Month: December 2010

I had promised to address that question.  Ideally, enforceable bond covenants should limit bank risk-taking, and ensure major bank solvency, but is that feasible?  I see a few problems with the idea:

1. It is very hard for a government or central bank to precommit to a "no bailout" policy.  This is partly because of powerful special interests, but most of all because political time horizons are short.  Most bailouts do patch things up in the short run, whether or not you like their longer-run consequences.  Bondholders know this, and they are less vigilant ex ante.

2. Bondholders don't and can't have much idea what is going on inside the trading book of a bank.  It doesn't matter how financially sophisticated the bondholders are; the point is that the trading book must remain fairly confidential and a lot of risk can be put in the trading book.

3. Some of the creditors — the short-term creditors — may be in on the deal.  They lend money to the banks, under the premise that risky strategies will be executed.  The short-term, collateralized creditors may not themselves be bearing much risk, given their superior "flight" capabilities and they also may be receiving a slight premium for such lending.

4. The net risk of a bank position is not determined solely by the bank's portfolio.  Say a bank lends money to homeowners and then those homeowners increase their leverage.  The bank is now in a riskier position, and de facto a more leveraged position, althoug it's measured leverage hasn't gone up a whit.

5. Experience with the ICE clearinghouse — one form of bank creditor — so far suggests that it serves bank interests, and indeed is largely controlled by the banks, rather than restraining them.

6. Let's say a no-bailout policy was credible, as indeed it was in the 19th century (there were no bailout facilities).  What does the equilibrium look like?  Is there less long-term lending to banks and more short-term lending?  Would that make banks more or less stable?  Few people think this is a positive development for countries.  Would banks be more subject to "capital flight" risk?

We also could expect greater mutualization of banks, as was the case before deposit insurance, and we could expect experimentation with corporate forms other than limited liability.  My view is this is what would be required to limit excess bank risk-taking.  Yet I believe that, for better or worse, it is politically impossible.  In a nutshell, big government needs big finance (or much higher taxes).

One reason that bailouts are so politically popular (not in rhetoric, but in their practice and in their effects) is that they make financial crises less common but, when they come, more severe because more leverage has built up.  That change in the structure of returns is usually a political winner, call it "Ticking Time Bomb."

Recently Scott Sumner visited us and I pondered the following.

Let's say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests.  If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank's announcement will be much heeded.  The announcement simply isn't very focal, relative to the panic.  A similar announcement, however, is more likely to work in calmer times, as the recent QEII announcement has boosted equity markets about seventeen percent.  But for the pronoucement to focus people on the more positive path, perhaps their expectations have to be somewhat close to that path, or open to that path, to begin with.

(Aside: there is always a way to commit to a higher NGDP path through currency inflation, a'la Zimbabwe.  But can the central bank get everyone to expect that the broader monetary aggregates will expand?)

The question is when literal talk, from the central bank, will be interpreted literally.

Much of the time, but not always.  Keep in mind that few informed people take the President literally.  Hardly anyone takes Congress literally.  Some people take the Fed literally but not always.  Literal speech, interpreted literally, is hardly the political default.  (One possible implication is that often a Fed cannot do much better than the political system it is embedded in, due to how people understand speech.)  Most people don't take their spouses literally either, or their children.

I view Scott as claiming that the world would be better off if the central bank would talk more literally.  If the central bank talks more literally, they will be (can be?) understood more literally as well.  Scott is a theorist of literality. 

In general I am sympathetic to this view and not only for the Fed.  I believe people should speak more literally in a wide variety of circumstances.

Since Treasury hardly ever speaks literally, I believe the Fed can speak literally, and be understood literally, only when it is fairly independent of Treasury.  That was not the case in the worst parts of 2008.

Central bankers usually speak with ambiguity.  Doing so conserves their influence, as has been presented in a number of important papers.  It is thus hard for the Fed to switch to a mode of pure literal speech.  Part of the difficulty is institutional, part lies with the audience (aren't you suspicious when a vague person sudden switches to direct, literal speech?), and part of the problem is political, since the Fed is not always independent.  Part of the problem lies in the Fed itself.  The Fed's mental model is often that speaking in a literal manner spends political capital and they are reluctant to do this, even when they ought to.  There is thus a public choice reason why the Fed serves up a suboptimal amount of literal speech.

Scott's views remind me of a concern of Robin Hanson's.  "Why can't those writers just come out and say what they mean?" Robin asked me once about the classic great books.  It was a plea for a more literal discourse.  Yet more literality is not always possible and not always more effective.

At the talk, Scott was superb in responding to questions and criticisms.  I enjoyed how much he gave the questions direct, literal answers.

Addendum: Mark Thoma has a good post on nominal gdp targeting.  Scott replies, Bill Woolsey too; I view Woolsey's reply as illustrating the difficulties with presenting literal speech.  Here is a DeLong reply.