Is Demography (Economic) Destiny?

The Economist blog writes,

An ageing population could hold down growth and interest rates through several channels. The most direct is through the supply of labour. An economy’s potential output depends on the number of workers and their productivity. In both Germany and Japan, the working-age population has been shrinking for more than a decade, and the rate of decline will accelerate in coming years (see chart). Britain’s potential workforce will stop growing in coming decades; America’s will grow at barely a third of the 0.9% rate that prevailed from 2000 to 2013.

Pointer from Tyler Cowen.

Along seemingly similar lines, Karl Smith writes,

It’s no accident that this phenomenon appeared in Japan first. As its population began to stagnate well before the rest of the industrialized world, investors found themselves with loads of capital, a dearth of workers, and repayment terms they could not meet.

First, think about this in the absence of inter-generational transfer schemes like Social Security.

1. If people live longer than they used to, then they either have to produce more (probably by retiring later) or consume less.

2. If birth rates decline, then you let capital depreciate faster than it would otherwise. Think of an economy where the only capital goods are houses that stay in good condition for fifty years. When birth rates are rising, you need to keep using some houses longer than fifty years, even though they no longer are in good condition. When birth rates are falling, you can take some houses out of service before fifty years, even though they still are in good condition.

This seems quite straightforward to me, and it is does not suggest that demographic changes should be highly disruptive. I am not persuaded by just-so stories about Japan. One can conjure many such stories. For example, maybe Japan slowed down because its corporatist approach to capital allocation was only effective for a decade or two.

How the Fed Became a Giant Hedge Fund

Jeffrey Rogers Hummel tells the story.

Phase Two of Bernanke’s policies transformed the Federal Reserve from a central bank confined primarily to managing the money supply into an institution that is now a giant government intermediary borrowing massive sums in order to allocate credit. In that respect, the Fed has become similar to Fannie or Freddie, with the important distinction that the Fed has greater discretion in subsidizing a wider variety of assets.

Government Accounting

Jason Delisle and Jason Richwine write,

The momentum for fair value accounting is building. The Congressional Budget Office has all but endorsed it, describing fair value as a “more comprehensive” accounting of costs. Scholars with the Federal Reserve, the Financial Economists Roundtable, and the Simpson-Bowles fiscal commission are on board as well. Reps. Paul Ryan and Scott Garrett have championed this issue in the House of Representatives, which passed legislation to put federal loan programs on fair value accounting earlier this year. That vote, however, mostly followed party lines, and the Senate has never advanced similar legislation.

If a private firm accounted for its future obligations the way that the government does, it would be prosecuted. One of the ideas I include in Setting National Economic Priorities (at this point, still vaporware) is government accounting reform.

Target Bubbles?

Ian Talley (WSJ) reports,

Financial market risk-taking is reaching excesses comparable to those that precipitated the global financial meltdown, José Viñals said

That is the “top adviser to the International Monetary Fund,” according to the story.

My point is not that I agree or disagree. My point is to note the following:

1. It is easier to picture policy makers doing something about excessive risk taking now, after they have seen what can happen, than in 2006.

2. Nothing is being done about this alleged risk-taking.

3. Therefore, it is very hard to picture policy makers doing something about excessive risk-taking in 2006.

Identifying clear and present financial danger is not as easy as it appears to be in hindsight.

The Single Point of Entry Solution

Rebecca J. Simmons writes,

The critical element of the SPOE strategy is the recapitalization of the company’s material operating subsidiaries with the resources of the parent company. For the SPOE top-down approach to work effectively, there must be sufficient resources at the holding company level to absorb all the losses of the firm, including losses sustained by the operating subsidiaries.

SPOE is being touted as the solution to the too-big-to-fail problem. You have a gigantic bank holding company that gets in trouble. You (the FDIC) want to keep all the subsidiaries going, because you want depositors and counterparties not to panic. So you put the holding company into receivership, and only pay off shareholders and debtholders of the holding company after your are sure you have got money to do that.

