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.

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.

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.

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.

More on TARP

Karl Smith has kindly responded to my post on TARP:

Then a broker-dealer went bankrupt. The process of chaos began to unfold. We had what looked very much like a run. Given that narrative the response was to somehow stem the run. This meant insuring creditors against losses.

Various schemes were proposed. In the end equity injections were settled upon. The terms where not what I would have wanted but I understand the pressure of being in the moment.

After the equity injections our measures of panic began to subside and indeed have not come back despite the fact that housing has not recovered. This lends credibility to those of us who said that housing and bad loans mattered only to the extent that they were possibly creating insolvency and fueling a run.

Do we know for sure that this is narrative is correct – no. However, the level of certainty I think Gupta is asking for is virtually never available to us in real time and is hard to ascertain even looking back. My core case is that the narrative holds and continues to hold as we accumulate more data.

The ultimate argument here is "Things were going very bad; we did something; and things ended up much better than we expected. Maybe things could have gone better, but things did end up going surprisingly well."

First -- there's the question of whether or not TARP "helped." Ultimately, this relies on the unknowable counterfactual of what the world looked like without TARP. It also relies on assuming that the entire recovery was due to TARP. Yet as Donald Marron points out, "One reason that TARP appears much less expensive than originally predicted is that many of its investments benefitted from other government actions whose costs show up elsewhere in the budget." We did a whole lot to help the banking sector, and would undoubtedly have done even more without TARP. So to give it the whole credit is probably a bit much.

There's also a key phrase here -- "in the end equity injections were settled on." This is an interesting way of putting it. What actually happened is that Treasury asked for a virtual blank check ostensibly to support asset purchases, and then decided to purchase bank equity instead because they wanted to.

It's worth emphasizing again that the narrative that Treasury was selling -- that the world would collapse if we didn't purchase toxic mortgage assets -- was completely wrong. In fact we didn't purchase many toxic assets, and the world went on. Had we enacted TARP as envisioned, written into law, and sold to the public -- the result would have been hundreds of billions of dollars of taxpayer losses.

So the fact that we "settled on" equity injections reflects my primary opposition to the bill -- that we basically left the decision of how to spend $700 billion dollars in the discretionary hands of the Treasury. We are indeed fortunate that Congress failed to implement any meaningful oversight on the bill and the ultimate decision Treasury opted for was not the worst thing in the world (though, of course, TARP money has also been used as a political slush fund for things like HAMP, auto bailouts, etc.). But what was at stake in the bill was really the democratic principle that the legislative branch, not unelected bureaucrats, decide what we spend money on. Do we really think that giving Treasury the right to spend hundreds of billions of dollars is a good idea? Can we continue to rely on them reading the right bloggers?

I am sympathetic to this view though I take a slightly different tact. I tend to think that the government should have simply squeezed the financial system for everything that it was worth on the grounds that its the responsibility of the Treasury Secretary to act in the best interest of his clients. The taxpayers were his clients. Making more money for you clients is generally preferable to making less thus he should have tried to make more money.

However, it is important to note that TARP as structured was profitable on the bank side. It wasn’t simply that the taxpayer got his or her money back. Their were warrants that that gave the taxpayers a bit of the upside. I just don’t think they were big enough.

I understand the moral outrage and all but my general take is that the Government in this capacity should act to maximize taxpayer profits, not express taxpayer outrage. I realize that this is not a majority view.

Since when is the government supposed to run a hedge fund? Since when should the maximization of "taxpayer profit" be an objective of government?

The issue here is why is the government doing this at all? If the government made money on at least some of its investments; and the banks did well; why couldn't private capital flow in?

Everyone agrees that banks in 2008 needed to be recapitalized. But it was an open question whether this would be achieved through bankruptcy, or some mechanism of forcing banks to raise capital, or so on. There were a lot of options, each with costs and benefits. Some of them wouldn't have involved public money.

Unfortunately, it looks from Swagel's account that Treasury -- though aware of this problem -- spent months doing nothing about this. They wound up in September with a three-page plan that, as I've mentioned, would have barely helped. Perhaps they had the excuse that they were rushed and didn't have the time to properly consider, say, Zingales' bankruptcy proposal. But it's been several years since then, and Treasury doesn't have any serious bank resolution mechanisms that don't require public money.

TARP was no Success

As over two years have passed since the extraordinary events of the worst days of the financial crisis in 2008, a new wave of retrospective and judgments are coming out to evaluate the nature of the federal government response.

