practically nothing. But we also want the ability to quickly disconnect nodes that become infected with toxins that don't lose their potency as they are diluted. And that's the problem, identifying when such a toxin hits a network is difficult -- there will always be denial if disconnecting nodes in the financial system costs people money -- and it may not be easy to quickly disconnect nodes from the network so that problem nodes can be isolated/quarantined before the toxin spreads.

We have been told that problems in places like Cyprus have been walled off -- nodes in the network have been isolated -- but so long as a few isolated connections still exist that are difficult to cut, highly toxic shocks can pollute the rest of the network. In addition, as we saw today when "Jeroen Dijsselbloem, the current head of the Eurogroup, held a formal, on-the-record joint interview with Reuters and the FT today, saying that the messy and chaotic Cyprus solution is a model for future bailouts" and financial markets reacted negatively (the statement is being walked back), some connections -- those involving expectations -- cannot be severed in any case.

Highly interconnected networks are highly desirable so long as (1) we can quickly identify trouble, and (2) nodes can be quickly and effectively isolated. But when those conditions are not present, the occasional highly toxic shock will cause quite a bit of damage.

'He Who Makes the Rules'

On the run today so I haven't had time to do more than skim this quickly (it's relatively long), but this article on how financial regulation is quietly being watered down comes highly recommended:

He Who Makes the Rules, by Haley Sweetland Edwards, Washington Monthly: In late 2010, Bart Chilton, one of three Democratic commissioners at the U.S. Commodity Futures Trading Commission (CFTC), walked into an upper-floor suite of an executive office building to meet with four top muckety-mucks at one of the biggest financial institutions in the world. ...

The main topic ... was the CFTC’s pending rule on what are known as “position limits.” If implemented properly, position limits would put a leash on speculation in the commodities market by making it harder for heavyweight traders at places like Goldman Sachs and JPMorgan Chase to corner a market, make a killing for themselves, and screw up prices for the rest of us. Position limits are also one of many ways to tamp down the amount of risk big institutions can take on, which ... minimizes the chance taxpayers will have to bail them out. ...

The passage ... Dodd-Frank ... explicitly directs the CFTC to establish position limits... “The Commission shall by rule, regulation or order establish limits on the amount of positions, as appropriate,” it reads.

Still, even with the strength of the law behind him, Chilton waited until the end of the meeting to broach what he knew would be a tense subject. ... They deferred ... to their top lawyer, who explained that the ... CFTC was not required to establish position limits at all. ... Their lawyer quietly referred Chilton to the end of the sentence in question: as appropriate..., the statute can be interpreted as saying that the commission shall—but only if appropriate—establish position limits, he explained. ...

But it’s still, rather obviously, just that: a linguistic sleight of hand. The words “as appropriate” have appeared in statutes governing the CFTC’s authority to implement position limits for at least forty years without challenge. ...

The meeting ended abruptly... One of the muckety-mucks from the meeting walked with him to the elevator. ... Chilton turned to his host. “You guys have got to be kidding about this ‘as appropriate’ stuff, right?” he said. “I know,” the muckety-muck replied, admitting it was a stretch. He let out a little chuckle—“but that’s what we’re going with.” “He laughed,” Chilton told me recently, remembering that day. “He was laughing about how ludicrous it was.”

A couple of months after that inauspicious meeting, the CFTC released a proposed rule establishing position limits on oil, gas, coffee, and twenty-five other commodities markets. ... Finally, in October 2011, the CFTC issued a final rule. It was a victory, but a short-lived one. Two months later, two powerful industry groups ... hired Eugene Scalia, the son of Supreme Court Justice Antonin Scalia, as their lead counsel, and launched a lawsuit against the CFTC. ...

House Democrats and nineteen senators, some of whom had drafted Dodd-Frank, petitioned the court to rule in favor of the CFTC, a handful of op-eds beseeched judges to do the right thing, and financial reform advocates called foul. None of it made a difference. In September 2012, the U.S. Court for the District of Columbia Circuit overturned the CFTC’s rule. ...[more]...

The Latest Plan in Cyprus

Some news on Cyprus:

Cyprus Passes Parts of Bailout Bill, but Delays Vote on Tax, NY Times: Cyprus’s parliament on Friday partly approved a revised formula for obtaining an international bailout to avert a default, amid strong signals that the plan would not pass muster with international lenders.

But they put off voting on a crucial new proposal until later this weekend — one that would confiscate a stunning 22 percent to 25 percent of uninsured deposits over 100,000 euros through a new tax to be placed on account holders in one of the nation’s most troubled banks.

And so, going into the weekend ahead of a Monday deadline imposed by the European Central Bank, it appeared there was still no immediate path to a lifeline of 10 billion euros, or $13 billion, that Cyprus needs to keep its banks from collapsing. ...

One of the provisions approved by Parliament on Friday would impose new restrictions on withdrawing cash or moving money out of the country when the banks reopen [capital controls]...

Lawmakers also voted to restructure the nation’s largest and most troubled bank, Laiki Bank, by hiving off its troubled assets into a so-called bad-bank. Accounts with no problem would be transferred to the nation’s largest financial institution, the Bank of Cyprus, which lawmakers are now proposing to hit with a 22 to 25 percent tax on uninsured deposits. That measure ... will be considered in coming days...

Cyprus’s so-called troika of lenders — the International Monetary Fund, the European Commission and the European Central Bank — still must approve the plan. ...

Cyprus is imposing the 22-25 percent levy in an attempt to save its largest bank, the Bank of Cyprus. From the WSJ:

As details of the latest plan emerged late Friday, there were signs that the country may be forced to also resolve Bank of Cyprus, its biggest lender, a prospect it was fighting to avert by proposing an even deeper levy on the lender's uninsured depositors than one demanded earlier by euro-zone partners.

However:

Two officials involved in the negotiations said the government in Nicosia was planning to impose a 20% levy on depositors with more than €100,000 in their accounts in Bank of Cyprus. The government hoped that would allow them to protect the lender, which holds more than one third of total deposits on the island, some €28 billion.

But senior European finance-ministry officials in a call Friday evening expressed doubts that the plan would raise enough money to ring fence the lender, according to two officials on the call. ... Resolving both banks "makes more sense," said [one] official. ...

Nevertheless:

The creation of a "good bank" and a "bad bank" could improve Cyprus's lot in two ways. First, creditors of the bad bank could be made to bear steep losses. That would reduce the amount of aid the Cypriot government needs to provide to the banking system. Second, by bolstering Bank of Cyprus, the plan could persuade the ECB to continue providing liquidity to the country's financial system—which it has threatened to cut off.

As it says above, there's "still no immediate path to a lifeline."

Paul Krugman: Treasure Island Trauma

Despite the risks to financial stability, tax havens like Cyprus "are still operating pretty much the same way that they did before the global financial crisis":

Treasure Island Trauma, by Paul Krugman, Commentary, NY Times: A couple of years ago,... Nicholas Shaxson published a fascinating, chilling book titled “Treasure Islands,” which explained how international tax havens — which are also ... “secrecy jurisdictions” where many rules don’t apply — undermine economies around the world. Not only do they bleed revenues from cash-strapped governments and enable corruption; they distort the flow of capital, helping to feed ever-bigger financial crises.

One question Mr. Shaxson didn’t get into..., however, is what happens when a secrecy jurisdiction itself goes bust. That’s the story of Cyprus right now. ...

Now what? There are some strong similarities between Cyprus now and Iceland ... a few years back. Like Cyprus now, Iceland had a huge banking sector, swollen by foreign deposits, that was simply too big to bail out. Iceland’s response was essentially to let its banks go bust, wiping out those foreign investors, while protecting domestic depositors — and the results weren’t too bad. ...

Unfortunately, Cyprus’s response to its crisis has been a hopeless muddle. In part, this reflects the fact that it no longer has its own currency, which makes it dependent on decision makers in Brussels and Berlin — decision makers who haven’t been willing to let banks openly fail.

But it also reflects Cyprus’s own reluctance to accept the end of its money-laundering business; its leaders are still trying to limit losses to foreign depositors in the vain hope that business as usual can resume,... they ... tried to limit foreigners’ losses by expropriating small domestic depositors. As it turned out, however, ordinary Cypriots were outraged, the plan was rejected, and, at this point, nobody knows what will happen.

My guess is that, in the end, Cyprus will adopt something like the Icelandic solution... We’ll see.

But step back ... and consider the incredible fact that tax havens like Cyprus, the Cayman Islands, and many more are still operating pretty much the same way that they did before the global financial crisis. Everyone has seen the damage that runaway bankers can inflict, yet much of the world’s financial business is still routed through jurisdictions that let bankers sidestep even the mild regulations we’ve put in place. Everyone is crying about budget deficits, yet corporations and the wealthy are still freely using tax havens to avoid paying taxes like the little people.

So don’t cry for Cyprus; cry for all of us, living in a world whose leaders seem determined not to learn from disaster.

'The Future of the Euro: Lessons from History'

Brad DeLong:

The Future of the Euro: Lessons from History: The 1919-1939 interwar period taught us four lessons:

1. In order for the world economy to be prosperous, adjustment to macroeconomic disequilibrium needs to be undertaken by both "surplus" and "deficit" economies--not by "deficit" economies alone.

2. If the world economy is to have any chance of avoiding or limiting crises, an integrated banking system requires an integrated bank regulator and supervisor.

3. In order for crises to be successfully managed, the lender of last resort must truly be a lender of last resort: it must create whatever asset the market thinks is the safest in the economy, and must be able to do so in whatever quantity the market demands.

4. In order for any monetary union or fixed exchange rate system larger than an optimum currency area to survive, it must be willing to undertake large-scale fiscal transfers to compensate for the exchange rate movements to rapidly shift inter-regional terms of trade that it prohibits.

