Category Archives: markets

Negative interest rates

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The WSJ reported,

there is more than $15 trillion in government debt around the world with negative yields. That means, essentially, that savers holding these bonds are paying the government to store their money.

I find this totally baffling. Why wouldn’t you rent a safe deposit box, exchange your government bonds for currency, and store the currency in the safe deposit box?

Actually, you should just invest in securities issued by the private sector, which offer higher returns and in some cases lower risk. Government debt is only risk-free as long as the consensual hallucination makes it so.

Social security, annuities, and revealed preference

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A commenter writes,

This seems like pretty strong evidence that Social Security benefits — a mandatory government annuity — are far too generous. If that weren’t so, then seniors would supplement Social Security by purchasing additional annuities from their savings. Apparently, the vast majority, if given the choice, would rather have less Social Security and keep the tax savings unannuitized.

If you believe that the annuities market works and that households are rational in choosing not to use them, then this analysis is correct. Instead, some economists believe that the annuity market fails because people have too much private information about their own longevity (of course, if that is true, then the life insurance market also should fail). And, as the original post pointed out, many economists believe that households only fail to annuitize because of irrationality. My views to the contrary are not widely shared.

The annuities puzzle

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Timothy Taylor writes,

Among economists, it’s sometimes known as the “annuities puzzle”: Why don’t people buy annuities as frequently as one might expect?

I think that the puzzle is why economists insist that annuities are a terrific idea.

The idea of an annuity is this:

1. Suppose that at age 65, you have $500 K and you retire.

2. If you are going to live to age 75, you can afford to spend a lot of money every year. But if you are going to live to be 100, you can afford much less.

3. If you trade your $500 K for an annuity, you can then spend the amount appropriate for an average life expectancy, regardless of how long you actually live. If you don’t live very long, the company that sells you the annuity wins. If you live longer than the average person, then the company loses.

Economists think that old people who do not annuitize their wealth are dumb. I decided a long time ago that it is the economists who are dumb.

Old people face many risks other than the risk of living longer than average. Many risks give rise to needing to spend a lot of money at once. You might develop an illness that is treatable but very expensive to deal with. You might find that you have grandchildren living in a different city, and while you are still relatively healthy you want to visit a lot or even pick up and move there.

The risk of excess longevity is one that you can transfer to your children. That is, you might plan to leave $250 K to your children if you die at age 85, but you leave them nothing if you die at age 95.

Off topic: Fantasy Baseball

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This is an annual tradition at askblog. If you want to see previous posts, type “fantasy baseball” in the search box. If you wish to comment on this post, please note that your points might be addressed in some of those earlier posts.

Let me define a reliable player as one who has performed at a high level for the past three seasons.

As a trend, I see a decline in the availability of reliable players of four types:

1. Catchers. Does that mean you should aim to get one of the most sought-after catchers anyway? Is it worth carrying an extra catcher to increase playing time at that position, at the risk of wasting a roster spot on a player who will contribute very little?

2. Slugging first basemen. I am inclined to favor paying a premium for one of the remaining reliable sluggers at that position.

3. Closers. Whether intentionally or not, most fantasy owners are going to be picking up their closers during the season rather than ahead of time.

4. Starting pitchers who account for 200 innings. [NOTE: after I wrote this post but before it appeared, a number of “professional” fantasy baseball pundits commented on this recent development.]

All of these trends are ongoing. But the one that has really snuck up on me is (4). It seems as though not that long ago 200-inning starters were plentiful. And among relievers, teams seem to be spreading the innings out over more pitchers, with fewer innings per reliever.

It used to be that if your league had a ceiling on the total number of innings that your pitchers could accumulate, you had to be careful about not going over that limit. Now, unless the league lowers its ceiling (unlikely), you can probably ignore it. Your challenge will be finding innings, not staying within limits.

I used to think that in a Yahoo league the innings ceiling meant that the ideal pitching staff had 6 relievers and just 4 or 5 starters. Now, that might cost you a lot of points in strikeouts because you don’t accumulate enough innings. It might be better to have 6 starters and 5 relievers, but that approach probably costs points in the ratio categories. I haven’t really decided how to approach pitching in light of the latest trends.