In particular, a number of commentators have remarked favorably on the TARP program. At the time, widespread financial collapse seemed a distinct possibility. The immediate injection of large amounts of public funds, though unpopular, was followed by a relative stabilization of financial markets. The money spent on the program may even be paid back in large amounts.
Yet there are several reasons to be skeptical of TARP-revisionism:

1. No Silver Bullet. The case that TARP was a successful program of equity injection is based on praise by association. TARP was passed; the financial sector seemed to revive itself; therefore TARP must have fixed the financial sector.

Yet it is impossible to causally trace the improvement of conditions in the financial sector to any one program. The federal government also implemented a number of other programs to ease conditions for financial firms — from increasing access to the Fed’s discount window (resulting in trillions of dollars of loans to insolvent institutions), to easing mark-to-market accounting rules that allowed banks to hide losses, to unprecedentedly low interest rates which allowed banks to accept cash deposits from customers while paying virtually nothing. The scale and scope of the federal government’s interventions in the banking sector were enormous, and TARP does not deserve the entire credit for turning things around.

And though the situation remains better than in the worst moments of the financial crisis, the supply of credit remains weak. Small businesses report difficulties in obtaining credit. The mortgage lending market is almost entirely handled by the government; while the securitization market — a large financing source during boom years for everything from mortgages to student loans and airplanes — remains a shadow of its former self.

2. Costlier than you think. Suppose Hank Paul went to Las Vegas and put down $700 billion of the government’s money on the roulette table. Suppose he happened to win; though the casino only allowed him to take back the amount of money he brought with him. Would we think this provided an acceptable rate of return?

The answer is obviously no. TARP was wagered on a “heads-I-win; tails-you-lose” basis. If banks had done worse than they actually did, the taxpayer would be on the hook for hundreds of billions of dollars. If the banks did well (as they subsequently seem to have); the government merely gets it money back.

In other words — the government was not provided an adequate risk-compensated return. In backing the American financial system, the Treasury Department took on an enormous financial gamble on behalf of the American taxpayer, one that could easily have gone bad. It is fortunate that things did, in fact, go well. But that doesn’t prove that the original risky gamble was sound; only that taxpayers were lucky, and under-compensated for their investment.

Nor is it even obvious that the government will, in fact, actually recoup its entire investment. Money lent to GM and AIG may never be repaid in full. Loans to a number of financial firms were repaid in the form of equity, which may not recover in value. And, of course, the faster that firms pay back TARP money, the less effective the program will be in actually improving bank balance sheets. Finally – there are the long-term costs. Now that the government has established a precedent for bailing out firms that are Too-Big-to Fail (which include domestic automobile companies), similar companies will expect comparable guarantees in future crises. This will encourage risky lending, increase the probability of future crises, and lead to further taxpayer-fueled bailouts in the future.

3. Horribly Conceived. Most of the discussions of TARP, including this article, focus on the manner in TARP was executed: in the form of equity injections in financial firms and debt guarantees. It is easy to forget that, initially; TARP was conceived in a radically different manner.

As its name (Troubled Asset Relief Program) suggests, the program was designed in order to purchase toxic assets, in particular poorly performing mortgage-backed securities. The idea was that a handful of bad assets were “clogging” the financial system, and were really worth more than market price. By purchasing these assets at above market value, the government could assist financial firms while creating a viable market for these assets.

In retrospect, this idea was clearly and disastrously wrong. Mortgage-backed securities were not cheaply priced because investors were “panicking”; rather, it was because they were worthless. If anything, they were priced too high in view of the subsequent collapse of the housing market. If TARP were executed as planned and authorized by law, taxpayers would have lost hundreds of billions of dollars purchasing toxic assets.

Of course, it is easy to say so in retrospect. Yet even at the time of the program’s announcement, a large group of eminent economists wrote a letter to counter the program. Many of these figures were banking experts who were not averse to government support of the financial system. But they were all opposed to the idea of handling the government’s role through the direct purchase of bank assets.

4. Subversion of the Democratic Process. If both the public and economic policymakers were opposed to the program, how on earth did TARP pass? How was it transformed into a program of equity injections? This is real problem with TARP: that it represents a form of undemocratic discretionary bureaucratic overstepping.

In late September two years ago, Treasury Secretary Hank Paulson went to Congress. His message was essentially: “The financial system is going to collapse. We need $700 billion dollars. Trust us.” Unsurprisingly, further financial crisis ensued. Yet the following crisis merely increased the feeling of crisis and panic, further increasing the hand of the Treasury Secretary.

Fortunately, over time, the asset purchase aspect of the program was shunted to the PPIP, and then dropped entirely.

