Results for “interest rates risk fed” 50 found
Don’t blame the Fed so much
Slow labor market recovery does not have to mean the core fix is or was nominal in nature, even if the original negative shock was nominal:
Recent critiques have demonstrated that existing attempts to account for the unemployment volatility puzzle of search models are inconsistent with the procylicality of the opportunity cost of employment, the cyclicality of wages, and the volatility of risk-free rates. We propose a model that is immune to these critiques and solves this puzzle by allowing for preferences that generate time-varying risk over the cycle, and so account for observed asset pricing fluctuations, and for human capital accumulation on the job, consistent with existing estimates of returns to labor market experience. Our model reproduces the observed fluctuations in unemployment because hiring a worker is a risky investment with long-duration surplus flows. Intuitively, since the price of risk in our model sharply increases in recessions as observed in the data, the benefit from creating new matches greatly drops, leading to a large decline in job vacancies and an increase in unemployment of the same magnitude as in the data.
That is from a new NBER working paper by Patrick J. Kehoe, Pierlauro Lopez, Virgiliu Midrigan, and Elena Pastorino. Essentially it is a story of real stickiness, institutional failure yes but not primarily nominal in nature.
Perhaps more explicitly yet, from the new AER Macro journal, by Sylvain Leduc and Zheng Liu:
We show that cyclical fluctuations in search and recruiting intensity are quantitatively important for explaining the weak job recovery from the Great Recession. We demonstrate this result using an estimated labor search model that features endogenous search and recruiting intensity. Since the textbook model with free entry implies constant recruiting intensity, we introduce a cost of vacancy creation, so that firms respond to aggregate shocks by adjusting both vacancies and recruiting intensity. Fluctuations in search and recruiting intensity driven by shocks to productivity and the discount factor help bridge the gap between the actual and model-predicted job-filling rate.
Again, a form of real stickiness more than nominal stickiness. The claim here is not that the market is doing a perfect job, or that the Great Depression was all about a big holiday, or something about video games that you might see mocked on Twitter. There is a very real and non-Pareto optimal coordination problem. Still, this model does not suggest that “lower interest rates” or a higher price inflation target from the Fed, say circa 2015, would have led to a quicker labor market recovery.
Even though the original shock had a huge negative blow to ngdp as a major part of it (which could have been countered more effectively by the Fed at the time).
Rooftops!
I am not sure there is any analytical inaccuracy I see on Twitter more often than this one, namely to blame the Fed for being too conservative with monetary policy over the last few years.
And please note these pieces are not weird innovations, they are at the core of modern labor and macro and they are using fully standard methods. Yet the implications of such search models are hardly ever explored on social media, not even on Facebook or Instagram! You have a better chance finding them analyzed on Match.com.
The verdict on the Fed’s interest rate hike
Good job, people. Just to recap what has been my perspective, here is from my September post, The Paradox of No Market Response:
…the good news scenario is if the Fed’s decision doesn’t matter much for the markets. Woe unto you if your economy is so fragile that a quarter point or so in the short rate, mixed in with some cheap talk, were to matter so much.
So if at first prices were to stay steady, following any Fed decision, then equities should jump in price. That is the “no news is good news” theory, so to speak. It’s a better state of the world if it is common knowledge that the Fed’s actions don’t matter so much in a particular setting.
Equity markets did in fact rise across most of the world, after a slight period of no reaction. And I wrote:
If I were at the Fed, I would consider a “dare” quarter point increase just to show the world that zero short rates are not considered necessary for prosperity and stability. Arguably that could lower the risk premium and boost confidence by signaling some private information from the Fed.
Someone at Bloomberg — I can no longer remember who — wrote at the time that this was the worst possible argument they ever had heard in favor of what the Fed was thinking of doing and subsequently did. Was it? Other commentators today have called this a “risk rally,” namely that fear of a prior risk seems to have diminished.
And to recap some broader points:
1. In most periods of crisis, central bankers are too reluctant to use expansionary monetary policy soon enough or strong enough.
2. However true that may be, it doesn’t describe our current situation.
3. Beware of models which rely too heavily on the Phillips curve, and two-factor “inflation rate vs. unemployment” considerations, especially in “long run” situations. I don’t see that any of the commentators working in this tradition had good predictions this time around.
4. The successful “lift off” still probably won’t matter very much, but better a success than not. Don’t think that America’s major economic problems somehow have gone away.
The housing shortage and low real interest rates
The mystery of low natural interest rates has become the topic of the hour, and everyone is perplexed by the mystery. Why are interest rates so low? Has anybody mentioned housing? This virus infected everyone’s brain so that we can only believe houses are too expensive or too plentiful, but not the other way around. So, nobody seems to notice that the return on real estate investments is very high.
I have posted some version of this graph several times. In the 1970s & 1980s, its tough to get a read on it because there weren’t markets in inflation-adjusted treasury bonds at the time. But, there is clearly a relationship between real estate returns and real interest rates. Why wouldn’t there be?
And this relationship broke down at the end of 2007 when we shut down real estate credit markets. The lack of access to home ownership made real estate returns go up while bond yields were going down. This is an important signal of financial breakdown, and nobody seems to notice.
So, no. Natural interest rates are not low. The real long term natural rate right now is about 2.5%. If you have tons of cash or you can run the gauntlet and get a mortgage, or if you are an institituional investor going through the difficult organizational process of buying up billions of dollars of rental homes, you get the preferred rate of 4% real returns.
If you aren’t, then you get the “class B” shares of low risk fixed income, which pay about 1% real (3% nominal).
