Do financial statements tell the truth?

I produced this as a handout for an introductory course in corporate finance. Maybe it is interesting, or maybe I just feel bad about how infrequently I am blogging.


Financial statements are often referred to as “reports”. As you scan the pages, you will find neat columns of precise numbers. Financial statements look objective. Looks can be deceiving. The questions that financial statements are intended to address do not have objectively true answers. Suppose a firm builds a factory, with custom-built machinery designed to specifically to produce the firm’s product. That factory would become an asset on the left-hand side of the balance sheet. How much is that asset worth?

Often in this course we will emphasize “market value”. But our specialized equipment may not be usable by other firms, so if we tried to sell it in the market, it’d be valued as scrap, and would be worth a fraction of what we paid for it. (The salvage value of firm assets is referred to as liquidation value, and is usually far less than what appears on a balance sheet.) Alternatively, we could estimate the value we believe the equipment will ultimately provide to our business, which will be substantially higher than the price we paid for it. After all, we designed and built our machinery because we anticipate we can put it to profitable use.

If we value the machinery at liquidation prices, we will take an immediate loss on our books when we buy the equipment, as cash on the books is exchanged for fancy high-tech robots that we treat as though it were scrap. The more we work to expand the capacity of our business, the less valuable our firm will appear to be. That doesn’t seem right.

Conversely, if we use our best estimate of the revenues our purchase of the equipment will eventually enable, we will show an immediate gain on our books. (We would not have bought the stuff if we didn’t think it was going to generate more cash than it cost us.) However, even if our firm’s managers are honest and competent, allowing them to conjure instant profits with optimistic estimates of asset values might tempt corruption. Potential investors might be reluctant to rely on statements compiled this way.

In the United States, firm assets are initially valued at “cost”. Very simply, we say an asset is worth whatever a firm paid for it. For our machinery, that value is almost certainly “wrong”: If our expansion works out as planned, the equipment will have been much more valuable than its cost, and if our expansion turns out poorly cost will have been an overoptimistic estimate. The great virtue of “historical cost” is not that it is a good estimate, but that it is objectively measurable. Accounting conventions seem to prefer objective, verifiable lies to subjective truths! Is that dumb?

No, it’s not.

Uncertainty and bias are unavoidable in financial statements. Fortunately, the purpose of financial statements is not to whisper truth in God’s ear, but to inform human action. Since “truth” is not on the menu, long-term investors prefer that estimates be conservative. When you are going to put money on the line based on a bunch of numbers, you prefer any surprises to be to the upside. Plus, managers have incentives to overstate firm performance, because their compensation is performance-linked or because they wish to attract cheap financing. Historical cost accounting helps prevent self-serving optimism. On average, businesses do recoup more than the cost of the assets they purchase, so on average historical cost is conservative.

US accounting conventions skew even further towards conservatism: Older assets are valued at the lower of depreciated historical cost or “market value”. But market value often can’t be known without a sale. So managers are allowed to use subjective estimates to “write down” assets, but they are generally forbidden from estimating values higher than cost. Again, this asymmetrical policy is not designed to render accounting statements accurate, but to render their distortions less harmful. The deeper we examine them, we find that accounting statements look less like “snapshots” of a corporation and more like impressionistic portraits. Some aspects of a firm’s situation are emphasized or skewed, while other aspects may be hidden. If accounting rules can’t render statements 100% accurate, they can at least go for “usefulness”.

What characteristics render financial statements useful? We’ve already talked about conservatism. Another important characteristic is consistency. Investors often need to make comparisions between firms, in order to decide where to invest money, or to evaluate firms they already own against industry peers. Accounting standards boards try to define consistent standards, but there are trade-offs between consistency and accuracy. For example, an accounting rule that computer equipment should be depreciated over 5 years may be appropriate for an ordinary firm, but not for a cutting-edge software company whose workstations must be replaced every 2 years. Enforcing that rule uniformly might lead to the software developer’s profits being overstated in some years and understated in others, rendering bottom-line profitability less comparable between firms!

If financial statements are designed to be “useful”, it’s worth asking the question, “useful to whom”? So far, we’ve mostly considered the interests of the long-term investor, who usually desires that statements be as accurate as possible, but conservative where estimation is required. There are other constituencies interested in financial statements, including creditors, analysts, regulators, tax authorities, and firm managers. There may even be conflicts of interest between these groups. Accounting choices affect reported profitability, and therefore taxable earnings. Managers and current investors may prefer accounting choices that defer recognition of profit, while tax authorities want profits to be recognized as quickly as possible. On the other hand, managers and shareholders of firms that borrow much of their capital — leveraged firms — may prefer optimistic choices that enhance apparent profitability, because lenders demand lower interest payments from firms that are “financially strong”. (Note that shareholders of leveraged firms have a kind of conflict of interest with themselves! On the one hand, they prefer conservative accounts in order to safely evaluate their own positions. On the other hand, they prefer “aggressive” accounts that paint a picture of financial strength, in order to help the firm get cheaper loans. Interest payments are a direct hit to shareholder profits, so shareholders of very leveraged firms may be willing to forego conservatism and accuracy of statements in favor of profitability.) Managers and short-term investors may wish to “smooth earnings”, because the stock market rewards reliable earnings, while long-term investors prefer clear information about the timing of firm performance. Analysts often desire consistency and comparability between firms above all, while investors and managers may wish to tailor accounting choices to the unique circumstances of their business.

How can all of these interests be accommodated by a single set of financial statements? They can’t be. The financial statements that are actually published are hard-fought compromises that try to square an impossible circle. Both at the accounting standards level (e.g. the Financial Accounting Standards Board in the United States) and within individual firms, different groups struggle to have their interests and preferences reflected in the disarmingly precise columns of numbers that will become the centerfold of annual reports.

This struggle takes place in boardrooms and public policy debates. But it leaves footprints, or more literally footnotes. Accounting statements are generally accompanied with a set of notes that is much longer than the statements themselves. These “drill down” into the summary values presented in consolidated statements, and explain the accounting choices beneath the published numbers. Usefully, the notes include quantitative information with which a dedicated analyst can compute alternative statements based on different accounting choices. Even a casual reader may learn more from a careful read of the footnotes than from the headline statements. When financial analysts wish to compare a group of firms, they need “apples-to-apples” financial statements. One of the first thingsthey do is adopt a uniform set of accounting choices and recompute the various firms’ financial statements, using information from the notes.

Financial statements are like fictional works “based on a true story”. They bear some relationship to actual events, but they are interpretations with their own biases and agendas. Successful investors and analysts will read them critically, piecing together clues, sometimes learning as much from the paths not taken as from the numbers actually published.


Thought questions:

1) Your textbook is very cognizant of the ambiguities surrounding accounting values. Rather than get all hermeneutical with financial statements, your book encourages you to circumvent them and rely on data that seems objective, especially market values and cash flows. What are some benefits and drawbacks of this strategy?

2) Prior to the 2008 financial crisis, financial firms found ways of circumventing the accounting conventions that generally render financial statements conservative. In particular, “gain on sale” accounting allowed banks to effectively write-up the value of recently purchased assets above historic cost (via the trick of “selling” the assets to a special purpose entity that the bank itself organized, as part of the process of securitization). Why would bank managers and employees want to do this? Don’t long-term shareholders generally prefer conservative accounts? Why might shareholders tolerate this practice at banks?

Monday at the Treasury: an overlong exegesis

Last Monday, I had the privilege to meet up with a bunch of bloggers and Treasury officials for what might be described as a “rap session”. The meeting was less formal than a previous meeting. There were no presentations, and no obvious agenda. Refugees from the blogosphere included Tyler Cowen, Phil Davis, John Lounsbury, Mike Konczal, Yves Smith, Alex Tabarrok, and myself. Our hosts at Treasury were Lewis Alexander, Michael Barr, Timothy Geithner, Matthew Kabaker, Mary John Miller, and Jake Siewart. You will find better write-ups of the affair elsewhere [Konczal, Lounsbury (also here), Smith, Tabarrok]. Treasury held another meeting, with a different set of bloggers, on Wednesday.

It is bizarro world for me to go to these things. First, let me confess right from the start, I had a great time. I pose as an outsider and a crank. But when summoned to the court, this jester puts on his bells. I am very, very angry at Treasury, and the administration it serves. But put me at a table with smart, articulate people who are willing to argue but who are otherwise pleasant towards me, and I will like them. One or two of the “senior Treasury officials” had the grace to be a bit creepy in their demeanor. But, cruelly, the rest were lively, thoughtful, and willing to engage as though we were equals. Occasionally, under attack, they expressed hints of frustration in their body language — the indignation of hardworking people unjustly accused. But they kept on in good spirits until their time was up. I like these people, and that renders me untrustworthy. Abstractly, I think some of them should be replaced and perhaps disgraced. But having chatted so cordially, I’m far less likely to take up pitchforks against them. Drawn to the Secretary’s conference room by curiosity, vanity, ambition, and conceit, I’ve been neutered a bit. There’s an irony to that, because some of the people I met with may have been neutered, in precisely the same way and to disastrous effect, by their own meetings and mentorings with the Robert Rubins and Jamie Dimons of the world.

Obviously the headline act was Timothy Geithner. Off the record (or “on deep background”), Geithner is entirely different from the sometimes stiff character who appears on television. He is fun to argue with, very smart, good natured, and intellectually wily. As Yves Smith quipped afterwards, Geithner “gives good meeting.”

Despite that, our seminar was an adversarial affair. We began by relitigating financial reform. Officials began by talking up the buzz of activity occasioned at Treasury by the Dodd-Frank Act — putting together the Financial Stability Oversight Council, “standing up” the CFPB — with the happy implication that good and important things were happening. We peppered them with skeptical questions. Mike Konczal asked what sort of metrics they would use to judge the success of the bill. (That’s a hard problem, they said.) It’s well and good that folks at Treasury are made busy by the Act, but is it having any effect on the behavior of banks? (There’s been some movement on overdraft protection, and banks are raising capital.) As Alex Tabarrok has already reported, Tyler Cowen asked the excellent question of how the Act has changed regulators’ incentives, of why we should believe that regulators won’t intervene next time as they did this time, bailing out bankers and creditors at the expense of taxpayers. Resolution authority was their answer. Regulators’ incentives were fine the first time around, but they simply didn’t have the tools they needed to take the appropriate actions, to chart a middle course between generous bailouts and catastrophic unwinds. I’m very skeptical of that account.

