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Competitiveness is about capital much more than labor

Besides justifying labor-hostile monetary policy, unit labor costs are often trotted out to blame unreasonable wage expectations for troubled economies’ “lack of competitiveness”. For example, here’s a chart published last year by Paul Mason (ht Paul Krugman):

It is a common trope that labor costs in the European periphery have grown to unsustainable levels, while in the prudent and virtuous North, costs have been contained.

But the chart is misleading. Let’s take a look at the same information presented a bit differently, from a wonderful Levy Institute working paper by Jesus Felipe and Utsav Kumar, “Unit Labor Costs in the Eurozone: The Competitiveness Debate Again”:

Rather than lazy Mediterraneans demanding high pay for little output, what has happened since 1980 is a convergence to prudent German norms. Workers in Southern europe are now paid roughly the same amount per unit of goods produced as their counterparts in Mitteleuropa. This is macroeconomics, so the meaning of a “unit of goods produced” is a fuzzy and contestable. But to the degree that unit labor cost statistics capture what they claim to capture, what they tell us is that European workers, North and South, have come to earn roughly equal pay for equal product.

Southern European workers do earn less overall, simply because they produce fewer or lower-value goods and services than their Northern neighbors. Unit labor costs are not the problem at all: it is the scale of aggregate output. And what determines the scale of aggregate output? Is it the laziness of workers? No, of course not. We all know that when residents of poor countries emigrate to rich ones, the same weak bodies and flawed characters that produce very little at home suddenly explode into economic vigor. The difference is “capital depth”, broadly construed to include all the physical equipment, business organization, public infrastructure, and governance that collude to enable two small hands and a broken mind to accomplish outsize things. Workers’ pay level is not the problem in Southern Europe. It is deficiencies in the arrangement of capital, again broadly construed, that have left Greece and Spain unable to produce value in sufficient quantity to compete with their neighbors.

One might argue that since “capital” is in some sense a scarcer factor in Southern Europe than in Northern Europe, unit labor costs “should” be lower in the South, as a “marginal unit of capital” adds more value than another hour of labor. I have to use the scare quotes though, because there really is no such things as a marginal unit of good institutions, and to the degree that’s even coherent as an idea, it has no relationship at all to financial returns on invested cash. If governance fairies came to Greece and demanded workers surrender some fraction of their per-unit wages in exchange for the institutional capital that enables German levels of productivity, that might be a good deal. (Perhaps Angela Merkel thinks of herself as just such a governance fairy. I don’t think a disinterested observer of her priorities and demands would agree.) In the real world, there is little consensus, with respect either to institutional development or deployment of physical capital, on how, in the context of a tradables glut from its neighbors, Southern Europe could increase its output of tradable goods and services. Looking backwards, with a converging European price level, restraint in unit labor costs relative to the European norm would have meant increased returns to financial capital, and financial capital was emphatically not a scarce factor in Southern Europe prior to the crisis. On the contrary, financial capital was abundant and enthusiastically misdeployed. That misdeployment, the tsunami of bank-mediated money that found its way into real estate and consumer loans rather than the production of competitive tradables, was the primary and proximate cause of Southern Europe’s diminished competitiveness.

In their role as borrowers, some Southern Europeans were complicit in this process. But, as always, it is creditors rather than borrowers who we must hold accountable for bad lending, if we want incentives consistent with good aggregate outcomes.

In their role as workers, Southern Europeans were victims rather than beneficiaries of the wave of malinvestment. Recall that unit labor costs can be decomposed into two factors, the price level and labor’s share of output. Let’s take a look at some more graphs, again from Jesus Felipe and Utsav Kumar:

In all countries other than Greece (including the rest of the “PIIGS”), labor’s share of output has been declining. Rather than winning unreasonable victories, workers have been receiving an ever smaller fraction of the output that they help to produce. The rise of unit labor costs in Portugal, Italy, Ireland and Spain have only partially compensated for the steeply rising prices that have attended European convergence.

Felipe and Kumar also estimate “unit capital costs” along the lines I described in the previous post. (See Table 1 of the paper.) For all countries other than Greece, payments to capital providers per unit output have been growing faster than payments to workers.

