More on Repos

After my last post on this, I went to look up some more facts on the repo market. This issue concerns not only the importance of "safe assets," but also the role of the repo market failure in precipitating further financial market instability. I ran into a paper by Krishnamurthy, Nagel, and Orlov that provides new data and presents a revisionist take on the role of repo in the shadow banking system. Here are some principal quotes:

The table also details the amount of these securities financed by repo. Total repo of non-Agency MBS/ABS is $171bn. Even if we include the repo extended against corporate bonds, the repo total is only $386bn. This is a small fraction of the out- standing assets of shadow banks. This observation underscores a principal finding of this study: repo was of far less importance in funding the shadow-banking sector than is commonly assumed.
If repo was not the principal source of funding, what was? The table details the direct holdings of these securities by MMFs and security lenders. The direct holdings are substantial, totaling $745bn. It is likely that such holdings are high grade and short maturity tranches of securitization deals...

First, while in their data average haircuts are frequently zero in 2007 for corporate debt and securitized products, the repos undertaken by MMF in our data always have average haircuts of at least 2%, even for Treasuries and Agency debt. Second, although our value-weighted averages (which is the most relevant measure of aggregate funding conditions) are difficult to compare with the equal-weighted averages in finer categories reported in Gorton and Metrick (2011b), an informal comparison suggests that haircuts in tri-party repos of MMF increased much less than the haircuts in their bilateral repo data (Gorton and Metrick report average haircuts in excess of 50% for several categories of corporate debt and securitized products).

Taken together with our findings of the relatively small amounts of MMF repos against private-label MBS and ABS collateral, these observations suggest that the “run on repo” may have had a more modest effect on aggregate funding conditions for the shadow banking system than what one may guess from the enormous increase in haircuts for securitized products in the bilateral repo market as reported by Gorton and Metrick (2011b)...

 This finding does not support the emphasis that Gorton and Metrick (2010, 2011b, 2011a) and Adrian and Shin (2010) have placed on the repo market in explaining the collapse of the shadow banking system. Instead, the short-term funding of securitized assets through ABCP and direct investments by money market investors are an order of magnitude larger then repo funding, and the contraction in ABCP is an order of magnitude larger than the run on repo. Troubles in funding securitized assets with repo may have been a major factor in the problems of some dealer banks that were most heavily exposed to these assets, but for the shadow banking system as a whole, the role of the repo market appears small.

These results are in strong contrast to Gary Gorton's work, which has focused on the bilateral repo market. His research suggested that the financial crisis could be understood as a bank run similar to past financial crises, as in the 1930s. However, in this case, the bank run simply came instead to the shadow banking system in the form of the repo market closing up. The implication is that much of the fallout in the last several years can be understood using the same framework for why maturity mismatch induces normal banks to face runs.

The results from Krishnamurthy and company are in some tension with this interpretation. Repo by itself seems to have constituted a small share of financing in the shadow banking system. Correspondingly, the "run" on repo had little impact on aggregate bank financing systems (though painful for certain individual banks). The run was concentrated on repos collateralized by private label AAA securities, not on repos in general. Even risky banks were able to obtain repo financing by collateralizing with different securities.

Meanwhile, repo haircuts for some assets mirror their levels during the crisis. This seems inconsistent with the idea that the crisis involved some extraordinary and temporary run, as opposed to a general shift in the attitude towards the risk of certain assets.

To be sure, the results are specific to repo supplied by dealers and money-market-mutual funds. It seems likely that their financing supply remained more inelastic throughout the crisis compared to financing between banks, which decreased dramatically in response to a credit crunch environment.

It's interesting to compare this narrative with Ivashina and Scharfstein, who argue that new bank lending had begun to decline in 2007Q3, well before the turmoil in repo/shadow banks became more pronounced. A GNI approach to the economy shows stagnation in this period as well, while mortgage defaults were starting to kick in.

One story consistent with all of this would emphasize the role of deteriorating productivity and credit conditions throughout the crisis, combined with a shadow-bank driven monetary crunch in 2008. Stagnating income for a substantial period of time induced higher levels of household borrowing; defaults on which triggered bank retrenching. In turn, this induced short-term financing effects that were important, but largely limited to inter-bank financing. The bank repo effect, however, comes with a money multiplier that continued to further amplify the crisis.

Is There a Global Shortage of Safe Assets?

David Beckworth has channeled Gary Gorton to write:

One of the key problems facing the world economy right now is a shortage of assets that investors would feel comfortable using as a store of value.  There is both a structural and cyclical dimension to this shortage of safe asset problem, with the latter being particularly important now given the recent spate of negative economic shocks to the global economy… 

Okay, so why does this safe asset shortage ultimately matter?  The first reason is that many of these safe assets serve as transaction assets and thus either back or act as a medium of exchange.  AAA-rated MBS or sovereigns have served as collateral for repurchase agreements, which Gary Gorton has shown were the equivalent of a deposit account for the shadow banking system.   The disappearance of safe assets therefore means the disappearance of money for the shadow banking system.  This creates an excess money demand problem for institutional investors and thus adversely affects nominal spending.  The shortage of safe assets can also indirectly cause an excess money demand problem at the retail level if the problems in the shadow banking system spill over into the economy and cause deleveraging by commercial banks and households.  

The logic here makes a lot of sense. Just as bank deposits serve in important ways as “money”; so other safe assets are used in a currency-like fashion in financial markets. Loss of faith in these assets can drive market exchange in financial markets into turmoil — as Gary Gorton argues happened with previously AAA-rated mortgage-backed securities and repurchase agreements.

I’ve grown skeptical of this line of thinking, however, after reading Jeffrey Friedman’s (and Vladimir Kraus') excellent book, Engineering a Financial Crisis. Friedman focuses on the distortions in bank actions caused by Basel financial regulation, and I think his argument is relevant in this case. There are three reasons here I can think of that the “global safe asset shortgage” might be overblown:

1. AAA-rated assets aren’t the only safe ones. Beckworth tallies up the number of AAA-rated assets worldwide, and find that their aggregate amount — including Treasuries, etc. — Is actually decreasing, due to downgrades of various bonds.  

But buying a AAA-rated asset isn’t the only way to ensure you own a risk-free security Alternatively, one could buy credit default protection on a riskier asset. Purchasing a risky asset and credit protection is economically equivalent to purchasing a risk-free asset; and credit default swaps are priced accordingly. Practically speaking, this is what banks did in order to hedge their holdings of risky European debt -- they bought credit protection to get out of credit risk. Further ratings drops don’t effect the immediate economic future of a bank whose holdings of risky debt are fully insured - short of the CDS counterparty going bankrupt, or Europeans conspiring to negate CDS contracts as they recently did.     

And the global supply of CDS is enormous. There is something like $43 trillion in sum notional value of credit default swaps. Now, netting out all of the various contracts and figuring out how much actual additional risk protection the CDS market provides is tricky. But certainly it seems this is a massive source of safe assets for any risk averse entity that wants them. 

