Category Archives: financial markets

Does More Government Debt Reduce Interest Rates?

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This is a random idea that is almost surely wrong. And if it is wrong, it will be wrong in a way that seems obviously stupid. So don’t expect me to stick with it.

Without blaming Nick Rowe, I started thinking about this when he wrote,

By “secular stagnation” I mean “declining equilibrium real interest rates”.

Most explanations of secular stagnation say it is caused by a rising desire to save and/or a falling investment demand. Call this the “Saving/Investment Hypothesis”.

But there are lots of different real interest rates. For example, the real interest rate on Bank of Canada currency is around minus 2%. (That currency pays 0% nominal interest, and the Bank of Canada targets 2% inflation). But people are willing to hold currency, despite that, because it is very liquid. But all assets differ in their liquidity. More liquid assets will have a lower real yield than less liquid assets. And if an asset becomes more liquid over time, its real yield will fall over time.

What if there is a sharp rise in the supply of government debt? The standard view is that this tends to raise interest rates, as debt absorbs more savings.

The alternative view I am putting out there is that government debt offers liquidity (in the limiting case, think of it as a very close substitute for money). If the supply of liquidity goes up, then there is less demand for banks to manufacture liquidity out of risky assets. The public wants fewer deposits backed by loans on fruit trees and instead is happy to hold mutual funds containing government bonds.

The result is fewer fruit trees planted. We would observe a decline in interest rates on low-risk assets and an increase in interest rates (or a loss of credit availability altogether) for risky investment projects.

Think of this as government debt crowding out private investment, even though the interest rate on safe assets, particularly government debt itself, can remain low and perhaps even fall as the crowding out gets larger. Again, this is probably wrong.

Relate this to Tobin’s q

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Justin Fox reported,

>Ocean Tomo calculates intangible assets simply “by subtracting the tangible book value from the market capitalization of a given company or index,” so the rise in intangibles since the 1970s is in part just a reflection of rising stock market valuations. But that’s not all it is: the cyclically adjusted price-earnings ratio on the Standard & Poor’s 500 Index has risen about 2 1/2 times since 1975, while the intangibles increase has been almost fivefold.

Tobin’s q is the ratio of the stock price to the replacement cost of capital. I am tempted to write:

q = P/K = (P/E)(E/K), where P is the stock price, E is earnings, and K is capital.

As Fox points out, a fair amount of the rise in q since the late 1970s comes from a higher P/E ratio. But I gather that if you think of K as tangible capital, then E/K also has soared.

Fox’s piece was mentioned in Scott Sumner’s discussion of what I called the fifth force. But Robin Hanson got me to take a look.

I would note that intangibles in the economy include not just firm-specific intangibles but also general intangibles that lead to better patterns of specialization and trade. Institutional improvements in India and China, as well as lower transportation and communication costs, come to mind.

Tyler Cowen has much more, including a hypothesis that accounting issues are involved.

Questions for Mark Thoma

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He writes,

Surprisingly, the loss of more than 800 independent banks wasn’t due to an unusually large number of bank exits during the financial crisis. Instead, it was due to a fall in bank entries, from around 100 new banks per year prior to the Great Recession to just three per year on average since 2010 (only four new banks appeared from 2011 to 2013).

1. Does too-big-to-fail play a role in this, by making it hard for smaller banks to compete? Are some conservative (e.g., Peter Wallison) complaints about Dodd-Frank reinforcing TBTF possibly valid?

2. Does the causality run the other way? That is, have business formation rates been low, and this reduces the demand for services of small banks?

These are genuine questions, not rhetorical ones–my inclination is to believe Thoma’s story. I do not know if it is possible to find data that would answer these questions, but I think that searching for answers could be interesting.

Hormones and Financial Intermediation

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A recent post reminded me that Jason Collins really liked The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust, by John Coates. Coates looks at how hormones are activated in traders. My guess is that I will get as much from Jason’s review as I would from the book. Jason writes,

In a bull market, testosterone surges through the population of traders. Each takes larger and larger risks, pushing markets to new highs and triggering further cascades of testosterone. Irrational exuberance has a chemical base.

Read the whole review. I would like to see the link between an individual short-term hormonal response and broad, long-term market trends established.