So what’s does all this mean? Two things:

  1. There’s a common narrative of the European crisis that pins the blame on workers. It is said that during the “good times”, when rivers of money flowed from Northern Europe to the Mediterranean, workers in Southern Europe were able to extract exorbitant wage hikes, forcing prices up and rendering their products uncompetitive in global markets. To put it gently, there is no evidence to support this narrative except perhaps in Greece. In the other PIIGS, unit labor costs failed even to keep up with the rising price level. Workers received a smaller share of the value they helped produce in 2007 than they took in 1980. Southern Europe’s unit labor costs converged with Northern Europe’s because the price levels of the two regions converged, not because Mediterranean workers took a greater share. If Southern Europe lacks competitiveness, the part of the cost structure that needs to be reformed has to do with rents paid to capital rather than the sticky wages of workers.

  2. We should beware reductionist accounts that put the blame for the periphery’s misery on inflated relative prices. Though one can tell an alarmist story looking at relative rates of change of unit labor costs, in terms of levels, the periphery’s labor structure looks competitive. Nor can we blame the problems in the periphery on a mere absence of capital. Prior to the crisis, there was plenty of capital available. The European periphery was rendered uncompetitive by toxic patterns of capital allocation, for which both Northern Europe’s financial institutions and Southern Europe’s regulators ought to be held accountable. Altering the relative price of labor between Northern and Southern Europe would not fix these problems. Real devaluation might provide temporary relief in terms of domestic employment, and that might provide breathing room for developing better policy ideas than accepting capricious capital flows and hoping they sustain asset bubbles. But breathing room is all that devaluation can provide. It cannot substitute for better policy. Mediterranean Europe already had much lower relative labor costs than the European “core” prior to the recent convergence. Look how that worked out. The PIIGS should work to avoid falling into a kind of macroeconomic “Groundhog’s day”, cycling between low relative costs, convergence, and crisis.

    Even though devaluation is no panacea, the nations of peripheral Europe might still wish to consider dropping the Euro. But the case for that is not, ultimately, about relative prices, but about sovereignty and bargaining power. As the MMTers correctly emphasize, control over money is essential to the sovereign power of a state. For now, the nations of the Eurozone have ceded a significant part of their sovereignty to European institutions. That would be fine, if those institutions could be trusted to look out for, or at least give fair weight to, the interests of the states which have surrendered sovereign powers. If I were a citizen of Portugal or Greece, Spain, Ireland, or Italy, I would conclude that European institutions have unduly little concern for my interests and unduly much concern for a transnational financial system and Northern European taxpayers. If that continues, I’d want my government to retract the sovereignty it had ceded, so that it has the freedom to maximize the forward-looking welfare and growth of my nation without hobbling itself in the interests of claimants to past loans that ought never have been made.

An obvious corollary to all this is that “internal devaluation” is absolutely idiotic. It’s one thing to accept chemotherapy when the disease is cancer and the pain might do some good. But if the disease is not cancer, chemotherapy is just eating poison. Peripheral Europe’s problem is an incapacity to produce tradable goods and services in sufficient quantity to pay for its import bill. That is a structural deficiency. The wages workers are paid for the goods and services they do produce are in line with the rest of Europe’s. Lower wages might help create incentives for new investment to resolve the structural deficiency. But that hasn’t worked in the past when the periphery’s labor has been unusually cheap. The clear and present miseries of “internal devaluation” should not be allowed to rest on so slim a reed.

Update History:

  • 26-Feb-2012, 2:05 a.m. EST: Dropped superfluous sentence “Patterns matter.” Corrected “Norther Europe” to “Northern Europe”. Reorganized awkward and oververbose sentence beginning with “In the real world…” to a still awkward and oververbose sentence. No substantive changes.

Restraining unit labor costs is a right-wing conspiracy

In an otherwise excellent post, Matt Yglesias commits one of the deadly sins of monetary policy:

[M]y favorite indicator of inflation is “unit labor costs”… Unit labor costs are basically wages divided [by] productivity. It’s not the price of labor, in other words, but the price of labor output. If productivity is rising faster than wages, then even if wages themselves are rising unit labor costs are falling. Conversely, if wages rise faster than prodictivity than unit labor costs are going up. Clearly there’s nothing wrong with a little increase in unit labor costs here or there. But over the long term, growth in unit labor costs needs to be constrained or else it becomes impossible to employ anyone. And you can see that in the seventies it’s not just that gasoline got more expensive, we had an anomalous spate of high unit labor cost growth. That was inflation and it’s what led to the regime change that’s governed for the past thirty years.

