Economist's View

Paul Krugman: Has Trumphoria Finally Hit a Wall?

"all of this would be manageable if key policymakers could be counted on to act effectively":

Has Trumphoria Finally Hit a Wall?, by Paul Krugman, NY Times: When talking about stock markets, there are three rules you have to remember. First, the stock market is not the economy. Second, the stock market is not the economy. Third, the stock market is not the economy.

So the market plunge of the past few days might mean nothing at all. ...

Still, market turmoil should make us take a hard look at the economy’s prospects. And what the data say, I’d argue, is that at the very least America is heading for a downshift in its growth rate; the available evidence suggests that growth over the next decade will be something like 1.5 percent a year, not the 3 percent Donald Trump and his minions keep promising. ...

But should we be worried about something worse than a mere downshift in growth?

Well, asset prices do look high: A widely used gauge of stock valuations puts them at a 15-year high, while a conceptually similar measure says that housing prices have retraced a bit less than half the rise that culminated in the great housing bust.

Individually, these numbers aren’t that alarming: Stocks, as I said, don’t look nearly as overvalued as they did in 2000, housing not nearly as overvalued as it was in 2006. On the other hand, this time both markets look overvalued at the same time, at least raising the possibility of a double-bubble burst like the one that hit Japan at the end of the 1980s.

And if asset prices take a hit, we might expect consumers — who have been spending heavily and saving very little — to pull back.

Still, all of this would be manageable if key policymakers could be counted on to act effectively. Which is where I get worried.

It’s surely not a good thing that Trump got rid of one of the most distinguished Federal Reserve chairs in history just before markets started to flash some warning signs. Jerome Powell, Janet Yellen’s replacement, seems like a reasonable guy. But we have no idea how well he would handle a crisis if one developed.

Meanwhile, the current secretary of the Treasury — who declared of Davos, “I don’t think it’s a hangout for globalists” — may be the least distinguished, least informed individual ever to hold that position.

So are we heading for trouble? Too soon to tell. But if we are, rest assured that we’ll have the worst possible people on the case.

Paul Krugman: Bubble, Bubble, Fraud and Trouble

"This will end badly":

Bubble, Bubble, Fraud and Trouble, by Paul Krugman, NY Times: The other day my barber asked me whether he should put all his money in Bitcoin. And the truth is that if he’d bought Bitcoin, say, a year ago he’d be feeling pretty good right now. On the other hand, Dutch speculators who bought tulip bulbs in 1635 also felt pretty good for a while, until tulip prices collapsed in early 1637.

So is Bitcoin a giant bubble that will end in grief? Yes. But it’s a bubble wrapped in techno-mysticism inside a cocoon of libertarian ideology. And there’s something to be learned about the times we live in by peeling away that wrapping. ...

In principle, you can use Bitcoin to pay for things electronically. But you can use debit cards, PayPal, Venmo, etc. to do that, too — and Bitcoin turns out to be a clunky, slow, costly means of payment. ... There’s really no reason to use Bitcoin in transactions — unless you don’t want anyone to see either what you’re buying or what you’re selling, which is why much actual Bitcoin use seems to involve drugs, sex and other black-market goods. ...

So are Bitcoins a superior alternative to $100 bills, allowing you to make secret transactions without lugging around suitcases full of cash? Not really... Bitcoin ... is ... an asset whose price is almost purely speculative, and hence incredibly volatile. ...

Oh, and Bitcoin’s untethered nature also makes it highly susceptible to market manipulation. ...

But what about the fact that those who did buy Bitcoin early have made huge amounts of money? ...

As Robert Shiller, the world’s leading bubble expert, points out, asset bubbles are like “naturally occurring Ponzi schemes.” Early investors in a bubble make a lot of money as new investors are drawn in, and those profits pull in even more people. The process can go on for years before something — a reality check, or simply exhaustion of the pool of potential marks — brings the party to a sudden, painful end.

When it comes to cryptocurrencies there’s an additional factor: It’s a bubble, but it’s also something of a cult, whose initiates are given to paranoid fantasies about evil governments stealing all their money (as opposed to private hackers, who have stolen a remarkably high proportion of extant cryptocurrency tokens). ...

So no, my barber shouldn’t buy Bitcoin. This will end badly, and the sooner it does, the better.