The real estate market is much larger than the treasuries market. This is a big deal. This should be just about the only thing anybody is talking about regarding natural rates. Household real estate is worth about $25 trillion. If we hadn’t stopped building homes a decade ago, and if home prices did not contain an access premium, there would be more than $40 trillion in real estate. It dwarfs the size of the treasury market. That’s why rates have not reacted to large deficits. The federal government couldn’t realistically accumulate enough debt to make up for the gaping hole we have created in real capital.
We need to make some mortgages and build some houses. We will not be doing that, because of the virus. So, it looks to me like we will be wondering about the big interest rate mystery for another decade.
That is all from the always-stimulating Kevin Erdmann, additional graph at the link.
Why are short-term real interest rates so persistently negative these days?
Low productivity will get rates low but not consistently negative. Why might they be negative is a question raised by Brad DeLong and also Paul Krugman, in response to my earlier post about the natural rate of interest.
The most obvious answer is “risk,” but unfortunately that is directly contrary to the data. The domestic and global economies have become much less risky since 2008-2009, and yet if anything negative real rates for safe short term assets seem all the more ensconced.
VIX volatility indicators are down (admittedly there is a spike back up since August, but that is not going to do the trick, try the ten-year series too), consumer confidence is back up, and so are business confidence indicators. The TED spread, Krugman’s own previously favored index of extreme volatility, has been way down for years. The eurozone crisis of 2011 has passed, at least for the time being. Some of the emerging economies aside, most market prices are signaling low risk. So it is strange to invoke high risk to explain current asset prices, when the relevant prices and yields do not seem to be moving with that risk. If it is indeed risk, it is risk of a kind which we do not know how to measure or perhaps even conceptualize.
The other hypotheses are interesting but unproven, let’s take a look:
1. The Fed. There is a well-known liquidity effect on short-term real rates, but it is usually pretty small. Plus German real rates were negative well before the ECB started its QE. If there is something here, it remains to be shown.
2. Growing corporate demands to hold cash. This is a secular long-run trend, and most corporations wish to hold safe assets for agency reasons, and that will depress rates of return on those assets. Maybe there is something here, but again the connection remains to be shown. But do read Richard Koo from 2004 (pdf) and also see Ed Conard’s book, which discusses why cross-border investment tends to “go safe.”
3. Growing legal and institutional requirements for T-Bills as collateral. I have played around with this hypothesis, but still its relevance remains to be demonstrated empirically. Furthermore commercial paper rates may be too low, and that gap too small, for this to be a major factor.
4. CPI mismeasurement. Maybe the world is seeing more deflation than we are measuring, and short rates aren’t negative at all, as Arnold Kling has suggested. I’m not myself convinced, but this list is a survey, not a summary of my opinion.
5. Other???
Given those options, it seems to me highly premature to assume we know what is going on with short-term negative real rates. And it is all the more premature to imagine that a “more negative” set of rates is a solution to our remaining macro problems. I also am not sure which of the above factors should count as “natural” or “artificial” determinants of rates, so again I find it wiser to not build in those concepts as part of one’s opening terminological gambits. Most generally, if someone is telling you that the answer to a question about real interest rates is “simple,” they are likely wrong. Especially these days.
Addendum: You’ll find various perspectives on negative real rates here.
Second addendum: This is not my main point for today, but I consider all of the above further reason for monetary policy to focus on ngdp rather than interest rates.
What would Fedcoin look like?
JW, a loyal MR reader, writes to me:
It’s 2018, Janet Yellen has been renominated to be Fed Chair by President Walker having served a successful first term of solid growth and low inflation. However, to achieve such growth Yellen has had to maintain very low interest rates. Then, disaster strikes. France leaves the Euro unexpectedly and causes a world wide credit crunch. It’s 2008 all over again. President Walker is unwilling to do any stimulus. Yellen decides that a regime change is necessary at the Fed.
Taking to heart MMT, Keynes, Bernanke, Yellen merges Keynes’ idea of burying money in jars with Helicopter Ben’s idea of dropping money from the sky. The Fed announces that the United States is going to create its own cryptocurrency, which can be exchanged for US dollars at any US regulated depository institution. No or minimal fees can be charged by the banks for this exchange. They will be created just like Bitcoin, decentralized and according to a mining algorithm. American citizens can mine them, create businesses to do so, and put people to work. Unlike Bitcoin, the supply of DollarCoin will not be finite, capped at 21 million. Instead, DollarCoin will be targeted to grow at an inflation rate consistent with an NGDPLT of 20 trillion US dollars. Liquidity is restored. No QE is necessary. CNBC starts cheerfully referring to DollarCoin as YellenCoin.
Meanwhile, Bitcoin plummets in value. With the US Government now accepting a cryptocurrency, its advantages vanish. People’s belief in its value goes away, and looking down, it crashes. Remittances are now sent to relatives in Africa and Latin America by YellenCoin, just as people once did briefly in Bitcoin.
It is interesting to think about why this is so implausible. There are a few reasons:
1. YellenCoin would be a means of payment but not the medium of account. This would move the economy into a currency substitution model, a’la Girton and Roper, but would not have the effects of a straightforward monetary expansion.
2. Cryptocurrencies are much more likely to be used for some kinds of transactions than others. So this act of “monetary policy” would be very much non-neutral.
3. Central banks are not supposed to be seen as taking major risks or overturning the established order of things. They are highly risk-averse when it comes to their public reputations, and their very much prefer sins of omission to sins of commission. If the Fed established Fedcoin and something went wrong with the idea, they would be subject to especially heavy blame. In the meantime, few people (are there exceptions?) are blaming them for not establishing a cryptocurrency.
