Category Archives: Financial Crises

Governments and financial fragility

Posted on by

John Cochrane grumps,

A sovereign default is bad enough. But if the banks are stuffed with government debt, then a sovereign default brings down the banking system. Depositors lose their shirts, and the banks, who know how to distinguish good from bad borrowers, are shut down. A calamity becomes a catastrophe. And an economy with failing banks will be bringing in a lot less tax revenue and more likely to default.

This is what I call the “two drunks” model. The banks are one drunk, leaning on the government for guarantees. The government is the other drunk, leaning on the banks to fund its debt. But will the drunks be able to support one another and stagger home?

Read the whole post. Government, which purports to be our bulwark against financial fragility, is more likely the main contributor.

Kotlikoff on PSST

Posted on by

Laurence J. Kotlikoff writes,

Economics has many theories of economies rapidly flipping from good to bad. They go under the headings multiple equilibrium, contagion, self-fulfilling prophecy, panics, coordination failures, strategic complementarities, sun spot equilibria, collective action, social learning, and herding.

Pointer from John Cochrane, who offers extensive comments. Read his whole post.

Kotlikoff argues that the mere perception that the economy was in trouble was enough to cause trouble.

Employers laid off their workers in droves to lower their payrolls before their customers stopped arriving. This was the worst of the many types of multiple equilibria associated with the GR.

…The slow recovery is hard to explain except as the result of everyone expecting a slow recovery.

I see this as a PSST story. Patterns of specialization and trade depend on business managers’ confidence that those patterns will continue.

I, too, have been thinking a lot about the contingent nature of economic outcomes. I am mulling an essay that will strongly criticize the view that the market acts like a set of equations providing a deterministic solution for given tastes, technology, and resource endowments. Instead, there are multiple equilibria that depend on people’s perceptions and beliefs.

Part of my argument is that hardly anyone in the economy has a measurable marginal product. Most of us are producing intangible output, even if we work in goods industries. For example, relatively few of the employees at a pharmaceutical company are actually bottling pills.

Businessmen operate in a world of high fixed costs, with mostly overhead labor. If they doubt that revenue is going to remain at current levels, one response is to cut costs by reducing overhead labor. If enough firms do this at once, their fears of recession becomes self-fulfilling. This sort of self-fulfilling recession is particularly easy to fall into when there is a financial crisis.

Kotlikoff’s main point, which Cochrane emphasizes and expresses support for, is that a financial crisis of 2008 was itself a sudden shift in perceptions that took place in the context of an inherently fragile financial system.

Kevin Erdmann responds to Dean Baker

Posted on by

Erdmann writes,

we imposed the “inevitable” bust on the owner-occupier housing market. Instead of looking for ways to stabilize mortgage markets, lending was largely cut off to the bottom half of the market from 2008 on, and we can see the devastating effect if we look within cities, most of which look like Atlanta, where low tier prices took a post-crisis hit to valuations, frequently of 30% or more. This has caused the market price of low tier homes to drop below the cost of construction, causing new building to dry up in low tier housing markets.

Read the whole post. Note especially the first chart. My thoughts:

1. That first chart depicts construction spending as a percent of GDP. Baker did the same thing. This makes 1986-1990 appear similar to 2006-2010. But the denominator, GDP, was rising in the early period and falling in the latter episode. So the slump in the numerator, construction spending, was probably much more pronounced in the latter period.

2. Some of the credit tightening in the mortgage market was inevitable. You could not keep lending on generous terms to non-owner occupants. At some point, the speculators had to get squeezed out.

3. But the political crackdown on mortgage lending was severe. I remember that it seemed as though in 2009 the only people who could get mortgages were those who did not need them.

4. Some day, people may look back at “quantitative easing” as a credit crunch. It steered banks toward holding interest-bearing reserves rather than lending to the private sector. I think of it as a credit-allocation scheme, in which government debt was favored (by the Fed, which n-tupled the size of its balance sheet) and private investment was dis-favored.

5. Instead of looking at aggregate demand, try to think of 2007 to the present from a PSST perspective. Perhaps patterns of specialization and trade related to the construction boom became unsustainable around 2007. Other patterns became unsustainable when the government took over the credit markets in 2008 and 2009. Other patterns became unsustainable when the Obama-era zeal for regulation had an impact. Only recently have new patterns of trade been emerging significantly faster than old patterns disappeared.

Dean Baker on the Great Recession

Posted on by

He writes,

Prices of non-residential structures increased by roughly 50 percent between 2004 and 2008 (see Figure 5 here). This run-up in prices was associated with an increase in investment in non-residential structures from 2.5 percent of GDP in 2004 to 4.0 percent of GDP in 2008 (see Figure 4).

This bubble burst following the collapse of Lehman, with prices falling back to their pre-bubble level. Investment in non-residential structures fell back to 2.5 percent in GDP. This drop explains the overwhelming majority of the fall in non-residential investment in 2009. There was only a modest decline in the other categories of non-residential investment.