How Tales of ‘Flippers’ Led to a Housing Bubble

Robert Shiller:

How Tales of ‘Flippers’ Led to a Housing Bubble: There is still no consensus on why the last housing boom and bust happened. That is troubling, because that violent housing cycle helped to produce the Great Recession and financial crisis of 2007 to 2009. We need to understand it all if we are going to be able to avoid ordeals like that in the future.

But the explanations for what happened in housing are not, I think, to be found in the conventional data favored by economists but rather in sociologically important narratives — like tales of getting rich through “flipping” houses and shares of initial public offerings — that constitute the shifting mentality of the era. ...

By now, the notion of getting rich by flipping houses is entrenched. I searched Amazon for books on “flipping houses” and came up with 325 hits, most written in the past few years..., many of these books make extravagant pitches and seem aimed at inspiring amateurs to plunge into risky ventures.

The public fascination with speculating in housing has been held in check by regulators empowered by the 2010 Dodd-Frank Act, but that restraint is tenuous with the election as president of a real estate promoter intent on reducing regulators’ power. These narratives are still potent and could easily spur further spirals in the housing market.

Darwin Visits Wall Street

“biology is a closer fit to economics than physics”:

Darwin Visits Wall Street, by Peter Dizikes, MIT News: If you have money in the stock market, then you are probably anticipating a profit over the long term — a rational expectation given that stocks have historically performed well. But when stocks plunge, even for one day, you may also feel some fear and want to dump all those stress-creating equities.

There is a good reason for this: You’re human.

And that means, to generalize, that you have both a rational side and some normal human emotions. To Andrew Lo, the Charles E. and Susan T. Harris Professor and director of the Laboratory for Financial Engineering at the MIT Sloan School of Management, accepting this basic point means we should also rethink some common ideas about how markets work.

In economics and finance, after all, there is a long tradition of thinking about investors as profit-maximizing rational actors, while imagining that markets operate near a state of perfect efficiency. That sounds nice in theory. But evidence shows that this view is not sufficient for understanding the radical swings that market sentiment creates.  

“When you and I are making investment decisions independently, we’ll exhibit different behavior,” Lo says. Those varied decisions help keep markets stable, most of the time. “But when we all feel threatened at the same time, we’re likely to react in the same way. And if we all start selling stocks at once, we get a market crash and panic. Fear can overwhelm rationality.”

Now Lo has written a new book about the subject, “Adaptive Markets,” published this month by Princeton University Press. In the book, he draws on insights from evolutionary theory, psychology, neuroscience, and artificial intelligence to paint a new picture of investors. Instead of regarding investors simply as either rational or irrational, Lo explains how their behavior may be “maladaptive” — unsuited to the rapidly changing environments that shifting markets present.  

In so doing, Lo would like to resolve the divergence between the realities of human behavior and the long-standing “efficient markets hypothesis” (EMH) of finance with his own “adaptive markets hypothesis,” to account for the dynamics of markets — and to provide new regulatory mechanisms to better ward off damaging crashes.

“It takes a theory to beat a theory,” Lo quips, “and behavioralists haven’t yet put forward a theory of human behavior.”

Path-dependent

To get a grip on Lo’s thinking, briefly examine both sides of the EMH debate. On the one hand, markets do exhibit significant efficiencies. Do you own a mutual fund that tracks a major stock-market index? That’s because it is very hard for individual investors or fund managers to beat indexes over an extended period of time. On the other hand, based on what we know about market swings and investor behavior, it seems a stretch to think markets are always efficient.

“The EMH is a very powerful theory that has added a great deal of value to investors, portfolio managers, and regulators,” Lo says. “I don’t want to be viewed as criticizing it. What I’m hoping to do is to expand its reach, by explaining under which conditions it’s likely to work well, and under which other conditions we require a different approach.”

As Lo notes in the book, the EMH assumes that individuals always maximize their expected utility — they find the optimal way to spend and invest, all the time. Lo’s adaptive markets hypothesis relaxes this dictum on two counts. First, a successful investing adaptation doesn’t have to be the best of all possible adaptations — it just has to work fairly well at a given time.

And second, Lo’s adaptive markets hypothesis does not hold that people will constantly be finding the best possible investments. Instead, as he writes in the book, “consumer behavior is highly path-dependent,” based on what has worked well in the past.

