Krugman’s “hangover theory”, revisited.

I’m trying to write something hard, and failing. I’ll keep trying. But this is easy, and I cannot resist. Paul Krugman is once again attacking “hangover theorists”, the idea that booms of a certain kind inevitably beget recessions. I do not buy the traditional Austrian story of hangovers — that misallocations and depletions of capital (including human capital) necessarily take time to undo. But I think that now and in his original piece, Krugman is far too quick in his dismissal of the idea that there must be something about some booms that makes subsequent recessions pretty hard to avoid. Krugmans writes that “[a] recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.” It is rather surprising, isn’t it, that “whatever reason” almost always happens subsequent to years of unusual prosperity? Choose your poison — if you don’t like the Austrians, go with Hyman Minsky — but if we don’t acknowledge the relationship between some kinds of booms and the bad times that follow, we’ll have a hard time preventing those bad times.

Krugman is absolutely correct to inveigh against the “morality play” that sometimes seeps into the Austrian rhetoric surrounding recessions. Personally, I think morality play deserves a much larger place in economics than it currently has, but a fable in which masses of innocents suffer to absolve the sins of the reckless wealthy is hardly moral. The “hangover theory” is best described as an immorality play, which we are watching unfold before our eyes this every moment as financial assets are relentlessly supported while the value of a pair of hands is let to plummet.

However, recessions and depressions do follow booms, and there are reasons for that. Austrians have their vices, but a vice of Keynesians is to underestimate the role of information. Krugman points out that the hangover theory…

doesn’t explain why there isn’t mass unemployment when bubbles are growing as well as shrinking — why didn’t we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

The obvious answer is that when there is a boom, entrepreneurs know into what sector resources must be reallocated, and pull already employed workers from existing jobs into the new big thing. During a bust, from a God’s eye view, the same process must occur: resources must be shifted out of some sectors and into others. But entrepreneurs are only human. They do not know to where resources might be productively employed, only that they cannot be productively employed where they are. This is the asymmetry, I think, that explains mass unemployment during busts.

Krugman also points out that the hangover theory…

doesn’t explain why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.

I think that this gets to the point about why it is that only certain kinds of booms lead to great and terrible busts. Industries rise and fall all the time, in good times as well as bad. In the 1980s, there was a great boom in the recording industry owing to the advent of compact discs. The boom eventually went bust, but mass unemployment did not ensue. Hangovers result not from booms in and of themselves, but from booms which result in unhealthy concentration of the aggregate investment portfolio. US capital, viewed as a whole, was overly concentrated in housing and construction this decade. China’s capital has been overly concentrated in exports and construction. Traditional portfolio theory views the menu of investments as fixed, and suggests that investors diversify among them. But in the aggregate, there is only one portfolio extant at any point in time. The art of “macro portfolio theory” is to control the evolution of that portfolio so that it remains reasonably efficient. The easy answers don’t work: Micro portfolio choices don’t necessarily compose into a dynamically sane macro portfolio. We have reason to be skeptical of very heavy-handed industrial policy. So we have work to do.

I’ll end with an intuition: I think that there’s a trade-off between microlevel diversification and macro-efficiency. Barry Bosworth warned that “diversification devalues knowledge”. One reason that micro portfolio choices fail to compose is because it is often sensible for investors to “buy the market”. Every individual has a unique information set, and ideally we would want all that decentralized knowledge “priced into the market” independently of the judgments of others. However, each individual knows that her own information is profoundly uncertain and incomplete, and that the market represents an aggregation of the judgments of millions of others. So, as passive-investment types have been telling us for more than a decade, it may be optimal for individuals to ignore their own information and defer to the judgement of the market-ex-me. (This is a kind of “information cascade“.) But, each person who defers to the market increases the concentration of investment decision making, and decreases the breath of information that is priced into the market. If the aggregate portfolio is disproportionately by the decisions of a relatively small group of people, there is no reason to suspect its quality would be better than that decided upon by a bureaucracy of planners. There is reason to suspect, in fact, that it would be worse, because at least the planners know they should at least pretend to serve a broad public interest, while private decisionmakers might quite legitimately think they’re just trying to get a piece of next year’s bonus pool.

In sum, I think there is a tension between micro diversification and macro diversification. If we want to maintain a well-diversified aggregate portfolio, it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk. We might be better off by letting individuals shed risk via some form of social insurance while forcing investment choices to be sharp, than by encouraging people to blur the information they present in their portfolio choices in order to diversify and hedge.


James Hamilton has an excellent post on the Federal Reserve and its changing balance sheet today. If you haven’t been following this stuff obsessively, it’s probably the single best primer to get up to speed.

To my mind, there are three signal facts about the brave new balance sheet:

  1. The size of the Federal Reserve’s balance sheet has ballooned, more than doubling over a period of three months. If we take the FOMC at its word for it, it’s not going to shrink anytime soon. Given new programs already announced, we should expect the Fed’s balance sheet to continue to grow.
  2. On the asset side, only a small fraction of the Fed’s holdings are now US Treasury securities. Excluding securities lent to dealers, just 12.5% of the Fed’s assets are Treasuries. The Fed has expanded the scope of its lending, from depository institutions, to primary dealers, to money-market funds and commercial paper issuers, to issuers of asset and mortgage backed securities, and very soon to private investment funds that invest in asset-backed securities. The Fed also periodically lends to support firms in, um, special circumstances, such as JPM/Bear and more recently AIG.
  3. On the liability side, the Federal Reserve has dramatically increased the degree to which it funds its activities with zero-maturity bank reserves, upon which it is now paying interest.

The Federal Funds rate is now effectively zero. We have hit the so-called “zero bound”.

There are many ways of trying to make sense of all this. One broad-brush view is that for all its radicalism, the Fed is just a thermostat. As the private sector delevered, the Fed had to lever up (McCulley). As foreign central banks shift their portfolio from agencies to Treasuries, the Fed has to shift its portfolio from Treasuries to agencies (Setser). More broadly, as the private financial sector has become unwilling to issue short-term, liquid liabilities against long-term illiquid assets, the Fed has had to do so to avoid a disorderly collapse of asset prices (see Kling). One might imagine a canoe carrying a wild beast (that would be our “rational” private markets). The beast writhes and bends, and the Fed must throw its weight in the opposite direction to force the tipping craft upright despite all the upheaval.

