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.

The Mervyn King Book

It is called The End of Alchemy. I can give it faint praise, but not much more than that.

1. It is long-winded.

2. I share his view that risk-based capital regulations inject a false sense of precision into bank regulation.

3. His main idea is this:

The aim of the PFAS [Pawnbroker for all seasons] is threefold. First to ensure that all deposits are backed by either actual cash or a guaranteed contingent claim on reserves at the central bank. Second, to ensure that the provision of liquidity insurance is mandatory and paid for upfront. Third, to design a system which in effect imposes a tax on the degree of alchemy in our financial system.

Here is how I understand the idea would work. A bank would make a risky loan of, say, $100. The bank and the central bank would agree that in an emergency the loan could be sold to the central bank for, say, $90. In that case, the bank could finance up to $90 of the loan with deposits. This would replace deposit insurance, risk-based capital regulations, and other attempts to reconcile the desire to prevent the bank from failing with the need to address moral hazard.

I do not see how this can handle modern financial instruments. Take AIG, for example. Their problem was that liquid liabilities appeared seemingly out of nowhere, as “collateral calls” on the credit default swaps that they had written on mortgage securities. There is no way that this contingency would have been built into King’s system. King writes,

No doubt there would be other practical issues to resolve, but the reason we employ high-quality public servants is to solve such problems.

That was the exact sort of hand-waving that came with the original TARP proposal to buy up the “toxic assets” in order to fix the financial system. Those of us who understood the financial instruments involved knew that it was impossible to work that way, and TARP as implemented did not work that way at all.

4. Perhaps of all the high-level officials involved in central banking over the past twenty years, King’s thinking is the most nuanced, realistic, and humble. And yet his ideas did not impress me. This is going to sound really arrogant, but I do not believe that the central bankers know enough about finance to be able to fulfill their promise to stabilize financial markets.

An Accounting Threat

The WSJ reports,

Starting in 2017, EU rules will require European governments to calculate the total amount they must pay current and future pensioners. Making this obligation more visible could spur them to deal with it, said Hans Hoogervorst, chairman of the International Accounting Standards Board and a former Dutch finance minister. “It will make clear that the current situation is unsustainable.”

Such a rule would be helpful here, as well.

Jason Collins on John Kay

Jason makes it sound like Kay’s book is worth reading.

One of the most interesting threads in the books is that many of the regulatory mantras are about the financial intermediaries, not the end users. The drives for transparency and liquidity in particular come in for criticism by Kay. First, the demand for transparency is a sign of the problem

The quoted passage that follows strikes me as very good. I also have argued that non-transparency is in some sense the point of financial intermediation. If I know everything about a bank’s portfolio, then I do not need the bank. I can just buy the portfolio myself.