Yet this only means that money budgeted for one purpose was directed to another. While Treasury was authorized to spend TARP money as it saw fit; it ultimately dispensed funds in a different manner than advertised. Rather than going to Congress to meet budgetary needs for a fixed plan, Treasury viewed the original $700 billion as a grant to spend as preferred. There is some evidence that TARP funding went out to banks in proportion to their political ties. This type of crony capitalist insider trading is not conducive to a proper financial recovery, or public trust in the financial system.

The redirection of TARP funds did not stop there. GM and Chrysler qualified for relief under TARP, though both are automakers rather than financial firms. Over the past two years, TARP has been used as a general slush fund to handle any sort of general government spending that proved inconvenient to finance democratically through the regular budgeting process. For instance, HAMP was created using $40-50 billion dollars of TARP funds, yet has proved to be a dismal failure. Few Americans will stay in their homes because of HAMP modifications; most will only experience a delay in the foreclosure processes. Granting this sort of broad mandate and extraordinary funds to unelected government bureaucrats is, as the humanities types say, “problematic.”

Incidentally, the fact that Treasury was able to change its favored strategy after a matter of weeks and drop the idea of large-scale asset purchases altogether suggests that their preferred narrative of the crisis – that outside events pushed them into certain catastrophe-prevention measures – cannot be the case. Surely if the world was about to fall apart without large-scale government intervention, yet nothing like that happened in the absence of government intervention; the folks who saw government intervention as necessary were less than perceptive. Surely if the Treasury were in fact acting under the presence of hard constraints, it would not be able to change its favored policy completely in a matter of weeks.

5. There were Better Alternatives. Few banking experts would doubt that recapitalizing the banking sector is an essential priority in the aftermath of a financial crisis. When banks do not have capital, they cease lending, and the economic recovery remains tepid.

Yet at the same time that TARP was proposed, better alternatives were floated. Garret Jones, an Economist from GMU, proposed the idea of a “Speed Bankruptcy” that would recapitalize financial firms by converting debt into equity in a forced swap under a bankruptcy-like procedure. This would allow for banks to be bailed out by private capital, rather than public money. It would have forced bondholders — who largely went through the crisis unscathed — to bear the risk for which they enjoyed the return. Luigi Zingales advocated for similar proposals – and Phillip Swagel’s account of his time in the Treasury makes it clear that these ideas were seriously considered. There were plenty of ways to induce a private sector recapitalization of the banking system, from reforming the bankruptcy code to simply ordering banks to accumulate more capital by fiat. These steps may have involved going to Congress or skirting the law. They may have involved a different set of cost-benefit calculations. Yet as Luigi Zingales notes, nowhere in Swagel’s account do we see evidence that Treasury properly weighed the costs and benefits of various bank recovery options in a systematic manner. Everything instead hinges on various political “constraints” that apparently make an amendment to the bankruptcy code impossible, but permit Treasury to demand a $700 billion blank check from taxpayers.

In fact, Treasury was hardly the white knight of the crisis, working with distinction to do the (presumably unique) right thing in the face of the idiots in Congress. They actively shaped the narrative of what was going on; presented only the solutions they favored; and only saw legal obstacles as binding when they applied to policies they did not favor. They may well have been patriotic workaholics as well. That only suggests that no such agency, well-staffed though it may be, should assume that level of power or influence.

Ultimately, the difficulty in evaluating a program like TARP lies in defining the proper benchmark. Many commentators have mentioned the government recouping its investment as a sign of the program’s success. Yet as Felix Salmon points out; earning a financial return is neither a necessary nor sufficient condition of a successful government intervention. A financial rescue operation that “cost” the government money may have been successful if it were paired with substantial mortgage modifications, recognition of bank losses, and an eventual recovery in lending. A rescue operation that earned the government a substantial pile of revenue may prove to be a failure if money were simply directed at banks that were already financially healthy.

In fact, there may be a contradiction between the goals of recouping government investments and assisting financial sector recovery. Investments in healthy banks – like Goldman Sachs – may maximize the government return; yet do little to foster overall economic recovery. On the other hand, lending to risky banks – like Citibank – may prove more financially risky. Yet exactly because Citibank faces tangible economic risks, lending to it provides the chance to shore up a struggling institution and raise the odds of a financial recovery.

The ultimate lesson from TARP is that rushed responses to severe events rarely pan out as their architects intended. Building a financial system that never breaks down is impossible; yet building one that fails gracefully is in our power, if we embrace rule-based and punitive bank resolution techniques like bail-ins, instead of discretion-centered responses that demand public money and fuel moral hazard.

