Category Archives: markets

Greenspan and Financial Regulation

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In his new biography of Alan Greenspan, Sebastian Mallaby says some things I agree with, but he also rides a number of hobby horses that I take issue with.

Where I agree:

1. I agree that it is hard to achieve financial soundness through regulation. Financial markets are too flexible and adaptive to prevent institutions from gaming the system. If you want to see that point made at greater length, read my essay The Chess Game of Financial Regulation.

2. From 1970 to 1990, we got rid of interest rate ceilings on deposits, restrictions on bank branches, and futile attempts to distinguish commercial banking from investment banking. The process was long and grueling, with lobbyists engaged in furious rent-seeking battles all along the way. What Mallaby points out, and that I hadn’t considered, is that when the dust settled, we had a more rational, integrated competitive financial sector, but we had the same archaic, fragmented regulatory structure. So we had a separate regulator for thrifts, even though institutions with thrift charters were doing things that the thrift regulator had never seen before. The same with commercial banks, insurance companies, and investment banks. It was a regulatory structure that was set up to fail.

Where I disagree:

1. Mallaby buys into the theory that Brooksley Born should have gotten her way and had all derivatives trading moved to exchanges. I disagree. It is possible to trade derivative contracts in Treasury bonds and bills on exchanges, because the underlying securities are generic and liquid. Traders can benchmark prices and cheaply engage in arbitrage transactions. What AIG and others were doing involved creating a separate credit default swap for each security. In effect, Born would have been asking the exchanges to set up hundreds of different markets, most of which would have been illiquid in terms of the underlying securities.

If Greenspan was reluctant to wade in with financial regulatory proposals, that may have been because he thought that the issues were over his head. In fact, that may be what I most respect about Greenspan. Regulators generally do not see their own limitations. Brooksley Born would be a prime example of a regulator willing to take on a task while lacking sufficient knowledge.

2. Although I agree with Mallaby on the challenges of reining in financial excesses using regulation, he takes the view that monetary policy can and should be used to prick bubbles. He writes as if a major lesson, perhaps even the main lesson, of the financial crisis is that central banks should raise interest rates to pop bubbles. He writes as if this is obvious, when in fact very few economists see it that way, even now. In fact, Timothy Taylor recently pointed to an IMF study saying that global debt is at an all-time high, and only on the extreme right are there economists suggesting that monetary policy needs to be tightened. The other day, I got to attend a talk by Mallaby and I posed this issue. He agreed that his views were not widely shared by the mainstream (the people who complain about low interest rates as a threat to financial stability tend to be on the far right), but he said that one of the perks of writing the book was putting his opinions out there. Fair enough.

3. Mallaby blames the crisis in part on inflation targeting. He sees this policy as the mindless result of Fed officials’ not-entirely-rational preference for low, stable inflation. He could have pointed out that it was the overwhelming consensus of academic economists of the 1980s and 1990s that low, stable inflation was exactly the right objective for monetary policy. They believed that demand-driven recessions were the result of the public’s errors in expectations about inflation. Get rid of those errors by stabilizing inflation, so the thinking went, and you would eliminate recessions. This was known as the so-called Divine Coincidence, because it meant that the Fed could just focus on keeping the rate of inflation steady and let full employment take care of itself.

4. Mallaby takes a cheap shot at the Basel II approach to risk-based capital requirements, in which regulators were to use a bank’s model of its risks to gauge the amount of capital it should have. He compares this to giving a teenager the keys to the Mercedes. (a) I think that Greenspan had retired before Basel II was widely implemented. Most banks, perhaps even all banks, were still on Basel I, which used risk buckets. (b) Rather than being silly, using models was a good idea. The Basel I approach treated a bank that hedged its risks and a bank that went unhedged as identical. Basel I had no coherent way of dealing with derivatives or securities with embedded options, such as mortgage-backed securities. You need to use a model to solve both of those problems. And because every bank codes its portfolio differently, it is impractical to try to input the data into any model other than the one that the bank itself uses. Since you cannot try other models on the data, the best you can do is audit the way the bank goes about its modeling process.

It’s not a perfect way to regulate, but there is no obviously better way. At his talk, Mallaby emphasized that he did not think that any regulatory policy could truly rein in risk-taking. This gets back to point 1 under “Where I agree.”

Grumpy About Stock Market Trading Volume

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John Cochrane writes,

We know what this huge volume of trading is about. It’s about information, not preference shocks. Information seems to need trades to percolate into prices. We just don’t understand why.

