Category Archives: Financial Crises

John Mauldin on Japan

Posted on by

He writes,

One has to assume that the law of gravity will not be repealed and that investors will want something more than 2% on the ten-year bond if inflation is at 2%. If the ten-year bond were to rise by 2%, Japan would soon be spending over 50% of its tax revenues on the interest carry alone.

Perhaps bond investors are willing to accept negative real rates of return. Folks have bid up TIPS in the U.S. to negative real rates.

Negative real interest rates are very good for holding down the ratio of debt to GDP. We saw that in the United States in the 1970s. But the 1970s are not so fondly remembered as far as economic performance and financial wealth are concerned.

The Physics of Wall Street

Posted on by

That is the title of a book by James Owen Weatherall. I received a review copy. I will say that I finished it, which is more than can be said for most books that I get sent to review. So I feel entitled to blog about it. The book offers short biographies of students of physics who applied their models in finance, along with layman-friendly explanations of the theories involved. A main theme of the book is that economists are too snotty toward physicists. For exaple, on p. 146-147 he describes attempts by the Santa Fe Institute to bring physicists and economists together in the late 1980s. This worked out poorly, but when the institute invited practitioners from Wall Street, “The traders proved much less defensive than the economists.”

I think that the complaint about snotty economists is pretty widespread. Experts in many disciplines, including psychology, sociology, and biology, believe that they bring techniques that would be useful to economists but are under-appreciated. I am not sure how to react. I think that what Weatherall calls the sociology of the economics profession is as bad as he says it is. But I am not part of the mainstream myself. If you ask folks in the leading departments about the state of economics, they will tell you that it is basically fine.

The book itself contains some well-written stories, a bit reminiscent of The Money Game, which most of you are too young to remember (Weatherall probably never heard of it). I learned little new from the early chapters, but I got a bit more insight into the Santa Fe Institute folks and the chapter on Didier Sornette and his models for sensing major changes was entirely new to me. After that, the book sort of petered out for me. At the end, he calls for a sort of “Manhattan Project” to apply physics to economics. Calling for a “Manhattan Project” on anything is a surefire way to put me off.

Sovereign Default Threshold Analysis

Posted on by

In a study of the prospects for Canadian provinces, Marc Joffe writes,

This method employs a multi-year fiscal simulation with a default threshold stated in terms of an interest expense to total revenue ratio (or interest bite). Using evidence from our historical survey, the conclusion is that default is likely at a 25% interest bite, so the simulations simply estimate the probability of each province reaching that level.

One way to think of this is that the political system will not tolerate debt payments that absorb more than 25 percent of revenue, and investors know that. So once the interest rate rises to the point where the interest bite hits .25, expect a debt crisis. That is, at that point, the government (in this case, a Canadian province) will consider default. The interest bite, B, is the average interest rate on debt, r, times the amount of debt, D, divided by tax revenue, T.

B = rD/T

Suppose that the ratio of debt to GDP is 50 percent and the ratio of revenue to GDP is 20 percent. Then we have

B = 2.5r

which means that once the average interest rate on debt hits 10 percent we are in crisis territory.

For the U.S. federal government, the ratio of debt to GDP is at least 70 percent (perhaps it is at least 100 percent), and the ratio of tax revenue to GDP tends to max out at 20 percent. At 70 percent, B = 35r. If we stick to the rule of thumb that a 25 percent interest bite is the point at which default becomes thinkable, then it would take an average interest rate of about 7 percent to reach that point. Note that because we have locked in low rates on some of the debt by issuing long-term bonds, it would take an increase in rates well above 7 percent in order to make the average interest rate on our debt reach 7 percent.

Some other thoughts:

1. It is hard to know what the rule of thumb might be for a U.S. default. It’s not like we have historical examples to serve as benchmarks.

2. For U.S. states, or for Canadian provinces for that matter, I wonder if pension payments to government workers should be added in order to estimate an “interest plus pension cost” bite. My thinking is that the political process may be stressed by taxpayers not receiving current services in return for their tax payments, and neither interest payments nor pension payments can be used to purchase current services.

3. Canadian provinces do not have balanced budget amendments, and consequently at least some of them are in more trouble than U.S. states. I am becoming more and more convinced that it is really hard to keep a democratic polity out of a debt trap in the absence of a Constitutional restraint.

4. Also, the Canadian single-payer health care system is run at the provincial level, so rising health care spending is a big driver of provincial fiscal problems.

5. I like the simplicity of Joffe’s rule of thumb. However, my own analysis of crisis triggers warns that the problem is complex and there are limits to what objective analysis can accomplish.

Balanced Budget Amendment?

Posted on by

Glenn Hubbard and Tim Kane write,

One new approach has been proposed by Congressman Justin Amash (a Republican from Michigan) and has won some bipartisan support. His plan would essentially involve balancing the budget over the years of a business cycle. For instance, the proposal’s rule constraining annual outlays (including changes in accrued net liabilities in entitlement programs, as noted above) to a level no greater than the average annual tax revenue of the previous three fiscal years would be far easier for Congress to adhere to. Congress could, with a three-fourths vote, override that constraint during wars or deep recessions.