Sentence of the Day

Germany, like China, is less prosperous than it seems, because its surplus production is geared to sale for claims that cannot credibly be redeemed for what the country’s citizens would want should they exercise their option to consume.

From Interfluidity.

Why we (still) need Cramdown

Recently, I ran into Phillip Swagel's account of his time in the Treasury during the worst days of 2007-2008. While I think many people glazed over the lengthy section on homeowner assistance, I think this portion unwittingly provides an excellent overview of why some sort of cramdown legislation (ie, allowing bankruptcy courts to write down principal due on a mortgage) makes a lot of sense, and why past attempts to resolve the housing crisis through servicer-started modifications haven't been enough. I say "unwittingly" because Swagel was, in fact, opposed to cramdown.

Some background: as Michael Konczal, Yves Smith, and others have emphasized: every foreclosure represents a missed opportunity to renegotiate debt with a borrower. I think this is a bit overstated -- some people really are in the wrong house, not the wrong mortgage. Some foreclosures are inevitable, and the historical record on this issue is difficult to interpret. But certainly the number of forced sales represents a huge market failure. Banks and borrowers alike would be both better off if more housing principal was written down though some sort of modification.

Not Enough Mods

The first problem is that servicers aren't doing enough modifications, which involve both what I'll call "informational" problems as well as other "institutional" problems. The informational problems center around the difficulties in identifying troubled borrowers and extending them modifications. One way to solve this problem would be to extend an automatic modification to all borrowers who are behind on their payments. As we (may) have found out in response to Countrywide's announced modification strategy (which limited eligibility to such delinquent borrowers), this could be a recipe to encourage others to miss payments as well to qualify. There are some people who recover from delinquency to making payments on their own, and a mass-modification approach would write down their mortgages too.

So servicers, in general, adopt their own screening processes for dealing with modification requests. The problem here is that the scale of the problem has overwhelmed every existing servicer. In the past few years, servicers have grown rapidly on the assumption that the business is prone to economies of scale -- that larger companies are more profitable. This is true if every borrower makes their payment, in which case the servicer does little other than forward payments. But in bad times, servicing transforms into a business that requires a great deal of case-by-case dealing with individual borrowers (Amar Bhide style). It's simply difficult to scale up operations to deal with the scale of housing problems and hire the necessary loan officers. So you end up with a world in which the vast majority of delinquent borrowers fail to receive a modification after several months-- something like 90% by one estimate.

Aside from the various difficulties that individual servicers and banks have with sorting and dealing with delinquent borrowers; there is broader "social fairness" point. The issue is to what degree public money ought to be directed towards indignent borrowers who fail to make payments on enormous McMansions. Remember that the infamous rant on the trading desks that started the whole Tea Party idea was primarily about venting against such borrowers receiving too much assistance. These concerns seem to have played a large role, according to Swagel, in limiting government involvement.

Then; there are the institutional problems, as Swagel lists in exhaustive detail. Second-liens attached to properties have the power to hold up a modification on the first mortgage; as they view the resulting higher cash flows as going primarily to the holder of the first mortgage. Securitized mortgages in general face institutional problems in providing for sufficient modifications, as the servicers on loans that were packaged and sliced are rarely properly compensated for bothering to modify a loan. Even among "portfolio" loans held by banks; banks are reluctant to realize capital losses on mortgages by writing down the principal. Finally -- there are broader social external consequences of foreclosure that banks don't take into account -- like the effects on nearby housing prices, and municipal revenues -- that mean we probably need more modifications than banks would prefer. It appears that Treasury has known much of this for quite some time.

Mods of the Wrong Type

Aside from extending too few modifications, servicers and banks are also extending modifications of the wrong type. Driven by the pressure to meet the demands of bondholders (in the case of securitized mortgages), or avoid realizing capital losses (in the case of portfolio loans and those held by Fannie/Freddie); private modification efforts have often worked by lowering the interest rate faced by the borrower; while in many cases extending the length of the loan. The principal on the loan then frequently does not change; this means that the economic value of the mortgage remains the same. If that property was underwater -- the mortgage worth less than value of the property -- this doesn't help at all.

Modifications, too often, only targeted the "front-end" debt-to-income ratio. That is, mortgages were only restructured so as to allow homeowners to pay at most about a third of their income on their mortgage. However, this ignores the various other debt commitments borrowers face -- like credit card and auto debt -- which are frequently binding constraints. While computing modifications on a front-end basis is a lot easier, it also leaves many homeowners with more debt commitments than cash flow.