Now, it may be the case that you actually need AAA-rated assets to use as a medium of exchange; so CDS contracts don’t help with that precise problem. But certainly it would seem that the presence of a massive asset class economically equivalent to AAA-rated assets should change our judgement of whether or not safe assets are scarce. If nothing else, we might expect that “true” AAA rated assets may start to be used exclusively for repos; while banks wishing to hold safe assets would switch to holding risky assets + credit insurance. 

2. Repos blew up due to bankruptcy laws. Why would you try to fund a shadow bank with repurchase agreements? In Beckworth’s piece, this is treated as a given — we just happen to have  a sophisticated banking system that relies on this particular form of short-term liability. 

However, as Mike Konczal and others have mentioned http://rortybomb.wordpress.com/2010/05/06/an-interview-about-the-end-user-exemption-with-stephen-lubben/: the repo market really took off after the 2005 bankruptcy law reform. That law granted repos and other derivatives prioritized status in the event of bankruptcy; and so dramatically raised the incentives to finance a shadow bank using these sorts of short-term debts. 

Yet there’s no reason in general to run a financial system on this type of risky short-term debt. No lawe decrees that short-term collateralized lending needs to be such a large part of a sophisticated banking system that sits apart from the normal loan-deposit world. This is as much a product of specific rules and regulations that encourage re-writing contracts in the form of derivatives; as it is of a general preference for “safe” assets.

3. It's all Basel's Fault Anyway. The final thing I think this narrative gets wrong is the motivation for why people want safe assets. The focus from Beckworth and Gorton is on AAA-rated assets used in their capacity as money. However, banks and other financial institutions also hold enormous amounts of AAA-rated securities that they store on their balance sheets. This fits in, say, with how we typically think of safe assets — as non-risky assets that some financial intermediary wants to hold on their balance sheet for some amount of time, not just as collateral to buy something else. There isn't a hard line between those two uses, but it certainly seems that there's a large pile of AAA-rated securities that aren't just functioning in the capacity of money. 

Here Jeffrey Friedman’s book comes in useful. Friedman notes the impact of Basel-I and Basel-II reforms on the capital consequences of asset holdings. Particularly after Basel-II prioritized the role of ratings agencies, banks started to face dramatically different consequences from holding “safe” and “risky” assets — as determined by credit agencies.

If a bank decided to hold a AAA-rated sovereign bond, for instance, they typically had to hold zero excess capital to meet regulatory standards. However, if they held an equivalent amount of an unsecured private loan, they were required to hold substantially more capital in response. 

The net effect of these capital regulatory standards is that safe assets came to be valued not just for their economic riskless value — but also for how alter bank capital requirements. Banks that face fewer capital requirements can be more levered, risky, and potentially profitable than banks whose assets force them to raise substantial amounts of additional capital. This motive, arguably, is why banks around the world are eager to purchase safe assets — not because they are useful in conducting repo. 

For instance, here is a recent news story from Australia, a country that (by virtue of low government debt) has relatively few safe assets. Liquidity coverage ratios required for Basel-III leave Australia in a problem, due to the local shortage of safe assets. The Reserve Bank of Australia describes in detail their response:

The issue in Australia is that there is a marked shortage of high quality liquid assets that are outside the banking sector (that is, not liabilities of the banks). As a result of prudent fiscal policy over a large run of years at both the Commonwealth and state level, the stock of Commonwealth and state government debt is low. At the moment, the gross stock of Commonwealth debt on issue amounts to around 15 per cent of GDP, state government debt (semis) is around 12 per cent of GDP.[¹] These amounts fall well short of the liquidity needs of the banking system. To give you some sense of the magnitudes, the banking system in Australia is around 185 per cent of nominal GDP. If we assume that banks’ liquidity needs under the liquidity coverage ratio (LCR) may be in the order of 20 per cent of their balance sheet, then they need to hold liquid assets of nearly 40 per cent of GDP.

In addition to government debt, the Basel standard also includes balances at the central bank in its definition of high-quality liquid assets (level 1 assets in the Basel terminology). That is, the banks’ exchange settlement (ES) balances at the RBA are also a liquid asset. Hence, one possible solution to the shortage of level 1 assets would be for banks to significantly increase the size of their ES balances to meet their liquidity needs. While this is possible, it would mean that the RBA’s balance sheet would increase considerably. The RBA would have to determine what assets it would be willing to hold against the increase in its liabilities, and would be confronted by the same problem of the shortage of assets in Australia outside the banking system. Similarly, the government could increase its debt issuance substantially with the sole purpose of providing a liquid asset for the banking system to hold. Again, it would be confronted with the problem of which assets to buy with the proceeds of its increased debt issuance. Moreover, it would be a perverse outcome for the liquidity standard to be dictating a government’s debt strategy. 

However, the Basel Committee acknowledges that there are jurisdictions such as Australia where there is a clear shortage of high quality liquid assets. In such circumstances, the liquidity standard allows for a committed liquidity facility to be provided by the central bank against eligible collateral to enable banks to meet the LCR.

It’s clear reading this description that the shortage of safe assets refers only to a shortage of assets declared safe by the Basel committee. Australia, absent international banking regulations, had no problem running a safe banking system. Yet the new banking regulations left Australia’s banks as exposed. The response, bizarrely enough, is a central bank that is acting as a shadow bank — adopting maturity mismatch in order to supply assets to banks that Basel will count as safe for the purposes of regulation. 

From my perspective, it seems that this decade-long obsession with safe assets is due in large part to financial institutions facing systematically different incentives. They went with repos because those were guaranteed even in bankruptcy. Financial institutions loaded up on AAA-rated mortgage-backed securities and sovereign paper — not just on the medium of exchange side, but also on their long-term balance sheet — because Basel wrongly declared these to be “risk-free.” Subsequent downgrades led to financial carnage; but the root of the problem lay in the assumption that credit ratings could substitute for prudential management by banks themselves. The global “shortgage” or demand for safe assets was really a demand for ways to conduct regulatory arbitrage; and the growth in structured products (as well as sovereign European debt) was a supply-side response to that demand. 

Delevering

Matt Rognile takes aim at people claiming “deleveraging” is an important reason behind the prolonged downturn:

In failing to understand this core logic, most commentary about “deleveraging” is rather bizarre. At some level, it’s the same cluelessness that we once saw from central planners: they’d trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy—when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.

Elsewhere, he argues that many households, despite the fall in home prices, do have substantial assets. 

The deleverage hypothesis argues that aggregate GDP will remain weak as long as household consumption is held back through the presence of debts. Rognile retorts that the balance of savings and investment is adjusted through interest rates; and that the changes in net assets can’t really support economically meaningful drops in consumption corresponding to the output declines we’ve seen. 

