Category Archives: financial markets

Eugene Fama on Fed Impotence

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He writes,

Section II uses autoregressions with error correction terms to document that the day-to-day
variation in rates for maturities of a month or more has little or nothing to do with the Fed’s target rate.
This is consistent with a Fed that has little control of rates, but we shall see that it is also consistent with a
powerful Fed whose predictable actions with respect to TF are built in advance into interest rates.

Thanks to John Cochrane for the pointer. Note that TF is the Fed funds rate. My remarks:

1. I do not trust any time series regressions.

2. I think it is interesting that a framework in which the Fed has no influence is observationally close to a framework in which the Fed controls interest rates but market participants anticipate the Fed’s actions very well.

3. We may be in an environment today in which long-term rates over-react to short-term changes in the Fed funds rate.

4. Still, I take the view that the Fed is not big enough in the financial markets to have much durable influence on market interest rates.

A Fiery Analogy

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Robert Shiller writes,

The reluctance to acknowledge the need for immediate intervention in a financial crisis is based on a school of economics that fails to account for the irrational exuberance that I have explored elsewhere, and that ignores the aggressive marketing and other realities of digital-age markets examined in Phishing for Phools. But adhering to an approach that overlooks these factors is akin to doing away with fire departments, on the grounds that without them people would be more careful – and so there would then be no fires.

Pointer from Mark Thoma.

There is a school of thought (I am not a member) that would instead compare the Fed to the 10-year-old boy who starts a fire and then claims to be a hero because he then calls the fire department to come in to save it. Similarly, this school would argue, the Fed’s expansionary policies caused the housing bubble, and now the Fed earns praise for saving the economy from the resulting crisis.

Indeed, in recent interviews, Shiller has warned that stock prices are too high and we could see a crash. He would say that this is because markets are irrational. As far as I know, he is not calling on the Fed to raise interest rates in order to try to stop what he might call another financial epidemic. Again, I am not of the school of thought that thinks that the Fed is responsible for the stock market boom. But I think that Shiller ought to engage with those who are of that school of thought.

Incidentally, I received a review copy of Phishing for Phools, by Shiller and fellow Nobel Laureate George Akerlof. My views of the financial crisis are informed by my knowledge of institutional characteristics and history of housing finance. Their views are not. I find that this is the case with many economists who have written on the crisis, but their book left me especially frustrated. UPDATE: Alex Tabarrok also reviewed the book negatively.

Double Liability for Bank Shareholders

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Howard Bodenhorn writes,

Beginning in the 1810s, several states imposed double liability on chartered commercial
banks. . .

Relying on cross-sectional data Macey and Miller (1992) and Grossman (2001) find that double liability actually increased measured bank leverage, an apparently counterintuitive result they attribute to double liability serving to reassure creditors that they would be made whole in the event of bank failure. To the extent that double liability served as an implicit, off-balance-sheet increase in the bank’s capital account, the increase in measured leverage overstates creditor risk and explains the counterintuitive result.

Remarks:

1. Double liability for shareholders is not as strong as a proposal that I have made, which is that bank managers serve prison terms in the event of bank failure.

2. I think that double liability works well only if the bank’s ownership is highly concentrated. In that case, I assume that the shareholders would be able to exert strong influence on the bank’s practices.

3. There are two forms of leverage: financial leverage, which is the ratio of debt to equity; and operating leverage, which is the risk of the firm’s assets. Assuming that bank creditors were rational, they must have believed that the double-liability firms were employing less operating leverage than their peers.

Against Identical Expectations

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Noah Smith writes,

rational expectations might really be wrong. People might make systematic errors, thinking that booms or busts will last forever. If that’s the case, then it will require the economics profession to abandon one of its strongest orthodoxies. But the payoff could be big if the profession devises models that successfully explain phenomena like bubbles and crashes.

Pointer from Mark Thoma.

Smith cites (preliminary?) research by Jesse Bricker, Jacob Krimmel and Claudia Sahm, who

looked at data from the Survey of Consumer Finances, from before and after the housing crash in 2008. They found that more optimistic ZIP codes — that is, places where people had unrealistically high expectations for their own incomes — were more likely to overpay for houses in the bubble run-up before 2008. These overoptimistic people also took on more debt, and they were more likely to increase borrowing in response to rising house prices.

