Friday, February 25, 2011

Irrationality in Action

From the NYT's profile on Chris Christie:

When he was a federal prosecutor, Christie told the audience, he got to choose from about 100 health-insurance plans, ranging from cheap to quite expensive. But as soon as he became governor, the “benefits lady” told him he had only three state plans from which to choose, Goldilocks-style; one was great, one was modestly generous and one was rather miserly. And any of the three would cost him exactly 1.5 percent of his salary.

“ ‘You’re telling me,’ ” Christie said he told the woman, feigning befuddlement, “ ‘that no matter which one I pick, the good one or the O.K. one or the bad one, I’m going to pay 1½ percent of my salary?’ And she said, ‘Yes.’

“And I said, ‘Then everyone picks the really good one, right?’ And she said, ‘Ninety-six percent of state employees pick the really good one.’

Who are that four percent? Seriously, this is a huge issue for any rational actor model. Forget twenty dollar bills on the sidewalk, picking the more generous health plan in this context requires absolutely no effort at all.

Thursday, February 24, 2011

Sweden's Socialist Republic of Children

In his Introduction to Ender’s Game, Orson Scott Card made an observation that’s stuck with me:
Ender’s Game asserts the personhood of children, and those who are used to thinking of children in another way—especially those whose whole career is based on that—are going to find Ender’s Game a very unpleasant place to live. Children are a perpetual, self-renewing underclass, helpless to escape from the decisions of adults until they become adults themselves. And Ender’s Game, seen in that context, might even be a sort of revolutionary tract.
It’s one of the interesting aspects of that book that it’s written exactly from the perspective of a child, and treats their feelings and judgements as seriously as anyone else’s. This is one of the reasons the book is so popular among kids; though unfortunately it seems to generate the same sort of ubermench mentality people frequently pick up from Ayn Rand or Nietzche.

At any rate, I was interested by a recent Marginal Revolution post on the adoption of children by gay couples in Sweden. In some sense, if you were to take the revolutionary implications of Ender’s Game seriously, you would treat the private nature of the family as the source of generational exploitation and seek to handle child-rearing in a more public manner. Sweden, arguably does this; while gay marriage has long been acceptable there, adoption of children by gays is much less so. The argument is that the Swedes treat childrearing as a very public thing, while they care less about marriage. One commenter there adds:
This is absolutely true. The Swedish attitude toward the raising of children is absolutely centered on the welfare of the child; the rights of the parents play a very small role. Corporal punishment has been illegal for more than 40 years now, and for Swedes it is a reviled practice (people basically see corporal punishment as domestic abuse). The law also close to universal support (there's eight parties in the Swedish parliament, ranging from far left to the christian right to the blatantly xenophobic, and not a single one wants to repeal it). The viewpoint expressed in that quote is basically accurate: consenting adults can do whatever they want and it's nobody's business, but the public has a very large interest in the welfare of children.
Another person adds:
There also is a specific “ombudsman” for children, whose main duty is to promote the rights and interests of children.
It’s interesting to imagine this treatment as resulting from a certain Marxist response to the perceived systematic oppression of a given underclass of children. It would be interesting to imagine a future in which many more people see things this way, and perceive our current behavior just as flawed as we perceive the moral flaws of, say, the American South circa 1840. Alternately, this is another reason why though Swedish children frequently live in households with unmarried parents, they end up receiving excellent childcare. That sort of public support and social norms are difficult to translate to unmarried parenthood in other parts of the world.

Sunday, February 20, 2011

Banking without Maturity Transformation

Japanese banking has a pretty bad reputation, what with financial and real estate losses linked to a period of economic stagnation stretching into its third decade. Yet as Anil Kashyap and Takeo Hoshi illustrate in their historical overview on the subject — Corporate Financing and Governance in Japan — there’s a rich history here that goes back far further than the past few decades.

