Category: Economics

Mark Thoma gives us eight credit series from the St. Louis Fed. He is somewhat surprised to discover that all show positive growth over last year. I think most people who have heard talk of the credit crunch would also find this surprising. Let’s be clear, however, almost all the series also show declining growth. Let’s also be clear that the financial sector is a huge mess. Furthermore, we are in a recession that is likely to get worse especially because growth is declining around the world.

I think of credit as not just a current period flow but also as an option; this is implicit in many of Fischer Black’s pieces, including "Banking and Interest Rates in a World Without Money."  If you lose the option to borrow that is a credit crunch too.  As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up.  Banks have felt liquidity squeezed, in part because of pending CDS settlements, in part because so many borrowers are exercising their borrowing options, and in part because of potential insolvency.  That liquidity scramble is why we have been seeing such a huge TED spread and near-zero nominal rates on T-Bills.  Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.

The collapse of "borrowing as an option" shows up in market prices and it also shows up in many anecdotes, as chronicled at calculatedrisk.blogspot.com.  It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.

I am puzzled by Alex’s admission that there is a recession; no matter which way you assign the causality, doesn’t that mean credit should be contracting?  Working within the confines of his own view, shouldn’t Alex be worried that credit flows remain so high?

I believe if we had an explicit series measuring the borrowing option. and its recent collapse, it would show the credit crisis very clearly.  In the meantime that crisis does show up in other pieces of information.

Addendum: Here is comment from Mark Thoma and also Felix Salmon.

Contra Tyler (see below) neither the post from Free Exchange nor Mark Thoma’s comments "rebutting" the Minn. Fed study, Four Myths About the Financial Crisis of 2008, are compelling or well thought out.  The Minn. Fed. presented data demonstrating that four widely reported claims about the credit crisis panic are myths – do either of the cited links claim that any of these myths are in fact true?  No.  Do either of the cited links present any data at all on the quantity of credit?  No.  Many people cite prices/rates/spreads as evidence for the crisis but what we ultimately care about is quantity not price.  The Fed. piece had lots of data on the quantity of credit.  Where is the rebuttal?  Does Tyler cite any data at all or lay out his counter-claims?  No.

Consider the major item that these links suggest as evidence of the crisis.  Amazingly, it’s "an unusual spike in bank lending during the
crisis period."  That’s right, an increase in bank lending is evidence of the crisis.  The argument is that lack of credit elsewhere means that firms are drawing on their line of credit at banks.  One problem with this is that Paul Krugman made this argument way back in February when I said that the lack of credit was being overblown.  Thus the "crisis period" keeps changing.  In February, the crisis was in February, now Thoma is saying it’s just the last few weeks.  More fundamentally, the whole point of a line of credit is to keep credit flowing when one source dries up.  A commentator at Thoma’s site nails this one:

Saying that credit availability is so ‘severely’ endangered that
borrowers are forced to utilize credit from banks isn’t the most
persuasive argument. What next?

"Gasoline supplies had withered to the point that I was forced to fill up at Texaco instead of Chevron!" 

Finally, Tyler and both of the cited pieces attack a stupid claim that obviously neither I nor the Minn. Fed. piece made, namely that the interventions by the Fed. have had no effect.  Obviously, they have.  But the story the media and the commentariat are reporting is that there is a credit crunch, credit is frozen, firms are starved for credit, we are on the verge of a Great Depression etc. The story has not been, ‘despite some problems in the banking sector quick action by the Federal Reserve and plenty of alternative non-bank credit has insured that credit continues to flow to nonfinancial firms.’

Short-term nominal interest rates are rising and that is good:

The nominal short rate is the "shadow real interest rate" (as defined by the investment opportunity set) plus the inflation rate, or zero, whichever is greater.

That’s from Fischer Black and the implication is not a cheery one.  It’s either deflation or an unproductive real economy or both.  Here is the full abstract:

Since people can hold currency at a zero nominal interest rate, the nominal short rate cannot be negative. The real interest rate can be and has been negative, since low risk real investment opportunities, like filling in the Mississippi delta, do not guarantee positive returns. The inflation rate can be and has been negative, most recently (in the U.S.) during the Great Depression. The nominal short rate is the "shadow real interest rate" (as defined by the investment opportunity set) plus the inflation rate, or zero, whichever is greater. Thus the nominal short rate is an option. Longer term interest rates are always positive, since the future short rate may be positive even when the current short rate is zero. We can easily build this option element into our interest rate trees for backward induction or Monte Carlo simulation: just create a distribution that allows negative nominal rates, and then replace each negative rate with zero.

…stochastic calculus porn…

That’s Arnold Kling on the state of modern macroeconomics.