I do believe that there are cycles of financial intermediation. Remember how I think of financial intermediation. Households and businesses want to hold riskless, short-term assets while issuing risky, long-term liabilities. Financial intermediaries accommodate this by doing the opposite. When there is too little financial intermediation, opportunities to take reasonable risks are foregone. When there is too much financial intermediation, there is excessive risk-taking.

To a first approximation, I am not sure that simple trading of financial assets should boost testosterone on net, because financial trading is not positive sum. It’s not like “you want meat and I want shoes, so I’ll trade you meat for shoes.” Financial trading is closer to zero sum, which is why when you win you get high. The guy who sold you that stock that went up 5 points right after you bought it probably feels badly. So why should a bull market make more people feel high? Perhaps because as share prices increase, net financial intermediation is going up overall. That is, there are more short-term, low-risk liabilities being backed by more long-term, high-risk assets. Maybe that increased financial intermediation is accompanied by and reinforced by a hormonal response. Perhaps that is plausible, but it seems to me to require more of a stretch and, above all, more of a story of how markets react in the aggregate, or how System 2 and System 1 interact over long periods of time and across an entire array of market individuals and institutional relationships.

Charles A.E. Goodhart Does Not Heart SPOE

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He writes,

there is no doubt that it is a clever and subtle idea. But there is no account of what might happen after this recapitalisation (of the op-co) has been put in place. In a game with many rounds, such as chess, the expert players are those that are trained to think many steps ahead. Within the bail-in process, the (main) operating subsidiary (the op-co) is meant to continue, so this is supposed to be a multi-stage exercise. Yet nothing is said in this paper about subsequent stages, nor the problems that might arise therein. I raise some queries about what might happen after the initial resolution is triggered.

Read the whole thing for specifics. Pointer from Mark Thoma.

SPOE stands for Single Point of Entry, which I think relates to what Goodhart calls TLAC. My hypothesis is that the regulators will start to look one step ahead just when the first big bank failure occurs, and what they see will convince them to do a bailout instead.

The Threat of Debt

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Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart write,

Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.

Much of the debt increase has taken place in emerging markets, notably China. I remain suspicious of aggregate debt-to-GDP numbers as an indicator. Indeed, the paper speaks to many of the issues with this measure that trouble me). However, the authors make a reasonable case to worry about two risks. One is that any adverse economic development will be multiplied by the defaults that result from high leverage. The other is that a “confidence crisis,” in which creditors lose faith in some debt instruments, becomes self-fulfilling. As the authors put it,

we outline the nature of the leverage cycle, a pattern repeated across economies and over time in which a reasonable enthusiasm about economic growth becomes overblown, fostering the belief that there is a greater capacity to take on debt than is actually the case. A financial crisis represents the shock of recognition of this over-borrowing and over-lending, with implications for output very different from a ‘normal’ recession. Second, we explain the theoretical foundations of debt capacity limits. Debt capacity represents the resources available to fund current and future spending and to repay current outstanding debt. Estimates of debt capacity crucially depend on beliefs about future potential output and can be quite sensitive to revisions in these expectations.

This report came out two months ago, and I do not recall it getting much play. I think it deserves your attention. Read the whole thing. For the pointer I thank Jon Mauldin’s email newsletter.

Rules, Discretion, Principles, and Incentives

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Timothy Taylor excerpts from a book on macroprudential regulation.

Paul Tucker: “Legislators have typically favoured rules-based regulation. That is for good reason: it
helps to guard against the exercise of arbitrary power by unelected officials. But a static rulebook is the meat and drink of regulatory arbitrage, which is endemic in finance. Finance is a ‘shape-shifter’.

Rules do not work, because banks figure out a way to manipulate the rules. Tucker gets this. So does Wolf Wagner, also quoted by Taylor.

Also, discretion does not work, in my opinion, because discretion tends to be procyclical, doing exactly the wrong thing at the wrong time. In good times, regulators ease up, and in bad times, they tighten up. Just look at how regulators behaved before and after the housing crash. Or compare Ben Bernanke’s discussion of bank supervision before and after he knew about the crisis.

I think that principles-based regulation might work better. That is, pass a law saying that managers and directors of financial institutions are responsible for prudent management. Require auditors to flag questionable practices.

Also, I think that incentives are important. Casual observation suggests that investment banking was more cautious when investment banks were partnerships rather than limited-liability corporations. We should look for ways to give bank executives more skin in the game in their institutions. Suppose you have a bank that goes bust in 2025. All of its top executives over the preceding 10 years would be held personally liable those losses, in proportion to the compensation that they received over that period.