I have not found a write-up of this work. UPDATE: slides here. But my thoughts:

1. “Rational expectations” is one of an entire class of expectations models that I reject. I call this class “identical expectations,” because it assumes that every individual has the same model of the market and the same information, thus arriving at the same set of expectations. I find this both unrealistic and, as Frydman and Goldberg have pointed out, un-Hayekian, because it assumes away any sort of local knowledge.

2. If we are going to attempt a simple model of expectations, then I would suggest one in which there are two types of traders–momentum traders and contrarian traders. Momentum traders live by the maxim “the trend is your friend.” When prices have risen recently, they expect them to continue to rise. Contrarian traders live by the maxim, “if something cannot go on forever, it will stop.” When prices have risen recently to the point where they are above historical norms relative to fundamental measures of value, contrarian traders expect them to fall.

Momentum traders never see bubbles. Contrarian traders see bubbles everywhere.

Economists tend to be contrarian traders. Robert Shiller is the leading exemplar of this. Not all economists share his views, of course, but hardly any economist would confess to being a momentum trader.

Still, I think that there are times and situations where momentum trading dominates. Both Shiller and John Cochrane see momentum trading as something that can persist for a while in housing markets, because of the high costs facing traders who would try to take advantage of even well-founded contrarian views.

Update: Smith recommends a paper by Hong and Stein.

Financial Advice for Bryan Caplan

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He says that he maintains as much housing debt as possible, in order to take advantage of the mortgage interest deduction.

My advice to him is to sell his stock portfolio, pay off his housing debt, and take long positions in stock index futures.*

*In practice, the prospect of incurring capital gains taxes might make this a bad move.

Here is my thinking.

1. If you maintain housing debt that you could pay off, you have to put the money to work somehow. The question is whether you can earn more on your money than the after-tax interest rate. If you invest in risk-free securities, the answer is obviously “no.” Borrowing at 3 percent to invest in a money-market fund is a losing proposition, tax deduction or no tax deduction.

2. There might be some bond that you can buy that earns more than the after-tax mortgage interest rate, but that bond is going to have some risk attached to it. And you will have to pay taxes on the interest from that bond.

3. That leaves stocks. If you maintain housing debt in order to own stocks, then you are saying that you are happy to have a leveraged position in stocks, because you think that the expected return on stocks is higher than your borrowing rate. In Pikettyian terms, you believe that g is greater than r.

Fine. But if that is true, then I am pretty sure that the most efficient way to take your position would be by holding a position in stock index futures, rather than by taking out a mortgage loan to invest in stocks.

If you don’t like paying taxes, I understand that. As much as I disparage non-profits, I give large amounts to non-profits because I prefer that to paying taxes. But from a purely financial perspective, I think that maintaining mortgage debt that you could afford to pay off strikes me as a losing proposition. You unnecessarily enrich the mortgage lender at your expense.

A Gentleman’s Bet on the Fed

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I would bet that five years from now the size of the Fed balance sheet will be at least 85 percent of what it is now. I would make the same bet for ten years from now, but it is easier to hold me accountable in five years. Unlike Bryan Caplan, I prefer non-money bets.

My view is that “monetary policy” is just a ruse. If you want to understand government’s role in financial markets, focus on credit allocation. From that perspective, I do not think that the Fed will want to reallocate credit away from government debt and mortgage securities any time soon. . .or, in fact, any time.

Bengt Holmstrom Re-discovers a Theory of Debt Contracts

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He writes,

The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by using over-collateralised debt that obviates the need for price discovery. Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity, as I will argue later.

Pointer from Timothy Taylor. The theory that debt is used when the underlying assets are opaque is not quite new. My articulation of it owes a bit to the delegated monitoring idea of Doug Diamond.

The natural error for economists to make is to assume that bank creditors “see through” the bank to the underlying assets. What Diamond got me thinking is that the whole point of a debt contract is to ensure that the creditor does not have to see through the bank unless the bank gets into trouble. That is the insight that Holmstrom is re-discovering.