Given those conditions, the market equivalent of natural selection weeds out poor investment strategies, Lo writes, and “ensures that consumer behavior is, while not necessarily optimal or ‘rational,’ good enough.” Not perfect, but decent.

In this light, consider fund managers who do beat the big stock indexes for a while. In many cases, their successes are followed by years of poor performance. Why? Because they did not keep adapting to a changing investing environment. This familiar dynamic, Lo contends, is one reason we should drop the physics-inspired notions of the market as an efficient mechanism, and think of it in evolutionary terms.

Or, as Lo writes in the book, “biology is a closer fit to economics than physics.” As the physicist Richard Feynman put it, “Imagine how much harder physics would be if electrons had feelings.”

Looking for policy impact

“Adaptive Markets” does not represent the first time Lo has put some of these ideas into print. It is the culmination of a long-term line of inquiry, and the most detailed, extended treatment he has given to the concept.

The book is written for a general audience but has received a wide hearing in academia. Nobuhiro Kiyotaki, an economist at Princeton University, calls “Adaptive Markets” a “wonderful book” that “presents many valuable findings” and “is itself a manifestation of the important finding that rational thinking and emotion go together.”

Lo says his hope for the book, however, is not just to change some minds among the public and other scholars, but to reach policymakers. Having served on multiple government advisory panels about regulation, Lo believes we need regulations that are more generally focused on limiting risk and large-scale crashes, rather than seeking to assess the legitimacy of umpteen new financial instruments.

The analogy Lo likes to make is that finance needs an equivalent of the National Transportation Safety Board, the federal agency that investigates the systemic causes of aviation accidents, among other things, and whose existence has helped engender a period of unprecedented air safety.

Even in the run-up to the 2008 financial-sector crisis, Lo contends, the notorious bond markets trading securities backed by subprime mortgages, and their derivatives, were not deeply “irrational.” After all, those markets had winners as well as losers; the problems included the way the markets were constructed and the opportunity for firms to wildly increase their risks while seeking big payoffs. 

“It’s not so much that market prices were wrong, it’s that the policies and incentives were flawed,” Lo contends.

That might generate some heated debate, but Lo says it is a discussion he welcomes.

“We aren’t really getting traction arguing either for or against efficient markets,” Lo says. “So maybe it’s time for a new perspective.”

Why Regulators Should Focus on Bankers’ Incentives

Charles Goodhart:

Why regulators should focus on bankers’ incentives: Last autumn, Charles Goodhart gave a special lecture at the Bank. In this guest post he argues that regulators should focus more on the incentives of individual decision makers.

The incentive for those in any institution is to justify and extol the virtues of the decisions that they have taken. Criticisms of current regulatory measures are more likely to come from outsiders, perhaps especially from academics, (with tenure), who can play the fool to the regulatory king. I offer some thoughts here from that perspective. I contend that the regulatory failures that led to the crisis and the shortcomings of regulation since are largely derived from a failure to identify the persons responsible for bad decisions. Banks cannot take decisions, exhibit behavior, or have feelings – but individuals can. The solution lies in reforming the governance set-up and realigning incentives faced by banks’ management. ...

There are two questions that need reconsideration. The first relates to the scope of responsibility for outcomes in a hierarchical institution; the second relates to the downside that those responsible should face when failure or bad behavior occurs. ...

He concludes with:

If a bank CEO knew that his own family’s fortunes would remain at risk throughout his subsequent lifetime for any failure of an employee’s behavior during his period in office, it would do more to improve banking ‘culture’ than any set of sermons and required oaths of good behavior. The root of the problem is the bad behavior of bankers, not of banks, who are incapable of behavior, for good or ill. The regulatory framework should be refocused towards the latter, with a focus on reforming incentives.

The Saga of Currency Unions and Trade

Douglas Campbell:

The Saga of Currency Unions and Trade: One of the first full papers I wrote was on currency unions and trade. I was taking Alan Taylor's field course at UC Davis, which was essentially and Open-Economy Macro History course, and the famous Glick/Rose findings that currency unions double trade was on the syllabus. Not to be outdone, Robert Barro and coauthors then found that currency unions increase trade on a 7-fold and 14-fold basis! This raised the prospect that Frenchman may suddenly go out and buy a dozen or more Volkswagens instead of settling for just one after the adoption of the Euro. Another paper, published in the QJE, found that currency unions even raise growth, via trade. In that case, one can only imagine what the Greek economy would look like if they hadn't joined the Euro. No result, it seems, can be too fanciful.