I may not fully understand this. Here is what I think happens. The value of the subsidiaries as ongoing concerns is positive, say $100. However, if you subtract the value of the outstanding debt of the holding company, the value of the holding company is negative. With, say, $150 in outstanding debt, the holding company’s value is -$50. The receivership creates a new holding company, which will eventually be sold back to the public, but without the outstanding debt. When the new holding company is sold, the debtholders in the old company get first dibs on the proceeds, and if there is anything after that, the equity holders can get it. Again, I could be completely wrong about this, but that is my understanding.

Simmons continues,

The capitalization of the bridge financial company must be sufficient…not only to allow the operating subsidiaries to obtain needed capital from the bridge to continue operations but also to allow stakeholders and the broader public to view the entity as safe and viable as it transitions from failed firm to bridge financial company, and ultimately to emergence as a new firm.

The problem is that financial firms have multiple self-fulfilling states of equilibrium. There is a state in which everyone believes in you, so you pay low interest rates on your debt, and you are fine. There is a state in which counterparties do not believe in you, so your interest costs soar, and you are dead. One key question about SPOE is whether it can prevent a jump from the good equilibrium to the bad equilibrium.

Suppose that we had this strategy in place, with all of the legal means for implementation. I still believe that if JP Morgan Chase or Citigroup got into trouble, the Fed Chairman and the Treasury Secretary would be wetting their pants. In a crisis, the probability that they would go through with SPOE, rather than undertake an ad hoc bailout, is very low.

Francis Fukuyama on Big Banks

In his latest book, Political Order and Political Decay, he writes,

Though no one will ever find a smoking gun linking bank campaign contributions to the votes of specific congressmen, it defies belief that the banking industry’s legions of lobbyists did not have a major impact in preventing the simpler solution of simply breaking up the big banks or subjecting them to stringent capital requirements.

It is taking me a long time to finish Fukuyama’s book. It is long and repetitive. I think that every time I read something from him, my temptation is to condense it to something much shorter. If I post a review, I will let you know, and my guess is that if you read my review you will not need to read the book.

He favors a combination of state capacity, rule of law, and democracy. In terms of our three branches of government, the executive branch is responsible for state capacity, the courts are responsible for the rule of law, and legislatures are to respond to democracy.

(Bryan Caplan is not happy with the concept of state capacity. He suspects that it is a meaningless yay-word. If nothing else, Fukuyama seems to me to endow the word with meaning. It means that bureaucrats are effective and ethical, as in Singapore, rather than ineffective and corrupt, as in India.)

Many on the right consider the administrative state, meaning government agencies operating independently, to be a bug. For Fukuyama, it is a feature. In his view, one main reason that these agencies function poorly in this country is that they face too much interference from Congress and from the courts. In my view, agencies are as easily captured by special interests as are legislators.

If David Brooks ever gets around to reading this book, he will heart it. Like Brooks, Fukuyama longs for a political system in which an autonomous elite governs on behalf of the public good. In Fukuyama’s view, the libertarian efforts to constrain government, including checks and balances as well as federalism, end up backfiring. They make government less effective while not constraining its growth.

The ideas are worth chewing on. Do I believe that the elites would, for example, fix the unsustainable entitlements promises if we had a parliamentary system? Or do I believe that a stronger government would be worse rather than better? It’s a tough call.

A Rant on Narrative vs. Reality re the Financial Crisis

1. Narrative: Subprime mortgages were a consumer protection failure. Thus, we need the Consumer Financial Protection Bureau.

Reality: By a strict definition, predatory lending is when the loan is made with the intent of going to foreclosure and allow the lender to take possession of the house. This was not a factor in the subprime boom, which was fueled by the originate-to-distribute model. In the originate-to-distribute value chain, there is no one whose goal is to take the house from the borrower.

I think you could accuse loan originators of Ponzi lending. That is, lending to borrowers who could only avoid defaulting on the loan by taking out a new loan. Taking out a new loan in turn required continual increase in home prices, so that the borrower could use the equity in the house as collateral. But I would say that the biggest pushers of Ponzi lending were the “affordable housing” lobby, and I think that the last thing we will ever see is the CFPB take on the affordable housing lobby.