From the comments, negative T-bill rates of return
On my somewhat complicated post on negative rates of return from last week, Robert Sams writes:
Very interesting post and #5 is crucial (it’s a geometric process). Two points.
1. I think that we can substitute “ability to leverage at near-treasury rates” for “special trading technologies” and get the same implied predictions yet put the relevant institutional factors into relief.
2. Your #1-3 still works with the wrong model of Treasury returns, as it implicitly models demand as if it’s coming from a “real money” portfolio sort of buyer. Those guys exist of course, and they’re basically buyers at any price (central banks, regulatory demand, etc.). But if we ignore CB policy expectations, the valuation is set in the leveraged market, which is much larger, and treasuries trade rich /not/ so much b/c people want safety and therefore want to buy them, but rather they trade rich because people want to /short/ them for hedging purposes (e.g., investor wants corporate credit w/o the interest rate risk.)
Sounds paradoxical, I know, but failure to appreciate this fact is the basic misconception of the entire “risk premia” way of modelling this stuff.
For any given treasury issue, X billion were sold by Treasury, but the outstanding amount of people long the issue will be many times X because of all those repo leveraged buyers of UST’s, and for every one of those repoed longs, there is a short on the other side doing reverse repo. The market clears with the repo rate, which can often be much lower than fed funds and indeed can go up to -300bps at times if the (primarily hedging) demand from shorts is extreme. (The effective repo rate in this market is rather different from the general collateral series you can pull from public sources.. it’s hard to get good data as it’s proprietary to the big IDB’s… why the Fed tolerates this degree of opacity, I’ve never understood.)
Treasuries can therefore be seen as a special financial “currency”, and the treasury market can be modeled as type of free banking regime, where the public debt is base money, the much larger qty of leveraged UST positions is broad money, and the repo market is an interbank lending market where USD cash is collateral instead of money.
Looked at this way, the phrase “shadow banking system” is a quite literal description. Turn a market monetarist lose in this parallel universe, and the low rate conundrum is due to UST “base money” not keeping up with demand and the Treasury is a tight fisted CB.
In this universe, the real return of treasuries isn’t the relevant variable, it’s the spread between the repo rate and the treasury yield, which acts as a sort of “fee” for the guy who wants a hedged Investment in a riskier asset and pari passu a benefit to the party who wants a leveraged bet that the Fed means what it says about ZIRP. In finance-land with its UST currency, that spread /is/ the ST interest rate, which is volatile and well-above zero.
Now we can define quite precisely your “entry fee” thesis: the entry fee is the relative credit terms (haircut’s, etc) you’ll get in this repo market. In a world of only non-bank dealers and traders, those terms are symmetrical b/c counter-party risk is broadly symmetrical. In the world of TBTF, naturally only the bank holdco’s get the best terms. So, to win the wealth-accumulation game in this world, be a bank or be a very good client of a bank.
Ponder at your leisure!
An “entrance fee” theory of why some real rates of return are persistently low
Some portion of the negative real returns on U.S. government securities can be explained by risk premia, but yet many other indicators of risk are these days not so extreme. Times appear pretty stable, if not exactly what we had hoped for. So how else might we fit these negative returns into a theory? Here is one attempt, by me:
1. Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.
2. The demand for these assets is now so high and so persistent that the assets have persistently low nominal returns and often negative real returns.
3. The holders of these assets do not however receive negative returns on their portfolio as a whole, when deciding to hold these T-Bills. Holding the T-Bills is like paying an entry fee into financial markets. And once they are in financial markets of the right kind, these market players can earn high returns by possessing special trading technologies (the technology may vary across market participants, but think HFT, hedge funds, prop trading, employing quants, and so on).
4. Let’s say you are not a major financial institution. Then you really will earn negative returns on your safe saving. You might try holding equities, but a) you are not wealthy and thus you are fairly risk averse, and b) as a small player you do not have access to these special trading technologies and indeed you must trade against those who do. You thus will often earn negative or low returns on your portfolio no matter what.
5. The implied prediction is that differential rates of wealth accumulation will be a driver of inequality over time. This seems to be the case.
6. This equilibrium is self-reinforcing. The crumminess of T-Bill returns drives some individuals into trading against those with special trading technologies, even though that means they do not get a totally fair deal. The ability to trade against these “suckers” increases the value of paying the entrance fee into the higher realms of financial markets and thus increases the demand for T-Bills and keeps their rate of return low.
6b. Bailouts and moral hazard issues may reinforce the high returns to the special trading technologies, at social and taxpayer expense.
7. In this equilibrium this is a misallocation of talent into activities which complement the special trading technologies.
8. Imagine a third class of agent, “Napoleon’s small shopkeepers.” These individuals earn positive rates of return on invested capital, though those returns are not as high as those enjoyed in the financial sector. You become a shopkeeper by saving some of your earnings and then setting up shop. Yet now it is harder to save and accumulate wealth for most people (the rate of return on standard savings is negative!), and thus the number of small shopkeepers declines. This hurts economic growth and it also thins out the middle class (“Average is Over”). Most generally, the quality of your human capital determines all the more what kind of returns you will earn on your financial portfolio and that is a dangerous brew for the long term.
9. Business cycles may arise periodically if those who control the special trading technologies periodically “empty out” the real economy to too high a degree; you can think of this as a collective action problem. Then the financial sector must shrink somewhat, but unfortunately the game starts all over again, following a period of recovery and consolidation.