Finally, I will re-iterate that I think that real baseball would be more fun to watch if there were more balls in play, with fewer strikeouts and home runs. My suggestion would be to use a slightly larger and less lively baseball.

Financial innovation is a warning sign

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Raghuram Rajan says,

I think you have to be a little careful. Every time you stop something, it’ll show up somewhere else if there’s a need for it. And is it better that it be in an entity that you regulate and you monitor reasonably closely? Or in an entity that you don’t regulate?

To the extent the entity you don’t regulate can absorb those losses, that’s not a bad thing. But to the extent that it cannot, and it all comes back into the system via these interconnected markets, you’re no better off. In fact, you’re worse off because you’re blindsided by the risks migrating to places you don’t look at.

That is from a conversation with Tyler Cowen.

In what I call the chess game of financial regulation, every regulatory move leads to a counter-move by the financial sector. Many regulatory ideas, including the idea that Rajan wisely scorns of not allowing banks to hold risky assets (requiring (narrow banking), are unwise if you look ahead one move.

I think that one way that you can tell you have made a bad move in the regulatory chess game is when you observe extensive financial innovation. It seems to me that a lot of innovation reflects attempts to take advantage of opportunities created by regulatory mistakes. Risks that you thought you were controlling are in fact changing shape or migrating.

The correct response is not to outlaw innovation. That just leads to another counter-move. The correct response when you see extensive financial innovation is to go back and understand how your regulations encourage that innovation and come up with ways to attenuate those incentives.

Cognitive failure and the financial crisis

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My review of A Crisis of Beliefs, by Nicola Gennaioli and Andrei Shleifer.

GS directly attack the hypothesis of “rational expectations,” which has dominated the economics profession for forty years. The rational-expectations doctrine holds that when economic actors make decisions that require forecasts, they make optimal use of the available information. They are not guilty of predictable irrationality.

. . .Think of a forecast as employing two types of information about a variable being forecast. One is a “base rate,” which is a very generic property of the variable. The other is “recent information” about that variable or about factors that could affect that variable. Recency-biased forecasting over-weights the recent information and under-weights the base rate.

Nobel Symposium on Banking

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John Cochrane writes,

I attended the Nobel Symposium on Money and Banking in May

Diamond and Rajan say that debt is necessary, because it disciplines managers. Debt holders are constantly monitoring management, and running at the first sign of trouble. In direct contrast, Gorton’s debt holders are paying no attention at all most of the time, and then dump debt out of blind fear.

One weak spot of the conference was that everyone was being too polite. Well, everyone but me. Here we have a glaring difference in views. Which is right? I asked the question.

Rajan’s response was very informative: Yes, most retail debt customers are “information insensitive,” and likely even most corporate treasuries using repo as a cash substitute. But among the New York banks who are funding each other very short term, yes indeed they are paying a lot of attention and will run when they see trouble. So the “discipline” story is narrow, for this class of lender and borrower. That seemed to me a nice reconciliation of dramatically opposing views that has troubled me for some time.

I have watched several videos from the event, including the one where the exchange between Cochrane and Rajan occurs.

Cochrane asked another question, which I don’t think anyone answered. In some sense, I think he was asking how there can be a shortage of liquid assets, given how easy it is to trade assets, including stock mutual funds. My thought is that if this phenomenon of a shortage of liquid assets is real (or was during the financial crisis of 2008), it is because of the enormous balance sheets that some of the financial institutions had assembled on very little equity, leaving them with tiny margins of error.

On the general topic of how financial intermediation operates in the economy, I keep saying that we need to appreciate the layering that takes place. Finance is a complex ecosystem, with many niches. Beware of models that simplify it. I would wager that many of the conference participants could not have been able, as of 2005, to explain the nature and significance of repo haircuts, super-senior CDO tranches, or credit default swaps on mortgage securities.

I think that Doug Diamond and Gary Gorton are a bit too much invested in the issue of runs on short-term debt. And from Cochrane’s second post on the conference, I gather that Ben Bernanke is the most invested of all.

