Month: October 2008

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.

In a time when many odd economic events are taking place, this saga nonetheless deserves comment:

Volkswagen’s shares more than doubled on Monday after Porsche moved to cement its control of Europe’s biggest carmaker and hedge funds, rushing to cover short positions, were forced to buy stock from a shrinking pool of shares in free float.

VW shares rose 147 per cent after Porsche unexpectedly disclosed that through the use of derivatives it had increased its stake in VW from 35 to 74.1 per cent, sparking outcry among investors, analysts and corporate governance experts.

This seesaw has been going on for some time and German regulators haven’t done much about it, despite complaints from hedge funds.  Today the share price rose by a factor of nearly five (!).  So for a brief while Volkswagen became the world’s largest company in terms of capitalization.  Who needs Exxon and WalMart?

I thank Ben, a loyal MR reader, for the pointer to this episode.

From the UK:

A consumer borrowing £100 on the card would be charged £35 in interest
on repayments of £5 a week over 27 weeks, giving an APR of 222.7%.

Is this for people who already have borrowed from the loan shark and must repay immediately or else?  Or do the borrowers simply not understand annualized interest repayments?  Of course micro-credit also involves high interest rates (in the 50-100 percent range, usually) but I can see two immediate differences.  First, micro-credit is often used to take the kid to the doctor when otherwise the outcome would be grim.  Second, micro-credit is usually marketed to the higher-IQ element in the village, not the lower-IQ element.

Addendum: Here is Virginia Postrel, defending consumer credit.

Critics of the measure point to the story of Barbara Wagner,
a cancer patient in neighboring Oregon, whose [state-run] insurance company denied
her request for coverage of potentially life-saving drugs, and instead offered her money for lethal drugs.

Here is more.  I do not expect this to be the last story of its kind.

The difference between yields on five-year Treasuries and
five-year TIPS was a minus 0.46 percentage point at one point
this week, a record. TIPS typically yield less than Treasuries
because their principal payments rise at the rate of inflation.
A shrinking yield gap indicates investors expect inflation to
slow.    

The market “is pricing in deep deflation,” said Michael
Pond, an interest-rate strategist in New York at Barclays
Capital Inc. one of the 17 primary dealers that trade directly
with the Fed.

Here is the story. 

Furthermore this market price indicator, in addition to showing deflationary expectations, has implications for the nature of our current crisis.  The price of oil already has done lots of its falling.  So you might say the market expects the broader monetary aggregates — credit — to be less than robust over coming periods.  I should add (contra Alex) that a rising monetary base, without a robust credit market, won’t get you much inflation.  In fact the base has so risen because the Fed desperately has been trying to prevent…a credit crunch.  Just imagine the credit boom that the observed recent path of the monetary base would have brought if we were not in…a credit crunch.

We all now seem to agree that credit in the United States is actually growing during this "credit crunch," albeit at a slower rate than a year ago.  Tyler and others argue that growing credit is actually a sign of the credit crunch.  A credit crunch may show up "counterintuitively as a spike in borrowing" as firms draw on lines of credit.  Contra Tyler this view is certainly "convenient" but I do agree with him that this view is not unfalsifiable.

To wit, let’s falsify it.  The last time we had talk of a big credit crunch in the United States was during the 1990-1991 recession.  Was credit growing during this time as firms drew on lines of credit?  No.  Most of the credit measures that today are growing were in 1990-1991 flat or shrinking.  You can look at the pictures here or look at Table 1 of Ben Bernanke and Cara Lown’s well known paper (Google preview, JSTOR here).  In 1990-1991, for example  business loan growth was zero while today it is well above 10% (the same thing was true in 2001).

Peculiarly, Tyler argues that lack of credit is a leading cause of the crisis but a lagging indicator!   As a result, he needs to resort to non-verified conjectures about credit options to support the credit crunch story.  I have a simpler story, credit is a lagging indicator because it’s credit demand not supply that is the problem.  My story also makes sense of the fact that credit usually lags on the upturn as well – a fact which option value has difficulty explaining.

One error that I believe Tyler is making is to assume that skepticism about the credit crunch implies that one must be downplaying the seriousness of current economic conditions.  Not true.  First, it’s quite possible to have a very serious recession with growing credit – we had this in 82, for example.  Second, if Tyler is correct that the credit crunch is the primary cause of our current conditions then bank recapitalization should restore the economy to good working order.  In contrast, I think the Paulson/Bernanke plan is in trouble because credit demand is shrinking faster than credit supply.

Addendum: In response to Tyler (below) and several people in the comments.  Interest rates are not unusually high, certainly nowhere near as high as you would expect given a "credit crunch."  In fact, interest rates on say 30 year mortgages are falling and are lower now than at the height of the boom and no higher than in 2002 near the beginning of the boom.  I suspect that real interest rates are even lower than nominal rates suggest – inflation expectations anyone?  I wish that more people would present their arguments with data and not with anecdotes.

I don’t agree with much of Alex’s take.  Is he suggesting that the crisis started because *borrowers* lost their appetite for loans?  If so, why in his view is the measured credit aggregate doing fine?  In terms of what really happened, the core story is that the financial systems of many countries have been hit by solvency shocks, some credit markets (not all) have frozen up, we have zombie banks, asset prices tank, and now yes the demand for credit will be going down as well. 

Does Alex deny the "solvency shock"?  Or does he think you can have such a shock without some credit markets freezing up?  His post does not tell us but I find either position extremely implausible.

By the way, LIBOR and many other interest rates are rising, not falling; that is not what you would expect if falling credit demand were the key problem.  Nor does Alex mention the "shadow banking system," a core part of the current disintermediation.  There is no way to explain away what is happening there and of course that is not counted in the aggregates Alex consults.  There also has been a massive liquidity scramble in some sectors which again is inconsistent with falling credit demand as the problem.

The current punishment of the banking system goes far beyond the early 1990s; today’s credit crisis is driven by insolvency and potential insolvency but the 90s did not devastate finance or anything like that.  And I’m not especially sanguine about bank recapitalization, as I’ve indicated in numerous posts to date.  For one thing, politicization has its own costs but more importantly there is no guarantee that recapitalized banks will lend on the appropriate scale.

I can at least say with confidence that either Alex or I is totally wrong on this matter.

Why not, I say?

Implicit government obligations represent the lion’s share of
government liabilities in the U.S. and many other countries. Yet these
liabilities are rarely measured, let alone properly adjusted for their
risk. This paper shows, by example, how modern asset pricing can be
used to value implicit fiscal debts taking into account their risk
properties. The example is the U.S. Social Security System’s net
liability to working-age Americans. Marking this debt to market makes a
big difference; its market value is 23 percent larger than the Social
Security trustees’ valuation method suggests.

Here is the paper, by Alexander W. Blocker, Laurence J. Kotlikoff, and Stephen A. Ross.  Here is an ungated version.  Do note that a worsening crisis will increase the magnitude of this difference.