Doug Elmendorf on the Debt

He writes,

Together with Brookings Senior Fellow Louise Sheiner, I have analyzed alternative explanations for low Treasury rates and the implications of each for budget policy (Elmendorf and Sheiner, 2016). We found that most explanations imply that the country should have a higher debt-to-GDP ratio than otherwise. We find that most explanations also imply that federal investment should be higher than otherwise, and I will come back to that later. The intuition for these results is that interest rates show the direct cost to the Treasury of its borrowing and provide information about the indirect cost to the economy of Treasury borrowing—and if costs will be persistently much lower than we are accustomed to, then more borrowing, especially for investment, passes a cost-benefit test.

Pointer from Tyler Cowen.

Of course, one possible explanation for low interest rates is that growth prospects are poor. Another possible explanation is that we are in a bond bubble. If either of those turns out to be the case, then we are going to wish that we had less debt to contend with.

Another Idiosyncratic Comment

Kevin Erdmannn comments,

It seems like you’re making the very mistake Smith is warning about. I don’t think historians looking at the newspapers of 2005 would be struck with the high level of trust we had in financial intermediaries. We imposed our distrust on them politically. The GSEs had four CEOs during the 2000s. All four were driven out. Ironically the second pair are accused of understating loss reserves in 2007. The first pair were paying fines in 2007 because they had been accused, among other things, of overstating loss reserves to manage earnings. It was impossible to be a GSE executive in the 2000s without being accused of fraud. The idea that the housing boom happened because of too much trust in financial intermediaries is laughably implausible. The only reason it seems plausible is because communal distrust is so ubiquitous that you will always find support for the idea that we trust them too much.

I agree that political meddling with Freddie and Fannie was harmful, and that they were better run before their CEOs were forced out in scandals that were either minor or perhaps not scandals at all. However, once that happened, confidence in Freddie and Fannie to invest in quality mortgages was unwarranted. More important, the confidence in the private mortgage securities market, based on AAA-ratings for mortgage tranches, was quite unwarranted. That form of financial intermediation got out of control.

Common-law Banks

A commenter asks,

What do you think of the limited purpose banking proposal advanced by Laurence
Kotlikoff and others? Link to PDF:

I am skeptical of the ability of government to design banks. It is one thing to write legislation that defines the activities that constitute banking and to issue charters and regulations to these legislatively-defined banks. It is something else entirely to keep banking from breaking out somewhere else.

Consider the money-market fund as an example of what I mean by a common-law bank. Money market funds are not banks as legally defined. They were not eligible for deposit insurance. And yet, I would argue that the regulators hit the panic button in 2008 because of what happened to Reserve Primary money market fund as a result of the Lehman failure. So from a common-law perspective, money market funds had become banks by the time of the financial crisis.

What Was Glass-Steagall?

I don’t think that Robert Reich actually knows.

Some argue Glass-Steagall wouldn’t have prevented the 2008 crisis because the real culprits were non-banks like Lehman Brothers and Bear Stearns. But that’s baloney. These non-banks got their funding from the big banks in the form of lines of credit, mortgages, and repurchase agreements. If the big banks hadn’t provided them the money, the non-banks wouldn’t have got into trouble. And why were the banks able to give them easy credit on bad collateral? Because Glass-Steagall was gone.

Pointer from Alex Tabarrok. Reich seems to think that Glass-Steagall was some sort of magical regulation that allowed regulators to keep banks from making unwise loans.

In fact, my understanding (like most commentators, I have not actually read the law itself) is that it was intended to separate commercial banking from investment banking. That is, one type of institution could take deposits and make loans, and another type of institution could underwrite securities. It started to fall apart in the 1970s, when money market funds were invented, allowing investment banks to issue debt that looked a lot like deposits. This caused banks to complain that financial activity was going to shift out of banks, which was going to hurt banks and make bank regulation irrelevant. The 1980s were spent with lobbyists and legislators trying to work out a fair way for commercial banks to compete in investment banking and vice-versa.

Ironically, what Reich is describing, with commercial banks lending to investment banks, shows that the two were still somewhat separate even ten years ago. I am willing to be corrected, but as far as I know, there was nothing in Glass-Steagall to stop a commercial bank from lending to an investment bank. Repurchase agreements and lines of credit were not forbidden. And when Reich says that non-banks received mortgages from commercial banks, he is completely unhinged.