It's easy to say "this is all obvious now"; but I think you could have said the same even before the crisis. Without really changing the structure of a mortgage by writing down its principal, you don't change the economic decision available to consumers.

Crucially, according to Swagel's account, all of these bad characteristics (which were initially the product of constraints faced by private subprime servicers) became written into government policy through the IndyMac modification effort (overseen by the FDIC) and HAMP.

Cramdown

Cramdown actually solves all of these problems. Rather than requiring banks to sort through millions of modification requests, bankruptcy puts the onus on borrowers and bankruptcy trustees. The homeowner actually needs to go ahead and file, which -- given the massive stigma and damage to credit that results -- represents a huge deterrent to casual filers. Upon filing for a Chapter 13 plan; borrowers' mortgage debt (along with all of their other debt) is instantly written down to a perhaps sustainable level, with little fuss. Bankruptcy can't do many things; but it is very good at filtering between types of borrowers. All the reasons why we have wimpy and too few modifications immediately vanish. Plus -- by granting homeowners a powerful stick -- servicers may be more aggressive in modifying on their own.

It also solves the "indigent borrower" issue. While many people are upset about government-sponsored HAMP efforts, many people at least see bankruptcy as characteristic of America's failure-tolerant culture. The costs of bankruptcy are principally borne by the borrower; not by taxpayers.

After outlining the various reasons that existing modification policy failed; Swagel provides an entirely unconvincing argument for why Treasury fought hard to avoid cramdown legislation (which did in fact pass the House): it would have drained "private capital" from the housing market.

The fairest way to interpret this statement is that Treasury at the time was concerned about maintaining supply and demand in the housing market. While cramdown would have reduced the flow of distressed properties hitting the market (by putting those borrowers in bankruptcy, and allowing them to meet smaller monthly payments); it may have also reduced the capital available for new borrowers. The net effect, in a given moment, is hard to figure out; but clearly Treasury was worried that it may force prices to go down even further.

But this is a very short-term assessment, a trend that seems to be inevitable during the course of a crisis. Sure, we have have temporarily lowered the flow of new buyers. But the long-term impact of fewer distressed properties hitting the market would have been massive. At what point should Treasury deal with the short-term pain to secure a huge long-term benefit? Also, as has been the case for quite some time, there is virtually no private money in the mortgage market. Virtually all mortgage originations are financed by the government, through Fannie/Freddie/FHA. Having less private capital flow into the mortgage market would be basically costless right now.

This other problem with this argument is that it completely fails to evaluate the costs and benefits of more private capital, instead seeing that as some sort of ultimate good (much like "liquidity" is often treated). Personally, I think higher capital costs for high-risk borrowers (resulting in smaller houses and more renting) would be phenomenal. We could even design cramdown to avoid impacts on future crises -- for instance, by making it retroactive only. Swagel might complain that this still signals to lenders that our approach to contracts has gotten more flexible. This may be the case, but that really seems a second-order consideration for (hypothetical) future private lenders.

Also, what's the alternative? Instead of cramdown, we got a horrible 50 billion dollar modification plan (HAMP) that has perpetuated all of the bad practices of previous subprime modification efforts. Suppose we think of cramdown as some sort of "tax" on all people with bad credit to benefit some homeowners who file for bankruptcy, paid for out of the higher cost of privately provided credit. By what logic is that better than an actual, massive, tax that redistributes income from renters to homeowners in a massively inefficient manner? Swagel might argue that he didn't institute HAMP. But as he argues elsewhere, there is a natural continuity between the Bush and Obama Administrations on housing policy. And the Bush Treasury's failure to properly put in modifications led directly to the Obama's Administration's push on this issue.

The last argument Swagel gives is that cramdown would revive the 2005 bankruptcy legislation. Personally, I see that as a good thing; given that I view that legislation as the source of all current evils (for instance, see this Michelle White paper on how making bankruptcy harder encouraged the foreclosure crisis). But then, as with so much of Swagel's account, this debate turns into unverifiable accounts on political possibilities. Well, the reality is that the House passed cramdown legislation without broader implications. Perhaps the Senate could have as well, if Treasury and other stakeholders were as committed to the idea as they were to HAMP and other abominations.

I can't guarantee that cramdown would have "worked." But I can guarantee that it would have allowed as many people that tried to qualify for HAMP a better way to afford their mortgage, without costing taxpayers 50 billion dollars. A lot of the criticism and commentary over the Treasury has focused on their high profile decisions to bail/not bail out Lehman, AIG, etc. But I hope more people look at their approach to homeowner assistance, and their decision on cramdown in particular.