Always a doubting Thomas, I was instantly skeptical. ...

So, I fired up Stata, and after a solid 30 minutess, I discovered part of what was driving the seemingly magical effect. Roughly one-quarter of the CU changes were of countries that had former colonial relationships... It turns out that the impact of the "former colony" dummy in the gravity equation has been decaying slowly over time. This led to a more interesting insight -- that history matters for trade... For other country pairs aside from colonies, there were other problems. ...

In any case, in 2015, I deleted this paper and my regression and code from my webpage, and assigned the paper to my brilliant undergraduate students. They alerted me to the fact that Glick and Rose had recently written a mea culpa, where the authors declared that they could no longer have confidence in the results. ... However, Glick and Rose changed their minds, and decided instead to double-down on a positive, measurable impact of currency unions on trade. This time, they concluded that the Euro has increased trade by a smaller, but still magical, 50%. ... 

In any case, Jeff Frankel at Harvard apparently used to assign his Ph.D.'s students a "search-and-destroy" mission on the original CU effect. Thus, thanks to the fact that Andrew Rose still provides his data online -- for which I'm grateful -- I've just assigned my students a similar mission on the new EMU result. Thus, we get to see if they can overturn anything that the good referees at the European Economic Review may have overlooked. If I were a gambling man, and I am, I would put my money on my sharp undergraduates at the New Economic School over the academic publication process. If I were Croatia, or Greece, contemplating the relative merits of joining/staying in the Euro, I would write off the academic literature on this topic completely. 

Fed Watch: Is Bank Lending A Concern?

Tim Duy:

Is Bank Lending A Concern?, by Tim Duy: I have seen some angst recently over declining growth in commercial bank lending. See, for example, the Wall Street Journal:

Bank loans across all categories are increasing 4.6% annually, the slowest pace since 2014, according to weekly Fed lending data from March 1. The trend is particularly marked in business loans, which are increasing 3.9% annually, a rate that is a nearly six-year low.

A number of factors are at play, including rising interest rates; bankers also said some business clients put borrowing on hold before the U.S. election and aren't confident enough to jump back in.

The slowdown is noteworthy because it is occurring when many metrics show the U.S. economy strengthening.

Looking at the weekly data, there does on the surface look to be some reason for concern:

These low rates of growth are rarely seen outside of recessions. Still, optical econometrics suggests this is more of a lagging than leading indicator. Moreover, we have another indicator that also exhibited behavior only seen in recessions. Spot the odd man out:

Recall a year ago when weak industrial production numbers raised recession concerns that proved unfounded. We could be seeing something similar in bank lending. Consider that industrial production might be a leading indicator for bank loans:

Here I focus on the post-1984 period (the Great Moderation). Optical econometrics again suggests to me that lending lags industrial production. To quantify that a bit more, I converted the data to log differences (multiplied by 100), and ran it through a 13 lag vector autoregression. Granger causality tests (the f-tests here) indicate that loans (DLOANS) do not cause (or are predictive of) industrial production (DIND):

Impulse response functions (in this case, the responses are converted to impacts on the levels of the variables) illustrate the dynamics of the system:

The impact of a shock to industrial production on commercial lending (lower left chart) is delayed six months and then builds gradually over the next 18 months. The impact of a shock to lending on industrial production (upper right chart) is negligible. Ordering of the variables does not affect these results. If I use the full sample (data begin 1947:1), both variables Granger cause each other, but the impact of loans on industrial production in the short-run is minimal and dies out in the long-run:

Bottom Line: The fall in commercial lending growth looks more consistent with a lagged impact from the industrial slowdown that weighed on the US economy last year than with a warning about future activity. Something to keep an eye on, to be sure, but if past history is a guide, it is more likely than not that lending will pick up over the next year.

