Category Archives: markets

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.

Government’s Cost of Capital

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Deborah Lucas writes,

Collectively, government investment and insurance operations dwarf those of the largest commercial banks. The size and scope of activities have grown over the last several decades to include the explicit and implicit guarantees of too-big-to-fail private and international financial institutions and non-financial firms, direct and guaranteed loans, and more traditional insurance and guarantee programmes such as for bank deposits.

She adds,

a universal mistake is that governments take their cost of capital to be their borrowing rate, irrespective of the risk of the investment under consideration.

Pointer from Mark Thoma.

Ever since the Basel Capital accords were adopted, the government in effect dictated that private bank loans must carry a risk premium over government bonds. Along with that, you have the mistake that Lucas identifies, which is the government evaluating its own loan guarantees and investment projects at a risk premium of zero.

Here is where this leads: if a private firm has to earn 8 percent interest to undertake a risky construction project, but the government can borrow at 2 percent to undertake that same project, then if that project is undertaken at all, it will be undertaken by the government rather than by the private sector. Thus, the system is rigged to put government in charge of where investment takes place.

We end up with something close to the worst of all worlds. Owners and managers of nominally private financial institutions earn outstanding returns. But we have capital allocation that closely approximates what would result from a socialist system.

Macro Theory and Macro Practice

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John Cochrane writes,

Perhaps academic research ran off the rails for 40 years producing nothing of value. Social sciences can do that. Perhaps our policy makers are stuck with simple stories they learned as undergraduates; and, as has happened countless times before, new ideas will percolate up when the generation trained in the 1980s makes their way to [the] top of policy circles.

I was with him up to the semicolon. But Fischer and his students made it to the top of policy circles some time ago. My sense is that their policy decisions are not driven by the models that they taught graduate students. They are going on the basis of intuition, and the intuition is in turn shaped more by the undergraduate IS/LM story than by anything else.

My own view is that the tools that they are playing with have very little impact on financial markets or the economy. Meanwhile, the bank regulations, both formal rules and informal slaps on the wrist, play a huge rule in directing bank capital toward government bonds and away from commercial loans. And that capital allocation has real consequences.

I Do Not Understand SPOE

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It stands for Single Point of Entry, and I wrote about it here. Peter Wallison and Paul Kupiec say that it won’t work.

Our analysis of the largest banks shows that most of these institutions could fail without causing their parent BHCs to be in default of danger of default. For the parent BHCs to be in danger of default, they would have to experience massive losses simultaneously in many or all of their bank and nonbank subsidiaries.

…For BHCs that will clearly become insolvent if their bank subsidiary fails, the SPOE can be invoked, but the mechanism it uses to prevent financial market disruptions is an extension of the government safety net…It will protect all large bank 39 creditors from losses by transferring bank losses to the parent BHC’s creditors and potentially to unaffiliated institutions that will be assessed to repay the OLF. Here, the SPOE strategy—because it promises to bail out failing large banks— reinforces the TBTF problem at the largestbanking institutions.

Think of two cases:

1. A bank subsidiary is in bad shape, but the overall holding company has positive value.
2. The holding company is insolvent.

I thought, perhaps naively, that the SPOE approach is not worth anything in case (2), but that it was supposed to apply to case (1).

However, Wallison and Kupiec say that the FDIC lacks the legal authority to implement SPOE in case (1). Their argument is that the FDIC was given a mandate to come up with a way to liquidate a failed bank, and SPOE is a way to recapitalize a failed bank, using the net worth of the holding company.

I think that the larger problem is the one I raised in my earlier post. I think that you tend to jump straight from an apparently solvent bank inside a solvent holding company to case (2) without stopping at case (1).

Perhaps I will gain more understanding of SPOE by watching the video of this event.