America’s banking system is based on a principle of maturity transformation that is well-articulated here by New York Fed President William Dudley (referenced by Ashwin Parameswaran):
“The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation—borrowing shorter-term in order to finance longer-term lending.”
By contrast, the Japanese system of banking has traditionally relied on strict silo-ing of finance. As envisioned by Matsukata Masayoshi, Finance Minister during the 1880s, banking evolved into three separate categories — commercial, industrial, and savings. Commercial banking was designed to provide flexible and short-term liquid instruments to firms; industrial lending was designed to meet the long-term, illiquid needs of industries, while the savings sector handled the needs of common folks.

In the jargon of finance, Japanese banks matched the maturity between borrowers and savers through specialized credit facilities. Industrial banks met the long-term needs of firms by getting capital from lenders willing to extend capital for long periods of time. The Japanese economy, between opening up and WWII, supplemented this specialized bank capital with active markets in equity and bonds.

After WWII, while most of the rest of the world downplayed the role of finance, Japanese policymakers spent a great deal of time figuring out how to fine-tune their financial system. Finance became highly regulated and even more segmented, with each individual sector of the economy financed through specialized banks designed to meet particular maturity needs. The national postal savings network channeled rural savings into the national network. Throughout the whole period, there was a belief that long-term investments ought be financed through long-term savings mechanisms, frequently raised in capital markets by banks, as opposed to consumer deposits.

Over time, banks started to play an increasing role in corporate governance, culminating in semi-oligarchic business groups for which the bank holding company called many of the shots. While these groups have been frequently disparaged, Kashyap and Hoshi note that, at least in the beginning, this form of relational finance allowed for effective oversight, governance, and reorganization of firms.

Japanese banking was a key factor behind Japan closing up to America before WWII, and recovering quickly afterwards. It certainly wasn’t perfect. But it’s worth noting that, before the banking crises in the late 1980s, liberalizers started to change the system. As Kashyap and Hoshi note, “This same pattern of botched liberalization preceding a major financial crisis has been told about many economies in the 1980s and 1990s. Japan’s was just the biggest of the disasters." Despite that major caveat, the authors still regard further liberalization and change along American lines as virtually inevitable and necessary — drawing numerous comparisons to supposedly superior Western banks. This is a rather bizarre stance to hold. I think in twenty years, you’ll be able to look at a book and figure out if it was written pre-2008 or post (this one is definitely before).

Instead of taking the view that deposits ought to match up with savings, American finance has chosen instead to operate via magic. Through magic, the idea is that you can take your liquid, small deposits that you put into an ATM and somehow turn this into large, illiquid investments in major companies. You can take a mortgage-backed security, and again — through magic! — use that as collateral for other purchases. The good part about this is that you can somehow operate the investment needs of a whole economy on virtually no domestic savings, but rather solely through the transactional cash in your checking account. The downside is that financial crises become virtually inevitable. Through deposit insurance, you didn’t see any banking runs on your checking account. But you did see banking runs on Investment Banks, and that’s really what made the crisis as bad as it was.

You're starting to hear people argue that the tools of modern finance lower the need for maturity transformation. Ashwin Parameswaran makes a pretty good case here, noting that we have plenty of long-term savers that can finance long-term investment projects without requiring the funds in your checking account. There are other good narrow banking options out there too. But these accounts typically still concede that maturity transformation made sense at one point in time. I think Masayoshi had things right all along, and had we looked there for inspiration earlier we could have gotten along without any maturity transformation at all.

Household Stagnation

I've been meaning to comment on Tyler Cowen's ebook The Great Stagnation for a while. The book relies heavily on two claims: 1) There has been a dramatic slowdown in productivity in the past ~40 years, attributable to us exhausting all the low-lying fruit; and 2) Household income has similarly fared poorly in this period.

I can't really comment on 1), which I grant seems true enough. But I've written some on 2), relying on the work of Terry Fitzgerald, which I'll copy here from e21:

1. Inflation. The price indices used to compute per capita income are different from those designed to compute median household income. The price indices typically used for household income (Chart 1) are taken from a composite of sources, some of which take into account the prices faced by wage earners. The price index for national labor surveys (Chart 2) on the other hand, corrects prices on the basis of personal expenditures – the basket of goods consumed every year. These different series have different measures of inflation, and so result in different estimates of real income. A true apples-to-apples comparison results in a closer match between these two graphs, favoring the depiction in Chart 2.