What Contract Theory Teaches Us about Regulating Banks

Caterina Lepore, Caspar Siegert, and Quynh-Anh Vo at Bank Underground:

What can Nobel-winning contract theory teach us about regulating banks?: The 2016 Nobel Prize in economics has been awarded to Professors Oliver Hart and Bengt Holmström for their contributions to contract theory. The theory offers a wide range of real-life applications, from corporate governance to constitutional laws. And, as the post will hopefully convince you, contract theory is also helpful in regulating banks! To this end, we will unpack the outline of the theory and apply it to a number of real-world conundrums: How to pay banks’ chief executives and traders? How to fund a bank’s balance sheet? How to regulate banks?

What is Contract Theory? ...

The Fed's Bank Bailout

New research on the Fed's bank bailout during the financial crisis:

The fed's bank bailout, EurekAlert!:...While many Americans know the Fed for its role in making monetary policy, it serves another lesser-known but hugely important purpose: providing temporary, short-term funds to banks as a "lender of last resort."

During the financial crisis from 2007-09, the Fed took drastic steps to ensure that banks had access to liquidity so they could continue lending. ...

For the first time, new research from Washington University in St. Louis examines data from the crisis to show how the Fed can effectively assist banks in times of financial uncertainty. No matter the program or the bank size, this infusion of liquidity spurred lending that ultimately reached homes and businesses, thereby benefiting the economy, the researchers found in their analysis.

"Perhaps contrary to popular beliefs, our research shows that the Fed's actions were effective in encouraging banks to lend. This suggests that the credit crunch we witnessed could have been a lot worse in the absence of these facilities," said Jennifer Dlugosz, assistant professor of finance at Olin Business School, and a former economist at the Board of Governors of the Federal Reserve System. ...

During the course of their research, Dlugosz and her co-authors [Allen Berger, professor of banking and finance at the University of South Carolina, Lamont Black, assistant professor of finance at DePaul University, and Christa Bouwman, associate professor of finance at Texas A&M University] found a total of 20 percent of small U.S. banks and 62 percent of bigger U.S. banks -- more than 2,000 in all -- used the Discount Window or the Term Auction Facility at some point during the crisis. The access to liquidity increased bank lending of almost all types. Meanwhile, they found no evidence that banks were making riskier loans.

"We examined whether or not the Discount Window and the Term Auction Facility helped encourage banks to lend during the crisis," Dlugosz said. "We find that it did. It looks like one extra dollar in liquidity support from the Fed to a bank results in somewhere between 30 to 60 cents in additional lending by the bank, depending on its size.

"It wasn't obvious at the time whether this was going to work. ..."

Why Dodd-Frank’s Orderly Liquidation Authority Should be Preserved

Ben Bernanke:

Why Dodd-Frank’s orderly liquidation authority should be preserved: The collapse of the investment bank Lehman Brothers in September 2008 was perhaps the defining event of the financial crisis. Lehman’s bankruptcy, followed by the near-collapse (save for government intervention) of the insurance company AIG, greatly intensified the fear and panic in markets, bringing the financial system and the economy to the brink of the abyss.

These events, including the government’s response, remain controversial. What should not be controversial is that ordinary bankruptcy procedures were entirely inadequate for the situation. The bankruptcy judge in the Lehman case—required, by law, to focus narrowly on adjudicating creditors’ claims against the company—had neither the tools nor the mandate to try to mitigate the effects of the failure on the financial system or the economy. The Fed, FDIC, and Treasury used the powers available to them, often in ad hoc ways, to try to preserve broader stability. But these agencies likewise lacked a framework for dealing systematically with failing financial giants.

The architects of the Dodd-Frank Act, which reformed financial regulation after the crisis, recognized that—in order to make the financial system safer and eliminate future taxpayer-funded bailouts—a better approach was needed. The first two sections, or titles, of the bill aimed to do just that. Title I extended the ordinary bankruptcy framework to better accommodate the complexities of large, interconnected financial firms. It also required large bank holding companies to submit to their regulators plans for how they could be successfully resolved in a crisis (“living wills”). ...