Again, the collapse of Lehman hastened this decline, but the end of this bubble was inevitable. In this respect, it is worth noting investment in non-residential structures is pretty much the same share of GDP today as it was at the trough of the Great Recession, supporting the view that the issue was levels were extraordinarily high before the downturn, rather than being extraordinarily low in the downturn itself.

Pointer from Mark Thoma.

I pass this along not because I am inclined to agree with it or any other aggregate-demand story, but because:

1. Explaining the depth of the recession is hard. It is easy to point to the financial crisis and do hand-waving, but as Baker points out, the actual chain of causation is not so clear.

2. Baker is someone who does not succumb to mood affiliation. His views, correct or not, are arrived at independently.

3. I had forgotten about the bubble in commercial real estate.

4. I expect to see an insightful response from Kevin Erdmann.

Cognitive failure and the financial crisis

Posted on by

My review of A Crisis of Beliefs, by Nicola Gennaioli and Andrei Shleifer.

GS directly attack the hypothesis of “rational expectations,” which has dominated the economics profession for forty years. The rational-expectations doctrine holds that when economic actors make decisions that require forecasts, they make optimal use of the available information. They are not guilty of predictable irrationality.

. . .Think of a forecast as employing two types of information about a variable being forecast. One is a “base rate,” which is a very generic property of the variable. The other is “recent information” about that variable or about factors that could affect that variable. Recency-biased forecasting over-weights the recent information and under-weights the base rate.

What I’m reading

Posted on by

I was sent a review copy of A Crisis of Beliefs, by Nicola Gennaioli and Andrei Shleifer (henceforth GS). They say that the financial crisis of 2008 illustrates a theory of expectations formation in which market participants both place too much weight on recent news and in some circumstances ignore tail risk.

We know from Tetlock, whose name does not appear in the index, that a good forecaster puts a lot of weight on baseline information–characteristics that are more universal and permanent. Inefficient forecasters instead tend to focus on information that is more recent and local. GS argue that financial market participants are inefficient forecasters.

So far, what I like about the book:

1. The writing is clear.

2. Years ago, I contrasted two classes of theories of the 2008 financial crisis. One I called “moral failure” and the other I called “cognitive failure.” The theory that GS builds falls within that latter class, which is the one on which I would place more weight.

3. GS take seriously data that comes from surveys of the expectations of market participants. They are not afraid to find fault with the rational expectations hypothesis.

What I don’t like:

GS use standard economic modeling methodology, as opposed to Bookstaber’s agent-based modeling. See my review of The End of Theory. In particular, I think that institutional details are important, and Bookstaber’s rich depiction of different classes of market participants is better than a standard mathematical model. Also, I don’t like the idea of collapsing divergent expectations into a single representative agent. Getting away from the representative-agent model is a point in favor of Frydman and Goldberg. Note that Bookstaber, Frydman, and Goldberg do not appear in the index, either.

How deficit spending plays out

Posted on by

Sarah Krouse in the WSJ writes about underfunded pensions at state and local governments.

When the math no longer works the result is Central Falls, R.I., a city of 19,359. Today, retired police and firefighters are wrestling with the consequences of agreeing to cut their monthly pension checks by as much as 55% when the town was working to escape insolvency. The fiscal situation of the city, which filed for bankruptcy in 2011, has improved, but the retirees aren’t getting their full pensions back.

She points out that the total unfunded liability of these pensions is $5 trillion.

The trouble with deficit spending, as I have pointed out, is that it sets the stage for political conflict. Retirees expect their benefits. Bond-holders expect to get paid back. Taxpayers expect current services. Some groups are going to be disappointed.

Nobel Symposium on Banking

Posted on by

John Cochrane writes,

I attended the Nobel Symposium on Money and Banking in May

Diamond and Rajan say that debt is necessary, because it disciplines managers. Debt holders are constantly monitoring management, and running at the first sign of trouble. In direct contrast, Gorton’s debt holders are paying no attention at all most of the time, and then dump debt out of blind fear.

One weak spot of the conference was that everyone was being too polite. Well, everyone but me. Here we have a glaring difference in views. Which is right? I asked the question.

Rajan’s response was very informative: Yes, most retail debt customers are “information insensitive,” and likely even most corporate treasuries using repo as a cash substitute. But among the New York banks who are funding each other very short term, yes indeed they are paying a lot of attention and will run when they see trouble. So the “discipline” story is narrow, for this class of lender and borrower. That seemed to me a nice reconciliation of dramatically opposing views that has troubled me for some time.

I have watched several videos from the event, including the one where the exchange between Cochrane and Rajan occurs.

Cochrane asked another question, which I don’t think anyone answered. In some sense, I think he was asking how there can be a shortage of liquid assets, given how easy it is to trade assets, including stock mutual funds. My thought is that if this phenomenon of a shortage of liquid assets is real (or was during the financial crisis of 2008), it is because of the enormous balance sheets that some of the financial institutions had assembled on very little equity, leaving them with tiny margins of error.

