Category Archive for: Financial System [Return to Main]

Thursday, September 01, 2016

When Asset Managers Go MAD

Thomas Belsham at Bank Underground:

When asset managers go MAD: What do the Cold War powers of the United States and the USSR have in common with modern day asset managers?  The capacity for mutually assured destruction.  During the 1950s game theorists described a model of strategic interaction to demonstrate how it might be that two nations would choose to annihilate each other in nuclear conflict.  Simply put, each nation had an incentive to strike first, as there was no incentive to retaliate.  Both would race to push the button.  Asset managers face a similar set of incentives.
The strategic interaction of these two superpowers was subsequently formalised as the “prisoner’s dilemma” by Albert W. Tucker.  In the prisoner’s dilemma, two rational decision makers choose to pursue an uncooperative course of action that is detrimental to both, rather than cooperate to arrive at a preferable one.  The reason the two parties can arrive at such an outcome is that for each individual, it is always better not to cooperate than to cooperate, regardless of the course taken by the other.
In the original thought experiment, there are two prisoners facing conviction of a crime, but they are suspected of a greater one.  The sentence for the less serious offence is two years.  Each is offered a deal:  snitch on your friend for the greater of the two crimes and you can go free.  But your friend gets seven years.  If both snitch, both gets five years.  So, to snitch or not to snitch?
What is clear is that it is better for both to keep quiet, and get two years, than for both to snitch, and get five each.  Yet snitching is the ‘rational’ outcome; it’s the best strategy for me regardless of what my partner does (notwithstanding the risk of reprisals after the seven years I’ve spent in the Bahamas while my partner been behind bars).

Table 1:  The prisoner’s dilemma

  Player 2
Don’t snitch Snitch
Player 1 Don’t snitch 2, 2 7, 0
Snitch 0, 7 5, 5
But what does that have to do with the asset management industry?  Well, arguably, because it may, under some circumstances, be possible to characterise the coordination problem faced by asset managers as a prisoner’s dilemma.  That stems from two factors.  The first, relates to the high degree of concentration of the asset management industry – which results in potential spillovers from the actions of one asset manager to the payoffs of others.  The second, relates to incentives arising from the practice of using peer comparison across individual asset managers to monitor performance – which make relative payoffs important.
The combination of these two features of the market could give rise to a situation in which, in period of financial stress, when there are concerns about falls in asset prices, rather than hold one’s nerve and stand pat, individual asset managers might reason that it is preferable to sell instead.  If all asset managers reason thus, the resulting rush for the exit – and downward pressure on asset prices – could result in considerably bigger losses for everyone, than if asset managers had coalesced on the cooperative outcome.
Putting this interaction in a formal context, in the asset manager game below, in a period of financial market stress, anticipating that there may be a fall in asset prices, each player can either hold his (or her) position, or sell.  In the event that both hold, each receives a loss of 1.  But each also has the option of selling, in the hope of being first out of the door.  If successful, that player reduces his own loss to 0, but increases the loss suffered by the other player to 2.  If both players sell, this is the worst outcome of all (each loses 3).

Table 2:  The asset manager’s dilemma
(players’ relative payoffs are shown in red)

  Player 2
Hold Sell
Player 1 Hold -1, -1

0, 0

-2, 0

-2, +2

Sell 0, -2

+2, -2

-3, -3

0, 0

Now, this isn’t quite the same as the prisoner’s dilemma above.  In the classic example, the bad outcome occurs because it makes sense not to cooperate no matter what the other player chooses.  Here, it is possible that both players will be greedy and sell – gambling that the other will hold.  But if one player knows that the other will sell, it would not be rational to sell as well.  This would increase that player’s own loss from 2 to 3.  The greedy player will simply be allowed to get away with it.  So what would make it in the interest of player 1 to make losses even worse by choosing to sell as well?
This is where the practice of benchmarking comes into play.  Asset managers tend to monitor performance against each other or against common benchmarks, to help investors compare investment propositions.  As a result, benchmarking creates an externality in which the performance of one’s peers, affects one’s own payoffs.  And it becomes in an individual asset manager’s best interest to minimise deviation from the rest of the pack – because his (or her) reputation and ability to raise a new fund and operate henceforth are a function of relative performance.
Now, in ‘good’ states of the world (the cooperative outcome, or the outcome in which the greedy gamble pays off) the externality does not affect behaviour:  if an asset manager cooperates, or successfully cheats, his performance is either as good, or better than that of his peers. “Look at me!  I’m doing at least as well as the other guy!”  Happily, here, the asset manager’s incentives are aligned with those of the investor.
But, importantly, in ‘bad’ states (non-cooperation, or being cheated on), if one’s opponent is cheating, it is preferable to cheat as well, and both incur a big loss, than to be cheated on and incur a smaller loss.  Better that, than stand out as an underperformer and risk losing one’s livelihood.  “Well, we all did terribly.  See you at the fundraiser!”  As a result, selling will be that much more widespread, and asset price falls that much bigger, than otherwise.  The asset manager’s incentives are not aligned with those of the investor.
Formally, each individual player’s preferred outcome is to cheat successfully (A).  And each player prefers small losses (B) to big losses (C).  But each would also prefer that both incur a big loss, than see the other profit at his own expense (D).  A is preferred to B, B to C, and C to D.  This is the general form of the classic prisoner’s dilemma (Table 3).  Regardless of the decision of Player 1, it is in the interest of Player 2 to sell.  For the investor in the asset manager game, however, it is clear that this represents a pretty miserable outcome.

Table 3:  The general form of the prisoner’s dilemma

  Player 2
Hold Sell
Player 1 Hold B, B D, A
Sell A, D C, C
The question then, is how to align the incentives of the asset manager with those of the investor?  The cooperative outcome becomes more likely, if each player’s rewards reflect the absolute return generated by the fund, rather than performance relative to benchmark.  This at least takes away some of the incentive to engage in mutually disadvantageous strategies, although greed on its own is still sufficient to yield the ‘sell, sell’ result.
To reduce the likelihood of that from happening, the academic literature on the prisoner’s dilemma suggests that in games where strategies are pursued on a probabilistic basis, a cooperative equilibrium becomes possible.  Mechanisms which lower the probability of ‘sell’ might help to nudge players towards the jointly preferred outcome.
Moreover, cooperative outcomes also sometimes result from repeated games of the prisoner’s dilemma, provided that the end point is not known (otherwise players reason that it makes sense to cheat on the last game, and knowing that the other player will reason thus, infer that it will also make sense to cheat in the penultimate game, and so on, right back to the very first interaction).  So perhaps we should embrace opportunities for players to arrive at the cooperative outcome; a little volatility may not be a bad thing.

Wednesday, August 31, 2016

Does Wall Street Do ''God’s Work''? Or Even Anything Useful?

Lynn Stout at ProMarket:

Does Wall Street Do “God’s Work”? Or Even Anything Useful?: In the wake of the 2008 crisis, Goldman Sachs CEO Lloyd Blankfein famously told a reporter that bankers are “doing God’s work.” This is, of course, an important part of the Wall Street mantra: it’s standard operating procedure for bank executives to frequently and loudly proclaim that Wall Street is vital to the nation’s economy and performs socially valuable services by raising capital, providing liquidity to investors, and ensuring that securities are priced accurately so that money flows to where it will be most productive. The mantra is essential, because it allows (non-psychopathic) bankers to look at themselves in the mirror each day, as well as helping them fend off serious attempts at government regulation. It also allows them to claim that they deserve to make outrageous amounts of money. According to the Statistical Abstract of the United States, in 2007 and 2008 employees in the finance industry earned a total of more than $500 billion annually—that’s a whopping half-trillion dollar payroll (Table 1168).
There’s just one problem: the Wall Street mantra isn’t true. ...

Wednesday, July 20, 2016

Is Finance a Powerful Driver of Growth?

Saleem Bahaj, Iren Levina, and Jumana Saleheen at the Bank of England's Bank Underground:

Is finance a powerful driver of growth?: Since the financial crisis the UK has experienced a period of weak productivity growth, weak investment coupled with a decline in credit to non-financial sectors of the economy. But there is debate about the direction of causality: did low growth and other structural factors mean firms and households wanted to borrow less – as argued by Martin Wolf? Or did the financial sector offer too few funds to the real economy in the wake of the crisis as banks tried to repair their balance sheets. Alternatively, the financial system may not be functioning properly in general, if much of the financial sector’s activity contributes little to the betterment of lives and efficiency of business – a point made by John Kay.
In this post, we analyse whether there has been enough finance to enable productive investment? This question was posed to the Bank of England by the Government last year, as part of its ‘productivity plan’. One concern is: Is the financial sector is holding back UK productivity? This post summarises our own insights on this topic, partly drawing on the recent Bank Discussion Paper. Importantly, our interpretation is blurred by the lack of data. But let’s start with the really interesting things we uncovered.
What we know
To measure the concept of finance for productive investment, we split our thinking into two questions:
(Q1) Are there unexploited productive investment opportunities in the UK? We found no conclusive evidence of investment deficiency....
(Q2) Is there enough finance to ensure productive investment takes place? Yes for the corporate sector as a whole, but not for all firms
The real question of interest here is if investment is low, is the blockage that is stopping investment taking place due to real economy factors – such as globalisation and secular stagnation – or financial factors – such as a lack of access to finance. ...
Large firms, with access to bond and stock markets, don’t appear to have problems financing themselves. Small firms that do have access to capital markets rely heavily on net equity issuance to finance their business... But the vast majority of small firms do not have access to market-based finance and are heavily dependent on bank funding or internal funds. Surveys show that small firms’ access to finance remains an issue, but it now affects a smaller proportion of firms than in recent years...
What next?
In an era of big data, we have discovered the presence of big data gaps. These data gaps may have blurred our bottom line: we have not found any conclusive evidence of investment deficiency in the UK; and the corporate sector as a whole appears to have an adequate supply of finance to fund their desired investment activities. ...

Sunday, July 03, 2016

Who Exactly Benefits from Too Big To Fail?

Chris Waller, research director at the St. Louis Fed (and a classmate in graduate school) argues that "TBTF status leads to a wealth transfer from new buyers to existing holders of the debt":

Who Exactly Benefits from Too Big To Fail?: Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, has revived discussion of the Too Big To Fail (TBTF) issue for large U.S. financial institutions. TBTF arises when the government and regulators fear that a bank’s failure would cause widespread damage to the financial system. Consequently, when a large bank or highly interconnected bank is on the verge of failure, the government steps in and prevents its collapse. When this happens, howls are heard that the government is “bailing out” equity and bond holders at taxpayer expense and that the proper action is to wipe them out.
Why is having a bank labeled TBTF a problem? First, by being viewed as TBTF, a bank receives an insurance policy against default from taxpayers but does not pay a premium for this insurance. Second, being provided with this insurance creates moral hazard since bank management can undertake riskier activities and reap the higher returns while shifting the risk of default to the taxpayer. Note that the first benefit occurs even if the bank does not change the risk structure of its balance sheet—e.g., even if it does not engage in moral hazard. Thus, it is important to keep in mind that having TBTF status is not just about moral hazard. It is also about the provision of free insurance to the bank by the taxpayer. This latter point is often overlooked in discussions of TBTF.
But, as heretical as it may sound, are the current equity holders and bank creditors the true beneficiaries of the bailout? The answer depends on whether or not the TBTF designation for a bank was accounted for in its equity and debt prices at an earlier date. If a bank is declared TBTF unexpectedly at the moment it is about to default, then equity and bond holders are bailed out since their asset positions did not price-in this status at the time of purchase.
However, what if the TBTF designation was given prior to default? Looking back at the financial crisis, this seems to be the more-relevant case. Ron Feldman and Gary Stern warned about banks having this designation in their 2004 book, Too Big to Fail: The Hazards of Bank Bailouts, and the risks it created for the U.S. taxpayer. They point out that the failure of Continental Illinois in 1984, the seventh largest bank in the U.S. at the time, and the government’s generous treatment of unsecured creditors brought TBTF front and center into the public policy arena. Feldman and Stern succinctly summarize the TBTF problem: “The roots of the TBTF problem lie in creditors’ expectations...and the source of the problem is a lack of credibility” that the government will let them fail. Thus, the problem with TBTF is that a bank is viewed this way long before it actually gets into trouble.
It is exactly this timing that makes it difficult to determine who benefits from TBTF. To make this scenario as stark as possible, suppose the government knows that its promises to let bank A fail are not credible. So the government simply announces at date t that bank A is too big to fail and will be bailed out if it is on the verge of default.
What will happen at the time of this announcement? Bank A’s equity price will increase to reflect the absence of default risk associated with this new designation. Fur­thermore, the price of the bank’s outstanding debt and its newly issued debt will increase to reflect the elimination of default risk.
So who benefits from this? Well, obviously those holding equity claims on bank A when the TBTF status is announced. They get a capital gain on their shares from the price appreciation. The same is true for those holding bank A debt—the higher price of bank A debt would generate a capital gain to the debt holders at the time of the announcement. This all happens even if the bank does not change the riskiness of its portfolio.1
But what about those who buy bank A stocks and bonds after the announcement? If financial markets are efficient, then the TBTF status should be fully capitalized into the value of the bank. As a result, a risk-neutral investor would be indifferent between (i) buying the stock at a low price without TBTF protection and (ii) buying the stock at a higher price but with TBTF status. In short, new buyers are paying for the TBTF insurance via higher equity and bond prices. They do not receive a windfall from the TBTF status assigned to bank A.
To illustrate with a simple example, suppose bank A has an outstanding simple discount bond at time t that matures in period t +1with face value of $1. Assume the probability of default is zero in period t but occurs with an exogenous probability π > 0 in t + 1. If default occurs, the bond holder gets zero. Since default is purely exogenous, moral hazard does not come into play. In the absence of TBTF status, the time t price of the bond that a risk-neutral investor would pay to acquire the bond is

where i is the discount rate used by all investors. Note that the bond price reflects the probability of default.
Now suppose that, at the beginning of period t, the government announces that bank A is too big to fail. Then the bond price will instantly jump to