I think there’s a lot true here. David Beckworth has also made  a number of powerful arguments connecting deleverage to monetary policy:

For every household debtor deleveraging there is a creditor getting more payments.  Yes, household debtors have cut back on spending, but so have creditors.  The creditors could in principle provide an increase in spending to offset the decrease in  debtors' spending.  They aren't and thus the economic recovery is stalled. In other words, the problem is as much or more about the build up of liquid assets by creditors as it is the deleveraging of debtors… 

The key problem is that there are households, firms, and financial institutions who are sitting on an unusually large share of money and money-like assets and continue to add to them.  This elevated demand for such assets keeps aggregate demand low and, in turn, keeps the entire term structure of neutral interest rates depressed too.

I think Beckworth actually makes a more powerful case than Rognile. Even if households had good reason to save more; it’s not obvious that lower household consumption would necessarily lead to lower aggregate output, so long as the banks and creditors receiving those payments went out and lent the money. Then the usual money multiplier arguments would ensure a rapid circulation of credit throughout the economy, raising output. After all, we typically think that higher saving and investment is a good thing for economies; as opposed to thinking that money saved is wasted. 

There are two reasons that isn’t going on, relating to an excess demand for money: households desperately want to hold more liquid assets and hold fewer debt commitments; while creditors also are inclined to hold liquid assets rather than lend those out. Logically, the only way that a flow of money from households to creditors can have any aggregate effects is if agents in an economy simultaneously have an excess demand for money not met by the central bank. 

When you think about it this way, it becomes easier to diagram how to think about deleveraging. There are basically three categories I see:

1) People who think that deleveraging is real, and no amount of monetary stimulus will help. 

These are people like Richard Koo. Their argument goes that the presence of excess debt is the key constraint holding back economic growth. No amount of monetary stimulus will fundamentally change the asset position of households, and so there’s no way it will alter consumption or output (or, at least, not to the degree that is necessary). Raghuram Rajan may believe something like this, as best as I can tell. The MMT folks are probably best placed here as well. 

As Beckworth and Rognile point out above, this view doesn’t make sense given the conventional understanding of how monetary policy ought to operate. If we desire greater spending from households or creditors; we can always make that happen by flooding the system with money. 

2) People who think that deleveraging is real, monetary stimulus could help, but the Fed won’t deliver enough. 

These are people like Paul Krugman. As Rognile points out — Krugman is careful to note how deleverage is only an issue if you’re in a liquidity trap, but that nuance tends to be lost among many other commentators. Elsewhere, he has argued that fiscal stimulus is only worthwhile as long as interest rates are zero — at other times, he often takes for granted that monetary policy ought to handle the brunt of aggregate demand management (or at least he did in the '90s). 

In that sense, Krugman actually agrees with Scott Sumner on more issues of intellectual substance than, say, with Keynes. It’s just that Krugman believes that in this particular instance, we happen to be in some kind of liquidity trap in which monetary policy won’t be sufficient to tackle the headwinds of a deleverage cycle. 

3) Then; there are people who believe that deleveraging may be a concern; but monetary policy (even with a zero-rate bound) ought to handle everything.

Here are the market monetarists like Scott Sumner and David Beckworth, as well as Matt Rognile. The belief is not only that monetary policy can fix any conceivable deleverage shock; but that the Fed could do so tomorrow given the set of tools they have; involving perhaps the adoption of a price level, getting more QE, imposing interest on reserves, or offering guidance on the future path of interest rates. 

Many people on sides 1 and 2 agree on issues; but there’s a fundamental conceptual difference there. Suppose, as Mike Konczal likes to imagine, that we wake up tomorrow and find that interest rates are actually 2%, rather than at 0% for the short-term Treasury rate. What should we do? Some people (like perhaps Koo?) would argue that changing that rate wouldn’t do very much. But people like Krugman would argue that, if we were in an environment in which conventional monetary policy could operate, then that’s basically the only policy channel we should use to get output back.

The only difference between sides 2 and 3 is whether or not the liquidity trap proves binding. This seems like a fairly trivial issue; but it determines entirely whether or not you think that we should adopt fiscal stimulus, or simply Ben Bernanke with a more aggressive Fed Chair. 

Where’s the Evidence for Deleveraging?

Some of the best evidence in favor of a deleverage model comes from cross-sectional cuts comparing debt to economic outcomes. For instance, Mian and Sufi find that high household debt areas have lower employment than low household debt areas:

One way to think about this is in some kind of Bernanke-Gertler approach in which households use their homes as collateral. When home prices were increasing, households used their houses like credit cards and extracted some of the equity. Now, when debt levels are high, the same households are cutting back; and employment is suffering. (Philippon and Midrigan have a paper highlighting this channel, though they also emphasize the role of monetary policy to counteract that)

The issue with this type of finding is ensuring identification. It seems intuitive that the parts of the country which participated in the housing boom most heavily would have some of the worst outcomes right now. But what’s the channel by which that operates? If it’s the debt, than we have some possible fixes — do some mass refinancing or mass principal writedowns (which may be good ideas themselves for other reasons).

But I don’t think it’s obvious that demand-side issues are at work in explaining the poor economic outcomes of post-real estate bust areas. Erik Hurst instead points to supply-side effects coming from the structural challenges in re-orienting a local economy away from real estate investment. He points to the following graph:

Here, he shows that the change in unemployment rate mirrors closely the change in the composition of output away from real estate-financial sectors. You have laid off construction workers, for instance, who find it difficult to retrain and find new jobs. Lowering outstanding mortgage principal won’t necessarily help retrain a laid-off-construction worker as a nurse. In fact, lowering the principal on a mortgage might induce that laid-off-worker to remain in a housing bust area instead of moving to North Dakota, where the unemployment rate might as well be zero; raising unemployment (this is basically what Lee Ohanian and Kyle Herkenhoff argue). The economy may just be in for a sustained period of slowdown as individual agents attempt to find a new sustainable equilibrium. 

I’m not wed to either the demand/debt or construction/supply approach — I just want to point out it’s not obvious to think about the role of debt, or even the relative ratio of supply side and demand side issues in explaining a weak economy. No one has credible causal estimates of how lowering debt burdens would help household or economy-wide welfare. Household and bank-centered approaches are very appealing in trying to explain why the recovery has been as weak as it is, but I don’t think all of the stories hang together. 

To Fix Bank of America: Rules not Discretion

Despite Warren Buffet's interventions, The troubles at Bank of America seem large. Over concerns of rising credit losses and lawsuit risk, the company’s stock has plummeted, while the price of credit default swaps to protect against default have risen.

Henry Blodget, at Business Insider, offers a plan to fix Bank of America:

First, Treasury Secretary Tim Geithner needs to set a "trigger price" for Bank of America stock. If Bank of America stock falls through this trigger price, he will then automatically put this plan into action…

·  Write down the value of Bank of America's assets by whatever it takes to make the balance sheet bombproof—focusing on second mortgages, commercial real-estate, European obligations, goodwill, and other "assets" that the market is skeptical about.

·  "Haircut" the unsecured creditors by whatever amount is necessary to close the gap between the asset writedown and the equity (BOFA currently has $222 billion of equity, so there's a lot to work with).

