Category Archives: financial markets

An Attempt to Explain Bill Dudley?

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Ryan Tracy of the WSJ discusses a new paper on the revolving door between Wall Street and regulators.

its findings suggest that the revolving door may be driven by an entirely different force. Instead of “regulatory capture,” the paper provides evidence consistent with “regulatory schooling” – the idea that people take regulatory jobs to become experts on complex regulations before cashing in with a private sector job. Instead of having an incentive to go easy on banks, the “regulatory schooling” hypothesis suggests regulators have an incentive to make rules more complex.

The paper comes from the research staff at the New York Fed.

Uber $17 Billion?

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The Seattle Times reports,

The funding positions the company at the front of a pack of Internet startups, at a valuation of about $17 billion, up from $3.5 billion in a financing last year.

Back in 1999, I started The Internet Bubble Monitor, a blog about that bubble. I tracked the absurd valuations of firms that had already gone public. This time around, it looks like the VCs want to front-run the public and bid firms up to absurd levels before anyone else can.

I would be curious to know what the investors think that the margins will be in the business in five years. Will Uber be able to collect $5 a ride? Fifty cents a ride? Maybe Facebook or Twitter will offer ride connections for free and hope to make a go of it on advertising revenue.

But, hey, I’m just an old man who doesn’t understand technology.

Economists Heart Banks

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The IGM forum polls responses to this statement:

There is a social value to having institutions that issue liquid liabilities that are backed by illiquid assets.

Not one of the economists polled disagrees.

For mood-affiliation purposes, I would have said “agree.” But I think it is uncertain, only because such institutions seem to always end up codependent with government in ways that detract from social value.

Ben Hunt on Financial Narrative

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He wrote,

the current Narrative associated with Federal Reserve policy is just as powerful and just as real as any historical Narrative I am aware of, including the Narratives of global religions and major nationalities. Fifty years from now, will we look back on Central Bank Omnipotence as a dead myth, as something akin to Manifest Destiny, or will it continue to shape our expectations and behaviors as the Founding Fathers

…What you want to know is what everyone thinks that everyone thinks about the Fed statement, and you can’t find that in the Fed statement, nor in any private information or belief. You can only find it in the Narrative that emerges after the Fed statement is released. So you wait for the talking heads and famous economists and famous investors to tell you how to interpret the Fed statement, but not because you can’t do the interpreting yourself and not because you think the talking heads are smarter than you are. You wait because you know that everyone else is also waiting. You are playing a game, in the formal sense of the word. You wait because it is the act of making public statements that creates Common Knowledge, and until those public statements are made you don’t know what move to make in the game.

I visited the web site because a John Mauldin email newsletter reprinted a different Ben Hunt essay. From yet another Ben Hunt essay:

the Narrative of Central Banker Omnipotence. Like all effective Narratives it’s simple: central bank policy WILL determine market outcomes. There is no political or fundamental economic issue impacting markets that cannot be addressed by central banks. Not only are central banks the ultimate back-stop for market stability (although that is an entirely separate Narrative), but also they are the immediate arbiters of market outcomes. Whether the market goes up or down depends on whether central bank policy is positive or negative for markets. The Narrative of Central Banker Omnipotence does NOT imply that the market will always go up or that central bank policy will always support the market. It connotes that whatever the central bank policy might be, it will drive a market outcome; whatever the market outcome, it was driven by a central bank policy.

…debate over the merits of open-ended QE only intensify the Common Knowledge that Fed policy was responsible for market outcomes in 2012.

In some sense, it does not matter whether you are in favor of QE or against it. If you are passionate about it, you reinforce the Narrative of Central Banker Omnipotence. Regular readers will know that I instead hold a view of central banker near-impotence. That makes me quite out of tune with the conventional narrative.

The Political Economy of Big Banks

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David Cay Johnston reviews All the Presidents’ Bankers, by Nomi Prins. He concludes,

But the banks are only big, not strong. Indeed, the “stress tests” to determine if the banks can withstand another financial shock are designed to test only for minor upsets, rigging the game in favor of the Big Six, which all engage in unsound practices, especially trading in derivatives. They remain big because of bad laws and enablers like Geithner and because politicians desperate for campaign donations listen to the pleas of bank owners more than those of customers. So the bankers live in grand style, lavished with subsidies that cost us more than food stamps for the poor. In return for this largesse, the bankers savage our modest savings.

Pointer from Mark Thoma. To me, Johnston’s rhetoric seems over the top, and if all Prin has to offer is rhetoric and conspiracy-mongering, then I see no need to read her book. Nonetheless, if you ask me about the political economy of big banks in this country, I would say that I believe that their profits come from rent-seeking in general and from the too-big-to-fail subsidy in particular. I think that breaking up the big financial institutions would provide a net public benefit.

However, I would caution you that Fragile by Design, by Calomiris and Haber, offers nearly the opposite perspective. For them, it is America’s historical hostility toward large banks, and the consequent fragmentation of banking, that is the original cause of fragility here. I think Prin would have a hard time arguing, as she apparently attempts to do, that concentrated banking has been a feature of the U.S. for over a century, when banking across state lines was all but impossible up until around 30 years ago. The other point in favor of Calomiris and Haber is the stability of Canadian banks, where the big six have a much higher market share than the big six in the U.S.

John Cochrane vs. Financial Intermediation

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He writes,

demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For [money-market?] funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable.