I continue to believe that the Nirvana Fallacy it what drives a lot of analysis of the financial crisis, and of government intervention in general. That is, if you believe that Nirvana is achievable through government intervention, then if we have disappointing outcomes it must be because government is being held back from intervening the way it should.

The overall Atlantic piece to which Tyler refers includes comments from some left-leaning economists that are actually reasonable concerning the irrelevance of Glass-Steagall. But on the whole, the left is locked into its Nirvana fallacy of financial regulation.

Larry Ball Gets Pushback

From Stephen G. Cecchetti and Kermit L. Schoenholtz:

There is certainly room for debate, but we see the question of whether Lehman’s net worth was negligible or sharply negative as ancillary to the real issue. In important ways, lending to a bank of doubtful solvency is little different from lending to one that is certainly so. It will continue to put other institutions, and therefore the system, at risk. In this case, central bank lending to Lehman, an institution widely thought to be bankrupt, would have tarnished everyone else.

Pointer from Mark Thoma. My thoughts:

1. For those of us inclined to agree with this point, an implication is that Citigroup should have been allowed to fail. In fact, the whole bailout policy was misguided. Remember how some banks were forced to take bailout funds even if they did not want them? The idea was exactly to “tarnish everyone else” in order to avoid tarnishing the insolvent banks!

2. Regardless of the merits of letting Lehman fail, one of Ball’s main points still stands. That is, Bernanke and others have been lying by claiming that the decision was based on legal considerations. Ball did not find any evidence that the Fed made a judgment based on such considerations. In fact, it appears that it was not the Fed’s judgment at all, and instead Hank Paulson was calling the shots.

Paulson, Bernanke, and Lehman, continued

James B. Stewart writes,

One of the more intriguing questions Professor Ball tackles is why Mr. Paulson, rather than Mr. Bernanke, appears to have been the primary decision maker, when sole authority to lend to an institution in distress rests with the Fed. The answer, he suggests, is to be found more in psychology than data.

“By many accounts, Paulson was a highly assertive person who often told others what to do, and Bernanke was not,” Professor Ball writes. “Based on these traits, we would expect Paulson to take charge in a crisis.”

Pointer from Mark Thoma.

Stewart, who did his own reporting on the events, supports Professor Ball’s view. My reading of Paulson is that he is a high-testosterone guy. My reading of Bernanke is that he isn’t. I have always viewed Paulson as the great villain of the financial crisis response. I do not believe that any of the bailouts were justified, and I view him as the driver of the bailouts.

Suppose you take a Bagehot view, which is that in a crisis the central bank should lend freely, on good collateral, at a penalty rate. In the case of Bear Stearns, my recollection is that the Fed took on crummy collateral. Ball claims that Lehman had good collateral that the Fed could have lent against.

Jason Collins reviews Jonathan Last

Collins writes,

So, if government can’t make people have children they don’t want and can’t simply ship them in, Last asks if they could help people get the children they do want. As children go on to be taxpayers, government could cut social security taxes for those with more children and make people without children pay for what they’re not supporting. (Although you’d want to make sure there was no net burden of those children across their lives, as they’ll be old people one day too. There are limits to how far you could take that Ponzi scheme.)

Keep in mind that lower birth rates are an international phenomenon, so I am reluctant to place much weight on U.S.-specific factors. My sense is that the decline in birth rates is correlated with, if not caused by, increased education of women. If that is the main causal factor, then it probably is not something that is going to be reversed.

Also, I am not convinced that there is such a down side to slower population growth and eventual decline. Yes, it messes up entitlement programs for the elderly, but that is because those programs are ill conceived, particularly in not indexing the age of government dependency to longevity. You should fix the entitlement programs to deal with the demography rather than try to fix demography to deal with entitlement programs.

The Fed and Lehman

Laurence Ball writes,

The people in charge in 2008, from Ben Bernanke on down, have said repeatedly that they wanted to save Lehman, but could not do so because they lacked the legal authority. . .