John Cochrane vs. Financial Intermediation

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He writes,

just why is it so vital to save a financial system soaked in run-prone overnight debt? Even if borrowers might have to pay 50 basis points more (which I doubt), is that worth a continual series of crises, 10% or more downsteps in GDP, 10 million losing their jobs in the US alone, a 40% rise in debt to GDP, and the strangling cost of our financial regulations?

My take:

1. As I have said before (scroll down to lecture 9), the nonfinancial sector likes to hold riskless, short-term assets and issue risky, long-term liabilities. Financial intermediaries emerge to take the other side.

2. When governments run deficits, they need help from banks, which hold government debt. It used to be that governments ran deficits to finance wars. Now they run deficits routinely.

3. Banks have an easier time convincing customers that bank liabilities (i.e., the funds customers hold on deposit) are riskless if government will provide implicit or explicit guarantees.

From (2) and (3), we see that banks and government are co-dependent. This co-dependency makes it unlikely that we will find a free-market banking system.

We can expect government policy to be ambivalent with respect to the financial sector. On the one hand, it wants the financial sector to thrive, so that deficits can be financed and the economy has plenty of credit available. That argues for lots of guarantees with limited regulation. On the other hand, it wants to restrain the moral hazard that leads banks to take on too much risk and make the system prone to crises. That argues for limited guarantees and lots of regulation.

Policy makers do not deal rationally with this ambivalence. Instead, over time both guarantees and regulation tend to increase. For instance, in the wake of the financial crisis the government has extended both its guarantees (money market funds) and its regulation (non-banks that are “systemically important”). It is true that some types of financial regulation, such as restrictions on interstate banking, interest-rate ceilings, or other anti-competitive rules, have declined over time. But in the area of safety and soundness regulation, over the years the effort has been to make regulation more sophisticated and effective. That this has not been successful is due in part to the greater prevalence of guarantees and also to what I call the regulator’s calculation problem.

Taming the Financial Sector

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Luigi Zingales writes,

there is precious little evidence that shows the positive role of other forms of financial development, particularly important in the United States: equity market, junk bond market, option and future markets, interest rate swaps, etc.

Found by Timothy Taylor.

Many financial practices are designed to evade regulations or optimize with respect to them. If regulators had not been so laggard in removing the interest rate ceilings on bank deposits, we might never have seen money market funds. If interstate banking had not been so restricted in the 1960s and 1970s, then there would have been no need for a mortgage securities market. If there were fewer short-sale restrictions and looser margin requirements in the stock market, then futures and options in the stock market might not have been created. My guess is that if you were to examine why firms use junk bonds rather than equity finance, you would find a regulatory story there as well.

Back in the early 1990s, someone coined the expression, “The Internet interprets censorship as damage and routes around it.” Financial markets attempt to do the same with regulation.

Do I Heart Elizabeth Warren?

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Simon Johnson writes,

Senator Warren puts forward two main sets of proposals. The first is to more strongly discourage the deception of customers. This is hard to argue against. Some parts of the financial sector are well-run, providing essential services at reasonable prices and with sound ethics throughout. Other parts of finance have drifted, frankly, into deceiving people – on fees, on risks, on terms and conditions – as a primary source of profits. We don’t allow this kind of cheating in the non-financial sector and we shouldn’t allow it in finance either.

…The second proposal is to end the greatest cheat of all – the implicit subsidies received by the largest financial institutions, structured so as to encourage excessive and irresponsible risk-taking. These consequences of these subsidies have already caused massive macroeconomic damage – this is why our crisis in 2008-09 was so severe and the recovery so slow. Yet we have made painfully little progress towards really ending the problems associated with some very large financial firms – and their debts – being viewed by markets and policymakers as being too big to fail.

Pointer from Mark Thoma.

It may seem surprising that I agree with Senator Warren on both of these points. However, I disagree that the Consumer Financial Protection Board is taking the best approach to solving the problem of skilled financial firms exploiting less-skilled consumers. As I wrote here,

Regulated industries are always ready to complain about the cost of complying with bright-line regulations. However, I have the opposite objection. Particularly when it comes to the financial sector, compliance with BLR is far too easy. The bankers are always able to outmaneuver the regulators, staying within the letter of the rules while mocking their spirit.

That essay is where I proposed principles-based regulation as an alternative.