 So the initial holder of the debt reaps a capital gain of

from selling his bond after the announcement. However, the new buyer has to pay a higher bond price to get this “insurance” from the government. Thus, the TBTF status leads to a wealth transfer from new buyers to existing holders of the debt. Note that the difference tpt is the fair market price for the insurance (the “premium”) that the existing bond holder would be willing to pay to avoid default. So, in short, the government provides the insurance but existing bondholders collect the premium from new buyers of the debt.2
A similar exercise can be done with equity pricing as well. Suppose the firm faces a constant and exogenous probability π of failing each period and pays a dividend d if it doesn’t fail and 0 otherwise. Using a simple present discounted value formula applied to the dividend stream yields the equity share price

Once the bank is declared TBTF, default goes to zero and the equity price jumps to3

which yields a capital gain of

But what about the buyers of bank A equity after the announcement? As we can see, they paid a much higher equity price in response. Again, they are paying for the default protection.4 The equity holders at the time of the announcement are the ones who reap the rewards of the TBTF status.
Now suppose the government chose to let bank A fail after this announcement and wiped out the equity holders and creditors. Well, the initial bondholders would not care. They received the insurance premium and sold the bond. They do not suffer. However, those who bought the bond at price t “paid” for insurance but did not get the promised payoff. They actually lose.5 Hence, it is not surprising that they would be upset by the government’s action. Who wouldn’t be upset after paying for insurance that didn’t pay off when it should have?6
A similar argument applies to equity holders. The initial stock holders wouldn’t care. They reaped their capital gains by selling their shares to new buyers. But a shareholder who bought shares at êt would again argue that they paid for the default protection. They would not be happy if they are told it’s “fair” that they should be wiped out ex post. If someone held a share of bank A stock prior to the time of the announcement until the government allowed them to fail, then they would receive no capital gain and would be wiped out appropriately since they paid et not êt. This seems to be the view of those opposed to bailing out equity holders: that those holding equity at the time of bank A’s failure were the same ones holding equity when the TBTF status was announced.
Moral hazard is a separate issue and an important one. But a similar logic applies. Bond holders care only about the default insurance. They do not reap the additional earnings from the riskier portfolio. Suppose the government sold a credit default swap (CDS) to potential buyers of bank A’s debt. They would be willing to pay t > 0 for the CDS and nothing more. Is this enough to compensate the government for taking on this risk? Most likely not, since under moral hazard the risk of default increases, say, to π̄ > π. But this is not the new bondholders’ problem. It’s a problem between the government and the equity owners.
For equity holders, moral hazard would imply bank management undertakes actions such that π̄ > π and > d. If markets could properly assess this behavior in pricing bank A’s changed risk structure, then the equity price would be

which reflects the fact that the shareholders reap the higher dividend stream but the government absorbs the downside risk since π̂does not appear. As before, a new buyer of equity is paying for (i) the default protection and (ii) the higher dividend stream arising from moral hazard. So, yes, they receive the benefits of moral hazard in the form of higher dividend payments but they paid for it via the price they paid to acquire the stock. The problem once again is that the government absorbs the downside risk but isn’t compensated for it by the equity holders at the time of the announcement. How severe the moral hazard problem is depends on its quantitative importance. And research is only now beginning to explore this.7
To summarize, the value of being designated TBTF is capitalized into the price of a firm’s equities and its bonds. TBTF provides a windfall capital gain to shareholders and creditors at the time of the designation. But after that, new buyers of equities and debt are paying for that status. Con­sequently, determining who gets “bailed out” when an institution is TBTF is a more complicated task than it appears.
If the government is unable to commit to letting banks fail or breaking them up is not a serious option, then the best that can be done is compensate taxpayers for the default insurance it provides to large financial institutions. Minneapolis Fed President Kashkari has advocated turning the banks into financial public utilities and regulating them accordingly. An alternative may be to have the government sell CDSs against the debt of large financial institutions. Debt holders would then pay the government directly for this insurance. Having the U.S. government sell insurance is already a common policy: The U.S. government currently sells crop insurance, flood insurance, disability insurance, etc. So it is not unprecedented. While this may not solve the moral hazard problem, it at least compensates taxpayers for providing default insurance.
1 The same logic applies to stock options of senior management. If the announcement of TBTF causes the equity price to jump high enough, then the strike price is below the market price of the stock, meaning senior executives are “in the money” and get a capital gain from their stock options.
2 Another way to think about this is to assume the government issues a credit default swap. If it sold the CDS on the market it would receive the premium tpt from the buyer of the CDS. If default does not occur, the taxpayer makes a profit from the CDS; if default does occur, the taxpayer is on the hook for the loss. Now suppose the government gives the CDS to the existing bondholders and lets them sell it. The current bondholders get the premium as a windfall profit without absorbing any risk. Meanwhile, the taxpayer gets zero if no default occurs and is on the hook for $1 if default occurs. The buyer of the CDS is not bailed out—he paid the fair market price for the insurance.
3 Since bond financing costs are lower, this would allow for a higher dividend payment after TBTF status is announced. Nevertheless, this is priced-in for new buyers of the equity.
4 Again, senior managers who join bank A after the TBTF designation now face a higher strike price for their stock options, which effectively lowers their executive compensation.
5 This applies even if the government could credibly remove the TBTF status of bank A.
6 This line of reasoning also applies to many situations. For example, consider the mortgage interest rate deduction. Many argue that it is a subsidy to homeowners and should be eliminated. However, the deduction has now been capitalized into the price of the house so a new owner would actually take a capital loss if the deduction was removed. Again, new homeowners have paid for the subsidy and get very angry when elimination of the mortgage interest deduction is discussed.
7 See Javier Bianchi’s “Efficient Bailouts” (forthcoming in American Economic Review; for an excellent attempt at quantifying the moral hazard problem in banking. Bianchi’s main finding is that moral hazard is not quantitatively important if bailouts are systematic as opposed to being focused on a particular bank.

Monday, June 20, 2016

Blinder's 'Financial Entropy Theorem'

This is from the introduction to an interview of Alan Blinder:

Alan Blinder on Over-Regulating Financial Markets: ...Professor Alan Blinder, former Vice Chairman of the Federal Reserve (June 1994 to January 1996), has been studying the financial system for close to 30 years. In 2014 he published a paper that did not get enough attention, but that students of regulation theory may find surprising: In order to get optimal regulation in the financial world, one should seek to over-regulate.7)
The idea of cyclical regulatory equilibrium in financial markets is not new, as Blinder immediately admits. In a 2009 paper, Joshua Aizenman wrote that “prudential” under-regulation may expose economies to future financial crises, which means that over-regulation may be the correct course8).  And, of course, Blinder also borrows from the “Minsky cycle”: Hyman Minsky’s idea that periods of financial stability encourage further and further risk-taking, even with borrowed money, until a phase–a “Minsky moment”–where asset values collapse.
“Financial regulations and their effectiveness tend to get weakened over time by (a) industry workarounds, (b) regulatory changes, and (c) legislative changes. The main exceptions come during and after financial crises or scandals, when public revulsion against financial excesses enables, perhaps even forces, a tightening of regulation,” Blinder writes.
Therefore, in Blinder’s view, over-regulation, when it can be achieved, is actually optimal. Or, in his words: “a simple, but not mathematically accurate, way of thinking about the optimality of over-regulation is that it gets the degree of regulation ‘right on average’ over time.” ...

Saturday, June 11, 2016

Impact of the 'Great Bailout': Evidence from Car Sales

At VoxEU:

Impact of the ‘great bailout’: Evidence from car sales, by Efraim Benmelech, Ralf R Meisenzahl, Rodney Ramcharan: Nearly a decade since it took place, the US federal government’s rescue of the financial system in 2008-2009 remains highly controversial. At the time, the Troubled Asset Relief Program (TARP), which injected equity into commercial banks and provided for the bailout of the General Motors Acceptance Corporation (GMAC) — the lending arm of General Motors— and the US automobile sector, was initially rejected by Congress as a ‘bailout to bankers’. And even today, populists on both the right and the left echo a similar refrain, as economic growth remains tepid while asset prices boom. Moreover, nuance and careful research by highly respected economists observe that more aggressive intervention to relieve the household debt burden might have made for a stronger economic recovery (Mian and Sufi 2014). It remains an open question, then, whether the government’s rescue of the financial sector helped the US economy beyond Wall Street. Or was the government’s focus on the financial sector fundamentally misplaced?
We may never have definitive answers to these questions. But in new research, we suggest that without federal intervention to stabilize financial markets and recapitalize some non-bank lenders such as GMAC, the magnitude of the economic collapse in 2008-2009 might have been much worse (Benmelech et al. 2016). Before the financial crisis, a large network of non-bank financial institutions, such as mortgage brokers and consumer finance companies —the shadow banking system — became increasingly important sources of credit in the US. For example, finance companies like GMAC financed about half of new car sales in 2005. The form of shadow banking financing differed markedly from traditional banks. While the latter use government insured deposits to make loans, non-bank lenders make loans using short-term uninsured wholesale funding, mostly from entities such as money market funds (MMFs) and pension funds.1 In 2008 and 2009, MMFs and pension funds became unwilling or unable to fund many of these non-bank lenders (Kacperczyk and Schnabl 2013). Car sales collapsed in the US, and GM and Chrysler entered bankruptcy...

Skipping ahead to the last paragraph:

It may difficult to definitively judge whether the federal resources and attention devoted to rescuing the financial system, relative to relieving household debt overhang, was appropriate. And the evidence in Mian and Sufi (2014) makes a compelling case that too little might have been done for households. But Wall Street and Main Street are intimately connected. And despite the enormous scale of the federal rescue of the US financial sector, our work and others show that the dislocations in financial markets resonated well beyond Wall Street. One can surmise then that without the rescue, the Great Recession of 2008-2009 might have been much more severe. ...

Saturday, May 28, 2016

How Bank Networks Amplify Financial Crises: Evidence from the Great Depression

On the road headed to my dad's 80th birthday party, so just a quick one for now. This is from VoxEU:

How bank networks amplify financial crises: Evidence from the Great Depression, by Kris James Mitchener and Gary Richardson: How financial networks propagate shocks and magnify recessions is of interest to both scholars and policymakers. The financial crisis of 2007-8 convinced many observers that financial networks were fragile, and while reforms are underway, much remains to be learned about how and why connections between financial firms matter for the macroeconomy. Indeed, the complexity and sheer number of linkages has made it particularly challenging to formulate empirical estimates of their role in amplifying downturns.
Economic theory suggests many channels through which networks may transmit shocks (Allen and Gale 2000, Cabellero and Simesek 2013) and empirical research has provided some evidence of contagious failures flowing through interbank markets, particularly for the recent financial crisis in the US and Europe (Puhr et al. 2012, Fricke and Lux 2012). History should have a lot to say about the role of networks in contributing to the severity of financial crises, but it is a surprisingly lightly studied aspect of earlier periods of financial turmoil – even for well-researched episodes such as the Great Depression. This lacuna exists despite the fact that financial networks of the past may be simpler in structure, thus making it somewhat easier to identify empirically how aggregate variables, such as lending, were affected when linkages were disrupted.
In a recent paper, we document how the interbank network transmitted liquidity shocks through the US banking system and how the transmission of these shocks amplified the contraction in real economic activity during the Great Depression (Mitchener and Richardson 2016). The paper contributes to the growing literature on financial networks and the real economy, illuminating both a mechanism for transmission (interbank deposits) as well as a source of amplification (balance-sheet effects). It also introduces an additional channel through which banking distress deepened the Great Depression and complements existing research on how bank distress during the Great Depression influenced the real economy.
We describe how a pyramid-like structure of interbank deposits developed in the 19th century, how the founding of the Fed altered the holdings of these deposits, and how this structure then influenced real economic activity during periods of severe distress, such as banking panics (Mitchener and Richardson 2016). The interbank network that existed on the eve of the Great Depression linked large money centre banks in New York and Chicago to tens of thousands of smaller rural banks throughout the US. The money centre banks served as correspondents holding deposits from institutions in the countryside. Interbank balances exposed correspondent banks to shocks afflicting banks in the hinterland. Interbank deposits were a liquid source of funds that could be deployed to meet sudden demands by depositors to convert claims to cash, and the removal of these deposits from correspondent banks peaked during periods that contemporary commentators described as – and that our detailed statistical analysis of bank suspensions confirms were – banking panics. Although the pyramided system of interbank deposits could handle idiosyncratic bank runs, when runs clustered in time and space (i.e. when panics occurred) the system became overwhelmed in the sense that banks higher up the pyramid were forced to adjust to these changes in liabilities by changing their assets (i.e. lending). ...
Ironically, the Federal Reserve System had been created with the purpose of preventing crises such as those that had regularly plagued the banking system in the 19th century. We help to explain why the Fed failed to fulfill this basic responsibility. ...

Friday, May 13, 2016

Ending "Too Big to Fail": What's the Right Approach?