I was pleased that, thanks to both Tyler Cowen and Yves Smith, we had a solid discussion of derivative clearinghouses. I am a big fan of standardized derivative exchanges and clearinghouses, and trade on them frequently. But I’m very fearful of the degree to which we will rely upon them under the new regime. Like a gas under pressure, the financial sector pushes and prods for places where high returns can be earned at someone else’s risk. During the last cycle, that included banks, shadow banks, and the GSEs, which earned profit on huge asset portfolios cheaply levered by virtue of perceived state guarantees (that were ultimately ratified). In theory, financial reform will firm up those weak spots, reducing permissible leverage and increasing its cost as resolution authority makes non-bailout of creditors credible. Suppose that actually happens. Then clearinghouses will stand out as institutions that are much too big to fail, and whose ultimate creditors (derivative traders) do not and cannot monitor creditworthiness. Clearinghouses are cleverly structured, so that the “members” through which clients trade are exposed to one another’s losses and do monitor each other’s financial health. But it is easy to imagine scenarios where it is in all members’ interest to allow a product to be undermargined. Regulated, highly leveraged financial institutions rationally accept “negative skewness“, arrangements that are profitable for them almost all of the time, but that fail catastrophically when something breaks. During long periods of stable profitability, an institution builds a track record to persuade regulators that risks are minimal and capably managed. The institution is permitted to take ever greater risks, and distribute ever greater profits to investors, while times are good. When, eventually, a catastrophic failure occurs, losses exceed the capital of the firm and are shifted elsewhere, usually to taxpayers. An undercapitalized and undermargined clearinghouse is a great vehicle for this sort of game, as low margins attract fee income from speculative trading, and members can trade on their own exchanges as a means of acquiring the cheap leverage that regulation might otherwise prevent. I’ve skimmed the relevant section of Dodd-Frank, and as far as I can tell, the hard and fast rules governing “derivatives clearing organizations” are very weak. We will be depending upon the discretion of regulators.

Gap risk and liquidity risk are kryptonite to clearinghouses. Yves Smith pointed out that clearing credit default swaps in particular could prove very challenging. These contracts sometimes “jump to default”, creating large losses very quickly for the protection sellers. If a clearinghouse were to insist on margins large enough to cover sudden jumps to default, the contracts would probably become unattractive to investors. If it does not, then a systemic shock that impairs many credits simultaneously could take down the clearinghouse.

Treasury officials had clearly thought about these issues. They pointed out, correctly, that despite formally concentrating risk, clearinghouses are better than bilateral trades, because in practice derivative markets engender systemic, not just bilateral, risk anyway and at least with a clearinghouse one can track, manage, and regulate that. Ultimately, their answer was that once we put this extra transparency in place, we just have to trust regulators to regulate well. In response to Yves’ skepticism of clearing CDS, one official suggested that regulators will insist on adequate margins, and if that renders some products uneconomical then so be it. I’ll believe that when I see it.

A disappointing moment in the conversation on financial regulation was when several officials suggested that increased capital requirements in and of themselves would do much of the work of solving bank incentive problems. I hope they were just trying snow us with this, because if they believe it, it suggests that they haven’t thought very carefully about how well aligned the incentives of equityholders, bank managers, and traders are at highly levered institutions. All three groups benefit by putting creditors’ resources at risk and earning outsize profit against limited costs (loss of equity value or loss of a job). Under the new regulation, our “strong” capital requirements will probably permit banks to be levered at least 15 times poorly measured common equity. That’s not nearly enough to tilt shareholder incentives decisively towards capital preservation. Shareholders would have to work very hard to oppose the interests of managers and traders. One official wondered aloud why bondholders failed to discipline banks, in order to prevent this sort of misbehavior. I’ll leave that one dangling as an exercise for readers.

The conversation next turned to housing and HAMP. On HAMP, officials were surprisingly candid. The program has gotten a lot of bad press in terms of its Kafka-esque qualification process and its limited success in generating mortgage modifications under which families become able and willing to pay their debt. Officials pointed out that what may have been an agonizing process for individuals was a useful palliative for the system as a whole. Even if most HAMP applicants ultimately default, the program prevented an outbreak of foreclosures exactly when the system could have handled it least. There were murmurs among the bloggers of “extend and pretend”, but I don’t think that’s quite right. This was extend-and-don’t-even-bother-to-pretend. The program was successful in the sense that it kept the patient alive until it had begun to heal. And the patient of this metaphor was not a struggling homeowner, but the financial system, a.k.a. the banks. Policymakers openly judged HAMP to be a qualified success because it helped banks muddle through what might have been a fatal shock. I believe these policymakers conflate, in full sincerity, incumbent financial institutions with “the system”, “the economy”, and “ordinary Americans”. Treasury officials are not cruel people. I’m sure they would have preferred if the program had worked out better for homeowners as well. But they have larger concerns, and from their perspective, HAMP has helped to address those.

Phil Davis, who made clear that his remarks were from the perspective of bank investors, thought Treasury was doing far too little to defuse the housing problem. He pointed out that even if the financial reform bill is beautifully crafted, its full implementation will take up to three years, during which the banking system will remain in peril, largely because of tenuous mortgages. He suggested that Treasury help pay down the mortgages of struggling homeowners until the remaining loan was solid. In exchange, Treasury would retain an equity claim on the home, from which in a good scenario taxpayers might be able to recover much of the cost of the program when the houses are eventually sold. A senior Treasury official gave the proposal a sympathetic hearing, but opined that exchanging a government claim against a homeowner for a bank’s claim against a homeowner in order to solidify bank balance sheets was not the best use of limited budgetary and policy implementation capacity. (For a change, I agreed with the Treasury official on this one.)

From HAMP, we segued briefly to a discussion of the GSEs. I got excited when one Treasury official explained that his inclinations were “minimalist”. I imagined winding down the GSEs, eliminating the mortgage interest rate deduction, cutting away the vast web of pernicious subsidies to home-lendership. My hopes were quickly deflated. By “minimalist”, the official meant parsimonious in terms of changes to the existing system. In a nutshell, he proposed insisting, by regulatory fiat, that future GSE’s borrowing costs be kept at a level appropriate to a private firm with no Federal backstop, implicit or otherwise. He thought there would be a continuing role for some kind of government guarantees of mortgages, but suggested this guarantee could be made more limited. (I think the idea would be to put private players — the Re-GSEs or originating banks — on the hook for a first loss.) In the spirit of Tyler’s question about regulatory incentives, I thought this proposal entirely naive. Over time, regulators would not succeed at forcing a substantial above-market spread on politically powerful private actors. (Well, private with respect to the upside, not if the downside, of their activities.) Further, the suggestion reflects an inadequate view of how creditors limit firm risk-taking. In the private sector, creditors do not only charge a higher spread for risk, but they participate in governing firms and constrain behavior directly via bond covenants. The name for bond covenants when imposed by a public sector creditor is “regulation”. Ultimately, this “minimalist” approach to managing the GSEs amounts to nothing more or less than keeping the existing system and proposing that it be better regulated, including specific regulatory suggestions that are foreseeably unlikely to withstand industry pressure. No offense to its very smart proponent, but this was a non-idea dressed up as reform.

I did express my skepticism to Mr. Minimalist. Unlike some of his colleagues, he was smart enough, or honest enough, to acknowledge that even with stronger capital ratios, it is naive to rely on the private capital structure of large, complex financial firms to enforce good behavior. So what is to be done, if not to regulate them as best we can? Almost as an aside, he noted that some people thought we should limit “size”, but that he couldn’t see how that would get at the problem, and had rejected the approach. Had there been time, I would have been glad to school him. “Size”, of course, stands in for and trivializes the notion of structural rather than supervisory regulation, an approach that many of us pushed desperately, only to be met by a wall of dismissal from Treasury and Congressional leaders. [*]

Perhaps Treasury officials really can’t see how limiting “size” might help. But I don’t think that’s right. These are very, very smart people. I think they understand the merits of the structural approach to financial regulation, but view the transition costs as simply too large to bear. But that begs the question of costs to whom, and whether (per the HAMP conversation above) it is wise to conflate the health of status quo financial institutions with the welfare of the economy as a whole.

Finally, our conversation turned to the current macroeconomic doldrums. Thankfully, there was none of the “let’s look on the bright side” chipperness of Timothy Geithner’s recent New York Times op-ed. Treasury officials didn’t downplay how bad things are. They did point out that considering the headwinds the economy faces, things are a bit better than they might be. The account went roughly like this: Last year, after the doldrums of March, the economy grew faster and performed better than most would have forecast. But recently it encountered two obstacles, one expected, the other an unexpected near cataclysm. The spurt of GDP growth due to post-panic inventory restocking was always going to end. But a sovereign debt crisis in Europe strong enough to shake confidence and financial markets in the US was not expected. Taking all that into account, things are a bit better than they might have been. One Treasury official pointed out that if we could return to the path of consensus growth forecasts from just before the troubles in Europe, we would have two or three difficult years ahead of us yet, but would be on a decent path. I took this as a kind of optimistic but plausible thought experiment on where we might be going.

I’m not going to belabor the obvious critique of this account, that it focuses too much on statistical growth and financial market performance and too little on employment (which, in the optimistic thought experiment, would follow statistical growth with a lag). Also, if we are enumerating headwinds to current GDP growth, I would have included the tailing off of Federal stimulus, a factor I don’t recall officials emphasizing.

I was impressed that Treasury officials had a pretty good understanding of the impediments to growth going forward. They understood that the core problem preventing business expansion isn’t access to capital but absence of demand. But I got the sense that, as they see things, they are boxed-in on that front, paralyzed and hoping for the best. When someone asked about monetary policy, an official said he really couldn’t comment on behalf of the Fed, but then proceeded to comment anyway, that in a very sharp downtown the Fed would have (presumably unconventional) ways to intervene, but that we were probably near the limits of what the central bank would do on the economy’s current path. Regarding their own bailiwick, an official perceptively pointed out that the set of spending programs Congress seems capable of delivering and the set of programs the public would consider wise and legitimate seem not to intersect. All of this resonated well with me: I view the current macro-sluggishness as a function of insufficient demand, yet stand with the hypothetical public in being hesitant to support “stimulus” and “jobs” programs that strike me as haphazardly targeted and sometimes wasteful or corrupt.

What ought a Treasury official do under these circumstances? Mike Konczal suggested that Treasury had latitude to stimulate without Congressional approval, pointing out that only a small fraction of the funds allocated to HAMP had been spent, and that with some cleverness the remainder could serve as a piggy bank. He was openly astonished when he was told that despite the tiny uptake thus far, according to Treasury’s extrapolations and accountings, at least $40 of the $50 billion allocated to HAMP would be used by the program and the funds were therefore already spoken for.

