Category Archives: Financial Crises

The Debt Spiral

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Several Hoover Institution scholars write,

In recent months, we have seen an inevitable rise in interest rates from their low levels of recent years. Rising interest rates and increasing deficits threaten to build upon each other to send public debt spiraling upward even faster. When treasury debt holders start to doubt our government’s ability to repay, or to attract future lenders, they will demand higher interest rates to compensate for the risk. If current spending and tax policy continue unaltered, higher interest costs will have to be financed by even more debt. More borrowing puts more upward pressure on interest rates, and the spiral continues.

If, for example, interest rates were to rise to 5 percent, instead of the Trump administration’s prediction of just under 3.5 percent, the interest cost alone on the projected $20 trillion of public debt would total $1 trillion per year. More than half of all personal income taxes would be needed to pay bondholders. Such high interest payments would crowd out financing of needed expenditures to restore our depleted national defense budget, our domestic infrastructure and other critical government activities.

See the post from John Cochrane, one of the authors. If investors, including the Chinese government, grow leery of U.S. government debt, then my guess is that we will see the tactics that are known as “quantitative easing.” That is, the Fed will grow the supply of reserves, so that it and the rest of the banking system absorb a lot of government debt. The trick will be to keep banks from doing a lot of lending other than to the government. My guess is that paying a low rate of interest on reserves won’t be sufficient, and instead some form of financial repression will be needed. By that I mean regulating banks in such a way that buying government debt is approved while making business loans is frowned on.

Wither the center? post-election Italy

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Alberto Mingardi writes,

A country like Italy ought to have a moderate, responsible, free enterprise-oriented right. But it is indeed an “ought”: not, in our case, an “is” and a truly felt tradition in this country.

Michael Barone writes,

As in France, Austria, the Netherlands, and Germany, the traditional center-left party largely collapsed, with just over 20 percent of the vote

My guess is that if the U.S. had a similar electoral system, we would observe the same thing. As of now, a center-left party would do less well than a far-left party. The right would be split among libertarians (not a large bloc), Trump supporters, and traditional conservatives, with the latter possibly split into a faction that stresses social issues and a faction that stresses the economy and foreign policy.

It could be that Martin Gurri is correct, and that the new media environment helps to foster a revolt against elites. But another possibility is that the financial crisis of 2008 had an effect on the perception of elites in America not unlike the Vietnam War. That is, the “best and the brightest” looked really foolish, and they lost the trust of many people.

Taste-makers in the press have not been kind to Vietnam War architects Robert McNamara, McGeorge Bundy, and Dean Rusk. But for policy makers involved in the financial crisis, the outcome has been different. Henry Paulsen, Timothy Geithner, and especially Ben Bernanke are often described by journalists in heroic terms, and they have vigorously patted themselves on the back in their memoirs. Barney Frank and Chris Dodd etched their names in history as the co-author of post-crisis banking legislation, blotting out their prior role as bosom buddies of Freddie Mac, Fannie Mae, and Countrywide Funding when those firms were running up dangerous risks.

The public may have a better intuitive sense of the policy elite’s role in all this. For the center not to wither, it has to earn the trust of the people.

Bitcoin and the prospects for a dollar collapse

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For Medium, I take a skeptical view of the value of Bitcoin as a hedge against hyperinflation.

For citizens looking for hard assets, gold is not the only option. Other commodities, such as copper or wheat, are traded in futures markets. By taking long positions in those commodities, you can profit from inflation. There are mutual funds that invest in commodity indexes, just as there are stock mutual funds that invest in stock indexes.

Cantercap Charlie on finance and the 2008 crisis

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He wrote,

if banks are doing their job, the banking system is illiquid, and the rest of the economy —us— have lots of cash. In Econ 101 this is known as “maturity transformation.” Liquidity-wise, the banking system is simply the mirror image of the economy. Thus, compelling banks to become more liquid inevitably drains cash from all of us who are not banks.

This is another way of saying what I like to say, which is that the public wants to issue risky, long-term liabilities and to hold riskless, short-term assets, and financial intermediaries accommodate this by doing the opposite. This implies that for financial firms, a liquidity crisis blends into a solvency crisis. Banks must shrink their activity if there is sudden pressure on them to make their balance sheets more liquid.

In a more recent post, he writes,

what did cause the crisis? The causes were complex, but one force overwhelmed all others: regulation. Bad regulation. Mainly, the Basel I and Basel II Capital Standards.

He is referring to the Financial Crisis of 2008. Actually, I don’t believe that Basel II was all that important, because it still was mostly unimplemented by the time of the crisis. I would focus on Basel I and also on the Recourse Rule of 2001, which we might think of as Basel I(a).

More interestingly, he goes on to say,

the great untold secret of the crisis was the strength of the US commercial banking industry.

As crazy as this sounds, it may be spot on. Yes, Citigroup was in trouble, as he acknowledges. But most other commercial banks were not in bad shape. Some U.S. investment banks (aka “shadow banks”) were shakier, but the real problems were in Europe. He writes,

European banks in 2007 had aggregate tangible equity of roughly 1 trillion euros (at the time, about $1.1 trillion.) With a sensible leverage ratio of 5.0%, this equity would have supported E20 trillion in assets. But by 2000, the average European bank leverage ratio already had dwindled to 3.8% (insufficient), and then fell further — to 3.0% (wow) in 2007.* That may not sound like a big deal, but it’s more than a 20% systemic increase in leverage in just 7 years. This meant that for European banks alone, the Basel Regs goosed asset demand by at least E7 trillion ($8 trillion).** To think of it another way, European bank assets in 2007 exceeded what would have been prudent leverage (i.e. 5%) by E13 trillion ($15 trillion) — a third of European banking system assets.