Ben Bernanke:

Ending "too big to fail": What's the right approach?: In a recent speech at the Hutchins Center at the Brookings Institution, Neel Kashkari, the new president of the Federal Reserve Bank of Minneapolis, argued that we need new strategies to tackle the problem of “too big to fail” (TBTF) financial institutions. On Monday, I’ll be on a panel at the Minneapolis Fed on the issue. This post previews my comments. In short, it seems to me that a lot of progress has been made (and more is in train)... To say that “nothing has been done” is simply not correct. ...
At the 50,000-foot level, a key question is the extent to which structural change in the financial industry is needed to end TBTF, and, to the extent it is, what that change should look like. The argument of this post is that, while substantial and even fundamental changes may ultimately be necessary, we don’t yet know exactly what they will be. Instead, the legacy of the Dodd-Frank Act, the Basel agreements, and other reforms is a sensible process which, with sustained effort, will help us solve the problem. A key element of the strategy is that it gives banks strong incentives to shrink or otherwise restructure themselves to reduce the risk they pose to the financial system.
Why not just break up big banks? ...
My takeaway is not that the problem is solved—that will take more time—but rather that the current approach amounts to a process that will help us find the solution. In particular, the government’s strategy for ending TBTF addresses the deficiencies, noted above, of imposing arbitrary limits on bank size. Most obviously, the strategy does not make the mistake of treating size as the only determinant of systemic risk (e.g., capital surcharges depend on a variety of criteria). ...
If, as seems probable, bank managers and shareholders better understand the institution’s motivations for size and complexity than regulators do, it makes sense to use that knowledge. To do that, the right incentives need to be provided: The privately perceived benefits of TBTF status need to be reduced and the costs increased, so that bank managers and shareholders are considering something closer to the social costs and benefits of size and complexity when they think about how to organize their business. ...
To a first approximation, that’s what the government’s approach aims to do. For example, the capital surcharge and similar regulations directed at systemically important institutions act like taxes on size and complexity. ... That is, the extra costs that regulators impose on systemic institutions force their decisionmakers to “internalize the externality” that their firms create for the financial system. [4] Similarly, the development of the liquidation authority (which raises the probability that creditors will take losses) and improvements in the overall resilience of the financial system (which would reduce any incentive that future regulators might have to try to engineer a bailout) should reduce the perceived benefits associated with TBTF status, as measured in terms of funding costs, for example. Putting creditors at risk also brings market discipline back into play, putting additional pressure on managers not to take excessive risks. Together with the requirements imposed by the living will process, better incentives for managers, shareholders, and creditors should lead, over time, to a banking system that is safer, but also more competitive and efficient.

Wednesday, April 27, 2016

The World Needs More U.S. Government Debt

Narayana Kocherlakota:

The World Needs More U.S. Government Debt: ...The federal government is causing great harm by failing to issue enough debt. ...
To some, the idea that the U.S. government isn't issuing enough debt may seem counterintuitive -- after all, federal debt outstanding has more than doubled over the past 10 years. But scarcity is not about supply alone. In the wake of the financial crisis, households and businesses are demanding more safe assets to protect themselves against sudden downturns. Similarly, regulators are requiring banks to hold more safe assets. Market prices tell us that the government needs to produce more safety in order to meet this increased demand.
The scarcity of safety creates hardships... Retirees can’t get adequate returns on their nest eggs. Banks can't earn enough on safe, long-term investments to cover the costs of attracting deposits (interest rates on which can’t fall much below zero). ...
The inadequate provision of safe assets also has profound implications for financial stability. Without enough Treasury bonds to go around, investors “reach for yield” by buying apparently safe securities from the private sector (remember all those triple-A-rated subprime-mortgage investments of the 2000s?). If such behavior becomes widespread, it can create systemic risks that tip the financial system into crisis. ...
No private entity would behave like this. Imagine a corporation with such a safe cash flow and such low borrowing costs. It would issue debt to fund expansions or payouts to its shareholders.
Analogously, the U.S. government should issue more debt, using the proceeds to invest in infrastructure, cut taxes or both. Instead, political forces have imposed artificial constraints on debt -- constraints that punish savers, choke off economic growth and could sow the seeds of the next financial crisis.

Monday, April 25, 2016

Paul Krugman: The 8 A.M. Call

Are the presidential candidates prepared to handle an economic crisis?:

The 8 A.M. Call, by Paul Krugman, NY Times: Back in 2008, one of the ads Hillary Clinton ran during the contest for the Democratic nomination featured an imaginary scene in which the White House phone rings at 3 a.m. with news of a foreign crisis, and asked, “Who do you want answering that phone?” ... As it turned out ... Mr. Obama, a notably coolheaded type who listens to advice, handled foreign affairs pretty well...
That 3 a.m. call is one thing; but what about the 8 a.m. call – the one warning that financial markets will melt down as soon as they open? ...
At this point there are three candidates who have a serious chance of receiving their party’s presidential nomination. ... So what do we know about their economic policy skills?
Well, Mrs. Clinton isn’t just the most knowledgeable, well-informed candidate in this election, she’s arguably the best-prepared candidate on matters economic ever to run for president. ...
On the other side, I doubt that anyone will be shocked if I say that Mr. Trump doesn’t know much about economic policy, or for that matter any kind of policy. He still seems to imagine, for example, that China is taking advantage of America by keeping its currency weak — which was true once upon a time, but bears no resemblance to current reality.
Oh, and coping with crisis in the modern world requires a lot of international cooperation. Things like currency swap lines... How well do you think that kind of cooperation would work in a Trump administration?
Yet things could be worse. The Donald doesn’t know much, but Ted Cruz knows a lot that isn’t so..., he demands a gold standard to produce a “sound dollar.” He chose, as his senior economic adviser, Phil Gramm — an architect of financial deregulation who helped set the stage for the 2008 crisis, then dismissed warnings of recession when that crisis came, calling America a “nation of whiners.”
Mr. Cruz is ... utterly divorced from reality and impervious to evidence... A financial crisis with him in the White House could be, let’s say, an interesting experience.
I don’t know how much play the candidates’ readiness for economic emergencies will get in the general election. There will, after all, be so many horrifying positions, on everything from immigration to Planned Parenthood, to dissect. But let’s try to make some room for this issue. For that 8 a.m. call is probably coming, one way or another.

Monday, April 11, 2016

Paul Krugman: Snoopy the Destroyer

Systemically important presidential elections:

Snoopy the Destroyer, by Paul Krugman, NY Times: Has Snoopy just doomed us to another severe financial crisis? Unfortunately, that’s a real possibility, thanks to a bad judicial ruling that threatens a key part of financial reform. ...
At the end of 2014 the regulators designated MetLife, whose business extends far beyond individual life insurance, a systemically important financial institution. Other firms faced with this designation have tried to get out by changing their business models. For example, General Electric ... sold off much of its finance business. But MetLife went to court. And it has won a favorable ruling from Rosemary Collyer, a Federal District Court judge.
It was a peculiar ruling. Judge Collyer repeatedly complained that the regulators had failed to do a cost-benefit analysis, which the law doesn’t say they should do, and for good reason. Financial crises are, after all, rare but drastic events; it’s unreasonable to expect regulators to game out in advance just how likely the next crisis is, or how it might play out, before imposing prudential standards. To demand that officials quantify the unquantifiable would, in effect, establish a strong presumption against any kind of protective measures.
Of course, that’s what financial firms want. Conservatives like to pretend that the “systemically important” designation is actually a privilege, a guarantee that firms will be bailed out. Back in 2012 Mitt Romney described this part of reform as “a kiss that’s been given to New York banks”..., an “enormous boon for them.” Strange to say, however, firms are doing all they can to dodge this “boon” — and MetLife’s stock rose sharply when the ruling came down.
The federal government will appeal..., but even if it wins the ruling may open the floodgates to a wave of challenges to financial reform. And that’s the sense in which Snoopy may be setting us up for future disaster.
It doesn’t have to happen. As with so much else, this year’s election is crucial. A Democrat in the White House would enforce the spirit as well as the letter of reform — and would also appoint judges sympathetic to that endeavor. A Republican, any Republican, would make every effort to undermine reform, even if he didn’t manage an explicit repeal.
Just to be clear, I’m not saying that the 2010 financial reform was enough. The next crisis might come even if it remains intact. But the odds of crisis will be a lot higher if it falls apart.

Thursday, March 31, 2016

'Modelling Banking Sector Shocks and Unconventional Policy: New Wine in Old Bottles?'

This is from the B of E's Bank Underground:

Modelling banking sector shocks and unconventional policy: new wine in old bottles?, by James Cloyne, Ryland Thomas, and Alex Tuckett: The financial crisis has thrown up a huge number of empirical challenges for academic and professional economists. The search is on for a framework with a rich enough variety of financial and real variables to examine both the financial shocks that caused the Great Recession and the unconventional policies, such as Quantitative Easing (QE), that were designed to combat it. In a new paper we show how using an older structural econometric modelling approach can be used to provide insights into these questions in ways other models currently cannot. So what are the advantages of going back to an older tradition of modelling? An ongoing issue for central bank economists is that they typically want to look at a wide range of financial sector variables and at a more granular, sector-based level of aggregation than typically found in macroeconomic models with credit and asset market frictions. For example, we often want to distinguish between the credit provided to firms separately from that provided to households or between secured lending and unsecured lending. We may also want to compare and contrast a number of policy instruments that work through different channels such as central bank asset purchases (QE) and macroprudential tools such as countercyclical capital requirements.
It is a tough challenge to incorporate all of these effects in the theoretical and empirical models that are typically used by macroeconomists, such as structural vector autoregression (SVAR) models and micro-founded general equilibrium (DSGE) models. For these reasons turning back to the older tradition of building structural econometric models (SEMs) – built from blocks of simultaneously estimated equations with structural identifying restrictions – can be useful. This approach can be thought of as a blend of the more theory-free VAR methods and a more structural model-based approach. The main advantage of the structural econometric frameworks are that they produce quantitative results at a sector level, which can still be aggregated up to produce a general equilibrium response. They also allow models to be built up in a modular way that allows replacing and improving sets of equations for particular blocks of the model without necessarily undermining the logic of the model as a whole. This older school approach to modelling has begun to appear in a variety of modern vintages. ...

Friday, March 25, 2016

Putting the Client Last: A Former Investment Banker Explains How Clients are Being Systemically Sucker-Punched

From ProMarket:

Putting the Client Last: A Former Investment Banker Explains How Clients are Being Systemically Sucker-Punched: As a former London employee of a major investment bank, I am often puzzled by the tone that top managers of investment banks use when speaking to the public. There is indeed a striking gap between the official communication and the internal behaviors I have observed (and taken part in). To me, banks are experts at exploiting asymmetries of information. Furthermore, they often amplify this asymmetry themselves by complexifying the products they offer or by disclosing only fractions of the information they have.
Of course, investment banks’ clients are the principal target of this type of strategy. While banks typically claim as their main value that their clients’ interests always come first, the reality is usually quite different. ...

Wednesday, March 23, 2016

'Cruz Seeks Economic Wisdom in the Wrong Place'

Barry Ritholtz:

Cruz Seeks Economic Wisdom in the Wrong Place:

Some people look at subprime lending and see evil. I look at subprime lending and I see the American dream in action. -- former U.S. Senator Phil Gramm, Nov. 16, 2008

...Gramm has been brought on as a senior economic adviser to Republican presidential candidate Ted Cruz. This isn't a promising development for Cruz... Not to put too fine a point on it, but I believe -- as do many others -- that Gramm was one of the major figures who helped set the stage for the crisis. ...

Gramm was a key sponsor of the ... Gramm-Leach-Bliley Act, which effectively repealed the piece of the Glass-Steagall Act... The damage caused by rolling back Glass-Steagall pales compared with ... the Commodity Futures Modernization Act of 2000. Gramm was a co-sponsor of the legislation, which exempted many derivatives and swaps from regulation.  Not only was the law problematic, but it veered into potential conflict-of-interest territory. ...

We got a chance to see those consequences a few years later when American International Group failed, thanks in part to swaps ... on $441 billion of securities that turned out to be junk. AIG wasn't required to put up much in the way of collateral, set aside capital or hedge its risk on the swaps. Why would it, when the law said it didn’t have to? The taxpayers were then called upon to bailout AIG to the tune of more than $180 billion.

Maybe it isn't too surprising that Cruz would seek advice from Gramm. Cruz, after all, seems to want to hobble modern economic policy by returning to the gold standard. ... We have seen these movies before, and they end in tragedy and tears. 

He also talks about Gramm's sad performance in his brief appearance as one of McCain's advisors in 2008.

Monday, February 29, 2016

"Financial Transaction Taxes in Theory and Practice'

From the Brookings Institution"

Financial transaction taxes in theory and practice, by Leonard E. Burman, William G. Gale, Sarah Gault, Bryan Kim, Jim Nunns and Steve Rosenthal: The Great Recession, which was triggered by financial market failures, has prompted renewed calls for a financial transaction tax (FTT) to discourage excessive risk taking and recoup the costs of the crisis. ...
[...Review of arguments for and against an FTT...]
Our review and analysis of previous work suggests several conclusions. First, the extreme arguments on both sides are overstated. At the very least, the notion that a FTT is unworkable should be rejected. ... On the other hand, the idea that a FTT can raise vast amounts of revenue ... is inconsistent with actual experience with such taxes.
Second, a wide range of design issues are critical to the formulation of a FTT... Third, although empirical evidence demonstrates clearly that FTTs reduce trading volume, as expected, it does not show how much of the reduction occurs in speculative or unproductive trading versus transactions necessary to provide liquidity. The evidence on volatility is similarly ambiguous: empirical studies have found both reductions and increases in volatility as a result of the tax.
Fourth, the efficiency implications of a FTT are complex, depending on the optimal size of the financial sector, its impact on the rest of the economy, the structure and operation of financial markets, the design of the tax, and other factors.
We also present new revenue and distributional estimates for hypothetical U.S. FTTs... We ... find the tax would be quite progressive. ...
[Paper: Financial Transaction Taxes in Theory and Practice"]

Wednesday, February 10, 2016

'Charge Senior Bank Bosses'

Phil Angelides asks a "simple question":

Charge senior bank bosses, says former commissioner, by Ben McLannahan, FT: Phil Angelides uncovered evidence of widespread fraud and corruption in the US mortgage market as chairman of the commission which produced the government report on the global financial crisis. Five years on, he is asking the Department of Justice why it has yet to call any senior bank executives to account. ... In a letter to Loretta Lynch, US Attorney General, Mr Angelides has challenged the DoJ to take action before the ten-year statute of limitation expires.
“I ask a simple question: how could the banks have engaged in such massive misconduct and wrongdoing without a single individual being involved? In a sense, it’s the immaculate corruption,” he told the FT. “It defies common sense, and the people of America know this" ... "it breeds a great amount of cynicism and anger about the nature of our judicial system.”