I, at least, thought that everybody--or everybody who mattered in governing the world economy--had learned these four lessons that 1919-1939 had so cruelly taught us. Now it turns out that the dukes and duchesses of Eurovia had, in fact, learned none of them. History taught the lesson. But while history was teaching the lesson, the princes and princesses of Eurovia and their advisors were looking out the window and gossiping on Facebook. ...

He goes on to try to explain why the system ended up with so many dysfunctional features. (I would add the us-them nature of the interactions between the nations in Europe that the various crises have exposed. It is not the "all for one and one for all" attitude that is needed to implement the things Brad is suggesting, e.g. a "a single Eurovia-wide banking regulator" and a " fiscal-transfer" system. Instead it's a point your finger at others and moralize about the differences in behavior. It's a lot like the peace we thought we had in macroeconomics -- the convergence of thought between the various schools that people like Olivier Blanchard talked about -- until the Great Recession exposed the deep divisions that still exist).

'Cyprus Set to Reject Bailout'

This is from Francesco Saraceno, "an Italian born economist working in France": 

Cyprus. Been There, Seen That: A small country is on the verge of bankruptcy. It is so small that the amount of money needed to save it (17bn euros) amounts to less than 0.12 per cent of the eurozone GDP (no typos here. It is around 30 euros per European citizen).

Been there, seen that. Just three years ago in another small country, Greece. At the time, procrastination, self interest, ineptitude, unpreparedness, made the small problem become huge. And we are all still paying the bill. The Greek crisis management was so successful that our leaders are happily embarking in the same dynamics: improvised, dangerous, half-baked solutions, supposedly designed to avoid free riding (the protestant syndrome, once again) and in fact destabilizing the whole system.

There is no need for me to repeat what has been understood everywhere except, as usual, in Berlin, Frankfurt and Brussels...

Here I just want to cite a few paragraphs from an excellent piece by Nick Malkoutzis...

There is really very little to add to this. Except maybe that Nick Malkoutzis is even too nice to Germany. It is interesting to notice that most of the time, in battered countries, Germany’s banks are among the top creditors. In this particular case, the exposure of German banks is 5.8 billions, exactly the amount that the tax should levy. Certainly a coincidence, but still…

I remember, a few years back, Joe Stiglitz accusing the IMF and the American treasury of imposing unnecessary austerity to crisis countries, in Latin America and in East Asia, with the objective to buy time for their banks to minimize their losses (or often times to cash their profits). The resemblance with the current situation in Europe, is worrisome. Very.

The latest:

Cyprus Set to Reject Bailout, Citing Tax on Bank Deposits: Cyprus’s Parliament is likely to reject an international bailout package that involves taxing ordinary depositors to pay part of the bill, President Nicos Anastasiades said Tuesday, despite a revision that would remove some objections by exempting small bank accounts from the levies. ...

Should the measure fail in Parliament, Mr. Anastasiades and his E.U. partners would have to return to the negotiating table. Analysts have also raised the possibility of bank runs and a halt in liquidity to Cypriot banks from the European Central Bank if the measure did not pass.

The bailout plan, negotiated over the weekend, has aroused harsh criticism in many quarters for its unprecedented inclusion of ordinary bank depositors — including those with insured accounts — among those who would have to bear part of the cost. ...

The managing director of the International Monetary Fund, Christine Lagarde, said Tuesday she was in favor of modifying the agreement to put a lower burden on ordinary depositors. ... She urged leaders in Cyprus to quickly approve the plan... She complained that critics have not recognized how much the agreement will force Cyprus banks to restructure and become healthier. ...

Financial Markets Haven’t Freaked Out over Cyprus (Yet?)

Neil Irwin with the latest on Cyprus:

Financial markets haven’t freaked out over Cyprus. That doesn’t mean we’re in the clear, by Neil Irwin: First the good news: Financial markets have been relatively stable ... over international authorities’ decision to force losses on those with deposits in Cyprus’s banks. ... [There are] signs of an adverse market reaction to the weekend’s news — but not evidence that a broader run on Europe is underway. ...

The modest declines in financial markets Monday are a sign that global investors are betting  that the losses being forced upon Cypriot bank deposits will be a one-off situation, and not form a precedent for future aid to banks in Greece, Spain, Portugal and beyond. ...

After outcry from the people of Cyprus and anyone who cares about financial markets and worries about the implications of a government suddenly seizing a chunk of the money people kept in supposedly safe bank accounts, the terms of the rescue deal were being renegotiated Monday. The most likely outcome is a new deal that protects Cypriots’ deposits up to 100,000 euros, though details were murky Monday. ...

 The international negotiators ... are right that they have principle on their side. It is unfair for the rest of the world to come to the rescue of Cyprus at a time when the Russian oligarchs who have used the country’s banking system to squirrel away money pay nothing. But sometimes it’s better to have a policy that is unfair than one that is destructive. Europe has spent the past three years trying to persuade global investors and ordinary citizens that their money is safe in European banks. They had finally succeeded in the last several months. But the punitive approach to depositors in Cyprus throws that success into new question. ...

See also his discussion in the article about “Deauville,” and the delayed reaction of financial markets to this somewhat similar event. His point is that despite today's relatively calm reaction, we are not yet in the clear.

European policy seems to follow a common path. There is some sort of crisis that results in one group or another having to take a large loss, and the moralizing and fighting over who that should be leads to brinksmanship until, just before things really fall apart, someone steps in with a temporary, kick-the can down the road fix of some sort. This is starting to look similar -- I hope -- but one of these times they are going to misjudge where the brink actually is.

'The Cypriot Haircut'

Next week could be fun for economists in search of natural experiments -- will there be a large bank run? -- but not so fun for Europeans:

The Cypriot Haircut, by Paul Krugman: ... With all the problems in Greece, Italy, Spain, and Portugal I wasn’t watching Cyprus. But that’s where the big euro news is this weekend; in return for a bailout, Cyprus is supposed to impose a large haircut — that is, loss — on all depositors in its banks.

You can sort of see why they’re doing this: Cyprus is a money haven, especially for the assets of Russian beeznessmen; this means that it has a hugely oversized banking sector (think Iceland) and that a haircut-free bailout would be seen as a bailout, not just of Cyprus, but of Russians of, let’s say, uncertain probity and moral character. ...

The big problem, however, is that it’s not just large foreign deposits that are taking a haircut; the haircut on small domestic deposits is a bit smaller, but still substantial. It’s as if the Europeans are holding up a neon sign, written in Greek and Italian, saying “time to stage a run on your banks!”

Tomorrow and the days immediately following should be very interesting.

Update:

Exclusive: plans to revise #cyprus deposit tax on wires: under 5% for €0-100k, under 10% for €100-500k, around 13% for €500k+ #wsjeuro @wsj

— @MatinaStevis

Can the Fed Burst the Next Bubble Before It’s Too Late?

The Fed is trying to figure out how to respond to asset price bubbles:

Can the Fed Burst the Next Bubble Before It’s Too Late?

The "Geenspan doctrine" is dead, but will it be replaced by the "Bernanke doctrine" or the "Stein doctrine"? I argue that both of these approaches miss an essential element for successful anti-bubble policy.

Booms and Systemic Banking Crises

Everyone at the conference seemed to like this model of endogenous banking crises (me included -- this is the non-technical summary, the paper itself is fairly technical):

Booms and Systemic Banking Crises, by Frederic Boissay, Fabrice Collard, and Frank Smets: ... Non-Technical Summary Recent empirical research on systemic banking crises (henceforth, SBCs) has highlighted the existence of similar patterns across diverse episodes. SBCs are rare events. Recessions that follow SBC episodes are deeper and longer lasting than other recessions. And, more importantly for the purpose of this paper, SBCs follow credit intensive booms; "banking crises are credit booms gone wrong" (Schularick and Taylor, 2012, p. 1032). Rare, large, adverse financial shocks could possibly account for the first two properties. But they do not seem in line with the fact that the occurrence of an SBC is not random but rather closely linked to credit conditions. So, while most of the existing macro-economic literature on financial crises has focused on understanding and modeling the propagation and the amplification of adverse random shocks, the presence of the third stylized fact mentioned above calls for an alternative approach.

In this paper we develop a simple macroeconomic model that accounts for the above three stylized facts. The primary cause of systemic banking crises in the model is the accumulation of assets by households in anticipation of future adverse shocks. The typical run of events leading to a financial crisis is as follows. A sequence of favorable, non permanent, supply shocks hits the economy. The resulting increase in the productivity of capital leads to a demand-driven expansion of credit that pushes the corporate loan rate above steady state. As productivity goes back to trend, firms reduce their demand for credit, whereas households continue to accumulate assets, thus feeding the supply of credit by banks. The credit boom then turns supply-driven and the corporate loan rate goes down, falling below steady state. By giving banks incentives to take more risks or misbehave, too low a corporate loan rate contributes to eroding trust within the banking sector precisely at a time when banks increase in size. Ultimately, the credit boom lowers the resilience of the banking sector to shocks, making systemic crises more likely.

We calibrate the model on the business cycles in the US (post WWII) and the financial cycles in fourteen OECD countries (1870-2008), and assess its quantitative properties. The model reproduces the stylized facts associated with SBCs remarkably well. Most of the time the model behaves like a standard financial accelerator model, but once in while -- on average every forty years -- there is a banking crisis. The larger the credit boom, (i) the higher the probability of an SBC, (ii) the sooner the SBC, and (iii) -- once the SBC breaks out -- the deeper and the longer the recession. In our simulations, the recessions associated with SBCs are significantly deeper (with a 45% larger output loss) than average recessions. Overall, our results validate the role of supply-driven credit booms leading to credit busts. This result is of particular importance from a policy making perspective as it implies that systemic banking crises are predictable. We indeed use the model to compute the k-step ahead probability of an SBC at any point in time. Fed with actual US data over the period 1960-2011, the model yields remarkably realistic results. For example, the one-year ahead probability of a crisis is essentially zero in the 60-70s. It jumps up twice during the sample period: in 1982-3, just before the Savings & Loans crisis, and in 2007-9. Although very stylized, our model thus also provides with a simple tool to detect financial imbalances and predict future crises.

