John Cochrane vs. Financial Intermediation

He writes,

demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For [money-market?] funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable.

I suppose Murray Rothbard would have liked this.

My own aphorism about financial intermediation is that the nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets, which the financial sector accommodates by doing the opposite. If that aphorism is correct, then Cochrane’s vision involves getting rid of financial intermediation.

I suspect that the optimal amount of financial intermediation is not zero. However, I suspect that it is not as much as we get in a world in which there is deposit insurance, too-big-to-fail guarantees, and tax advantages of leverage. Here, Cochrane’s tactical approach is interesting.

Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.

The way I put it is that you cannot make financial institutions too regulated to fail. So instead of trying to make financial institutions harder to break, try to make them easier to fix. This means taking away the incentives to adopt unstable financial structures. Cochrane would go further and penalize unstable financial structures using taxes.

Meanwhile, Peter Wallison warns that the command-and-control approach to regulation has a logic of ever-widening jurisdiction.

The Financial Crisis and Wealth Transfer

Amir Sufi writes (with Atif Mian).

The strong house price rebound in high foreclosure-rate cities likely reflects these markets bouncing back after excessive price declines. But these foreclosed properties are not being bought by traditional owner-occupiers that plan on living in the home. Instead, they have been bought by investors in large numbers.

This is from a new blog spotted by Tyler Cowen, and both of the first two posts are worth reading in their entirety.

The picture that I get is of a pre-crisis economy in which middle- and lower-middle-income households thought they were doing well in the housing market. Then their house prices collapsed. Vulture investors swooped in to buy. Meanwhile, the government bailed out big banks and the stock market boomed. Some folks will credit the Fed for the latter. I don’t, but that is a bit beside the point here.

Net this all out–the sucker bets on housing by the non-rich, followed by big gains by wealthier folks in stocks and in foreclosed houses, and you get a picture of a huge regressive wealth transfer engineered in Washington. Carried out primarily by those who profess to be outraged by inequality.

Attribution to the Fed

David Beckworth writes,

The figures below document this failure by the FOMC. The first figure shows the 5-year ‘breakeven’ or expected inflation rate. This is the difference between the 5-year nominal treasury yield and the 5-year TIPs yield and is suppose to reflect treasury market’s forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and half months leading up to the September FOMC meeting. This forward looking measure was screaming trouble ahead, but the FOMC ignored it.

He includes several charts. Read the whole thing. If you tell me that the expected inflation rate has declined from 2.72 percent to 1.23 percent, I think that this is somewhat bearish news. But it is not the end of the world.

See also Matt O’Brien‘s reading of the Fed minutes of 2008. It is quite stunning to consider Ben Bernanke’s behavior during September. On the one hand, he participated in the Paulson Panic, supporting TARP and going all out to save the banks. On the other hand he thought that the risks of inflation and recession were relatively balanced. It is consistent with my view of how the Fed looks at the world, which is through the eyes of the big NY financial institutions.

Still, the way I see it, the attempt to attribute the Great Recession to monetary policy seems forced. The people who believe it really believe it. And I cannot tell you that it is absolutely impossible that a small change in expected inflation can send the economy down the toilet. But I think that the human bias to try to find simple, single causes for things is something to correct for here.

Scott Sumner on the Fed Transcripts

He writes,

Note that on the very day of the September 16 meeting, the meeting at which the Fed refused to cut rates due to fear of “high inflation,” the TIPS spreads were showing only 1.23% inflation over the next 5 years, well below target. The Fed should have ignored its own worries about inflation, and instead relied on the wisdom of the crowds. The crowd is not always right, but they are more reliable than the Fed, especially when conditions are changing rapidly. Market participants saw the bottom dropping out of the economy using millions of pieces of highly dispersed information, while the clumsy Fed waited for macro data that comes in with long lags.

The idea of relying on market forecasts is what puts the “market” in market monetarism. An interesting question is how much the Fed would have had to do to cause both actual and expected inflation (or nominal GDP) to change. My inclination is to believe that a lot more M would have merely resulted in a lot less V.

What I’m Reading

I finished Gregory Clark’s new book. I put it in the must-read category. I hope to publish a review on line in the next few months.

I am now reading Fragile by Design by Charles Calomiris and Stephen Haber. I posted a few months ago on an essay they wrote based on the book. I also attended yesterday an “econtalk live,” where Russ Roberts interviewed the authors in front of live audience for a forthcoming podcast. You might look forward to listening–the authors are very articulate and they speak colorfully, e.g. describing the United States as being “founded by troublemakers” who achieved independence through violence, as opposed to the more boring Canadians.