That all sounds reasonable. But Yglesias has fallen into a trap. Unit labor costs are not “basically wages divided [by] productivity”. That’s not the right definition at all. [See update below.] Unit labor costs are nominal wages per unit of output. With a little bit of math [1], it’s easy to show that

UNIT_LABOR_COSTS = PRICE_LEVEL × LABOR_SHARE_OF_OUTPUT

An increase in unit labor costs can mean one of two things. It can reflect an increase in the price level — inflation — or it can reflect an increase in labor’s share of output. The Federal Reserve is properly in the business of restraining the price level. It has no business whatsoever tilting the scales in the division of income between labor and capital.

Yet throughout the Great Moderation, increases in unit labor costs were the standard alarm bell cited by Fed policy makers as an event that would call for more restrictive policy. And all through the Great Moderation, except for a brief surge during the tech boom, labor’s share of output was in secular decline. (More recently, the Great Recession has been accompanied by a stunning collapse in labor share. Record corporate profits!)

Correlation is not causation, and undoubtedly much of the decline in labor share can be attributed to factors unrelated to monetary policy, such as the integration of China into global labor markets. But even if the Fed didn’t “cause” the decline in labor’s share, Great Moderation monetary policy made it very difficult for labor’s share to grow. Consider a simple rearrangement of the equation above:

LABOR_SHARE_OF_OUTPUT = ( UNIT_LABOR_COSTS / PRICE_LEVEL )

For labor’s share to expand, either the price level must fall, or unit labor costs must rise faster than the price level. But the Fed responds aggressively to rising unit labor costs, and is committed to preventing any decrease in the price level. Under this policy regime, expansions in labor’s share are pretty difficult to come by! There was that late 1990s surge in labor’s share. But that is the exception that proves the rule: The Fed, to its credit, tolerated an expansion in unit labor costs from 1997 through 1999 without raising interest rates.

In addition to its direct suppression of labor’s share of output, the Fed’s hawkish rhetorical hawkishness on unit labor costs had debilitating indirect effects. Politicians view contractionary monetary policy as a threat to reelection. George H.W. Bush famously blamed the Greenspan Fed for not easing sufficiently prior to his failed reelection bid. Bill Clinton famously chose Rubinomics over, say, Reichonomics, and he cultivated a cordial detente with the Fed. Far too much attention is given to keeping central banks independent of politicians, and far too little is given to keeping politicians independent of central banks.

Since the early 1990s, all actors in the US political system have understood that policies that increase unit labor costs risk a response by the “inflation fighting” central bank, whose “credibility” was swaggeringly defined as a willingness to provoke recession rather than risk inflation. In this environment, the decline of labor unions and their shift in focus from wage growth to working conditions was understandable. If workers won on wages, they would lose when the recession put them out of work. As long as wages were contained, monetary policy was “accommodative”, and workers could supplement their purchasing power with borrowings and asset appreciation. During the Great Moderation, wage growth was rendered obsolete. A superior means of middle class prosperity had been invented. Or so it seemed, until we experienced the toxic after-effects in 2008. Now we have grown skeptical of debt-fueled pseudoprosperity. But the covert hostility to wage growth that underpinned Great Moderation monetary policy remains unchallenged.

I imagine some readers saying to themselves, “But still. If the labor cost of ‘stuff’ is allowed to grow, how can that not be inflationary? It’s common sense.” And that’s true, as far as it goes. But if the capital cost of stuff grows, that must also be inflationary. Suppose we define the complement to unit labor costs, unit capital costs. Unit capital costs might be defined as “business profits per unit of output”. Would it be politically tolerable in the United States to have a central bank that prevented expansions of business profit per unit sold? Is restraining profitability of investment a proper role for a central bank? If suppressing returns to capital would be improper, why on Earth do we tolerate a central bank that opposes returns to labor?