'How To (Maybe) End Too Big To Fail'

This is from a St. Louis Fed write-up of the following Dialogue:

St. Louis Fed economist William Emmons led the Dialogue, titled “Robo-signing, the London Whale and Libor Rate-Rigging: Are the Largest Banks Too Complex for Their Own Good?” Joining Emmons for the Q&A that followed were Mary Karr, senior vice president and general counsel of the St. Louis Fed; Steven Manzari, senior vice president of the New York Fed’s Complex Financial Institutions unit; and Julie Stackhouse, senior vice president of Banking Supervision and Regulation at the St. Louis Fed. See the videos and Emmons’ presentation slides at www.stlouisfed.org/dialogue.

Here's the last part of the write-up on dealing with the too big to fail problem:

The Big Banks: Too Complex To Manage?, Central Banker, Winter 2012, FRB St. Louis:

... How To (Maybe) End “Too Big To Fail”

So, how will we deal with the megabanks? Emmons outlined two basic approaches: radical and incremental. The radical approach involves structural changes imposed on the banks themselves or the creation of a different legal definition of what a bank is and what it can do. Radical proposals include:

• Reduce their complexity and size – Revive the 1933 Glass-Steagall Act (partially repealed by the 1999 Gramm-Leach-Bliley Act) prohibiting combining commercial banking with investment banking or insurance underwriting. Also, reduce their size by placing limits on banks’ assets or deposits. However, Emmons said this proposal likely wouldn’t succeed because combining commercial and investment banking was not the main source of problems; in fact, many of the “too-big-to-fail” institutions that caused problems during the crisis would have been allowed to operate under Glass-Steagall.
• Create “narrow banks” – Separate payments functions from all other financial activities. Such a bank would take deposits and make payments but not make loans except those that have very little default risk. Emmons said this proposal wouldn’t be successful either because such banks are not likely to be viable. Narrow banks likely would seek to make riskier loans to improve their profitability, while non-narrow banks would seek to enter the payments business in one way or another.

“In fact, we have chosen not to pursue radical approaches to solving the ‘too-big-to-fail’ problem,” he said. “Instead, we’re implementing incremental—albeit significant—reforms of the existing legal, regulatory and governance frameworks in which banks operate.” Meanwhile, bankers, regulators and legislators won’t know whether the regulatory reform efforts will actually work until they are actually used. Those efforts, which have sparked a lot of profound debate throughout the financial industry, include:

• The 2010 Dodd-Frank Act – The law includes living wills for orderly dissolution, capital requirements, stress tests, risk-based assessments on deposit insurance, FDIC orderly liquidation authority, the Volcker Rule and investor protections. “These are all pushing banks to be more effective in internal discipline,” Emmons said.
• Basel III Accord – The third round of the Basel Accords is looking to improve the quality of bank capital and make other changes related to capital so that big banks demonstrate that they “have more skin in the game,” Emmons said.

Emmons also offered another proposal: Make a strictly enforced “death penalty” regime, a law mandating that any bank requiring government assistance would be nationalized, with a plan to sell it back to new shareholders at some point in the future. “The crux of the matter would be carrying through this pledge to re-privatize the institution,” he said. “It should reduce the incentives to take risk because the ‘death penalty’ is such a severe penalty that it would act as a deterrent.” Emmons noted that TARP (the Troubled Asset Relief Program) was a half-step in this direction, in which the federal government took noncontrolling equity positions in megabanks—preferred instead of common equity—and didn’t wipe out shareholders or management.

“It’s not so radical of a proposal because we did impose a ‘death penalty’ on Fannie Mae and Freddie Mac: Their shareholders and management were wiped out. General Motors and Chrysler were forced into bankruptcy, and AIG was effectively nationalized,” he said.

“If this were to be the plan, we would need (to continue the metaphor) an undertaker standing by—an institution that would be ready to exact this discipline on the firms,” he said, pointing to other nations’ permanent “sovereign wealth funds” that can take equity positions in firms.

The Jury Is Still Out

While investigations and lawsuits continue, regulations are written for new laws, and the industry wrestles with proposed capital and other standards, the question remains: Will any of this solve “too big to fail,” successfully rein in systemic risk or prevent future “misbehaviors”? Simply put, we don’t know yet.

“I think it’s really important to realize that these are the early days in terms of the reform efforts for the financial system, and many firms still have to navigate a pretty complex set of changes to the regulatory landscape, how the world is unfolding and how they’re going to generate profits,” Manzari said during the Q&A portion.

Stackhouse noted that of the 400 or so regulations and rules required by the Dodd-Frank Act, only about one-third are actually in place. “The financial community, large banks in particular—those with over $50 billion in assets—have a lot ahead of them,” she said. “The Dodd-Frank Act right now is the mechanism on the table to deal with these very large firms. The jury is still out on how that particular rule making will take place and how effective it will be.”

A strictly enforced "death penalty" sounds good to me, but I'd also like to reduce the ability of large financial institutions to influence politicians and regulators. The discussion does note that:

The revelations of recent controversies such as robo-signing, the London Whale and Libor rate-rigging—explored in the “Big Bank Misbehaviors” sidebar at the bottom—as well as other problems not mentioned here indicate that something critical was lacking in the discipline of large, complex banks.

But the regulatory capture aspect of large banks isn't addressed.

I mostly wanted to highlight this slide from the presentation because it answers a question I've been asking for a long time, how big do banks need to be in order to reach the minimum efficient scale?

And from another slide, the size of the largest banks:

Some summary measures:

The conclusion seems obvious to me.

Jordi Galí: Monetary Policy and Rational Asset Price Bubbles

Another paper to read:

Monetary Policy and Rational Asset Price Bubbles, by Jordi Galí, NBER Working Paper No. 18806, February 2013 [open link]: Abstract I examine the impact of alternative monetary policy rules on a rational asset price bubble, through the lens of an overlapping generations model with nominal rigidities. A systematic increase in interest rates in response to a growing bubble is shown to enhance the fluctuations in the latter, through its positive effect on bubble growth. The optimal monetary policy seeks to strike a balance between stabilization of the bubble and stabilization of aggregate demand. The paper's main findings call into question the theoretical foundations of the case for "leaning against the wind" monetary policies.

What's the key mechanism working against the traditional "lean against the wind" policy? That rational bubbles grow at the rate of interest, hence raising (real) interest rates makes the bubble grow faster. From the introduction:

...The role that monetary policy should play in containing ... bubbles has been the subject of a heated debate, well before the start of the recent crisis. The consensus view among most policy makers in the pre-crisis years was that central banks should focus on controlling inflation and stabilizing the output gap, and thus ignore asset price developments, unless the latter are seen as a threat to price or output stability. Asset price bubbles, it was argued, are difficult if not outright impossible to identify or measure; and even if they could be observed, the interest rate would be too blunt an instrument to deal with them, for any significant adjustment in the latter aimed at containing the bubble may cause serious "collateral damage" in the form of lower prices for assets not affected by the bubble, and a greater risk of an economic downturn.¹

But that consensus view has not gone unchallenged, with many authors and policy makers arguing that the achievement of low and stable inflation is not a guarantee of financial stability and calling for central banks to pay special attention to developments in asset markets.² Since episodes of rapid asset price inflation often lead to a financial and economic crisis, it is argued, central banks should act preemptively ... by raising interest rates sufficiently to dampen or bring to an end any episodes of speculative frenzy -- a policy often referred to as "leaning against the wind." ...

Independently of one's position in the previous debate, it is generally taken for granted (a) that monetary policy can have an impact on asset price bubbles and (b) that a tighter monetary policy, in the form of higher short-term nominal interest rates, may help disinflate such bubbles. In the present paper I argue that such an assumption is not supported by economic theory and may thus lead to misguided policy advice, at least in the case of bubbles of the rational type considered here. The reason for this can be summarized as follows: in contrast with the fundamental component of an asset price, which is given by a discounted stream of payoffs, the bubble component has no payoffs to discount. The only equilibrium requirement on its size is that the latter grow at the rate of interest, at least in expectation. As a result, any increase in the (real) rate engineered by the central bank will tend to increase the size of the bubble, even though the objective of such an intervention may have been exactly the opposite. Of course, any decline observed in the asset price in response to such a tightening of policy is perfectly consistent with the previous result, since the fundamental component will generally drop in that scenario, possibly more than offsetting the expected rise in the bubble component.

Below I formalize that basic idea... The paper's main results can be summarized as follows:

• Monetary policy cannot affect the conditions for existence (or nonexistence) of a bubble, but it can influence its short-run behavior, including the size of its fluctuations.
• Contrary to the conventional wisdom a stronger interest rate response to bubble fluctuations (i.e. a "leaning against the wind policy") may raise the volatility of asset prices and of their bubble component.
• The optimal policy must strike a balance between stabilization of current aggregate demand -- which calls for a positive interest rate response to the bubble -- and stabilization of the bubble itself (and hence of future aggregate demand) which would warrant a negative interest rate response to the bubble. If the average size of the bubble is sufficiently large the latter motive will be dominant, making it optimal for the central bank to lower interest rates in the face of a growing bubble.

...

But before we lower interest rates in response to signs of an inflating bubble, it would be good to heed this warning from the conclusion:

Needless to say the conclusions should not be taken at face value when it comes to designing actual policies. This is so because the model may not provide an accurate representation of the challenges facing actual policy makers. In particular, it may very well be the case that actual bubbles are not of the rational type and, hence, respond to monetary policy changes in ways not captured by the theory above. In addition, the model above abstracts from many aspects of actual economies that may be highly relevant when designing monetary policy in bubbly economies, including the presence of frictions and imperfect information in financial markets. Those caveats notwithstanding, the analysis above may be useful by pointing out a potentially important missing link in the case for "leaning against the wind" policies.

'Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market'

I need to read this paper:

Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market, by Tomasz Piskorski, Amit Seru, and James Witkin: Abstract: We contend that buyers received false information about the true quality of assets in contractual disclosures by intermediaries during the sale of mortgages in the $2 trillion non-agency market. We construct two measures of misrepresentation of asset quality -- misreported occupancy status of borrower and misreported second liens -- by comparing the characteristics of mortgages disclosed to the investors at the time of sale with actual characteristics of these loans at that time that are available in a dataset matched by a credit bureau. About one out of every ten loans has one of these misrepresentations. These misrepresentations are not likely to be an artifact of matching error between datasets that contain actual characteristics and those that are reported to investors. At least part of this misrepresentation likely occurs within the boundaries of the financial industry (i.e., not by borrowers). The propensity of intermediaries to sell misrepresented loans increased as the housing market boomed, peaking in 2006. These misrepresentations are costly for investors, as ex post delinquencies of such loans are more than 60% higher when compared with otherwise similar loans. Lenders seem to be partly aware of this risk, charging a higher interest rate on misrepresented loans relative to otherwise similar loans, but the interest rate markup on misrepresented loans does not fully reflect their higher default risk. Using measures of pricing used in the literature, we find no evidence that these misrepresentations were priced in the securities at their issuance. A significant degree of misrepresentation exists across all reputable intermediaries involved in sale of mortgages. The propensity to misrepresent seems to be unrelated to measures of incentives for top management, to quality of risk management inside these firms or to regulatory environment in a region. Misrepresentations on just two relatively easy-to-quantify dimensions of asset quality could result in forced repurchases of mortgages by intermediaries in upwards of $160 billion.

'The Blame Someone Else Crowd'

Paul Krugman explains why the false charge that government housing policy caused the financial crisis and recession is harmful:

...No, the CRA wasn’t responsible for the epidemic of bad lending; no, Fannie and Freddie didn’t cause the housing bubble; no, the “high-risk” loans of the GSEs weren’t remotely as risky as subprime.

This really isn’t about the GSEs, it’s about the BSEs — the Blame Someone Else crowd. Faced with overwhelming, catastrophic evidence that their faith in unregulated financial markets was wrong, they have responded by rewriting history to defend their prejudices.

This strikes me as a bigger deal than whether Rubio slurped his water; he and his party are now committed to the belief that their pre-crisis doctrine was perfect, that there are no lessons from the worst financial crisis in three generations except that we should have even less regulation. And given another shot at power, they’ll test that thesis by giving the bankers a chance to do it all over again.

I've taken this myth on more times than I can remember, and the evidence against the claim that housing policy caused our problems is very clear. But the myth isn't going away. First, it's a convenient story for the Republican view that trying to help poor people is bad for them, and bad for everyone else too. Social insurance such as unemployment compensation makes them lazy, raising the minimum wage actually hurts them overall, attempts to help lower income households purchase a house crash the economy, and so on. It's all at odds with the evidence but it gives them, as Krugman notes, a shield against tax increases, regulations, and so on that are needed to deal with these problems. The second reason is just as important, there's no political cost to making these claims. One of the most prominent members of the Republican Party can give an address to the nation in response to the State of the Union that makes false claims, and nothing happens. Telling easily rebutted falsehoods brings little media response from traditional media outlets, but take a drink of water...

'In Defense of the EMH'

One more quick one before heading to the airport for that long, long flight from SF to Eugene -- Noah Smith defends the efficient markets hypothesis, and along the way he says you probably aren't as smart as you think you are when it comes to investing in stocks and bonds:

In defense of the EMH, b Noah Smith: The "Efficient Markets Hypothesis" is a popular target of anger and derision among lay critics of the econ profession. How can financial markets be "efficient" when they just crashed and took our economy down with them? And when sensible people like Bob Shiller, Nouriel Roubini, Bill McBride, et al. were screaming their heads off about a housing bubble years before the pop? Of course I have some sympathy for these complaints. But the more I learn about and teach finance, the more I learn what an important and useful idea the "EMH" in fact is. I don't want to say that the EMH is unfairly maligned, but I do think that its vast usefulness is usually ignored in the press. ...

 

Fed Worried about Bubbles, Not Inflation

Binyamin Appelbaum:

Fed Official Sees Tension in Some Credit Markets, by Binyamin Appelbaum, NY Times: Some credit markets are showing signs of overheating as investors take larger risks in response to the persistence of low interest rates... Fed Governor Jeremy Stein, highlighted a surge in junk bond issues, the popularity of certain kinds of real estate investment trusts and shifts in bank balance sheets as areas the central bank is watching closely...

Mr. Stein gave no indication that the Fed is contemplating any change in its aggressive efforts to hold down interest rates. Rather, he described the overheating as a trend that might require a response if it intensified over the next 18 months. But the speech nonetheless underscored that the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth. ...

Central bankers historically have been skeptical that asset bubbles can be identified or prevented from popping. Moreover, they tend to regard financial regulation as the appropriate means to prevent excessive speculation and not changes in monetary policy ... But the crisis has forced central bankers to reconsider both the importance of financial stability and the role of monetary policy. ...

And he closed on a cautionary note. “Decisions will inevitably have to be made in an environment of significant uncertainty,” he said. “Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension.”

With fiscal policy moving in the wrong direction -- deficit reduction rather than employment enhancing stimulus, e.g. infrastructure -- if monetary policymakers begin getting skittish, then the unemployed will lose the one institution that seemed to actually care about their struggles. Not good.

[See also Paul Krugman on the limits of monetary policy in the present economic environmemnt, and why "Austerity right now is a really, really bad idea."]

The Case For and Against Too-Big-to-Fail Banks

I've been asking for some time now what amounts to a simple question, "What is the minimum efficient scale for financial institutions?" Unfortunately, the answer is much harder to formulate than the question, and there hasn't been anything convincing (at least to me) on this topic. Here's the latest on this topic from Neil Irwin:

The case for the too-big-to-fail banks, by Neil Irwin: ...[I]n the last few months, there's been a new wave of calls to break up the "too big to fail" banks that were at the center of the crisis — and the beneficiaries of a massive wave of bailouts.

So, is splitting those banks up the answer? ... The move ... has a growing list of powerful allies. ... But what is the counterargument? ... A new paper from Patrick Sims of Hamilton Place Strategies, a policy and communications firm led by Bush administration White House and Treasury official Tony Fratto, amounts to a case for the big banks. (Hamilton Place counts major banks and their trade associations among its clients)..., here are some of the arguments that I believe have the most merit.

The first argument is also the simplest. This is a huge and complex global economy. With trillions of dollars in global trade and companies with hundreds of billions in assets, it takes giant banks with a global reach to supply them with the financial products they need to do business. ...

This is related to a second line of argument: That without huge, regulated banks, companies will turn to the unregulated "shadow banking" sector to meet their financial needs... The collapse of the shadow banking system was a crucial factor in the 2008 crisis... If a bank break-up sparked a vast expansion of shadow banking, it would make the financial system more vulnerable.

I find less persuasive Sims's argument that we shouldn't worry too much about concentration in the banking system because it's not quite as severe in the United States as in other countries. One of the paper's tables notes that the largest U.S. bank, JPMorgan Chase, has assets that amount to 15 percent of U.S. GDP...

As the too-big-to-fail debate heats up, these are the questions... What real value do megabanks create for the world? Do they need to be this huge to fulfill their roles? Can regulation be enough to tame their inherent risks, or do they need to be split up? ...

Here are some past posts on this topic. This was a response to a speech by William Dudley on the too big to fail problem (November, 2012):

Solving the Too Big to Fail Problem: ...One thing we really need to understand better is the minimum efficient scale for various financial activities. Whenever the topic of breaking banks into smaller pieces is raised, we hear that a "much reduced size threshold could sacrifice socially useful economies of scale and scope benefits." The key word is "could." As far as I can tell, the evidence on this point is very shaky -- we just don't know for sure what size is necessary to exploit efficiencies. My own view is that the minimum scale is likely smaller than many firms today, and hence there would be no harm in reducing firms size. This may not help much with stability, but there are still perhaps many benefits (e.g. reduced political and economic power) from reducing firm size and increasing the number of institutions engaged in important financial activities.

A response to Tyler Cowen's alternative to breaking up big banks (February, 2012):

Break Up the Banks? Here’s an Alternative: ... Some notes: First, there's an implicit assumption in this article about the minimum efficient scale for a bank. Tyler worries that breaking up banks will result in less efficient banking operations (i.e. higher cost) causing the smaller banks to fail altogether, or be less competitive with foreign banks.

However, I have not seen convincing evidence that banks need to be as large as they are for efficiency reasons (here's some evidence, but as I noted, I am not convinced by it). I am not advocating a per se rule here -- we shouldn't break them up just because. But if there's evidence that the size leads to undue political or economic power that is being exploited in the banks' favor, and if mega-mega-size is not necessary for efficiency, then there is definitely a reason to break them into smaller pieces. From my perspective, there is quite a bit of evidence that these banks have far too much political influence, and I think a case can also be made that it's unhealthy for the economy to have firms with such a large market share in particular segments of financial markets.

So I think that, absent of strong evidence that there actually are economic efficiencies associated with size (in which case they ought to be treated more like a regulated monopoly than a competitive marketplace), and the evidence that these banks are highly influential politically -- to the point where regulatory capture is more than a passing worry -- we should break these banks into pieces that are closer to the "minimum efficient scale" for financial institutions. ...

