For Medium, I take a skeptical view of the value of Bitcoin as a hedge against hyperinflation.
For citizens looking for hard assets, gold is not the only option. Other commodities, such as copper or wheat, are traded in futures markets. By taking long positions in those commodities, you can profit from inflation. There are mutual funds that invest in commodity indexes, just as there are stock mutual funds that invest in stock indexes.
more than just soft information is lost when lenders rely on generic credit scores. Practical obstacles — and in some cases political considerations — exclude from the scores factors, such as income and education, that self-evidently affect creditworthiness. Moreover, score-based lenders, like Friedrich Hayek’s central planners, rely on “statistical information” that ignores “crucial circumstances of time and place.” From their far-away perch, they cannot recognize substance abusers, nor can they distinguish workers in plants scheduled to close from judges with lifetime tenure.
He argues that we need more traditional banking, involving credit judgment and originate-to-hold, and less securitization using credit scores. My thoughts.
1. Although in theory underwriting judgment could lead to wise decisions to over-ride credit scores, in practice I do not think this happens. Human underwriters are not geniuses. And they do not necessarily know when the information they have is really news to the scoring system. Maybe the scoring system does not explicitly know that someone is a substance abuser, but it may nonetheless observe behavior that reflects that substance abuse. I believe that judgmental over-rides tend to lead decisions that are worse, not better.
2. As Bhide points out, some of the shift toward originate-to-distribute was influenced by capital regulations.
3. In mortgages, the private securitization market remains pretty dormant. That is, without a guarantee from Freddie and Fannie, investors are reluctant to buy mortgage securities just based on loan-to-value ratios and credit scores.
4. I think that for bank regulation, stress testing is the least bad way to promote safety and soundness. Stress tests for mortgage portfolios should include scenarios of falling house prices. Stress tests for consumer portfolios should include rising unemployment.
For Medium, I wrote on financial bubbles, with plenty of Bitcoin trolling thrown in.
it is mathematically impossible for all of the bullish investors to get out with a profit. If a stock goes from $10 a share to $100 a share and back down to $5 a share, then on average the shares bought on the way up have to be sold for less than their purchase price on the way down. If you buy into a bubble, then the chances are you will lose.
All existing cryptocurrencies are designed around a math problem that gets exponentially harder to solve as time goes on. However, the number of “coins” you achieve for solving it is fixed irrespective of where on the curve you solve it. This is a Ponzi scheme by definition since the first people obtain a given reward for little effort yet later people must expend exponentially greater effort for the same reward, and the laws of mathematics say that eventually the reward cannot be had for any rational (or even possible) expenditure.
…Ponzi scheme. They are thus all illegal — every one of them — under said laws, and are designed to funnel money from later adopters to earlier adopters.
Sounds as though he agrees with my chain-letter analogy. But to be honest, I do not follow the substance of what he is saying.
He is one of 21 alleged experts interviewed on that page, and most of them are reluctant even to call “bubble,” much less “scam.”
Pointer from Miles Kimball.
Merry Christmas.
With crypto-assets, I am carrying wealth more generally into the future. The person who most wants that payoff structure for the wealth carry will end up owning the crypto-asset.
Read the whole thing, with which I do not agree one bit. Tyler knows more than I do about the topic, but for what it’s worth, here is my view.
I think of Bitcoin as functioning like a chain letter, of the sort where you say “Send ten dollars to the person at the top of this list scratch that person off the list, put yourself on the bottom of the list, and then send this letter to six of your friends.” If the chain letter keeps going until you are at the top of the list, you might get thousands of dollars.
A chain letter is a redistribution scheme that creates a few big winners and a lot of little losers. I see Bitcoin playing out the same way. As long as the Bitcoin chain letter keeps reaching new people, its value will rise. Once Bitcoin runs out of new suckers, er, investors, it will crash. Then we will find out who were the winners and losers. The few who sell before the crash will have made fortunes at the expense of those who paid up for it and held on for too long.