There is an orthodox answer to this question. Wages, it is said, are sticky, while returns to capital are highly flexible. Elevated wage levels distort the economy, or force us to tolerate inflation in order to reduce real wages. Capital prices respond to market forces and find their efficient level. That might all be true at a micro level, but at a macro level our experience is opposite. The fraction of expenditures we pay into corporate profits has ratcheted upward pretty continuously since the mid-1980s, with a brief lull in the late 1990s and an even briefer one during the Great Recession. The share we pay as wages has fallen precipitously. In aggregate, labor has proven very flexible in its demands while the rentier class has been quite rigid. Economists like to be microfounded and all, but this is macroeconomics, and actual macroeconomic evidence has to count for something.

All of this is one more reason to prefer the NGDP path target promoted by Scott Sumner and his merry Market Monetarists. It might prove difficult in practice to target inflation without paying some especial attention to wage growth. But a central bank can target the path of aggregate expenditure without playing favorites about who pays what to whom. Simple neutrality by the central bank in the contest between capital and labor would be a huge improvement over the status quo.

Many thanks to Nick Rowe, who probably doesn’t agree with any of this, but helped me think these issues out in the comments here.


Update: It is easy to show that unit labor costs are not equal to total wages divided by labor productivity. But Nick Rowe points out in the comments that unit labor costs are equal to the average hourly wage divided by labor productivity. So, depending on how you want to interpret “wages”, I was too quick in tweaking Matt Yglesias for a misstatement. Sorry!

Thanks to Rowe, Dan Kervick, and JKH who work this out carefully in the (excellent) comment thread.


[1] Here’s the math. By definition…

UNIT_LABOR_COSTS = NOMINAL_WAGES_PAID / QUANTITY_OF_REAL_OUTPUT
UNIT_LABOR_COSTS = (NOMINAL_WAGES_PAID / TOTAL_NOMINAL_EXPENDITURES) (TOTAL_NOMINAL_EXPENDITURES / QUANTITY_OF_REAL_OUTPUT)

But (NOMINAL_WAGES_PAID / TOTAL_NOMINAL_EXPENDITURES) is just labor’s share of GDP and (TOTAL_NOMINAL_EXPENDITURES / QUANTITY_OF_REAL_OUTPUT) is the price per unit of output, or the price level. So we have…

UNIT_LABOR_COSTS = LABOR_SHARE_OF_OUTPUT × PRICE_LEVEL

Update History:

  • 22-Feb-2012, 12:30 a.m. EST: Added update re alternative definition of “wages divided by productivity”. Added “[by]” where quote read “wages divided productivity”.

Starter Savings Accounts

So, here’s a thing I think we should do.

The Federal government should offer inflation-protected savings accounts to individual citizens, but with a strict size limit of, say, $200,000. These accounts would work like bank savings accounts, and might even be administered by banks. But deposits would be advanced directly to the government (reducing borrowing by the Treasury), and the government would be responsible for repayment. The accounts would promise a tax-free real interest rate of 0% on balances up to the limit. Each month, accounts would be credited with interest based on the most recent increase in the Consumer Price Index (adjusted for any revisions to estimates for previous months).

The purpose of this plan would be to offer a no-frills, low risk savings vehicle for middle-class workers. Ordinary bank savings accounts no longer do the job. They already pay negative real interest rates, and those rates might well get worse if we experience more inflation. TIPS don’t do the job. They expose savers to interest rate risk and liquidity risk. Small savers must compete with large savers for the same very limited pool of securities, resulting in negative yields. The option implicit in the floor on principal isn’t easy to price. It takes a degree of risk-tolerance and sophistication to manage a portfolio of TIPS that we ought not demand of waitresses and schoolteachers. They should be able to just open an inflation-protected savings account at their local bank.

Republicans should love this proposal. It would reward “virtuous” savers who are currently punished by negative real rates, and the benefit would be tilted upwards towards the relatively prudent and productive. People with substantial savings gain more from the tax and interest rate subsidy than people putting just a few dollars away. Democrats should love it too, as rewarding savers is a bipartisan trope, and the $200,000 limit keeps it a middle-class program, preventing a huge giveaway to the top 1%.

These “starter savings accounts” would be a popular vehicle for ordinary people who want convenience and safety with as little entanglement as possible in casino finance.