10. The John Taylors and Stephen Williamsons of the world are right to suggest there is something screwy about the persistently low interest rates, and thus they grasp a central point which many of their critics do not. Yet they don’t diagnose the dilemma properly. Tighter monetary policy would simply add another problem to the mix without curing the underlying dysfunctionality.
11. In this model, fixing the negative dynamic requires financial sector reform of such a magnitude that real rates of return on safe assets rise significantly. That is hard to pull off, yet important to achieve.
11b. It would help for the Chinese and some other East Asian economies to diversify their foreign holdings into riskier and higher-earning investments. They need a new trading technology in a different way, and you can think of their demands for safe assets as a major market distortion. Edward Conard saw a significant piece of this puzzle early on, by noting that a globalized world will skew real rates of return on safe assets (it is easiest to overcome “home bias” on the safest and most homogenized assets of a foreign country). Singapore and Norway are to be lionized in this regard for their risk-taking abroad.
12. If you so prefer, monetary and fiscal policies can have the “standard” properties found in AS-AD models. Yet in absolute terms they will disappoint us, and this will lead to fruitless and repeated calls to “do much more” or “do much less,” and so on.
13. In this model, the activities of the Fed can be thought of in a few different ways. In one vision, the Fed is the world’s largest hedge fund and has the most special trading technology of them all. Forward guidance on rates is actively harmful and the Fed should instead commit to a higher rate of price inflation or a higher rate of ngdp growth.
13b. Under another vision of the Fed, they understand this entire logic. Interest on reserves is a last resort “finger in the dike” attempt to keep rates higher than they otherwise would be. Of course both visions may be true to some extent. (And here I am expecting Izabella Kaminska to somehow make a point about REPO.)
14. Unlike in models of demand-side “secular stagnation,” the observed negative real rates of return do not imply negative rates of return to capital as a whole and thus they do not have unusual or absurd implications. They do require some degree of market segmentation, namely that not everyone has access to the special trading technologies, but those who do have enough wealth to push around the real return on T-Bills, especially if China is “on their side.”
That is what I was thinking about on my flight to Tel Aviv. It should be thought of as speculative, rather than as a simple description of my opinions. Still, it fits some of the data we are observing today. Another way to put it is this: the recent secular stagnation theories need a much closer examination of the financial sector and its role in our current problems. We should focus on the gap in returns, rather than postulating a general negativity of returns per se.
Is this as good as it gets? How much can social risk ever decline?
Karl Smith reports:
Are we so sure there is a better way?
Real interest have famously been on the decline for thirty years. A rougher historical record suggests that English real interest rates may have been in decline since at least 1600.
The standard explanation here is better governance and lower systemic risk.
Yet, lets imagine a simple model where we have two sources of risk. There is background you cannot avoid. And, there is personal risk that you create by through your own choices.
Policy makers have since Thomas Hobbes been attempting to drive down background risk. They have larger been successful. As a result our lives are getting more and more stable.
As that happens, however, folks are going to tend to take on more personal risk. There is a tradeoff between risk and reward. As you face less background risk, for which you not rewarded it makes sense to go for more personal risk for which you are rewarded.
When I take on more personal risk, however, it bleeds over slightly into everyone else’s background risk. People depend on me. If I take risks and lose so big that I debilitate myself then my family and my friends will surely suffer. But, so will my employer, my creditor and the businesses who count on me as a regular. When I go down, they go down.
So, putting it all back together and we come up with something of a risk floor, if you will.
Policy makers drive down systemic background risk. This makes everyone safer. In response, each individual takes on a little more personal risk and contributes slightly to the general background risk.
Eventually we will reach a point where policy makers have driven out so much systemic background risk that any marginal decrease systemic background risk will simply induce individuals to take on more personal risk until they raise the total risk level back up to where it was before.
Safer policy then has little net effect.
Said another way, attempts to prevent bubbles from forming will only make folks more complacent about bubbles. Eventually, a bubble will slip through the cracks. However, folks will deny it’s a bubble, because don’t you know, bubbles are a thing of the past. Even as it grows to massive proportions the smartest minds will argue that it only looks like a bubble. If it were a real bubble, surely the Fed would have popped it by know.
And, so it grows larger and larger and larger. When it pops the downdraft is so great that policy makers don’t have the tools to deal with it. Perhaps, in a technical sense they do. They could stand firm on an NGDP target or pass the mother of all stimulus bills.
However, emotionally they are at a loss. They have never seen anything like this and until recently thought it was impossible. Now, they are being asked to approve policies that no one has used since the dark ages, while in the middle of a crisis no living person understands.
This is a task few people have the nerve to handle. And, so they don’t handle it and the downdraft smashes the entire global economy to bits.
Such, is often the problem of “over-solving” the problems of the past.
Would more planned savings be good? How can we lower perceived risk premia?
One common claim these days can be put in terms of the expectations theory of the term structure: since short-term rates cannot much fall, long-term rates cannot much fall either.
Yet I would not put this argument forward as the best available understanding of the issue. First, the expectations theory of the term structure has a dubious empirical record. Long and short rates change for somewhat mysterious reasons and the long rates do not forecast future short rates very well. Second, there is a distinction between Treasury and corporate rates and the latter are not zero, especially for small businesses.
One possibility is that true corporate real rates are better reflected by the status of letters of credit, standby loan agreements, and the like. One can view borrowing in terms of the value of an option, rather than a single numerical rate. Many businesses no longer feel they have lots of liquidity "on tap" when they might need it from their banks and so they hesitate.