2. Fringe benefits. Employers are increasingly likely to compensate workers in the form of fringe benefits, rather than cash income. In part, this is because certain fringe benefits, like employee-provided health insurance, are exempt from taxes. Estimates of household income do not take these into account, while they are an important part of the economy.

This is an important adjustment to consider, because we are frequently concerned with the overall quality of life for households, rather than the mechanism by which they consume goods.

Simply taking the first two points into account (using a common price index and counting fringe benefits) results in compensation that has grown 28% from 1976 to 2006 for the median worker, rather than stagnating.

3. Changing Composition of Households. Fewer people live in each household today than they did thirty years ago, and so gains in household income are divided against a greater number of households. While 64% of households consisted of married couples in 1976, this was true of only 51% of households in 2006.

Fitzgerald finds that every household type had large gains in income growth – gains obscured due to the changing composition of households. Married couples saw household income gains of 42% from 1976 to 2006, while single-female residences saw gains of 56%.

To be sure, inequality may account for some of the difference between household income and aggregate income. Fitzgerald estimates that Census income per person grew by 65%, while median income per person grew by around 50%. The remaining difference may be accounted for by a rise in inequality. But the important point is that households are not stagnating in the aggregate. America’s phenomenal productivity gains have reached its households.

Supply Side Mortgage Financing

On the recommendation of Mike Konczal, I checked out Adam Levitin’s account of the housing (with Susan Wachter). It’s a pretty long paper with a single core idea: to figure out what happened with the financial crisis, look at prices and quantities. Levitin observes that the yields (ie, interest rates above other interest-bearing assets) on mortgage-backed securities fell dramatically during the subprime boom, while the quantity of such products grew dramatically. The lesson to draw from that is that a rising supply of mortgage finance must be the chief culprit for the crisis, not demand. If the demand for mortgages was rising (say, from federal housing policy), the price of risk in mortgage markets would steadily rise. The fact that they instead fell points to the role of increasing supply in lowering the risk premia on mortgages. Levitin attributes this falling cost to mispriced mortgage securities.

Here’s a graph from a Fed paper by Diana Hancock and Wayne Passmore I'll get to in a bit that illustrates this pretty well:

If you compare the pre-boom era "Normal" with the subprime boom, it’s clear that mortgage yields fell dramatically relative to Treasury rates (ignore the crisis era stuff).

This is a clever idea, but attributing all of that fall in interest rates to mispricing seems a pretty bad assertion. There are many reasons why yields could fall. As I just blogged, large foreign inflows of capital could lead to a lower price of risk, though this scenario isn’t mentioned in the paper. Though Levitin dismisses monetary policy quickly, Rajan has argued that periods of absolutely low interest rates might generate a pattern of increased leverage and yield-seeking that would describe this data equally well.

But what I found most troubling was the use of simple market yields. It’s true that a fall in mortgage yields could imply a lower risk premium, all else equal. But when pricing a mortgage, a lot more goes in than just credit risk. Borrowers of mortgages typically have the ability to pay back the mortgage in full — for instance, by refinancing their mortgage to a lower rate. This is bad from the point of view of an investor, since borrowers are most eager to "prepay" their mortgage once interest rates are low. So, at exactly the point when interest rates fall (and you have fewer good investment options), mortgage borrowers give you all this cash. To deal with this, when you lend money in the mortgage market, you receive a prepayment premium for taking on that risk, and that goes into pricing a mortgage. The factors determining prepayment risk, as well as other risk determinants, changed dramatically during the subprime boom era, so it's not clear whether a falling risk premia explains everything.

Fortunately, the Fed paper from above does break this out. While this can get very complex, one simple check is to compare the MBS yield over Treasury (graphed above) to the option-adjusted spread (OAS) over Treasury (graphed below).

The OAS here is designed to pick up the portion of the mortgage yield attributable to the prepayment risk. You see that the OAS spread went down quite a bit during the subprime boom years as well. Overall, the MBS yield over Treasury (which Levitin interprets only as credit risk) fell by ~.7%. Yet ~.55% of that fall is attributable not to changes in risk preferences, but instead due to changes in the premia for carrying prepayment risk.