…If you ask a high speed trader about signals about liquidating dividends, they will give you a blank stare. 99% of what they do is exactly inferring information from prices — not just the level of the price but its history, the history of quotes, volumes, and other data. This is the mechanism we need to understand.

I would be so desperate as to posit a taste for trading, aka Adam Smith’s “propensity to truck and barter.” I would actually want to examine what psychological mechanisms make investment managers decide that the portfolio mix that they held one second ago is not the right mix now.

Timothy Taylor on Shadow Banking

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He writes,

if you still think banks are the core representative institutions in the financial system of high-income economies, you are a few decades out of date. If you are concerned about the dangers of financial sector risks cartwheeling into the real economy, you need to think about the shadow banking sector. Muscatov and Perez point out that while banking regulators do try to think about risks from the shadow banking sector, “Still, many areas of NBI remain obscured from regulators’ view, and not all NBI is subject to supervision.”

NBI is “non-bank intermediation.” Read the whole post.

Freddie and Fannie are non=bank intermediaries. Back in the late 1980s and the 1990s, they drove traditional lending institutions out of a large segment of the mortgage market. They did not do this through inherent advantages of scale or business model. They did it because they enjoyed small advantages from a regulatory standpoint, including lower capital requirements.

The moral of the story is that the “better” job you do of regulating banks, the more room you leave for other financial intermediaries to take over niches. I do not think that you can get financial regulation to achieve the goal of stabilizing the financial system. I think that it just winds up being a tool for allocating credit to politically preferred uses.

The Trust Variable

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Noah Smith worries about the way economists invoke trust.

So although trust, in some form, is probably important in our economic lives, we don’t yet have the tools to measure it, we don’t know exactly how it’s important, and we definitely don’t know how to control or alter a society’s level of trust. Until we understand trust a lot better, it would be a mistake to rely on it too much when trying to explain the world around us.

Read the entire essay. I agree with his qualifications, but I would rephrase his conclusion. It sounds like he could be saying that if something is hard to measure and control, then look for other variables to explain and control the world. Instead, I would say that one should be humble about one’s ability to explain and control the world.

The first step in getting a better handle on trust is to define it well. As Smith indicates, the standard practice is to measure people’s answers to very broad survey questions (“How strongly do you agree with the statement that most people can be trusted?”) That is very unsatisfying.

When I worked at Freddie Mac, we were subjected to given some management training of the “teambuilding” sort, one of the goals of which was to improve trust within the organization. This lead us to think about trust, and one insight that some of us arrived at was that trust involves more than just a belief that someone else is well motivated. Often, trust breaks down because we lose confidence in other people’s competence. Even if you have very general views about other people’s motives, you are likely to assess other people’s competence relative to their specific occupations.

This factor of competence assessment is embedded in my views of the role of finance in economic fluctuations. In Specialization and Trade, I argue that financial intermediation can expand when people trust financial intermediaries. In particular, as we experience financial intermediaries meeting their obligations, we gain confidence in their competence (as well as in their motivation). This leads to more trust, more expansion of financial intermediation, and so on, until, in Minsky fashion, the intermediaries are engaged in dangerous activities, and we get a collapse, including a collapse of trust.

So trust is not “social capital” that you want to see increased indefinitely. At least in the case of financial intermediation, it is best for trust to be at some intermediate level. Not so low that relatively low-risk, high-return investment opportunities are missed. But not so high that you get an excess of relatively high-risk, low-return projects (e.g., sub-prime mortgage loans) that are funded.

Who Needs Liquidity?

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Lynn Stout writes,

Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”

Pointer from Mark Thoma.

I was appalled by this paragraph (and by others in her essay), for a number of reasons.

1. It appears on a site calling itself “pro-market.” The conceit is that they are battling crony capitalism. However, the essay does not assert, much less establish, any connection between cronyism and trading volume.

2. Note that since 1976, some activities have been affected by the advent of a device known as the computer chip. The fact that we have nearly 10 times as much trading as then should be no shock. The cost of trading has likely fallen by way more than 10 times (feel free to compare brokerage charges adjusted for inflation). Who is Lynn Stout to suggest that the price elasticity of trading ought to be zero?

3. I would appreciate it if Lynn Stout could tell us how she thinks we should measure the benefit of liquidity. I believe that any thoughtful economist would say that this is a difficult issue. I have said that as individuals and nonfinancial firms we wish to hold liquid, riskless assets and issue risky, illiquid liabilities. Financial firms do the opposite. I am quite sure that this produces real benefits. But I would be hard pressed to arrive at even a conceptual approach to quantifying those benefits.

