Margin Requirements and Entrance Fees

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Tyler Cowen writes,

Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.

Think of what AIG was doing when it was writing credit default swaps on mortgage securities. It was taking tail risk by writing out-of-the-money options. If you believe Gary Gorton, they were fine, except that in 2008 their counterparties demanded collateral that they did not have, not because the options were in the money but because the options were closer to being in the money.

Today, if you want to pick up the nickels that you can earn by taking tail risk, you need to put up more margin. What Tyler is suggesting is that this increases the demand for safe assets relative to what it was prior to 2008. So even if the real return on T-bills is negative, they are worth it for financial institutions who use them to meet margin requirements on trades that enable them to make a profit.

If the financial institution is helping the economy by taking the tail risk, then it’s all fine. But Tyler suggests that the financial institution is not helping the economy (AIG was an enabler of the housing bubble). In that case, we would be better off with less tail-risk taking, which in turn would reduce the demand for safe assets and lead to a better allocation of saving and investment.

Stricter bank regulation may or may not help. The effect of risk-based capital regulations was to increase the demand for AAA-rated securities, which in turn increased the demand for credit default swaps written by AIG. So that was a case in which stricter bank regulation actually created (apparent) profit opportunities in taking tail risk. If regulation still has that effect, then it will increase the fundamental distortion in financial markets.

Business Psychology, Business Reality, AD-AS, and PSST

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Nick Rowe writes,

For an open economy, like Canada, a lot of our PSSTs are with foreigners. Americans especially. That’s why Canadian recovery depends on US recovery, even though we have our own monetary policy so we can make our own AD curve shift independently of the US AD curve, if we want to. The Canadian recovery has been slow because the US recovery has been even slower. We can’t rebuild some of our PSSTs until the Americans rebuild some of theirs. We are waiting for the Americans to join in our cross-border PSSTs.

One way to think about PSST vs. AD-AS is to think about reversible or irreversible shifts in patterns of specialization and trade. If it’s reversible, then AD-AS is probably the best way to think about it. Because of excess inventory, housing construction and durable goods manufacturing are cut back, but that gets reversed when inventory/sales ratios get back down to normal levels. If it’s not reversible, then PSST may be the best way to think about it.

Now, on to business psychology and business reality.

If you like the old paradigm, then think of business psychology as if it were aggregate demand and business reality as if it were aggregate supply.

In business reality, opportunity can be high or low, and adversity can be high or low. Four possibilities for the overall state of business reality:

1. High-opportunity, low-adversity would describe an economy unleashed. This is a rare combination. Maybe the U.S. in the post-WWII hegemonic period? Maybe the parts of the Chinese economy that were freed by reforms? There are lots of opportunities to create new patterns of sustainable specialization and trade, but old patterns are not heavily threatened.

2. Low-opportunity, high-adversity. This typically reflects major government policy mistakes. Wage-price controls in the U.S. in the early 1970s? Hyperinflation in Zimbabwe. There are few opportunities to create new patterns of sustainable specialization and trade, and old patterns become unprofitable.

3. High-opportunity, high-adversity. This would be a very dynamic economy. The 1920s in the U.S.? 1990-2007 in much of the world? New patterns of sustainable specialization and trade are created, while old patterns break down.

4. Low-opportunity, low-adversity. This would be a relatively stagnant economy. Think of sectors where regulation restricts entry (health care and education come to mind). It’s hard to get into business and hard to be driven out of business.

Now, superimpose on this business reality the state of business psychology. Are entrepreneurs highly attuned to opportunities, or are they relatively timid? Are incumbent businesses highly attuned to adversity, or are they relatively blithe? These psychological conditions affect overall employment. The four possible psychological conditions:

1. High-opportunity, low-adversity. Something like the late 1990s, when new firms are chasing opportunities but old firms are not seeing the handwriting on the wall (Amazon expands, but Borders does not realize that its under threat).

2. Low-opportunity, high-adversity. You have the 1930s, or the past five years. Old firms are firing, because they are very attuned to adversity, but new firms are not thriving and growing.

3. High-opportunity, high-adversity. The economy is dynamic, and everybody knows it. Rapid restructuring takes place. The telecom industry in the U.S., where hundreds of thousands of telephone operators lost their jobs, but the cell phone industry created even more jobs.

4. Low-opportunity, low-adversity. An economy that tunes out the dynamism in the world. The economy fails to restructure, but few people get fired. Japan in the 1990s?

Note that this is close to the way Schumpeter thought about things. Note that “stagnation” can be primarily in business reality (#4 in the first list) or primarily in business psychology (#2 in the second list). Possibly both.

Normal Macro and Financial Crises: Road Friction and Flat Tires

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Economists these days seem to want to describe two financial regimes. One is a “normal” regime, which can be regulated by conventional monetary policy. The other is a “crisis” regime, which cannot. Here is a metaphor to think about:

Imagine the economy as a car, with Fed monetary policy consisting of pressing on the accelerator pedal. The Fed tries to maintain a constant speed, and sometimes that means pushing hard on the accelerator and other times it means letting up. In the normal regime, the Fed just deals with road friction and hills.