Instead, I preferred the speakers, like Alan Taylor, who emphasized dramatic changes in asset values, rather than liquidity. Yes, a sort of run took place in 2008 in the inter-bank lending market, and that run really got the attention of Wall Street and policy makers. But the big build-up in mortgage debt and house prices, followed by a crash, was not a liquidity crisis.

Do you remember my post on the Eric Weinstein interview? One of his glib, provocative comments was

The so-called great moderation that was pushed by Alan Greenspan, Timothy Geithner, and others was in fact a kind of madness, and the 2008 crisis represented a rare break in the insanity, where the market suddenly woke up to see what was actually going on.

I would like to have seen some of the conferees respond to that remark.

A question about monetary systems

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From a reader:

When in real-world, human-designed systems, is fiat money an example of theoretically easy to fix and cryptocurrencies an example of theoretically hard to break?

The reader is referring to my notion of “easy to fix” vs. “hard to break” as a way to think about financial regulation. Permitting, and even encouraging, concentration of financial markets and then regulating the resulting giant firms as carefully as possible is an attempt to make the key firms hard to break. But when one of those firms does fail, the results are catastrophic. Instead, encouraging a wide variety of financial firms, with no single firm vitally important to the system, is an attempt to allow the failure of a single firm to be easy to fix, as other firms take over the failed firm’s functions. Another way to make the system easy to fix is to encourage a low ratio of debt to equity, since equity degrades smoothly while debt default is more of a shock.

In the case of money, I would think that the “easy to fix” approach would be to allow for competing currencies. If one currency gets corrupted, then people can switch to using another one. Having a single government currency is the hard-to-break approach, since the government can insist that its currency is legal tender, using it to pay for goods and services and accepting it as payment of taxes. Of course, when a government currency “breaks” due to hyperinflation, it breaks catastrophically.

I am still a skeptic about crypto-currencies, for the following reasons.

1. They seem to operate like chain letters, as I have written.

2. The most important “use case” for crypto-currencies appears to be for illegal transactions. This means that many of the people who employ crypto-currencies do not feel bound by mainstream social norms. That is not a good crowd to run with.

Can online tracking beat credit scoring?

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Tobias Berg and others have an abstract that says,

We analyze the information content of the digital footprint – information that people leave online simply by accessing or registering on a website – for predicting consumer default. Using more than 250,000 observations, we show that even simple, easily accessible variables from the digital footprint equal or exceed the information content of credit bureau (FICO) scores. Furthermore, the discriminatory power for unscorable customers is very similar to that of scorable customers. Our results have potentially wide implications for financial intermediaries’ business models, for access to credit for the unbanked, and for the behavior of consumers, firms, and regulators in the digital sphere.

This is interesting for many reasons.

Were mortgage securities badly mis-rated?

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Juan Ospina and Harald Uhlig write,

AAA securities did ok: on average, their total cumulated losses up to 2013 are 2.3 percent. . .Losses for other rating segments were substantially higher, e.g. reaching above 50 percent for non-investment grade bonds. . .

Cumulative losses of 2.2% of principal on AAA-rated securities surely is a large amount, given that rating. Such losses after six years may be expected for, say, BBB securities, and not for AAA securities. AAA securities are meant to be safe securities, and losses should be extremely unlikely. From that vantage point, an average 2.2% loss rate is certainly anything but “ok”. We have chosen this label not so much in comparison to what one ought to expect from a AAA-rated security, but rather in comparison to the conventional narrative regarding the financial crisis, which would lead one to believe that these losses had been far larger. Ultimately, of course, different judgements can be rendered from different vantage points: our main goal here is to simply summarize the facts.

Authors’ emphasis. They also say,

these facts provide challenge the conventional narrative, that improper ratings of RMBS were a major factor in the financial crisis of 2008.

I object to this conclusion. The capital requirements for the securities depended on the ratings. Because of the AAA ratings, the capital requirement was less than what the loss percentage turned out to be.

As I see it, the facts in the paper support the conventional narrative. If the securities had been correctly rated, then there would have been no financial crisis. If the securities had been properly assigned BBB ratings, or any ratings below AA, banks could not have bought the securities without having at least five times the amount of capital that was required for AAA.

The charitable interpretation is that the authors do not appreciate the significance of capital regulations. The uncharitable interpretation is that they are trolls.