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.

Ed Kane on Financial Regulation

The headline on the interview is confusing, but his remarks are not.

She [Hillary Clinton] goes part way toward Senator Sanders in proposing to give regulators more power to break up financial firms. But federal regulators have a lot of authority already. The key is to give them the incentive to use that authority. When a bank is in distress, fear of disrupting the system becomes their dominant concern.

Pointer from Mark Thoma. Kane has been around for a long time, and he has been for right for a long time. In the 1980s, he was among those warning about the weakness of capital requirements and the political power of big banks. The fact that his warnings today are similar tells you that Dodd-Frank and other responses to the financial crisis were not sufficient.

The Big Short on Outsider Personalities

This weekend I watched The Big Short. The movie makes a big deal, as does the book, about the odd personalities of the investors who saw the financial crisis coming more clearly than others. Some thoughts on that:

1. If the typical normal person (or normal investor or normal regulator) saw a financial crisis coming, then it would not occur.

2. At any one time, there are lots of outsiders forecasting extreme events. If you bet on outsiders all the time, most of the time you will lose.

3. The challenge for insiders is to filter out the noise from outsiders without filtering out the signal.

4. You filter out signal when you hold as sacred hypotheses beliefs that really should be questioned. As the movie points out, the hypothesis that AAA-rated securities are safe was sacred. The hypothesis that house prices never go down in more than a few locations at the same time was sacred. The hypothesis that new risk management techniques made old-fashioned mortgage underwriting standards obsolete was sacred.

5. People with outsider personalities are less likely to fall into the trap of holding hypotheses as sacred. If you don’t need to get along with the insiders, then you question them. You question them when they are right and you question them when they turn out to be wrong.

6. As you know, I think that MIT economics has produced a set of insiders who hold sacred hypotheses. Math equals rigor. AS-AD. Market failure always justifies government intervention. Etc. The Book of Arnold is an attempt to call them out on it.

Market Monetarism Watch

David Beckworth, with Romesh Ponnuru, makes the NYT.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy.

In a way, this is an easy argument to make.

1. A recession is, almost by definition, the economy operating below potential.

2. Operating below potential is, almost by definition, a shortfall in aggregate demand. The only other type of adverse event is a supply shock, which reduces potential but does not force the economy to operate below that reduced potential.

3. The Fed controls aggregate demand.

4. Therefore, all recessions are the fault of the Fed. Either by commission or omission, the Fed has messed up if we have a recession.

It is an easy argument to make, but I believe close to none of it. I do not believe in the AS-AD framework. And I do not believe (3). If you do not know why I have my views, go back and read posts under the categories “PSST and Macro” and “Monetary Economics.”

My view is that the housing boom and the accompanying financial mania helped hide some underlying adjustment problems in the economy. The crash, the financial crisis, and the response to that crisis all helped to aggravate those underlying adjustment problems. I suspect that, on net, the bailouts and the stimulus diverted resources to where they were less useful for maintaining employment than would have been the case if the government had not intervened. My basis for this suspicion is my belief that people who do not need help are often more effective at extracting money from the government than people who do need it.

There has been much other commentary on the op-ed–see Scott Sumner’s post.

Greg Ip on The Big Short

He says,

But what I think it’s not including in that story is the extent to which these Wall Street guys honestly thought that what they were doing wasn’t that risky. They thought that a Double-A- or Triple-A-rated security had so much protection through various ways, there’s just no way this thing could blow up. And I would say that, in terms of going forward, one of the challenges we as the public and citizens and our government is: How do you create a financial system, how do you create an economy that both gives us the safety that we need to both be happy and to prosper and to take risks without destroying our selves but doesn’t create those fatal levels of complacency?

This is from a Russ Roberts podcast, with much more in the conversation.

Opaque Leverage and Self-Deception

Regarding the movie The Big Short, Tyler Cowen wrote,

There is no central villain, none whatsoever. The filmmakers succeed in showing how the collective actions of many, operating together, can give rise to structural problems and systemic risk. And yet the story remains suspenseful.

People prefer stories with villains.

I think that the story of the financial crisis has to include leverage. Individual home buyers did not put up much of their own capital. The lenders did not put up much of their own capital. The mortgage securities were structured and rated so that banks could hold them with minimal capital.