In general, I think of this crisis as having damaged a lot of agency relationships, and as having led to tighter leashes. For instance, if you are a worker of um…"ambiguous" marginal product you may no longer get the benefit of the doubt. The high perceived risk premium in the labor market is preventing a lot of reemployment.
Returning to interest rates, the question is what could call true real rates to fall. The expectations theory of the term structure is not very useful in analyzing this problem. Changes in the perceived risk premium have been an embarassment and a confounding factor for the expectations theory for a long time.
Given that background, should we plan to save more? On the no side, I would not push "more savings" is the magical elixir in lowering real rates, since the major issue is again the perceived risk premium.
(By the way, if we lower real rates through Sumneresque inflation — which I favor — we are altering the spectrum of these agency dealings and injecting more risk into those relationships, possibly in a socially optimal manner; in any case that second-order effect has not seen enough analysis.)
Another anti-savings argument runs like this: if we switch from spending to savings, that requires longer-term production processes and resource reallocations. The new market forecasts of what to produce involve greater risk, namely Keynes's "dark forces of time and ignorance". If that increase in the risk is too stiff, an increase in planned savings could lead to a greater collapse in output, exacerbating both AD and AS problems.
A pro-savings argument runs like this: We're overly dependent on Chinese capital. T-Bill auctions are now being soaked up much more by domestic lenders and that is a good thing for the world state where the Chinese economy implodes.
Another pro-savings argument is about balance sheet repair and about satisfying the preferences of consumers for greater long-term risk protection.
A major pro-savings argument is: If savings are not to go up now (and they have been rising since the onset of the crisis, supposed Keynesian paradoxes aside), then when?
The long-run boundary conditions require Americans to save more at some point and here's a fundamental point about macro. I believe we are in a situation where the short-run and long-term boundary conditions are interacting. People want to see the longer-term "we have to save more" problem (as well as some other longer-term problems) partially resolved before having much lower shorter-term risk premia and thus a freer flow of capital and private investment and also more ambitious hiring policies.
That makes the ride especially bumpy and the recovery especially slow. Both the long-run and short-run conditions require partial resolution, at the same time, and yet the long- and short-run conditions point in some different directions.
I get nervous when I see Keynesian models emphasizing the short-term only or non-Keynesian approaches emphasizing the long-term only. The more insightful approaches see the short-term and long-term factors interacting in a not always so helpful manner.
Addendum: Krugman has a recent post on savings. I am confused by his insertion of the Fed into the classical loanable funds mechanism, which does not require a central bank. I am also surprised that he associates the paradox of saving with the liquidity trap; Keynes for instance believed in the paradox of saving even though he thought he had never seen a liquidity trap. It could be, however, that I am misreading him on both counts; I found the post difficult to parse.
Why hasn’t the Fed been targeting two or three percent inflation?
I've been thinking about this question more and I've come up with a speculative possibility. Right now banks are earning their way back into profitability by playing the spread. They're paying close to zero on deposits and earning fair sums on long-term loans. Perhaps this term structure is sustainable because people are expecting little inflation in the short run but moderate inflation in the longer run, plus there is some risk on the loans. (These inflationary expectations may be changing; if you wish pretend I am writing this six months or a year ago.)
So let's say we move from zero expected short-term inflation to three percent short-term expected inflation. The nominal short rate rises to three percent and the real short rate remains more or less constant. Long rates would go up a bit but not much, since beyond the short run there is already an expectation of moderate inflation. In sum, the spread between short and long rates might narrow.
Here is the key point: from the bank's point of view, what is the correct measure of the real rate of interest? Is it defined by the nominal rate relative to the expected growth in the CPI? I doubt it. When you're near the bankruptcy or nationalization constraint, it's often nominal profits that matter (relative to fixed nominal liabilities, accounting standards, capital standards, etc.), not "real profits" defined relative to the CPI.
In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread. Maybe we need that zero nominal short rate or at least the Fed thinks we do.
I don't wish to push too hard on this hypothesis, it is speculative rather than confirmed by evidence. And propositions about the term structure of interest rates do not always run the way you think they will or should. I'm aware of other problems. What kind of zero profit condition is imposed on the banks? Given the odd objective function of the banks, how exactly does the Fisher effect work in the short run? Or is it imposed from without by competition from non-bank lenders? I'm not sure on these questions and they suggest possible holes in the above speculation.
I also regard this as a somewhat gruesome hypothesis. It means that "Main Street" is paying for "Wall Street" (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one's savings. Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.
The term structure also implies that the market is expecting rising short rates, so if the bank mess isn't cleaned up soon, heaven forbid. The spread, as a means of restoring bank profitability, won't last forever.
Interest on reserves, continued
I was intrigued by this passage, from Interfluidity:
Interest rates are, for the moment, excruciatingly low. But a subsidy
to the banking system, once put into place, will be quite hard to
dislodge. So, let’s imagine that the Fed will pay interest on bank
reserves in perpetuity, that it will pay such interest at or near the
risk-free short-term interest rate, and that the expansion of the Fed’s
balance sheet is more or less permanent. How large a subsidy to the
banking system do the interest payments on reserves represent? Some
problems are arithmetically challenging, but not this one. The present
value of a perpetual stream of market-rate interest payments is
precisely the amount of the principal. Therefore, the present value of
the Fed’s de facto commitment to pay interest to banks on $800B
of freshly created reserves is $800B. We fought and wailed and gnashed
our teeth over potentially overpaying for TARP assets. Meanwhile, we
are quietly allowing the Fed give away, as a direct, literal subsidy,
more than the entire $700B that Paulson was allowed to play with. Note
there is no question about this being an "investment": The interest
payments that the Fed is now making to banks on its suddenly expanded
balance sheet are not loans. The banks owe taxpayers absolutely nothing
in return for this windfall.
