Category Archives: markets

DeLong-Term Interest Rates

Posted on by

Brad DeLong writes,

when I look at the sub-zero 5-Year TIP and at the 0.6%/year 6-10 Year TIP I read that as Ms Market decoupling its inflation expectations from its real growth and real interest rate expectations, and not in a good way.

Read the whole thing. Pointer from Mark Thoma. My thoughts:

1. To me, the biggest macroeconomic/financial mystery today is the low ten-year real interest rate.

2. Ten years ago, the biggest macroeconomic/financial mystery to me was the low ten-year real interest rate. That, combined with loose mortgage credit standards, fed a housing bubble.

3, Why aren’t corporations borrowing like crazy? Issuing long-term bonds to buy back stock would seem akin to owning a money-printing press. (And yes, this is an argument that stocks are not overvalued.)

4. One possible story is that savers in China and Russia do not trust their domestic financial markets, so that their savings are pouring into the U.S., and from here spilling over to western Europe. But that would presumably make it expensive for Chinese and Russian borrowers. Is that the case?

Ralph Musgrave on 100 percent reserve banking

Posted on by

He writes,

if it is thought that a 25% or so capital ratio really DOES MAKE banks entirely safe, then there is no difference between the risk run by bank shareholders and depositors. That is, shareholders and depositors essentially become the same thing. And that is what full reserve consists of: it is a system where only shareholders fund lending entities / banks

Pointer from John Cochrane.

The way I think of this is that there are several ways that people take positions in bank assets. You can be an insured depositor. You can be an uninsured creditor. You can be a shareholder. And you can be a taxpayer who sometimes takes part in bailouts.

As the bank’s capital requirements go up, some of the uninsured creditors and insured depositors have to be induced to become shareholders and/or the bank has to hold fewer assets. Unless the bank is able to offset these effects by taking on higher risk, this will reduce the value of the subsidy provided by taxpayers.

It is my view that relatively few people want to hold mutual funds that invest in risky projects. They would prefer instead to be insured depositors. They probably are willing to collectively provide insurance. However, in practice, the government ends up eager to bail out not only insured depositors but uninsured creditors and often shareholders as well.

The Fed and Money Markets

Posted on by

Jon Hilsenrath writes,

Because banks have so much cash, the fed-funds market where they tap reserves experiences very little day-to-day trading. One New York Fed study shows daily trading volume in the market has contracted from an already-thin $200 billion before the financial crisis to nearly $50 billion. Moreover, traditional U.S. commercial banks are especially inactive. The most active players are government sponsored Federal Home Loan Banks and foreign banks.

“The fed funds market is but a shadow of what it was prior to the crisis,” Raymond Stone, an analyst at Stone McCarthy Research, said in a note to clients Wednesday. “It is no longer clear that the funds rate is the key determining factor of the behavior of short-term interest rates.”

Read the whole thing.

The Courage to Desist

Posted on by

Robert Shiller writes,

I wrote with some concern about the high ratio in this space a little over a year ago, when it stood at around 23, far above its 20th-century average of 15.21. (CAPE stands for cyclically adjusted price-earnings.) Now it is above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.

Pointer from Mark Thoma. Here is my take:

1. I think investors look at the zero interest rate on short-term money-market instruments and say, “I can’t possibly settle for that.” As they reach for yield, long-term interest rates fall.

2. At low interest rates, long-term bonds become very speculative investments. A small decline in market interest rates, and the market value of your bonds shoots up. Conversely, it takes only a small increase in market interest rates to create a negative return on a bond mutual fund (holding the actual bond rather than a bond fund avoids marking your losses to market, but on an opportunity-cost basis, an actual bond still gives you a negative return in a rising-rate environment.)

3. If Shiller is right and stocks are over-priced, your best strategy may be to sit on those low-yielding short-term instruments and wait for prices to come down. This is hard to do. It is my strategy in fantasy baseball auctions–watch the first 50 players get chosen at prices that I think are too high, and then wait for prices to come down. If prices are too high early, this has to work, because the fixed budgets given to owners mean that prices have to come down eventually. I am not saying you win a fantasy league that way, because luck tends to dominate any advantage you might appear to gain in the auction. But if you wait, you can get good value cheap. I think that we are in that type of stock market.

4. Having said that, we know that for every credible theory that stocks are over-priced there must be an equal and opposite theory that they are under-priced. (See Brad DeLong’s response to Shiller. See also this comment that Tyler Cowen found on his blog) Otherwise, prices would not be as high as they are. The thing is, most of the movement in stock returns is due to changes in the taste/toleranace for risk, and there is no guarantee that this parameter will head toward one particular value.

Related: James Hamilton on the San Diego public employee pension fund reaching for yield.

The Problem of Monopoly

Posted on by

Tim Harford writes,

No policy can guarantee innovation, financial stability, sharper focus on social problems, healthier democracies, higher quality and lower prices. But assertive competition policy would improve our odds, whether through helping consumers to make empowered choices, splitting up large corporations or blocking megamergers. Such structural approaches are more effective than looking over the shoulders of giant corporations and nagging them; they should be a trusted tool of government rather than a last resort.

Pointer from Mark Thoma.