“Stability” — price stability, financial stability — are to my mind like “liquidity“: qualities widely considered virtues that are often actually vices. Nevertheless, the Fed pursues these goals, and in the immediate term, the thermostat analogy works pretty well. I don’t doubt that we’d have tipped into steep deflation, outright collapse of core financial institutions and an in-the-streets economic crisis without the Fed’s extraordinary measures. Had the Fed not played thermostat from 2001-2003, perhaps the beast would have been chastened by a mild dunking, and today’s heroics might have been less inevitable. But it was stability über alles then, when the bubble first tried to burst, and now we are where we are.

So, thanks to the Fed, things are better than they might have been. But I think there is as much to squirm about than to celebrate in how the Fed has comported itself.

On the asset side, as has been widely noted, the Fed has been taking on extraordinary levels of credit risk. We do not know against precisely what collateral the Fed is extending its trillions in loans, and how conservatively that collateral is being valued. We wish Bloomberg luck in their lawsuit. (ht CR, Alea).

We do know that the Fed is becoming ever more brazen about its risk-taking. When the Fed made a non-recourse loan in connection with the collapse of Bear Stearns, Chairman Bernanke was summoned by Congress to discuss the unusual move. A non-recourse loan is economically something between lending and purchasing. The Fed has the authority to lend to whomever it pleases under “unusual and exigent” circumstances, but it is not empowered to spend outright what are in the end US taxpayer dollars. Anticipating objections, Dr. Bernanke was very careful during the Bear debacle to ensure that since the taxpayer would “own” most of the downside, it would also capture the upside. Still, he was called to account for what was widely understood to be an unusual move of very questionable legality. But now, under TALF, the Fed will extend non-recourse loans to just about anyone. The Fed will assume much of the downside, while private investors capture the upside. In my view, it is not quite legal for the Fed to extend non-recourse loans, and the practice should be curtailed. Non-recourse loans should be approved by Congress and executed by the Treasury department. The recipients of loans from the Federal Reserve should be bankrupt before taxpayers take losses. Remember, the Fed is an an unelected technocracy “cognitively captured” (as Willem Buiter puts it) by the sector it purports to regulate. Yes, Congress sucks. But the Fed sucks too, and the rule of law does matter.

For all of that, it is the liability side of the Fed’s balance sheet that is most interesting. The Fed is financing its gargantuan balance sheet expansion by conjuring unsterilized bank reserves. A year ago, there were less than $18B of reserves deposited at the Fed. Today there are $800B. A year ago the Fed wasn’t paying interest on bank reserves. Today it is.

Interest rates are, for the moment, excruciatingly low. But a subsidy to the banking system, once put into place, will be quite hard to dislodge. So, let’s imagine that the Fed will pay interest on bank reserves in perpetuity, that it will pay such interest at or near the risk-free short-term interest rate, and that the expansion of the Fed’s balance sheet is more or less permanent. How large a subsidy to the banking system do the interest payments on reserves represent? Some problems are arithmetically challenging, but not this one. The present value of a perpetual stream of market-rate interest payments is precisely the amount of the principal. Therefore, the present value of the Fed’s de facto commitment to pay interest to banks on $800B of freshly created reserves is $800B. We fought and wailed and gnashed our teeth over potentially overpaying for TARP assets. Meanwhile, we are quietly allowing the Fed give away, as a direct, literal subsidy, more than the entire $700B that Paulson was allowed to play with. Note there is no question about this being an “investment”: The interest payments that the Fed is now making to banks on its suddenly expanded balance sheet are not loans. The banks owe taxpayers absolutely nothing in return for this windfall.

Now the bankers will object, as they always do. Bankers have forever cried that they are required to hold reserves at the Fed, that to be forced to lend their cash interest-free to the central bank is a hidden tax. I hope we all understand by now that the pronouncements of the banking industry are about as reliable as a monthly statement from Bernie Madoff. The reserves in the banking system are created by the Fed, and the quantity outstanding is now enough to cover banks’ regulatory and settlement needs many times over. This is not in any sense “their” money. It is money the Fed printed in order to pursue its own objectives. The banks have no right whatsoever to earn interest on this money, and absolutely do not merit an $800B subsidy. Further, the core rationale for paying interest on reserves has disappeared entirely. Originally, the Fed wanted the power to pay interest on reserves so that it could expand its balance sheet to pursue “stability” goals without stoking inflation by letting the short-term interest rate fall to zero. Now the short-term interest rate has fallen to zero, and the dominant concern is that we are in a “liquidity trap”. Yet we are still paying the banks 25 basis points to hold this freshly created money at the Fed. James Hamilton, towards the end of his piece, points out that this is counterproductive. I want to point out that it is also obscene.

Now I have to admit that, personally, I feel a bit caught out, bent out of shape, gypped, by the whole paying-interest-on-reserves thing. A long while back, I argued against giving the Fed this power, because I knew they would abuse it. During the TARP debate, I did a one-eighty. At least the Fed, I reasoned, would only lend taxpayer money. If we took losses, the institutions that shoved them onto us would go down first. Paulson clearly wanted to assume bank liabilities outright by overpaying for toxic assets. Having the Fed lend taxpayer money seemed like a better deal than letting Paulson give it away. The cost of paying interest on reserves, when I had written about it previously, was about only $11B in present value terms, insignificant in the grand scheme of things. (By the end of September, when I flipped, reserves had already grown to $100B… but I missed that.) Now we have the worst of all worlds: Not only has our corrupt, dysfunctional banking system won the small subsidy it has long lobbied for, but the size of that subsidy has grown by almost 8000%. The Fed is no longer lending only to financial institutions that would have to go under before taxpayers eat their losses. Under TALF, the Fed will lend to anyone who owns the kind of securities whose prices the Fed wants support. The borrowers will take the upside, while taxpayers eat the downside. (Does anybody know what kind of leverage the Fed will support under TALF? I’ve looked, but haven’t found.) The non-recourse lending that was extraordinary and barely legal when Bear went down is now the new normal, except that the Fed no longer bothers to ensure an upside for taxpayers. By institutionalizing non-recourse lending, the Fed has arrogated the power to do everything the original TARP would have done, except without the opportunity for people like me to write Congress in anger.