'Rescuing a SIFI, Halting a Panic: the Barings Crisis of 1890'

Eugene White at the Bank of England's Bank Underground:

Rescuing a SIFI, Halting a Panic: the Barings Crisis of 1890, Bank Underground: The collapse of Northern Rock in 2007 and Bear Sterns, Lehman Brothers, and AIG in 2008 renewed the debate over how a lender of last resort should respond to a troubled systemically important financial institution (SIFI). Based on research in the Bank of England Archive, this post re-examines a crisis in 1890 when the Bank, supported by central bank cooperation, rescued Baring Brothers & Co. and quashed a banking panic and a currency crisis, while mitigating moral hazard. This rescue is significant because it combined features similar to those mandated by recent U.K., U.S., and European reforms to ensure an orderly liquidation of SIFIs and increase the accountability of senior management (e.g. Title II of the Dodd-Frank Act (2010); the U.K. “Senior Managers Regime”).
Financial historians (Bordo (1990); Schwartz (1986); Bignon, Flandreau, & Ugolini, (2012)) have argued that, when faced with a crisis in the nineteenth century, the Bank of England simply followed Bagehot’s Rule to lend freely at a high rate to preserve market liquidity (Bagehot (1873)). This “historical fact” has lent support to policy recommendations to strictly follow Bagehot in a crisis. By downplaying the rescue and treating the 1890 crisis as minor (Turner (2014)), historians have overlooked its significance and that of its French precursor; thus they have missed important examples of successful pre-emptive intervention that limited damage to the economy and future risk-taking. ...
The rescue package provided to Barings was modelled on the 1889 rescue of the Comptoir d’Escompte. This commercial and investment bank had supported an effort to corner the copper market with loans and vast off-balance sheet guarantees of forward contracts. When copper prices fell, the Comptoir’s president committed suicide, prompting a run. The Banque de France provided loans of 140 million francs to meet withdrawals and, co-operating with the Minister of Finance, formed a bankers’ guarantee syndicate to absorb the first 40 million francs of losses. Contributions were assigned according to banks’ ability to pay and their role in the crisis, measured by how closely they were tied by interlocking directorships to the Comptoir. In addition, substantial fines and clawbacks were imposed on the directors and senior management. The run on the Comptoir abated and spread no further. A “good bank”, the Comptoir National d’Escompte, was recapitalized, while the Banque de France took over the liquidation of the toxic copper assets (Hautcoeur, Riva & White (2014)).
The British press had chronicled this Parisian rescue in detail; and London bankers were well-informed. But, given that policy was formulated quickly behind closed doors, histories have been silent on the importance of the French example. The key connection is found in Alphonse De Rothschild letter of November 14 (Figure 2), where he compared the two crises and declared: “La situation à l’égard de la Baring est exactement la même que celle dans laquelle se trouvait le Comptoir d’Escompte” – roughly translated, “The situation with regards to Barings is exactly the same as the one in which the Comptoir d’Escompte found itself” (Rothschild Archives, London). He then laid out the role that the House of Rothschild should play, pushing for the formation of a British guarantee syndicate, and specifying the Rothschild contribution. ...
The Barings rescue or “lifeboat” was announced on Saturday November 15, 1890. The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities. A four-year syndicate of banks would ratably share any loss from Barings’ liquidation. The guarantee fund of £17.1 million included all institutions, and some of the largest shares were assigned to banks whose inattentive lending had permitted Barings to swell its portfolio. The old firm was split into a recapitalized “good bank”, Baring Brothers & Co. Ltd., which took over the still profitable trade finance and a “bad bank” that retained its name and its toxic assets, managed by the Bank of England.
The Barings’ partners agreed to this arrangement, delivering powers-of-attorney over their property, avoiding the danger of a fire sale. But, as unlimited liability partners, they were still expected to cover any losses. The partners’ investments, country homes, town houses and their contents were to be sold with the proceeds moved to the asset side of the bad bank’s balance sheet (Figure 3). This assessment paralleled the liability imposed on the board of directors and senior management of the Comptoir. These payments covered most losses; and neither the French or British syndicates were called upon. Ultimately, the remains of the “bad” Barings bank was sold to a group of investors for £1.5 million, closing the liquidation. The heavy assessments on the Barings appear to have dampened risk-taking, as no other major bank failed before World War I and in general banks became more conservative (Baker & Collins (1990)). ...
This new research reveals that the two most important central banks of the late nineteenth century did not exclusively adhere to Bagehot’s rule. While the Bank of England and the Banque de France responded to panics by lending freely at high rates on good collateral, they also intervened to rescue deeply distressed SIFIs. Central bank cooperation to obtain liquidity and coordination with the Treasury were then critical to ensure that toxic assets were liquidated in an orderly fashion to minimize losses. Combined with penalties levied on the responsible principals, they were strikingly bold and successful rescues. While one may object that recent crises erupted because of system-wide incentives to take risk (Too Big To Fail, deposit insurance and flawed governance), these two episodes should be thought of as identifying appropriate policies to manage individual troubled SIFIs if the system-wide incentives can be brought under control.

Monday, February 08, 2016

'The Scandal is What's Legal'

Cecchetti & Schoenholtz:

The Scandal is What's Legal: If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. ...
But we’re not film critics. The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financal crisis. The financial corruption depicted in the movie is deeply troubling (we’ve written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven’t addressed these properly.
We can’t “cover” the causes of the crisis in a blog post, but we can briefly explain our top three candidates: (1) insufficient capital and liquidity reflecting poor risk management and incentives; (2) the ability of complex, highly interconnected intermediaries to take on and conceal enormous amounts of risk; and (3) an absurdly byzantine regulatory structure that made it virtually impossible for anyone, however inclined, to understand (let alone manage) the system’s fragilities. ...[long explanationss of each]...
To say that this is a scandal that makes the system less safe is to dramatically understate the case.
Now, we could go on. There are plenty of other problems that policymakers have ignored and are allowing to fester (how about the government-sponsored enterprises?). But we focused on our top three: the need for financial intermediaries to have more capital and liquid assets; the need to improve the ability of both financial market participants and authorities to assess and control risk concentrations through a combination of central clearing and better information collection; and the need to simplify the structure and organization of the U.S. regulatory system itself.
Only if people learn how far the financial system remains from these ideals, only if they understand that the scandal is almost always what is legal, will there be much chance of making the next crisis less severe. ...

Sunday, January 17, 2016

'The Price of Oil, China, and Stock Market Herding'

Olivier Blanchard:

The Price of Oil, China, and Stock Market Herding: The stock market movements of the last two weeks are puzzling.
Take the China explanation. A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. ...
Take the oil price explanation. It is even more puzzling. Traditionally, it was taken for granted that a decrease in the price of oil was good news for oil importing countries such as the United States. ... We learned in the last year that, in the short run, the adverse effect on investment on energy producing firms could come quickly and temporarily slow down the effect, but this surely does not undo the general conclusion. Yet the headlines are now about low oil prices leading to low stock prices. ...
Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy... Maybe…
I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. ...
So how much should we worry? This is where economics ... gives the dreaded two-handed answer. If it becomes clear within a few days or a few weeks that fundamentals are in fact not so bad, stock prices will recover... If, however, the stock market slump lasts longer or gets worse, it can become self-fulfilling. Low stock prices lasting for long lead to lower consumption, lower demand, and, potentially, to a recession. The ability of the Fed, fresh out of the zero lower bound, to counteract a slowdown in demand remains limited. One has to hope for the first scenario, but worry about the second.

Sunday, January 10, 2016

'Market Bubbles: What Goes Up Doesn't Always Come Down'

I wonder if conditioning on the type of bubble (e.g. driven by housing) would make a difference (though not sure it would be possible to fit them into tidy categories). I guess another way to ask the question is whether the cases of a "dramatic market rise followed by an equally spectacular fall" have anything in common:

Market Bubbles: What Goes Up Doesn't Always Come Down, by Matt Nesvisky, NBER Digest: The great majority of booms during which market values doubled in a single year were not followed by crashes wiping out those gains.

Do market booms inevitably result in busts? History suggests not, according to William N. Goetzmann in Bubble Investing: Learning from History (NBER Working Paper No. 21693).
A dramatic market rise followed by an equally spectacular fall, such as a doubling in prices that is followed by a halving in value, is often regarded as a bubble followed by a bust. Seeking out such events, Goetzmann analyzes returns for 42 stock markets around the world from 1900 through 2014. He finds that bubble-and-bust episodes are uncommon, and urges caution in drawing conclusions from the widely-reported and discussed great bubbles of history.
Conditional upon a market boom amounting to a stock price increase of 100 percent or more in a three-year period, crashes gave back prior gains only 10 percent of the time. Market prices were more likely to double again following a 100 percent price boom. The frequency of a market crash over a five-year period is significantly higher when that market has just experienced a boom, but the frequency of doubling over the next five years is not much affected by whether a market has recently boomed. Thus a boom does raise the probability of a crash, but the probability of a crash remains low. Probabilities of a crash following a boom in which prices doubled in a single calendar year were also higher, however the great majority of such extreme events were not followed by crashes that wiped out those gains.
Goetzmann suggests that his findings are relevant for regulators who are considering the desirability of deflating bubbles. If bubbles are often associated with investment in promising, albeit risky, new technologies, then when considering policies that may deflate them, policy-makers may face a trade­off between staving off a financial crisis and encouraging fruitful investment. They may evaluate this trade-off differently if the probability of a crash following a boom is low rather than high.

Wednesday, December 16, 2015

'The Real Issue with Fannie and Freddie'

Dean Baker:

Private Profit with Public Guarantee: The Real Issue with Fannie and Freddie: The NYT had a column by Jim Parrot and Mark Zandi on reforming Fannie Mae and Freddie Mac. ... The article argues that the problem with Fannie Mae and Freddie Mac was that they were considered too big to fail. It therefore puts forward the case for ending their monopoly on issuing government guaranteed mortgage-backed securities (MBS).
This argument seriously misrepresents the issues with Fannie Mae and Freddie Mac. The real problem was that they issued trillions of dollars in MBS that were implicitly backed up by the government. At the time they failed in the summer of 2008, the generally held view in financial circles was that the government would be obligated to honor their MBS regardless of whether or not it kept Fannie Mae and Freddie Mac in business. ...
This was a direct result of the perverse incentives created by a system where private shareholders and top executives stood to profit by passing risk off to the government. This incentive does not exist today. ... As long as Fannie and Freddie are essentially public companies, that do not offer high returns to shareholders and pay outlandish salaries to CEOs, no one has incentive to take excessive risks.
This changes if we allow private banks to issue mortgage backed securities with the guarantee of the government. This would mean that Goldman Sachs, Citigroup and the rest would be able to issue the same sort of subprime MBS they did in the bubble years with assurance that even in a worst case scenario the government would reimbursement investors for almost the full value of their investment. This is a great recipe for pumping up financial sector profits and another housing bubble. It does not make sense as public policy.

Monday, December 07, 2015

Hillary Clinton: How I’d Rein In Wall Street

Hillary Clinton's plan for Wall Street:

Hillary Clinton: How I’d Rein In Wall Street: Seven years ago, the financial crisis sent our economy into a tailspin. ...
Under President Obama, our economy has come a long way back. ... And we have tough new rules on the books, including the Dodd-Frank Act, that protect consumers and curb recklessness on Wall Street.
But not everyone sees that as a good thing. Republicans, both in Congress and on the campaign trail, are dead-set on rolling back critical financial protections. ...
President Obama and congressional Democrats should do everything they can to stop these efforts. But it’s not enough simply to protect the progress we have made. As president, I would not only veto any legislation that would weaken financial reform, but I would also fight for tough new rules, stronger enforcement and more accountability that go well beyond Dodd-Frank. ...

Thursday, December 03, 2015

'Fed Emergency Lending'

Ben Bernanke:

Fed emergency lending: Earlier this week, the Federal Reserve’s Board of Governors approved a rule implementing restrictions on its emergency lending powers that were mandated by Congress in the 2010 Dodd-Frank Act. On the whole, the rule is a sensible compromise which clarifies the procedures for Fed lending in a panic while responding to critics’ concerns. ... Going forward, however, we should be wary of any further changes that might have the effect of deterring financial firms from borrowing from the Fed during a financial panic. ...

In a financial panic, providers of short-term funding to financial institutions refuse to renew their lending, out of fear that an institution might fail. ... When banks or other financial firms cannot obtain funding, they ... stop extending credit to households and businesses, which can bring the economy to a halt.

The most important tool that central banks (like the Fed) have for fighting financial panics is their ability to serve as a lender of last resort... Crucially, the Fed retains the authority to lend freely in a panic. ...

My biggest concern about the collective impact of the reforms is related to what economists call the stigma of borrowing from the central bank. For lender-of-last resort policies to work, financial institutions have to be willing to avail themselves of the central bank’s loans. If they fear that by doing so that they will be identified by the marketplace as weak, and thus subject to even more pressure from creditors and counterparties, then they will see borrowing from the Fed as counterproductive and will stay away. This is the stigma problem... Deprived of access to funding, financial firms will instead hoard cash, dump assets, cut credit, and call in loans, with bad effects on the whole economy.