But the real benefit would be macroeconomic. “Market monetarists”, MMTers, and old-fashioned Keynesians love to squabble with one another, but they have a great deal in common. By whatever combination of monetary and fiscal policy, in a depression, all these groups agree that some manner of expansionary intervention should be pursued to maintain spending and effective demand. But any such policy increases the risk of inflation, and so is opposed by people holding debt or fixed-income securities. The people with the most to lose from inflation are the very wealthy, who hold a disproportionate share of financial claims. But middle-class savers value their small nest eggs just as dearly, and make common cause with multibillionaires to oppose inflation. By providing means for small savers to protect themselves from inflation when intervention is called for, we can stop the very wealthy from using middle-class retirees as human shields, and thereby create political space to adopt expansionary policy.

The existence of these accounts would be mildly contractionary, as smaller savers could no longer be scared into spending by the threat of inflation. But while pushing small savers to spend their way into precarity might contribute to short-term GDP, the overall costs of that approach probably exceed the benefits. Expansionary policy should encourage consumption and investment by people with the means to bear risk rather than threaten the savings of people who cannot afford to spend.

The limited size of “starter savings accounts” would leave the wealth of large savers at risk, and with fewer places to hide. That is as it should be. The risk of the aggregate investment must be borne by someone. Patterns of aggregate investment are determined by the behaviors of savers, or the people to whom they directly or indirectly delegate investment decisions. If we want a high quality of investment, we have to ensure that these investors bear the cost when aggregate investment disappoints. All savers would enjoy protection of their “starter savings”, but people trying to push large sums of wealth into the future would have to take responsibility for directing the use of their capital, and for monitoring the quality of the institutions through which capital is allocated generally. When the process fails, when capital allocation goes badly awry, large savers would bear the costs directly via writedowns or indirectly via inflation. It will be hard to push for bail-outs when middle-class nest eggs are insulated from the vagaries of capital markets and banks. It will be hard to push for austerity when middle-class nest eggs are immune from inflation. Wealthier savers would still be protected from penury, if they wisely max out their starter savings accounts before piling into CDOs and auction-rate securities.

The program proposed would, for now, be a subsidy to small savers, since real risk-free interest rates are negative. In better times, the program would impose a small “tax”, because the government would pay less to depositors than the positive real rates it pays on other borrowings when the economy is growing. But this would not actually be a tax, because participation would be optional. When times are good, banks and brokers will relentlessly encourage savers to migrate into higher yielding assets. Savers may choose to buy whatever Wall Street is selling, or to stick with what is simple and safe. Even in good times, a guaranteed, perfectly liquid, inflation-protected savings vehicle would be popular with many savers. Starter savings accounts would be a useful and voluntary program with a negative fiscal cost.

Some practical considerations:

  • Limiting the size of the accounts is absolutely crucial. Failing to do so could put the finances of the state into dangerous jeopardy. A currency-issuing government’s nominal “debt” is best classified as equity. Inflation-protected debt is much more debt-like, and can put the solvency of the state into question. Nominal debts can always be repayed in extremis by printing money. But that is not true of inflation-protected debt, on which a government may be forced to default, overtly or tacitly (by corrupting the inflation indices). The US government, very wisely, keeps its TIPS issuance very small. It should keep the aggregate size of the starter savings program small as well. At $200,000 per person, the program could succeed catastrophically if the relatively well-off take to it en masse. To manage this, the government might set a ceiling on the aggregate size of the program (perhaps 25% of GDP), and adjust the limit of inflation protection as necessary to remain beneath the ceiling. (The government would announce periodic adjustments, up or down, to the limit. The government would pay the ordinary 30-day Treasury bill rate on balances above the inflation protection ceiling.)

    Alternatively, the government could discourage overuse by publishing a diminishing real-interest rate schedule, so that the first few thousand dollars in an account would accrue interest at a sharply positive real rate while “late” dollars are punished with ever more negative real rates.

  • The accounts would have to be nonhypothecable. To put that in English, loans and other contracts that pledge the contents of these accounts as security should be prohibited and unenforceable. Otherwise, when real interest rates are negative, financial engineers will bundle loans secured against many poorer individuals’ accounts into unlimited sized accounts for rich people. This sort of indirect use of the accounts is impractical if the loans are unsecured and their repayment is at the discretion of the borrower. (Every sort of contractual encumbrance or automatic withdrawal should be prohibited, to prevent schemes where administering banks enforce security arrangements that the law would not.)