2. Narrative: The 1980s deregulation in banking was driven by the free-market ideology of Reagan and Greenspan.

Reality: The three main regulations that were dropped were the restrictions against banks paying market rates for deposits, the restrictions on interstate banking, and the restrictions on combining commercial banking with investment banking. I do not recall any pushback by the left on any of these–until 2008, when they made the retroactive claim that getting rid of Glass-Steagall caused the financial crisis.

In fact, these three regulatory boats had started sinking in the 1960s. The legislation that was passed in the 1980s and 1990s was simply the final order to abandon ship.

In the 1970s and 1980s, the big fight in bank regulation was not left vs. right, or deregulation vs. regulation. It was interest groups battling it out. Wall Street, big banks, savings and loans, and small banks had divergent interests, and that caused gridlock in Congress until things unraveled so much that Congress had no choice but to act.

If you want a parallel today, look at the battles between Amazon and the book publishers, or between Verizon and Google. You aren’t seeing legislators line up on ideological lines in those contests.

3. Free-market economists wanted to turn bankers loose to take whatever risks they wanted, and they got their wish.

Reality: Free-market economists were the strongest proponents of higher bank capital regulations and the biggest skeptics of the Basel risk-based capital regulations. We see the same thing today, with free-market economists skeptical of Dodd-Frank, and mainstream, establishment types like Stan Fischer saying things like

The United States is making significant progress in strengthening the financial system and reducing the probability of future financial crises.

In other words, this time will be different. Pointer from Timothy Taylor.

Bank Breakup Worries

1. I am worried that breaking up the biggest banks would not make the system safer.

I do not believe that having smaller banks would have prevented the 2008 crisis or the next crisis. I do not believe that regulatory policy can prevent such crises. My only solution for systemic financial risk is to try to make the financial system easier to fix when it does break. I think it is easier to fix when there is less debt, so I would look for ways to reduce incentive to take on debt. Instead of subsidies for mortgage borrowing, how about subsidies for down-payment saving? Instead of favorable tax treatment for debt, why not favor equity–or at least be neutral between the two? etc.

For me, breaking up the banks is not a safety issue. It is instead an issue of restoring democracy and the rule of law. Really big banks are crony banks, whose interactions with government officials are at the highest levels. Instead, I would like to see the biggest banks dealt with by career civil servants who are following clear, predictable rules and guidelines.

2. I am worried that it would be difficult to define size.

Once you decide that banks above a certain size should be broken up, you need a definition of size. Among the problems with doing this, the first one that comes to my mind is accounting for derivatives. If you ignore derivatives, then in very short order banks will mutate their loan portfolios into derivative books. But if you try to include derivatives, then the whole notional-value vs. market-value argument is going to kick in. Also, gross exposure vs. net exposure.

Instead, I am attracted to using the amount of insured deposits as a measure of size. It is a clean measure that cannot be gamed using accounting transactions. It is a measure of the potential impact of the bank on the FDIC. Charging a risk premium that is graduated by size would be a reasonable rule-of-law approach to discouraging large banks. Banks could avoid the risk premium by spinning off branches. The giants that were assembled by mergers could be dis-assembled by spin-offs.

3. I am worried about large shadow banks.

You can do a lot of banking without a lot of deposits. You can finance with commercial paper. You can finance with repo. You can write a ton of derivatives. I do not think that this is bad per se. But, just as with large commercial banks, large shadow banks could acquire the political power of large commercial banks.

I welcome suggestions for dealing with shadow banking. I am not thinking about how to reduce the risk of shadow banking. My view is that systemic risk is systemic risk, and you cannot get rid of it by breaking up banks.

What I am concerned with is the political power that might be concentrated in a large financial institution. The problem is that, once you get away from deposits, measuring “large” becomes quite tricky.

Remembering the Suits vs. Geeks Divide

I’ll provide a post-mortem on my appearance at this panel on whether or not to break up the banks after I’ve had more time to reflect.