We faced a serious stigma problem during the recent crisis, and, collectively, the reforms to the Fed’s lending authorities have probably made the problem worse. An example is the effect of new reporting requirements. Dodd-Frank requires that the identities of all borrowers (including non-emergency borrowers through the discount window) be disclosed... These provisions serve the important purposes of advancing transparency, accountability, and democratic legitimacy, and I am not advocating that they be changed. But we should be aware that, by increasing the risk of early disclosure of borrowers’ identities, these requirements will probably reduce the willingness of firms to borrow from the Fed in a panic... 

I don’t see an easy remedy for this problem. As is often the case, policymakers must trade off competing goals. However, in contemplating possible future changes to the Fed’s authorities, we should be very careful to avoid anything that might worsen further the stigma problem...

Monday, November 30, 2015

'The Euro Debate and the Abuse of Language'

Colm McCarthy writing at The Irish Economy blog:

The Euro Debate and the Abuse of Language: Defenders of the Eurozone’s initial design, subsequent management and purported reform invariably refer to the system as a ‘monetary union’. So do academic commentators including the authors of the recent Vox piece on the origins of the crisis. Whether intended or unconscious, this is an abuse of language.
Monetary unions do not experience selective bank closures, the re-introduction of exchange controls or the numerous other manifestations of financial fragmentation that have occurred before and after the Eurozone ‘reforms’. Germany is a monetary union. In 1974 the Herstatt Bank collapsed in Cologne and several banks based in Dusseldorf went down in the recent crisis. Both cities are in Nordrhein Westfalen, but there was no closure of bank branches in the state nor were exchange controls introduced by the state authorities on either occasion. Interest rates in Nordrhein Westfalen did not detach from rates elsewhere in Germany nor did bank deposits flee the state.
When the Continental Illinois Bank went under in 1984, at the time the largest-ever US bank failure, the state of Illinois was not expected to handle the fall-out. ... The USA is also a monetary union and there is federal responsibility for bank supervision, bank resolution and the protection of bank creditors.
The Eurozone in contrast was established in 1999 as no more than a common currency area, with a ‘central bank’ responsible only for monetary policy in the aggregate, in pursuit of an inflation target. To describe it as a ‘monetary union’ is to deny that there is any distinction between a common currency area and a monetary union. If the Eurozone really was a monetary union in 2008 the history of the crisis would have been very different.
Language matters. ... The danger is that relentless description of the Eurozone as a monetary union deflects attention from the awkward truth that it is not, and from the political unwillingness to make it so.

Friday, October 16, 2015

Paul Krugman: Democrats, Republicans and Wall Street Tycoons

Financial tycoons broke up with Democrats. Now they ♥ Republicans (or maybe they are just using them with their money):

Democrats, Republicans and Wall Street Tycoons, by Paul Krugman, Commentary, NY Times: Hillary Clinton and Bernie Sanders had an argument about financial regulation during Tuesday’s debate — but it wasn’t about whether to crack down on banks. Instead, it was about whose plan was tougher. The contrast with Republicans like Jeb Bush or Marco Rubio, who have pledged to reverse even the moderate financial reforms enacted in 2010, couldn’t be stronger.
For what it’s worth, Mrs. Clinton had the better case. ... But is Mrs. Clinton’s promise to take a tough line on the financial industry credible? Or would she ... return to the finance-friendly, deregulatory policies of the 1990s? ...
To understand the politics of financial reform and regulation, we have to start by acknowledging that there was a time when Wall Street and Democrats got on just fine. Robert Rubin of Goldman Sachs became Bill Clinton’s most influential economic official; big banks had plenty of political access; and the industry by and large got what it wanted, including repeal of Glass-Steagall.
This cozy relationship was reflected in campaign contributions, with the securities industry splitting its donations more or less evenly between the parties, and hedge funds actually leaning Democratic.
But then came the financial crisis of 2008, and everything changed.
Many liberals feel that the Obama administration was far too lenient on the financial industry in the aftermath of the crisis. ... But the financiers didn’t feel grateful for getting off so lightly. ... Financial tycoons loom large among the tiny group of wealthy families that is dominating campaign finance this election cycle — a group that overwhelmingly supports Republicans. Hedge funds used to give the majority of their contributions to Democrats, but since 2010 they have flipped almost totally to the G.O.P. ... Wall Street insiders take Democratic pledges to crack down on bankers’ excesses seriously. And it also means that a victorious Democrat wouldn’t owe much to the financial industry.
If a Democrat does win, does it matter much which one it is? Probably not. Any Democrat is likely to retain the financial reforms of 2010, and seek to stiffen them where possible. But major new reforms will be blocked until and unless Democrats regain control of both houses of Congress, which isn’t likely to happen for a long time.
In other words, while there are some differences in financial policy between Mrs. Clinton and Mr. Sanders, as a practical matter they’re trivial compared with the yawning gulf with Republicans.

Thursday, October 08, 2015

'The China Debt Fizzle'

Here at the University of Oregon, one of our specialties is developing models where agents in the macroeconomy don't have rational expectations, instead they learn about the economy over time. Of course, these models need to be taken to the data to see if people do actually learn in the way the models predict. But if the data sets contain too many "Very Serious People", the tests will surely fail. They learn nothing from experience:

The China Debt Fizzle, by Paul Krugman: Remember the dire threat posed by our financial dependence on China? A few years ago it was all over the media, generally stated not as a hypothesis but as a fact. Obviously, terrible things would happen if China stopped buying our debt, or worse yet, started to sell off its holdings. Interest rates would soar and the U.S economy would plunge, right? Indeed, that great monetary expert Admiral Mullen was widely quoted as declaring that debt was our biggest security threat. Anyone who suggested that we didn’t actually need to worry about a China selloff was considered weird and irresponsible.
Well, don’t tell anyone, but the much-feared event is happening now. As China tries to prop up the yuan in the face of capital flight, it’s selling lots of U.S. debt; so are other emerging markets. And the effect on U.S. interest rates so far has been … nothing.
Who could have predicted such a thing? Well,... anyone who seriously thought through the economics of the situation ... quickly realized that the whole China-debt scare story was nonsense. But as I said, this wasn’t even reported as a debate; the threat of Chinese debt holdings was reported as fact.
And of course those who got this completely wrong have learned nothing from the experience.

Monday, October 05, 2015

Ben Bernanke: Execs Should Have Gone to Jail

From an interview in USA Today:

The decision about whether to prosecute individuals wasn't up to him, [Bernanke] says. "The Fed is not a law-enforcement agency," he says. "The Department of Justice and others are responsible for that, and a lot of their efforts have been to indict or threaten to indict financial firms. Now a financial firm is of course a legal fiction; it's not a person. You can't put a financial firm in jail."

From another report:

Asked if someone should have gone to jail, he replied, "Yeah, I think so."

There's a video of the interview at the first link.

Sunday, September 27, 2015

Bank Panics and the Next 30 Years

The end of an essay by David Warsh:

... Many regulators and bankers contend that the thousand-page Dodd Frank Act complicated the task of a future panic rescue by compromising the independence of the Fed. Next time the Treasury Secretary will be required to sign off on emergency lending.
Bank Regulators?  Some economists, including Gorton, worry that by focusing on its new “liquidity coverage ratio” the Bank for International Settlements, by now the chief regulator of global banking, will have rendered the international system more fragile rather than less by immobilizing collateral.
Bankers?  You know that the young ones among them are already looking for the Next New Thing.
Meanwhile, critics left and right in the US Congress are seeking legislation that would curb the power of the Fed to respond to future crises.
So there is plenty to worry about in the years ahead. Based on the experience of 2008, when a disastrous meltdown was avoided, there is also reason to hope that central bankers will once again cope. Remember, though, as the Duke of Wellington said of the Battle of Waterloo, it was a close-run thing.

Update: See Brad Delong's reply.

Saturday, September 26, 2015

''A Few Less Obvious Answers'' on What is Wrong with Macroeconomics

From an interview with Olivier Blanchard:

...IMF Survey: In pushing the envelope, you also hosted three major Rethinking Macroeconomics conferences. What were the key insights and what are the key concerns on the macroeconomic front? 
Blanchard: Let me start with the obvious answer: That mainstream macroeconomics had taken the financial system for granted. The typical macro treatment of finance was a set of arbitrage equations, under the assumption that we did not need to look at who was doing what on Wall Street. That turned out to be badly wrong.
But let me give you a few less obvious answers:
The financial crisis raises a potentially existential crisis for macroeconomics. Practical macro is based on the assumption that there are fairly stable aggregate relations, so we do not need to keep track of each individual, firm, or financial institution—that we do not need to understand the details of the micro plumbing. We have learned that the plumbing, especially the financial plumbing, matters: the same aggregates can hide serious macro problems. How do we do macro then?
As a result of the crisis, a hundred intellectual flowers are blooming. Some are very old flowers: Hyman Minsky’s financial instability hypothesis. Kaldorian models of growth and inequality. Some propositions that would have been considered anathema in the past are being proposed by "serious" economists: For example, monetary financing of the fiscal deficit. Some fundamental assumptions are being challenged, for example the clean separation between cycles and trends: Hysteresis is making a comeback. Some of the econometric tools, based on a vision of the world as being stationary around a trend, are being challenged. This is all for the best.
Finally, there is a clear swing of the pendulum away from markets towards government intervention, be it macro prudential tools, capital controls, etc. Most macroeconomists are now solidly in a second best world. But this shift is happening with a twist—that is, with much skepticism about the efficiency of government intervention. ...

Monday, September 21, 2015

'Virtual Frenzies: Bitcoin and the Block Chain '

For the bitcoin/blockchain enthusiasts, this is from Cecchetti & Schoenholtz:

Virtual Frenzies: Bitcoin and the Block Chain: Bitcoin has prompted many people to expect a revolution in the means by which we make and settle everyday payments. Our view is that Bitcoin and other “virtual currency schemes” (VCS) lack critical features of money, so their use is likely to remain very limited.
In contrast, the technology used to record Bitcoin ownership and transactions – the block chain – has potentially broad applications in supporting payments in any currency. The block chain can be thought of as an ever-growing public ledger of transactions that is encrypted and distributed over a network of computers. Even as the Bitcoin frenzy subsides, the block chain has attracted attention from bank and nonbank intermediaries looking for ways to economize on payments costs. Only extensive experimentation will determine whether there are large benefits.
Again, however, we are somewhat skeptical. Today’s wholesale payments systems are so efficient that it is hard to see how or why one would make the costly and time-consuming effort to replace them. And the apparently high costs of retail transfers at least partly reflect factors that the block chain technology is unlikely to address. ...

After much discussion of these and other points:

So, what’s the bottom line? We share with Bitcoin advocates the desire to protect privacy (see, our post on paper money), but remain skeptical about the potential for any private currency – digital or otherwise – to do the job better than what we currently use. And the evidence so far is that government fiat monies – dollar, euro, yen, or whatever – are far more stable than Bitcoin. Not only that, but if there’s to be profit from issuing a currency, then we believe that it is the public that should benefit.
As for the block chain, there’s plenty of room for experimentation – with the potentially greatest benefits coming where the current payments system is the least developed. But it remains to be seen whether the public ledger can compete against the big clearinghouses that dominate wholesale payments and settlement, and whether it can ensure payments providers have the ability to reliably filter out illegitimate transactions.
Of course, even a big clearinghouse might find the block chain technology useful (see WSJ-gated story here). Wouldn’t it be ironic if it did so, but wished to keep the innovation private?

Wednesday, September 16, 2015

Lessons from the 'Great Crisis'

The Gloomy European Economist, Francesco Sarsceno, says before complaining about US policy, take a look at Europe:

Lessons from Lehman: Jared Bernstein has a very interesting piece on the lessons we (did not) learn from the great crisis. He basically makes two points:
First, the attitude towards lenders, while somewhat schizophrenic (Bear Sterns, up; Lehman, down. Why? We still don’t know), was forgiving to say the least. in his words, ” Borrowers get austerity, joblessness, and poverty. Lenders get bailouts when credit is scarce and bribes not to lend when it’s too plentiful”. He then argues that both letting lenders fail and bailing them out has large costs, that should be avoided ex ante through better regulation (and we are not there, yet).
Bernstein is perfectly right, but he neglects mentioning a third option, that was advocated at the time, for example by Joe Stiglitz: temporary bank nationalization. ... Temporary nationalization ... would have avoided the “Heads I win Tail you lose” feature of financial sector bailouts.
The second point Bernstein makes is that regardless of the strategy chosen to save the financial sector, fiscal policy should have been much more aggressive in fighting the downturn. ...
Well, he says it all. What drives me nuts, is that the he complains about the US, THE US, where the Fed showed incredible activism, where the Obama administration voted and implemented a huge stimulus package (the American Recovery and Reinvestment Act) just weeks after been sworn in office, while it took us 7 years, to decide to adopt a cumbersome investment plan that will make little or no difference.
Without even mentioning the fact that the whole Greek crisis, since 2010, has been managed with an eye to (mostly German and French) lenders’ needs, rather than to the well-being of European (and in particular Greek) taxpayers.
I really would like to know what would Bernstein say, were he to comment the EMU lessons from the crisis…

Wednesday, September 02, 2015

'The Evolution of Scale Economies in U.S. Banking'

This is a question I have wanted to see an answer to for a long time. What is the minimum efficient scale for financial institutions? This is an important question with respect to breaking up large banks into smaller entities. Some have argued, based on very little compelling evidence as far as I can tell, that breaking up big banks would be costly because large banks are able to exploit economies of scale. Others disagree, but again evidence for either point of view is unclear. I don't mean there is no evidence at all, the existing research is described in the introduction to this paper, but the results do not point strongly in any particular direction. Hopefully, more work on the topic will shift the weight of the evidence in one direction or another:

The Evolution of Scale Economies in U.S. Banking, by David C. Wheelock and Paul W. Wilson, August 2015: Abstract Continued consolidation of the U.S. banking industry and general increase in the size of banks has prompted some policymakers to consider policies to discourage banks from getting larger, including explicit caps on bank size. However, limits on the size of banks could entail economic costs if they prevent banks from achieving economies of scale. The extent of scale economies in banking remains unclear. This paper presents new estimates of returns to scale for U.S. commercial banks based on nonparametric, local-linear estimation of bank cost, revenue and pro t functions. We present estimates for both 2006 and 2012 to compare the extent of scale economies in banking some four years after the financial crisis and two years after enactment of the Dodd-Frank Act with scale economies prior to the crisis. We find that most banks faced increasing returns to scale in cost in both years, though results for the very largest banks in 2012 are somewhat sensitive to specification. Further, most banks faced decreasing returns in revenue in both years, though nearly all banks could still increase revenue and pro t by becoming larger.