Quantitative Easing

To clear up the debate over quantitative easing, there are only three relevant questions: (1) Should the Fed ease ever? (2) Should the Fed ease now? and (3) Is 'Quantitative Easing' the right strategy? If you disagree with the Fed about QEII, you have to say no to one or more of those questions.

Should the Fed Ease Ever?

This is a surprising one. If you would have talked to me a few years ago, I would have said that there is a widespread consensus around the idea that the Fed should loosen policy to make recessions easier (and ideally tighten in good times).

Yet now there has been an outpouring of anger at this idea -- led by intellectuals of many stripes, but politically primarily by Republicans. The concern is that "printing money" is not sufficient to handle "primarily structural" problems in the economy. The underlying idea here is that purely nominal changes reflecting the money supply can't have an effect on the real economy (according to Paul Ryan, they never have).

The other critique, bizarrely, enough, is that the Fed eased too much during the boom years, generating a "bubble," and more easing now might lead to runaway inflation. Sometimes, you hear both concerns from the same people. But let me focus first on the idea that monetary policy can't do anything.

As Christina Romer (former CEA Chair) has pointed out, the entire recovery the US had from the Great Depression can be accounted for by monetary stimulus -- in particular, the decision to get off the Gold Standard (which removed a huge constraint on how much money we could print). Vockler generated a huge recovery in 1983 by loosening policy. And as recently as 2000-01, the Fed’s easing prevented what were actually quite enormous real economic losses (comparable to subprime losses) from turning into worse outcomes.

The theory of how this happens has been explained by Milton Friedman, among others. Paul Krugman has a particularly good explanation of this using a parable of the baby co-op, that I'll provide a lengthy excerpt from:

A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?…

Now what happened in the Sweeneys' co-op was that, for co

mplicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op's members were lawyers, it was difficult to con

vince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy….

Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking.

Sometimes, your problems really are just monetary. When the demand for holding money shoots up, and we don’t respond by increasing the supply (we refuse to "debase our currency"); people start to hoard cash, and we get a recession.

But even if you don't buy that logic; clearly we can't go on with the same money stock that existed, say, in 1913. We need more money from time to time, and that happens through two channels -- (1) banks can do more lending, resulting in more privately generated money, or (2) the Fed can exchange bonds held by banks for cash, in effect giving banks a "licence" to print more money. In our system, the actual process of money generation actually happens through banks, but the government has a key role through monetary operations that allow or cancel what are in effect "money printing licences."

Again -- there really shouldn't be any debate over this. We need to print money from time to time. This is especially important when there is an excess demand for money -- at which point purely nominal changes can result in actual, large-scale effects in the economy. Room for reasonable debate starts at:

Should the Fed ease Now?

We have various statistics on governing monetary aggregates and indicators. Most of them suggest that money growth is below trend:

M2 is a basic standard of "money;" the one preferred by Milton Friedman. Here, you can see that growth in M2 is below recent trends:


M3 is another measure, that incorporates broader monetary items. According to Gary Gorton, it's a better measure of money in the modern world, where financial instruments -- like repos or Treasuries -- serve as money in financial markets. That's actually declining.

Then there is inflation. The most recent data show that “core” inflation is weighing in at .6%. If you were to better impute ongoing house price declines (or hedonistic quality improvements), that would be even lower. (It would be higher if you counted some commodities. But the price growth in those items is driven primarily by strong demand from emerging countries, not from monetary expansion in the US.)

Of course, low current inflation may be a temporary sideshow. Inflation could jump up in the future, as people have argued for several years now. But instead of relying on unfalsifiable fears or concerns -- I prefer to look at the markets. What do markets think about future inflation? The Cleveland Fed has the best figures; that show inflation expectations are low and falling:


So, by every possible measure, the money supply is low and trending lower. It’s projecting to be low in the future as well. If you think that money growth should be a little counter-cyclical to meet greater money demand, it's too low by far. Even if you think that the Fed should only have an inflation target around 2% — money supply is too low.

As you have probably heard, Japan spent a lost decade (really, now 18 years) going through a deflationary period enduring all sorts of economic pain. Here’s America relative to Japan on that path:


Deflation, in general, isn't necessarily a bad thing. America went through deflationary trends in the 1860s-1870s and the 1920s but did just fine. When deflation is driven by supply-side technological improvements that reduce secular prices, the Fed does not need to deliver inflation (arguably, this was the case in the 2000s; when trade and technology may have reduced prices on their own; and Fed intervention just led to a "housing bubble."). Deflation is a bigger problem when it’s driven by shortfalls in demand; and gets you a world like the baby co-op where all members are afraid to run down babysitting script for fear that they would be unable to pick one up later.