I take that calculation to be a very rough one, and possibly an overstatement, but the point remains of interest. It also can be argued that interest on reserves is a bad signal for at least two reasons:
1. It signals the Fed fears being left holding the intra-day Fedwire bag if a major bank goes under, and
2. It signals the Fed thinks major banks need such a subsidy.
The cited post is interesting throughout.
Can the Fed in fact pop bubbles?
Megan McArdle wonders:
Prospectively, if you want to do it effectively, you probably need to intervene in the very early stages. The Fed raised interest rates in the late 1920s, to no effect–indeed, it encouraged foreign capital to flow in. Iceland’s central bank, too, tried to quiet its financial bubble, but borrowers simply ignored them–borrowed at the higher rate, or stupidly took on currency risk by getting auto loans and mortgages from abroad. Meanwhile, more lenders were attracted by the higher rates. If you think house prices will go up 10% every year, a 1% increase in mortgage interest rates is not really that worrying.
Do you know any good pieces on this topic? Daniel Gross also says it is hard to do. Here is one article on Bernanke’s bubble laboratory.
Regulation Can’t Prevent the Next Financial Crisis
That is the topic of my latest Bloomberg column, here is one piece of it:
For another, an effort to make banks safer can effectively push risk into other sectors of finance. It can move into money market funds, commercial credit lenders, fintech, insurance companies, trade credit, and elsewhere. These institutions are generally less regulated than are banks and don’t have the same kind of direct access to the Federal Reserve’s discount window.
This is no mere hypothetical: In the 2008 crisis there were major problems with both money market funds and insurance companies.
There is a temptation, in light of recent events, to greatly stiffen bank capital requirements — to raise them to, say, 40%. Again, that would make banks safer, but it would not necessarily make the financial system as a whole safer.
And so policymakers allow banks to continue along their potentially precarious path. Whatever their reasons, the fact remains that bank regulations can get only so tough before financial risk starts spreading to other, possibly more dangerous, corners of the system.
And:
During the 2008 financial crisis, for example, there was an excess concentration of derivatives activity in AIG, later necessitating a bailout. Financial derivatives acquired a bad name in many quarters, and government securities were viewed as a safe haven. With Silicon Valley Bank, the problem was the inverse: Its portfolio was insufficiently hedged with derivatives and interest-rate swaps, leaving it vulnerable to major swings in interest rates. It should have used derivatives more.
It is easy enough to say, “We can write regulations so this won’t happen again.” But those regulations won’t prevent new kinds of mistakes from happening.
Classical liberalism vs. The New Right
It has become increasingly clear that the political Right in America is not what it used to be. In particular, my own preferred slant of classical liberalism is being replaced. In its stead are rising alternatives that don’t yet have a common name. Some are called “national conservatism,” and some (by no means all) strands are pro-Trump, but I will refer to the New Right. My use of the term covers a broad range of sources, from Curtis Yarvin to J.D. Vance to Adrian Vermeule to Sohrab Ahmari to Rod Dreher to Tucker Carlson, and also a lot of anonymous internet discourse. Most of all I am thinking of the smart young people I meet who in the 1980s might have become libertarians, but these days absorb some mix of these other influences.
I would like to consider where the older classical liberal view differs from these more recent innovations. I don’t so much intend a cataloguing of policy positions as a quest to find the most fundamental difference, at a conceptual level, between the classical liberal views and their New Right competitors. That main difference – to cut to the chase — is how much faith each group puts in the possibility of trustworthy, well-functioning elites.
A common version of the standard classical liberal view stresses the benefits of capitalism, democracy, civil liberties, free trade (with national security exceptions), and a generally cosmopolitan outlook, which in turn brings sympathy for immigration. The role of government is to provide basic public goods, such as national defense, a non-exorbitant safety net, and protection against pandemics.
In the classical liberal view, elites usually fall short of what we would like. They end up captured by some mix of special interest groups and poorly informed voters. There is thus a certain disillusionment with democratic government, while recognizing it is the best of available alternatives and far superior to autocracy for basic civil liberties.
That said, classical liberals do not consider the elites to be totally hopeless. After all, someone has to steer the ship and to this day we do indeed have a ship to steer. Most elites are intelligent and also they are as well-meaning as the rest of us, even if the bureaucratic nature of politics hinders their performance. We can entrust them with supplying basic public goods, and indeed we have little choice. Those truths hold even if the DMV will never be as efficient as Amazon, and even if sometimes our elites commit grave errors, for instance when the Johnson administration escalated the Vietnam War, to cite one example of many.
In the classical liberal view, the great failing of elites is that they do not keep society as free as it ought to be.
The New Right thinkers are far more skeptical of elites. They are more likely to see elites as evil and pernicious, and sometimes they (implicitly) see these evil elites as competent enough to actually wreck society. The classical liberals see checks and balances as strong enough to limit the worst outcomes, whereas the New Right sees ideological conformity and indeed collusion within the Establishment. Checks and balances are a paper tiger.