[As I've written many, many times, I do not think that breaking up big banks will do a lot to reduce our susceptibility to bank crises. After all, we had a financial crisis about every 20 years in the 1800s, and this continued through the Great Depression, and at that time banks were relatively small. Thus, it seems that crises have more to do with the diversity of activity and connectedness than bank size. I favor breaking up the biggest banks to reduce their political power, which I believe is excessive, and to reduce their economic power. If the above results had shown that the minimum efficient scale was much smaller than the typical large, systemically important bank, breaking them up would be an easy call. But that's not what the results imply. Thus, in this case, there is a tradeoff between the benefit or reducing political and economic power versus losing economies of scale (not sure how steep the cost function is at the existing size -- if it's relatively flat the loss of scale economies could be small). The other alternative is to treat them along the lines of a public utility. We allow them to be large to exploit scale economies, then regulate pricing and other behavior. However, this is where the political power of the large banks matters, and it's not clear that a policy of "large but with regulatory oversight" is the best option to pursue.]

'QE and Financial Interests'

Simon Wren-Lewis says:

Corbyn, QE and financial interests: ... I want to talk about Quantitative Easing (QE). The basic idea behind QE is that by buying long term assets at a time when their price is high (interest rates are low) to make their price even higher (interest rates even lower) in the short term, and selling them back later when asset prices are lower (and interest rates higher), you could stimulate additional demand. At first sight it seems not too dissimilar to a central bank’s normal activities in changing short rates. There are however two major differences....

After discussing the differences, and some of the problems with QE, he continues with:

That should mean that everyone is looking around for a better way of doing things when short rates hit their lower bound. Fiscal stimulus is the obvious candidate, but we know the political problems there. ...
In the absence of an appropriate government fiscal policy, I find the logic for helicopter money compelling and the arguments against it pretty weak. But just as with fiscal policy, just because something makes good macroeconomic sense does not mean it will happen. I have always been reluctant to pay too much attention to the distributional impact of monetary policy, because it seemed like one of those occasions when even well meaning attention to distribution can mess up good policy. Yet in terms of the political economy of replacing QE, perhaps we should.
It is more likely than not that QE will lead to central bank losses. ... After all, they are buying high, and selling low. That is integral to the policy. Who gains from these losses. Where does the money permanently created because of these losses go? To the financial sector, and the owners of financial assets (who are selling to the central bank high, and buying back low). In that sense, likely losses on QE will involve a transfer from the public to the financial sector.
If QE was the only means of stabilizing the economy in a liquidity trap, because fiscal policy was out of bounds for political reasons, then so be it. The social benefits would far outweigh any distributional costs, even if the latter could not be undone elsewhere. But if QE is a highly ineffective instrument, and there are better instruments available, you have to ask in whose interest is it that we stick with QE?

Tuesday, September 01, 2015

'Leveraged Bubbles'

The conclusion to "Leveraged bubbles," by Òscar Jordà, Moritz Schularick, and Alan Taylor:

... In this column, we turned to economic history for the first comprehensive assessment of the economic risks of asset price bubbles. We provide evidence about which types of bubbles matter and how their economic costs differ. Our historical analysis shows that not all bubbles are created equal. When credit growth fuels asset price bubbles, the dangers for the financial sector and the real economy are much more substantial. The damage done to the economy by the bursting of credit boom bubbles is significant and long lasting.
In the past decades, central banks typically have taken a hands-off approach to asset price bubbles and credit booms. This way of thinking has been criticised by some institutions, such as the BIS, that took a less rosy view of the self-equilibrating tendencies of financial markets and warned of the potentially grave consequences of leveraged asset price bubbles. The findings presented here can inform ongoing efforts to devise better macro-financial theory and real-world applications at a time when policymakers are still searching for new approaches in the aftermath of the Great Recession.

Friday, August 28, 2015

Paul Krugman: Crash-Test Dummies as Republican Candidates for President

It's a good thing Republicans, at least in theory, take a hands off approach when it comes to the economy (they actually don't, but let's pretend) because they "haven't a clue":

Crash-Test Dummies as Republican Candidates for President, by Paul Krugman, Commentary, NY Times: Will China’s stock crash trigger another global financial crisis? Probably not. Still,... this is a test:  How would the men and women who would be president respond if crisis struck on their watch?
And the answer, on the Republican side at least, seems to be: with bluster and China-bashing. Nowhere is there a hint that any of the G.O.P. candidates understand the problem, or the steps that might be needed if the world economy hits another pothole.
Take, for example, Scott Walker... So what was his suggestion to President Obama? Why, cancel the planned visit to America by Xi Jinping, China’s leader. That would fix things!
Then there’s Donald Trump,... he simply declared that U.S. markets seem troubled because Mr. Obama has let China “dictate the agenda.” What does that mean? I haven’t a clue — but neither does he.
 ...According to Mr. Christie, the reason U.S. markets were roiled ... was U.S. budget deficits, which he claims have put us in debt to the Chinese and hence made us vulnerable to their troubles. ... Did the U.S. market plunge because Chinese investors were cutting off credit? Well, no. ...
In fact, talking nonsense about economic crises is essentially a job requirement for anyone hoping to get the Republican presidential nomination.
To understand why, you need to go back to the politics of 2009, when the new Obama administration was trying to cope with the most terrifying crisis since the 1930s. ...Republicans, across the board, predicted disaster. ...
None of it happened. ... Instead, the party’s leading figures kept talking, year after year, as if the disasters they had predicted were actually happening.
Now we’ve had a reminder that something like that last crisis could happen again — which means that we might need a repeat of the policies that helped limit the damage last time. But no Republican dares suggest such a thing.
Instead, even the supposedly sensible candidates call for destructive policies. Thus John Kasich is being portrayed as a different kind of Republican because as governor he approved Medicaid expansion in Ohio, but his signature initiative is a call for a balanced-budget amendment, which would cripple policy in a crisis.
The point is that one side of the political aisle has been utterly determined to learn nothing from the economic experiences of recent years. If one of these candidates ends up in the hot seat the next time crisis strikes, we should be very, very afraid.

Thursday, August 27, 2015

Shiller: Rising Anxiety That Stocks Are Overpriced

Robert Shiller (a reason to agree with Tim Duy):

Rising Anxiety That Stocks Are Overpriced: Over the five trading days between Aug. 17 and Aug. 24, the U.S. stock market dropped 10 percent — the official definition of a “correction,” with similar or greater drops in other countries. ...
But there are reasons to question whether this was a quick, effective slap on the wrist, or if the market is still too overactive, and thus asking for a more extended punishment. ...
It is entirely plausible that the shaking of investor complacency in recent days will, despite intermittent rebounds, take the market down significantly and within a year or two restore CAPE ratios to historical averages. This would put the S. & P. closer to 1,300 from around 1,900 on Wednesday, and the Dow at 11,000 from around 16,000. They could also fall further; the historical average is not a floor.
Or maybe this could be another 1998. We have no statistical proof. We are in a rare and anxious “just don’t know” situation, where the stock market is inherently risky because of unstable investor psychology.

Monday, August 24, 2015

Paul Krugman: A Moveable Glut

 What' causing so much instability in the world economy?

A Moveable Glut, by Paul Krugman, Commentary, NY Times: What caused Friday’s stock plunge? What does it mean for the future? Nobody knows, and not much. ...
Still, investors are clearly jittery..., the world as a whole still seems remarkably accident-prone. ... But why does the world economy keep stumbling? ...
More than a decade ago, Ben Bernanke famously argued that a ballooning U.S. trade deficit was the result, not of domestic factors, but of a “global saving glut”: a huge excess of savings over investment in China and other developing nations... He worried a bit about the fact that the inflow of capital was being channeled, not into business investment, but into housing; obviously he should have worried much more. ...
Of course, the boom became a bubble, which inflicted immense damage when it burst. Furthermore, that wasn’t the end of the story. There was also a flood of capital from Germany and other northern European countries to Spain, Portugal, and Greece. This too turned out to be a bubble, and the bursting of that bubble in 2009-2010 precipitated the euro crisis.
And still the story wasn’t over. With America and Europe no longer attractive destinations, the global glut went looking for new bubbles to inflate. It found them in emerging markets... It couldn’t last, and now we’re in the middle of an emerging-market crisis...
So where does the moving finger of glut go now? Why, back to America, where a fresh inflow of foreign funds has driven the dollar way up, threatening to make our industry uncompetitive again
What’s ... important now is that policy makers take seriously the possibility, I’d say probability, that excess savings and persistent global weakness is the new normal.
My sense is that there’s a deep-seated unwillingness, even among sophisticated officials, to accept this reality. Partly this is about special interests: Wall Street doesn’t want to hear that an unstable world requires strong financial regulation, and politicians who want to kill the welfare state don’t want to hear that government spending and debt aren’t problems in the current environment.
But there’s also, I believe, a sort of emotional prejudice against the very notion of global glut. Politicians and technocrats alike want to view themselves as serious people making hard choices — choices like cutting popular programs and raising interest rates. They don’t like being told that we’re in a world where seemingly tough-minded policies will actually make things worse. But we are, and they will.

Sunday, August 16, 2015

'The U.S. Foreclosure Crisis Was Not Just a Subprime Event'

From the NBER Digest:

The U.S. Foreclosure Crisis Was Not Just a Subprime Event, by Les Picker, NBER: Many studies of the housing market collapse of the last decade, and the associated sharp rise in defaults and foreclosures, focus on the role of the subprime mortgage sector. Yet subprime loans comprise a relatively small share of the U.S. housing market, usually about 15 percent and never more than 21 percent. Many studies also focus on the period leading up to 2008, even though most foreclosures occurred subsequently. In "A New Look at the U.S. Foreclosure Crisis: Panel Data Evidence of Prime and Subprime Borrowers from 1997 to 2012" (NBER Working Paper No. 21261), Fernando Ferreira and Joseph Gyourko provide new facts about the foreclosure crisis and investigate various explanations of why homeowners lost their homes during the housing bust. They employ microdata that track outcomes well past the beginning of the crisis and cover all types of house purchase financing—prime and subprime mortgages, Federal Housing Administration (FHA)/Veterans Administration (VA)-insured loans, loans from small or infrequent lenders, and all-cash buyers. Their data contain information on over 33 million unique ownership sequences in just over 19 million distinct owner-occupied housing units from 1997-2012.


The researchers find that the crisis was not solely, or even primarily, a subprime sector event. It began that way, but quickly expanded into a much broader phenomenon dominated by prime borrowers' loss of homes. There were only seven quarters, all concentrated at the beginning of the housing market bust, when more homes were lost by subprime than by prime borrowers. In this period 39,094 more subprime than prime borrowers lost their homes. This small difference was reversed by the beginning of 2009. Between 2009 and 2012, 656,003 more prime than subprime borrowers lost their homes. Twice as many prime borrowers as subprime borrowers lost their homes over the full sample period.
The authors suggest that one reason for this pattern is that the number of prime borrowers dwarfs that of subprime borrowers and the other borrower/owner categories they consider. The prime borrower share averages around 60 percent and did not decline during the housing boom. Although the subprime borrower share nearly doubled during the boom, it peaked at just over 20 percent of the market. Subprime's increasing share came at the expense of the FHA/VA-insured sector, not the prime sector.
The authors' key empirical finding is that negative equity conditions can explain virtually all of the difference in foreclosure and short sale outcomes of prime borrowers compared to all cash owners. Negative equity also accounts for approximately two-thirds of the variation in subprime borrower distress. Both are true on average, over time, and across metropolitan areas.
None of the other 'usual suspects' raised by previous research or public commentators—housing quality, race and gender demographics, buyer income, and speculator status—were found to have had a major impact. Certain loan-related attributes such as initial loan-to-value (LTV), whether a refinancing occurred or a second mortgage was taken on, and loan cohort origination quarter did have some independent influence, but much weaker than that of current LTV.
The authors' findings imply that large numbers of prime borrowers who did not start out with extremely high LTVs still lost their homes to foreclosure. They conclude that the economic cycle was more important than initial buyer, housing and mortgage conditions in explaining the foreclosure crisis. These findings suggest that effective regulation is not just a matter of restricting certain exotic subprime contracts associated with extremely high default rates.