Deflation during times of economic stagnation is nothing short of catastrophic. The Japanese have been unable to generate enduring economic growth for, again, close to two decades now. High inflation is easy enough to end with central bank that cares about the issue -- but deflation on Japanese lines is near impossible to cure. In my view, the massive costs of persisting in a Japan-like ditch are sufficiently large (and the odds that it will happen are high enough); suggesting that we should be prepared to pay a high premium for an insurance policy against such an outcome. Fortunately for us, this is really a negative premium considering the benefits that inflation closer to target would have for us today.

If anything, our experience would be worse than Japan’s. As Michael Pettis points out, Japan had the fortunate chance of dealing with economic stagnation by undergoing domestic rebalancing. Though economic growth was slow, households earned a steadily larger share of the pie. America doesn’t have that option, given how large household consumption already is. American households in a deflationary environment would likely be hit by a double-whammy — as growth stagnated, households would readjust their consumption share downwards as they started to save.

If the costs of low inflation are high, the costs of dealing with high inflation are manageable. As Scott Sumner has argued; the Fed has many more tools to combat inflation that in the 1970s. Futures markets indicate market expectations about future inflation, ensuring that the Fed won't be caught off guard by unexpected rises in inflation. Plus, with economic slack and underutilized labor and equipment, rises in nominal spending would presumably manifest in the form of greater utilization, rather than higher prices. This allows the Fed a greater degree of cushion in setting policy.

The Fed also has a new tool — it’s policy of paying interest rates on bank excess reserves. Banks now have the option of holding extra money at the Fed and earn interest, instead of extending loans in the real economy or buying bonds. The Fed’s decision to undertake this policy explains in part why the traditional monetarist fears about a larger monetary base generating inflation haven’t panned out. The Fed’s (brand new) policy has short-circuited the normal process of money creation. The upside is that future increases in inflation will be easily curbed by the Fed if it is willing to use this tool.

Finally, there's the fact that while higher inflation is hardly a cure-all, the costs of having unprecdentedly low inflation right now make solving nearly every other problem in the economy much harder. It’s harder to rebalance global consumption (more savings in the US, more consumption elsewhere) while the dollar is strong. It’s harder to dig out of a housing debt overhang when inflation is lower than home buyers anticipated when they drew up contracts. It’s harder to deal with government debt if the Fed isn’t purchasing that debt. All of these are “real” economic problems, but they’re impossible to manage in the presence of deflation, and difficult enough when inflation is as low as it is.

While easing may generate the "risk" of inflation, it's worth considering what that means. There's no good economic evidence that inflation has any bad consequences until it hits the double digits. India, for instance, is managing 8% economic growth just fine even as inflation nears 10%. Inflation was around 4% when Vockler declared a victory against high inflation (subsequently, he was attacked by Republican officeholders for letting inflation fall below that — how times have changed).

Why QE?

To sum up; we have a deflationary environment; the Fed has ample tools to attack inflation in the future, and it has in effect a "magic ball" that allows it to anticipate changes in inflation before they happen. On top of that, higher inflation would, if anything, be good; while the costs of extended deflation could be quite bad.

The only reason to have a debate about this at all is that the traditional tool of monetary policy — the Fed purchasing short-term Treasury debt in exchange for money — has run out. With short-term interest rates near zero, banks simply take the money from any Fed asset purchases and send it right back to the Fed to earn comparable interest rates as excess reserves. Short-term asset purchases now simply change one low-interest bearing government asset for another.

But suppose, as Rortybomb and others have suggested, that we simply find that we are mistaken about interest rates, and the Fed actually could ease a little more through the conventional route. It’s tough to imagine that anyone would actually then oppose further easing. After all, the Fed bought a great deal of government bonds (lowered interest rates) in 2007-2008; a period of time during which growth was higher than now, inflation was higher, and growth in monetary aggregates was also higher. No one complained about debasing the currency then.

The entire debate thus revolves around the fact that the Fed, in trying to ease while short-term interest rates are zero, is going to purchase government bonds of slightly longer duration (quantitative easing). That's the only difference. You can call this an "unprecedented" or "risky" strategy if you like, but really it’s virtually identical to the policy we would all like to do if short-term interest rates were a few points higher.

There is one and only one new concern that QE raises, as Greg Mankiw points out:

If future events require higher interest rates, the Fed will end up making losses on its portfolio. And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds. Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles). Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.