(For each year, take the five most heavily compensated executives, and put their total compensation into a hypothetical pool. Add these to get a company total for fifteen years. Then divide each executive’s total compensation over the 10 years by the company total to get the fraction of losses for which that executive is liable.)

Actually, I don’t think that the formula needs to be perfectly “just.” The point of any such system is to make executives manage banks as if they were risking their own money, because they would be.

Yes, Blame Oil Speculators

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James Pethokoukis writes,

If greedy speculators were to blame for the $7.50 per barrel (and 10.6%) increase in oil prices during the first half of this year that motivated your anti-speculation bill in early July, do oil speculators now get any of the credit for the $43.60 (and 41%) drop per barrel in oil prices during the last half of 2014?

1. Oil is a speculative asset. The price of oil today and the price expected for oil ten years from now are necessarily linked. See Hotelling pricing of natural resources.

If you believe that the oil price is going to be high ten years from now, then you try to leave more of it in the ground today, raising its price today. If you believe that the price is going to be low ten years from now, you try to sell it now, while you can still get a decent price. This drives the price down today.

2. Although I cannot find the post now, I recall James Hamilton suggesting that the oil market is subject to speculative overshooting and undershooting. More recently, he wrote,

It’s just a matter of how long it takes for the high-cost North American producers to cut back in response to current incentives. And when they do, the price has to go back up.

3. Why would someone expect oil prices to be low for the next several years? Perhaps low-cost energy supplies will emerge (note that fracking is not low-cost) rapidly. Perhaps world economic growth will be very slow for many years. However, it strikes me as at least plausbile that low-cost energy supplies will not emerge and that world economic growth will be decent, in which case I would expect the price of oil to rise. Most important, there is still the possibility that all the money-printing going on in the world will amount to something, and even if the supply-demand balance in energy markets stays where it is, the nominal price of oil will go up a lot. If I were a speculator now, I would be inclined to be long oil.

4. It is possible that what is going on is a cave-in on the part of speculators who had been betting that money-printing would cause a lot of inflation. One can interpret the decline in interest rates and the softness in commodity prices as reflecting speculators giving up on those positions.

5. As is often the case, in looking at financial markets I find myself feeling confused and out of synch.

John Cochrane Walks Back, and Now I am Grumpy

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He writes,

Now, if you read FOMC minutes, Fed speeches, or talk to people at the Fed about policy, you will see that this intertemporal, expectation-focused approach resulting from the revolutions of the 1970s permiates [sic] the policy-making process. For example, “forward guidance” is the rage. It only takes one beer for the conversation to quickly acknowledge that QE likely worked as much by signaling low interest rates for a long time than it did by exploiting some sort of permanent price-pressure in Treasury markets.

Consider two questions:

1. Why does employment fluctuate?

2. How does the Fed affect financial markets?

If you want to use the term “intertemporal, expectation-focused approach” to talk about (1), I am not convinced. I think that this dubious idea took hold because economists were writing down models of a GDP factory, abstracting from the question of which goods to produce. The only meaningful choice left was intertemporal–do you run the GDP factory faster now or next year? This is a case in which an overarching theory was dictated by a simplistic modeling strategy.

If you want to use the term “intertemporal, expectation-focused approach” to talk about (2), you have a strong case. I believe in at least the weak form of the efficient markets hypothesis. When you incorporate that into your thinking, then you have to think of the Fed either as affecting markets with surprises or with rules. As Cochrane points out, this leads to a discussion of rules.

However, there is another consideration, which is that perhaps in financial markets the Fed is throwing small pebbles into a big pond. Maybe in the grand scheme of things, monetary policy does not do much to change long-term interest rates, stock prices, and other important market rates. Yes, I know that many investors believe that Fed policy matters, and there is this whole industry of trying to “read” the Fed, and it is possible that the Fed can influence the readers in some way–but again, markets are overall weakly efficient.

What I keep coming back to is my view that the Fed’s regulatory policies have big effects on credit allocation. Tell banks that they can multiply the interest rate on regulator-designated low-risk assets by three to get their regulation-adjusted rate of return, and by golly banks will load up on regulator-designated low-risk assets. But I am doubtful that its monetary policies do anything.