Despite all this, I am becoming rather Zen about the Federal Reserve lately. I have some sympathy: They are dancing to a tune that they no longer call, struggling to keep pace with an accelerating beat. The Bernanke Fed is clever and inventive, delightful as spectator sport. So many trillions of dollars have been spent or committed or guaranteed, that the amounts have gone meaningless. I think that the current financial system and the Fed itself are quite doomed, and I’m less inclined to get bent out of shape by the particular ordering of the death throes. There will be a great crisis. Hopefully it will only be a financial crisis. I’d prefer it to be an inflationary rather than a sharp deflationary crisis, both because I think that a great inflation would be less destructive, and because that’s the way my own portfolio tilts. So really, I should root for the Fed. Let the printing presses turn and the helicopters fly, but please don’t confiscate my gold.

Since the current Fed loves bold and unorthodox action, I thought I’d end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them. If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)

Of course there would be tricky consequences: Gresham’s law would kick in, as people would hoard physical cash to avoid the tax. Coins and bills would cease to be used for exchange, but would be held as stores of value. That would introduce some friction into small transactions: we’d end up using debit cards to buy candy bars, accelerating our transition to a cashless economy. But electronic money would be legal tender, and the appreciation of paper money would be no more relevant to the overall price level than the fact that older “wheat pennies” are worth much more than 1¢. With a sufficiently large electronic monetary base, there need be no zero-bound on nominal interest rates, and we can use “conventional” monetary policy to fight deflation by letting nominal rates go negative. I laugh in the maw of your liquidity trap.

FD: Long precious metals, short 30-yr Treasuries (youch!).


One of the funniest words in the lexicon of business is “overcapacity”.

Here’s Bloomberg:

China’s economic slowdown is deepening, with overcapacity in almost all industries, and won’t bottom out until after the first quarter of next year, two senior officials said today.

Think about that: “overcapacity in almost all industries”. Perhaps we exist in a more enlightened world than I ever imagined. I’ve always thought that human want for material goods was basically unlimited. Apparently not! We have enough, not just here in the once gluttonous U.S. of A., but everywhere. All of the nearly seven billion humans of planet Earth have no use for anything more than they already have. Subsistence farmers in Africa prefer to live as they do, because it plays charmingly in National Geographic. If you offered them 10 million Yuan and a shopping trip, they’d shyly refuse.

The world does not now, and never has had, a general problem with “overcapacity”. It might be sensible to talk about overcapacity with respect to a particular good or service in a particular setting. Maybe five Starbucks Cafes really are too many for one city block. But as a macroeconomic phenomenon, overcapacity is bullshit. Capacity can be misaligned — there might be too many sock factories for too few shoe factories. But there can be no general overcapacity, only underutilization.

We, collectively, have not figured out a means of addressing an incompatibility between the incentives by which we encourage production and the means by which we distribute it. Human effort is driven by positional as much as material incentives: We measure ourselves against one another. Two centuries ago, a person could be rich with no running water, electricity, or internet person. But wealth was still wealth, and people worked just as hard to be rich then as now. But since wealth is positional, people’s desire for wealth may far exceed their intention or ability to consume. When great wealth is earned by contributing to production, this leads to a surplus, which seems like a good thing, but creates the “problem” of excess capacity. The obvious solution is to redistribute claims on production, so that those with unmet wants make use of the excess. But doing so reduces the differences in station that inspire Herculean efforts to produce, and provokes conflicts over who gets what.

The macroeconomic stories of this decade have all been about squaring this circle: Rather than redistributing claims outright, we adopted the fiction of trading present goods for future claims. The ambitious grew wealthy by accumulating claims on the future of the less ambitious, in exchange for which the less ambitious (and sometimes very distant) consumed present production, and demanded more. Entrepreneurs could measure their position against their fellows by the quantity of their claims. Others could consume in proportion to their ability to manufacture claims that entrepreneurs would accept, that is, they could consume what they could borrow. But high quality claims on future wealth are in reality very scarce. An economic system that depends upon ever expanding claims on the future in order to provide current incentives to produce can not be stable. Once the “wealthy” learn that many of their claims are worthless, the system falls apart. The less-wealthy have no means of consuming, as new claims are shunned. Owners of capital gain nothing but bear costs for maintaining productive infrastructure. “Excess capacity” appears.

There is no iron law of economics, no physics of resource constraints, that prevents us from using all the productive capacity we have ever developed. Our problem is distributional and organizational: How can we match potential consumers with capacity (broadly defined) in a way that maximizes current well-being, and that offers sufficient information and incentives to inspire and direct future production? That’s not an easy problem. In fact, it’s a deep problem, philosophically and ethically, the substance of which is mostly neglected or assumed away by modern economics. Nevertheless, it is the real problem, not “overcapacity”. The world still needs more, and better. We should be careful of what we destroy because, for the moment, it seems “uneconomic”.

Update History:
  • 13-Dec-2008, 2:50 p.m. EST: I’ve fixed some poor writing in the paragraph on positional incentives and bit about using future claims as a fudge to redistribute present consumption. The rest of the poor writing remains unchanged.

Expenditure vs investment — thinking clearly

I like this little graphic that’s been making the rounds, courtesy of Voltage Creative, hat-tip nonSense, Simoleon Sense, Paul Kedrosky.

Paul Kedrosky is a reasonable fellow, and takes care to note that the numbers “are in current dollars, and all treat expenditures and investments as equivalent.” Kevin Drum is even more reasonable:

This stuff has gotten completely out of hand, with “estimates” of the bailout these days ranging from $3 trillion to $7 trillion even though the vast bulk of this sum comes in the form of loan guarantees, lending facilities, and capital injections. The government will almost certainly end up spending a lot of money rescuing the financial system (I wouldn’t be surprised if the final tab comes to $1 trillion over five years, maybe $2 trillion at the outside), but it’s not $7 trillion or anything close to it. People really need to stop throwing around these numbers as if the bailout is comparable to World War II or something. That’s not reality based, folks.

But reasonable and right are sometimes different, and this graphic helps to think it through. We have some idea what we paid for, for example, with the $851,000,000,000 for NASA. We bought space shuttles, satellite systems, a moon shot, planetary probes, a lot of research and development, some air bases and research facilities.

What are we buying when the government purchases mortgage-backed securities, or buys preferred shares of banks that can only pay if a portfolio of real-estate loans does not totally sour? We are buying “paper”, right?

No. We are not buying paper. Ironically, the pejorative term “paper” hides what we are actually doing in a way that is overflattering. All of the iffy securities that are weighing down the banking system represents money already spent on real projects or consumption. When the government purchases a security, it is taking the place of the party that originally fronted money for that expenditure. Every penny of government “investment” is retroactive expenditure on housing, real-estate, consumer credit, whatever.