Friday, August 14, 2015

Paul Krugman: Bungling Beijing’s Stock Markets

The Chinese leadership appears to be "imagining that it can order markets around":

Bungling Beijing’s Stock Markets, by Paul Krugman, Commentary, NY Times: ... Is it possible that after all these years Beijing still doesn’t get how this “markets” thing works?
The background: China’s economy is ... slowing as China runs out of surplus labor. ... The ... problem is how to sustain spending during the transition. And that’s where things have gotten weird.
At first, the Chinese government supported the economy in part through infrastructure spending, which is the standard remedy for economic weakness. But it also did so by funneling cheap credit to state-owned enterprises. The result was a run-up in these enterprises’ debt, which by last year was high enough to raise worries about financial stability.
Next, China adopted an official policy of boosting stock prices... But the consequence was an obvious bubble, which began deflating earlier this year.
The response of the Chinese authorities was remarkable: They pulled out all the stops to support the market — suspending trading in many stocks, banning short-selling, pushing large investors to buy, and instructing graduating economics students to chant “Revive A-shares, benefit the people.”
All of this has stabilized the market for the time being. But it is at the cost of tying China’s credibility to its ability to keep stock prices from ever falling. And the Chinese economy still needs more support.
So this week China decided to let the value of its currency decline... But Chinese authorities seem to have imagined that they could control the renminbi’s descent, taking it a couple of percent at a time.
They appear to have been taken completely by surprise by the market’s predictable reaction; namely, the initial devaluation of the renminbi was ... a sign of much bigger declines to come. Investors began fleeing China, and policy makers abruptly pivoted from promoting currency devaluation to an all-out effort to support the renminbi’s value.
The common theme in these wild policy swings is that China’s leadership keeps imagining that it can order markets around, telling them what prices to reach. ... Do the country’s leaders really not understand why that won’t work?
If they really don’t, that’s a big concern. China is an economic superpower — not quite as super as the United States or the European Union, yet, but big enough to matter a lot. And it’s facing tough times. So if its leadership is really as clueless as it has been looking lately, that bodes ill, not just for China, but for the world as a whole.

Thursday, August 13, 2015

'Do Asset Purchase Programs Push Capital Abroad?'

Thomas Klitgaard and David Lucca at the NY Fed's Liberty Street Economics"

Do Asset Purchase Programs Push Capital Abroad?: Euro area sovereign bond yields fell to record lows and the euro weakened after the European Central Bank (ECB) dramatically expanded its asset purchase program in early 2015. Some analysts predicted massive financial outflows spilling out of the euro area and affecting global markets as investors sought higher yields abroad. These arguments ignore balance of payments accounting, which requires any financial outflow from the euro area to be matched by a similar-sized inflow, absent a quick and substantial current account improvement. The focus on cross-border financial flows also is misguided since, according to asset pricing principles, the euro and global asset prices can move without any change in financial outflows. ...
The recent experience with quantitative easing in Japan helps illustrate our point. In late 2012, the yen started to depreciate with the increased likelihood that the country would expand its asset purchase program. In April 2013, when the policy was actually implemented, commentary similar to that on the ECB program anticipated a “wall of money” flowing out of Japan in search of higher yields and affecting global asset prices. Indeed, analysts worried that emerging countries would have trouble absorbing these flows, leading to asset price bubbles. While asset prices and exchange rates adjusted in Japan and abroad, a surge in outflows never occurred. ... The wall of money never materialized.
Nor does euro area data suggest substantial financial outflows. ...
The euro’s fall has been a key channel through which the ECB’s asset purchase policy has affected financial markets in the rest the world. However, the idea that foreign asset prices would be pushed up by a surge in money flowing out of the region, as some observers predicted, runs contrary to balance of payments accounting and asset pricing principles and should be discounted.

Wednesday, August 12, 2015

'The Aftermath of LIBOR and Penny-Shaving Attacks'

Tim Taylor:

The Aftermath of LIBOR and Penny-Shaving Attacks: Anyone remember the LIBOR scandal from back in spring 2008? A trader for UBS Group and Citigroup named Tom Hayes was just sentenced by a British court to 14 years imprisonment for his role as a ringleader of the scandal. Darrell Duffie and Jeremy C. Stein discuss both the scandal and--perhaps more interesting to those of us who bleed economics--the economic function of financial market benchmarks in  "Reforming LIBOR and Other Financial Market Benchmarks," in the Spring 2015 issue of the Journal of Economic Perspectives. (All JEP articles back to the first issue in 1987 are freely available online courtesy of the American Economic Association. Full disclosure: I've worked as Managing Editor of the JEP since that first issue.)

For those who have blotted the episode from their memories, LIBOR stands for London Interbank Offered Rate. It's the interest rate at which big international banks borrow overnight from each other. A main use of LIBOR in financial markets was as a "benchmark" for adjustable interest rates. For example, if you are a potential borrower or lender worried about the risk that interest rates might shift, you might be able to agree on a loan where the interest rate was, say, the LIBOR rate plus 4%. Duffie and Stein point out that using LIBOR as a benchmark interest rate for international loans dates back to 1969, when "a consortium of London-based banks led by Manufacturers Hanover introduced LIBOR in order to entice international borrowers such as the Shah of Iran to borrow from them." 

Two key details set the state for the LIBOR fraud. The first detail is that after LIBOR became well-established as a basis for interest rates on loans, the finance industry began to use LIBOR as the basis for lots of more complex financial transactions: for example, "exchange-traded eurodollar futures and options available from Chicago Mercantile Exchange Group, and over-the-counter derivatives including caps, floors, and swaptions (that is, an option to engage in a swap contract)." I won't plow through an explanation of those terms here. The key takeaway is that the benchmark LIBOR interest rate wasn't just linked to about $17 trillion in US dollar loans. It was also linked to $106 trillion in interest rate swap agreements, and tens of trillions more in interest rate options and futures, as well as cross-currency swaps. As a result, if you had some information on how LIBOR was likely to change on a day-to-day basis--even if the change was a seemingly tiny amount that didn't much matter to borrowers or lenders--you could make a substantial amount of money in these more complex financial markets. 

The second detail involves how LIBOR was actually calculated. Banks did not actually submit data on the costs of borrowing; indeed, someone at a bank responded to a survey each day with an estimate of what it would cost that bank to borrow--even though on a given day many of these banks weren't actually borrowing from other banks. In addition, during the financial crisis as it erupted in 2007 and 2008, no bank wanted to admit that it would have been charged a higher interest rate if it wanted to borrow, because financial market would be quick to infer that such bank might be in a shaky financial position. 

So on one side, LIBOR is a key financial benchmark that affects literally tens of trillions of dollars of continuously traded and complicated financial instruments.  On the other side, you have this key benchmark being determined by a survey of the opinions of fairly junior bank officers who have some incentive to shade the numbers. The British court found that Tom Hayes led a group of traders who sent messages to the bankers who responded to the LIBOR survey, requesting that the LIBOR rate be jerked a little higher one day, or pushed a little lower another day. Again, those who were just using the LIBOR rate as a benchmark for loans probably wouldn't even notice these fluctuations. But traders who knew in advance how the LIBOR was going to twitch up and down could make big money in the options and futures markets. 

What's the solution here? Duffie and Stein point out that financial benchmarks like LIBOR are extremely useful in financial markets. However, you need to design the benchmark with some care. For example, instead of using a survey of bank officers, it makes a lot more sense to use an actual market-determined interest rate for a benchmark. Moreover, the LIBOR rate is based on banks borrowing from banks, and so it will reflect risk in the banking sector. For certain kinds of lending and borrowing, it's not clear that you would want your interest rate to rise and fall with changes in the riskiness of the banking sector. Thus, they discuss the virtues of benchmark rates that are market-determined and not linked to the banking sector--like the interest rate for short-term borrowing by the US government. (They also discuss the merits of using some other less well-known  benchmark interest rates, like the Treasury general collateral repurchase rate or the  overnight index swap rate, fo those who want such details.)

More broadly, it seems to me that the LIBOR scandal is the actual real-life version of what seems to be an urban legend plot: the story of how a fraudster finds a way to program the computers of a bank or financial institution so that a tiny amount of certain transaction is siphoned off into a different account (for examples, see the 1983 movie Superman III, or the 1999 movie Office Space). The problem with these "penny-shaving" or "salami-slicing" attacks in real life is that if you steal a little bit from a large number of transactions, it's quite possible that no individual party will notice. But if you take a few million dollars out of a financial institution, the accountants are going to notice! 

In the LIBOR scandal, however, the fraud happened by knowing about tiny little changes in LIBOR a day in advance. Those who lost out from not knowing these changes in advance had no way of knowing that they were being cheated. In a similar scandal from earlier this year, Citicorp, JPMorgan, Barclays, Royal Bank of Scotland and UBS pled guilty to felony charges for their actions in foreign exchange markets. Again, these are very large markets, and so small acts of dishonesty can add up to large amounts. As the US. Department of Justice described it:

"According to plea agreements to be filed in the District of Connecticut, between December 2007 and January 2013, euro-dollar traders at Citicorp, JPMorgan, Barclays and RBS – self-described members of “The Cartel” – used an exclusive electronic chat room and coded language to manipulate benchmark exchange rates. Those rates are set through, among other ways, two major daily “fixes,” the 1:15 p.m. European Central Bank fix and the 4:00 p.m. World Markets/Reuters fix. Third parties collect trading data at these times to calculate and publish a daily “fix rate,” which in turn is used to price orders for many large customers. “The Cartel” traders coordinated their trading of U.S. dollars and euros to manipulate the benchmark rates set at the 1:15 p.m. and 4:00 p.m. fixes in an effort to increase their profits.

As detailed in the plea agreements, these traders also used their exclusive electronic chats to manipulate the euro-dollar exchange rate in other ways. Members of “The Cartel” manipulated the euro-dollar exchange rate by agreeing to withhold bids or offers for euros or dollars to avoid moving the exchange rate in a direction adverse to open positions held by co-conspirators. By agreeing not to buy or sell at certain times, the traders protected each other’s trading positions by withholding supply of or demand for currency and suppressing competition in the FX market."

A trader at Barclay's reportedly wrote in the group's electronic chat room: “If you aint cheating, you aint trying,” Clearly, situations where relatively small groups of people can cause relatively small and almost imperceptible  tweaks in values that affect a very large market are ripe for manipulation. 

Tuesday, August 04, 2015

'The US Financial Sector in the Long-Run: Where are the Economies of Scale?'

 And one more  before heading out the door. From Tim Taylor:

The US Financial Sector in the Long-Run: Where are the Economies of Scale?: A larger financial sector is clearly correlated with economic development, in the sense that high-income countries around the world have on average larger markets for banks, credit cards, stock and bond markets, and so on compared with lower-income countries. But there are also concerns that the financial sector in high-income countries can grow in ways that end up creating economic instability (as I've discussed herehere, and here). Thomas Philippon provides some basic evidence on the growth of the US financial sector over the past 130 years in "Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation," publishes in the April 2015 issue of the American Economic Review (105:4, pp. 1408–1438). The AER is not freely available online, but many readers can obtain access through a library subscription.

There are a couple of ways to think about the size of a country's financial sector relative to its economy. One can add up the size of certain financial markets--the market value of bank loans, stocks, bonds, and the like--and divide by GDP. Or one can add up the economic value added by the financial sector. For example, instead of adding up the bank loans, you add up the value of banking services provided. Similarly, instead of adding up the value of the stock market, you add up the value of the services provided by stockbrokers and investment manager.

Here's a figure from Philippon showing both measures of finance as a share of the US economy over the long run since 1886.

The orange line measured on the right axis is "intermediated assets," which measures the size of the financial sector as the sum of all debt and equity issued by nonfinancial firms, together with the sum of all household debt, and some other smaller categories. Back in the late 19th century, the US financial sector was roughly equal in size to GDP. By just before the Great Depression, it had risen to almost three times GDP, before sinking back to about 1.5 times GDP. More recently, you can see the financial sector spiking with the boom in real estate markets and stock markets in the mid-2000s at more than 4 times GDP, before dropping slightly. The overall trend is clearly up, but it's also clearly a bumpy ride.

The green line shows "finance income," which can be understood as a measure of the value added by firms in the financial sector. For the uninitiated, "value added" has a specific meaning to economists. Basically, it is calculated by taking the total revenue of a firm and subtracting the cost of all goods and services purchased from other firms--for example, subtracting costs of supplies purchased or machinery. In the figure, most of the "value-added" that measures  "finance income" includes all wages and salaries paid by a firm, along with any profits earned.

An intriguing pattern emerges here: finance income tracks intermediated assets fairly closely. In other words, the amount paid to the financial sector is more-or-less a fixed proportion of total financial assets. It's not obvious why this should be so. For example, imagine that because of a rise in housing prices, the total mortgage debt of households rises substantially over time, or because of rising stock prices over several decades, the total value of the stock market is up. Especially in an economy where information technology is making rapid strides, it's not clear why incomes in the financial sector should be rising at the same pace. Does a bank need to incur twice the costs if it issues a mortgage for $500,000 as compared to when it issues a mortgage for $250,000? Does an investment adviser need to incur twice the costs when giving advice on a retirement account of $1 million as when giving advice on a retirement account of $500,000? Shouldn't there be some economies of scale in financial services?

Philippon isn't the first to raise this question: for example, Burton Malkiel has asked why there aren't economies of scale in asset management fees here. But Philippon provides evidence that, for whatever reason, a lack of economies of scale has been widespread and long-lasting in the US financial sector.

Full disclosure: The AER is published by the American Economic Association, which is also the publisher of the Journal of Economic Perspectives, where I have worked as Managing Editor since 1986.

