Category: Economics

Today the Fed starts to pay interest on reserves.  The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax.  Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed.  Overall, however, this is small potatoes.

More interesting is why the Fed. will pay interest on excess reserves.  In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets?  My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong’s terms this gives them an additional tool to do it on the Pan-Galactic scale.  In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize.  Although paying interest on excess reserves brings this whole operation under the Fed house it’s unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.

Forget about particular details for a moment, in conceptual terms what led so many financial institutions to take so much excess risk?  Bob Frank addresses that question and here is my list of major factors:

1. Collective stupidity: A lot of Greeks believed in Zeus and a lot of people in 1938 thought Hitler would be good for Germany.  They were just plain, flat out wrong.  I’ll also put "model error" under this heading.  The relevant stupidity concerned both the fate of home prices and the degree of acceptable leverage.

2. Writing the naked put: This is Bob Frank’s main explanation, noting that he uses different terminology and adds a relative status dash to the argument.  If you don’t know options theory, just imagine betting against the Washington Wizards to win the NBA title every year.  For a lot of years you’ll earn super-normal returns, but one year (not anytime soon, I can assure you) you’ll be wiped out.  That is essentially the strategy the banks were playing.  They were going "short on volatility," so to speak.  In the meantime they reaped high returns and some amazing perks for private life.  It’s hard to just call the party to an end, even if you have a relatively long time horizon.

3. The neutering of debtors. This is the sophisticated form of the moral hazard argument.  Bailouts mean that debtors and depositors don’t have enough incentive to keep safe the firms they give their money to.  Note that #3, as a corollary, suggests that equity holders do not on their provide adequate safeguards against a crash.

Evaluation: You can pin most of the blame on #3 provided you think that a) our government really could let these firms default on their debts ex post and b) society is willing to live with significantly less liquidity transformation up front and also lower returns for depositors.  I reject this mix for reasons of time inconsistency, namely that ex post the bailout is always on its way so this is simply something we have to live with. 

You’re left with #1 and #2 but it is hard to assign relative weights because they work together.  The people earning money under #2 won’t work terribly hard to disillusion the fools and frauds operating under #1.

At times I am tempted to add #4 to the mix:

4. The increasing value of human capital: Bankruptcy is no longer so painful for the wealthy.  You can always get another high-paying job plus you have $10 million squirreled away somewhere in Switzerland.  You could end up working for the guv’ment for $130K a year and your life still is pretty good once you get over the shock of adjustment.  So why not take lots of risk and try to get ahead of the other guy?

The full story then involves additional resources being put on the table — for possible risky investment — as a result of easy monetary policy, pro-housing government policies, the global savings glut, and simple bad luck.  I’ll cover those factors in more detail soon.  And I’ll also have more to say about some of the details of mortgage-backed securities and accounting practices and regulation; those were factors too, although not at the level of generality I am covering here.

Addendum: Here’s Mark Thoma and Barry Ritzholz.  In the comments Robert Feinman is square on, read him.

Second addendum: Megan McArdle adds quite a bit.

It turns out there won’t be one.  In fact we are seeing the opposite:

"We will work cooperatively and in a coordinated way within the
European Union and with our international partners," it [the statement] added. "In the
spirit of close cooperation within the European Union, we will ensure
that potential cross-border effects of national decisions are taken
into consideration."

This language was seen as a rebuke to Ireland, which last week
decided to offer guarantees to all Irish depositors. The decision,
taken unilaterally, irked Brown and his lieutenants in London, who
feared it might lead Britons to pull their money out of British banks
and put it in Irish banks instead to enjoy the guarantee.

British depositors were already crowding to get into the nationalized Northern Rock but they were turned away at the proverbial door.  Other news is that the German government-led bank consortium to rescue Hypo Bank has fallen apart, not a good sign.  The German government has today moved to guarantee all "private savings deposits" [private Sparanlagen], also not a good sign.  Which other countries will now follow suit?  All of them?  Europe as a whole lacks a safe asset as focal, liquid, and available as T-Bills and now that is becoming a problem.

Gartner’s keys to success as a supplier in reverse auctions are: (a)
Thorough preparation – it’s essential to know your costs, your
suppliers, and your market to the greatest extent possible – tiny
details can make the difference between winning and losing, and between
being profitable or not; (b) Reverse auctions should be largely kept to
the supply of commodity products rather than proprietary ones; and (c)
Having a strong, competent bidder leading your effort at the time of
the auction, with clear guidelines on when to bid and when to fold is
essential.