Frederik writes to me:

In the classifieds on the web of the daily Iceland newspaper Mbl, you find hard currency for sale (US dollar, Danish kroner, and Euro) ranging from USD 300 to USD 12000. With the breakdown of the official exchange rates, the market has emerged.

The article is here, in splendid Icelandic.  Just imagine using classified ads to buy foreign currency; I don’t see any market on U.S. eBay but maybe I just don’t have the right keywords.

Back in February I pointed out that despite all the talk of a credit crunch commercial and industrial loans were at an all-time high and increasing.  In September I once again pointed to data showing that bank credit continued to be high (even if growth was slowing.)  At that time I also discussed how bank loans were not the only source of funds for business investment and that many substitute bridges exist which transform and transmit savings into investment.  I suggested that despite the panic the problems which exist in the financial industry may be relatively confined to that industry.   

Three economists at the Federal Reserve Bank of Minneapolis, Chari, Christiano and Kehoe, now further support my analysis pointing to Four Myths about the Financial Crisis of 2008. 

The myths

1. Bank lending to nonfinancial corporations and individuals has declined sharply.
2. Interbank lending is essentially nonexistent.
3. Commercial paper issuance by nonfinancial corporations has declined sharply and rates have risen to unprecedented levels.
4. Banks play a large role in channeling funds from savers to borrowers.

Each of these myths is refuted by widely available financial data from the Federal Reserve.  It’s a short paper, read the whole thing.

None of this means that everything is cheery.  Like most people I think that we are in a recession which is likely to get worse but we need to remind ourselves that recessions are normal.  What is not normal is the current level of panic.  The panic feels to me like an availability cascade.

Hat tip to Mike Moffatt.

Addendum: By the way, I wouldn’t be surprised if credit does start to go down but it will do so because of a fall in the demand for credit not primarily because of a fall in the supply, again an entirely normal aspect of all recessions.

More trouble at Chicago, this time among the econ faculty, regarding the Milton Friedman Institute.  Sad. 

Hat tip to Steve Levitt.

Consider that the Greenspan Fed maintained a
1.75% Fed fund for 33 months (December 2001 to September 2004),
a 1.25% for 21 months (November 2002 to August 2004), and
lastly, a 1% Fed funds rate for 12+ months, (June 2003 to June
2004).

Here is the link.  But no, I don’t side with Austrian Business Cycle Theory in citing loose monetary policy as the main factor in the artificial boom which preceded the crash.  I view the boom as having been fueled by new global wealth, most of all in Asia, and the liquification of that wealth through credit and the desire for additional risk.

Note that if an increase in real wealth fuels the investment boom, consumption can be robust or even go up at the same time as the rise in investment.  Now, in the boom preceding the current bust, was American consumption robust?  Sure.  If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here.  (Try a rebuttal here.)

Loose monetary policy did contribute to the bubble.  In that sense I would defend a modified Austrian theory.  But other reasons also suggest that monetary policy was not the main driver.  Money has a much bigger effect on short-term rates than long-term rates.  Even long-term real rates have only mixed predictive power over real economic activity, including investment.  The Austrians have never developed much of a theory of bubbles.  Ideally you would have a good bubble theory, with Austrian-like monetary factors stirring up the bubble even more.  But you can’t get away with pinning so much of the blame on the government, as modern Austrians are wont to do.  "Bubbliness" is a private sector imperfection and relabeling it as "government distorting price signals through monetary policy" doesn’t much change that.

She offers a clear statement of the previous default point of view:

…this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

This is almost certainly true if the number of "problem banks" is sufficiently small.  It works less well if the number of problem banks is very large.  And why might you believe the number of problem banks is large?:

1. The very actions of Bernanke and Paulson — both smart and competent people and in the case of Bernanke with libertarian sympathies — are signaling that the number of problem banks is large.

2. The credit freeze signals that the number of problem banks is large.

3. We cannot afford to take the chance that the number of problem banks is large.

4. Direct knowledge that the number of problem banks is large.

#1-3 seemed increasingly persuasive to me as the crisis went on, but it would be nice to shore up #4, which to this day remains weak.  Of course since #4 is not independent of what government is doing at any point in time, the signal extraction problem is significant.  If we see banks doing poorly, it could simply be that markets do not like the chosen remedy.  Furthermore share prices reflect what the market thinks banks are worth, but only conditional on what policies the market expects.

From the comments at MR:

…we had all better hope that there will be some stupid groups in the
future, because if not, then our society will be poorer due to a
societywide excessively high price of risk. an excessively high price
of risk isn’t as spectacularly catastrophic as the excessively low
price of risk of the last 10 years, but compounded over time it can do
just as much damage…

I hold a few beliefs:

1. For a while the price of risk had been too low.

2. Currently the price of risk is too high.

3. In response to the crisis, we will regulate to prevent the particular previous manifestations of #1.  The bad news is this will be an overreaction; the good news is that because of #2 the regulatory overreaction won’t matter for some while.