In the crisis regime, the car has a flat tire. The Fed can press really hard on the accelerator pedal, and yet the car is not going to go as fast as people want.

Until recently, macroeconomic theory focused on the normal regime, dealing with road friction and hills. What are the microfoundations? What policy rules work best? etc.

But what about the crisis regime? Scott Sumner’s view would be that there is no such regime. He would say that we are seeing a normal regime in which the Fed has stubbornly failed to press hard enough on the accelerator pedal.

When I hear mainstream economists praise TARP, I think they believe that troubled banks were the macroeconomic equivalent of a flat tire, and you needed TARP to patch the tire. Perhaps this is correct. However, I do not think we can tell this story very well by using the models that were designed to describe the normal regime. As of now, I think that there is a huge gap between mainstream intuition, which thinks in terms of the flat tire, and mainstream modeling, which deals with road friction. In particular, treating financial markets as if they were just another potential source of road friction is probably not going to cut it.

I also do not think that “the zero bound” is the flat tire.

What might be the flat tire is an adverse equilibrium in an economy with multiple equilibria. Think of the economy as having channels of trust. When the channels of trust are open, we have the good equilibrium. When the channels of trust are closed, we have the bad equilibrium. Finance is particularly subject to these multiple equilibria. If people believe that financial instruments are safe, then borrowers can obtain lenient credit at low rates. But in an adverse equilibrium, creditors have doubts, and borrowers are constrained.

In the adverse equilibrium, there is less economic activity. This might explain the intuition that the financial crisis was horrible, and bailing out banks kept things from getting worse. However, it does not necessarily support the intuition that fiscal policy and quantitative easing are helpful.

And I do not necessarily endorse this particular model of the flat tire.

Richard Robb on the Origins of the Financial Crisis

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He writes An Epistemology of the Financial Crisis, appearing in the current issue of Critical Review.

Subprime mortgages retained by U.S. banks for their own portfolios performed at least as badly as those they securitized for sale to others….A study by Wei Jiang, Ashlyn Nelson, and Edward Vytlacil [various versions available] examined one large lender and concluded that mortgage “loans remaining on the bank’s balance sheet are, ex post, of owrse quality than sold loans.” They concluded that RMBS [residential mortgage backed securities] investors had information advantages over banks. This is the very opposite of the view that banks sold the worst loans to unsuspecting third parties.

Robb’s theme is that the crisis was caused by imperfect knowledge rather than greed/adverse incentives. I have many comments

1. This same theme may be found in Jerry Muller’s similarly titled Our Epistemological Depression and my The Financial Crisis: Moral Failure or Cognitive Failure?, neither of which hare cited by Robb.

2. It is no surprise that Robb did not see the articles by Muller or me, nor is it likely that many people will see Robb’s. The mainstream narrative is available to everyone, while our narrative has been relegated to the most obscure publication outlets.

3. Robb writes,

One clue to what went wrong comes from a study that Fitch conducted [may be found here] on borrowers who defaulted within six months of taking out a mortgage. The study looked closely at 45 “early payment defaulters” from 2006. [It] found that 66 percent of them committed “occupancy fraud,” falsely claiming that they intended to occupy the home.

There are some forms of fraud that are often the fault of the lender, and the borrower is relatively blameless. Overstating borrower’s income is an example. But when it comes to occupancy fraud, you have to blame the borrower, and for lenders it is one of the most difficult forms of fraud to detect prior to making the loan. However, blaming the borrowers runs counter to the conventional narrative.

4. Contrary to what I have written, Robb argues that lenient risk-based capital rules for highly-rated mortgage securities were not implemented soon enough to be implicated in the financial crisis. On the Recourse Rule, a 2001 regulation that some of us believe encouraged subprime securitization, Robb writes,

While on the margin the Recourse Rule encouraged investment in highly rated ABS [asset backed securities], the incentives were not so great as to justify holding these securities unless banks thought they were safe.

5. Robb writes,

An unambiguous regulatory failure was the decision to allow Lehman Brothers to fail. The market expected the U.S. Treasury to cobble together a last-minute rescue over the weekend….largely because…Bear Stearns, had been rescued six months earlier by being absorbed into JPMorgan Chase. Lehman was 25 times large4r than Bear Stearns and far more interconnected…the Securities and Exchange Commission had no plan for an orderly transfer of clients’ assets…institutional clients with claims over $5000,000 had to wait until the summer of 2013.

6. According to Robb, the financial community never expected house prices to decline. But I would like to point out that you cannot just look at what investors were expecting on average. Instead, think of investors as assigning probabilities to various paths for house prices. I think it is fair to say that investors under-estimated the probability of a large decline in house prices. However, a sophisticated investor would not have assigned a zero probability to a path in which house prices declined.

7. Robb views post-crisis risk aversion as a major source of problems. He provides examples of assets that in hindsight were ridiculously undervalued by investors.

during a crisis, they learn to be skeptical of the probabilities, no matter how those probabilities are presented.

All in all, it is one of the most provocative essays I have read on the financial crisis.