I believe that there is cronyism embedded in the relationship between Wall Street and Washington. But that does not justify pure demagogic bashing of investment bankers.

Finance, Fragile, and Anti-Fragile

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Tyler Cowen writes,

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

America’s mortgages are structured so that the lender-investor is going short on volatility. If interest rates do not move much, the lender does well. If home prices do not move much, the lender does well. But if interest rates rise, the lender is stuck with a below-market asset. And if home prices fall, the lender gets stuck with a house with a value below the amount of the loan.

Tyler is saying that for the typical financial market player, going short on volatility is a great personal strategy. When it works, you get a nice salary and bonus. When it fails, someone else–a shareholder, a taxpayer–bears much of the cost.

If you know your Nassim Taleb, you will recognize going short volatility as “fragile,” with the opposite strategy as “anti-fragile.”

I wonder if stock market investment is one of those fragile strategies nowadays. You can make money year after year going long the market–until it stops.

Anyway, Tyler argues that the changes in the income distribution of recent decades

a) have been focused at the top 1 percent, not between the 99th percentile and the lowest percentile

b) been driven by finance

c) and within finance have been driven by these short-volatility, fragile strategies.

He is pessimistic about regulators’ ability to stop the short-volatility strategies. I think he is wise in that regard.

Was the Fed necessary?

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George Selgin writes,

Nationwide branch banking, by permitting one and the same bank to operate both in the countryside and in New York, would have avoided this dependence of the entire system on a handful of New York banks, as well as the periodic scramble for legal tender and ensuing market turmoil.

Selgin’s thesis is that the banking laws as of 1900 gave privileges to New York banks and that part of the impetus for the creation of the Fed was the preservation of those privileges.

Rep. Hensarling on Risk-Based Capital

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He said,

Risk-weighting is simply not as effective. First, it is far too complex, requiring millions of calculations to measure capital adequacy. Second, it confers a competitive advantage on those large financial institutions that have the resources to navigate its mind-numbing complexity. Third, regulators have managed to get the risk weights tragically wrong, for example, treating toxic mortgage-backed securities and Greek sovereign debt as essentially risk-free. One myopic globally imposed view of risk is itself risky. Finally, risk-weighting places regulators in the position of micro-managing financial institutions, which politicizes credit allocation. Witness the World Bank recently advertising its zero risk rating under the Basel Accords for their “green bonds.”

Clearly, he understands what I call The Regulator’s Calculation Problem. Pointer from John Cochrane.

Read the rest of John’s post and weep. Weep because this could have been a year when a strong center-right Republican Presidential candidate, running on an agenda that includes these sorts of proposals, could have been so easy to support.

The Fed is not about Monetary Policy

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Lawrence H. White writes,

The fact that M2 has hardly budged from its established long-term path indicates that quantitative easing was not a change in monetary policy, in the sense that it was not used to alter the path of the standard broad monetary aggregate in a sustained way.

I think that the best way to think of all forms of government intervention in financial markets, including regulation and so-called monetary policy, is to remember that the goal is to allocate credit. Talk about financial stability or economic management is just smoke and mirrors.

White’s paper is on the problem of “exit” for the Fed, meaning reducing its balance sheet. But “exit” is not desired if my hypothesis, that the goal of government is credit allocation, is correct. Already, the balance sheet has remained large for far longer than was expected by anyone who thought of the Fed as conducting monetary policy. My hypothesis predicts that five years from now the Fed will have a balance sheet of approximately the same size, or larger. If the Fed were about monetary policy, such a prediction would seem ludicrous.

Another Minsky Moment?

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That was my reaction to reading this.

Brian Lockhart says, “The payout ratio for S&P companies was $200 billion more than GAAP earnings. Companies are borrowing money to buy back stock to drive up earnings-per-share. How do they pay that back? They have to take future earnings in order to pay back the debt they’re using.”

In my talk in Oslo on bubbles, I said that whenever asset prices are high relative to some historical pattern, there are always two narratives available. One narrative says “Bubble.” The other narrative says that historical norms have been superceded by new patterns. In other words, “This time is different.”

I do not have a strong view about which narrative best fits the current stock market.* I do take it as given that the ratio of share prices to earnings is on the high side relative to historical norms.

*My portfolio has for quite some time been relatively light on stocks, but I have not bailed completely and not gone short.