And the fault for that goes exactly to the Fed/global investors. The Federal Reserve promoted a climate of low interest rates, while global investors too pushed interest rates down. In response, carrying the prepayment risk of mortgages became lower (as borrowers didn’t have much room to refinance at substantially lower rates), and mortgages became more attractive as an asset class. The net change in mortgage yields due factors other than the prepayment risk should be something like 15 basis points; and some of that may also be attributable to other changes in the financing climate (the authors claim a sizable fall in the roll-over risk in this period associated with having to refinance debt holdings. This, too, can be attributed to interest rates that were persistently low). Though the authors of the Fed paper don’t seem to break this out — it’s very possible that the credit risk for mortgages actually went up during the subprime years.

Not only that, but the stock of borrowers grew quickly in response to these shifts in interest rates, suggesting that homeowners in this period were highly responsive to the price of mortgages. It’s possible that factors like land use regulations, a bubble mentality, lower downpayments, etc. may have been responsible for that, and that responsiveness is as important as the initial shock.

To be sure, the fact that the risk premium seems to have remained roughly constant even as worse borrowers took out mortgages may suggest that the risk premium may not have been high as it should have been. And I don’t understand this field nearly as well as I should, so please check out both papers and tell me where I’m getting things wrong. But I call this as another win for the camp blaming the Fed/foreign investors.

Edit: Adam Levitin has responded in the comments. He makes the good point that the Fed paper only looked at Agency MBS; while the pattern may well be different for private-label MBS, many of which were given out to loans on an adjustable-rate mortgage.

For Capital Autarky

V Anantha Nageswaran at The Gold Standard makes an excellent connection that may clear up the issue of economic “dark matter.” The basic idea behind the dark matter concept is spelt out in this piece by Ricardo Hausman and Frederico Sturzenegger, and relates to the presence of global imbalances. The United States, for the past decade, has managed to run up a massive current accounts deficit; meaning that the value of American exports has been consistently less than the value of American imports. To pay for this, there has been a corresponding boom in the degree of assets held by foreigners in the US. That is, America has been importing all sorts of goods from other countries, like say cheap toys or oil. To pay for that, instead of producing other forms of goods and services, foreigners have been content to hold American assets denominated in dollars.

This is where the dark matter comes in — it is the value of the financial assets held in the US by foreigners that are otherwise not accounted for. Figuring out what this stuff is was an big question before the financial crisis made other issues more relevant. But (much like the physical dark matter), it’s presence could be assumed from the nature of other statistics — in this case, the value of American goods and services.

Here’s a graph that sort of sums this up:

ie, there is a massive and growing current accounts deficit unless you calculate the value of these domestic asset holdings.

Now, cue Ben Bernake. With a group of co-authors, he has revisited international financial flows, and found some interesting results:
We present evidence that, in the spirit of Caballero and Krishnamurthy (2009), foreign investors during this period tended to prefer U.S. assets perceived to be safe. In particular, foreign investors—especially the GSG countries [“global savings glut” countries, primarily Asia and oil exporters]—acquired a substantial share of the new issues of U.S. Treasuries, Agency debt, and Agency-sponsored mortgage-backed securities. The downward pressure on yields exerted by inflows from the GSG countries was reinforced by the portfolio preferences of other foreign investors. We focus particularly on the case of Europe: Although Europe did not run a large current account surplus as did the GSG countries, we show that it leveraged up its international balance sheet, issuing external liabilities to finance substantial purchases of apparently safe U.S. “private-label” mortgage-backed securities and other fixed-income products. The strong demand for apparently safe assets by both domestic and foreign investors not only served to reduce yields on these assets but also provided additional incentives for the U.S. financial services industry to develop structured investment products that “transformed” risky loans into highly-rated securities.
To spell this out a little more: the argument here is that the United States experienced such massive inflows — roughly a trillion dollars a year for the US at the height of the boom — that they were sufficient to adjust interest rates and borrowing on a massive scale. The “dark matter” people wondered about were held in exactly the mortgage-backed securities (both by the GSEs and private suppliers) that performed horribly in the crash. Most countries that experience such forms of capital inflows have serious problems — think Asian countries before their crisis in 1997. In particular, these countries tend to see massive price appreciation in non-tradable, durable goods (especially real estate, but really all sorts of assets), and a loss of competitiveness in the tradable good sector.