·  Inject $300 billion (or some multiple of the asset write-off) of fresh capital into the bank in the form of preferred and common stock—enough to make the bank extremely well-capitalized.

His prescription has much in common with several bank resolution strategies like  speed bankruptcy and a new bankruptcy chapter code. The common thread through these solutions is a reliance on a rules-based system for handling bank liabilities that would place the bulk of the burden on the holders of junior liabilities like equity and junior debt. These would be written off or written down in order to facilitate an orderly recapitalization under new management.

Of course, it remains to be seen what sort of credit losses Bank of America will ultimately bear. It may well the case that the company will manage without any writedowns. However, given the importance that Bank of America has on the larger economy, it’s essential to have in place a viable back up option.

Unfortunately, it seems unlikely, however, that Geithner and colleagues will actually follow the rules-based back up outlined above. Instead, if Bank of America requires a bailout, it will happen in a similar manner to the bailouts during the financial crisis — which were ad hoc and driven by regulatory discretion.

New revelations from the Fed reveal the extensive nature of those bailouts. In response to inquiries from Bloomberg news, the Fed has revealed the existence of loans offered to major financial institutions. These loans may be defended on the grounds that such lending fits with the Fed’s mandate as a central bank, and were essential to allowing  the financial system to weather the panic. However, the lack of transparency that surrounded their disbursement and the quality of the assets used as collateral is certainly troubling.

This new discovery helps make sense of a research finding by Daron Acemoglu, Simon Johnson, and colleagues. In a paper, this group found that Geithner’s appointment was associated with stock gains among companies with close ties to Geithner. These gains were not present among financial firms generally — suggesting that connections, rather than Geithner’s performance as Treasury Secretary, drove these firms profits. Interestingly, this same group of companies suffered as Geithner’s tax problems led to lengthy confirmation battle.

The overall pattern in the last several years has brought new waves of crony capitalism to the foreground. Firms have received loans and bailouts in line with personal connections, and have seen their share values fluctuate in proportion with the career prospects of individual bureaucrats. Dodd-Frank enshrines this discretion-based approach into law, and does not auger well for the creation of a functioning financial system. Instead, we need a financial system based on rules. Bank of America could be a good place to start depending how the market value of its liabilities and equity hold up over the coming weeks.

Are Capital Markets Inherently Risky?

A new NBER paper by Michael Bordo, Angela Redish, and Hugh Rockoff look further into the causes of the superior performance of the Canadian Banking system:

The financial crisis of 2008 engulfed the banking system of the United States and many large European countries. Canada was a notable exception. In this paper we argue that the structure of financial systems is path dependent. The relative stability of the Canadian banks in the recent crisis compared to the United States in our view reflected the original institutional foundations laid in place in the early 19th century in the two countries. The Canadian concentrated banking system that had evolved by the end of the twentieth century had absorbed the key sources of systemic risk—the mortgage market and investment banking—and was tightly regulated by one overarching regulator. In contrast the relatively weak, fragmented, and crisis prone U.S. banking system that had evolved since the early nineteenth century, led to the rise of securities markets, investment banks and money market mutual funds (the shadow banking system) combined with multiple competing regulatory authorities. The consequence was that the systemic risk that led to the crisis of 2008 was not contained.

The superior performance of the Canadian banking system relative to the American one is a well-known fact in the banking literature. The decision by various populists and other forces to regulate American banking in a poor manner remains one of the single largest unforced errors in American economy history. Branch restrictions and other regulations led to a large fragmentation in the American banking sector, while Canadian banks were relatively more centralized. This meant that American banks were strongly undercapitalized and unable to deal with localized geographic agricultural shocks -- leading to chronic bank runs.

Canada avoided that. Even in the Great Depression, they largely avoided bank failure. Nor did they have deposit insurance until the 1960s. So it's not that the maturity transformation that banks do is inherently risky; or that financial systems are inherently prone to collapse. Instead, Canada just opted for a more stable, nationally centralized system that performed much better historically.

This paper adds to that knowledge by pointing out another key factor extending Canada's banking performance - the role of capital markets. American banks compensated for their geographical fragmentation by creating liquid capital markets on which to trade debt and other contracts.

The authors argue that this led to something of an inbuilt American national bias to rely on capital markets -- culminating recently with structured products like mortgage-backed securities. In Canada, comparable lending is still handled by banks extending loans to individuals. "Shadow banks" like Investment Banks have always been around in the US underwriting commercial paper or other offerings. These markets frequently failed during crises.

Interestingly, this difference also pops up in Japan, which I discussed here. The old Japanese school of Finance relied extensively on bank finance through the 80s. At that point, there was a large deregulatory shift in favor of capital markets, and also a financial crisis. That evidence isn't necessarily causal, but it is perhaps another reason to think that banking-oriented finance, as opposed to capital market-oriented finance, may have some advantages.

Dreaming of A World Without (Public) Debt

If there's one thing the S&P's debt downgrade reinforces -- it's that public debt is bad. It's bad for taxpayers and bad for stability of the financial system. Ideally, we need to get rid of all of it.

The case for debt as a bad for taxpayers is easy enough. We spent some $200 billion every year on net interest on debt, or roughly $2 trillion a decade -- for which taxpayers receive absolutely nothing at all in return. This interest expense wouldn't exist in a world of saner budgeting in which expenses equalled income over reasonable periods of time.

Then, there's the foregone capital gains on that as well. Gilts are tax-free. If we had no debt and investors held the same amount of debt in the form of private debt, the IRS would be receiving a sizable chunk of revenue a year.

In theory, debt financing makes sense if an entity is making some fundamental investment, for which future cash flows will finance future interest payments. But that's not how the government works -- we borrow from tomorrow to finance consumption today. We're paying billions of dollars extra because the folks in 2003 were too short-sighted to finance their consumption in 2003 rather than later. That's no good reason to pay billions in the form of interest payments and foregone capital gains income. Think of how much easier it would be to handle budget problems with that extra buffer. Instead, we're taking those interest payments and throwing those back on the credit card. We'll end up paying substantially more than one dollar in future taxes to finance one dollar of consumption.

Does getting rid of the debt altogether sound crazy? Australia has typically held basically no public debt over the business cycle. They have a little more today due to the financial crisis, but will in all probability wind that down back to basically zero.

Then, there are the warping knock-on effects that "safe" sovereign debt has on the entire financial system. As Perry Mehlring outlined in The New Lombard Street, the Fed was once optimized for a world where the entire system of payments and debt revolved around private debt. What we dub "quantitative easing" was once done sort of more routinely as the Fed manipulated the prices of privately issued debt in order to determine country-wide credit and money ability.

FDR's enormous deficits -- and the resulting stock of public debt -- changed that. The Fed altered its mandate to only mess with public debt, only recovering that old role during the financial crisis, when a zero-rate bound on short-term Treasury debt and broader financial problems brought about financial interventions into private debt. But had FDR not bothered with basically useless fiscal stimulus programs (ie, decided to follow his campaign pledges), and instead stuck with the monetary interventions that actually worked -- we could imagine an alternate central banking world in which shaping interest rate expectations on private debt would constitute the totality of Fed operations. That would have been a much more stable world to live in.