If a government were to borrow funds in order to build a new stadium, we’d call that an “expenditure”, even if we fully expect use fees and incremental tax revenues to eventually turn a profit for the fisc. Politicians supporting the project would call it an “investment”, quite justifiably. But the project would still count as government spending.

If a private party builds the same stadium, and then is reimbursed by the government in exchange for rights to future revenue, that doesn’t change the economic substance of the transaction at all. But in the second case, the government would buy “paper” — it would enter into a contract trading current government funds for future revenues. That “security” doesn’t make the transaction any more or less an investment than if the government had purchased the stadium itself.

So, in economic substance, the government is currently spending through a financial time machine on the exurban subdivisions and auto loans of several years past. We are retroactively turning in the entire mid-decade “boom” into a gigantic Keynesian stimulus project. Apparently that stimulus was not so successful, since we are likely to enact a brand new massive stimulus very soon. To be fair, it should be easier to design a good stimulus program in the present tense — financial time machines are persnickety things. But the expenditures we are planning to undertake and the “investments” we are making via the universal bail-out are not so different in kind.

I hope that the infrastructure we build next year turns out to be a wise investment, both in financial and use-value terms. It might be, but just because we hope to recoup the cost, we won’t pretend that no money was actually spent. We’ll call the whole thing an expenditure, even though that will probably overstate the ultimate burden. But if a power grid counts as an expenditure on government books, so should a security derived from a mortgage or credit card loan made two years ago. You can argue that the latter are more likely to pay-in-full than the former. Or you can easily argue the opposite, given the prices that the government is paying for its financial investments relative to private-sector bids. But you can’t claim that securities are “investments” while a power grid, or NASA, or even World War II are mere “expenditures”. (It does not seem unlikely that the US government earned has earned more in tax and other revenues over the years having entered WWII than it would if it had not, perhaps by a large enough margin to justify the financial costs of the war.)

Figures of 7 or 8 trillion dollars recently bandied about by the Communists at Bloomberg are overstated, since they do not distinguish between expenditures and guarantees, which are contingent liabilities. The government’s contingent liabilities aren’t usually counted as spending until the contingency has been triggered. But the amount of money already spent or committed on “financial investments” to date is more than $3 trillion dollars, and it is perfectly right to call that government spending on the financial bail-out.

The scale of the largely unlegislated current government program to save the financial system is breathtaking and quite unprecedented. Taxpayers might be made whole, in financial terms, or might reap sufficient dividends in terms of suffering avoided to justify the program. But don’t let anyone convince you that the scale of this intervention is “overstated” because it is all “investment”. NASA and the Marshall Plan were investments too, and pretty good ones.


Tanta has died. It is all over the wires. It is in the New York Times.

She was a wonderful writer, an amazing analyst, teacher of aspiring ubernerds, a delightful, tart wit. She will be terribly missed.

I am struck, for the second time in just a few months, by the odd intimacy of this medium. The newspapers are full of joyful and terrible tidings. Celebrities die. It washes over me.

When Paul Krugman won his Nobel, I was oddly euphoric. I’ve never met the man, or even corresponded with him, but he felt like somebody I know, somebody I talk to, because he participates so actively in this endless sprawled-out conversation that I’m involved in. You sometimes see these images of website clustering, how neighborhoods form, cyberglobs of dense interlinkage. When Krugman won a Nobel, it felt like a kid from my neighborhood had hit the big time, and I was proud.

I’ve never met or corresponded with Tanta, though I have long been a fan. But this doesn’t feel like the death of a distant celebrity. The intimacy of the medium cuts both ways.

Tanta came out of nowhere and contributed greatly to the public understanding of housing economics. She described the mortgage industry in amazing detail, without ever being dry or dull. (Is that even possible?) A quirky, brilliant voice has disappeared. Her silence will be loud in the cacophony.

I am sad.

Should “bad” financial contracts be banned?

Despite all that’s gone down over the last few years, I’m an enthusiast of “financial innovation”. I think it essential that we remake our financial system into something so different from what it has been that we would hardly recognize it. Doing so will require a lot of innovation.

But there’s no question that the current financial crisis was abetted and largely enabled by many of the “innovations” that became ubiquitous in the financial sector earlier this decade — CDOs, SIVs, (arguably) CDSs, etc. To square the circle, I resorted to an old cop-out: the revolution hasn’t been tried. There’s good innovation and there’s bad innovation. The stuff that didn’t work was the bad stuff. Lame as that may be, it is what I think, and I did try to put some flesh on how we could distinguish good from bad going forward. Then Dani Rodrik came back with some fair questions:

OK, now that we have collectively gotten over our finance fetishism, and are willing to accept that some innovations can be bad, what does this mean for regulatory and supervisory approaches?

For example, it is one thing to say that good innovations are those that are transparent, and another to figure out how policy sorts out the degree of transparency of innovations and how policy makers treat innovations of different kinds. Does this line of thinking imply that some degree of paternalism in regulation is unavoidable (“no, you cannot issue this particular complicated derivative!”)

I think we need to discriminate here between the structural and substantive terms of financial instruments. A contract is “structurally” transparent if, conditional on any set of observable real economic outcomes, it is clear what cash flows are compelled of all parties. A contract is “substantively” transparent if the economic outcomes that determine the cash flows are themselves susceptible to analysis. A mortgage-backed security, for example, might be structurally transparent but substantively opaque: Knowing the performance of the bundled mortgages, it might be easy to calculate the cash flows payable to all tranches. But as a practical matter, it might be impossible to estimate the performance of a thousands of heterogeneous loans in a volatile housing market. Common stock is arguably both structurally and substantively opaque: Even if one knows with certainty the long-term performance of a firm, the cash flows due a stockholder can be difficult to predict. And the future performance of a firm is itself very hard to estimate.

I think a strong case can be made for regulatory promotion of structural transparency. Contracts can be made arbitrarily complex, and there is little reason to think that skill at crafting and understanding challenging legal documents overlaps with peoples’ ability to evaluate economic risks and outcomes. It would be useful to have standardized contracts so that those not expert in the law of finance can participate in financial markets without fear of getting screwed because their lawyers missed something. Also, I think regulators have a legitimate interest in ensuring that investors do not accept contingent liabilities foreseeably beyond their capacity to pay. To do so, regulators must be able to estimate the liabilities that counterparties could be called upon to bear. The potential extent of those liabilities should be evaluable without a lot of analysis or guesswork.