I conclude that the explanation offered by Fed officials is incorrect, in two senses: a perceived lack of legal authority was not the reason for the Fed’s inaction; and the Fed did in fact have the authority to rescue Lehman. I base these broad conclusions on the following findings:

  • There is a substantial record of policymakers’ deliberations before the bankruptcy, and it contains no evidence that they examined the adequacy of Lehman’s collateral, or that legal barriers deterred them from assisting the firm.
  • Arguments about legal authority made by policymakers since the bankruptcy are unpersuasive. These arguments involve flawed interpretations of economic and legal concepts, and factual claims that do not appear to be accurate.
  • From a de novo examination of Lehman’s finances, it is clear that the firm had ample collateral for a loan to meet its liquidity needs. Such a loan could have prevented a disorderly bankruptcy, with negligible risk to the Fed.
  • More specifically, Lehman probably could have survived by borrowing from the Fed’s Primary Dealer Credit Facility on the terms offered to other investment banks.

In short: Bernanke lied, Lehman died.

My thoughts:

1. Whenever you look at government policy in financial markets, assume that the primary goal is to allocate credit to preferred borrowers, particularly toward governments themselves. This goes for regulatory policy and so-called monetary policy.

2. I am inclined to interpret the decisions made in 2008 as credit allocation decisions based on Hank Paulson’s personal whims. Note that Ball says

The record also shows that the decision to let Lehman fail was made primarily by Treasury Secretary Henry Paulson. Fed officials deferred to Paulson even though they had sole authority to make the decision under the Federal Reserve Act.

The decisions helped some investment banks, including Goldman Sachs (the “AIG bailout” was mainly a funneling of short-term Treasury securities to Goldman and other investment banks). The decisions hurt Freddie Mac, Fannie Mae, and Lehman. I think that is what Paulson wanted to see happen.

3. Whereas Ball seems to suggest that the Fed should have bailed out Lehman, I am more inclined to believe that the government should have allowed institutions to go through bankruptcy or to make concessions among themselves. By the latter, I mean that if nobody bails out AIG, then maybe Goldman and the others decide that “collateral calls” are only going to hurt themselves in the long run, so they allow AIG to keep some near-term liquidity, and it ultimately survives.

4. The consensus story from the establishment is that Bernanke and Paulson saved the country from another Great Depression. Maybe that story is right, but with my heterodox views I do not believe it. I think that many ordinary citizens do not believe it, either. The widespread suspicion of the establishment gave rise to such phenomena as the Tea Party and, arguably, Donald Trump. It would be easier to defend the establishment if you could say that Bernanke was telling the truth.

The Bond Bubble

Balazs Csullag, Jon Danielsson, and Robert Macrae write,

A rational buy-and-hold investor who trusts the central banks should not buy long-dated bonds. While a high degree of central bank credibility used to be important to bond holders, today this seems to be no longer the case, especially for those buying German bonds.

The only way to get decent long-term returns with current yields so low is to go back to the persistent deflation of the gold standard, because most post-war inflation rates imply losses. For example, there are only eight years in Germany with lower than breakeven inflation for our 30-year buy-and-hold investor today.

Pointer from Mark Thoma.

The thing is, once interest rates start rising, they could explode, because at that point people may doubt the ability of governments to pay back their debts.

What if the central banks hold all of the bonds? That means that those central banks will be sitting on losses. If their cost of funds rises (say, because the central bank has to pay a higher interest rate on reserves), then central banks become a drain on the treasury.

Consolidating the Central Bank and the Treasury

Thomas Klitgaard and Harry Wheeler write,

The discussion above offers up a perspective on what is meant by “monetizing debt.” This term refers to a central bank buying government bonds and promising to keep them on its balance sheet with the result that the increase in reserves in the banking system translates into higher prices. This outcome, though, requires that the central bank not pay the appropriate interest rates on reserves. If it does, then an asset purchase program is just an effort that shortens the maturity of public-sector debt and will likely have few or no implications for future inflation.

Pointer from Mark Thoma.

Another implication is that it makes the interest cost of the government more sensitive to movements in short-term interest rates. So a sudden loss of confidence in the government by investors which raises interest rates would become self-reinforcing. And if the only way out of such a debt crisis is to print money, then there are implications for future inflation.