In particular, you don't have the nonsense of "safe" debts underpinning the architecture of the entire financial world. Gary Gorton talks about the creation of structured finance as a way to meet some "shortage" of safe assets provided by the government. I would instead say that the fallacy of assuming that safe assets exist is invariably the cause of financial crises. Rather than worrying about what a debt downgrade will do to the financial system - the goal should be to build a system with is tolerant to (normal! expected!) downgrades of certain types of debt. Rather than pricing everything on the basis of Treasuries, we could have a world where everything has an assumed credit risk, and people bear enough capital to handle expected credit shocks.

This doesn't say anything about the mechanism by which debt goes to zero - whether we get there by higher taxes or lower spending. Obviously, right now, that's hard to imagine. But Australia seems to have figured something out, and even countries like Sweden and Canada have made important steps in that direction. At least in terms of how to imagine debt, I think it's important to say, "piling up this much debt was a really bad idea we should reverse as soon as possible," rather than, "interest rates are low, so let's pile on as much more of this as possible." The price of debt tells us nothing about it's value.

We Should Have Defaulted

Any particular reason why we had a market crash now? Wasn't the extension of the debt ceiling supposed to ward off a market collapse? Arnold Kling offers a contrarian take:

Apparently, the resolution of the debt ceiling restored the dollar's status as a safe haven in the eyes of the world's investors. That accelerated the flight from European sovereign debt and European banks. That in turn raised fears in financial markets, driving down stocks, including in the United States.

I think one can make a plausible argument that we would be better off continuing debt ceiling games in the US. It looks as if certain European countries -- the usual suspects of Italy, Greece, and Spain among them -- face self-fulfilling beliefs regarding the quality of their debt. They can survive only if investors continue to lend to them at low rates. There are multiple equilibria here -- either peripheral countries continue to borrow at cheap rates reflecting a low probability of default, or they borrow at high rates reflecting a high probability of default.

Which equilibria we are in is determined by the initial level of capital willing to invest in Europe versus America. As Kling points out, the resolution of "uncertainty" in the US shifted the balance in favor of the US, pushing Europe to the bad equilibrium, with internationally disastrous consequences. Of course, keeping America a risky destination for capital probably isn't the best long-term strategy. But perhaps a more stringent regime of capital flows could have alleviated some of the short-run European liquidity problems, buying time to deal with the solvency concerns.

Elsewhere, Ryan Avent offers a useful historical perspective comparing today with the 1930s. It is a useful analogy, one that largely fits the narrative I got from the excellent Wages of Destruction. The euro, in this reading, in some sense serves the same function as the Gold Standard did for European countries -- a straightjacket preventing adequate monetary easing in poorly functioning economies, who have contracted out the ability to ease and do not receive fiscal transfers from elsewhere.

Asset Prices, the Business Cycle, and Unemployment

A few months ago, I blogged about research done by Roger Farmer and Naryana Kocherlakota on understanding unemployment; and in particular relating trends in unemployment to asset markets and investor confidence.

The key issue is that it's difficult to understand why unemployment remains so high so far after the financial crisis. A real business cycle approach would look for real shocks to production; in particular idiosyncratic shocks to technology. Yet it appears that this recession involves a number of nominal and financial-sector related frictions difficult to rationalize using that model.

Another approach relies on New Keynesian thinking. In this view, prices are “sticky” as it is costly to adjust prices in the short-run in response to a moderate shock. This induces a friction in in economic activity, especially in the market for labor, that can be fixed through macroeconomic stabilization in the form of monetary or fiscal stimulus. However, if you look at scanner data, retail prices are actually fairly flexible. On top of that, the economy faced such a substantial shock, and we are sufficiently far out in the future, that surely price-setters have had the chance to adjust prices by now.

In short: the particular frictions and shocks underlying traditional macroeconomic models seem to be of limited relevance in explaining this recession. As a result, I’ve been trying to read up on alternate models — relying, for instance, on financial market frictions, household balance sheets, etc. Roger Farmer, in a new paper, offers up another such model that relies on old-style Keynesian thinking.

The basic logic comes out in this graph:

This shows asset prices and unemployment being closely linked throughout the business cycle; which isn’t a trivial fact. The logic is that asset prices follow bubbles and crashes due to self-fulfilling optimism and pessimism from investors. These booms and crashes result in larger social consequences in the form of higher unemployment through search frictions in the labor market.

In this model — as in some sense as in Keynes original work — investors do have rational expectations. They expect a bubble; and a bubble happens. They expect an economy that performs poorly over an extended period of time; and that too materializes.

Nevertheless, the paper still relies heavily on psychological assumptions about investor behavior. Investor confidence drives both asset prices, as well as willingness to hire. This response is, as I suggested in my last post, asymmetrical, as it is harder to hire than it is to fire.

I find this paper interesting as it brings the problem of unemployment into the domain of asset pricing. While Farmer emphasizes the psychological basis of bubbles and busts, someone like John Cochrane would emphasize how ultimately discount rates — the rates at which we value future income relative to current income — determine the values of current financial assets (which are just claims to future cash flows).

In Cochrane’s world — asset prices fluctuate in conjunction with macroeconomic outcomes. Is the economy looking bad? Do you anticipate losing your job, your business, or other such negative shock? If so, you wish to hold less risky assets. Yet we can’t all rebalance away from risk, as there are only so many stocks and bonds and so forth. Instead, the price of stocks and bonds fall in order to compensate us for bearing this sort of risk in a time of economic uncertainty.

Yet Farmer would point out that the process also works in reverse. High discount rates — equivalently, “pessimism” — felt by the owners of capital manifest themselves in an unwillingness to hire, particularly if there are frictions in the labor search process.

I suspect that tying Farmer’s model into a more "rational" model of asset prices that emphasizes the links between financial markets and real markets would amplify the multiple equilibrium nature of unemployment. This was the key feature of Keynes of course, and it’s interesting to see Farmer resuscitate this idea. And with unemployment at 9% or what have you it doesn’t seem implausible to think that numerous economic possibilities are open to us, depending on the nature of economic equilibria we end up at.

Unemployment and Recalculation

There are two ways to think about current deep and persistent rates of unemployment. One point of view is that these merely reflect the poor rate of economic growth, and ought be remedied by stimulus either fiscal or monetary. Another point of view is that high unemployment reflects the degree of economic restructuring that needs to happen to cover the malinvestment of the housing boom; and so easy fixes are not available for the labor market. The first set of views are held by a number of people across the right and left; with the preference for fiscal/monetary stimulus varying by ideology. The second set of views are held by a motley of individuals, from Austrians to Raghuram Rajan, to Minnesota Fed President Narayana Kocherlakota, to Arnold Kling and his idea of PSST (patterns of sustainable specialization and trade).

One point of evidence in favor of the “structural” view is the pattern of hiring and firing — in which many jobs across a range of dying industries are disappearing. According to that school of thought, this indicates that those industries are experiencing a reallocative shock.