Prior to the panel, I Googled one of the other panelists, and I found that he had hopes for the Volcker Rule, which would try to keep banks from doing proprietary trading. I am not a fan of the Volcker Rule. In fact, in recent years, I have not been a fan of Paul Volcker, because I think he has what I call a low geek quotient.

What I call Geek Finance has emerged over the past thirty years. It is used extensively in derivatives markets and in mortgage finance. It involves very complex probabilistic simulation models that are used to assign values to long-term, deep out-of-the-money options. Some thoughts.

1. Is Geek Finance a good thing? On the one hand, I would say that we need some rational way of valuing these sorts of options. On the other hand, it is important to be aware of the assumptions that go into such models and not to have too much faith in their precision. In the case of mortgage default risk, for example, it matters whether you assume that house prices across different locations are highly correlated or nearly independent. It matters whether you assume that a large nationwide house price decline is practically impossible or just somewhat unlikely.

2. Shortly after the financial crisis, Robert Merton, who shared the Nobel Prize for developing option price theory, gave a lecture in which he suggested that many top corporate executives did not really understand what was being done by the practitioners who worked for them. I termed this the Suits vs. Geeks divide. Many CEOs, and also many top officials in Washington, had low geek quotients.

3. Whether you love or hate geek finance, whether you want to tolerate it or would seek to get rid of it, you have to understand it. I think that Suits with low geek quotients are dangerous.

4. In 2003, Freddie Mac’s Board ousted a CEO with a high geek quotient and replaced him with a CEO with a low geek quotient. The main change that resulted from that was that Freddie Mac greatly increased its exposure to risky loans.

5. In 2006, Goldman Sachs lost a CEO with a low geek quotient. Subsequently, and this may have been purely coincidental, Goldman was relatively good at reducing its exposure in the mortgage market.

6. The original idea of TARP, which was to use government funds to buy toxic assets, had a low geek quotient. As a geek, I did not think it was workable. Of course, this idea was never implemented. Instead, the TARP money pile was used to inject capital into banks, to restructure GM and Chrysler, and ….well, whatever the President and Treasury Secretary felt like spending it on, it seems.

7. Back to the Volcker Rule. I don’t think it can fly. My prediction is that they will get it off the ground to save face, then it will wobble at low altitude for a bit, and within a few years you will find it resting on the ground. I imagine a sequence of conversations going something like this:

Volcker rulers: Banks, you cannot touch securities.

Banks: But you do want us to hedge our risks, don’t you?

Volcker rulers: Hmmm. OK, but you have to hold your hedging instruments until they mature.

Banks: But when interest rates change, you do want us to rebalance, don’t you?

Volcker rulers: Hmmm. OK, but…

etc., etc., until there is no rule left

People, Countries, and Debt

James Kynge writes about China,

Total debts owed by the government, companies and households have ballooned to 240 per cent of gross domestic product, virtually double the level at the time of the global financial crisis.

This ratio, it is true, remains modest next to some in the west; US debts stand at 322 per cent of GDP, Ireland’s at more than 400 per cent, while Greece and Spain are at about 300 per cent each.

Pointer from Tyler Cowen.

To me, it seems careless to add up the liabilities of government, companies, and households. I object to taking the sum of these numbers and saying “China owes ___.” The debt is not owed by an entity called the country of China. It is owed by disparate entities within the country of China. And much of it is owed to disparate entities within China.

Speaking of which, it also seems careless to ignore assets. Suppose somebody has a $300,000 mortgage and a $30,000 income. You might say, “wow, their debt is 1000 percent of their income!” But that is not so alarming if they have $1 million in assets (maybe the house itself is worth $1 million).

I’m not trying to dismiss the issue. Just the other night, one of my favorite economists pointed out that if the debt burden on the Chinese government starts to pinch, then it might have to stop buying (or even start selling) American government bonds. That could fuel a rise in interest rates, and then the debt burden of the American government would spike up. If that happens, have a nice day. But a high ratio of total liabilities of all of the entities within in a country to its GDP is at best a very imprecise indicator of financial distress.