Problems with Spectrum Property Rights

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Dale Hatfield and Phil Weiser write,

For a band like that traditionally used for AM broadcasting, it seems impractical, if not impossible, to provide licenses with anything close to certainty in terms of interference protection…a station in an adjacent–or more remote–geographic area could seek damages or injunctive relief based on a series of natural conditions that happen only infrequently…the realities of radio wave propagation in this region of the spectrum simply do not lend themselves to clear and enforceable boundaries for the geographic are dimension of the spectrum resource.

The authors do point out that the properties of the PCS band (the frequency range used by cell phones) are less problematic for a property-rights regime. Moreover,

the commonality of interest among cellular and PCS providers reflects a shared understanding that there is a mutual threat of interference and a mutual benefit to cooperation…Consequently, even though the reality of the spectrum property right is “muddy,” the affected parties are still able to agree on mutually beneficial accomodations.

How to Regulate Comcast and Verizon FIOS

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Brock Cusick writes,

Require utility companies to lease space on their rights-of-way to at least four ISPs, at cost.

Call it infrastructure neutrality, or open leasing. This proposal should independently provide most of the benefits in changing the Internet companies’ status to “telecommunications service,” as mere competition between local firms will discourage them from withholding any service or level of service offered by their local competitors. This competition would thus provide the consumer protections that voters are looking for, while allowing Internet companies to remain more lightly regulated (and thus more innovative) “information services.”

This sounds like a terrific idea to me. Competition is not a perfect regulator, but it is a better regulator than the FCC.

Uber’s Most Important Customers

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Emily Badger of the WAPO wonkblog reports that Uber is being used heavily in the DC area by politicians and their staffs. Pointer from Mark J. Perry, who comments,

Here’s my economic forecast for the transportation industry: Expect continued and very strong hurricane-strength Schumpeterian gales of creative destruction, with a high likelihood of market disruption for Big Taxi

Or, as Clubber Lang would put it, pain.

Annuities

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Timothy Taylor writes,

Annuities may turn out to be one of those products that people don’t like to buy, but after they have taken the plunge, they are glad that they brought. One can imagine an option where some degree of annuitization of wealth could be built into 401(k) and IRA accounts. For example, it might be that the default option is that 30% of what goes into your 401(k) or IRA goes to a regular annuity that kicks in when you retire, another 20% goes to a longevity annuity that kicks in at age 80, and the other 50% is treated like a current retirement account, where you can access the money pretty much as you desire after retirement. If you wanted to alter those defaults, you could do so. But experience teaches that many people would stick with the default options, just out of sheer inertia–and that many of them would be glad to have some additional annuity income after retirement.

The theory of an annuity is that you insure against the risk of outliving your money. Economists tend to be big fans of annuities, and they view the reluctance of people to buy annuities as a behavioral economics puzzle.

I actually think that it is perfectly rational to shun annuities. My reasons:

1. You are charged more than the actuarially fair premium. Part of that is overhead and profit, and maybe part of that is adverse selection–the insurance company has good reason to fear that you are in better health than someone else your age. In any event, the result is that an annuity reduces your consumption possibilities by as much as would be the case if you over-estimated your lifespan by several years and budgeted accordingly.

2. Taylor notes that

people fear that they might need to make a large expense in the future, perhaps for health care or to help a family member, and if they have annuitized a large share of their retirement wealth they would lose that flexibility.

This is a very reasonable fear. An annuity is risk-reducing if the only risk you face is additional longevity. In fact, other risks may be more serious. You could easily find yourself needing to take out a loan if your savings are tied up in an annuity and your spouse requires a home health aide. (Speaking of which, long-term care insurance is something that I think does make sense, but you should buy it to get through age 75 and then self-insure thereafter).

3. It is reasonable to think in terms of declining consumer expenditures as you age. Will I really spend as much at age 90 as I spend at age 60? Medicare will cover many health expenses, and if I need to spend more of my own money on health care it is likely that I will have much less interest in vacation travel or buying a new car.

4. It is possible to substitute inter-generational insurance. If my mother-in-law had outlived her money, we could have supported her. From our family’s perspective, self-insuring in this way was cheaper than buying an annuity.