Ricardo Caballero comments on this in an interview with the Minnesota Fed:

Q: And should we be concerned about jobless recovery in the United States? Do you think there might now be a higher level of structural unemployment?

This was a time when the important work of Steve Davis and John Haltiwanger in documenting the nature of the process of job creation and destruction in U.S. manufacturing led to an explosion of research trying to explain this process.

One of the key features of their findings was that recessions come with sharp spikes in job destruction. Somehow, other researchers jumped to the conclusion that this spike meant that job reallocation was strongly countercyclical. That is, that reallocation increased during recessions: a sort of Schumpeterian cleansing. Many theories were written about this phenomenon.

Mohamad and I made the rather obvious observation that a spike in destruction in itself does not mean that reallocation increases during recessions, since this would also require that creation increases. Steve and John had already documented that job creation actually falls at impact. We explored whether the initial spike in destruction translated into abnormally high creation during the recovery phase of the cycle, which would be a dynamic version of the countercyclical reallocation story. Not only did we not find this increase in creation during the recovery, but we found that job creation was actually below normal levels. That is, cumulative restructuring is procyclical, not countercyclical.

We then went on to show that a model where financial constraints tighten as a result of the recession could explain such patterns. I think this is the connection with the current recovery. This was a recession which severely damaged the financial sector; hence, it is not surprising that hiring is so muted.

I don’t think this view is inconsistent with the idea that the economy does face long-term structural challenges in adapting to new social and technological changes. However, I’d say it tackles the idea that such reallocative challenges are an argument for weaker stimulative efforts. Rather, this seems to say that proper economic recovery goes hand in hand with reallocation. No need to view AD/PSST as opposed from the policy point of view.

Energy Prices

Matt Rognile is blogging again, and has a post up on how the federal government ought to provide some sort of insurance against the cost of rising gas prices.

I’m sympathetic to this sort of thinking. I think it’s clear that a large part of what motivates hard money advocates is the fact that constant energy fluctuations leave an immediate impact on the purchasing power of families. Raj Chetty, someone who I seem to cite all of the time, has emphasized the role of commitment goods (like mortgage or auto payments) in reducing the discretionary income available for families. Fluctuations in the price of an essential good can hurt families tremendously, even if the actual price or consumption impact is small in relative terms, especially if families are credit constrained.

Meanwhile, to the extent that energy fluctuations signal permanently higher prices, they also induce structural changes in the household demand for items like energy saving cars. Yet, again due to credit constraints, households may be unable to adjust their assets — while the higher immediate cost of making gas payments may actually make it harder for them to change cars.
A recent paper by Nick Souleles and co-authors have some evidence suggesting that the Bush economic stimulus payments in 2008 ended up performing exactly this insurance role. Aside from delivering payments around the worst time of the oil shock — these payments (roughly $300-1200 ) also relieved a collateral constraint for many families. Their evidence suggests that many families used the money as down payments for more gas-efficient cars. Jonathan Levin's research (in part, what has won him a John BatesClark Medal) suggests that amounts of this size can indeed serve as down payments for subprime auto loans.

On top of the household benefits of hedging against an unexpected rise in prices for constrained households, there are the larger effects of oil shocks. Increasing durable consumption right at this time may have helped auto companies avoid even worse losses. Also, there's the issue that gas prices make macroeconomic stabilization much more difficult. A large part of this last recession was attributable to high gas prices, while a persistent oil deficit worsens the current account deficit. In classical theory, that isn’t so worrisome by itself, as a current account deficit will eventually be balanced out by higher future exports or capital inflows.

But high capital inflows can be very dangerous. In general, they tend to be associated with asset price appreciation, and a skew in domestic prices away from (increasingly uncompetitive) tradable goods and towards durable, non-tradable goods (like housing and real estate). This has been a contributing factor behind the Asian crisis, and may have been a large factor behind the most recent crisis.

However, despite bemoaning this state of affairs, the Fed has decided to do very little about this. Bernanke’s research has pointed to the need to respond to an energy shock by loosening policy; yet the dictates of an inflationary target would demand a contractionary response just as the economy is reeling from the effects of higher oil prices. His paper in fact found that energy shocks are contractionary exactly in part due to a misguided monetary shock. This debate is basically going on now, as higher oil prices driven by global factors are hurting the economy; yet are used by hard money advocates as evidence that easing has gone too far.

Bernanke has also complained about the impact of a global “supply glut” that led to large capital inflows, and fueled the demand for structural financial products that could offer seemingly high rates of return at low cost. Yet he hasn’t taken the next step of thinking through (publicly) how the US should respond. Some set of measures imposing capital controls or active management of foreign reserves to target international currency rates would affect net financial flows. Yet these ideas, while implemented routinely in the world’s central banks, remain verbotten at the Fed. This sort of stuff is the job of the Treasury, which has no tools to implement any of these targets, and in any case is mostly interested in obtaining as low interest rates for federal debt as possible.

However, even without trying out capital controls, simply lowering the level of imports of oil would have an enormous effect on current accounts deficit, and so on the degree of net capital inflows that result. As Calculated Risk always points out, America would be much closer to trade balance excluding the impact of oil.

America's dependence on oil is bad. It's bad for households and it's bad for the economy. It's not crazy to think about ways to move away from oil, both to avoid the impact of transitory shocks, as well as the costs of long-term dependance.

Bubbles and Unemployment

There’s a lot of commentary going around on why unemployment has proved to be persistently high during the recovery. As Yglesias notes, this boils down to the question “Are recessions caused by asset price busts fundamentally different from recessions caused by central bank efforts to curb inflation?” Paul Krugman has a strong take on this:

Brad DeLong has recently written up a clearer version of a story I’ve been telling for a while (actually since before the 2008 crisis) — namely, that there’s a big difference between inflation-fighting recessions, in which the Fed squeezes to bring inflation down, then relaxes — and recessions brought on by overstretch in debt and investment. The former tend to be V-shaped, with a rapid recovery once the Fed relents; the latter tend to be slow, because it’s much harder to push private spending higher than to stop holding it down.

The idea that the precise conditions of this recession are different has implications for the favored policies of both the right and left. On the left, some folks believe that the notion of balance sheet recessions calls for more measures to tackle household negative equity, optimism for fiscal policy, and skepticism regarding monetary policy (say, Krugman). On the right, other people emphasize mismatch problems in the labor market and the role of structural forces behind unemployment. They are frequently skeptical of how fiscal policy can fix these problems (sometimes, also monetary policy). In general, there are widespread beliefs that some particular features of the crash have limited the scope for traditional macroeconomic stabilization policies.