Jumping ahead to the conclusion:

...Conclusion Recent experience has taught us that the uncontrolled collapse of a systemically important financial firm can do enormous damage to the broader financial system and the economy. The Dodd-Frank Act modified bankruptcy law to better accommodate large, complex financial firms, but also wisely provided a  backstop framework—the Orderly Liquidation Authority of Title II—that can be invoked when overall financial stability is at stake. Critically, the OLA draws on the expertise and planning of the FDIC and the Fed. The OLA is not a bailout mechanism, since all losses are borne by the private sector. The government can provide temporary liquidity under OLA (as it probably would have to do under Title I, as well), but not permanent capital. Taxpayers are fully protected.

To be sure, controversies remain over how effective in even a Title II resolution would be in the context of a significant financial crisis. Still, drawing in particular on the FDIC’s decades of experience in dealing with failing banks, a good bit of progress has been made. The tools provided by Title II are a significant advance over what was available during the recent crisis.

Have we ended bailouts? Current lawmakers can’t bind future legislators, and we can’t guarantee that a future administration and Congress, fearful of the economic consequences of a building financial crisis, won’t authorize a financial bailout. But the best way to reduce the odds of that happening is to have in place a set of procedures to deal with failing financial firms that those responsible for preserving financial stability expect to be effective. That’s what the OLA is intended to provide.

Jeb Hensarling's Alternative Facts

Adam Levitin:

Jeb Hensarling's Alternative Facts: House Financial Services Committee Chairman Jeb Hensarling (R-Texas 5th) has an alternative fact problem. In a Wall Street Journal op-ed Hensarling alleged that "Since the CFPB’s advent, the number of banks offering free checking has drastically declined, while many bank fees have increased. Mortgage originations and auto loans have become more expensive for many Americans.”

The problem with these claims?  They are verifiably false.  Free checking has become more common, bank fees have plateaued after decades of steep increases, and both mortgage rates and auto loan rates have fallen. One can question how much any of these things are causally related to the CFPB, but using Hensarling's logic, the CFPB should be commended for expanding free checking and bringing down mortgage and auto loan rates. Hmmm.  

Below the break I go through each of Chairman Hensarling's claims and demonstrate that each one is not only unsupported, but in fact outright contradicted by the best evidence available, general FDIC and Federal Reserve Board data. ...

...Bottom line:  Jeb Hensarling's claims about the CFPB are based on a set of utterly concocted alternative facts. This is not the way we should be making policy.

Trump Picks Wall Street Over Main Street

Mike Konczal:

Trump Picks Wall Street Over Main Street: President Trump fired the first round in his war against financial regulations by signing two executive orders on Friday.

The first calls for the Treasury secretary to conduct a review over the next 120 days of regulations stemming from the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The second calls for a review of the Department of Labor’s “fiduciary rule,” which requires investment professionals to act in the best interest of their clients, rather than seek the highest profits for themselves...

Though they don’t do too much by themselves to roll back these reforms, the directives do offer important details on how Mr. Trump will approach the financial industry in the next four years — and provide three reasons that people on Main Street should be scared about how Mr. Trump will help Wall Street.

The first is that President Trump, contrary to the hopes of many, has no intention of getting tough with finance. ...

Second, while Mr. Trump wants to repeal the fiduciary rule, he appears to have no interest in a replacement for it. ...

Third, rather than meet with regulators, small businesses or community banks, Mr. Trump met with the titans of Wall Street before announcing the directives. ...

It’s no wonder financial stocks have been soaring since Mr. Trump was elected. Voters who hoped he would “drain the swamp” and upset the elite are in for a big surprise. ...

The Tip of the Iceberg: The Implications of Climate Change on Financial Markets

Yuliya Baranova, Carsten Jung, and Joseph Noss at Bank Underground:

The tip of the iceberg: the implications of climate change on financial markets: There has been a recent increase in awareness of investors that limiting emissions to prevent climate change might leave a substantial proportion of the world’s carbon reserves unusable, and that this could lead to revaluations across a range of financial assets. If risks are left unaddressed, this could result in large losses for some investors. But is this adjustment in financial market prices likely to be abrupt?  And – even if it is – is it likely to pose risks to financial stability?  We argue that the answer to both these questions could be yes:  financial valuations can move sharply even if the transition to sustainable energy were smooth.  And exposures are sufficiently large to warrant attention from both investors and policymakers. ...