The parenthetical remark about accrued net liabilities is important. Each year, as demographics and other factors change, the outlook for Social Security and Medicare changes (typically, for the worse). Accrual accounting would put these changes onto the budget.

Money, Inflation, and Wile E. Coyote

Posted on by

Before 2008, the bubble that some economists expected to pop was the value of the dollar. Paul Krugman used a colorful metaphor to describe this.

So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar’s value doesn’t make sense, and that value plunges.

I found this in an old post from Mark Thoma. Feel free to use Google to find other citations.

Nowadays, when he looks at the prices of U.S. government bonds, Krugman sees rational expectations at work. He looks at the low long-term interest rates as a sign of the market’s wisdom in predicting low inflation for ten years.

But what I see is a market that could have a Wile E. Coyote moment. Once enough investors decide to dump our bonds, interest rates will rise. It will become clear that at those interest rates the government cannot afford to pay off the bonds, so more investors will dump bonds. etc.

Now the Fed can always buy our bonds. It is doing a lot of that, and I can see where an investor with a sufficiently short time horizon who believes that he won’t be the one still holding bonds when they start to lose value might say, “Don’t fight the Fed. Just ride the yield curve for a little while longer.”

But suppose that our Wile E. Coyote moment comes when inflation has been heating up. (Indeed, the Wile E. Coyote moment could come because inflation heats up, and at that point investors decide that the Fed may no longer be their friend.) Under this scenario, the Fed wants to be a bond seller, not a bond buyer, in order to keep inflation in check. If the Fed feels constrained not to sell too many bonds, then inflation could really take off.

How can I justify a fear of inflation, given recent behavior? In recent years, the Fed has created a lot of money, and we have not seen a lot of inflation. What is going on?

1. Perhaps money and inflation have no connection. We should go back to using the Phillips Curve. When unemployment is high, inflation is low, and conversely. After all, wages are 70 percent of costs, and it seems unlikely that wage inflation will get much traction with folks having a hard time finding jobs.

2. Perhaps we are suffering from tight money. This is the Scott Sumner argument. Money and inflation (he would prefer nominal GDP) are related, inflation is low, ergo we must have tight money.

For the short run, I believe something like (1). However, I am old enough to remember the 1970s. Based on that experience, I would say that inflation is subject to regime shifts. There is a regime in which inflation is low and relatively stable. There is another regime in which inflation is high and volatile. Finally, there is a regime of hyperinflation.

I think that with enough persistence, the Fed can move us between the low, stable regime and the high, volatile regime. The Fed spent the 1970’s getting us into the high, volatile regime, and it spent the 1980s getting us out of it.

Hyperinflation is a fiscal phenomenon. A government that can balance its budget is never going to have hyperinflation.

The scenario I have in mind is one in which the economy has begun to shift to the regime of high and volatile inflation. Then the Wile E. Coyote moment arrives, and the Fed feels pressed to keep the U.S. bond market “orderly” by not selling bonds. In fact, interest rates are rising so quickly that the Fed decides that it needs to buy bonds. This sets off a spiral of money-printing and price increases, threatening to bring on hyperinflation. In which case, the bond market will not be orderly. Nor will anything else.

Year-end Stories

Posted on by

In 2005, I listed five stories that I thought would have long-term significance: productivity; cognitive neuroscience, solar power, cancer therapy, and mainstream media meltdown. All five were areas where the trends were not clear. My inclination at the time was to take the optimistic view in all areas (in the case of the mainstream media, being optimistic to me means believing that the meltdown will be rapid).

Today, I would be less optimistic. Moreover, I think that the unsustainable fiscal outlook and its consequences have become one of the most important stories.

In 2003, I wrote one of my favorite essays, on what I called The Great Race between Moore’s Law and Medicare. There is an optimistic scenario for economic growth (think Ray Kurzweil) which would make all concerns about the long-term budget outlook seem foolish. However, other scenarios are less favorable. Recently, the budget situation has been deteriorating faster than the technological outlook has been improving. In terms of the great race, the wrong horse is gaining.

Peter Suderman Predicts the Fiscal Cliff Outcome

Posted on by

This essay appeared almost three weeks ago.

just as the doc fix has become a yearly congressional ritual with no end in sight, it may be that many of the temporary policies of the fiscal cliff become permanent fixtures on our policy calendar.

And if the doc fix is any guide, that will have deleterious effects on both the budget and the economy. It will provide a convenient way to hide long-term spending commitments inside repeat extensions of temporary policies. And it will result in nagging economic uncertainty as the private sector endlessly worries that this year just might be the fluke year that Congress won’t act like it normally does and make a deal. At the same time, it will have the larger effect of distracting Congress from fixing the budget’s real long term problems by focusing legislators’ attention on an infinite loop of short-term problems. It’ll be the doc fix for everything—and the fiscal cliff forever.

Read the whole thing. Along with my Lenders and Spenders, it provides you with a pretty complete cynical picture.