But we shouldn't fool ourselves into thinking that breaking up big banks into smaller pieces will necessarily make the financial system more stable. We had bank runs and financial meltdowns in eras where there were predominately small banks, think of the Great Depression for example. That's because it's the interconnectedness of banks that causes the problems, and smaller banks can be just as interconnected and hence just as vulnerable to a systemic shock as large banks. Perhaps there's a bit more diversification in larger banks that offers some protection, but the evidence is not strong on this point and big banks appear to be just as vulnerable as small banks to systemic troubles (and vice versa). ...

But whatever we do, we need to get on with it. Despite the Dodd-Frank financial reform bill and its directive to address this issue, the problem of bank runs in the shadow system -- a key factor in the financial sector collapse -- has not yet been solved. Work on this is underway, and new regulations are in the works, but for now the problem has not yet been resolved.

And a response to Bernanke's "smaller banks are not necessarily the answer" (October, 2009):

Bernanke: Smaller Banks Not Necessarily the Answer: ... Ben Bernanke does not want to lose "the economic benefit of multi-function, international (financial) firms," so he is hesitant to break large banks into smaller sized institutions. I don't have much problem with the economics, if there are efficiencies that come with bank size we should exploit them, especially if breaking up banks into smaller entities does little to reduce systemic risk but instead simply fragments the problem into many more pieces (though I'd still like to know where the minimum efficient scale is, anything larger than that is unnecessary). Obtaining resolution authority for banks in the shadow system is also very important, so I don't disagree with the emphasis on this in Bernanke's remarks.

But there seems to be the view that if they have resolution authority, higher capital requirements, etc., that will make the probability of a major breakdown small enough so that the expected benefits of size outweigh the expected costs. While I agree that obtaining resolution authority and other regulatory change is extremely important, I wouldn't bet my house, or housing and asset markets more generally, that this will eliminate the chance of a major breakdown, or make the chance small enough to justify huge, powerful, market-dominating institutions.

I would like to see more effort to measure and regulate connectedness within the system (which can be very high even with banks broken into smaller pieces) since that would add another layer of protection, the degree of leverage should come under scrutiny as well, and I would also like to see more attention to the political risks (e.g. capture of legislators and hence regulation) posed by large financial firms

Finally, A response to David Altig (this is the entire post from April, 2009):

Breaking Up Big Banks: As Usual, Benefits Come with a Side of Costs: David Altig warns that breaking up big banks could reduce efficiency:

Breaking up big banks: As usual, benefits come with a side of costs, by David Altig. macroblog: Probably the least controversial proposition among an otherwise very controversial set of propositions on which financial reform proposals are based is that institutions deemed "too big to fail" (TBTF) are a real problem. As Fed Chairman Bernanke declared not too long ago:

As the crisis has shown, one of the greatest threats to the diversity and efficiency of our financial system is the pernicious problem of financial institutions that are deemed "too big to fail."

The next question, of course, is how to deal with that threat. At this point the debate gets contentious. One popular suggestion for dealing with the TBTF problem is to just make sure that no bank is "too big." Two scholars leading that charge are Simon Johnson and
James Kwak (who are among other things the proprietors at The Baseline Scenario blog). They make their case in the New York Times' Economix feature:

Since last fall, many leading central bankers including Mervyn King, Paul Volcker, Richard Fisher and Thomas Hoenig have come out in favor of either breaking up large banks or constraining their activities in ways that reduce taxpayers' exposure to potential failures. Senators Bernard Sanders and Ted Kaufman have also called for cutting large banks down to a size where they no longer pose a systemic threat to the financial system and the economy.

…We think that increased capital requirements are an important and valuable step toward ensuring a safer financial system. We just don't think they are enough. Nor are they the central issue…

We think the better solution is the "dumber" one: avoid having banks that are too big (or too complex) to fail in the first place.

Paul Krugman has noted one big potential problem with this line of attack:

As I argued in my last column, while the problem of "too big to fail" has gotten most of the attention—and while big banks deserve all the opprobrium they're getting—the core problem with our financial system isn't the size of the largest financial institutions. It is, instead, the fact that the current system doesn't limit risky behavior by "shadow banks," institutions—like Lehman Brothers—that carry out banking functions, that are perfectly capable of creating a banking crisis, but, because they issue debt rather than taking deposits, face minimal oversight.

In addition to that observation—which is the basis of calls for a systemic regulator that spans the financial system, and not just specific classes of financial institutions—there is another, very basic, economic question: Why are banks big?

To that question, there seems to be an answer: We have big banks because there are efficiencies associated with getting bigger—economies of scale. David Wheelock and Paul Wilson, of the Federal Reserve Bank of St. Louis and Clemson University, respectively, sum up what they and other economists know about economies of scale in banking:

…our findings are consistent with other recent studies that find evidence of significant scale economies for large bank holding companies, as well as with the view that industry consolidation has been driven, at least in part, by scale economies. Further, our results have implications for policies intended to limit the size of banks to ensure competitive markets, to reduce the number of banks deemed "too-big-to-fail," or for other purposes. Although there may be benefits to imposing limits on the size of banks, our research points out potential costs of such intervention.

Writing at the National Review Online, the Cato Institute's Arnold Kling acknowledges the efficiency angle, and then dismisses it:

There's a long debate to be had about the maximum size to which a bank should be allowed to grow, and about how to go about breaking up banks that become too large. But I want to focus instead on the general objections to large banks.

The question can be examined from three perspectives. First, how much economic efficiency would be sacrificed by limiting the size of financial institutions? Second, how would such a policy affect systemic risk? Third, what would be the political economy of limiting banks' size?

It is the political economy that most concerns me…

If we had a free market in banking, very large banks would constitute evidence that there are commensurate economies of scale in the industry. But the reality is that our present large financial institutions probably owe their scale more to government policy than to economic advantages associated with their vast size.

I added the emphasis to the "probably" qualifier.

The Wheelock-Wilson evidence does not disprove the Kling assertion, as the estimates of scale economies are obtained using banks' cost structures, which certainly are impacted by the nature of government policy. But if economies of scale are in some way intrinsic to at least some aspects of banking—and not just political economy artifacts—the costs of placing restrictions on bank size could introduce risks that go beyond reducing the efficiency of the targeted financial institutions. If some banks are large for good economic reasons, the forces that move them to become big would likely emerge with force in the shadow banking system, exacerbating the very problem noted by Krugman.

I think it bears noting that the argument for something like constraining the size of particular banks implicitly assumes that it is not possible, for reasons that are either technical or political, to actually let failing large institutions fail. Maybe it is so, as Robert Reich asserts in a Huffington Post item today. And maybe it is in fact the case that big is not beautiful when it comes to financial institutions. But in evaluating the benefits of busting up the big guys, we shouldn't lose sight of the possibility that this is also a strategy that could carry very real costs.

I'd like to know the source of the scale economies. The paper linked above estimates returns to scale, but not their source. As noted in the introduction (and also noted by David):

Our results indicate that as recently as 2006 banks faced increasing returns to scale, suggesting that scale economies are a plausible (though not necessarily only) reason for the growth in bank size...

Without knowing the source of the changes in costs as banks increase in size, the (non-parametric) results -- results that differ from most previous work -- are hard to evaluate. I've been hoping for good estimates of the size and nature of the economies of scale for banks, but I'm not fully convinced by this evidence.

One final note. Even if the scale economies are there, we may still want to restrict the size of banks. The benefit from larger scale must be balanced against the increased risk to the financial system and the increased risk of political/regulator capture that comes with size and power. If the costs of size outweigh the benefits, then size should be restricted below the minimum efficient scale (How much risk comes with size depends, in large part, upon your faith in resolution authority discussed above. I am not fully convinced it will work.)

Securitization Lead to Riskier Corporate Lending

João Santos, vice president in the Research and Statistics Group of the Federal Reserve Bank of New York:

Did Securitization Lead to Riskier Corporate Lending?, by João Santos: There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize. ...

Our evidence that securitization led to riskier corporate lending is in line with similar findings unveiled by studies of the effects of securitization on mortgage lending. Taken together, these studies confirm an important downside of securitization.

Paul Krugman: Friends of Fraud

Will Senate Republicans be able to kill, or at least defang, the Consumer Financial Protection Bureau?:

Friends of Fraud, by Paul Krugman, Commentary, NY Times: Like many advocates of financial reform, I was a bit disappointed in the bill that finally emerged. Dodd-Frank gave regulators the power to rein in many financial excesses; but ... the financial industry’s wealth and influence can all too easily turn those who are supposed to serve as watchdogs into lap dogs instead.

There was, however, one piece of the reform that was a shining example of how to do it right: the creation of a Consumer Financial Protection Bureau... And sure enough, Senate Republicans are going all out in an attempt to kill that bureau. ...

Now, you might be tempted to say that while we need protection against financial fraud, there’s no need to create another bureaucracy. Why not leave it up to the regulators we already have? The answer is that existing regulatory agencies are basically concerned with bolstering the banks; as a practical, cultural matter they will always put consumer protection on the back burner...

So the consumer protection bureau serves a vital function. But as I said, Senate Republicans are trying to kill it. ...

What Republicans are demanding, basically, is that the protection bureau lose its independence. They want its actions subjected to a veto by other, bank-centered financial regulators, ensuring that consumers will once again be neglected, and they also want to take away its guaranteed funding, opening it to interest-group pressure. These changes would make the agency more or less worthless — but that, of course, is the point. ...

And as always, you should follow the money. Historically, the financial sector has given a lot of money to both parties, with only a modest Republican lean. In the last election, however, it went all in for Republicans, giving them more than twice as much as it gave to Democrats (and favoring Mitt Romney over the president almost three to one). All this money wasn’t enough to buy an election — but it was, arguably, enough to buy a major political party.