I would add that many of the beneficiaries of the “AIG bailout” were European banks.

There is a lot of potential for revisionist history here.

Complexity illustrated by the financial crisis

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This IGM poll of leading economists on the importance of various factors in the financial crisis of 2008 provides interesting results. The poll lists 12 factors, and all of them receive at least some positive weight. In fact, this under-estimates the complexity of the causal mechanisms, because some of the factors are themselves multi-faceted. For example, the first factor, “flawed financial sector regulation and supervision,” could mean many different things to many different people. It could mean the repeal of Glass-Steagall (a favorite among non-economists on the left) or it could mean the Basel accords (one of my personal favorites).

Overall, I think it vindicates the broad, multi-causal approach that I took in Not What they Had in Mind.

Regulatory miscalculation

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Two examples.

1. Stephen Matteo Miller writes,

While these findings do not establish that the Recourse Rule caused the financial crisis, they are consistent with the view that the rule encouraged securitizing banks, especially the largest ones, to hold the assets that turned out to be at higher risk of distress. In other words, though the Recourse Rule may have been intended to lower risk-taking, it may have encouraged greater risk-taking on the part of these banks.

The Recourse Rule got its name because its primary provision was to force banks to keep capital against assets that had been sold with recourse, meaning that the assets could be put back to the bank if they lost value. But another provision of the rule allowed banks to reduce capital against mortgage securities with AA and AAA ratings. Freddie Mac and Fannie Mae warned about the distortions this would create at the time the rule was issued, in 2001. I have discussed its role in the financial crisis of 2008 in Not What They Had in Mind and in The Regulator’s Calculation Problem, the latter focusing on the book by Jeffrey Friedman and Wladimir Kraus that emphasizes the role that capital (mis-)regulation played in the lead-up to the crisis.

2. Saad Alnahedh and Sanjai Bhagat write,

Regulations were announced by the U.S. Securities and Exchange Commission (SEC) in July 2014 to increase MMF [money market funds] disclosures, lower incentives to take risks, and reduce the probability of future investor runs on the funds. The new
regulations allowed MMFs to impose liquidity gates and fees, and required institutional prime MMFs to adopt a floating (mark-to-market) net asset value (NAV), starting October 2016. . .we find that institutional prime funds responded to this regulation by
significantly increasing risk of their portfolios, while simultaneously increasing holdings of opaque securities.

The CBO gets worse

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John Taylor writes,

The second CBO procedural change was to discontinue the use of the “alternative fiscal scenario” in the long-term projections

There is more at the link.

I think that CBO modeling is way over-rated and biased toward interventionist policies. I would take them out of the modeling business almost entirely.

For budget projections, you need to do modeling. Budget projections are numbers, after all.

But models are subject to all sorts of errors. GDP growth could turn out to be higher or lower than expected. Interest rates could be higher or lower than expected. Your estimates of the cost of programs could be off, because people may respond to incentives differently than what you expect. Laws may change.

Given these sources of error, scenario analysis is a must. The CBO should be doing more scenario analysis, not less. I am increasingly convinced that the CBO as it currently operates is performing a huge disservice to public policy. Congress should make major reforms to the mission and operations of the CBO.

Debt and the economy

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Kevin Erdmann comments,

Debt isn’t a sign of risk taking. Equity is. The reason Ford has lots of debt isn’t because risk-seeking shareholders demand that they leverage up. Risk-seeking shareholders buy unleveraged Tesla shares. The reason Ford has lots of debt is because a lot of investors want cash flow certainty, and Ford, with a large base of physical assets, can credibly provide it.

I am inclined to disagree. My thinking is that small changes in perception of the risk of debt have larger effects than small changes in the perception of the risk of equity. In 2000, people really changed their perception of dotcom stocks by a lot, and the economy experienced a minor blip. In 2007-2008, people revised their perception of the risk of mortgage securities, and all sorts of bad things happened.

If people revise up their perception of the risk of sovereign debt, I predict that this will lead to the greatest economic disruption of our lifetimes.

Stanley Fischer, pre-crisis

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He writes,

We have a better capitalized and more liquid banking system, less run-prone money markets, and more robust resolution mechanisms for large financial institutions. However, it would be foolish to think we have eliminated all risks. For example, we still have limited insight into parts of the shadow banking system, and–as already mentioned–uncertainty remains about the final configuration of short-term funding markets in the wake of money funds reform.

Debt has been exploding, and folks at the Bank for International Settlements have pointed out that the debt/GDP ratio is higher than it was before the 2008 crisis. If there is another crisis, Fischer will be able to say that he did not claim that all risks were gone. Still, it is a very smug assessment, and if the debt bomb (and I include the government debt bomb) explodes in the next year or two, this will be the sort of speech that will indicate that policy makers were blind.

If it takes longer than a couple years for the debt bomb to explode, then I imagine that there will be other speeches made between now and then that will look worse in hindsight.

Is Illinois the trailer for the debt movie?

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I assume you have been following the story.

Illinois is now grappling with $15 billion of unpaid bills and an unthinkable quarter-trillion dollars owed to public employees when they retire.

This would be the third year in a row that America’s fifth-largest state has failed to pass a constitutionally required budget.

The U.S. government, too, can only pay its bills with borrowed money. The U.S. government, too, has an unthinkable level of unfunded liabilities–I believe it is close to $80 trillion. The U.S. government, too, is unable to pass a real budget.

Politicians love to borrow other people’s money. They don’t know how to cope with paying it back.

If you want to see how the political process functions when confronted with unpleasant reality, watch Illinois.