That said, I don’t think the best approach would be to forbid nonstandard contracts. Instead, regulators could “bless” certain contractual forms as well-defined, while creating penalties for those who offer contracts that are structurally opaque or that serve to hide embedded leverage. Parties who have good reason to deviate from very standard contracts would have the ability to do so, but would risk of being punished if those instruments are deemed to have violated standards of clarity. In other words, instead of eliminating “bad” contracts, regulators should take on the role of organizations like ISDA and proactively define “good” contracts that meet needs they identify by monitoring “exotics” that gain prominence in the market. Unlike ISDA, however, regulators’ primary mandate would be to ensure that the contracts they bless are well thought out from the public’s perspective: that “catastrophic success” of those contracts would not create fragile networks of counterparties or other hazards. “Blessed” contracts might well include obligations to periodically report contract valuations notional and net, and collateralization to a public registrar. They would rely upon collateral much more than counterparty for security (to restrict embedded leverage), and provide for standardized means of termination or novation, to prevent the emergence of economically useless but systemically hazardous multilaterally offset positions. They might work proactively to encourage the formation of centrally cleared exchanges, to permit counterparty neutrality with less collateral or risk of early termination, as new forms of contract grow popular.

The case for regulatory promotion of substantive transparency is much weaker. Economic problems that appear inscrutable to distant regulators might in fact be quite tractable to those “in the know”. (Pace Arnold Kling and Richard Serlin, it’s important to point out that when I take “transparency” as desirable, I am not suggesting that people should be compelled to reveal hard-won information without compensation. People who can predict economic outcomes should be paid for doing so. But contracts should generally be structured so that the relationship between economic outcomes and contract cash flows is clear. How much “inefficiency” is desirable, meaning how slowly contract prices should respond to information revelation, creating opportunities for the informed to profit, is a complicated question. We need to balance the interests of uninformed investors, whose capital may be required for large projects, and information workers, who need incentives to evaluate competing projects.)

Suppose a group of people learned that, in the near future, there would be an incredible economic need for COBOL programmers, and looked for a way to monetize this. Noting that former COBOL programmers are much more creditworthy than their FICOs suggest, they might wish to buy up the loans of this dispersed, obscure population. Knowledgeable individuals would not want to buy up individual loans: instead they would want diversified exposure to the pool of COBOL programmer loans, since individual circumstances vary widely. Our cabal only knows that on average COBOL programmer loans are underpriced.

So, our insiders should hire up some financial engineers, and construct an asset-backed security containing a pool of consumer loans to COBOL geeks. They could each take diversified shares of the pool, with some assurance of having bought undervalued assets. Once the ABS is established and divvied up, they would have every incentive to reveal their information, explain to the world why COBOL is the next big thing (and how their ABS was structured), and sell to the world at fair-ish value for a quick profit.

This chain of events is informationally idyllic: Knowledgable people are compensated for revealing hard-won information, and economic assets become more accurately priced, which should feed forward into better decision-making. But if regulators are empowered to evaluate the “substantive transparency” of investment contracts, they would certainly have nixed an ABS made up of loans to an eclectically selected population of individuals without justification. Up-front revelation of the justification to regulators, however, might leak and allow a larger player to buy up the whole pool, eliminating the opportunity.

Also, consider common stocks. No rational regulator concerned with substantive transparency would approve of common stock, if it were a novel investment vehicle. It guarantees no cashflows whatever, its “control rights” are so weak for most purchasers that representations thereof should be viewed as fraudulent. Empirically common stock behavior is very weakly coupled to the performance and health of the firms that stocks fund. The only instrument in wide use more substantatively opaque than common stock is fiat money.

I think common stock is a deeply imperfect instrument, one that we should work to improve upon and eventually replace. But, there’s little question that over the several hundred years between the invention of joint stock companies and the advent of information-technology that might make more fine-grained claims practicable, common stock served a useful purpose, both in terms of pooling capital and risk, and promoting information discovery and revelation.

Still, much of our current catastrophe was caused by investors investing overeagerly in securities whose structures were clear enough, but the economic substance of which they were entirely incapable of evaluating. Rather than banning such securities, we should turn our attention to understanding why they did this. A lot of very opaque securities (both substantively and structurally) were invented, sure. But how did they vault from idiosyncratic experimentation to widespread implementation? This had to do with the structure of financial intermediation, and it is there that I believe that regulatory energy should be focused, rather than on evaluating the terms of contracts.

Flawed financial instruments only become policy issues when people responsible for investment on a significant scale decide that what they don’t know won’t hurt them. This can happen by virtue of fads and fashion, the madness of crowds: consider internet stocks, or blind faith in diversification and “stocks for the long run”. But most poor investment, in dollar-weighted terms, is not taken by foolish individuals placing their own money. Bankers and institutional investors are on the one hand granted the power to control investment on a very large scale, and on the other hand make consistently awful choices. Delegated money, rather than trading off return and safety, often trades return for safe-harbor. Absurd contracts that appear to offer high returns are very attractive to money managers of all stripes, if they offer a veneer of safety and “prudence”, or better yet, if they become conventional.

Getting regulators in the habit of banning some classes of contracts (or worse, requiring them to approve novel contracts) would have the perverse effect of certifying the instruments that are permitted. A better approach would be to eliminate safe-harbor for intermediaries by insisting that they be substantially invested in the funds they manage, and on the hook — financially, not just reputationally — for losses as well as gains. (Obviously, we should eliminate safe-harbor that derives from rating agency certifications or statistical risk models. But that won’t be sufficient — professionals will always manufacture “best practices” and find safety in numbers, or hide behind consultations with experts and representations by prestigious sources.)

Fundamentally, the agency problems associated with financial intermediation are deep, and it will take a lot of reform — and innovation — to find good solutions. Regulation to promote structural clarity in investment contracts and manage leverage and counterparty risk may help limit the damage, but won’t be nearly enough. I think we need a fairly wholesale restructuring of financial intermediation, one that limits the scale and leverage of intermediaries, segregates transactional balances and noninformational savings from informational risk investment, and ensures that those who do manage large quantities of wealth land in penury or in prison before the taxpayers are on the hook to make private losses whole. But having regulators review and restrict the substantive terms of financial contracts strikes me as a bad idea.

Apology to commenters

The last couple of posts have generated some very high quality comments, many of which I’m still itching to respond to. I usually try to participate in comment threads. I very much enjoy the conversations, and learn a great deal from the give and take. But my participation has been limited and will probably continue to be so, at least for the next couple of months.