James Kurth on Conservatism

Posted on by

He writes,

The economic and fiscal thinking of the Tea Party movement had much in common with that of traditional American conservatism, and with theorists such as Friedrich Hayek and Ludwig von Mises. It had much less in common with the economic and fiscal thinking of reinvented conservatism, and with theorists such as Friedman and the monetarists. Indeed, the thinking of the Tea Party movement was largely the same as that of the libertarian movement, which had long been a marginal element within the Republican Party.

…American conservatism is now split between two tendencies: (1) a partially-discredited reinvented conservatism, which nevertheless continues to dominate the leadership or “establishment” of the Republican Party because it corresponds to the economic interests of the party’s elites and big donors, and (2) a partially-revived traditional conservatism, which is a significant insurgent force within the Republican Party, because it corresponds to the economic interests of much of the party’s base and many of its core voters.

It is a long essay, which I recommend reading even though I disagree with a fair amount of it. Some thoughts:

1. What is the plural of post mortem? It seems to me that we have seen a lot of them after the election. I had a traumatic experience after 2008, in which I made the case that the U.S. was going to turn into a one-party state. Bryan Caplan challenged me to a bet, which I lost when the Republicans won the House in the 2010 mid-terms. Still, I may have been correct, at least in terms of national politics. But it is interesting that so many states are in Republican hands.

2. Kurth’s history of conservatism has traditional conservatives favoring free markets, while what he calls “reinvented conservatism” comes across as cronyism. He associates “reinvented conservatism” with Milton Friedman and Ronald Reagan, which I am sure will annoy fans of those two icons.

3. As those of you have read Not What They Had in Mind know, I disagree with Kurth’s narrative in which banks fought for and achieved deregulation, leading to the financial crisis. First, this ignores the role played by housing policy and capital regulations. Second, it ignores the views of regulators, who did not think that they were loosening up the reins but thought that they were in fact exercising better control and fostering an environment of reduced risk-taking by banks. There is a huge hindsight bias in claiming that the regulators were intentionally easing up.

4. Kurth summarizes the current state of affairs as follows:

The core voting groups for the progressive coalition and the Democratic Party are (1) blacks, (2) Hispanics, and (3) workers in the public sector. Conversely, the core voting groups for the conservative coalition and the Republican Party are (1) economic and fiscal conservatives; (2) Evangelical or Bible-believing Protestants; and (3) white male workers in the private sector

…there remains one immense independent or swing group, and that is white women. A substantial majority of these now vote for Democratic candidates, with economic issues being primary for working-class women and social issues being primary for middle-class women. If these women continue to vote for the Democratic Party in the future, the prospects for the Republican Party to win most presidential and senatorial elections will remain bleak.

5. I think that what potential factor that could shape up electoral politics is the government debt problem. Will it cause continued political friction, as I predict? And will voters perceive the problem as unsustainable progressive programs or Republican recalcitrance? Keep in mind that objective reality, even assuming that it is knowable, may play little or no role in public perceptions.

Re-defaults

Posted on by

The blogger at Sober Look writes,

This is telling us that mortgage modification programs have not been very successful, as the probability of re-default rises. By modifying mortgages, banks in many cases are simply kicking the can down the road – and now some are writing down these mortgages (which may be what is driving the higher charge-off numbers). We are therefore seeing an increase in delinquencies, but mostly among modified mortgages and concentrated in sub-prime portfolios.

It actually helps to have some experience in the mortgage business. Unlike Joseph Stiglitz, Martin Feldstein, Glenn Hubbard, and others who have written op-eds and influenced policy makers, I actually know something about the track record of giving delinquent borrowers a “break” by modifying their mortgages. What lenders have found is that, even in good times, loan modifications just set borrowers up to fail again. Maybe in the confines of your faculty office you can design a program that should work in theory. But in the real world, we observe failure in practice.

The U.S. Debt Problem

Posted on by

Timothy Taylor discusses an article by Daniel Thornton on the origins of the debt problems in the United States.

Thornton locates the start of the problems back to about 1970. In the chart of annual deficits, for example, notice that after about 1970 a pattern of volatile but growing deficits emerges. The pattern is interrupted for a few years in the late 1990s by the higher tax revenues and lower social spending resulting from the unsustainable dot-com boom, but a return to the larger deficits was coming eventually.

Recall that in this post I said that in the 1960s two taboos were broken. One was a taboo against deficit spending in peacetime. The other was a taboo against Social Security surpluses in order to spend elsewhere.

In deference to the season, I would say that we face the ghosts of deficits past, deficits present, and deficits future. The ghost of deficits past is the debt we accumulated starting in the 1960s in spite of good economic performance and falling defense expenditures (as a share of GDP). The ghost of deficits present is what Keynesians call the “fiscal cliff,” meaning the horrible recessionary consequences that they predict would follow were Congress to actually follow through on its recent commitments to try to reduce deficit spending from currently high levels. The ghost of deficits future is the fact that projections for spending going forward show increases to unprecedented levels relative to GDP, driven largely by health care spending. The ghosts of deficits future mean that (a) we cannot count on a “peace dividend” to solve the budget problem and (b) we cannot easily inflate our way out of the problem (inflation will raise the cost of future obligations and send interest expense soaring).