My suggestion was that Treasury should take the lead from Congress and propose a “two-year guaranteed income program”. If I were writing a proposal, I’d offer a lot of detail and caveats, but during a short meeting with scarce air-time, that was the sound-bite I came up with. As regular readers know, I think the government ought to be transferring equal sums of money to all adult US citizens irrespective of tax or employment status. That’s a form of stimulus that seems fair on face, that doesn’t pick winners and losers or skew the direction of the economy, and is plainly not corrupt. “Guaranteed income program” can be interpreted in lots of different ways, though, and I have no idea how Treasury officials took this. In any case, the quick response was to say it wouldn’t pass Congress, as though that were that. Later on, I suggested officials should push it anyway, and “go down, or up, with the ship”.

Putting aside the merits and demerits of my own proposal, under the present circumstance, where things are going badly and officials believe that some forms of policy activism would be wise but are politically impossible, how ought public servants behave? Is it too much to ask, as I did, that officials choose good policy and push it, even if that means tilting at windmills in ways that could erode political capital and be harmful to their careers? One can make the case, as I suspect Treasury officials would, that policy idealism makes the best into the enemy of the good, and results in less achievement than a more pragmatic approach. Sometimes that might be true, but I think it is dead wrong right now. We are currently trapped in a political dynamic under which the contours of what is conventionally possible are so terribly straitened, and so terribly corrupt, that “achievements”, like health care reform, even when they are incremental improvements in policy, are painful blows to the public’s sense of the potency and legitimacy of government. We have a President who campaigned under the slogan “Yes we can!”, but then governed by cutting deals with status quo interest groups and limiting options to what powerful lobbies could live with. I was not lying when I said at the beginning of this piece that I like the people at Treasury personally. I have no great wish that they should lose their jobs. But for the good of the country, I do think they should come up with what they think would be the best economic policy imaginable and push it on its merits, publicly and unapologetically, even if it costs them their positions, and even though I might be horrified by what they’d choose. (Despite all the conversation, I have absolutely no idea what they would choose.)

Amid the talk about flagging demand, blogger John Lounsbury had the courage to “drop a stink bomb”, as he put it. He said that in his view, the United States needed to move from a consumption to a production oriented economy, and that we ought to use the tax system to get there, increasing taxes on consumption and reducing taxes on capital. I agree with John that the US economy needs to shift so that it produces as much value as it consumes (see below) but I’m entirely unenthusiastic about this sort of tax policy. John’s proposal amounted to a full U-turn from our how-to-inspire-demand conversation, but the Treasury official with whom we were speaking didn’t miss a beat. He nodded sympathetically, and said that while he couldn’t discuss specifics of what the deficit commission was doing, they were doing good work. I left with a serious case of heebie-jeebies about what the deficit commission might be up to, but no details at all.

Despite my disagreement with John regarding tax policy, I share his concern that the US economy has habitually failed to achieve a “sustainable pattern of specialization and trade”, as Arnold Kling likes to put it. The most obvious reflection and enabler of this, I think, is the United States’ large, structural trade deficit (which recently spiked). I asked Treasury officials what they intended to do about this, keeping in mind that the problem runs much deeper than our bilateral relationship with China, as well as the importance of avoiding distortionary protectionism, unfair discriminatory policies, or trade wars. Alex Tabarrok (who fascinates me as a writer, but spoke far too little at the meeting) pointed out that Treasury had done a good job so far at avoiding conflict over trade and resisting pressure to impose foolish barriers. He is right about that, but Treasury has also done little thus far to address the structural imbalance. The trade deficit did decline briefly during the recession, but given its quick resurgence, that seems to have been a mechanical effect of the pause in economic activity rather than a sustainable change in trade patterns.

A Treasury official agreed enthusiastically about the importance of finding more sustainable patterns of trade. But he characterized trade balance as a medium-term issue that might resolve itself over time, especially if China (which he described as the “anchor” of a whole block of trade partners) allows its exchange rate to appreciate. He suggested that although the issue is important, we could worry about other things for now and save trade balance for later if it fails to self-correct.

I disagreed. I think that the trade imbalance makes stimulus both intellectually and politically difficult to defend (including my own “guaranteed income program”), because the pattern of business expansion we would stimulate would continue to overproduce domestic services and underproduce tradable goods relative to the patterns of production we will require when unsustainable international flows cease or reverse. In Austrian terms, I think demand stimulus in the context of continuing trade deficits will lead to malinvestment and another dangerous recession when what can’t go on forever stops. Rather than reinforcing patterns of investment that will have to be reversed, we should begin to wean ourselves of unbalanced trade flows, so that investors find it profitable to bolster the sectors we will require in order to pay for current consumption with current production. Unfortunately, it did not sound as though nondiscriminatory tools for enforcing trade balance, such as capital controls or “import certificates“, were anywhere on Treasury’s radar screen.

Overall, as I said at the start, the meeting was a lot of fun. I spend a lot of time around universities, and our meeting resembled nothing so much as an unusually lively seminar. Unfortunately, just like an academic seminar, I left with the feeling that there were a lot of bright ideas and brilliant people, but nothing much was going to come of it all, at least not anytime too soon.


[*] No one claims that limiting “size” alone, defined as market cap or balance sheet assets, would be sufficient to solve any problem. One dollar of equity can pull the whole universe into a financial black hole if it is sufficiently leveraged. But proponents of structural regulation understand that status quo large financial firms simply cannot be regulated, either privately by equity and debt holders or publicly by civil servants. As discussed above, when a firm is highly leveraged, equity holders switch from sober stewards of capital to risk-loving looters of creditor wealth. When a firm’s creditors are formally guaranteed, or when as a group they are sufficiently large, interconnected, and incapable of bearing losses, creditors also switch sides, ignoring risk and seeking yield on the theory that the social costs of forcing them to eat losses would be far higher than the fiscal cost of bailing out the bank. The entire private capital structure of systematically important financial firms wants to maximize risk-taking while minimizing regulatory costs, looting the public purse and splitting the proceeds between creditors, shareholders, managers, and other employees. Relying on “market discipline” for this sort of firm cannot work. Relying on public sector supervision ignores resource asymmetry and political constraints, as well as the information and incentive problems faced by even smart, well-intentioned regulators. Large, complex, leveraged and interconnected financial firms simply cannot be regulated, by the private or public sector. Without regulation they quite rationally maximize stakeholder wealth in a manner that happens to be socially and economically destructive. The only way around this is to change the incentives of all stakeholders, and that could only happen by placing them in a different kind of firm. We have to limit the size and composition of firms’ creditor base, so we can be sure losses to creditors would be socially and politically tolerable. (We do this already, or try to, with hedge funds.) We have to limit the scale of firm exposures, including on-balance-sheet, off-balance-sheet, and synthetic exposures, so we can be sure that the cost of nonperformance to counterparties would also be tolerable. Less obviously, we have to limit the scale of economic exposures relative to the number of independently responsible asset managers, so that no asset manager manages so much money that one or a few years of performance-based compensation would leave them set for life. The incentives of managers at small, nonprestigious banks are much better aligned with the long-term viability of their firms than hot-shots at glamour banks, who flit between high-paying gigs and hope to get their “fuck you money” fast. We have to limit the scope of operations at individual banks, because a complex bank is a bank that can’t be regulated, publicly or privately.

Also, small banks rationally allocate capital differently than very large banks. Big banks seek economies of scale to exploit. They trawl through vast streams of systemized data looking for patterns that can be widely applied to inform lending and investment decisions. Smaller banks seek out advantage based on local information and specific relationships. These are distinct strategies, and banks of different size will find different approaches adaptive. Lions and house cats are superficially similar, but thrive in different ecological niches. Large banks cannot effectively exploit local information, because local information is usually “soft” — that is, difficult to quantify and objectively verify. Lending based on soft information is inherently discretionary and prone to abuse, and large banks find it difficult to discipline the qualitative instincts of thousands of loan officers. Conversely, large bank employees find it impossible to defend inevitable failures, when, ex post, investments look to have been based on glorified hunches. (Small bank loan officers would have gotten buy-in up front from senior management, so failures get more sympathetically reviewed.) Further, most businesses will find it difficult to form credible relationships with very large banks, while small banks can have a real stake in an individual client’s success. But small banks can’t do what big banks do, as they lack sufficient data to mine client-order flow or tease out subtle relationships between FICO scores, patterns in checking and credit-card behavior, and loan performance. Small banks and large banks set about the task of allocating financial capital very differently. If you take a Hayekian view of capital allocation, small banks are likely to do a superior job.

(Small banks will do a better job in aggregate, even though those that fail will be found to have made more ludicrous and scandalous mistakes. Also, while most large-bank strategies are pathological, there is a well-known pathological small-bank strategy, “herding” or “information cascades”. In a small-bank-centric world, regulators would have to penalize copycat behavior, for example by taxing or increasing regulatory capital requirements when banks choose to invest in asset classes that are already overrepresented in the aggregate banking sector portfolio.)

Update History:

  • 22-August-2010, 10:00 p.m. EDT: Removing some excess verbiage: “less achievement overall” → “less achievement”, “in policy terms” → “in policy”. Removed some unnecessary commas. Fixed use of the word “diffuse” where “defuse” was intended, many thanks to Nemo for pointing this out!
  • 22-August-2010, 10:55 p.m. EDT: “There’s some irony to that” → “There’s an irony to that”

Monetary policy for the 21st century

Twentieth Century monetary policy can be understood very simply.

One can imagine that, prior to the 1980s, the marginal unit of CPI was purchased from wages. That made managing inflation difficult. In order to suppress the price level, central bankers had to reduce the supply of wages. But reductions in aggregate wages don’t translate to smooth, universal wage cuts. For institutional reasons, attempts to restrain aggregate wages generate unemployment. Prior to the 1980s, central bankers routinely had to choose between inflation or recession.

Then came the “Great Moderation”. The signal fact of the Great Moderation was that the marginal unit of CPI was purchased from asset-related wealth and consumer credit rather than from wages. Under this circumstance, central bankers could fine-tune the economy without disruptive business cycles. When resources, especially humans, were under-employed, expansionary monetary policy could be used to inflate asset prices and credit availability, until increased expenditures on consumption goods took up the economy’s slack. When inflation threatened, contractionary monetary policy restrained asset price growth and credit access, reducing the propensity of the marginal consumer to spend. (“Asset-related wealth” includes speculative gains, the capacity to borrow against appreciated collateral, and the increased willingness of consumers to part with wages and savings due to a “wealth effect”.)

Regular readers know that I am not a fan of the Great Moderation. Central bankers and economists found it pleasant at the time, but sustaining that comfort required that cash wage growth be suppressed, that credit be expanded regardless of overall loan quality, that asset prices be frequently manipulated, as means to a macroeconomic end. In exchange for price stability and moderate business cycles, we mangled the price signals that ought to have disciplined capital allocation, we levered and impoverished American households, we transformed our financial system into a fragile and corrupt cesspool of self-congratulatory rent-seekers. I call that a very poor bargain. (I want to emphasize, because it always comes up, that it was not central bankers primarily that suppressed wages during the period. Globalization and declining union power did most of that work. But central bankers understood very well the importance of wage suppression, and emphasized their willingness, their “credibility”, to push back hard against any increase in the share of income accruing to labor.)