I suppose Murray Rothbard would have liked this.

My own aphorism about financial intermediation is that the nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets, which the financial sector accommodates by doing the opposite. If that aphorism is correct, then Cochrane’s vision involves getting rid of financial intermediation.

I suspect that the optimal amount of financial intermediation is not zero. However, I suspect that it is not as much as we get in a world in which there is deposit insurance, too-big-to-fail guarantees, and tax advantages of leverage. Here, Cochrane’s tactical approach is interesting.

Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.

The way I put it is that you cannot make financial institutions too regulated to fail. So instead of trying to make financial institutions harder to break, try to make them easier to fix. This means taking away the incentives to adopt unstable financial structures. Cochrane would go further and penalize unstable financial structures using taxes.

Meanwhile, Peter Wallison warns that the command-and-control approach to regulation has a logic of ever-widening jurisdiction.

Brad DeLong on Piketty

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Brad writes,

We have a world in which some eminent economists (Larry Summers) say r1 is too low, and other eminent economists (Thomas Piketty) say r2 is too high…

The difference between r1 and r2 is the risk premium. In a well-functioning market economy with well-functioning financial markets, there are powerful reasons to believe that this risk premium should be small: less than 1%-point per year. The fact the risk premium appears to me to be 7%-points per year today is a powerful evidence of the profound dysfunctionality of our financial markets, and of their failure to do their proper catallactic job. But that is a separate and largely independent discussion: that is a dysfunction of our modern market economy which is different from either the dysfunction feared by Summers or the dysfunction freaked by Piketty. For the moment, simply note that it is perfectly possible for all three of these major dysfunctions to occur together.

Pointer from Mark Thoma. Read the whole thing. The risk-premium solution was also suggested here in a comment by Matt Rognlie.

So far, the left-wing journalistic verdict on Piketty is rapture. Economists, even those inclined to agree with Piketty’s conclusions, seem somewhat unsatisfied with with his treatment of capital and interest.

Wealth, Income, and Stock Prices

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As I start to read Piketty, the following train of thought occurred to me.

How would I explain fluctuations in the ratio of wealth to income? In particular, why did that ratio fall in the 1930s and why has it risen in recent decades?

My first thought is to look at stock prices, and at the P/E ratio. As the P/E ratio goes up, the ratio of stock market wealth to earnings goes up.

What drives the P/E ratio? The standard explanation would use some version of the discounted earnings model. That is, the P/E ratio will be high when the discount rate is low and/or expected future earnings are high. Over the past century, stock prices have trended upward because of one or both of these factors. That is, investors have been willing to discount earnings at lower rates or they have raised their expectations for earnings.

Call the discount rate r and the expected growth rate of earnings g. In short, the discounted earnings model says that the P/E ratio will be high when r is low and/or g is high.

Yet Piketty sees the rise in the ratio of wealth to income as caused by the opposite configuration. That is, he thinks it has taken place because r is high and g is low.

Of course, his r is “return to capital,” not the discount rate. And his g is the growth rate of total income, not corporate earnings. But I wonder how one sorts this all out, and how one goes about choosing between the finance-theoretic explanation of changes in the ratio of wealth to income and the Piketty-Marxist explanation.

UPDATE: James Galbraith writes,

when asset values collapsed during the Great Depression, it mainly wasn’t physical capital that disintegrated, only its market value. During the Second World War, destruction played a larger role. The problem is that while physical and price changes are obviously different, Piketty treats them as if there were aspects of the same thing.

And….?

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Nick Timiraos writes,

Mortgage rates could rise by as much as 1.5 percentage points for homeowners with weaker credit or smaller down payments under various legislative proposals to overhaul Fannie and Freddie Mac, according to a study prepared for an industry group.

The study purports to estimate what is seen. How about what is unseen? That is, suppose we reduce the distortions in capital markets that funnel money into high-risk mortgages. That means that the interest rate on high-risk mortgages goes up. And…? Some other interest rate goes down. It might even be the interest rate paid by firms undertaking productive investment.

Why I Want to Break Up the Big Banks

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Matthew C. Klein writes,

Using the lowest estimates, the big banks can attribute almost a fourth of last year’s profits to taxpayer largess. Higher estimates suggest that almost all of the big banks’ earnings in 2013 were due to subsidies rather than productive activity. The IMF notes that even “these dollar values likely underestimate the true TITF subsidy values” because, among other things, the calculations are based on the assumption that shareholders in bailed-out banks would lose everything, which isn’t usually what happens.

Pointer from Patrick Brennan.

Of course, the NY Fed will tell you that there are terrific economies of scale in banking, and that explains the profits of large banks.

UPDATE: Actually, one economist at the NY Fed, Joao Santos, thinks it’s a too-big-to-fail subsidy.

Using information from bonds issued over the past twenty years, this study finds that the largest banks have a cost advantage vis-à-vis their smaller peers. This cost advantage may not be entirely due to investors’ belief that the largest banks are “too big to fail” because the study also finds that the largest nonbanks, as well as the largest nonfinancial corporations, have a cost advantage relative to their smaller peers. However, a comparison across the three groups reveals that the largest banks have a relatively larger cost advantage vis-à-vis their smaller peers. This difference is consistent with the hypothesis that investors believe the largest banks are “too big to fail.”

Pointer from David Dayen via Mark Thoma.