The issue is that, if higher inflation hits, the Fed will be forced to deal with that. If it contracts by selling the same long-term bonds it purchases today, it may be forced to realize a nominal loss. But losses from central banks are a little odd to think about. The Fed practically has a license to print money. It’s normal activities also generally produce a sizable surplus, which typically goes to the Treasury (but a greater proportion of which could stay with the Fed to counter realized losses). Bernanke considered this issue extensively in his speech to the Bank of Japan (in which he urged the adoption of various tactics to deal with Japan’s deflation and zero-rate problem), suggesting that:

In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy.

He also suggested a bond conversion (or interest-swap) proposal between the Bank of Japan and the Ministry of Finance (here, the Fed and the Treasury) that would protect the Bank of Japan (Fed) from any subsequent interest rate changes. This would, in effect, reduce the scary-sounding “quantitative easing” to normal monetary policy — on which there should exist broad consensus that we need to ease.

So, again, that's the only real "risk" that QE induces -- the risk that inflation will somehow jump up dramatically (even though money growth is trailing GDP, and markets don't expect it), that the Fed burns through trillions of dollars of short-term bonds in responding to that (bearing minimal losses); and that the Fed then somehow takes minor nominal losses on their long-term bond purchases. And we even have solutions to that if we can get the proper coordination between the Treasury and the Fed (bond conversion or the Fed keeping more of the money they make). When balanced against the risk of letting inflation expectations de-anchor from historical norms and lead to a deflationary spiral, I think that's a pretty fair tradeoff. Certainly I don't think this risk in any way justifies the sort of vituperative rage that has been directed against the Fed.

Plus, I don't think QE skeptics have fully thought through their position. It is entirely resonable, in my view, to suggest that the zero-rate bound should represent a real constraint on the actions of the Fed -- that the Fed should simply not purchase any long-duration assets. So if short-term interest rates are zero; tough luck.

But if you really believe that, the resulting low inflation means low (nominal) interest rates, which means that the Fed will run out of its traditional ammo and hit the zero-rate bound again and again, and be left paralyzed. This means that we really need insurance against hitting this bound, in the form of higher inflation that results in higher nominal interest rates.
Put differently -- if you want low inflation (ie, 2%); you also need to give the Fed the tools it needs to conduct monetary policy when interest rates hit zero, as they will frequently with inflation that low. Just complaining about printing money isn’t an option — everybody needs to believe in easing now (if you don’t think the zero-rate bound is a real barrier), or easing later (to generate higher long-term inflation).

The criticisms I take more seriously argue that QE will do little. I think the market responses to the anticipation and announcement of QE2 demonstrate that it can do some good; but I also think it won't do much.

But what we need to do then is pair it with policies that will do good. For instance, we can end the Fed policy of paying interest on excess reserves, and then have the Fed buy many more government bonds of all durations. That way, banks will take the money and put it somewhere in the economy. Even if they park it in other bonds, that will lower interest rates, push the seller to do something with the money, and at some point result in higher nominal spending. Or, the Fed could just eliminate this policy now, see what the current $1 trillion of parked reserves could do, and then think about future asset purchases.

Alternatively, the Fed could try to push money out by other ways. A combined Treasury-Fed operation is a commonly envisioned tactic -- this would work by having the government spend money in some way, and have the Fed foot the bill by buying the resulting additional government bond issuances. Even John Cochrane, who is skeptical of both monetary and fiscal policy, agrees that this would have some effect. So do the modern monetary theory guys. Bernanke, too, stressed this sort of monetary and fiscal cooperation in his speeches to the Japanese. Either his logic was wrong then, or it’s wrong now.

Finally, I'll say that for me, this issue is as much moral as it is purely practical. I was drawn to the bipartisan, technocrat economic management school not because of the patently unrealistic assumptions about human behavior, but because I saw it had real solutions to solve major economic problems. You don't have to suffer a Great Depression -- you just need to set your monetary policy correctly, etc.

Now, I'm worried that so many commentators have seemingly checked out of these debates. You see many people complaining about new policies, and worrying about supposed "risks" or "worries" that don't exist in data coming in statistics or financial markets. There are fewer and fewer people with tangible solutions on how to solve this mess. I think that erodes the moral legitimacy of capitalism. I think no economic system that tolerates 10% unemployment is acceptable; and something must be done. If you don't like QE; if you don't like the alternate options here; then what's your plan? What's your strategy for avoiding a Japan death trap/Mad Max world? For Krugman and Bernanke, it was frustrating to watch policymakers in Japan seemingly self-destruct in the face of difficult economic times. Turns out it's also frustrating to live in that world.