However, some of this leverage was opaque. People did not understand the way that AIG was contractually obligated to put up billions in collateral if prices moved against them. People did not understand that while Fannie Mae and Freddie Mac were reporting that their sub-prime exposure was less than 2 percent, their exposure to risky loans was closer to 30 percent. People did not understand that mortgage securities rated AAA were not really comparable to AAA-rated bonds. People did not understand that banks had created “structured investment vehicles” and other dodges that made them much more levered than they appeared to be. And by “people,” in all cases I mean regulators and investors.

But finally, the opaque leverage was less intentional bad behavior on the part of financial executives than it was self-deception. Suppose that you had asked executives in 2007 to answer honestly, “Relative to what people outside the firm think, how exposed are you to a decline in house prices and problems in the mortgage market?” My guess is that almost all of them would have said, “We are less exposed than other people think.” And they would have been telling the truth from their point of view.

That is what made the speculators in The Big Short so special. They managed to dig through to reality.

And don’t forget that I coined the term, “Suits vs. Geeks Divide.”

Narayana Kocherlakota on How the Fed Spoiled the Economy

Scott Sumner correctly sees Kocherlakota as supporting Sumner’s view of Fed policy during the financial crisis and its aftermath. Kocherlakota says,

I use the public record to document that, as of late 2009, the FOMC felt that it would be appropriate to use its monetary policy tools to foster a relatively slow recovery in both prices and employment. (The recovery that actually unfolded was slower than the FOMC intended in terms of employment, but close to the FOMC’s intentions in terms of inflation.) I argue that the FOMC’s guarded response can be traced back to its pre-2008 policy framework—that is, to the Taylor Rule. Indeed, because of this baseline “normal” policy framework, the FOMC and many outside observers actually saw the Committee as pursuing a highly accommodative policy.

Read the entire speech, or at least read Sumner’s excerpts from it.

Kocherlakota has lobbed a grenade into the macro establishment’s room. If he (and Sumner) are correct, then history will not be kind either to the Bernanke Fed or to the Taylor rule.

Much as I would love to see those icons brought down, for the moment I am going to stick to my view that the Fed did not set the course for the economy.

Spare the Bank, Spoil the Economy

George Selgin writes,

In contrast to the Fed’s actions in August 2007, its subsequent turn to sterilized lending had it, not buying, but selling Treasury securities, with the aim of preventing its emergency lending from resulting in any overall increase in the supply of bank reserves. Financial conditions were thus “eased,” not generally, but for particular institutions and their creditors. For the rest, credit was actually tightened. Because it serves to redistribute credit rather than to alter its overall availability, sterilized lending is properly regarded, as Marvin Goodfriend insists, as an exercise in fiscal policy rather than one in monetary policy in the strict sense of the term. The principle beneficiaries of this fiscal policy were the creditors of the aided institutions, while the losers were those prospective borrowers who were denied credit because the Fed had directed the reserves that might have supported lending to them elsewhere.

The bailouts were done in the name of saving the economy. What Selgin points out (read the whole thing) is that the Fed went out of its way to offset whatever stimulative effects the bailouts might otherwise have had on the economy.

Also, go back and read what I wrote on September 27, 2008.

What macroeconomic theory says that we run the risk of a Depression if we don’t have a bailout? Try to come up with an argument that is either already in a textbook or that you would put in a textbook. If macro is a genuine discipline, it has to consist of something more rigorous than “If Bernanke is worried, then so am I.”

I was angry then, and I am angry now. Leading pundits and economists will tell you that the bailouts were heroic. They have no use for any thinking that contradicts that narrative.

Good Turner, Bad Turner

In Between Debt and the Devil, Adair Turner writes (p. 61),

Textbook descriptions of banks usually assume that they lend money to businesses to finance new capital investment…But in most modern banking systems most credit does not finance new capital investment. Instead, it funds the purchase of assets that already exist and above all, existing real estate.

…Different categories of credit perform different economic functions and have different consequences. Only when credit is used to finance useful new capital investment does it generate the additional income flows required to make the debt certainly sustainable. Contrary to the pre-crisis orthodoxy that the quantity of credit created and its allocation between different uses should be left to free market forces, banks left to themselves will produce too much of the wrong sort of debt.

What is good about the book is that he invites us to examine how credit is created and where it goes. As he points out, standard macro models have totally ignored this issue.

What is bad about the book is embedded in the last sentence quoted above. We are left to assume that the huge allocation of credit toward housing was the operation of “free market forces.” I do not know about other countries, but for the United States this is totally false. The government was very much involved in channeling credit, and it channeled as much as it could toward housing finance.

Still, I think that what is good about the book makes it worth reading. I plan to say more when I have finished it.