Via Stephen Williamson, Minneapolis Fed President Narayana Kocherlakota has a new paper that goes into this issue. He draws on the Keynesian work of Roger Farmer, who shows this graph:



Farmer’s idea is that the rate of unemployment at any time is indeterminate due to problems in the labor search market. In the absence of markets for the search time of workers, price signals are not necessarily sent to match workers with the right jobs. Instead, the level of unemployment is determined by expectations of the strength of economic activity, which is proxied by stock market performance. One problem for this idea lies in explaining why unemployment has been slow to recover even as the stock market has recovered. Farmer writes,

This paradigm provides us with a new way to think about large recessions like the Great Depression and the Great Recession of 2007—2009. Using the model from this paper I would argue that the world economy in 2008 was headed rapidly towards a high unemployment, low wealth, equilibrium. The move to this bad equilibrium was triggered by a loss of confidence in the value of assets, backed by mortgages in the US subprime mortgage market. The inability to value these assets led to an amplification of the crisis as panic hit the global financial markets.

In the winter of 2011, the US labor market had still not recovered. I believe that much of the problem is connected with a lack of confidence bylobal investors who are concerned with the possibility of a further collapse. Even though the US stock market may be appropriately valued based on historical price earnings ratios — market participants are concerned that the value of stocks could fall further. Variations in the level of confidence are manifested in changing risk premia that are fully rational given the unpredictable behavior of future traders in the asset markets.

I find this argument more persuasive in explaining the employment dowturn than the failure of employment to recover; but it is easy to imagine alternate models in which employment growth is asymmetric with respect to the business cycle.

Kocherlakota's innovation is to bring this unemployment picture into a broader model involving bubbles and monetary policy. While his model is fairly complex, the end result is simple — as with Farmer’s model, the level of unemployment is ultimately determined not by prevailing wages, but rather by the amount of aggregate demand. The collapse of an asset bubble results in a substantial drop in demand, and will result in a hike in unemployment unless the central bank proves sufficiently accommodative in lowering nominal interest rates.

One way to think about this is to compare the stock market bust in 2000 with the housing bust in 2008. In both cases, you have an asset that drops dramatically in value (tech companies, housing) that results in large drops in comparable financial securities (tech stocks, mortgage-backed securities). The total wealth loss in the economy was roughly comparable between the two cases. Yet for the 2000 crash, the Fed was able to lean against the drop by moving conventional monetary policy enough. In the second case, the Fed quickly hit the short-term nominal interest rate barrier of 0, and was unable to ease further though conventional channels. It did pursue unconventional policies like QE2, but was hesitant to do so and faced unprecedented levels of backlash for the easing that they did happen.

So, one way to read Kocherlakota is the following: given that monetary policy-induced demand fixes the rate of unemployment, recovery difficulties now reduce to the fact that the Fed has been insufficiently accommodating as the some interest rates hit the zero-rate bound. If the Fed instead proved more willing to consider unorthodox policies like quantitative easing or currency depreciation, we could have whatever degree of unemployment we liked.

The ultimate origin of a recession, in this model, is completely irrelevant to the possibility for the recovery. Issues with debt overhangs, structural unemployment, etc. are all second order effects relative to the fact that Fed-induced nominal spending has lagged; and the optimal recipe is not fiscal stimulus, but further Fed-based easing. Recessions caused by asset-bubble bursts do not differ from the garden variety recession, as long as the Fed is in fact appropriately accommodating.

So, the real issue is not that bubble-induced recessions are diffrerent in some way, but rather that policymakers respond to them differently. Rather than saying “the recovery in the 80s was quick because it was a Fed induced recession”; the issue instead is that the Fed had more scope to tackle that recession than this one.

Bankruptcy Reform and Financial Crises

Mike Konczal has a fascinating idea that he expands in an interview: that the 2005 bankruptcy reform may have contributed to the severity of the financial crisis. The idea is that a change in the law expanded exemptions for derivatives during bankruptcy proceedings. This allowed derivative counterparties to end contracts and seize collateral as soon as bankruptcy was filed, moving to the head of the line among creditors.

There were several problems with this. First, this created incentives to restructure normal contracts, such as agreements to supply fuel to an airline company, in the form of swaps or derivatives. This was a win-win for creditors and debtors. Creditors were assured easy contract termination, even if the firm entered bankruptcy. Debtors were not generally required to post collateral for their contracts, allowing them to operate with a leaner capital structure.

Second, these rules expanded to define mortgage-backed securities as repos for the purposes of the safe harbor. This was potentially a huge change. Gary Gorton has argued that the demand for short-term securities, fulfilled by mortgage-backed securities, was fueled by the demand for information-insensitive, safe assets. Andrei Shleifer has suggested that these sorts of new, exotic securities were mispriced. While both of these may be a part of the story; there is another interpretation. The surge in securitization can be seen as a form of regulatory arbitrage designed to create short-term funding that would hold up in bankruptcy court. Without the penalty of potentially losing assets during bankruptcy, lenders were more willing to provide short-term funding to over-levered Investment Banks.

As Mike’s interlocutor points out: for non-bank institutions, this change was not the end of the world. Quick liquidation of existing contracts is akin to the Chapter 7 process (rather than the lengthy reorganization of Chapter 11). There are often advantages to slowing down the bankruptcy process, but small firms can be liquidated in an orderly manner.

The same is not true for banks. The special treatment of repos and derivatives in bankruptcy resulted in early termination and seizure of contracts by bank counterparties during moments of crisis or bankruptcy. The going-value of a bank—the excess value they have above and beyond the market value of its assets—is crucially dependent on its solvency and liquidity. Illiquid banks, by virtue of their leverage, are forced to sell their assets at fire sales, which can lower prices, which can lower the value of their assets further in a destructive spiral. Ensuring that certain forms of short-term funding and derivatives went to the front of the line in the Lehman case all but ensured that its bankruptcy would be a disaster.

The unintended systemic consequence of this treatment of bankruptcy was illustrated once before, during the failure of Long Term Capital Management. Intervention by the Federal Reserve happened precisely because regulators were worried that the failure of LTCM would cause a disorderly liquidation; a liquidation that would be worse exactly because derivative contracts could be terminated early.

As Mark Roe points out, the exemption that derivatives and repos enjoyed also warped their incentives to monitor the risk-taking going on at Investment Banks. The rule also possibly artificially increased the amount willing to be lent to banks, and gave them lower borrowing costs.

All of this points to a need to reform the bankruptcy code in order to treat derivatives on par with other claims. While legislative and popular pressure has focused on derivatives as being inherently bad, it would be better to fix legislation that encourages the over-use of derivative contracts and risk-taking; rather than leaving these elements in place, and hoping that other regulatory fixes elsewhere would solve the problem.

Revisionism on Deposit Insurance

One of my personal pet peeves is the existence of Federal Deposit Insurance. Arnold Kling well characterizes the point of view I believe ("revisionist") against the standard position:

The standard view is that banking in a free market is inherently fragile, which makes deposit insurance necessary. In fact, some would argue that the concept of insurance needs to be extended to the so-called "shadow banking system." I think of Perry Mehrling and Gary Gorton as being in that camp.