Still, if Great Moderation monetary policy sucked, pre-Moderation business cycles sucked as well. Is there a better way?

It’s no good when the marginal unit of CPI is purchased from wages. That’s the bad old days. It’s no good when the marginal unit of CPI is purchased from asset wealth or consumer credit. That’s the Ponzi scheme that got us into our current troubles. So what kind of dollar should buy the marginal unit of CPI? Ideally, it should be something central banks can “fine tune” without provoking recessions or bubbles, and something that doesn’t involve a macroeconomic imperative to expanded indebtedness.

Here’s my proposal. We should try to arrange things so that the marginal unit of CPI is purchased with “helicopter drop” money. That is, rather than trying to fine-tune wages, asset prices, or credit, central banks should be in the business of fine tuning a rate of transfers from the bank to the public. During depressions and disinflations, the Fed should be depositing funds directly in bank accounts at a fast clip. During booms, the rate of transfers should slow to a trickle. We could reach the “zero bound”, but a different zero bound than today’s zero interest rate bugaboo. At the point at which the Fed is making no transfers yet inflation still threatens, the central bank would have to coordinate with Congress to do “fiscal policy” in the form of negative transfers, a.k.a. taxes. However, this zero bound would be reached quite rarely if we allow transfers to displace credit expansion as the driver of money growth in the economy. In other words, at the same time as we expand the use of “helicopter money” in monetary policy, we should regulate and simplify banks, impose steep capital requirements, and relish complaints that this will “reduce credit availability”. The idea is to replace the macroeconomic role of bank credit with freshly issued cash.

Of course we will still need investors. But all that transfered money will become somebody’s savings, and having reduced the profitability of leveraged financial intermediaries, much of that will find its way to some form of equity investing.

There are details to consider. Won’t this proposal render central banks almost immediately insolvent? After all, conventionally, currency is a liability of a central bank that must be offset by some asset, or the balance sheet will show a gigantic hole where the bank’s equity ought to be. But that’s easy to remedy. Central banks can just adopt an old accounting fudge and claim that policy-motivated transfers purchase an intangible asset called “goodwill”. But, you may object, fudging the accounts doesn’t alter economic realities. Quite so! But what are the economic realities here? Balance sheet insolvency is nothing more or less than a predictor of illiquidity. No firm goes out of business because it’s shareholder equity goes negative. Firms die when they are presented with a bill that they cannot cover. But a central bank with liabilities in its own notes can never be illiquid, since it can produce cash at will to satisfy any obligation. It is book insolvency, not intangible goodwill, that would misrepresent the economic condition of the bank. If the central bank does not pay interest on reserves (which it should not), currency’s status as a “liability” is entirely formal. Central bank accounts should be defined by economic substance, not by blind analogy to the accounts of other firms. The purpose of a central bank’s balance sheet is to present a snapshot of its cumulative interventions, not to measure solvency. Consistent with that objective, a placeholder asset that offsets the formal liability incurred from past transfers would render transparent the cumulative stock and net flow of policy-motivated transfers. [1]

Then there are more interesting problems, like how routinizing transfers from the central bank to citizens might reshape society. “Free money” would certainly carry consequences, both good and bad, foreseeable and unforeseeable. My suggestion would be that the central banks should make equal transfers to all adult citizens irrespective of income, job, or tax status. That would be simple to understand and administer, and it is “fair” on face. It has other good points. To the degree that transfers are motivated by wasteful idleness of real resources (e.g. unemployment), flat transfers are guaranteed to put money in the hands of cash-constrained people who will spend it. Flat transfers are much more effective stimulus than income tax cuts (much of which are saved), and more effective even than payroll tax cuts (because people with jobs are more likely to save an extra dollar than people without). Further, because such transfers would be broadly distributed, the information contained in the spending patterns provoked by such transfers is more likely to be representative of sustainable demand than other means of stimulus. Status quo monetary policy, in obvious and direct ways, distorts economic activity towards the financial assets and debt-financed durable goods. I hope it’s obvious by now why that’s bad. Transfers to the already wealthy (e.g. income tax cuts) amplify the influence of a relatively small group of people whose desires are already overrepresented in shaping patterns of demand.

There is also a kind of macro-level justice in combating depressions with flat transfers of cash. During booms, income inequality typically grows as workers and investors in “hot” sectors do very well. In theory, there’s a positive sum social bargain that encourages us to tolerate that inequality. If people are growing rich by performing activities that are genuinely of great value, even very unequal distribution of the new wealth may leave everybody better off, and the fact that people at the center of that production get rich provides a useful incentive for people to do great things. However, when booms are followed by great busts, it suggests that some of the apparent wealth created during the boom was in fact illusory. Ideally, we’d have a system where the producers of illusions lose their wealth when it is revealed that they had in fact produced nothing of value. But in a world where everything is liquid, where risks are easily transfered and apparent gains can be converted to cash on a moment’s notice, the relationship between quality of production and wealth-you-get-to-keep becomes murky. Episodes of illusory production end up causing aggregate pain, even while the illusionists keep their gains. Using flat transfers to combat the aggregate pain compresses the distribution of relative income, taking back some of the advantage that, in retrospect, was not well earned during the boom.

The most obvious hazards of monetary policy transfers have to do with dependency and incentives to work. If people grow accustomed to getting sizable checks from the central bank, that would change behavior. But not all changes are bad. For example, it may be true that many workers would be pickier about what jobs to take if government transfers generated incomes they could get by on without employment. Employers would undoubtedly have to pay people who work unpleasant jobs more than they currently do. But that’s just another way of saying that workers would have greater bargaining power in negotiating employment, as their next best alternative would not be destitution. That we’ve spent 40 years increasing the bargaining power of capital over labor doesn’t make it “fair”, or good economics. Supplementary incomes are a cleaner way of increasing labor bargaining power than unionization. Unionization forces collective bargaining, which leads to one-size-fits-all work rules and inflexible hiring, firing, and promotion policies, in addition to higher wages. If workers have supplementary incomes, employment arrangements can be negotiated on terms specific to individuals and business circumstances, but outcomes will be more favorable to workers than they would have been absent an income to fall back upon.

Still, it is possible that too many people would choose to “live off the dole”, or that people would come to depend upon income from the central bank, limiting the bank’s flexibility to reduce transfers when economic conditions called for that. So here’s a variation. Rather than distributing cash directly, the central bank could make transfers by giving out free lottery tickets. The winnings from these lottery tickets would constitute transfers from the central bank to the public. But the odds that any individual would win in a given month could be made small, in order to prevent people from growing dependent on a regular paycheck from government. Plus, it would be easier for the central bank to reduce the “jackpot” offered in its free lottery than to scale back payments that people have come to expect. If you buy the thesis that poor people experience increasing marginal utility to wealth, paying out large sums occasionally rather than modest sums frequently might be ideal.

I know this all sounds a bit crazy, a new normal under which central banks would print money to fund lottery payouts and then fake an asset on their balance sheets to offset the spending. But these are perfectly serious proposals. Futurama, baby.


[1] There is a theory that the value of a currency is somehow related to the strength of the issuing central bank’s balance sheet, so a currency issued against fictional “goodwill” would quickly become worthless. Suffice it to say that, with respect to non-redeemable fiat currencies, there is absolutely no evidence for this theory. There is no evidence, for example, that the purchasing power of the US dollar has any relationship whatsoever to the Fed’s holdings of gold or foreign exchange reserves. The assets of existing central banks are mostly loans denominated in the currency the bank itself can produce at will. You may argue that those assets are nevertheless “real”, because repayments to the central bank will be with money earned from real activity. But that assumes what we are trying to explain, that people are willing surrender real goods and services in exchange for the bank’s scrip. Perhaps fiat currency derives its value from coercive taxation by government, as the MMT-ers maintain. Perhaps the imprimatur of the state serves as an arbitrary focal point for the coordination equilibrium required for a common medium of exchange. I don’t know what makes fiat currency valuable, but I do know that the real asset portfolio of the issuing central bank has very little to do with it.

The stickiest price

Here’s a question for the macroeconomists.

“Sticky prices” are the foundation of “Great Moderation” monetary policy, the core justification for why we have inflation stabilizing central banks. As the bedtime story (or DSGE model) goes, if only prices were perfectly flexible, markets would always clear and the great equilibrium in the sky would prevail and all would be right and well in the world. Hooray!

Unfortunately there are… rigidities. Shocks happen (economists are bashful about that other s-word), and prices fail to adjust instantaneously. Disequilibrium persists or oscillates and all kinds of complex dynamics occur, because the system, once outta whack, doesn’t get back in whack very quickly. Disequilibrium is followed by its terrible twin distortion, which shrieks through the night, ravaging the villagers with suboptimal resource utilization, most especially suboptimal utilization of the villagers themselves who are let to starve because their wage expectations are too damned sticky.

If my tone betrays a certain disdain for this account, that is because, in my view, central bankers have used it to harm people and blame the victims. The policy regime that we have crowed over from Volcker through Bernanke and Trichet “naturally” led to the conclusion that (1) central banks should stabilize inflation, so that predictable price adjustments are mostly sufficient to keep things in equilibrium; and (2) that central banks ought to focus especially on stabilizing the stickiest prices, leading to distinctions between overall and “core” inflation. Among the stickiest prices, of course, is the wage rate. In practice, from the mid 1980s right up through 2008, the one thing modern central bankers absolutely positively refused to tolerate was “inflation” of wages. God forbid there be an upcreep in unit labor costs, implying that a shift in the income share away from capital and towards workers. Central banks jack up interest rates right away, because what if the change in relative prices is a mistake? We wouldn’t want that to stick, oh no no no no no. But when the capital’s share of income shifted skyward while deunionization and globalization sapped worker bargaining power? Well, we learned the meaning of an asymmetric policy response.

Even today, now that it has all come apart, economists maintain a laser-like focus on the stickiness of wages. Why can’t Greece compete? Because its “cost structure” has grown too high. In English, that means people expect to be paid too much. The solution is “adjustment”: workers’ real wages must be reduced to restore competitiveness. American economists, following in the footsteps of Milton Friedman, trumpet the glory of floating currency regimes, with which one can reduce the wages of a whole nation of workers with a single devaluation (and without the workers having much opportunity to object). The Greeks, of course, must suffer, because they are part of a fixed currency regime, and workers and employers are unable to organize the universal wage collapse that would be good for them in the way of vegetables at the dinner table.