Right now, all the media focus is on the obvious hot issues — immigration, guns, the sequester, and so on. But let’s try not to let this one fall through the cracks: just four years after runaway bankers brought the world economy to its knees, Senate Republicans are using every means at their disposal, violating all the usual norms of politics in the process, in an attempt to give the bankers a chance to do it all over again.

'The Real, and Simple, Equation That Killed Wall Street'

I'm sympathetic to the argument that excess leverage was a problem in the financial crisis, but I don't see it the primal cause of the recession. Instead, leverage iss a magnifier that makes things much, much worse when problems occur:

The Real, and Simple, Equation That Killed Wall Street, by Chris Arnade, Scientific American: ...It ... is the overly simple narrative that many in the media have spun about the last financial crisis. Smart meddling kids armed with math hoodwinked us all.

One article, from the March 2009 Wired magazine, even pinpointed an equation and a mathematician. The article “Recipe for Disaster: The Formula That Killed Wall Street,” accused the Gaussian Copula Function.

It was not the first piece that made this type of argument, but it was the most aggressive. ...

This theme plays on the fallacy that danger always comes from complexity. ...

The reality is much simpler and less sexy. Wall Street killed itself in a time-honored fashion: Cheap money, excessive borrowing, and greed. And yes, there is an equation one can point to and blame. This equation, however, requires nothing more than middle school algebra to understand and is taught to every new Wall Street employee. It is leveraged return. ...

The Gaussian Copula Function, opaque to most, is convenient to blame. It allows us to shake off our collective sense of guilt. It obscures the real crime...

I'm willing to blame leverage for contributing to the magnitude of the crisis, and I've long-called for limits on leverage to mute the negative effects of the next financial recession, which will come no matter how hard we try to avoid it. But I don't think it's correct to blame leverage itself for our problems, i.e. that "there is an equation one can point to and blame."

[The article actually notes many other factors, e.g. bad incentives for ratings agencies, failures of regulation, easy moneary policy by the Fed, and so on, but still ends up focusing on the leverage component as the key factor. In any case, the article is directed squarely at Felix Salmon, and I'm posting this in the hope that it will help prod him into responding.]

Gorton and Ordonez: The Supply and Demand for Safe Assets

I need to read this:

The Supply and Demand for Safe Assets, by Gary Gorton and Guillermo Ordonez, January 2013, NBER [open link]: Abstract There is a demand for safe assets, either government bonds or private substitutes, for use as collateral. Government bonds are safe assets, given the governments’ power to tax, but their supply is driven by fiscal considerations, and does not necessarily meet the private demand for safe assets. Unlike the government, the private sector cannot produce riskless collateral. When the private sector reaches its limit (the quality of private collateral), government bonds are net wealth, up to the governments own limits (taxation capacity). The economy is fragile to the extent that privately-produced safe assets are relied upon. In a crisis, government bonds can replace private assets that do not sustain borrowing anymore, raising welfare.

'Why Financial Markets are Inefficient'

Roger Farmer (I have a short comment at the end):

Why financial markets are inefficient, by Roger E. A. Farmer , Vox EU: Writing in a review of Justin Fox’s book The Myth of the Efficient Market, Richard Thaler (2009) has drawn attention to two dimensions of the efficient markets hypothesis, what he refers to as:

• ‘No free lunch’, what economists refer to as ‘informational efficiency’;
• ‘The price is right’, what economists refer to as ‘Pareto efficiency’.

My recent research with Carine Nourry and Alain Venditti argues that while there are strong reasons for believing there are no free lunches left uneaten by bonus-hungry market participants, there are really no reasons for believing that this will lead to Pareto efficiency, except, perhaps, by chance (Farmer, Nourry, Venditti 2012).

In separate work, I look at the policy implications of this, showing that the Pareto inefficiency of financial markets provides strong grounds to support central bank intervention to dampen excessive fluctuations in the financial markets (Farmer 2012b). These are strong and polarising claims. They are not made lightly.

Not irrationality, frictions, sticky prices nor credit constraints

Some economists will be sympathetic to my arguments because they believe that financial markets experience substantial frictions. For example, it is frequently argued that agents are irrational, households are borrowing constrained or prices are sticky. Although there may be some truth to all of these claims, my argument for direct central bank intervention in the financial markets does not rest on any of these alleged market imperfections.

Other readers of this piece will wish to challenge my view based on the assertion that competitive financial markets must necessarily lead to outcomes that cannot be improved upon by government intervention of any kind. That assertion has been formalised in the first welfare theorem of economics that is taught to every first-year economics graduate student.

The first welfare theorem provides conditions under which free trade in competitive markets leads to a Pareto efficient outcome, a situation where there is no way of reallocating resources that makes one person better off without making someone else worse off. In my work with Nourry and Venditti (Farmer, Nourry, Venditti 2012), we show why the conditions that are necessary for the theorem to hold do not characterise the real world.

We make some strong but standard assumptions:

• Households are rational and plan for the infinite future;
• They have rational expectations of all future prices;
• There are complete financial markets in the sense that all living agents are free to make trades contingent on any future observable event;
• No agent is big enough to influence prices.

Crucially, in our model, there are at least two types of people who discount the future at different rates; patient and impatient agents. We show that, even when both types share common beliefs, the belief itself can independently influence what occurs. This follows an important idea originating at the University of Pennsylvania in the 1980s, what David Cass and Karl Shell (1983) call ‘sunspots’, or what Costas Azariadis (1981) refers to as a ‘self-fulfilling prophecy’¹.

The first welfare theorem, birth and death

What could possibly go wrong when agents are rational, hold rational expectations, there are no frictions, and markets are complete? Well, the first welfare theorem does not account for the fact that people die and new people are born. In our world:

• Patient and impatient agents each recognise that the financial markets are fickle and that the value of the stock market could rise or fall;
• If the markets boom then the patient savers, feeling wealthier, will lend more to the impatient borrowers;
• If the markets crash, then the savers will recall their loans, made in better times.

But in our model environment, booms and crashes occur simply as a consequence of the animal spirits of market participants. Why should we care if there are big movements in the asset markets? After all, the borrowers and lenders are rational and they have made bets with each other in full knowledge that these large asset movements might occur.

• The problem is that the next generation is unable to insure against swings in wealth that have a big influence on their lives.

Steve Davis and Till von Wachter (2011) have shown that the present value of lifetime income of new entrants to the labour market can differ substantially depending on whether their first job occurs in a boom or a recession. In our model, the lifetime income of the young can differ by as much as 20% across booms and slumps.

Given the choice, the young agents in our model would prefer to avoid the risk of a 20% variation in lifetime wealth. There is a feasible way of allocating resources that would insure them against this risk, but financial markets cannot achieve this allocation, except by chance. The inability of our children to trade in prenatal financial markets is sufficient to invalidate the first welfare theorem of economics.

In short, sunspots matter. And they matter in a big way.

Conclusions

We show that financial markets cannot work well in the real world except by chance because:

• There are many equilibria;
• Only one of them is Pareto efficient;
• For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way that they would prefer to avoid, if given the choice.

Our paper makes some classical assumptions, but has Keynesian policy implications. Agents are rational, they have rational expectations and there are no financial frictions. Even when agents are rational, markets are not.

References

Azariadis, Costas (1981), “Self-fulfilling Prophecies”, Journal of Economic Theory, 25, 380-396.

Cass, David and Karl Shell, “Do Sunspots Matter?” (1983), Journal of Political Economy, 91(2), 193-227.

Davis, Steven and Till Von Wachter (2011), “Recessions and the Costs of Job-Losses”, Brookings Papers on Economic Activity.

Farmer, Roger E A (2012a), “The Evolution of Endogenous Business Cycles”, NBER Working Paper 18284 and CEPR Discussion Paper 9080.

Farmer, Roger E A (2012b), “Qualitative Easing: How it Works and Why it Matters”, NBER working paper 18421 and CEPR discussion paper 9153.

Farmer, Roger E A, Carine Nourry and Alain Venditti (2012), “The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World”, CEPR Discussion Paper No. 9283.

Fox, Justin (2009), The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street, New York, Harper.

Thaler, Richard (2009), “Markets can be wrong and the price is not always right”, Financial Times, 4 August.

References

1 See my survey (Farmer 2012a), which documents the evolution of the Pennsylvania School of Endogenous Business Cycles.

______________________________

My question is whether these results hold if there were Barro ("Are Bonds Net Wealth") preferences, i.e. if the utility of the parent depends upon the utility of the child?:

U = U_p(x₁, x₂, x₃, ..., x_n, U_c)

I asked Roger Farmer this question, and he replied this was a good research topic:

My guess is that Barro preferences are not enough. Why? Because the trades required to eliminate sunspot equilibria would require that some agents are born with negative net worth in some states of the world.  Since the courts would not enforce those trades, the equilibrium would unravel.  

Paul Krugman: The Big Deal

Progressives should cheer up:

The Big Deal, by Paul Krugman, Commentary, NY Times: On the day President Obama signed the Affordable Care Act into law, an exuberant Vice President Biden famously pronounced the reform a “big something deal” — except that he didn’t use the word “something.” And he was right..., if progressives look at where we are as the second term begins, they’ll find grounds for a lot of (qualified) satisfaction.

Consider, in particular, three areas: health care, inequality and financial reform.

Health reform is, as Mr. Biden suggested, the centerpiece of the Big Deal. Progressives have been trying to get some form of universal health insurance since the days of Harry Truman; they’ve finally succeeded. …

What about inequality? ... Like F.D.R., Mr. Obama took office in a nation marked by huge disparities in income and wealth. But where the New Deal had a revolutionary impact, empowering workers and creating a middle-class society that lasted for 40 years, the Big Deal has been limited to equalizing policies at the margin.

That said,... through new taxes ... 1-percenters will see their after-tax income fall around 6 percent... This will reverse only a fraction of the huge upward redistribution that has taken place since 1980, but it’s not trivial.