4. We do not know how to regulate to prevent other, future, hitherto unexperienced manifestations of an excessively low price of risk.

5. Maybe #4 is wrong, but beware of any huff-and-puff polemic discussion that is not at least considering these points.

The column is titled "Three Trends and a Train Wreck."  I attempt to explain the financial crisis in as simple and general terms as possible.  Here is one paragraph:

Over all, then, the three fundamental factors behind the crisis have
been new wealth, an added willingness to take risk and a blindness to
new forms of systematic risk. All three were needed to bring about the
scope of the current mess – so that means we’ve had some very bad luck
on top of everything else.

I have about nine hundred words to flesh this out and to discuss Fischer Black as well; Black is a neglected but insightful macroeconomic theorist who starts with ideas from finance.  Here is another paragraph:

Subprime loans collapsed first because those were the investments most
dependent on relatively poor borrowers who were the most likely to
fail. Since then, we’ve seen asset values fall throughout the economy.
Subprime borrowing was the canary in the coal mine, but it was hardly
the only problem. It now seems that a wide range of asset prices were
artificially inflated. The market for contemporary art, which depends
almost exclusively on very wealthy buyers, will probably be the last
market to plummet but that development is almost certainly on its way.

One thing to keep in mind is how international the crisis has been; any explanation should start there.  I wish in the column I had had space to discuss Spain, which has had relatively prudent banking regulation but still will have one of the biggest downturns in Europe.  It is also worth considering Norway, Canada, and some of the other countries which limited their risk exposure all along.  I mention Japan, but Brazil and Mexico also already have their banking crises behind them in the former decade and they too form other valuable points of comparison.

I am not sure I understand this Daniel Davies post, but it may have some overlap with my arguments.

Addendum: You might want to read this Jacob Weisberg column saying that the financial crisis refutes libertarianism.  His paragraph starting with "There’s enough blame to go around…" is exactly the foil I had in mind.  His overall thesis is worth pondering but he doesn’t once consider any cross-sectional variation across nations; such consideration wouldn’t help his thesis.  Am I allowed to say that the experience of Iceland refutes the small nation, social democratic model?  Probably not, nor should I be.

Second addendum: Tim Harford has a humorous piece comparing the crisis to Monopoly the board game.

As many people suspected someone was manipulating Intrade to boost John McCain’s stock price:

An internal investigation by the popular online market Intrade has revealed that an investor’s purchases prompted “unusual” price swings that boosted the prediction that Sen. John McCain will become president.

Over the past several weeks, the investor has pushed hundreds of thousands of dollars into one of Intrade’s predictive markets for the presidential election, the company said.

This is big news but not for the reasons that most people think.  Although some manipulation is clearly possible in the short run, the manipulation was already suspected due to differences between Intrade and other prediction markets.  As a result,

According to Intrade bulletin boards and market histories, smaller investors swept in to take advantage of what they saw as price discrepancies caused by the market shifts – quickly returning the Obama and McCain futures prices to their previous value.

This resulted in losses for the investor and profits for the small investors who followed the patterns to take maximum advantage.

This supports Robin Hanson’s and Ryan Oprea’s finding that manipulation can improve (!) prediction markets – the reason is that manipulation offers informed investors a free lunch.  In a stock market, for example, when you buy (thinking the price will rise) someone else is selling (presumably thinking the price will fall) so if you do not have inside information you should not expect an above normal profit from your trade.  But a manipulator sells and buys based on reasons other than expectations and so offers other investors a greater than normal return.  The more manipulation, therefore, the greater the expected profit from betting according to rational expectations.

An even more important lesson is that prediction markets have truly arrived when people think they are worth manipulating.  Notice that the manipulator probably doesn’t care about changing the market prediction per se.  Instead, a manipulator willing to bet hundreds of thousands to change the prediction of a McCain win must think that the prediction will actually affect the outcome.  And if people think prediction markets are this important then can decision markets be far behind?

Hat tip to Paul Krugman.

Why would you leave your money in UBS?

I’m not a close observer of the company, but I have to wonder how they would now describe their business model to a new and eager customer.  Bernard Bauhofer had a funny way of putting it:

The big question is whether high net worth individuals are
willing to stay with an institution incapable of surviving on its
own…

Meanwhile, over at the state-owned bank:      

Clients seeking to open an account last week at ZKB’s
central branch on Bahnhofstrasse in Zurich, a block from UBS’s
headquarters, had to wait as long as an hour. "We don’t know what to do with all the money right now,”
ZKB spokesman Urs Ackermann said.