Now, not all economists are heartless. Left economists love workers. They urge governments to devalue if possible, to chop the broccoli into chocolate cake and hope that nobody gags. These economists rail against the fixed exchange rates, because nominal wages cuts usually occur only alongside the human tragedy of unemployment. They beg governments, if they can, to just borrow money and pay workers their accustomed wages (to do some important thing or another) and hope that things work out well.

But it is always about the workers. Workers are the core problem. Macroeconomic policy, as a practical matter, is mostly about finessing “rigidities” associated with workers’ stubborn wage expectations.

Yet there is an even stickier price in the economy, a price economists have mostly ignored although it is at least as ubiquitous as wages. The price of a past expenditure, the nominal cost of escaping a debt, is fixed in stone the moment a loan is made and then endures in time, perfectly rigid, while the economy fluctuates around it. It is certainly a price, but can only be made flexible via bankruptcy — a disruptive institution, rarely modeled by macroeconomists, and rarely deployed at scale. Surely, the price of manumission must be as nimble as the price of petrol if the economy is to keep its equilibrium while being battered and buffeted by shocks.

This is an odd way of putting things, but no great insight. Everyone knows that we are loaded to the gills with debt, the real burden of which has grown as the business cycle turned. Disinflation has left us teetering on the edge of mass default and deflationary spirals, distortion, depression, destruction. The holograph sputters to life and Princess Leia implores, “Help us Obi-wan Bernanke, you’re our only hope.”

So, macroeconomists: For at least 40 years sticky wages have been a central concern, perhaps the central practical concern, of your profession. (In the models, yes, it is abstract goods prices that are sticky. But in practice, it was always and obviously about sticky wages.) You justified ending Bretton Woods gold convertibility and moving to a floating-rate regime specifically in terms of frictions associated with innumerable downward wage adjustments. Your central triumph was “beating” the inflation of the 1970s. You pretended that was a painful but technocratic exercise in monetary policy, but the durability of “price stability” had everything to do with Reagan’s breaking of union power and a free-trade regime that put pressure on the wages of all but the special. (Economists are very special, of course.) Back in the Great Moderation, central bankers chose not to emphasize the role of these political choices in explaining their “success”. It was all about targeting the interest rates cleverly, just like the DSGE models say. It was “scientific”, “independent”.

Don’t worry! I’m with you. I think unions are a poor means of supplying labor bargaining power, and wish them good riddance. I am proglobalization and free trade, or would be, if we had sense enough to subject our free trade to a balance constraint. I’ll keep your secrets. We’ll keep telling the little people that all we do is interest rates and blame whatever went wrong on Wall Street.

But here’s my question. Looking forward to the next thirty years, after we have decisively defeated wage rigidity by ensuring that the unemployed are numerous and miserable, don’t you think we should devote just a bit of our attention to tackling that other sticky price? As we reduce the bargaining power of labor, perhaps we should think about the bargaining power of creditors as well, so that if we get ourselves into a pickle where the “cost structure” of honoring debts is high, we have technocratic and politically acceptable means of managing the burden of loan contracts just as we’ve developed mechanisms to control wages.

In the 1970s and 80s, we threw away an international monetary regime and revamped the practice of central banking in order to give leaders the tools to push down hard on any upward creep in sticky wages. (Notice how there is never any talk of having Germany raise, rather than Greece reduce, its wages to “restore balance”?) Our new monetary system also made the price of escaping of some debt less sticky, specifically debt owed to international creditors foolish enough to lend in borrowers’ now-unredeemable currency. And that has helped, a lot! We’d be living in Mad Max USA already if dollar debts could be redeemed for anything other than more dollars.

But the job is not done. Domestic creditors, and international creditors who lend in their own money, still have sufficient bargaining power to make past prices stick, regardless of whether those prices remain appropriate. If renegotiating down labor contracts is hard, renegotiating down millions of debt contracts via bankruptcy is nearly impossible. Perhaps debts should be enforceable only in a pseudocurrency whose convertability to current dollars is routinely adjusted as a policy variable by the wise, technocratic central bank. Perhaps we should develop less disruptive means than bankruptcy for writing down or equitizing onerous debt. Perhaps since sticky-priced debt contracts have less rigid near substitutes called “equity”, macroprudential policy should heavily favor the latter. Put Trichet and Bernanke in a room together, and let ‘em figure it out. They’re brilliant, both of ‘em. Surely they can come up with something. But do they want to? Do they, as their models suggest, think that any pervasive sticky price is dangerous, or is it only uppity workers that trouble them?

A naive noneconomist might imagine that consistently suppressing one sticky price while assiduously supporting an even stickier price is not a way to avoid distortion, but a means of introducing it.

Isn’t it time macroeconomists stopped beating down wages and turned their attention to the stickiest price?

Preventing 2006

Brad DeLong periodically reproduces the following bit from Keynes:

While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history….

Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities could not always be in just the appropriate relation to that of others. But, on the whole, I see little sign of any serious want of balance such as is alleged by some authorities. The rates of growth [of different sectors]… seem to me, looking back, to have been in as good a balance as one could have expected them to be. A few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied….

It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924–29] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a ‘prolonged liquidation’ to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanantion of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity…

I won’t comment on the “wonderful outburst of productive energy” Keynes attributed to the late 1920s. But I do have an opinions about the quinquennium from 2004 to 2008.

It was stupid. We were profoundly stupid. We mismanaged resources catastrophically, idiotically. We substantially oriented our economy around residential and retail development that was foreseeably excessive and poorly conceived. We encouraged ordinary consumers, rather than entrepreneurs, to take on debt, and let the credit thus created serve as the kitty in a gigantic casino of egoism. We saw the best minds of a generation destroyed by madness, glutted hysterical in suits, dragging themselves through the Street at dawn, looking for an angry bonus. We accelerated the unraveling of physical, social, and intellectual infrastructure that took a century to build and that we will desperately need some day, perhaps quite soon. We celebrated our stupidity. Based on some back-of-the-napkin theorizing, we turned virtues like planning and prudence into cost centers, and eliminated them. We idolized “the market” while at the same time reorganizing it so it would tell us exactly what some privileged groups found convenient to hear.

I am sure someone will shout “20/20 hindsight”. That’s bullshit. Everything I am saying now was obvious five years ago, and lots of smart people knew and understood it. Some of us even bought into “arbitrage” fairy tales and tried to profit from getting our views “impounded into market prices”. We learned to take a different Keynes quote seriously, the one about markets remaining irrational longer than you can remain solvent. [Shlieffer and Vishny’s famous coinage, “the limits of arbitrage” is not strong enough, because it suggests that efficient arbitrage is the norm subject to some exceptions and limitations. It is more accurate to view efficient arbitrage as the unusual special case, in bond markets as well as in equity markets.]

John Hussman, in an excellent weekly note, has a very mean quote:

The true debate in economics is…between economists who care about the productivity of resource allocation and those who only pay lip service.

That is harsh, but not wrong. I’d draw the lines a bit more mildly, and say that the core argument is between people who think we are in a financial crisis that has engendered an economic crisis, and others (like me) who think that the financial crisis is the outgrowth of longstanding and continuing economic mistakes.

Don’t worry. Even if you think the economic problems preceded the financial crisis, you still get to be mad at bankers. I feel about the financial sector the same way I would feel about my morphine dealer after looking down to find piranha feeding between my ribs. It’s worse than that. It’s like you pay some guy to find the best swimming holes in the Amazon and not only is he clueless, but he anesthetizes you so you don’t notice when he screws up and he eventually starts taking kickbacks from the fish. The financial sector failed three times. First it screwed up real capital allocation, throwing money at housing and consumer lending rather than finding and funding projects that would situate us well going forward. Then it failed again by seeming to succeed, when a good financial system would quickly render poor investment decisions unmistakably noxious. It’s best not to find yourself swimming among piranha in the first place, but if it happens, you want the very first nibble to hurt like hell. Finally, the financial sector failed by keeping itself rich and its creditors whole, which, despite protestations to the contrary, amounts to a failure at an institutional level to understand how badly it fucked up and make corrections going forward.

If “malinvestment” (and related maldistribution) is at the root of our problems, does it follow that austerity is the solution going forward? Not at all. Past poor investment is a sunk cost, our task now is to maximize the usefulness of resources that we still have. Failing to use perishable resources, especially resources that decay with disuse, is terribly dumb. “Stimulus” and “austerity” are both simpleminded and poorly specified strategies. In theory, we have two overlapping systems, a financial system and a political system, whose shared purpose is to make information-dense decisions about how best to use or conserve our resources. It’s not clear how we should make these decisions when both systems seem badly broken. But you go to the future with the institutions you have, not the institutions you might want or wish to have at a later time.

As we evaluate financial reform and political change, we should keep in mind that it is not 2008 that we must struggle to prevent. It’s 2006 that was the worst of times, the piranha were feeding while we splashed and giggled in our water wings.


Some notes: If you didn’t catch the references, I’ve mutilated quotes from the Alan Ginsberg poem Howl and from former US Defense Secretary Donald Rumsfeld in the text, and sourced them only via links. Regarding my own experience trying to help “arbitrage away” the credit bubble, I was short US equities from around 2005 until late 2008. The market was irrational until I was almost, but not quite, insolvent. Eventually I took a decent profit, but it was sheer luck that the market didn’t remain irrational just a bit longer and force me from my positions at a terrible loss.

Update History:

  • 13-July-2010, 7:40 a.m. EDT: Added missing “what” as in “exactly what some privileged groups found convenient to hear”.

Rob Parenteau gets sectoral balances right

Note: This post will only format decently in a browser window opened very wide. The equations will probably be garbled in an RSS reader.

First and foremost, I owe Rob Parenteau a big apology. Parenteau is the originator and first user of the clever term “Austerian”, which I erroneously attributed to Mark Thoma. Thoma never claimed parentage. I first encountered the term on his blog and a quick Google search turned up no antecedents, so I went with that. But Google does not index everything. I apologize for the error, and thank Marshall Auerbach who first pointed it out to me.

Parenteau’s contributions go far beyond a catchy neologism, however. I recommend his most recent post at Naked Capitalism, which is the best use of the “sectoral balances approach” to economic analysis that I have seen in the blogosphere.