This basically also describes the US, with two important areas of divergence. One, the financial sector had an active supply response as well, doing a great deal to manufacture the sorts of safe assets that were in high demand internationally (greater demand than American manufactures, at least). Many economists were broadly sympathetic to large amounts of foreign capital coming into America on the hypothesis that America’s sophisticated financial markets were best capable of handing these sums. Unfortunately, they were instead sophisticated enough to hide risks and create assets that appeared safe, but were in fact quite dangerous.

And second, there was no currency collapse after the boom. Several Asian countries after 1997, for instance, saw capital flee the country, followed by a major currency collapse. That hasn’t happened with America (though there was a great deal of fear prior to the crisis that exactly this outcome would happen), presumably because America’s crash means systematic failure for the world, and in response to that capital wants to remain in America.

Of course, it is difficult to establish causality here. Why did countries like China, Germany, South Korea, and Saudi Arabia invest their trade surpluses (from cheap goods, electronics, and oil) in America rather than purchasing American goods? For Asian countries, there was the goal of keeping a cheap currency and boosting exports; while the motivation for oil-exporting states is a little murkier. What's going on in Europe is even less clear, as they managed to end up with large amounts of assets in American MBS while having a roughly balanced import/export profile.

This narrative isn’t particularly new; if you’ve been following folks like Nouriel Roubini or Menzie Chinn this should be pretty familiar. So here’s some value added: the reformist goal of globalizing capital has been a catastrophic failure. Virtually every time countries import large amounts of cash, their economy gets trashed. In theory, this FDI could go to productive uses. In reality, it goes into unsustainable patterns of asset booms and crashes. There is the added worse impact of hurting the tradable sector of the economy, which is ultimately responsible for economy-wide productivity; as well as the added worse impact that the domestic financial sector also gets trashed, hurting you for years to come. A few decades ago, there was a big push to get capital to go from rich to poor countries, on the grounds that this could help them grow. Roughly, this failed. In the last few years, the argument instead has been that capital going from poor to rich countries could result in better global financial management. This, too, ended up pretty badly.

Playing financial regulation in an economy getting drowned in cash is like playing whack-a-mole. Even if somehow you prevent asset booms in any one particular area of the economy; the systemic impacts of capital flows ensure that some part of the economy will blow up. Banks will find ways to assume leverage and risk, regardless of what your regulations were before the boom. The political pressures of restraining this debt-fueled boom in consumption and investment are impossible to manage.

Really the only solution here is to return to some sort of Bretton Woods style world of tightly restrained capital flows. This is virtually impossible to re-generate, but the Fed doesn’t need any sort of international agreement to make international capital flow/currency regulation a major priority. This is already the case in many foreign central banks, but it is a mandate completely lacking at the Fed.

Which is why this situation is a little odd. On one hand, Bernanke is the guy arguing that these foreign capital flows are responsible for a large chunk of our problems (and not, say, the low interest rates he was a party to setting). But then he refuses to do anything about them, despite the fact that the Fed is the one actor in the economy with the capacity to do so. If you look around at developing countries, there are plenty of solutions one can come up with — Tobin taxes on capital flows, actual limits on capital flows, active currency interventions, and so forth. I’m all for free trade, free markets, etc.; but there’s no excuse for the Fed not taking these actions more seriously -- especially in light of their own view that this is what blows up crises.

Edit: Just to be clear, "autarky" was a poor wrong wording choice. Capital can and should flow from country to country, but these flows should balance themselves out on net, corresponding to a balance in trade as well.