Finally, there’s financial reform. The Dodd-Frank reform bill is ... not the kind of dramatic regime change one might have hoped for… Still, if plutocratic rage is any indication, the reform isn’t as toothless as all that. …

All in all, then, the Big Deal has been, well, a pretty big deal. But will its achievements last? ... I ... think so. For one thing, the Big Deal’s main policy initiatives are already law. ... And ... the Big Deal agenda is, in fact, fairly popular — and will become more popular once Obamacare goes into effect...

Finally, progressives have the demographic and cultural wind at their backs. Right-wingers flourished for decades by exploiting racial and social divisions — but that strategy has now turned against them...

Now, none of what I’ve just said should be taken as grounds for progressive complacency. The plutocrats may have lost a round, but their wealth and the influence it gives them in a money-driven political system remain. Meanwhile, the deficit scolds (largely financed by those same plutocrats) are still trying to bully Mr. Obama into slashing social programs. ...

Still, maybe progressives — an ever-worried group — might want to take a brief break from anxiety and savor their real, if limited, victories.

Financial Collapse: A 10-Step Prevention Plan

Alan Blinder lists "10 financial commandments, all of which were brazenly violated in the years leading up to the crisis":

Financial Collapse: A 10-Step Recovery Plan, by Alan S. Blinder: ...let me try to encapsulate what we must remember about the financial crisis...:

1. Remember That People Forget ...

2. Do Not Rely on Self-Regulation ...

3. Honor Thy Shareholders ...

4. Elevate Risk Management ...

5. Use Less Leverage ...

6. Keep It Simple, Stupid ...

7. Standardize Derivatives and Trade Them on Exchanges ...

8. Keep Things on the Balance Sheet ...

9. Fix Perverse Compensation ...

10. Watch Out for Consumers ...

Mark Twain is said to have quipped that while history doesn’t repeat itself, it does rhyme. There will be financial crises in the future, and the next one won’t be a carbon copy of the last. Neither, however, will it be so different that these commandments won’t apply. ...

Fed Watch: Safe Assets and the Coordination of Fiscal and Monetary Policy

Tim Duy:

Safe Assets and the Coordination of Fiscal and Monetary Policy, by Tim Duy: Kansas City Federal Reserve Bank President Esther George considers the long-run consequences of Federal Reserve policy:

But, while I agree with keeping rates low to support the economic recovery, I also know that keeping interest rates near zero has its own set of consequences. Specifically, a prolonged period of zero interest rates may substantially increase the risks of future financial imbalances and hamper attainment of the FOMC’s 2 percent inflation goal in the future.

A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system...The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels. Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

Brad DeLong wonders:

The Fed's current Quantitative Easing ∞ program involves its buying risky bonds--thus diminishing the pool of risky assets that the private sector can hold. Esther George objects because… it does not make complete sense to me...Because there is less in the way of risky assets for the private sector to hold--and because that pushes prices of risky assets up and returns on risky assets down--QE ∞ actually makes private-sector portfolios riskier? Is that the argument?

I think DeLong is looking at a continuum of assets from safe to risky, where cash anchors the safe end of the continuum. Right next to cash is the somewhat riskier Treasury security. Thus by exchanging cash for Treasury securities, you by definition must be removing risk from the continuum, and thus the public's portfolio is now less riskier.

But, as he notes, this is obviously not how George views the situation. And, note that George claims that the intention of Fed policy is in fact to push people into riskier portfolios, which implies that the Fed believes that they are in fact making the public's portfolio more, not less, risky. This implies that DeLong's view is not just in opposition to George's, but to that of the majority of policymakers as well.

I think a way you can explain George's position if you consider Treasuries as less risky than cash. At first, this sounds crazy, but if you assume there is no default risk (which I don't think there should be if you can print currency of the same denomination as the bond), then the Treasury bond may be perceived as a safer because it provides some return. Assuming no default risk, for any given inflation rate, the Treasury bond will thus be a safer store of value. If you viewed the world from this perspective, then the Fed is increasing riskiness of the public's portfolio.

This, however, is not how I think the Fed considers the situation. I think the Fed tends to view the public's desired cash holdings as roughly constant (although the rise in deposits would call this into question). If by QE the Fed swaps out some of the safe Treasury securities for cash, the public, not wanting to hold anymore cash, takes the cash and, by default, purchases riskier assets, and thus is left with holding a portfolio of riskier assets. George believes this disrupts the natural order of things by creating financial market distortions.

In any event, I tend to take this in a different direction from here. George appears to be saying that the Fed is eliminating (more accurately, removing) the safe assets that the public wants to hold. Suppose that this is true. Does this mean that the Fed should reverse policy to increase the proportion of safe assets in the public's hands? Or does it mean that another agency - perhaps a fiscal authority, hint, hint - should take action to increase the proportion of safe assets in the public's hands?

Once again, we come back to the issue of coordinating monetary and fiscal policy. If the public has a strong demand for noncash safe assets, monetary policy has something of a secondary role by providing an accommodative environment by which the fiscal authority can issue those assets. If the proportion of safe to risky assets is not "correct", the the fiscal authority should have a role in correcting that imbalance. In this world, then, it is not really the actions of the monetary authority that is creating the financial sector imbalances that concern George. It is the lack of action by the fiscal authority that creates those imbalances. George should be criticizing the fiscal authorities, not the monetary authority.

In other words, if a recession is the result of the public shifting to safe assets, the Fed is trying to respond by taking away the option of safe assets, leaving only risky assets. Instead, the Fed should view their role creating an environment (making clear that default is not an option) that allows the fiscal authority to issue more safe assets.

All of this, however, suggests that fiscal policy has a much greater role in stabilizing economy activity than conventional wisdom would hold. I suspect, however, that thinking along these lines is anathema to Federal Reserve officials who maintain that stabilization policy is the domain of monetary policy only. But if in fact there needs to be greater cooperation, and instead we continue to rely solely on monetary policy, then we will continue to experience less-than-satisfactory economic outcomes which will eventually endanger the cherished independence of central banks.

In short, I don't think you can have a discussion about the influence of monetary policy on the riskiness of the public's portfolio without including some discussion about the role of the issuer of those safe assets, the fiscal authority.

'During Periods of Extreme Growth and Decline, Human Behavior is Not the Same

From an interview of MIT's Andrew Lo:

Q: Many people believe that the financial crisis revealed major shortcomings in the discipline of economics, and one of the goals of your book is to consider what economic theory tells us about the links between finance and the rest of the economy. Do you feel that economists understand enough about the nature of financial instability or liquidity crises?

A: I think that the financial crisis was an important wake-up call to all economists that we need to change the way we approach our discipline. While economics has made great strides in modeling liquidity risk, financial contagion, and market bubbles and crashes, we haven't done a very good job of integrating these models into broader macroeconomic policy tools. That's the focus of a lot of recent activity in macro and financial economics and the hope is that we'll be able to do better in the near future.

Q: Let me continue briefly on this thread. One topic has been particularly controversial concerns the efficient-market hypothesis (EMH). Burton Malkiel discusses the issue in his chapter in Rethinking the Financial Crisis, but I wanted to ask your opinion of this idea that EMH fed a hands-off regulatory approach that ignored concerns about faulty asset pricing.

A: There's no doubt that EMH and its macroeconomic cousin, Rational Expectations, played a significant role in how regulators approached their responsibilities. However, we should keep in mind that market efficiency isn't wrong; it's just incomplete. Market participants do behave rationally under normal economic conditions, hence the current regulatory framework does serve a useful purpose during these periods. But during periods of extreme growth and decline, human behavior is not the same, and much of economic theory and regulatory policy does not yet reflect this new perspective of "Adaptive Markets."

The Reason We Lose at Games: Implications for Financial Markets

Something to think about:

The reason we lose at games, EurekAlert: Writing in PNAS, a University of Manchester physicist has discovered that some games are simply impossible to fully learn, or too complex for the human mind to understand.

Dr Tobias Galla from The University of Manchester and Professor Doyne Farmer from Oxford University and the Santa Fe Institute, ran thousands of simulations of two-player games to see how human behavior affects their decision-making.

In simple games with a small number of moves, such as Noughts and Crosses the optimal strategy is easy to guess, and the game quickly becomes uninteresting.

However, when games became more complex and when there are a lot of moves, such as in chess, the board game Go or complex card games, the academics argue that players' actions become less rational and that it is hard to find optimal strategies.

This research could also have implications for the financial markets. Many economists base financial predictions of the stock market on equilibrium theory – assuming that traders are infinitely intelligent and rational.

This, the academics argue, is rarely the case and could lead to predictions of how markets react being wildly inaccurate.

Much of traditional game theory, the basis for strategic decision-making, is based on the equilibrium point – players or workers having a deep and perfect knowledge of what they are doing and of what their opponents are doing.

Dr Galla, from the School of Physics and Astronomy, said: "Equilibrium is not always the right thing you should look for in a game."

"In many situations, people do not play equilibrium strategies, instead what they do can look like random or chaotic for a variety of reasons, so it is not always appropriate to base predictions on the equilibrium model."

"With trading on the stock market, for example, you can have thousands of different stock to choose from, and people do not always behave rationally in these situations or they do not have sufficient information to act rationally. This can have a profound effect on how the markets react."

"It could be that we need to drop these conventional game theories and instead use new approaches to predict how people might behave."

Together with a Manchester-based PhD student the pair are looking to expand their study to multi-player games and to cases in which the game itself changes with time, which would be a closer analogy of how financial markets operate.

Preliminary results suggest that as the number of players increases, the chances that equilibrium is reached decrease. Thus for complicated games with many players, such as financial markets, equilibrium is even less likely to be the full story.