If you participate in a chain letter, the odds are very low that you will make it to the top of the list. Similarly, with Bitcoin, the odds are very low that you will sell your Bitcoin before it goes down in value. The majority of Bitcoin investors will buy high and sell low.
if banks are doing their job, the banking system is illiquid, and the rest of the economy —us— have lots of cash. In Econ 101 this is known as “maturity transformation.” Liquidity-wise, the banking system is simply the mirror image of the economy. Thus, compelling banks to become more liquid inevitably drains cash from all of us who are not banks.
This is another way of saying what I like to say, which is that the public wants to issue risky, long-term liabilities and to hold riskless, short-term assets, and financial intermediaries accommodate this by doing the opposite. This implies that for financial firms, a liquidity crisis blends into a solvency crisis. Banks must shrink their activity if there is sudden pressure on them to make their balance sheets more liquid.
In a more recent post, he writes,
what did cause the crisis? The causes were complex, but one force overwhelmed all others: regulation. Bad regulation. Mainly, the Basel I and Basel II Capital Standards.
He is referring to the Financial Crisis of 2008. Actually, I don’t believe that Basel II was all that important, because it still was mostly unimplemented by the time of the crisis. I would focus on Basel I and also on the Recourse Rule of 2001, which we might think of as Basel I(a).
More interestingly, he goes on to say,
the great untold secret of the crisis was the strength of the US commercial banking industry.
As crazy as this sounds, it may be spot on. Yes, Citigroup was in trouble, as he acknowledges. But most other commercial banks were not in bad shape. Some U.S. investment banks (aka “shadow banks”) were shakier, but the real problems were in Europe. He writes,
European banks in 2007 had aggregate tangible equity of roughly 1 trillion euros (at the time, about $1.1 trillion.) With a sensible leverage ratio of 5.0%, this equity would have supported E20 trillion in assets. But by 2000, the average European bank leverage ratio already had dwindled to 3.8% (insufficient), and then fell further — to 3.0% (wow) in 2007.* That may not sound like a big deal, but it’s more than a 20% systemic increase in leverage in just 7 years. This meant that for European banks alone, the Basel Regs goosed asset demand by at least E7 trillion ($8 trillion).** To think of it another way, European bank assets in 2007 exceeded what would have been prudent leverage (i.e. 5%) by E13 trillion ($15 trillion) — a third of European banking system assets.
I would add that many of the beneficiaries of the “AIG bailout” were European banks.
There is a lot of potential for revisionist history here.
You can start with Tyler, and work backwards.
I don’t think it is easy to get around having a part of the economy which is both systemically risky, and also debt-intertangled, as the evolution of shadow banking over the last fifteen years seems to indicate.
As spelled out in Specialization and Trade, my simple account of financial intermediation is this.
1. We start with a risky investment, fruit trees, and it is costly to observe how the fruit trees are doing and how much skill and dedication the entrepreneur is contributing.
2. It helps to finance these fruit trees in part with debt. This is not because debt is easier to trade than equity, but because it is a less expensive way to align incentives.
3. It helps to have a bank buy the debt and issue short-term, risk-free liabilities. This is because people do want to hold and exchange short-term, risk-free liabilities. An intermediary that backs the fruit-tree debt with a combination of bank equity and demand deposits makes people better off.
So I am afraid that I am with Tyler on this one.
Fredrik Erixon and Björn Weigel write,
In 2013, natural persons owned only 40 percent of all issued public stock, down from 84 percent in the 1960s. And if we take all issued equity, the trend has been even more pronounced. In the 1950s only 6.1 percent of all issued equity was owned by institutions but, in 2009, institutions held more than 50 percent of all equity.
…the shift from capitalist ownership to institutional ownership has undermined the ethos of capitalism and has created a new class of companies without entrepreneurial and controlling owners. Contrary to some expectations, that has not created new space for free-wheeling and entrepreneurial managers to act on their own judgment instead of following the instructions of owners. Rather, managers are subject to a growing number of rules and guidelines designed for and by risk-averse owners with little knowledge about their investees.
I am not convinced that the current system is as dire as the authors make it out to be. Fifty years ago, it was difficult to keep a large firm from throwing capital at investments with poor returns. Today, reallocating away from firms with poor opportunities is easier.