Anticipating Hank Paulson, Gartner adds:

"I know most people don’t look at reverse auctions positively, but we see them as a process that makes you better,"

Here is the link.  The article will soon be much longer.  Here is a website devoted to summarizing the research against reverse auctions; it appears unrelated to critiques of Paulson and the Paulson plan.  It seems to be fighting a personal war and so I doubt its objectivity:

The bottom line is BUYERS should not use reverse auctions because the amount of savings that can actually be achieved is greatly overstated. In addition, reverse auctions create numerous other problems for buyers.  SELLERS should not participate in reverse auctions because there is nothing in it for them; especially incumbent suppliers. In almost every case, neither buyers nor sellers benefit from this purchasing tool because it is an unhealthy continuation of zero sum power-based bargaining that degrades the competitiveness of both parties. Reverse auctions are undeniably a bad purchasing practice and a wrong approach to spend management.

I hope to soon consider other research on reverse auctions.

Greg Mankiw shows that real interest rates are rising on inflation-adjusted government bonds.  Paul Krugman shows that short-term Treasury yields are down.  The state of California cannot get short-term financing.  There is simply no one willing to lend.  Yet I would have no trouble buying a second home and getting another mortgage at a reasonable rate of interest and I am hardly a rich man.

Credit market segmentation is always there but it doesn’t usually matter this much.  The parts of the credit market that are paralyzed by fear are the major problem right now.  And until that problem is cleared up, we will witness a step-by-step disembowelment of the American economy. 

The clock is ticking.  We need very rapidly to get to the point where natural lenders are willing to lend and "cross-market arbitrage" is no longer a dirty word.

A new blog to track the financial crisis.  It provides a good overview of mainstream sources and general background.  By the way, they point to this IMF paper on previous international crises.

Hat tip to Fimoculous blog.

Here is Franklin Allen and Elena Carletti, circa 2006:

When liquidity plays an important role as in times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. We show that a shock in the insurance sector can cause the current value of banks’ assets to be less than the current value of their liabilities so the banks are insolvent. In contrast, if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities. Mark-to-market accounting can thus lead to contagion where none would occur with historic cost accounting.

Here is a comment on that same paper.  I thank Scott Cunningham for the pointer.

The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.  Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself.  Krugman would prefer a recapitalization in the form of nationalization.  In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.)  In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways. 

The consensus policy of economists would put most of the burden of adjustment on politically powerful holders of equity and bonds.

There is also a consensus among economists that the bailout bill is not the right policy.  None of the above economists, for example, is enthusiastic about the bailout.  My bet is that all of us think that the bailout has a substantial likelihood of failing.  The support that exists is born out of hope and fear not judgment and experience.  Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.   

Addendum: Lynne Kiesling draws the Olsonian conclusion.

It is now on-line.  Contributors include Armen Alchian, Gary Becker, Avinash Dixit, Claudia Goldin, Greg Mankiw, Paul Romer, Pete Boettke, Tyler Cowen, Bryan Caplan, Russ Roberts and many others.

On another topic, from elsewhere, here is Arnold Kling on net worth certificates.  And here is Russ Roberts on home prices.  Here is Bill Easterly’s Op-Ed on development and the crash.

A second view is that because the methodologies used for rating CDOs are complex, arbitrary, and opaque, they create opportunities for parties to create a ratings “arbitrage” opportunity without adding any actual value. It is difficult to test this view, too, although there are reasons to find it persuasive. Essentially, the argument is that once the rating agencies fix a given set of formulas and variables for rating CDOs, financial market participants will be able to find a set of fixed income assets that, when run through the relevant models, generate a CDO whose tranches are more valuable than the underlying assets. Such a result might be due to errors in rating the assets themselves (that is, the assets are cheap relative to their ratings), errors in calculating the relationship between those assets and the tranche payouts (that is, the correlation and expected payout of the assets appear to be higher and therefore support higher ratings of tranches), or errors in rating the individual CDO tranches (that is, the tranches receive a higher rating than they deserve, given the ratings of the underlying assets). These arguments are complex and subtle…

That is from a very interesting paper by Frank Partnoy.  The paper is not always easy reading but so far it is the best piece on its topic I have found.  This was another good section:

If the mathematical models have serious limitations, how could they support a $5 trillion market? Some experts have suggested that CDO structurers manipulate models and the underlying portfolio in order to generate the most attractive ratings profile for a CDO. For example, parties included the bonds of General Motors and Ford in CDOs before they were downgraded because they were cheap relative to their (then high) ratings.67 The primary reason that the downgrades of those companies had an unexpectedly large market impact was that they were held by so many CDOs.

Thus, with respect to structured finance, credit rating agencies have been functioning more like “gate openers” rather than gatekeepers. The agencies are engaged in a business, the rating of CDOs, which is radically different from the core business of other gatekeepers. No other gatekeeper has created a dysfunctional multi-trillion dollar market, built on its own errors and limitations.