The “sectoral balances approach” (frequently attributed to Wynne Godley) decomposes financial stocks and flows by virtue of a tautology. Every financial asset is also some entity’s liability. The sum of all financial positions is by definition zero. So we can write:

NET_WORLD_FINANCIAL_POSITION = 0 [0]

Suppose that, quite arbitrarily, we divide the world into a “foreign” and a “domestic” sector. Then we have:

NET_FOREIGN_FINANCIAL_POSITION + NET_DOMESTIC_FINANCIAL_POSITION = NET_WORLD_FINANCIAL_POSITION = 0 [1]
NET_FOREIGN_FINANCIAL_POSITION + NET_DOMESTIC_FINANCIAL_POSITION = 0 [2]

Suppose that, again arbitrarily, we decompose the domestic economy into a public and private sector:

NET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + NET_PUBLIC_DOMESTIC_FINANCIAL_POSITION = NET_DOMESTIC_FINANCIAL_POSITION [3]

Substituting into our previous expression, we get

NET_FOREIGN_FINANCIAL_POSITION + NET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + NET_PUBLIC_DOMESTIC_FINANCIAL_POSITION = 0 [4]

We can also write this in terms of changes or flows. Since the sum above must always be zero, it must be true that any changes in one sector are balanced by changes in another:

ΔNET_FOREIGN_FINANCIAL_POSITION + ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + ΔNET_PUBLIC_DOMESTIC_FINANCIAL_POSITION = 0 [5]

Two of the flows in the equation above have conventional names, so we can rewrite:

CURRENT_ACCOUNT_DEFICIT + ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION + CONSOLIDATED_GOVERNMENT_SURPLUS = 0 [6]

Rearranging…

ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION = -CURRENT_ACCOUNT_DEFICIT + -CONSOLIDATED_GOVERNMENT_SURPLUS [7]
ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [8]

This decomposition has been quite prominent in the blogosphere. I first encountered it in conversation with the always excellent Winterspeak, and associate it with the “Modern Monetary Theorists” or “chartalists”. But it’s been used widely, very recently for example by Martin Wolf.

The usual argument goes something like this: In the aftermath of a terrible credit bubble, in most countries, the private sector is desperate to “delever”, or reduce its indebtedness, which is equivalent to increasing its net financial position. As a matter of pure arithmetic, equation 8 must always be in balance. If the private sector of a country is to force the left-hand term positive, the country must either run a current account surplus (e.g. by exporting more than it imports) or else its government must run a deficit. Some countries may “export their way” to financial health, but not all can, since every current account surplus must be matched by a deficit elsewhere. If we put “beggar thy neighbor” strategies aside and set the current account to zero, any improvement in the financial position of the private sector must be offset by a deficit of the public sector.

This is true by definition. Once the terms have been defined, there is nothing to argue about. If we want the financial position of the private sector to improve (defined as increasing total financial assets less liabilities), and we consider a country whose external account is in balance or deficit, then the public sector must run a deficit.

However, a thing can be true but still misleading. The catch is an assumption, that an increase in the net financial position of the private sector is a good thing, something that we should encourage or at least accommodate. This is where Parenteau is great. He decomposes the domestic private sector into a household and business sector:

Δ(NET_HOUSEHOLD_FINANCIAL_POSITION + NET_BUSINESS_FINANCIAL_POSITION) = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [9]
ΔNET_HOUSEHOLD_FINANCIAL_POSITION + ΔNET_BUSINESS_FINANCIAL_POSITION = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [10]

(Note that “business” here means any non-household private entity that could have a financial position. It would include, for example, non-profit organizations.)

Let’s try to come up with better names for ΔNET_HOUSEHOLD_FINANCIAL_POSITION and ΔNET_BUSINESS_FINANCIAL_POSITION.

ΔNET_HOUSEHOLD_FINANCIAL_POSITION is just net household financial income.

NET_BUSINESS_FINANCIAL_POSITION is, by definition, all business financial assets minus all business liabilities (including shareholder equity). On a business’ balance sheet, “all business liabilities (including shareholder equity)” is necessarily the same as “total business assets”. So we can write:

NET_BUSINESS_FINANCIAL_POSITION = BUSINESS_FINANCIAL_ASSETS – BUSINESS_FINANCIAL_LIABILITIES_AND_EQUITY [11]
NET_BUSINESS_FINANCIAL_POSITION = BUSINESS_FINANCIAL_ASSETS – TOTAL_BUSINESS_ASSETS [12]
NET_BUSINESS_FINANCIAL_POSITION = -(TOTAL_BUSINESS_ASSETS – BUSINESS_FINANCIAL_ASSETS) [13]
NET_BUSINESS_FINANCIAL_POSITION = -BUSINESS_NONFINANCIAL_ASSETS [14]

Now use our new definitions to rewrite equation [10]:

NET_HOUSEHOLD_FINANCIAL_INCOME + Δ(-BUSINESS_NONFINANCIAL_ASSETS) = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [15]
NET_HOUSEHOLD_FINANCIAL_INCOME – ΔBUSINESS_NONFINANCIAL_ASSETS = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT [16]
NET_HOUSEHOLD_FINANCIAL_INCOME = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT + ΔBUSINESS_NONFINANCIAL_ASSETS[17]

Now we can tell what I think is a much more informative story. It is not the “private sector” whose financial position needs to improve. Businesses exist to increase the value of their liabilities to shareholders and creditors. They do not “delever” by reducing the sum of those liabilities. “Leverage” properly refers to the ratio between different sorts of liabilities, debt versus equity, not the total quantity of claims. In a good economy, the financial indebtedness of business entities will be increasing, as the value their real assets grows! Growth in the “net private sector financial position” could come from an increase in household income (yay!) or a decrease in the value of real business assets (yuk!). We certainly shouldn’t make policy decisions based on promoting or accommodating such an ambiguous outcome. Instead, we should craft our policies to be consistent with what we actually want, which is household financial income. (Note that this analysis necessarily excludes nonfinancial income, such as unrealized gains or losses on the value of a home.)

Reviewing equation [17], there are three ways a nation can improve the financial positions of its household sector. It may (i) run a current account surplus, usually by exporting more than it imports; (ii) have the government run a deficit, improving household financial position by having the government run a deficit, or (iii) increase the value of business nonfinancial assets. Approach (i) can’t work for everyone, of course. Assuming external balance, it is obvious (at least to me) that approach (iii) is ideal. Parenteau, I think, agrees:

Remember the global savings glut you keep hearing about from Greenspan, Bernanke, Rajan, and other prominent neoliberals? Turns out it is a corporate savings glut. There is a glut of profits, and these profits are not being reinvested in tangible plant and equipment. Companies, ostensibly under the guise of maximizing shareholder value, would much rather pay their inside looters in management handsome bonuses, or pay out special dividends to their shareholders, or play casino games with all sorts of financial engineering thrown into obfuscate the nature of their financial speculation, than fulfill the traditional roles of capitalist, which is to use profits as both a signal to invest in expanding the productive capital stock, as well as a source of financing the widening and upgrading of productive plant and equipment.

What we have here, in other words, is a failure of capitalists to act as capitalists. Into the breach, fiscal policy must step unless we wish to court the types of debt deflation dynamics we were flirting with between September 2008 and March 2009. So rather than marching to Austeria, we need to kill two birds with one stone, and set fiscal policy more explicitly to the task of incentivizing the reinvestment of profits in tangible capital equipment.

So what is the role of approach (ii), which stimulus proponents and MMT-ers frequently advocate? Note how Parenteau phrases things: because “capitalists [fail] to act as capitalists”, because businesses are not increasing the value of their nonfinancial assets, fiscal policy must be employed to avoid “debt deflation dynamics”. Here we reach the formal limits of the sectoral balance approach. This style of analysis gives us no insight into the dynamics or distribution of financial positions within any of the categories we have carved out.

Nevertheless, consider the following (counterfactual) thought experiment. Imagine that the NET_HOUSEHOLD_FINANCIAL_POSITION is negative, and that people go nuts in a harmful way when they are formally insolvent. Suppose also that the current account cannot be brought to surplus, and that businesses cannot expand the value of their nonfinancial assets in a short time frame. Under these conditions, by running a deficit, government could create financial income for households until their net financial position turns positive and people stop behaving like antisocial lunatics. In this scenario, fiscal policy does nothing to change the real asset position of the economy. But by shifting around financial assets and liabilities, government alters the behavior of agents in the economy in a manner that improves future performance, increasing overall wealth.

In real economies, people may well behave in ways that are harmful to the economy when their financial positions are very tenuous, although their actions are more likely caused by illiquidity than lunacy. But in real economies, some people have strong financial positions while others have weak financial positions, and the sort of intervention described above would be useless if the income created by a stimulus went primarily to households that were not financially stressed. Government funds spent purchasing goods and services from existing firms, or deficits created by income or payroll tax cuts, go first to people who are already employed, or who already have financial claims on businesses, and these may not be the most stressed groups. Designing a “good” stimulus where the object is to alter the character of real behavior by shifting financial variables is well beyond the scope of this post, but it would necessarily involve distributional questions and complex behavioral assumptions. If you target a stimulus to the deeply indebted, you may improve their behavior, but damage the behavior of others who feel aggrieved that prudence went unrewarded. If it was me, I’d make flat transfers unrelated to income or employment status, so that on the one hand the program seems “fair” — the prudent benefit along with the bankrupt — yet on the other hand it is guaranteed to improve the financial position of even the worst-situated households.

What about approach (iii)? What could cause an increase in the value of business nonfinancial assets, improving household financial positions? Fundamentally, there are two ways: Businesses could borrow or use their own cash to purchase real assets from the household and government sectors (holding the public sector deficit constant), or else the value of existing business nonfinancial assets can somehow be made to increase. Parenteau suggests policies that would push businesses to purchase real assets. But note that any sort of increase in the valuation of business nonfinancial assets, including intangible assets, would be sufficient to improve the household-sector financial balance. That would include events as insubstantial as a pure inflation, but also real improvements in business productivity. Again, looking beyond where sectoral balances can take us, distribution matters. If “debt deflation dynamics” occurs primarily through households whose weak financial positions include few claims on businesses, then increasing the value of business nonfinancial assets might not help very much.

p.s. Edward Harrison offered a response to Parenteau’s piece that is very much worth reading. In particular, he focuses on the quality of business investment, a topic about which sectoral balance decomposition can tell us very little. Mechanically, low quality investment should improve the valuation of business nonfinancial assets less than high quality investment, and should therefore exert a drag on household financial balances. Harrison uses an Austrian (though not Austerian!) perspective to suggest that stimulus may reduce the quality of business investing, implying a trade-off between approaches (ii) and (iii) above.


[MMT Note] Agree or disagree, the “MMTers” are among the most interesting and provocative thinkers in the economics blogosphere. In addition to Winterspeak, I’d include Bill Mitchell, Warren Mosler, Scott Fullwiler (who occasionally writes at Economic Perspectives from Kansas City), Marshall Auerbach, and perhaps Parenteau himself in this group. I agree with much but not all of what the MMTers have to say. I have learned profoundly much from disagreeing and squabbling with them. I do hope that Kartik Athreya will someday have the pleasure.