Unfortunately, I can imagine “assertive competition policy” creating more monopoly power. The problem is that government is by far the most secure monopolist. The more “assertive” is government, the more assertive is this monopolist. One can hope that this monopoly power will be exercised wisely. I, for example, hope that the government could break up big banks wisely.

But the public choice of the matter, as Harford points out, is not reliable.

Good Sentences from Timothy Taylor

Posted on by

He writes,

I fear that most people have reacted to Dodd-Frank as a sort of Rorschach test where the word “financial regulation” are flashed in front of your eyes. If you look at those words and react by saying “we need more financial regulation,” then you are a Dodd-Frank fan. If you look at those words and shudder, you are a Dodd-Frank opponent. odd-Frank allowed a bunch of pro-regulation Congressmen to take a bow by passing it, and a bunch of anti-regulation Congressment to take a bow by opposing it. But for those of who try to live our lives as radical moderates, the issue isn’t to be generically in favor of regulation or generically against it, but to try to look at actual regulations and whether they are well-conceived. In that task, the Dodd-Frank legislation mostly used fairly generic language of good intentions, ducked hard decisions, and handed off the hot potato of how financial regulation should actually be written to others.

He points to the fact that many of the rules called for by Dodd-Frank had yet to be written four years after the law passed. He also notes,

A completed rule doesn’t mean that business has yet figured out how to actually comply with the rule. For example, there is a completed rule which requires that banking organizations with over $50 billion in assets write a “living will,” which is a set of plans that would specify how their business would be contracted and then shut down, without a need for government assistance, if that situation arose in a future financial crisis. The 11 banks wrote up their living wills, and the Federal Reserve and the Federal Deposit Insurance Corporation rejected the plans as inadequate. They wrote up second set of living wills, and a few days ago, the Federal Reserve and FDIC again rejected the plans as inadequate.

I have said many times that if the big banks are not going to be contracted and shut down now, then it is not going to happen during a crisis.

Too Correlated to Fail

Posted on by

V.V. Chari and Christopher Phelan write,

the anticipation of bailouts creates incentives for banks to herd in the sense of making similar investments. This herding behavior makes bailouts more likely and potential crises more severe. Analyses of bailouts and moral hazard problems that focus exclusively on bank size are therefore misguided in our view, and the policy conclusion that limits on bank size can effectively solve moral hazard problems is unwarranted.

Pointer from James Pethokoukis. My argument against big banks is not that they are more prone to moral hazard. It is that they are better able to exploit political power to obtain regulatory leniency ex ante and bailouts ex post.

What Banks Do

Posted on by

Samuel G. Hanson, Andrei Shleifer, Jeremy C. Stein, and Robert W. Vishny write,

the specialness of traditional banks comes from combining stable money creation on the liability side with assets that have relatively safe long-run cash flows but possibly volatile market values and limited liquidity. To make this business model work, banks limit their leverage, rely on deposit insurance, but also hold loans and securities that are relatively safe in the long run even if they are vulnerable to short-term price fluctuations.

…In a cross-section of types of financial intermediaries, intermediaries with stickier liabilities hold less liquid assets. Banks, in particular, appears as having extremely sticky liabilities as well as very illiquid assets…act as a bridge between households who want to put their money in a safe place they do not need to watch, and securities markets where even assets with relatively low fundamental risk can have volatile market prices.

My mantra is that the nonfinancial sector wants to hold riskless, short-term assets and to issue risky, long-term liabilities. The financial sector accommodates by doing the opposite. Government is tempted to back the financial sector with insurance and guarantees, and this in turn can cause the financial sector to become larger and riskier than it would be otherwise.

Banks as Secret Keepers

Posted on by

Gary Gorton and co-authors write,

banks will choose to create private money by investing in projects that are less risky and more opaque; opacity makes the cost of information acquisition higher. Note that the implied allocation of projects between banks and financial markets does not rely on any comparative advantage that banks have in evaluating and overseeing its assets.

I like the basic picture of financial intermediaries as holding information-rich assets and issuing low-information liabilities. This is similar to George Gilder channeling Arnold Kling.

I am not convinced that banks’ comparative advantage comes from corporate debt being more opaque than corporate equity. I suspect that what differentiates 20th-century banks from other financial intermediaries is their relationship to the government.

Securitization and Government Backing

Posted on by

Stephen G. Cecchetti and Kermit L. Schoenholtz write,

That is, only 18% of U.S. securitization – primarily auto loans and credit card debt – are free from government guarantees! Even at the peak of private-sector securitization in mid-2007 – before the financial crisis grew intense – the government-backed share exceeded 60%.

To put these numbers into perspective, we can look at another part of the U.S. financial system: insured bank deposits. You may be surprised to learn that (again, as of end-March 2014) only $6,094 billion out of $9,922 billion in bank deposits are insured. That is, 61% of bank deposits are government backed (see chart below) versus 82% of securitizations.

Pointer from Mark Thoma.

In my view, the political economy of banking works like this:

1. Financial intermediaries want to issue risk-free, short-term liabilities backed by long-term, risky assets.

2. Governments want to allocate credit, both to their own borrowing and to favored constituents.

To accomplish (2), governments guarantee the liabilities of particular financial intermediaries. This in turn allows those intermediaries to accomplish (1).

When government creates agencies, such as the Fed, the FDIC, it does so in the name of financial stability. But you should think of these agencies as tools for credit allocation, not as tools that actually stabilize the financial system.