Often my proposals are pie-in-the-sky, after-the-revolution sort of affairs. But this one strikes me as practical, achievable within the present political context. “Starter savings accounts” would represent a form of middle class social insurance that I think a lot of people are thirsting for. They would have a small near-term fiscal cost, and would likely pay for themselves over the long-term. Since the program would be structured as personal savings, it flatters the American policy establishment’s devotion to “bourgeois virtues“. I think the existence of these accounts would open up a great deal of political space for better macroeconomic policy. They would reduce resistance to expansionary monetary/fiscal intervention. They would reduce the press for bailouts and corrupt reflations when the stock market swoons or some megabank coughs blood. Shouldn’t we do this?

Haitao Zhang’s macro stabilization proposal

I first “met” Haitao Zhang seven or eight ago, when we were both frequent commenters at Brad Setser’s remarkable blog. After I wrote about NGDP targeting, Zhang forwarded to me a paper he composed and sent around several years ago. He has graciously given me permission to republish it.

It’s an interesting piece, in the spirit of a several proposals (Abbott, Parameswaran, TradersCrucible, me) that try to combine the benefits of fiscal policy with the institutional agility and rule-orientation associated with monetary policy. Zhang’s proposal is a particularly creative and ambitious contribution.

From the abstract:

In this essay I propose that the central bank be freed from its role of using interest rate policy to support aggregate demand. Instead, a truly variable public spending program is suggested to regulate aggregate demand. The program should be running constantly in order to minimize the time delay of fiscal responses. The amount of spending is variable and can be automatically computed from the realized nominal GDP so as to target a fixed growth rate for the nominal GDP. In order to gain popular support and avoid the pitfalls of traditional Keynesian stimulus programs, I propose that an electronic national market be set up to give voters direct control over where such stimulus spending is applied.

Read the whole thing!


P.S. Scott Sumner, the Timothy Leary of NGDP targeting, seems to have endorsed the Abbott paper. If so, there is a lot less daylight than I thought between his views and my own. Which is a shame — he’s fun to argue with!

Update History:

  • 2-Feb-2012, 7:00 p.m. EST: Added TradersCrucible’s TC rule to the list of rule-oriented fiscal policy proposals.

Bad rhetoric

I’ve had a fair amount of feedback and correspondence following my recent posts on “opaque finance” (1, 2, 3). Much of that has been positive, though certainly many readers disagree and dispute my points. That’s par for the course. But I’ve had several letters outraged in a way that I haven’t so much encountered before, from correspondents who felt mistreated, like their ideas and concerns had been bulldozed by my rhetoric.

Looking back at the posts, especially the second in the series, I think that those correspondents have a point. I try to keep interfluidity mostly pretty civil, and hope to be respectful of readers who disagree with me. I think I failed to do so in this series.

As a blogger and a polemicist, I do a lot of thinking aloud. I try to liven things up in voices, hyperbolic, outraged, absurd, gruff, petulant. I mean to present ideas that I think matter, and to do so in ways that are fun to read and write. I intentionally allow my moods and passions to flow into the tone. My moods and passions have been dark recently, and I let that excuse a degree of license that I should not have taken.

Although I’m entirely done blogging the subject, I think the ideas I presented on “opaque finance” are interesting and important. But I regret my categorical use of the word “true”. I should have listened to this guy:

The quality of mind I value in other people and strive for in myself is a kind of nimbleness, a fluidity of mind. The world is too complex for any particular narrative to be perfect. Good judgment, I think, comes from the ability to slip between and among stories, to understand the ways different accounts might be true, to marshall evidence and reasoning on both sides and then assign weights to a superposition of competing, sometimes contradictory ideas, all of which play a role in ones choices.

Wait. That was me. But you’d never know it reading this.

I certainly reserve the right to vigorously defend my ideas, and not to walk on eggshells when I do so. I think the perspective I presented captures something very real about the role that finance plays in human affairs. But it isn’t the one true story, there are lots of other important narratives, and I apologize to readers who, with some justice, felt as though I shouted them down.

Is opacity an excuse?