Update 2010-07-01, 6:40 am EDT: For reasons I do not understand (my big fat finger?), this post “disappeared” for a few hours. It reverted from “published” to “draft” in WordPress. The post is back, and the comments seem to be intact, but my apologies to all for the disappearance!

Austerity is stupid, stimulus is dangerous, lying is optimal, economic choices are not scalar

I’ve been on whatever planet I go to when I’m not writing. Don’t ask, your guess is as good as mine.

When I checked out out a few weeks ago, there was a debate raging on “fiscal austerity”. Checking back in, it continues to rage. In the course of about a half an hour, I’ve read about ten posts on the subject. See e.g. Martin Wolf and Yves Smith, Mike Konczal, and just about everything Paul Krugman has written lately. While I’ve been writing, Tyler Cowen has a new post, which is fantastic. Mark Thoma has delightfully named one side of the debate the “austerians”. [Update: “austerians” was actually coined by Rob Parenteau.] Surely someone can come up with a cleverly risqué coinage for those in favor of stimulus?

Here are some obvious points:

Austerity is stupid. Austerity is first-order stupid whenever there are people to whom the opportunity cost of providing goods and services that others desire is negative. To some economists, that sentence is a non sequitur. After all, nothing prevents people from providing goods and services for free, if doing the work is more beneficial to them than alternative uses of their time right? Economists who make this argument need to get out more. Doing paid work has social meaning beyond the fact of the activity, and doing what is ordinarily paid work for free has a very different social meaning. It is perfectly possible, and perfectly common, that a person’s gains from doing work are greater than their total pay, so that in theory you could confiscate their wages or pay them nothing and they would still do the job. But in practice, you can’t do that, because if you don’t actually pay them, it is no longer paid work. The nonmonetary benefits of work are inconveniently bundled with a paycheck. Under this circumstance, having the government pay for the work is welfare improving unless the second-order costs of government spending exceed both the benefits to the worker in excess of pay and the benefit to consumers or users of the goods and services purchased.

Stimulus is dangerous. The second-order costs of government spending are real, and we are very far from being able to understand or estimate them. Here are some second order costs:

  1. Transfers of relative purchasing power from other citizens to the beneficiaries of government spending may call into question the legitimacy of the distribution of opportunity, wealth, and influence and of the government itself. Perceptions of make-work or corrupt contracting are deeply corrosive. Deficit spending commits government to future transfers that may come to seem undesirable or illegitimate.

  2. Government spending choices may lead to lower quality uses of real resources than would have occurred if the government had not acted. Since economic activity is habit forming and temporary interventions become permanent, the cost of poor government choices can be high. It matters very much what work the government is paying for. Work must be well-tailored to the talents, interests, and future prospects of individuals. Employing people badly is much worse than just giving them money.

  3. If funds are spent, directly or indirectly, on resources in scarce supply, prices may be harmfully propped or bid up. That might take the form of a general inflation, or a narrower effect on the prices of specific commodities or assets.

  4. High levels of government debt may have a destabilizing effect on prices, increasing price volatility and impairing economic calculation even in the absence of a general inflation, or even in a deflation. Government obligations are liquid and hypothecable, and the availability of good collateral increases the degree to which subjective changes in relative valuation translate to changes in nominal pricing.

  5. There exist theories of government solvency which suggest that the safety and value of currency is related to the indebtedness of the issuing government. Those theories may or may not be reasonable. They may or may not find support in the historical record. Regardless, to the degree they are widespread, they may be self-fulfilling. Whether sensible or sunspot, loss of confidence in a currency is possible. Currency crises represent a “tail risk” whose likelihood and cost are difficult to estimate.

There are second order benefits to stimulus as well as costs: multipliers, consumer confidence, etc. But these are also difficult to estimate.

Lying is optimal. The debate among public officials about austerity cannot be taken at face value. Savers really could flee the euro, dollar, yen or yuan. Interest rates here or there could suddenly spike. A sudden dash to gold is possible. None of these financial market events would directly affect the real resources at our disposal, but any of them could devastate our ability to organize economic behavior, and would call into question the legitimacy of economic outcomes and the stability of governments. For policymakers who seek positive short-to-medium term outcomes, the optimal strategy is to avoid the first-order costs of austerity by spending and avoid second-order costs #1 and #5 by obfuscating their spending as much as possible. Costs #2, #3, and #4 tend to bite over the medium-to-long term, leading policymakers to discount them. I think we should expect a lot more austerity theater than actual austerity, for better and for worse. Expect central bankers especially to preach austerity while intervening madly in the shadows. That’s just what they do. By the same reasoning, we should expect policymakers to justify their actions with a lot of intuitive but awful theory. As the Modern Monetary Theorists remind us, the analogy between a fiat-currency-issuing government and a budget-constrained household is poor. It is, nevertheless, the framework under which most citizens and savers understand government accounts, and forms the basis of conventional discourse. Irrespective of what is a better or worse description of reality, it is safer for policymakers to frame their communication in terms of conventional theory than to promote a profoundly destabilizing paradigm shift. Expect President Obama to keep talking about how we are “out of money” even though he knows better.

Economic choices are not scalar. I think the austerity debate is unhelpful. There are complicated trade-offs associated with government spending. If the question is framed as “more” or “less”, reasonable people will disagree about costs and benefits that can’t be measured. Even in a depression, cutting expenditures to entrenched interests that make poor use of real resources can be beneficial. Even in a boom, high value public goods can be worth their cost in whatever private activity is crowded out to purchase them. Rather than focusing on “how much to spend”, we should be thinking about “what to do”. My views skew activist. I think there are lots of things government can and should do that would be fantastic. A “jobs bill”, however, or “stimulus” in the abstract, are not among them. If we do smart things, we will do well. If we do stupid things, or if we hope for markets to figure things out while nothing much gets done, the world will unravel beneath us. We have intellectual work to do that goes beyond choosing a deficit level. The austerity/stimulus debate is make-work for the chattering classes. It’s conspicuous cogitation that avoids the hard, simple questions. What, precisely, should we do that we are not yet doing? What are the things we do now that we should stop doing? And how can we make those changes without undermining the deep social infrastructure of our society, resources like legitimacy, fairness, and trust?


FD: I’m long precious metals and short long-term Treasuries. (My exposure to both is primarily via futures.) So perhaps I am thinking my book when I take the tail risk of currency crises more seriously than others do.

Update History:

  • 29-June-2010, 11:50 p.m. EDT: Added update attributing coinage of “austerians” to Rob Parenteau. Thanks to Marshall Auerbach for pointing this out in the comments, and Barry Ritholtz for investigating.

Singling out Goldman Sachs

Regular readers know that I have few nice things to say about Goldman Sachs lately.

Goldman fully deserves the attention that the SEC has brought to it, and the attention that the Department of Justice may soon bring to it. The conduct that the firm is trying to defend is inexcusable, and its unwillingness to acknowledge that even more so.

However, it is unlikely that bad conduct was limited only to Goldman. The fact that others were misbehaving is no defense. A high crime rate doesn’t make burglary okay. But I fear that Goldman Sachs may have become a shield and lightning rod, deflecting scrutiny from other firms also in need of disinfection.

Financial firms are fragile in at least three different ways. They are financially leveraged, so they are vulnerable to deteriorating asset values. They fund illiquid assets with short-term money, so they are vulnerable to runs. A less widely appreciated fragility has to do with the degree to which the boundaries of the state and financial institutions blur. A financial institution that is at odds with the state is a freakish, frightening thing. It may suffer a loss of confidence for reasons that can’t be fully explained in economic terms. Famously, “no major financial firm has survived criminal charges.

I think it entirely possible that Goldman could go the way of Arthur Anderson or Drexel. If so, the firm will have no one to blame but itself.

Nevertheless, there is a danger that we will make a ritual sacrifice of Goldman and pretend to have exorcised our demons, while other firms that have engaged in similar conduct continue undisturbed. It would be a sad irony if, in single-minded pursuit of Goldman Sachs, we not only let other perps escape unscathed, but also hand them the windfall of a less competitive industry. Rather than forcing traumatic self-appraisal and reform at surviving banks, Goldman’s fall might lead managers elsewhere to congratulate themselves for savvy positioning, for playing the system. Competitors would swallow the corpse of Goldman Sachs, thinking they had eaten what they’d killed.

I have no reason to think that the government’s focus on Goldman is motivated by anything other than having discovered particularly bad conduct there. Nevertheless, the cynic in me cannot help but notice that, according to media reports, Jamie Dimon and the Obama Administration have been very close at times. Dimon’s bank, JP Morgan Chase, has much to gain from Goldman’s misfortune. The more reasonable me is sure that there is no connection, that the mere suspicion is crank conspiracy theory. Still, less-than-exemplary conduct by investment banks during the bubble was widespread. It would be comforting to see evidence that the cops on the beat are walking the Street, and not just holing up in front of Goldman Sachs. Call it avoiding an appearance of impropriety.

Usually when people accuse law enforcement of a “fishing expedition”, they are asking the police to stand down. I do not want the police to stand down. The SEC and the Justice Department should treat Wall Street the way big city cops treat “open air drug markets”, with engaged and loving attention. But instead of a “fishing expedition” we need a “trawling expedition”. There are a swarm of piranha in the swimming pool, not just one vampire squid.

Goldman Sachs may die. If it does, I will shed a tear. My feelings about the firm are not unmixed. Nevertheless, if Goldman dies, it will be the fault of its own managers, and there will be some justice in it.

But let’s not imagine that Goldman’s passing somehow redeems JP Morgan, or Deutsche Bank, or Citi, of their sins.

A knife fight is not a mediation

The excellent Ezra Klein has ruined his electoral career for nothing. That’s a shame; I’d vote for him. Ezra writes:

If an investment bank is structuring a trade for two clients, it has an obligation to serve its clients. That is to say, it needs to structure the trade they want to be part of and disclose all relevant information necessary for them to evaluate the trade. But if the firm, or the employees structuring this trade, think that one side is going to win and the other is going to lose, I don’t think they have an obligation to warn the losers… The SEC’s case against Goldman simply says that they failed to disclose relevant information that one side needed to decide for themselves whether going long on the Abacus deal was a good or bad trade. That is to say, the issue isn’t whether Goldman acted in the client’s best interest but whether they made it unnecessarily difficult for the client to act in his own best interest.

Goldman wasn’t structuring a trade between two clients, as far as IKB and ACA were concerned. It was working to form a business entity called ABACUS 2007-AC1, LTD and underwriting an issue of securities by that entity. The only clients formally involved were IKB and ACA, and they were on the same side of the deal.