'Why Paul Krugman should be President Obama's Pick for US Treasury Secretary'

I took three days to drive down the coast of Oregon and California on the way to the ASSA meetings in San Diego -- sort of a needed break that seemed to only put me further behind -- but I only have one day to get back, today. It's going to be a long, long day, so just a few quick posts before hitting the road:

Apparently, there's a petition circulating in support of this:

Why Paul Krugman should be President Obama's pick for US treasury secretary, by Mark Weisbrot: President Obama hasn't picked a treasury secretary yet for his second term, so he has a chance to do something different.

He could ignore what Wall Street and conservative media interests want and pick somebody who would represent what the electorate voted for. ... I know what you are thinking: this is impossible. There is too much money and power on the other side of this idea. Well, maybe.

But Obama has surprised us before. Last June, he picked Jim Kim to run the World Bank. ... So, for the post of treasury secretary, to replace the outgoing Tim Geithner, Obama could afford to make another bold choice: Paul Krugman.

Krugman would be tough to oppose on any substantive grounds. He has a Nobel Prize in economics (also the John Bates Clark award for best economist under 40). The New York Times columnist is probably the best-known living economist in the United States, and perhaps the world.

Krugman has been right about the major problems facing our economy, where many other economists and much of the business press have been wrong. ... Most importantly, Krugman is on the side of the majority of Americans. ... After all, why should the secretary of the treasury have to prioritize the interests of Wall Street and the "criminal enterprise" of big finance...

The US treasury secretary also has an important influence on the rest of the world, as the most powerful force within the IMF, G20, and G7 groupings. Krugman has written extensively about the stupidity of the last few years of economic policy in Europe...

Imagine a treasury secretary who favored employment, poverty reduction and development, rather than unnecessary austerity...

It would be great to have a treasury secretary who can cut through all that crap. ...

The renowned actor and human rights activist Danny Glover has launched a petition to the president for him to nominate Paul Krugman for secretary of the treasury. It's worth signing.

When Paul Krugman hears about this (I predict) he will tell us all the reasons why he'd be lousy at this job (as he's done before with similar suggestions).

'The Blame the Community Reinvestment Act Industry'

Dean Baker:

The Blame the Community Reinvestment Act Industry, by Dean Baker (Creative Commons License): One of the major occupations for economists these days is blaming efforts to help poor people for the housing bubble and bust. The main villains in this story are Fannie Mae, Freddic Mac, the Federal Housing Authority (FHA) and the Community Reinvestment Act (CRA). A reader recently sent me another work in this proud tradition.

I just did a quick reading of the paper, but it seems that the smoking gun in this one is that banks subject to the CRA appeared to do more lending in CRA tracts in the periods where their lending behavior was being scrutinized by regulators. Just to remind folks, the CRA requires banks to make loans in the areas from which they were taking deposits, in particular focusing on areas that are disproportionately African American or Hispanic. The authors take this timing result, which is especially pronounced in the peak bubble years of 2004-2006, as evidence that the CRA played a major role in the pushing of bad loans on moderate income people. As they note, the loans issued in these tracts in these periods had a much higher default rate than other loans.

It's not clear that this gun is smoking quite as much the paper implies. First, it is important to remember that the biggest peddlers of subprime loans were mortgage lenders like Ameriquest and Countrywide. These lenders were for the most part not subject to the CRA since they were not banks (they raised money through the capital markets, not by taking deposits). Therefore the CRA was not a gun to the head of these lenders forcing them to make bad loans.

However even for the banks to whom the CRA did apply the evidence in this paper is less compelling than it may seem. Let's assume that banks do care about their CRA ratings for the reasons mentioned in the paper. (The CRA rating would likely be a factor that would come up when a bank was interested in a buyout or merger.) Let's also imagine that banks time their loans to CRA tracts so that they can show more loans in the periods where their compliance is being reviewed. Let's also hypothesize that in total the CRA doesn't get banks to make any more loans to CRA tracts than they would otherwise.

In this case, we would get exactly the sort of pattern of lending found in this study. Banks that are subject to the CRA would refrain from focusing on CRA tracts when they know no one is looking. Then when the light is on, they would make a stronger effort to make loans in the neighborhoods covered by the CRA. If banks engaged in this sort of timing of loans to CRA tracts, we would find that loans during CRA review periods were higher than in other times, even if there was no net increase in loans as a result of the CRA.

As a practical matter, I would be surprised if the CRA had no effect whatsoever on lending to the covered tracts. But it's not clear how this paper can distinguish a timing effect from a situation where banks actually increased lending to CRA tracts beyond what they would have done without the law.

In the process of prosecuting the case against the CRA, the paper produces some exonerating evidence for Fannie and Freddie. It finds that the CRA effect was strongly associated with private securitization because the investment banks had lower standards than Fannie and Freddie. It comments on this finding:

"We conjecture that banks are more likely to originate loans to risky borrowers around CRA examinations when they have an avenue to securitize and pass these loans to private investors after the exam."

And, just to remind folks, the FHA became almost irrelevant in the peak bubble years, with its share of the market dwindling to almost nothing. At the time it was derided as an outmoded relic since the private sector was so much more efficient in providing loans to low and moderate income families.

Anyhow, I don't think there is any doubt that the efforts to push homeownership went seriously awry in the bubble years. Many of the organizations that encouraged moderate income families to buy homes at badly inflated prices as a wealth building strategy should be wearing bags over their heads for the next three decades. But there is no escaping the fact that the main motivation for issuing the bad mortgages was money: the banks were booking huge profits in these years. And no believer in the free market can think that bankers have to be told by government bureaucrats to go out and make money.

Unpuzzling the Puuzzled

Greg Mankiw says he is puzzled:

A Krugman Puzzler

Brad DeLong does the unpuzzling that, as he notes, shouldn't be needed:

In Which Greg Mankiw Pretends to Be Puzzled...

PGL explains what Mankiw should be puzzled about:

Paul Krugman Puzzles Greg Mankiw

Adam Ozimek continues the discussion:

Krugman vs Mankiw on Interest Rates

Paul Krugman with more on the topic:

Bond Vigilantes and the Power of Three

Nothing to add, that pretty much covers it, but I do wonder: When Greg Mankiw asks, relative to 2003, "are circumstances different now?" just how much eggnog has he had?

'What Does the New CRA Paper Tell Us?'

Mike Konczal:

What Does the New Community Reinvestment Act (CRA) Paper Tell Us?, by Mike Konczal: There are two major, critical questions that show up in the literature surrounding the 1977 Community Reinvestment Act (CRA).

The first question is how much compliance with the CRA changes the portfolio of lending institutions. Do they lend more often and to riskier people, or do they lend the same but put more effort into finding candidates? The second question is how much did the CRA lead to the expansion of subprime lending during the housing bubble. Did the CRA have a significant role in the financial crisis?   There's a new paper on the CRA, Did the Community Reinvestment Act (CRA) Lead to Risky Lending?, by Agarwal, Benmelech, Bergman and Seru, h/t Tyler Cowen, with smart commentary already from Noah Smith. (This blog post will use the ungated October 2012 paper for quotes and analysis.) This is already being used as the basis for an "I told you so!" by the conservative press, which has tried to argue that the second question is most relevant. However, it is important to understand that this paper answers the first question, while, if anything, providing evidence against the conservative case for the second. ...

"the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis." ...

'State Costs of the 2008 Icelandic Financial Collapse'

[Three quick ones before hitting the road.] Is Iceland an exception when it comes to bailing out banks?:

State Costs of the 2008 Icelandic Financial Collapse, by Thorolfur Matthiasson & Sigrun Davidsdottir: Outside Iceland it is widely believed that the collapse of the Icelandic financial sector in October 2008 came at no expense to Icelandic taxpayers. This contrasts with taxpayers in Ireland, the UK, Greece, Spain and Portugal, who have recapitalized their banking sectors. However, based on a recent estimate of public funds put into the financial sector since the collapse, we calculate that the cost accruing to the Icelandic State amounts to 20 to 25% of GDP – which means that Iceland cannot be taken as an example of a country that did not bail out any banks. This is of some interest since Iceland is now a popular comparison for economists studying crisis-stricken European countries.

'Europe’s Avoidable Collision Course'

Tyler Cowen on Europe:

... Until a broad solution is enacted, the system remains within the danger zone for a broader crash. ... Unfortunately, the relevant governments — and their citizens — still don’t seem close to accepting the onerous financial burdens they need to face. And when those burdens are unjust to mostly innocent voters, no matter whose particular story you endorse, acceptance becomes that much tougher.

Still, we shouldn’t forget that a solution exists. In essence, the required debt write-down is a large check lying on the table waiting to be picked up. No one knows how costly it is, but estimates have ranged from the hundreds of billions to the trillions of dollars. It need only be decided how to divide the bill. The reality is this: The longer that the major players wait, the larger that bill will grow. That they’ve yet to split the check is the worst news of all.

'High-Frequency Trading and High Returns'

Have to teach classes in a bit, and running late, so just have time for a quick post -- this is from Ricardo Fernholz, a professor of economics at Claremont McKenna College:

High-Frequency Trading and High Returns, The Baseline Scenario: The rise of high-frequency trading (HFT) in the U.S. and around the world has been rapid and well-documented in the media. According to a report by the Bank of England, by 2010 HFT accounted for 70% of all trading volume in US equities and 30-40% of all trading volume in European equities. This rapid rise in volume has been accompanied by extraordinary performance among some prominent hedge funds that use these trading techniques. A 2010 report from Barron’s, for example, estimates that Renaissance Technology’s Medallion hedge fund – a quantitative HFT fund – achieved a 62.8% annual compound return in the three years prior to the report.

Despite the growing presence of HFT, little is known about how such trading strategies work and why some appear to consistently achieve high returns. The purpose of this post is to shed some light on these questions and discuss some of the possible implications of the rapid spread of HFT. ...