Tuesday, February 15, 2011

The Decline of the Stock Market

Felix Salmon has written a provocative piece arguing that stock markets are increasingly irrelevant to American capitalism. Reihan Salam has responded, arguing that a shift away from arms-length financing tools, like stocks, towards relationship-based lending, like private equity, could be a good thing:
I’m definitely on this matters, but I’ll just say that I think the death of the stock market is mostly good news. My admittedly crude sense is private equity firms do a fairly good job of allocating capital efficiently. We have evidence, from Nicholas Bloom and John Van Reenen in the JEP and elsewhere, that they have a managerial edge over publicly-owned and family-owned firms. As Amar Bhide argues in his wonderful new book A Call for Judgment, a case can be made that the U.S. has relied too heavily on arms-length finance rather than relationship finance, the approach taken by VCs that have deep, long-term relationships with the companies in which they invest. (Indeed, he argues that public markets in the U.S. suffer from excessive liquidity.) Our securities laws make relationship finance difficult if not criminal in many domains, and it is far from obvious that this has been good for the real economy.
Amar Bhide has written a good book, but I'm not entirely convinced. It's important to understand why stocks have become more important. If it were the case that companies on their own were choosing other financing options, this trend might be welcome. Rather, companies are instead frequently pushed away from the stock market by various worrying factors.

As Jeffrey Stewart argues, one such factor is new regulatory pushes (for instance, Sarbanes-Oxley) which have pushed the cost of listing higher to prohibitive levels. The whole market has also changed, possibly because of regulation, but also because of technology. Investment banks are perhaps less interested in underwriting new companies than in doing their own trading. Institutional managers are more interested in high-frequency trading among very liquid stocks than dealing with illiquid, new issues. Finally, there's an issue Felix has raised elsewhere -- that the tax code penalizes dividends and equity investments much more than raising debt, encouraging firms to stay away from equity. Overall, the stock market is less interested in deploying capital to entrepreneurial sectors of the economy than it is in making money on whether the tenth decimal place of a given price is correct.

It's true that Angel Investors, Venture Capitalist firms, and Private Equity have filled in the gap to some extent, particularly for tech firms. But even these financiers often require re-selling the company on a public exchange to cash out, so a poorly functioning stock market hurts them as well. The relationship funders rely on cooperating with arms-length finance too.

All these changes may make it harder for companies to get the financing needs they need as they grow up. Many companies around today -- Apple, Amazon, Microsoft -- went public very early on, and used that equity to finance future growth without giving up management. Yet new companies like Twitter or Facebook today rarely access the stock market until they get much larger. To an extent, venture capital funding may fill their early financing needs, though those backers may also be more likely to kill the company if it doesn't generate a quick, early return. You also need to be able to find such backers on a personal basis, rather than calling up some bankers and letting anyone buy your shares.

But the other alternative is selling out to a larger company, which seems to be one of the dominant next steps in the absence of cashing out through an IPO. This can frequently make capital allocation worse, to the extent big companies are bad at managing smaller companies they takeover. Many big companies, at least in tech, seem intent on buying out others simply to stifle competition.

A lack of easy access to capital markets also hurts incumbent firms that are already listed. Felix points to the high degree of corporate savings. In theory, companies should spend now if they have profitable projects, confident that the market will be able to meet any future capital needs. Instead, they are often opting to go for internal funding always. This can result in sizable capital inefficiencies over time.

You also need to think about the impact on investors. While the gyrations of the Dow may not have too much to do with real economic conditions, they certainly impact the 401(k)s of many individual investors. If the stock market remains a preserve of old, stagnant firms (missing Facebook, Twitter, and so forth); individual investors will miss out on the capital gains of a large sector of the economy, which will go instead only to a handful of connected insiders.

For an counterpoint to Amar Bhide, Anil Kashyap and others have a good book tracing Japan's financial evolution. I'll be blogging more on this soon, and am probably closer to Bhide than them. But they make some persuasive arguments -- Japan relied on a very equity-based system of financing pre-WWII, which worked very well; while the relationship style of banking that developed after the war resulted in substantial losses, particularly by the 90s.

It's hard to get a good sense of how much of this matters, particularly if you think that companies in general may need less capital to get going these days. But it certainly strikes me that lowering the capacity of the stock market to allocate capital was a particularly destructive move that has taken away an important financial choice for many companies. It's helpful that forms of relationship capital have filled in the gap in important ways. But surely it would be better to have both more venture capitalists, as well as a better functioning stock market.