I do read every word (and usually follow the links too). And I very much appreciate your taking the time to read, and to write.

It’s actually a bit silly for me to apologize for my nonparticipation, though. I’d only bring down the level. I’m honored that you choose to chatter here.

“Investing” in AIG et al

Ceci n’est pas un post.

I don’t have time to post right now, and besides, I promised myself that the next post would be a disquisition on regulation, in response to Dani Rodrik. (My two neurons are working real hard on that.)

But, today I am white-hot mad over AIG, and I need to vent. Yves Smith has done a beautiful job of describing the ridiculous awfulness of today’s “restructuring”. More importantly, she uses words with the appropriate intensity and valence: “banana republic”, “looting”, “Mussolini-Style Corporatism”.

For so many years, Milton Friedman passionately argued that there is a relationship between economics and political life. In particular, he believed capitalism to be uniquely compatible with a free society.

What kind of society is compatible with an economy managed by a cadre of large, politically connected firms whose operations and those of the state are intimately connected, and which cannot be permitted to fail since that would bring “chaos”? Friedman would have remembered. “Mussolini-style corporatism” can’t be quarantined at the corner of Liberty Street and Maiden Lane. Trillion dollar bail-outs represent claims on scarce resources. If times get hard, the idea of scarcity will become a lot less abstract. The state will be called upon to enforce “property rights”, including rights to the property that the state is right now giving away (and which in turn are being given away to the truly deserving). First there are economic emergency measures. Later there may be emergency measures of a different sort. Mixing my libertarians, there is more than one road to serfdom.

It is so odd, how we are becoming inured to these sums, $150 billion for AIG, $140B in tax breaks to encourage consolidation into bigger and more dangerous banks, the hundreds of billions in equity infusions under the modified TARP plan, etc. The Fed’s balance sheet has expanded by more than a trillion dollars over the course of several weeks, almost all of which is used to offer one form or another of covert subsidy to financial firms. A bit hyperbolically, I thought, I once compared the scale of the Fed’s interventions to the direct cost of the Iraq War. Now that seems quaint. The scale of the government’s response to the financial crisis now completely dwarfs the direct costs of that war, as well as any plausible estimates of the indirect (financial) costs. (Obviously, the real costs of war are not financial, and run much deeper than our economic problems. I hope the comparison doesn’t seem flip.)

Of course, we are constantly told, all of this is an “investment”, no money has been spent, the taxpayer may even turn a profit.

That’s an argument that sounds reasonable only until you give it a moment’s thought. Nearly all “government spending” (outside of entitlement transfers) is investment. When we build schools, run head start programs, buy fighter jets, and fund our court system, that is not “consumption”. We don’t do those things because we enjoy them, but because they create ongoing payoffs that we believe outweigh the opportunity cost of our funds.

When a firm purchases inventory, when it installs new machinery or operates a research lab, we don’t claim that it has “consumed” its wealth. Investment is something we do in the real world. Financial claims are only faint, imperfect echoes of real investment. There is a bitter irony in the fact that, precisely when bankers have profoundly debauched the value of paper claims, taxpayers are being told that they are not spending, they are investing, when they buy unmarketable securities. Of course it would be “spending” to build a power grid or an airport.

Now, perhaps the government is a very poor investor. But do we have reason to believe that it is more skilled or less corrupt when it invests in financial claims rather than real projects? I find the case for a 16% real return on early childhood education far more compelling than the case for 5% nominal coupon on Goldman preferred stock.

It is likely that taxpayers will turn a paper profit on their paper claims against financial institutions. But that’s not because they are good “investments”. It’s making these investments good is now a constraint on government action. The Fed cannot behave in ways that would compromise the value of the trash on its balance sheet. Once AIG was too big to fail, it cannot fail, no matter how big the black hole grows. Once GM enters the penumbra, very soon now, it also must not fail. Of course, we will not count this terrible loss of policy freedom as a cost.

That cost may be quite large. A commonly held view is that yes, the Fed’s interventions are extraordinarily expansionary, and yes that could lead to inflation sometime far in the future. But for now we have D-leveraging, D-flation, D-pression to worry about. The Fed retains its traditional tools to fight inflation with, when the time comes. It will be able to sell Treasury bonds for cash and “mop up” all this “liquidity” it has “injected” into “the system”.

But wait. The Fed doesn’t hold very many Treasury securities any more (see Kady Liang). It would have to sell off some of the other stuff. Maybe we get lucky, and by the time we need to fight inflation, all those “money good” CDOs turn marketable again. Maybe not, though, and then the Fed will have little choice but to tolerate a great inflation or watch its own balance sheet implode. When the inflation comes, bright investment bankers will have already converted the bonuses we paid them into real property. It will be ordinary savers, and especially workers without bargaining power, who will be stiffed with the bill.

I think either a great inflation or a catastrophic deflation are pretty much unavoidable. It’s the distributional effects that have me white hot with rage. We are sowing the seeds of inflation by making those most deserving of catastrophe whole, while doing nothing for those whose wages may soon achieve purchasing power parity with the emerging world. I’m actually cool with inflation — hey, all my money’s in gold. A sharp inflation would be a kind of large-scale Chapter 11, a systemic debt-to-equity cramdown, debtholders get their claims devalued but the firm’s nation’s economic life goes on. However, inflation is a wealth transfer, and we should be conscious of from whom and to whom. For every dollar of Federal largesse that goes into the Wall Street bonus pool, three dollars should go into extremely generous unemployment benefits, paid sabbaticals for workers to return to school and retool, anything and everything to give people bargaining power to negotiate higher wages without all the hassle a union. Let’s pass the “Take this job and shove it act of 2009″.

Because the only thing worse than a great inflation with a wage/price spiral is a great inflation without one.

If we only had a financial system…

Here’s Paul Krugman:

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine’s plea: “Grant me chastity and continence, but not yet.” For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.

…The capitulation of the American consumer, then, is coming at a particularly bad time. But it’s no use whining. What we need is a policy response.

…[W]hat the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

Tyler Cowen responds:

Krugman… calls for fiscal stimulus… I am more inclined to think that consumers need to cut their spending now. It is widely understood that consumers have been living beyond their means. Let us say instead that consumers maintain their spending (say through fiscal stimulus, a cut in sales taxes, or sheer exhortation) but that everyone knows consumer spending will fall in three years time. In three years time, the “liquidity trap” (not exactly how I think of it) will be over, but in the meantime investment commitments will be lackluster, given that people will be waiting for the economy to digest the forthcoming change. Maybe we need to spend less now and get the adjustment over with more quickly, even though that will be painful.