Once you start seeing elites as so bad and also so collusive, many other changes in your views might follow. You might become more skeptical about free speech, because you view it as a recipe for putting a lot of power in the hands of (often Democratic-led) major tech companies. And is there de facto free speech if a conservative sociologist cannot get hired at Yale? You also might become more skeptical about immigration, not because you are racist (though of course there are racists), but because you see it as a plot of the Democratic Party to remake America in a new image and with a new set of voters (“you will not replace us!”). Free trade becomes seen as a line peddled by the elite, and that is an elite unconcerned with the social and national security costs of a deindustrialized America. Globalization more generally becomes a failed project of the previous elite.
The New Right doesn’t entirely reject the basic principles of free market economics, but it does try to transcend libertarian views with a deeper understanding of the current power structure. In each case there are sociological forces operating that are seen as more important than “mere” free market economics. In this regard the New Right has a more interdisciplinary worldview than do many of the classical liberals. The New Right thinkers regard most power as cultural in nature, rather than rooted in coercive government alone.
Using this kind of contrast, just about every classical liberal view can be redone along New Right lines. The policy emphasis then becomes learning how to use the government to constrain the Left and its cultural agenda, rather than ensuring basic liberties for everyone. The New Right view is that this obsession with basic liberties leads, in reality, to the hegemony of a statist Left, and a Left that will use its power centers of government, media and academia to crush and cancel the New Right.
There is also a self-validating structure to New Right arguments over time. You can’t easily persuade New Right advocates by pointing to mainstream media reports that contradict their main narrative. Mainstream media is one of the least trusted sources. Academic research also has fallen under increasing mistrust, as the academy predominantly hires individuals who support the Democratic Party.
Most classical liberals are uncomfortable with the New Right approaches, and seek to disavow them. I share those concerns, and yet I also recognize that hard and fast lines are not so easy to draw. The New Right is in essence accepting the original classical liberal critique of the state and pushing it a few steps further, adding further skepticism of elites, a greater emphasis on culture, and a belief in elite collusion rather than checks and balances. You may or may not agree with those intellectual moves, but many common premises still are shared between the classical liberals and the New Right, even if neither side is fully comfortable admitting this.
The New Right also tends to see the classical liberals as naïve about power (the same charge classical liberals fling at the establishment), and as standing on the losing side of history. Those aren’t the easiest arguments to refute. Furthermore, the last twenty years have seen 9/11, a failed Iraq War, a major financial crisis and recession, and a major pandemic, mishandled in some critical regards. It doesn’t seem that wrong to become additionally skeptical about American elites, and the New Right wields these points effectively.
While I try my best to understand the New Right, I am far from being persuaded. One worry I have is about how it initially negative emphasis feeds upon itself. Successful societies are based on trust, including trust in leaders, and the New Right doesn’t offer resources for forming that trust or any kind of comparable substitute. As a nation-building project it seems like a dead end. If anything, it may hasten the Brazilianification of the United States rather than avoiding it, Brazil being a paradigmatic example of a low trust society and government.
I also do not see how the New Right stance avoids the risks from an extremely corrupt and self-seeking power elite. Let’s say the New Right description of the rottenness of elites were true – would we really solve that problem by electing more New Right-oriented individuals to government? Under a New Right worldview, there is all the more reason to be cynical about New Right leaders, no matter which ideological side they start on. If elites are so corrupt right now, the force corrupting elites are likely to be truly fundamental.
The New Right also overrates the collusive nature of mainstream elites. Many New Right adherents see a world ever more dominated by “The Woke.” In contrast, I see an America where Virginia elected a Republican governor, Louis C.K. won a 2022 Grammy award on a secret ballot and some trans issues are falling in popularity. Wokism likely has peaked. Similarly, the New Right places great stress on corruption and groupthink in American universities. I don’t like the status quo either, but I also see a world where the most left-wing majors – humanities majors – are losing enrollments and influence. Furthermore, the internet is gaining in intellectual influence, relative to university professors.
The New Right also seems bad at coalition building, most of all because it is so polarizing about the elites on the other side. Many of the most beneficial changes in American history have come about through broad coalitions, not just from one political side or the other. Libertarians such as William Lloyd Garrison played a key role an anti-slavery debates, but they would not have gotten very far without support from the more statist Republicans, including Abraham Lincoln. If you so demonize the elites that do not belong to your side, it is more likely we will end up in situations where all elites have to preside over a morally unacceptable status quo.
The New Right (and the classical liberals I might add) also seem to neglect the many cases where American governance has improved over time. My DMV really is many times better than it was thirty years ago. New York City is currently seeing some trying times, due to the pandemic aftermath, but the city is significant better run today than it was in the 1970s. Social Security, for all of its flaws, remains one of the world’s better-functioning retirement systems. The weapons the U.S. military is supplying to Ukraine seem remarkably effective. The Fed and Treasury, for all their initial oversights, did forestall a great depression in 2008-2009. Operation Warp Speed was a major success and saved millions of lives.
It is missing the point to provide a counter-narrative of all of our government’s major and numerous screw-ups. The point is that good or at least satisfactory elite performance is by no means entirely out of our reach. We then have to ask the question – which philosophy of governance is most likely to get us there next time around? I can see that some New Right ideas might contribute to useful reform, but it is not my number one wish to have New Right leaders firmly in charge or to have New Right ideology primary in our nation’s youth.
Finally, I worry about excess negativism in New Right thinking. Negative thoughts tend to breed further negative thoughts. If the choice is a bit of naivete and excess optimism, or excess pessimism, I for one will opt for the former.