I think it is an outstanding book, although in my opinion it is marred by their focus on CRA lending as a cause of the recent financial crisis. This is a flaw because (a) they might be wrong and (b) even if they are right, they will turn off many potential readers who might otherwise find much to appreciate in the book. Everyone, regardless of ideology, should read the book. It offers a lot of food for thought.

I am only part-way through it. The story as far as I can tell is this:

1. There is a lot of overlap between government and banking. Governments, particularly as territories coalesced into nation states, needed to raise funds for speculative enterprises, such as wars and trading empires. Banks need to enforce contracts, e.g., by taking possession of collateral in the case of a defaulted loan. Government needs the banks, and the banks need government.

2. If the rulers are too powerful, they may not be able to credibly commit to leaving banks assets alone, so it may be hard for banks to form. But if the government is not powerful enough, it cannot credibly commit to enforcing debt contracts, so that it may be hard for banks to form.

3. Think of democracies as leaning either toward liberal or populist. By liberal, the authors mean Madisonian in design, to curb power in all forms. By populist, the authors mean responsive to the will of popular coalitions of what Madison called factions.

4. If you are lucky (as in Canada), your banking policies are grounded in a liberal version of democracy, meaning that the popular will is checked, and regulation serves to implement a stable banking system. If you are unlucky (as in the U.S.), your banking policies are grounded in the populist version of democracy. Banking policy reflects a combination of debtor-friendly interventionism and regulations that favor rent-seeking coalitions who shift burdens to taxpayers. The result is an unstable system.

I may not be stating point 4 in the most persuasive way. I am not yet persuaded by it. In fact, I think libertarians will be at least as troubled as progressives are by some of the theses that the authors promulgate.

Brad DeLong’s Questions

His post is here. I will insert my answers.

Why is housing investment still so far depressed below any definition of normal?

In the U.S., politicians shifted from punishing mortgage lenders for making type II errors (turning down borrowers for loans that might have been repaid) to punishing them for making type I errors (lending to borrowers who might default). In addition, politicians interfered with the foreclosure process. This kept markets from returning to normal, and it further discouraged mortgage lending. What good is the house as collateral for a loan in a world where the government keeps the lender from getting at it?

Why has labor-force participation collapsed so severely?

I believe that this is a trend, amplified by the cycle. Many workers are facing stiff competition from foreign labor and from capital. At the same time, the non-wage component of compensation has gone up, because of health insurance costs. These factors put extreme downward pressure on take-home pay for many workers, and they have responded by dropping out of the labor force.

Why the very large spread between yields on safe nominal assets like Treasuries and yields on riskier assets like equities?

I lean toward a Minsky-Kindleberger answer. During the Great Moderation, confidence in financial intermediation grew. We thought that banks had discovered new ways to manufacture riskless, short-term assets out of risky, long-term investment projects. Then came the financial crisis, and distrust of financial intermediation soared. This made it harder to convince people that you could provide them with riskless, short-term assets backed by risky, long-term projects.

Why didn’t the housing bubble of the mid-2000s produce a high-pressure economy and rising inflation?

It took place in the context of the long-term trend to displace many American workers with capital and with foreign labor. The bubble took us off that trend and the crash put us back on it.

To what extent was the collapse of demand in 2008-2009 the result of the financial crisis and to what extent a simple consequence of the collapse of household wealth?

Great question. It appears that the collapse of household wealth is a sufficient explanation. But if so, then what was the point of TARP and the other bailouts? Of course, putting on my PSST hat, I would reject a phrase like “collapse of demand.” I would say instead that in the wake of the financial crisis, the psychology of existing businesses was that it was a good time to shore up profits by trimming the work force, and the psychology of entrepreneurs was that it was not a good time to try to obtain funding for new businesses.

Why has fiscal policy been so inept and counterproductive in the aftermath of 2008-9?

Not a question that I can answer, given that we disagree on what constitutes inept and counterproductive.

Why hasn’t more been done to clean up housing finance (in America) and banking finance in Europe)?

Politicians care about what happens on their watch. That is why you can count on them to bail out failing financial firms (“Yes, we should worry about moral hazard. But risk some sort of calamity because of a visible financial bankruptcy? Not on my watch.”) That is why you can count on them not to institute major financial reforms. (“Of course, we need a new design here. But do something that could cause short-term disruption to some constituents? Not on my watch.”)