I love this exchange, because it beautifully dances around the elephant that is not in the room.

Krugman’s point is that, ordinarily, a dip in consumer spending could be offset by an investment boom, courtesy of the Federal Reserve. As always, there’s model just behind Dr. Krugman’s words, summarized in this case by an accounting identity:

Y = C + I + G + NX

If C (consumer spending) contracts, and I (investment) cannot be made to grow, then Y (GDP — truth, goodness, and happiness) must fall, unless we start messing with G (government spending) and NX (net exports). Hoping for an export boom during a global recession seems daft (although NX shifting toward zero from recent negative values may help), so we are left to work with G. It’s time to ramp up government spending.

You can almost hear the words of Hayek echoing in Dr. Cowen’s rejoinder: “Mr. Keynes’ Krugman’s aggregates conceal the most fundamental mechanisms of change.” Cowen’s rather subtle point is that if we artificially support current patterns of consumption by having the government spend money into people’s pockets, we won’t know what future, sustainable patterns of consumption might look like. Without that, we won’t know what to invest in. Paradoxically, we might exacerbate the short-term problem by suppressing private investment. Longer term, we cannot run the economy off of government spending indefinitely, and if we just postpone the pain, we will find ourselves with fewer resources when we have to deal with the underlying problem.

The elephant that is not in the room is a financial system. By a financial system, I don’t mean the tottering cartel of banks and insurers loudly sucking newly printed cash into “collateral postings” and “deleveragings” and other meaningless nonactivities. That is no financial system at all. It is an ecology of intestines and tapeworms, tubes through which dollars flow and are skimmed en route to destinations about which the tripe-creatures have little interest or concern.

No, a financial system would be forward-looking. A financial system would be interested in the world, rather than fascinated by the patterns that formed behind its own mathematical eyelids. A financial system would hunger for information. It would leave no human preference overlooked and no technological possibility unconsidered. A financial system would embrace us all, would want to learn from us all. It would not be something external, something outsourced to specialists in London or Manhattan. It would want “savers” to express what they plan to do, how they hope to live, rather than offering generic claims on money along a disembodied spectrum of “risk”. It would thirst for proposals, ideas, business plans designed to meet the preferences thus expressed, or to achieve possibilities not widely considered. A financial system would be creative. No stock exchange could contain the vast and multifarious tapestry of investable ideas a financial system would educe. A financial system would offer us opportunities to invest not in distant opportunities where we are disadvantaged, but in projects that are informationally, if not physically, near to us. A financial system would be ruthless. It would allow us to have a voice in the most important decision we collectively make, but would force us each to bear the costs of our errors.

We simply do not have such a system. We don’t have anything remotely like such a system.

If we did, Dr. Krugman’s preferred remedy would have worked five years ago, when the Fed still could, and did, stimulate an investment boom. If we had a financial system, we would not have invested in luxury housing and disinvested from tradables while our current account deficit ballooned. We would not have securitized current consumption, and the called it “investment”. Extrapolation is not foresight, and Ponzi schemes do not generate wealth. We did not have a financial system on 2003. That is how we got to 2008.

If we had a financial system, we wouldn’t require the world economy to collapse, just so we could learn how it might be put back together again (with expectations sufficiently lowered). Our financial system would be considering a wide array of possible futures, and using us all to push the world toward to a future that actually makes sense. If we had a financial system, we would be saving by spending to enable future production, not by making sure our dollars are in the kind of bank accounts the government guarantees. Strained consumers would shift from C to I without depleting Y, by purchasing claims on future goods and services, which investors would sell while funding projects designed to ensure the production of those goods. The very act of cutting back current consumption would generate new information about the structure of future consumption, as nervous savers factor price into claims on the future and nervous investors compete to offer claims at prices low enough to sell but high enough that they can ensure profitable fulfillment through an uncertain future.

Of course, this is a kind of dumb utopianism. If we had a magic wand, we’d have better options too. But I suggest you look at it the other way around: the “financial system” that we actually have is an awful dystopia. Yes, it will be impossible to create the perfect massively decentralized optimizer of collective and individual human futures. Screw perfection, but we should at least go for mediocre. Right now, banks don’t even bother to sell themselves to savers on the basis of their superior acumen in choosing real investments. Investors in mortgage-backed securities never believed there was a deficiency of luxury exurban housing. People don’t invest in index funds because they have a considered belief that the projects available to listed firms are superior on average to other projects that might be pursued. We have methodically erased information about real-world activities from the financial decision-making process. We’ve created an intrafinancial mandarin class, treated as experts, entrusted with wealth, but lacking knowledge of anything other than the arcane wheels and gears of finance, as if the finance exists apart from the workaday world of producing and consuming, serving and being served.

There will never be a perfect financial system. But the system we have is so far from reasonable that it must be undone, or it will be our undoing. We should not be propping it up. We should be tearing it down, and using all these hundreds of billions of dollars to replace it with something sensible.

By the way, as a policy matter, in this world as it is, I don’t mean to criticize either Krugman or Cowen. I think they are both right. Per Krugman, for now we have little choice but to have government do a lot of spending, since we have no financial system to convert present savings into real investment. But, for the reasons that Cowen highlights, I think we should channel any stimulus towards basic consumption by those facing hardship (e.g. unemployment benefits, food stamps, etc.) and obviously necessary infrastructure investment (fixing bridges, dams, power grids, etc.). In any reasonable future, everybody will eat, so offering money to those struggling to put food on their table or a roof over their heads will create less uncertainty about future tradeoffs than subsidizing discretionary consumption by those better off. And it’s a cliche, but a true cliche, that our public infrastructure is crumbling. Pulling forward restoration projects that will be necessary unless there are radical changes in the structure of American life also introduces relatively little noise.

But the most important thing we should be doing is building a real financial system.

Update: This post has attracted an extraordinary comment thread. A lot of bright people are looking past all the logos and glass-and-steel towers that try to persuade us that what we have is permanent, a fact of nature, necessary. Some are so old-fashioned as to try to build a better mousetrap and outcompete the slime creatures. (It would be peevish to point out that trillion dollar subsidies and captured regulators may leave upstarts with a not-quite-level playing field.)