I’ve been getting a lot of concerned feedback from people I respect on my claim that status quo finance requires opacity and some degree of trickery in order to function. (See previous posts.) If prosperity is connected to “opaque, faintly fraudulent, financial systems”, is that an excuse for looting and predation by financial intermediaries? Won’t it be used as one?

Though it may be counterintuitive, rather than excusing misbehavior, opacity in finance implies that misbehavior of intermediaries must be policed more vigorously and punished more punitively than in a world that could be made transparent. If finance were as transparent as baseline neoclassical models suggest, there would have been no “flaw” in Alan Greenspan’s ideology, and no need to regulate markets or root out fraud. Creditors would themselves vet and monitor their financial arrangements, would assume risks in full knowledge of all potential mishaps ex ante, and could therefore be required to accept responsibility for losses ex post. There would be no need for any heavy-handed meddling by the state or vitriolic second-guessing by nasty bloggers. The harms of malinvestment would be internalized by investors who were capable of bearing the risks. When things go wrong, it would be none of the rest of our business.

It is when the relationship between capital provision and investment choice becomes intermediated and opaque that we must impose institutions of accountability. If we permit you to invest other people’s money behind closed doors, if, even worse, we institute society-wide cons (deposit insurance, rating agencies) to trick people into bearing the risk of your schemes, then it is absolutely essential that you perform your duties to a very high ethical standard, and that you have strong incentives to deploy the pilfered capital well rather than to squander or expropriate it.

Opacity creates a very serious technical problem: as we allow finance to be opaque and complex, it may become difficult to police and impose good incentives. So we may, as a society, face an unpleasant tradeoff. Tolerating more opacity may help mobilize capital for useful purposes, but any benefit may be offset by a diminishment of our capacity to regulate and police. At one extreme of opacity, financial intermediaries simply steal everybody else’s wealth. That’s no good. At the other extreme, if we insist on perfect transparency (without big changes in how we organize our affairs), the result will be extreme underinvestment. Which is no good either.

There are some issues that we’ll need to unpack. When we talk about “transparency”, a core question is transparent to whom? My thesis is that status quo finance must be opaque to beneficial investors, that is to the innumerable people who must be persuaded to bear some portion of the risk of aggregate investment when their informed preference would be to defensively hoard. That does not mean that finance must be opaque to, say, regulators, who themselves participate in the con by assuring people it is “safe to get in the water”. (Ultimately it cannot be made safe.) In theory, we could design a system that is opaque to the broad public, but transparent to regulators who police the intermediaries. That is the architecture that our present system strives for. But the many practical problems of this architecture are widely known: the capital allocators are more numerous than the regulators, and as a matter of practice, they tend to be much better remunerated (a fact which itself is a kind of regulatory failure). If bankers wish to invest recklessly (or simply to loot) and it boils down to a cat-and-mouse competition, the bankers are likely to win. The potential spoils from looting are very large, large enough that bankers can offer to share the spoils with regulators or the politicians who control them, leading to revolving doors and see-no-evil regulation. Regulators are supposed to stand in as agents of people who’ve ceded control of capital to opaque intermediaries, ultimately the broad public. But it is difficult to prevent them from being “captured” — socially, ideologically, and financially — by the groups that they are supposed to regulate. Regulators themselves often prefer opacity and complexity for reasons analogous to those that sucker end-investors. Regulators don’t like to fight with their friends and future benefactors, and they fear the operational and political headaches that would come with reorganizing large banks. But they don’t like to be put in a position where misbehavior is plainly before them, so inaction would be unmistakably corrupt. They find it a great relief to be persuaded that “sophisticated risk management” models, rating agencies, and “market discipline” mean they don’t have to look very hard or see very much. It seems better for everyone. Everyone gets along and feels fine. Until, oops.

All that said, to the degree that we can maintain high quality supervision, regulators who pierce the veil of opacity, prevent looting, and ensure high quality capital allocation are a clear positive. If we posit very good regulators, there is no tradeoff at all between supervision and effective capital mobilization. On the contrary, opaque finance is unlikely to deploy capital effectively without it, since, with actual capital providers blind, there is no one else to provide intermediaries with incentives to invest carefully rather than steal. An opaque financial system is an argument for vigilant regulation, not deregulation. If regulators allow themselves to be blinded by complexity and opacity, if financial intermediaries are permitted to arrange themselves so that legitimate practices and looting are difficult for regulators to distinguish, that becomes an argument for very punitive regulation whenever plain misbehavior is discovered, because as the probability of detection diminishes the cost must increase to maintain any hope of effective deterrence.