The revisionist view is that deposit insurance is a case of the government concocting a solution to a problem that was created by government in the first place. That is, the U.S. banking system was unstable due to regulations that promoted small, local banks and inhibited the creation of diversified nationwide banks. Had banks been allowed to branch across state lines or had national bank holding companies been allowed to grow naturally, then (according to this argument) we would have seen few bank failures, even in the 1930's. Hence, there would be no need for deposit insurance.

There are several good reasons to argue against the traditional view that banking is naturally risky and therefore requires deposit insurance:

1. Maturity Mismatching is unnecessary. Japan, for instance, has historically adopted the view that lending of a certain type and duration should be matched with a liability similarly constructed. So instead of using flighty deposits to fund long-term projects, your deposits are funneled into assets with low risks and returns. Without crossing maturity lengths, the possibility of a bank run gets a lot smaller.

2. Absurd populist demands of the 19th century limited the number of branches a given bank could open. That resulted in a very geographically fragmented banking system prone to crisis every time agricultural yields fell in a given area. As a result, banks failed often and the entire business cycle was highly volatile.

Canada illustrates that the problem was exactly those banking restrictions, not banking in general. Canada's banking laws were far more permissive in terms of where banks could open branches, and the country developed a highly concentrated, well-regulated system of banks. By drawing on the deposits of an entire country, tiny shocks were not enough to force bank failure. In fact, the country barely experienced bank failures, and never saw banking panics -- even during the Great Depression. They did not even bother instituting deposit insurance until 1967. Canadian banks again outperformed American ones in the most recent crisis.

3. The past experience of deposit insurance before the 1930s was mixed. As Amar Bhide notes in A Call for Judgement, many of the state deposit plans performed quite badly through the Great Depression, frequently proving insufficient to cover all losses. The Indiana plan worked best by making other bank branches jointly responsible for the failure of a given bank. The national clearinghouse model also provided another vehicle for banks to collectively guarantee their deposits and prevent a panic, without requiring insurance. This sort of collective monitoring was not followed by other state plans, which performed poorly in sheltering depositors from bearing bank losses. Rather, by pushing some of costs of risky lending onto another party, they may have further encouraged bad lending and hastened banking crises.

The eventual adoption of FDIC insurance during the Great Depression drew on the disastrous experience of the standard issue insurance plans, as opposed to the successful mutual responsibility plans. It was was opposed by several interests -- including big banks, FDR, and the Treasury. Many of these actors were concerned by the poor performance of state insurance plans. However, federal insurance had the benefit of further entrenching the power of small banks, which would otherwise be a competitive disadvantage relative to their larger banking peers. We adopted the FDIC not as a part of a well-thought out plan to stem banking problems based on past evidence; but rather to satisfy the small bank lobby responsible for banking fragility in the first place.

4. The moral hazard aspects of deposit insurance have been tested internationally, and the results are fairly negative. A study by Aslι Demirgüç-Kunt and Edward J. Kane finds that countries with the highest coverage levels of deposit insurance are five times as likely to have a financial crisis as countries with low coverage limits. Better institutional quality (presumably leading to more prudential regulation) reduces the moral hazard caused by deposit insurance, but not entirely.

5. It's not clear that a banking crisis from one firm necessarily spreads to other, healthy, banks. The key test for this was the Great Depression, and my understanding is that studies point both ways on this.

At this point, FDIC insurance seems here to stay -- though it's worth pursuing policies to limit the amount of money covered by the insurance (say, at $100,000 per taxpayer, rather than $100,000 at each bank you have money at) or increasing bank co-insurance plans.

But this debate remains very relevant in thinking through the Shadow Banking crisis. One school of thought, best represented by Gary Gorton, feels that the problem there is similar to the issue in normal banking, and the solution lies in making repos -- the equivalent of deposits for Shadow Banks -- effectively riskless. Rather, the perspective above would point out the flaws in maturity mismatching generally, and would push against the institutional aspects of banking that make it more fragile by hiding risks and promoting moral hazard -- for instance, skewed salaries, the end of the partnership structure, and the bankruptcy treatment of derivatives.

The Savings Glut

I've ran into a few papers reinforcing the tie between global flows of capital, US monetary policy, and the financial crisis:

- This VoxEU article by Filipa Sa, Pascal Tobin, and Tomasz Wieladek argues that capital inflows, low interest rates, and a greater degree of domestic securitization were all linked to greater housing appreciation.

-Courtesy of David Beckworth, this paper by Rudiger Ahrend argues that persistently low interest rates are associated with larger rises in asset prices.

-Also by Beckworth, this paper by Thierry Bracke and Michael Fidora argues that monetary shocks, or liquidity, explain trends in global financial flows.

All in all, this seems increasingly damning for the Fed. Even if one accepts their excuse that foreign capital flows explain the whole issue, and that foreign preferences for savings and investment explain those flows -- that still would argue for some sort of action to curb capital flows.

Scott Winship and Inequality

Scott Winship has a new post on inequality, arguing that the rising income share of the top 1% are replicated across a host of countries, suggesting that similar trends are driving growing inequality. This takes on arguments that, say, the demise of American unions is driving up incomes for the rich. If instead top earners are making more throughout the world, it seems more likely that some common technological or economic trend is driving that result. Here's his basic chart behind the idea:

This graph measures the share of income held by the top 1%, and the solid black line is America -- which is moving on trend with other countries.

This chart makes the following "correction" -- it assumes that the rise in reported American income after 1986 can be attributed to the 1986 Tax Reform Act, which sharply reduced marginal tax rates, and resulted in a sharp rise in self-reported income. Winship wants to interpret this result as a permanent shift in reported income. However, if you look between ~1983-1998, it looks like a fairly clean linear trend, with a temporary spike around 1986. There is also a small drop in reported labor income to evade the 1993 tax hike. It's possible that the 1986 tax reform only resulted in a transitory rise in reported income; certainly this is the argument in Piketty and Saez, where the US data comes from. Without that correction, the US becomes a slight outlier in terms of top income share.

Regardless, this data seem to support the idea that dynamics are very different within the Anglosphere and elsewhere. Canada, America, the UK, and Ireland all saw a sharply rising share of top 1% income in the past few decades. Countries like France, Germany, Sweden, and Japan also saw rising inequality, though not to the same degree. This points to winner-take-all dynamics operating within the large linguistic zone of English-speakers, as top talent moves smoothly between these countries. It's also notable that several of these countries have seen seen a comparatively greater role of Finance in recent years. From a paper by Reshef and Philippon:

It's telling that the drop and rise in relative wages in Finance mirrors the experience of top income inequality for the US as a whole. It's interesting to think through why the presence of the financial sector would alter income distributions for whole economies around the world. One explanation is that the role of leverage and arbitrage allows a select group of highly-skilled managers to concentrate a far greater share of income. Another possibility is that this reflects the role of opaque markets, information asymmetry, or some broader mispricing that is penalizing the real economy.

Another set of arguments this take on are those (ie, like that by Rajan) that argue for a causal role of income inequality in fueling the recent financial crisis. If instead inequality was broadly rising around the world, it becomes a more complicated story why the crisis began here.

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.