Kathleen M. Kahle and René M. Stulz write (link now fixed),
US public firms are very different now compared to 1975 or 1995: fewer, larger, older, less-profitable, with more intangible capital, less investment, and other changes. The US firms that remain public are mostly survivors. Few firms want to join their club. A small number of firms account for most of the market capitalization, most of the earnings, most of the cash, and most of the payouts of public firms. At the industry level, revenues are more concentrated, so fewer public firms are competing for customers. A large fraction of firms do not earn profits every year and that fraction is especially large in recent years, which helps to explain the high level of delists. Accounting standards do not reflect the importance of intangible assets for listed firms, which may make it harder for executives to invest for the long run.
The authors discuss various explanations for this, but my inclination is to tell the story as follows:
Think of any investment project as going through two phases. First, there is the start-up phase, which may or may not produce profitable results. Then, for successful projects, there is the cashing-in phase, where the profitable enterprise gets sold to a wider set of investors.
Forty years ago, a lot of investment projects were started within large public firms. With the firm already public, there was no need for an additional cash-in phase. The stock already was widely held. Meanwhile, if a not-yet-public firm launched a successful enterprise, the best deal it could get in the cash-in phase was often to go public.
Today, large public firms are doing less of the first-phase risky investment. Instead, they are letting private firms take the risks and then handling the successful start-ups’ cash-in phase for them by buying them.
So that’s a story. A leading example of that model would be pharma. A lot of the speculative research gets done at small start-ups. Once a start-up is successful, its best option is to be acquired by big pharma. The legacy firms have a comparative advantage in handling the second phase. The start-ups have a comparative advantage in the first phase.
Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas write,
For the last few decades, with minor cyclical interruptions, the supply of safe assets has not kept up with global demand. The reason is straightforward: the collective growth rate of the advanced economies that produce safe assets has been lower than the world’s growth rate, which has been driven disproportionately by the high growth rate of high-saving emerging economies such as China. If demand for safe assets is proportional to global output, this shortage of safe assets is here to stay.
The signature of this growing shortage is a steady increase in the price of safe assets, necessary to restore equilibrium in this market. Equivalently, global safe interest rates must decline, as has been the case since the 1980s. Simultaneously, we observed a surge in cross-border purchases of safe assets by safe asset demanders—many of them located in emerging economies—from safe asset producers, mostly the United States.
I get their point, but I do not like the idea of talking about the quantity of safe assets as the problem. Remember my view of finance: people want to issue risky, long-term liabilities and hold riskless, short-term assets. Financial intermediaries accommodate this by doing the opposite. Hence these thoughts:
1. What my framework suggests is that if there are too few riskless, short-term assets, then there must also be too few risky, long-term liabilities. That is, there is a general shortage of financial intermediation.
2. There does not appear to be a general shortage of financial intermediation. Relative to the economy, the financial sector has been growing, not shrinking.
3. In the “safe assets” framework, government helps to solve the problem of safe-asset scarcity by printing more money and issuing more short-term debt. In my framework, more government liabilities are not helpful. Government’s short-term, riskless liabilities are not backed by long-term risky assets.* So government is not increasing the amount of financial intermediation. Government instead is crowding out financial intermediation.
*You could say that the government’s risky, long-term assets are future tax revenues. But it is not the case that governments are raising money in order to invest in projects that will lead to increased future tax revenues. They are mostly making transfer
payments.
4. In fact, a lot of financial activity is associated with funding the government. So it could be that what I think of financial intermediation has declined even though financial activity has increased.
5. In other words, perhaps the financial sector is growing but not increasing its holding of risky, long-term assets. If so, this could be due to many things, but I think that the political assault on banks (regulations, “settlements” with prosecutors) comes to the top of my mind. Politicians bash the financial sector as being unproductive even as they increase the intensity of their utilization of the financial sector to channel money toward political ends.
6. The interest rate on safe assets is not a good measure of where interest rates are relative to some Wicksellian natural rate. In other words, don’t worry about the interest rate on safe assets being too low. Worry about the interest rate on a typical risky, long-term asset being too high relative to its natural rate. But changes in any given market interest rate on long-term, risky assets get confounded with changes in expected inflation and in risk perception.