Making America's Risk of a Financial Crisis Great Again

Me, at MoneyWatch:

Making America's risk of a financial crisis great again: In the decades prior to the financial crisis, the U.S. underwent a period of financial deregulation under the assumption that market forces would prevent financial institutions from taking excessive risk. In particular, the shadow banking system -- financial institutions that don’t operate as traditional banks -- was lightly regulated. 

However, as Alan Greenspan admitted in testimony on Capital Hill after the financial crisis, that assumption turned out to be wrong. The traditional banking sector, which is highly regulated, weathered the storm fairly well, but the shadow banking system came crashing down -- and brought the economy with it.

Nevertheless, Republicans are determined to roll back financial regulation, particularly measures implemented under the Dodd-Frank financial reform package passed in the aftermath of the financial crisis. I believe that’s a mistake. ...

Venetians, Volcker and Value-at-Risk: 8 Centuries of Bond Market Reversals

Paul Schmelzing of Harvard University:

Venetians, Volcker and Value-at-Risk: 8 Centuries of Bond Market Reversals: The economist Eugen von Böhm-Bawerk once opined that “the cultural level of a nation is mirrored by its interest rate: the higher a people’s intelligence and moral strength, the lower the rate of interest”. But as rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre”.

Bond “bull markets” since 1285 ...

CFPB Tales Told Out of School

Adam Levitin:

CFPB Tales Told Out of School: Former CFPB enforcement attorney Ronald Rubin has a lengthy attack on the CFPB in the National Review. It's got lots of sultry details, but there's nothing new and verifiable in the piece.  Instead, it's all tales told out of school, unverifiable personal anecdotes by Rubin, who seems to have an particular axe to grind with certain other CFPB staffers, and an ideological one too. Incredibly, Rubin, a former Managing Director for legal and compliance at Bear Stearns, holds up the oft-feckless SEC as a model of good enforcement practice, and criticizes the CFPB for any departures from that practice. 

The point of the piece seems to be that the CFPB is an agency gone rogue and that this wouldn't have happened if the CFPB had just been structured as a bi-partisan commission. That's hogwash. Assume that everything Rubin claims is true and correct. Even if so, every single problem Rubin identifies in the piece could just as easily have occurred at a bi-partisan commission. ...

Rubin's conclusions just don't follow from his non-verifiable personal evidence. Indeed, the very fact that the CFPB hired people like Rubin and Leonard Chanin seems to belie his claims of partisan hiring practices; Rubin is a guy who went from the CFPB to be a Republican staffer for the House Financial Services Committee, after all. Rubin's conclusions do follow from his anti-regulatory world view whose "primary influences were my business-school professors at the University of Chicago, the epicenter of free-market capitalism." Yup.

Jeb Hensarling and the Allure of Economism

James Kwak:

Jeb Hensarling and the Allure of Economism: The Wall Street Journal has a profile up on Mike Crapo and Jeb Hensarling, the key committee chairs (likely in Crapo’s case) who will repeal or rewrite the Dodd-Frank Wall Street Reform and Consumer Protection Act. It’s clear that both are planning to roll back or dilute many of the provisions of Dodd-Frank, particularly those that protect consumers from toxic financial products and those that impose restrictions on banks (which, together, make up most of the act).

Hensarling is about as clear a proponent of economism—the belief that the world operates exactly as described in Economics 101 models—as you’re likely to find. He majored in economics at Texas A&M, where one of his professors was none other than Phil Gramm. Hensarling described his college exposure to economics this way:

“Even though I had grown up as a Republican, I didn’t know why I was a Republican until I studied economics. I suddenly saw how free-market economics provided the maximum good to the maximum number, and I became convinced that if I had an opportunity, I’d like to serve in public office and further the cause of the free market.”

This is not a unique story...

Introductory economics, and particularly the competitive market model, can be seductive that way. The models are so simple, logical, and compelling that they seem to unlock a whole new way of seeing the world. And, arguably, they do: there are real insights you can gain from a working understanding of supply and demand curves.

The problem, however, is that the people ... forget that the power of a theory in the abstract bears no relationship to its accuracy in practice. ...

Hensarling, who likes to quote market principles in the abstract, doesn’t appear to have moved on much from Economics 101. ... This ritual invocation of markets ignores the fact that there is no way to design a contemporary financial system that even remotely resembles the textbook competitive market: perfect information, no barriers to entry, a large number of suppliers such that no supplier can affect the market price, etc. ...