Incidentally, I diagnosed the “not on my watch” bias toward bailouts way back in 2008. Also in September of 2008, I wrote,

Five years from now, we could find ourselves with no exit strategy. My guess is that we’ll be pretty much out of Iraq by then. But it would not surprise me to see Freddie and Fannie still in limbo.

You can read Robert Waldmann’s answers here. Pointer from Mark Thoma.

Ben Bernanke’s Valedictory

He says,

The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions

The Bagehot policy is to lend freely, at a penalty rate. If you lend freely at a penalty rate, you effect financial triage. Banks that are fine don’t borrow. Banks that are insolvent go under anyway. And banks that are temporarily illiquid use your loans to recover. Instead, if all you do is lend freely, then you are simply handing out favors, which turns banking into an exercise in favor-seeking.

He goes on to say,

Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries.

This is a popular story among Keynesians now. It was not in the textbooks before the crisis.

Scott Sumner will be disappointed to see that Bernanke does not believe in the theory of monetary offset.

Fun Re-reading

For the macro book that I am working on, I wanted to refresh my memory for how the financial crisis played out. I went back to blog posts that I wrote in 2007. You can find them here. Scroll down to December, and look for posts “subprime daily briefing” (sometimes named slightly differently).

I staked out an early position against bailing our borrowers. I have no regrets there. At one point I said that the total wealth loss from the crisis would not be as large as the loss from popping the dotcom bubble–I think I was wrong about that.

I also staked out an early position in favor of capital forbearance by bank regulators, meaning that they would not force banks to sell assets at distressed prices to meet capital requirements. I still think that compared with what regulators actually did, this was a better approach.

Also interesting are the various links from the posts. For example, I found a paper by Michael Bordo, dated September 28, 2007.

Many of the financial crises of the past involved financial innovation which increased leverage. The 1763 crisis was centered on the market for bills of exchange, Penn Central on the newly revived (in the 1960s) commercial paper market, the savings and loan crisis of the early 1980s on the junk bond market, LTCM on derivatives and hedge funds.

In the most recent episode, the financial innovation derived from the securitization of subprime mortgages and other loans has shifted risk away from the originating bank into mortgage and other asset backed securities which bundle the risk of less stellar borrowers with more creditworthy ones and which were certified by the credit rating agencies as prime . These have been absorbed by hedge funds in the US and abroad, by offshore banks and in the asset backed commercial paper of the commercial and investment banks. As Rajan ( 2005) argued, shifting the risk away from banks who used to have the incentives to monitor their borrowers to hedge funds and other institutions which do not, rather than reducing overall systemic risk increased it by raising the risk of a much more widespread meltdown in theevent of a tail event as we are currently witnessing.

Bernanke and History

the WSJ presents Five takes, three positive and two negative. Michael Bordo writes,

During the Fed’s first 100 years, it has shifted gradually from being a banker-run to an economist-run central bank, culminating in Ben Bernanke’s assumption of the chairmanship in 2006. His appointment promised to bring the academic rigor of modern monetary economics to the chairmanship. Bernanke’s research, advocating greater transparency and better communication to enhance the central bank’s credibility, augured well for continuing low and stable rates of inflation.

Bordo’s take is negative. I have to say that I cannot agree that Bernanke made the Fed an economist-run central bank. During the crisis, it seemed to me to be a banker-run central bank.

Normal AD vs. the Credit Channel

‘Uneasy Money’ writes,

try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

Pointer from Tyler Cowen. This argument broke out five years ago, and it is no closer to being settled. I might phrase it as the following multiple choice question:

a) the economic slump caused the financial crisis (the Sumnerian view, endorsed above)

b) the financial crisis caused the slump (the Reinhart-Rogoff view; also the mainstream consensus view).

c) both are symptoms of longer-term structural adjustment issues (I am willing to stand up for this view. Tyler Cowen also is sympathetic to it. Note that I do not wish in any way to be associated with Larry Summers’ view, which is that the structural issue is that we have too much saving relative to productive investments.)

d) both are symptoms of a dramatic loss of confidence. As people lose confidence in some forms of financial intermediation, intermediaries that are heavily weighted in those areas come to grief. Se see disruptions to patterns of trade that depend on those forms of intermediation. Moreover, as businesses lose confidence, particularly in their ability to access credit, they trim employment and hoard cash.

I want to emphasize that I see a reasonable case to be made for any of these views. There may be yet other points of view that I would find reasonable (although Summers’ “secular stagnation” is not one of them). In macroeconomics, if you think you have all the answers, then I cannot help you. I think that this is a field in which doubts are more defensible than certainties.