On the general topic of how financial intermediation operates in the economy, I keep saying that we need to appreciate the layering that takes place. Finance is a complex ecosystem, with many niches. Beware of models that simplify it. I would wager that many of the conference participants could not have been able, as of 2005, to explain the nature and significance of repo haircuts, super-senior CDO tranches, or credit default swaps on mortgage securities.

I think that Doug Diamond and Gary Gorton are a bit too much invested in the issue of runs on short-term debt. And from Cochrane’s second post on the conference, I gather that Ben Bernanke is the most invested of all.

Instead, I preferred the speakers, like Alan Taylor, who emphasized dramatic changes in asset values, rather than liquidity. Yes, a sort of run took place in 2008 in the inter-bank lending market, and that run really got the attention of Wall Street and policy makers. But the big build-up in mortgage debt and house prices, followed by a crash, was not a liquidity crisis.

Do you remember my post on the Eric Weinstein interview? One of his glib, provocative comments was

The so-called great moderation that was pushed by Alan Greenspan, Timothy Geithner, and others was in fact a kind of madness, and the 2008 crisis represented a rare break in the insanity, where the market suddenly woke up to see what was actually going on.

I would like to have seen some of the conferees respond to that remark.

The Fed and Lehman Brothers

Posted on by

I haven’t read Laurence Ball’s book, but I did see the movie working paper. Ball’s thesis is that the Fed could have and should have lent Lehman the money to enable it to reach a more orderly resolution than declaring bankruptcy at the peak of the financial crisis of 2008.

Long after the episode, Fed officials justified their (in-)action by claiming that Lehman lacked adequate collateral, and that this lack of adequate collateral made it technically illegal for the Fed to lend the amount required. Ball points out that at the time, this legal argument was not used in the internal discussion. Instead, Chairman Bernanke and others were thinking that (a) the Lehman bankruptcy would not cause major new problems and (b) public hostility toward the perceived “bailouts” of Bear Stearns and other firms made it politically dangerous to lend to Lehman.

My own views:

1. I am inclined to cut Bernanke and the Fed officials some slack in allowing them to dissemble about the rationales for not bailing out Lehman. I think that the case against bailing out Lehman is pretty strong, and I am not persuaded by the view of Ball and others that a Lehman bailout would have worked wonders for resolving the financial crisis. Even if Ball is right, I think that the officials’ view that a bailout had low economic benefits and high political costs was reasonable ex ante.

2. The doctrine of “lender of last resort” does not suggest that you have to lend to any particular firm. The point is to provide liquidity in order to keep the crisis contained. So, contrary to what Ball seems to be saying, the Fed could perform its lender-of-last-resort function without bailing out Lehman.

3. During the crisis, I thought that more attention should have been paid to reducing the demand for liquid assets, not just trying to make more supply available. A lot of the “collateral calls” and “haircuts” were outlandish. I would have used jawboning to try to scale those demands back to something more reasonable.

4. I am intrigued by analysis suggesting that the actual banking crisis was more severe in Europe than in the U.S. European finance is more concentrated in its banking system. If every financial institution with heavy exposure to U.S. mortgage securities had failed, the U.S. would still have had a lot of functioning banks and other financial institutions. Not so in some European countries. I don’t think that Lehman bailout would have solved the problems in Europe.

Were mortgage securities badly mis-rated?

Posted on by

Juan Ospina and Harald Uhlig write,

AAA securities did ok: on average, their total cumulated losses up to 2013 are 2.3 percent. . .Losses for other rating segments were substantially higher, e.g. reaching above 50 percent for non-investment grade bonds. . .

Cumulative losses of 2.2% of principal on AAA-rated securities surely is a large amount, given that rating. Such losses after six years may be expected for, say, BBB securities, and not for AAA securities. AAA securities are meant to be safe securities, and losses should be extremely unlikely. From that vantage point, an average 2.2% loss rate is certainly anything but “ok”. We have chosen this label not so much in comparison to what one ought to expect from a AAA-rated security, but rather in comparison to the conventional narrative regarding the financial crisis, which would lead one to believe that these losses had been far larger. Ultimately, of course, different judgements can be rendered from different vantage points: our main goal here is to simply summarize the facts.

Authors’ emphasis. They also say,

these facts provide challenge the conventional narrative, that improper ratings of RMBS were a major factor in the financial crisis of 2008.

I object to this conclusion. The capital requirements for the securities depended on the ratings. Because of the AAA ratings, the capital requirement was less than what the loss percentage turned out to be.

As I see it, the facts in the paper support the conventional narrative. If the securities had been correctly rated, then there would have been no financial crisis. If the securities had been properly assigned BBB ratings, or any ratings below AA, banks could not have bought the securities without having at least five times the amount of capital that was required for AAA.

The charitable interpretation is that the authors do not appreciate the significance of capital regulations. The uncharitable interpretation is that they are trolls.