Regulatory policy that presumes well-functioning markets that don’t exist is unlikely to work well in the real world. Actually, Bill Clinton and George W. Bush tried that already, and we got the financial crisis. But to people who believe in economism, theory can never be disproved by experience. Hensarling is “always willing to compromise policies to advance principles,” he actually said to the Journal. That’s a useful trait in an ideologue. It’s frightening in the man who will write the rules for our financial system.

Currency Authority Proposes Ban on Bank Investments in Commercial Metals

Jayme Wiebold at Regblog:

Currency Authority Proposes Ban on Bank Investments in Commercial Metals: In addition to typical banking activities such as issuing home loans and administering savings accounts, should your neighborhood bank be able to buy and trade metals like copper and gold? Presently, financial institutions can legally participate in commodities markets—which include trading in these precious metals—creating a state of affairs that some regulators and politicians say may increase commodities prices for consumers and create financial instability. ...

The Office of the Comptroller of the Currency, which regulates and supervises national banks and federal savings associations, recently ... proposed [a] rule that would prohibit banking institutions from buying or selling metals including copper, aluminum, and gold. ...

Designating dealing in certain commercial metals as an out-of-bounds activity for commercial banks marks a reversal of position for the Currency Comptroller. It previously issued an interpretive letter stating that national banks could buy and sell copper—an industrial metal—because such trading was functionally equivalent to trading in precious metals like gold—an activity considered within the “business of banking.”

As indicated by the proposed rule, the Comptroller no longer believes that investing in copper markets is principally the same as dealing with coins made from precious metal or other types of gold. ...

The Comptroller’s proposed rule comes on the heels of a report it co-authored with the Federal Reserve and Federal Deposit Insurance Corporation, which contains several recommendations to ensure the separation of traditional banking activities from more commercial activities. The report specifically states that the Comptroller would publish a proposed rule about limits on trading copper.

In the report, the Federal Reserve also recommends several other reforms that aim to “help ensure the separation of banking and commerce.” It proposes repealing a rule that allows bank holding companies to participate in commodities activities similar to those addressed by the Comptroller’s proposed rule for national banks and recommends strengthening standards for other commodity-related activities like trading derivatives. The report’s authors also recommend repealing authority for financial holding companies to participate in merchant banking activities like buying a stake of ownership in a company instead of providing a traditional loan.

The Comptroller’s proposed rule is part of a growing trend of regulatory and political pressure to separate traditional banking activity from commercial activity. ...

It Takes a Village to Maintain a Dangerous Financial System: Q&A with Anat Admati

At ProMarket:

It Takes a Village to Maintain a Dangerous Financial System: Q&A with Anat Admati: Stanford professor Anat Admati discusses her new paper, in which she explains how a mix of distorted incentives, ignorance, confusion, and lack of accountability contributes to the persistence of a dangerous and poorly regulated financial system. ...

Evaluating Germany’s Success in Regulating High-Frequency Trading

Alex Walsh at Regblog:

Evaluating Germany’s Success in Regulating High-Frequency Trading: ...Although many countries have attempted to regulate the meteoric rise of high-frequency trading, no plan has been more ambitious than Germany’s High-Frequency Trading Act (HFT Act). Rather than regulate trading speed alone, the HFT Act targets the complex core of high-frequency trading: financial algorithms.

And there may be some evidence that the HFT Act is working—at least in part. In a recent paper, Nathan Coombs, a Research Fellow at the University of Edinburgh, grappled with the complexities of trying to define, identify, and monitor well-guarded financial algorithms, and concluded that the HFT Act—although far from perfect—has had a notable degree of success. ...

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.

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. ...

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. ...

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 p̂_t – p_t 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 p̂_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 ê_t 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 e_t not ê_t. 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 p̂_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 d̄ > 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.

Notes

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 p̂_t – p_t 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; https://www.minneapolisfed.org/research/wp/wp730.pdf) 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.

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.” ...

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. ...

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

On the road headed to my dad's 80^th 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. ...

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.

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.

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.

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.

'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. ...

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. ...

'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.

"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"]

'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.

'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. ...

'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.

'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.

'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.

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. ...

'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...

'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.

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.

'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.

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.

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.

''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. ...

'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?