There is also a good discussion of how the ratings agencies have claimed First Amendment protection for their activities, more or less successfully.  p.96 offers some good policy conclusions.

A famous paper in economics showed how cigarettes became a medium of exchange in a POW camp (even leading to booms and slumps depending on Red Cross deliveries).  For a long time cigarettes were the money of choice in American prisons as well but today, according to a great piece in the WSJ, the preferred medium of exchange is mackerel.

There’s been a mackerel economy in federal prisons since about 2004,
former inmates and some prison consultants say. That’s when federal
prisons prohibited smoking and, by default, the cigarette pack, which
was the earlier gold standard.

Prisoners need a proxy for the dollar because they’re not allowed to
possess cash. Money they get from prison jobs (which pay a maximum of
40 cents an hour, according to the Federal Bureau of Prisons) or family
members goes into commissary accounts that let them buy things such as
food and toiletries. After the smokes disappeared, inmates turned to
other items on the commissary menu to use as currency…in much of the federal prison system mackerel has become the currency of choice.

I loved this point which raised the possibility of significant mack seignorage.

…Mr. Muntz says he sold more than $1 million of mackerel for federal
prison commissaries last year. It accounted for about half his
commissary sales, he says, outstripping the canned tuna, crab, chicken
and oysters he offers.

Unlike those more expensive delicacies, former prisoners say, the
mack is a good stand-in for the greenback because each can (or pouch)
costs about $1 and few — other than weight-lifters craving protein —
want to eat it.

Thanks to Brandon Fuller for the link.

One alternative is a "net worth certificate" program along the lines of
what Congress enacted in the 1980s for the savings and loan industry.
It was a big success and could work in the current climate. The FDIC
resolved a $100 billion insolvency in the savings banks for a total
cost of less than $2 billion.

Here is more.  Here is an FDIC summary of the program, under the heading "Other Resolution Alternatives."  To the extent bank recapitalization is needed, this is the best way to do it.  As Andrew Sullivan will tell you, experience really does matter.  I would like to see more economists promote this idea as an alternative to Treasury warrants. 

Keith asks, as do others:

I had been curious as to how this whole situation will effect the dollar…If you find the time, I would like to know or see the future of the dollar in this situation.

Please note that I am a "buy and hold" guy, not a trader, and I am certainly not a currency trader.  But I’ll cover the dollar vs. the Euro.

My inclination is to think the dollar will hold its value.  I don’t trust any of the macro models of currency values and we do know that purchasing power parity, while very approximate, and exerting its force only in the long run, does not imply a bearish stance toward the dollar.

Here is a list of European banks with assets greater than the gdp of their respective home countries.  And read this.

As for this country, the Chinese now regard us as "battle tested."  We have been through some truly major bumps, yet no major U.S. politician has called for "not paying back the Chinese."  We’ve even guaranteed the $350 billion in agency securities held by the Chinese central bank and without a stir.  I think the Chinese are shocked by that and in many ways they now trust their investments more than before, not less.

The Chinese do not have comparable trust in "Europe."  If something went wrong in the financial realm, who would they call up on the phone?  Which country?  What do they think is the power base of the head of the ECB?  What political party does that person belong to?  What favors can be traded and with whom?  Whose answer would count as definitive?  Keep in mind that for all of China’s modernity, their leaders are still communist party functionaries.

The negative scenario for the dollar is where the Chinese economy collapses, not where the Chinese become too afraid to buy dollar-denominated assets.

Bush, Bernanke, Paulson — we call them leaders.  The Chinese think of them as the customer service department.  I suspect the Chinese get straighter answers from them than we ever do.

There is the O’Neill plan:

His plan to deal with the crisis would start with a "discounted cash-flow analysis” of distressed instruments that are clogging the financial system. The government would guarantee the assets, paring back the support as principal and interest payments were made, he said. "That should take care of the liquidity problem because if they have a government guarantee at a specified level they should trade just like cash,” O’Neill said.

Or the Soros plan.  And here is a "SuperBond" plan to recapitalize the banking system. 

And then there is the Phelps plan for capital injection in return for warrants.  Not to mention the French plan.

Or how about the Wright plan:

…to let any American with a mortgage swap it out for a government one at 7% for up to 50 years (to get the monthly payment down to where the borrower can handle it). The Treasury will pay off the existing mortgage with bonds (which it can sell cheap right now). If a borrower wants to default instead s/he can do so, and then the lender can mortgage the property on the above terms.

So many plans!

Here are some solar greenhouse plans.  And here are Silly Billy’s World’s Elementary Lesson Plans.

They are a good outline to many events behind the current crisis; many of you have been writing to me and asking for background reading.

Another of my colleagues, David Levy, just published this short piece (with Sandra Peart) on the ratings agencies and the idea of experts.