Perhaps most of all, it is dangerous when “how much can we trust elites?” becomes a major dividing line in society. We’ve already seen the unfairness and cascading negativism of cancel culture. To apply cancel culture to our own elites, as in essence the New Right is proposing to do, is not likely to lead to higher trust and better reputations for those in power, even for those who deserve decent reputations.
Very recently we have seen low trust lead to easily induced skepticism about the 2020 election results, and also easily induced skepticism about vaccines. The best New Right thinkers will avoid those mistakes, but still every political philosophy has to be willing to live with “the stupider version” of its core tenets. I fear that the stupider version of some of the New Right views are very hard to make compatible with political stability or for that matter with public health.
I would readily grant that my opinion of our mainstream elites has fallen over the last five to ten years, and in part from consuming intellectual outputs from the New Right. But I don’t long for tearing down the entire edifice as quickly as possible. That would break the remaining bonds of trust and competence we do have, and lead to reconstituted governments, bureaucracies, and media elites with lower competence yet and even less worthy of trust. If you yank out a tooth, you cannot automatically expect a new and better tooth to grow back.
The polarizing nature of much of New Right thought means it is often derided rather than taken seriously. That is a mistake, as the New Right has been at least partially correct about many of the failings of the modern world. But it is an even bigger mistake to think New Right ideology is ready to step into the space long occupied by classical liberal ideals.
The Diamond and Dybvig model
The Diamond and Dybvig model was first outlined in a seminal paper from Douglas W. Diamond and Philip H. Dybvig in 1983 in a famous Journal of Political Economy piece, “Bank Runs, Deposit Insurance, and Liquidity.” You can think of this model as our most fundamental understanding, in modeled form, of how financial intermediation works. It is a foundation for how economists think about deposit insurance and also the lender of last resort functions of the Fed.
Here is a 2007 exposition of the model by Diamond. You can start with the basic insight that bank assets often are illiquid, yet depositors wish to be liquid. If you are a depositor, and you owned 1/2000 of a loan to the local Chinese restaurant, you could not very readily write a check or make a credit card transaction based upon that loan. The loan would be costly to sell and the bid-ask spread would be high.
Now enter banks. Banks hold and make the loans and bear the risk of fluctuations in those asset values. At the same time, banks issue liquid demand deposits to their customers. The customers have liquidity, and the banks hold the assets. Obviously for this to work, the banks will (on average) earn more on their loans than they are paying out on deposits. Nonetheless the customers prefer this arrangement because they have transferred the risk and liquidity issues to the bank.
This arrangement works out because (usually) not all the customers wish to withdraw their money from the bank at the same time. Of course we call that a bank run.
If a bank run occurs, the bank can reimburse the customers only by selling off a significant percentage of the loans, perhaps all of them. But we’ve already noted those loans are illiquid and they cannot be readily sold off at a good price, especially if the banks is trying to sell them all at the same time.
Note that in this model there are multiple equilibria. In one equilibrium, the customers expect that the other customers have faith in the bank and there is no massive run to withdraw all the deposits. In another equilibrium, everyone expects a bank run and that becomes a self-fulfilling prophecy. After all, if you know the bank will have trouble meeting its commitments, you will try to get your money out sooner rather than later.
In the simplest form of this model, the bank is a mutual, owned by the customers. So there is not an independent shareholder decision to put up capital to limit the chance of the bad outcome. Some economists have seen the Diamond-Dybvig model as limited for this reason, but over time the model has been enriched with a wider variety of assumptions, including by Diamond himself (with Rajan). It has given rise to a whole literature on the microeconomics of financial intermediation, spawning thousands of pieces in a similar theoretical vein.
The model also embodies what is known as a “sequential service constraint.” That is, the initial bank is constrained to follow a “first come, first serve’ approach to serving customers. If we relax the sequential service constraint, it is possible to stop the bank runs by a richer set of contracts. For instance, the bank might reserve the right to limit or suspend or delay convertibility, possibly with a bonus then sent to customers for waiting. Those incentives, or other contracts along similar lines, might be able to stop the bank run.
In this model the bank run does not happen because the bank is insolvent. Rather the bank run happens because of “sunspots” — a run occurs because a run is expected. If the bank is insolvent, simply postponing convertibility will not solve the basic problem.
It is easy enough to see how either deposit insurance or a Fed lender of last resort can improve on the basic outcome. If customers start an incipient run on the bank, the FDIC or Fed simply guarantees the deposits. There is then no reason for the run to continue, and the economy continues to move along in the Pareto-superior manner. Of course either deposit insurance or the Fed can create moral hazard problems for banks — they might take too many risks given these guarantees — and those problems have been studied further in the subsequent literature.
Along related (but quite different!) lines, Diamond (solo) has a 1984 Review of Economic Studies piece “Financial Intermediation and Delegated Monitoring.” This piece models the benefits of financial intermediation in a quite different manner. It is necessary to monitor the quality of loans, and banks have a comparative advantage in doing this, relative to depositors. Furthermore, the bank can monitor loan quality in a diversified fashion, since it holds many loans in its portfolio. Bank monitoring involves lower risk than depositor monitoring, in addition to being lower cost. This piece also has been a major influence on the subsequent literature.
Here is Diamond on google.scholar.com — you can see he is a very focused economist. Here is Dybvig on scholar.google.com, most of his other articles in the area of finance more narrowly, but he won the prize for this work on banking and intermediation. His piece on asset pricing and the term structure of interest rates is well known.
Here is all the Swedish information on the researchers and their work. I haven’t read these yet, but they are usually very well done.
Overall these prize picks were not at all surprising and they have been expected for quite a few years.