If this had been an adversarial deal, Goldman would have had no obligation to inform the side that wasn’t paying it whether they were making a good trade. But if this had been an adversarial deal, Goldman would have been advising one party or the other. Both parties could not have been its customers.

Imagine you are trying to buy a house. It is contentious. Disputes arise over price, warranties, settlement terms, etc. You would hire an agent, and the other party would hire an agent. Those agents would be different people. The hazards of relying on the same advisor in a difficult negotiation are obvious.

IKB/ACA may have been “sophisticated”. They may have been dumb, or corrupt, or unlucky. But, in an adversarial negotiation with John Paulson, they would not have shared the same agent with him. A knife fight is not a mediation.

The whole issue is that IKB/ACA did not know that they were in an adversarial negotiation and that the other guy had Goldman Sachs as its agent. They thought Goldman Sachs was working for them, underwriting securities of a special purpose entity it was putting together to satisfy investor interest. If IKB/ACA had been negotiating a very complex $192M custom trade with John Paulson, there would not have been a “flipbook” and a “prospectus”, just sign the dotted line. There would have been conference rooms and long hours and thousand-page paranoid contracts scrutinized and initialed in triplicate.

There is no circumstance where an investment bank “structures a trade for two clients” whose interests are opposed when the terms are anything but standard. I mean, really. Think about it. It’s Orwellian — Goldman calls a practice that is absurd on face “market making”, and suddenly it’s normal except for technical questions about who picked what securities or who should have suspected something.

What happened here is nothing like what a market maker does. A market maker takes the other side of client-initiated trades, and then lays off the risk. ABACUS was initiated and sold by Goldman Sachs, at a hidden party’s request. Goldman was unwilling to make a market for Paulson at a price he would have accepted, so it manufactured an entity willing to do so. Investors in that entity were not informed that they were dealing with an active, involved adversary. And Goldman has the nerve to call both sides of the arrangement “customers”.

This was a high finance version of the same pump-and-dump schemes you get by e-mail. Paulson needed buyers for what he was selling. Goldman sent around the flipbook until it found some, and without revealing that a hidden counterparty wanted to dump. This is not an ethical practice. I don’t know whether it’s illegal. But if really smart, well-intentioned people like Ezra can’t quite see that it’s disreputable, if it seems like a he-said, she-said technical kind of thing, we are in deep trouble.


P.S. For this deal to be okay, Paulson’s role would have had to be disclosed plainly and in writing. His name need not have been mentioned, although it would not have remained hidden for long. But Goldman would have had to reveal that a party wishing to take a large short position had initiated the deal and would be involved in its design. Goldman would also have had to make clear, in writing, that this party was its client.

Like many Goldman apologists, I suspect that by the time the deal closed, some of the ACA guys probably knew or had guessed what was going on. Maybe the IKB guys knew too. That doesn’t matter. Individuals taking bonuses for deals at ACA and IKB were not the “investors”. ACA and IKB’s shareholders were the investors, and ultimately British and German taxpayers. Goldman had an obligation to put important facts in writing. By not doing so, Goldman created plausible deniability for employees at ACA and IKB who had a personal interest in closing the deal. The wink-wink/nudge-nudge act mitigated career risk, helping to enable corrupt stupidity. Informal disclosure does an end run around risk managers at both firms, who would have expected discussion of an active, adversarial counterparty in the documents they reviewed. Even if some people at ACA knew, the deal might never have gotten done had ACA or IKB formally known. $192M deals that become $1B deals should be fully documented, in ink.

Update History:

  • 28-April-2010, 10:10 a.m. EDT: Changed “sharing the same agent” to “relying on the same advisor”.
  • 29-April-2010, 7:00 a.m. EDT: Shortened first link to Ezra Klein’s piece. Removed one “really” where there were two in last sentence before postscript.

Goldman and “hope”

On Friday, Goldman published a letter called Goldman Sachs: Risk Management and the Residential Mortgage Market . Here’s a bit of it:

In a “synthetic” CDO, two parties enter into a derivative transaction, which references particular assets. By the very nature of a synthetic CDO, one counterparty must be long the risk (i.e., hoping to benefit from an increase in the value of the referenced assets), and the other counterparty must be short the risk (i.e., hoping to benefit from a decrease in the value of the referenced assets).

I have made this point before, but I will bore with repetition. Both in theory and in practice, there need be no identifiable party “hoping to benefit from a decrease in the value of the referenced assets”. Historically, in the vast majority of deals, there was no such party. Does anybody wish to dispute this as a factual matter? Mr. Blankfein?

Synthetic CDOs began as a tool for balance sheet management by banks. In these deals, a bank issues a synthetic CDO whose reference portfolio is composed of debt that the bank actually holds. The bank retains the first-loss “equity” tranche, but sells mezzanine and senior tranches. It may or may not retain the risk of the “super senior” tranches.

Banks derive two advantages from this arrangement:

  1. They limit losses with respect to their loan portfolio. When all senior tranches have been sold away, banks total exposure to loan losses is limited to the size of the first-loss tranche, usually a very small fraction of the total assets. It is as if they have bought insurance on their loan portfolio, but the policy includes a small deductible. When banks retain the risk of “super senior” tranches, the structure becomes analogous to an insurance policy with a small deductible and a lifetime cap that is less than the total value of the loans. In either case, banks effectively lay off some of the risk of their porfolio.

  2. Banks don’t need to hold regulatory capital against debt that is insured by a CDO with sufficient collateral to guarantee that insured losses will actually be covered. If investors in a CDO require a smaller premium than a bank pays to holders of regulatory capital, the bank profits by shifting credit risk to the structure (either by redeeming excess capital or, more likely, by using the capital to make new loans). This is called “regulatory capital arbitrage”.

As long as the yield investors demand is not too high, banks gain from issuing synthetic CDOs. If investors and rating agencies pay more attention to the correlation structure of portfolios than the characteristics of the underlying debt, the ability to cheaply lay off risk to CDOs might encourage banks to make riskier loans than they otherwise would. Like a John Paulson, banks doing these deals would try to cram the riskiest debt they could into reference portfolios. (Rating agencies are said to be particularly attentive to the debt selection process in bank balance sheet deals.) But in no sense do banks, the short counterparty, hope the deals go bad. Their best case scenario by a long shot is that every penny of debt gets paid, so that they earn a good yield on the equity tranche.

During the 2000s, for a lot of familiar reasons, AAA debt with a yield premium to Treasuries could be sold very easily, so entrepreneurs began structuring synthetic CDO deals based on debt they did not actually hold. In these deals, arrangers sold credit protection to investment banks, who may then have been economically short the credit, depending on how they were initially positioned. If investment banks retained those unhedged short positions, then there would, as Goldman alleges, have been a party “hoping to benefit from a decrease in the value of the referenced assets”. But investment banks were market makers and underwriters for these deals; they were not typically speculative counterparties. If you don’t believe me, here’s Goldman:

Goldman Sachs did not engage in some type of massive “bet” against our clients. The risk management of the firm’s exposures and the activities of our clients dictated the firm’s overall actions, not any view of what might or might not happen to any security or market…We maintained appropriately high standards with regard to client selection, suitability and disclosure as a market maker and underwriter. As a market maker in the mortgage market, we are primarily engaged in the business of assisting clients in executing their desired transactions. As an underwriter, the firm is expected to assist the issuer in providing an offering document to investors that discloses all material information relevant to the offering.

A market maker takes reactive positions dictated by customers who seek liquidity. The essence of market-making is accepting a risk that one might not otherwise choose in exchange for a fee or a spread. Since another party forces ones positions, and that other party might know something that the market maker does not, market makers usually strive to avoid carrying “inventory”, risk that accumulates as a byproduct of taking the other side of customer trades. The business of market-making is the art of hedging, of laying off risk forced onto the market maker by her customers. For large, complex positions, it is rarely possible for a market maker to find a single party to take the other side after it has assumed the risk of a client-initiated bet. [1] The market maker’s expertise is decomposing risk forced upon it by clients into smaller, more easily marketed positions, and neutralizing that risk via arms-length exchanges.

In synthetic CDO deals prior to 2006, the investment banks that served as market makers and took the initial short position on the CDO credit usually strove to be neutral or long the deals. They did as market makers do, and laid off their initial exposure by hedging, statically when possible, dynamically when necessary. Investment banks also frequently went long the deals they issued by retaining exposure to the super senior tranches. Out there, somewhere in the world, there may have been parties that stood to gain from events that would also have harmed CDO investors. But there was literally no one “hoping to benefit from a decrease in the value of the referenced assets” in totality. If you die, a whole bunch of people whom you don’t know and who don’t know you might benefit from buying your crap cheaply at your estate sale. There are even professional estate sale vultures, who make a business of taking the other side of estate liquidations. But it’s quite a jump from dispersed market interest to a claim that there is someone out there hoping to benefit specifically from your death. Dispersed market interest by estate sale junkies is not “material” to how you conduct your life. But if someone in particular really hopes you will die so that they can take your shit, you’d want to look over your shoulder.

I won’t go so far as to say that Goldman is lying, when it claims that “[b]y the very nature of a synthetic CDO”, one party hopes to benefit from an increase and another party hopes to gain from a decrease in the value of the referenced assets. But I will say that that the statement is factually wrong, and that Goldman knows very well it is factually wrong. If we are generous, we might categorize the statement as a sloppy simplification, a rhetorical imprecision that happens to flatter Goldman Sachs.


[1] If a position is not client-initiated, but initiated by the bank in response to some other party’s wishes, then the bank is not acting as a market maker but as an agent for the initiating party. An investment bank is free to act as an agent for a client when it trades at arms-length in public markets. But it may not act as an agent of a client while transacting with underwriting clients, unless it discloses the nature of the relationship. This failure to disclose is the essence of Goldman’s ethical foul in the ABACUS deal. It is also, I think, why Goldman is fighting the case so hard. Goldman gains competitive advantage by letting underwriting-driven demand take on customer risk that Goldman itself is unwilling to accept. There is, in the lingo, a synergy. But it is also an unethical practice, in violation of Goldman’s duty to its underwriting clients. I think Goldman is fighting so hard because it benefits from this synergy and wants to keep it. Goldman wants to normalize the practice, and rhetorically attempts to do so every time it protests that market makers don’t disclose the identity of counterparties. When Goldman is shifting risk that it did not wish to bear or hedge to an underwriting client, it is not acting as a market maker. Rather it is acting as an agent for a client wishing to take a position, while imposing the burden of liquidity provision on uncompensated and uninformed underwriting clients. When a bank arranges and underwrites deals to meet its own hedging needs, or especially to take an opposing speculative position, that is also ethically questionable if not plainly disclosed.