Update History:
  • 10-Nov-2008, 5:50 p.m. EST: Added update re comment thread.

Share buybacks and uninformed investors

Today I was reading Felix

[F]or many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream — one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.

In the late 70s and early 80s, the S&P 500’s dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.

Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price.

And then Mish

How many billions of dollars did GE [whose stock currently trades for about $18] waste buying shares back over the years at $40 or greater? $35 or greater? $25 or greater? $20 or greater? Think of where GE might be if it used the money to pay down debts rather than buy shares at absurd prices.

I see that GE is paying a dividend of 6.6% while borrowing money from taxpayers to fund operations. How long can that dividend last?

If you take an introductory finance class, you will learn that firms can return cash to their shareholders in two ways. They can issue dividends, or they can use the same money to buy-up shares from shareholders. Fundamentally, you will learn, these two approaches are equivalent: With a dividend, all investors receive some cash, but the stock they hold loses value. In a buyback some investors sell shares and receive cash, leaving investors who hold their stock with a less “diluted” claim on the assets of the firm, making the payout equitable to all shareholders.

To clarify, suppose there is a firm whose sole asset is $1,000,000 in cash and two shareholders. The firm could pay a dividend of $500,000, giving $250,000 in cash to each shareholder. Alternatively, the firm could buy out one of the shareholders, paying $500,000. In the first case, both shareholders end up with $250,000K worth of stock and $250,000 in cash. In the second case, one shareholders ends up holding $500K in cash while the other shareholder holds stock worth $500K. In financial terms, everyone gets a fair deal either way.

However, conventional wisdom has it that share buy-backs offer important advantages that may make them superior to dividends payments:

  • Preferential tax treatment — Investors are more lightly taxed with buybacks, especially if dividends are taxed more heavily than capital gains. With buybacks, those who sell are taxed only on net gains (a smaller amount than the cash actually received, and perhaps at a lower capital gains rate), while those who don’t sell are not taxed at all until they sell sometime in the indefinite future.

  • Flexible reinvestment with low tax and transaction costs — With a dividend, people who want to stay invested in a firm have to accept and pay taxes on the dividend, and then incur transaction costs to reinvest the proceeds back in the firm. With a buy-out, investors who want to stay invested very efficiently do nothing, while those who want cash can sell into the buyback.

  • Cash-management flexibility for the firm — For whatever reason, firms are expected to keep dividend payments stable and increasing over time, even though business profits and cash needs may be very volatile. Firms that cut regular dividends are often punished by the market. Discretionary stock buyback programs allow firms to return cash to shareholders when business conditions permit and withhold payouts as cash needs grow while maintaining a smooth and stable dividend policy.

All of this would be well and good in a world with perfectly efficient markets, no asymmetric information, and investors whose portfolio preferences are continuously enforced.

But consider an uncertain world in which firms are frequently mispriced, and where many investors have limited attention and rebalance their portfolios only infrequently. (Among this latter group would be buy-and-hold investors who hold a fixed portfolio and either consume the dividends or reinvest them pro rata in a broad portfolio rather than in the issuing firm directly.) In this more realistic world, share repurchases benefit informed and flexible investors at the expense of their less informed or more rigid partners, while dividend payments reduce the ability of informed investors to profit at the expense of other investors.

Let’s first consider the case where some investors know a firm’s stock to be overpriced. Informed investors are more likely to sell into overpriced buyouts, extracting cash from firms at the inflated share price while concentrating the burden of future write-downs on long-term, less-informed investors. A dividend, on the other hand, would return cash equitably to all investors, automatically disinvesting slower investors from the overpriced stock, and forcing informed investors to share in losses. Of course, informed investors who know a stock to be overpriced can still sell, but without the support of a buyback program, their selling might inform the market of the firm’s poor prospects, and cause the share price to fall before they can exit. (That’s how information is supposed to get impounded into markets prices!) With or without the buyback program, investors in an overpriced firm must suffer the cost of a downgrade, but the cash disbursal policy affects the distribution of the losses. Returning cash via buybacks lets the informed shift losses to the uninformed, while the same cash distribution via dividends reduces the eventual cost to slow investors and forces informed investors to share more of the pain.

With an underpriced firm, the difference is less stark. Only ill-informed or liquidity constrained investors sell their shares into a buyback, concentrating future gains in the hands of both informed investors and slow buy-and-hold investors. So although informed investors do gain, the gains are more broadly shared: “slow money” as well as “smart money” benefits, the losers are ill-informed investors or random people who need cash. When an underpriced firm issues dividends, all investors are partially disinvested from a firm whose shares are destined to appreciate. But active, informed investors are likely to reinvest, potentially informing the market and provoking a revaluation towards fair value that benefits all investors. If the market adjusts quickly to the reinvestment flow, informed investors may not be able repurchase very much stock at all from less informed investors before the price adjusts, leaving the revaluation gains broadly shared among all investors rather than captured mostly by the informed.

An easy way to think about all this is just in terms of information: Share buybacks of an overvalued firm create artificial, potentially price-insensitive demand that allows informed investors to exit without suffering adverse price movements from revealing their information. Dividend payouts serve as a shock to investor portfolios that forces informed investors to periodically reveal their information, diminishing their advantage over less informed investors. So uninformed, buy-and-hold investors are less likely to be taken advantage of if they invest in firms that issue frequent, substantial dividends and don’t repurchase stock than if they invest in firms that don’t pay substantial dividends but use stock buybacks to “return cash”.

This line of thinking opens up interesting questions about for whom a firm is to be managed. The party line is that firms should be managed for the benefit of shareholders. Even if that is true, for which shareholders should it be managed? One might conjecture that more active, informed investors have a greater influence than passive buy-and-hold investors, and create incentives for management to buyback overpriced shares even though in some sense this is bad for “the firm”. (There are lots of anecdotes about hedge funds and other activist investors lobbying successfully for share repurchases by firms that turned out to be overpriced.)

Even if one imposes a fiduciary obligation on management to treat all shareholders equally, it’s not clear that management is betraying its trust by working to inflate share prices and creating opportunities for the savvy to cash out. Even if the strategy harms future earning streams, it creates a valuable option that is ex ante available to all shareholders, and the option value of a firm is a real and often substantial component of its worth. If markets are not efficient, it’s quite possible that maximizing current shareholder value is inconsistent with maximizing discounted infinite horizon profit streams, which leads one to question whether current shareholder value is a very useful metric of firm value from a social welfare perspective.