Cognitive Capture

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Acemoglu and Robinson write,

the excess returns of connected firms may be a reflection of the perception of the market (and likely a correct perception) that during turbulent times there will be both heightened policy discretion and even more of the natural tendency of government officials and politicians to rely on the advice of a small network of confidants. For Timothy Geithner this meant relying on, and appointing to powerful positions, financial executives from the firms he was connected to and felt comfortable with. But then, there is no guarantee that these people would not give advice favoring their firms, knowingly or perhaps subconsciously (for example, they may be under the grips of a worldview that increases the perceived importance of their firm’s survival for the health of the US economy).

This refers to an “event study” that looks at how the prices of different financial firms responded to the announcement that Timothy Geithner would be Treasury Secretary. Pointer from Mark Thoma.

I tend to discount event studies. For one thing, I suspect that there is a lot of “survivor bias” in that event studies that fail to lead to results that show something the authors want to show probably never see the light of day. But I happen to agree with the hypothesis that financial regulators are subject to cognitive capture by the large financial firms.

Cosmos and Taxis

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A new journal that looks interesting.

emergent orders are unplanned and exhibit orderly development trajectories, but only some of them are spontaneous orders in the sense of providing easily interpreted feedback to order participants. Examples of emergent orders that are not spontaneous in the sense of Hayek or Polanyi are civil society, the ecosystem, and human cultures.

That is from the editorial introduction by David Emanuel Andersson. Pointer from Jason Collins.

Knowledge, Power, and PSST

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James DeLong invited me to connect the two during the Q&A period here. What I would say is this:

PSST says that in a complex economy, employment fluctuates as unsustainable patterns of trade fall apart and new sustainable patterns get created. In that context, government spending creates new patterns that are unsustainable, such as those in now-failed “green energy” firms that received loan guarantees. The patterns that government creates tend to be unsustainable because of a knowledge-power discrepancy. Government has the power to command resources, but it does not have the knowledge that the market system provides about how to use resources.

So that is the sense in which one might relate the two.

Polarization, the 1960s, and Today

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I have been thinking about this. During the era of Vietnam protests, politics was quite heated. I would describe it as confrontational, with traces of violence. The tactics today strike me as milder (or subtler). However, I think we were better off back then in two ways.

1. The vast majority of the American people were repelled by confrontations with traces of violence, and they expressed this through voting for Richard Nixon, particularly his landslide re-election in 1972. I hate to give Nixon credit for anything, but he did provide a vehicle through which the silent majority got its message across. Today, it may be the case that most people are sick of partisanship, but it is less likely that they will find a vehicle with which to express that. Primaries being what they are, could we wind up in 2016 with Ted Cruz vs. Elizabeth Warren? Even if a centrist were elected, would the polarization in Congress remain too intense to be overcome?

2. Back then, elite individuals changed their minds and reversed course. A lot of prominent supporters of the Vietnam War, including Senators who voted for the Gulf of Tonkin resolution, recanted and turned against the war. The economists who had enthusiastically supported “incomes policies” (meaning wage and price controls) and pooh-poohed monetary policy as an inflation-fighting tool recanted, based on experience. I don’t see that sort of mind-changing being possible today. If Obamacare ends up helping millions more people than it harms, will its opponents recant? If Obamacare ends up harming millions more people than it helps, will its supporters recant?

I am most worried about problem (2), the way that people are closing their minds. I have said that very few bloggers or newspaper columnists seek to communicate with people on the other side or to open minds of people on their own side. Instead, the goal seems to be to ensure the opposite–that people on your own side keep their minds closed. You reinforce mind closure by demonizing the other side, using ad hominem and straw-man arguments, and by working intensively to reinforce your side’s narrative through using spin, denial, and bullying.

And Yet They Stay in Yuma

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The WSJ reports,

The October unemployment rate was a staggering 31.9% in the metro area of Yuma, Ariz., and 25.2% in El Centro, Calif., according to a Labor Department report released Thursday. They had the highest unemployment rates, which aren’t seasonally adjusted, among the 372 metro regions measured by the Labor Department’s monthly report.

Other regions — namely, those benefiting from a natural resources boom — are humming. Bismarck, N.D., for example, had the nation’s lowest unemployment rate in October at 1.7%.

I think we know how those on the right would try to explain why people stay unemployed in Yuma rather than move to Bismarck. What is the explanation that comes from the left? Mark Thoma? Brad DeLong? Anyone?

I am quite serious. I do not want sarcastic answers from people on the right. I would like someone on the left to offer a reasonable counter to the obvious story that someone on the right would tell.

The Confiscation Option

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Romain Hatchuel writes,

As applied to the euro zone, the IMF claims that a 10% levy on households’ positive net worth would bring public debt levels back to pre-financial crisis levels. Such a tax sounds crazy, but recall what happened in euro-zone country Cyprus this year: Holders of bank accounts larger than 100,000 euros had to incur losses of up to 100% on their savings above that threshold, in order to “bail-in” the bankrupt Mediterranean state. Japanese households, sitting on one of the world’s largest pools of savings, have particular reason to worry about their assets: At 240% of GDP, their country’s public debt ratio is more than twice that of Cyprus when it defaulted.

I consider this to be one of the most likely scenarios.