Monday, August 03, 2015

Paul Krugman: America’s Un-Greek Tragedies in Puerto Rico and Appalachia

Austerity for Puerto Rico would be a "terrible idea":

America’s Un-Greek Tragedies in Puerto Rico and Appalachia, by Paul Krugman, Commentary, NY Times: On Friday the government of Puerto Rico announced that it was about to miss a bond payment. It claimed that for technical legal reasons this wouldn’t be a default, but that’s a distinction without a difference.
So is Puerto Rico America’s Greece? No, it isn’t, and it’s important to understand why.
Puerto Rico’s fiscal crisis is basically the byproduct of a severe economic downturn. The commonwealth’s government was slow to adjust to the worsening fundamentals, papering over the problem with borrowing. And now it has hit the wall. ... But ... while the island’s economy has declined sharply, its population, while hurting, hasn’t suffered anything like the catastrophes we see in Europe. ... Why have the human consequences of economic troubles been muted?
The main answer is that Puerto Rico is part of the U.S. fiscal union. When its economy faltered, its payments to Washington fell, but its receipts from Washington — Social Security, Medicare, Medicaid, and more — actually rose. So Puerto Rico automatically received aid on a scale beyond anything conceivable in Europe.
Is Puerto Rico’s status as part of the U.S. all good? A recent report ... argues that its economy is hurt by sharing the U.S. minimum wage, which raises costs, and also by federal benefits that encourage adults to drop out of the work force. ...
But the evidence that minimum wages or social benefits are really a problem is, as one careful if older study put it, “surprisingly fragile.” Notably, Puerto Rico’s low rate of labor force participation probably has more to do with outmigration than with welfare: when job opportunities dry up, young, able-bodied workers move elsewhere, while the least employable stay in place. ...
There is, of course, the problem of maintaining public services for those who remain. ... What this tells us ... is that even for a part of the United States, too much austerity can be self-defeating. It would, in particular, be a terrible idea to give the hedge funds that have scooped up much of Puerto Rico’s debt what they want — basically to destroy the island’s education system in the name of fiscal responsibility.
Overall, however, the Puerto Rican story is one of bad times that fall well short of utter disaster. And the saving grace in this situation is big government — a federal system that provides a crucial safety net for American citizens in times of need, wherever they happen to live.

Saturday, August 01, 2015

'Lehman Brothers Once Again...'

Brad DeLong:

Lehman Brothers Once Again…: Ah. The debate continues:

David Zaring: Did The Fed Fail To Save Lehman Brothers Because It Legally Couldn’t?: “The Fed’s lawyers said, after the fact, that no, they didn’t have the legal power to bail out Lehman…

…Peter says yes they did, Philip says no, and I’m with Peter on this one...

I have two points to make here…

My first point is one that is obvious to an economic historian. But I do not see picked up by the lawyers. It is that central banks are government-chartered corporations rather than government agencies precisely to give them additional freedom of action. Corporations can and do do things that are ultra vires. Governments then either sanction them, or decide not to.

During British financial crises of the nineteenth century, the Bank of England repeatedly violated the terms of its 1844 charter restricting its powers to print bank notes. The Chancellor the Exchequer would then not take any steps in response to sanction it. Such a policy–of writing a charter for the central bank with the expectation that in an emergency the Bank would do whatever was needed to stabilize the economy in spite of the limitations placed on it by its charter, was clearly envisioned by the author of the 1844 charter, then Prime Minister Robert Peel, who expected to see the Governor of the Bank of England take responsibility for doing what was needed...

Peel saw a choice: either (i) give the Bank of England explicit powers (and so run the risk that financiers, expecting that those powers would be used, would exploit moral hazard and so produce irrational exuberance, extravagant overleverage, and repeated frequent financial crises), or (ii) forbid the Bank of England from acting and rely on financial statesmen in the future to take actions ultra vires under the principle that in the end salus populi suprema lex. Peel chose (ii). To him and his peers, the risks that granting explicit powers would enable moral hazard appeared greater than the risks that when a crisis should come the makers of monetary policy would not understand their proper role. And the Federal Reserve banks have inherited their non-agency but corporation legal structure from the Bank of England.

My second point is that Bernanke, Geithner, and their company at the head of the Federal Reserve in 2008 really, really, really want their decision not to have rescued Lehman in the fall of 2008 to have been a judgment call that went wrong.

They really do not want to have let a situation develop in which there is a systemically-important financial institution that they cannot support. Should any systemically-important financial institution ever approach a state in which the central bank could not support it in an emergency, the most elementary principles of central banking command that such an institution be resolved or shut down immediately.

To fail to do so is complete and total central banking malpractice.

Friday, July 31, 2015

Paul Krugman: China’s Naked Emperors

What can we learn from the response of the Chinese government to the problems in China's stock market?:

China’s Naked Emperors, by Paul Krugman, Commentary, NY Times: ... We’ve seen ... strange goings-on in China’s stock market. In and of itself, the price of Chinese equities shouldn’t matter all that much. But the authorities have chosen to put their credibility on the line by trying to control that market — and are in the process of demonstrating that, China’s remarkable success over the past 25 years notwithstanding, the nation’s rulers have no idea what they’re doing. ...
China is at the end of an era — the era of superfast growth... Meanwhile, China’s leaders appear to be terrified — probably for political reasons — by the prospect of even a brief recession. ... China’s response has been an all-out effort to prop up stock prices. Large shareholders have been blocked from selling; state-run institutions have been told to buy shares; many companies with falling prices have been allowed to suspend trading. ...
What do Chinese authorities think they’re doing?
In part, they may be worried about financial fallout. It seems that a number of players in China borrowed large sums with stocks as security, so that the market’s plunge could lead to defaults. This is especially troubling because China has a huge “shadow banking” sector that is essentially unregulated and could easily experience a wave of bank runs.
But it also looks as if the Chinese government, having encouraged citizens to buy stocks, now feels that it must defend stock prices to preserve its reputation. And what it’s ending up doing, of course, is shredding that reputation at record speed.
Indeed, every time you think the authorities have done everything possible to destroy their credibility, they top themselves. Lately state-run media have been assigning blame for the stock plunge to, you guessed it, a foreign conspiracy against China, which is even less plausible than you may think: China has long maintained controls that effectively shut foreigners out of its stock market, and it’s hard to sell off assets you were never allowed to own in the first place.
So what have we just learned? China’s incredible growth wasn’t a mirage, and its economy remains a productive powerhouse. The problems of transition to lower growth are obviously major, but we’ve known that for a while. The big news here isn’t about the Chinese economy; it’s about China’s leaders. Forget everything you’ve heard about their brilliance and foresightedness. Judging by their current flailing, they have no clue what they’re doing.

Wednesday, July 29, 2015

'Using Math to Obfuscate — Observations from Finance

More from Paul Romer on "mathiness" -- this time the use of math in finance to obfuscate communication with regulators:

Using Math to Obfuscate — Observations from Finance: The usual narrative suggests that the new mathematical tools of modern finance were like the wings that Daedalus gave Icarus. The people who put these tools to work soared too high and crashed.
In two posts, here and here, Tim Johnson notes that two government investigations (one in the UK, the other in the US) tell a different tale. People in finance used math to hide what they were doing.
One of the premises I used to take for granted was that an argument presented using math would be more precise than the corresponding argument presented using words. Under this model, words from natural language are more flexible than math. They let us refer to concepts we do not yet fully understand. They are like rough prototypes. Then as our understanding grows, we use math to give words more precise definitions and meanings. ...
I assumed that because I was trying to use math to reason more precisely and to communicate more clearly, everyone would use it the same way. I knew that math, like words, could be used to confuse a reader, but I assumed that all of us who used math operated in a reputational equilibrium where obfuscating would be costly. I expected that in this equilibrium, we would see only the use of math to clarify and lend precision.
Unfortunately, I was wrong even about the equilibrium in the academic world, where mathiness is in fact used to obfuscate. In the world of for-profit finance, the return to obfuscation in communication with regulators is much higher, so there is every reason to expect that mathiness would be used liberally, particularly in mandated disclosures. ...
We should expect that there will be mistakes in math, just as there are mistakes in computer code. We should also expect some inaccuracies in the verbal claims about what the math says. A small number of errors of either type should not be a cause for alarm, particularly if the math is presented transparently so that readers can check the math itself and check whether it aligns with the words. In contrast, either opaque math or ambiguous verbal statements about the math should be grounds for suspicion. ...
Mathiness–exposition characterized by a systematic divergence between what the words say and what the math implies–should be rejected outright.

'Spare Tire? Stock Markets, Banking Crises, and Economic Recoveries'

From Ross Levine, Chen Lin, and Wensi Xie at Vox EU:

Spare tire? Stock markets, banking crises, and economic recoveries: Do stock markets act as a ‘spare tire’ during banking crises, providing an alternative corporate financing channel and mitigating the economic severity of crises when the banking system goes flat?

In 1999, Alan Greenspan, then Chairman of the Federal Reserve System, argued that stock markets could mitigate the negative effects of banking crises, including more fragile businesses and greater unemployment. Using the analogy of a spare tire, he conjectured that banking crises in Japan and East Asia would have been less severe if those countries had built the necessary legal infrastructure so that their stock markets could have provided financing to corporations when their banking systems could not. If firms can substitute equity issuances for bank loans during banking crises, then banking crises will have less harmful effects on the public.

But researchers have not evaluated the spare tire view. Although official entities and others discuss the spare tire argument (e.g. US Financial Crisis Inquiry Commission 2011, Wessel 2009), we are unaware of systematic assessments of the testable implications emerging from Greenspan’s view of how financial markets can ease the effects of systemic banking failures.

In a recent paper, we provide the first assessment of the spare tire view... The findings are consistent with the three predictions of the spare tire view. ... The estimated economic effects are large...

Tuesday, July 21, 2015

Financial Regulation: Which Reform Strategy is Best?

Today is the 5th anniversary of the Dodd-Frank financial reform bill. When the bill was being debated, I was torn on which strategy is best, to strike while the iron is hot -- to implement financial reform legislation as soon as possible -- or to take a patient approach that allows careful consideration and study of proposed regulatory changes:

Kashyap and Mishkin ... may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians. By the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

More and more, I think doing what you can while passions are inflamed, and then defending the legislation as much as possible when the inevitable attack from the industry comes is the best strategy. For example, in the WSJ two days ago, there was an opinion piece with the title "After Five Years, Dodd-Frank Is a Failure," and the sub-header "The law has crushed small banks, restricted access to credit, and planted the seeds of financial instability."

There is a problem with small banks. Here's an email I received earlier this year (last March, in response to an article of mine at CBS MoneyWatch on the decline in the number of small banks and how that could harm smaller buinesses):

Mr. Thoma,
I am a regular reader of your columns, and lean more to the left than virtually any banker I know, but I have to tell you that you are on to something with the decline in the number of small banks, and regulations. As the Chairman of a small bank in [state omitted], the shear amount of regulations that have come out since the banking crisis started are incredible. I know of banks in the area which have simply had to hire a full time staff person to help with compliance. Our bank has had to hire the CPA firm [omitted] to have them come in once a quarter to help us keep up with the compliance. Obviously, this crimps our profits, as does the ZLB which we have had to deal with for six years now, through no fault, at all, of our own.
Don't get me wrong, I understand why all these regulations have been put in place, but unfortunately for us, most of these have little to do with our small bank. They seem to be designed to keep the behemoths out of trouble, and we got dragged along. There needs to be a different set of rules for banks under a certain size. Banks like ours, who keep all our loans in house, and aren't a threat to the economy as a whole, have never been ones to "screw" our customers, or write "bogus" loans, and sell them. Our loan losses since 2008 have been minimal to say the least, because we try very hard to make loans that are going to be repaid. Our total losses over the last six or seven years are not any worse than, and probably, better than they were before the banking crisis arrived.
We, as a board of the bank, have talked on numerous occasions in the last few years on what to do about this problem, and have brought it up with the federal regulators at our last two exams, but have really gotten no where as far as coming up with any ideas on what to do to try and alleviate these burdens on small banks. Any suggestions, or publicity regarding the issue, would be greatly appreciated.

The point I'm trying to make is this. There are two choices when trying to fix a financial system after a crisis. The first is to move fast while the politics are supportive, and put as many of the needed rules and regulations in place as possible. Then, over time, *carefully* adjust the rules to overcome unforeseen problems (while resisting attempts to rollback needed legislation, a delicate balance). The second is to proceed slowly and deliberately and "consider the regulatory moves carefully" before implementing legislation. But by the time this deliberate procedure has been completed, it may very well be that the politics have changed and nothing will be done at all. So I'd rather move fast, if imperfectly, and then fix problems later instead of waiting in an attempt to put near perfect legislation in place and risk doing very little, or nothing at all.

Tuesday, July 14, 2015

Who Should Pay for Recessions?

I have a new column:

Who Should Pay for Recessions?: Over the last several hundred years, financial panics have repeatedly caused severe economic turmoil. For example, there were financial panics every 10 to 20 years in the late 1700s, 1800s, and early 1900s, many of which resulted in severe recessions. 
To combat this instability, new rules and regulations were imposed on the financial sector after the Great Recession, and for approximately 50 years this seemed to be very successful. The bank panics that had caused so much trouble appeared to be over. But in recent years there has been a return of financial instability in the relatively unregulated shadow banking system, and a “Great Recession” associated with a financial meltdown. 
The conclusion seems obvious. No matter what we do in terms of regulating the financial sector, the risk of a financial collapse and subsequent recession is always present. Given this, a question to ask is who should pay the costs of the inevitable meltdown? That is, when the financial sector gets into trouble, as it surely will at some point in the future, who should shoulder the burden? ...

Wednesday, July 08, 2015

'Trading on Leaked Macroeconomic Data'

Carola Binder:

Trading on Leaked Macroeconomic Data: The official release times of U.S. macroeconomic data are big deals in financial markets. A new paper finds evidence of substantial informed trading before the official release time of certain macroeconomic variables, suggesting that information is often leaked. Alexander Kurov, Alessio Sancetta, Georg H. Strasser, and Marketa Halova Wolfe examine high-frequency stock index and Treasury futures markets data around releases of U.S. macroeconomic announcement...
They consider the 30 macroeconomic announcements that other authors have shown tend to move markets...
Why do prices start to move before release time? It could be that some traders are superior forecasters, making better use of publicly-available information, and waiting until a few minutes before the announcement to make their trades. Alternatively, information might be leaked before the official release. Kurov et al. note that, while the first possibility cannot be ruled out entirely, the leaked information explanation appears highly likely. ...
I wish I had a better sense of who was obtaining the leaked information and how much they were making from it.