I am pretty pessimistic about this architecture. I think that high quality financial regulation is very, very difficult to provide and maintain. But for as long as we are stuck with opaque finance, we have to work at it. There are some pretty obvious things we should be doing. It is much easier for regulators to supervise and hold to account smaller, simpler banks than huge, interconnected behemoths. Banks should not be permitted to arrange themselves in ways that are opaque to regulators, and where the boundary between legitimate and illegitimate behavior is fuzzy, regulators should err on the side of conservatism. “Shadow banking” must either be made regulable, or else prohibited. Outright fraud should be aggressively sought, and when found aggressively pursued. Opaque finance is by its nature “criminogenic”, to use Bill Black’s appropriate term. We need some disinfectant to stand-in for the missing sunlight. But it’s hard to get right. If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles. If all we get is “tough” regulation that makes it frightening for intermediaries to accept even productive risks, the whole purpose of opaque finance will be thwarted. Capital mobilized in bulk from the general public will be stalled one level up, and we won’t get the continuous investment-at-scale that opaque finance is supposed to engender. “Good” opaque finance is fragile and difficult to maintain, but we haven’t invented an alternative.

I think we need to pay a great deal more attention to culture and ideology. Part of what has made opaque finance particularly destructive is a culture, in banking and other elite professions, that conflates self-interest and virtue. “What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities. That this wealth is coaxed deceptively into their care ought increase the standard to which they hold themselves. If stolen resources are placed into your hands, you have a duty to steward those resources carefully until they can be returned to their owners, even if there are other uses you would find more remunerative. Bankers’ adversarial view of regulation, their clear delight in treating legal constraint as an obstacle to overcome rather than a standard to aspire to, is perverse. Yes, bankers are in the business of mobilizing capital, but they are also in the business of regulating the allocation of capital. That’s right: bankers themselves are regulators, it is a core part of their job that should be central to their culture. Obviously, one cannot create culture by fiat. The big meanie in me can’t help but point out that what you can do by fiat is dismember organizations with clearly deficient cultures.

But don’t my paeans to the role of opacity in finance place arrows in the quiver of those seeking to preserve and justify financial predation? Perhaps. People who benefit from corrupt arrangements will make every possible argument to rationalize and preserve their positions. But the fact that ones views might be misused doesn’t mean we should self-censor. I was rude, in the previous post, to assert categorically that my argument “is true”, but I do think that it is. My tone was sardonic and bleak, and perhaps it ought not to have been, but these ideas have always been “out there”, and it’s best we acknowledge and deal with them. Nearly every proposed financial regulation is greeted with stern warnings that it will cause “credit to contract”. It is worth trying to understand the mechanics of real-world capital mobilization, and its role in underwriting prosperity (or perhaps militarism). I don’t think we have to fear talking about this stuff. The proposition that looting and misdeployment of capital serve the public good is easy to debunk. The proposition that there are arrangements which serve useful purposes but also create space for corruption is not controversial. We need to understand how institutions actually function and how they are abused if we are to have any hope of minimizing their pathologies while preserving their benefits. And we have to understand the purposes our institutions actually serve if we are to have any hope of replacing very problematic arrangements with something better.


P.S. I should define what I mean by “transparent” and “opaque” investment. An investment is transparent if the investor is well informed ex ante of the potential risks of the use to which her capital will be deployed, and fully assents to bear those risks, such that there is little question or controversy ex post over who must bear losses should the investment not work out. An investment is “opaque” if the apportionment of potential losses is not well specified and clearly assumed by capable parties ex ante, so that in a bad outcome, allocation of losses would foreseeably become a subject of conflict and controversy ex post. Investments in which losses will “clearly” be borne by the state are opaque, because the actual incidence of those losses (in terms of taxation, inflation, or foregone government spending elsewhere) are unknowable ex ante and a matter of political conflict ex post. Transparency is ultimately about the quality of loss allocation.

Opacity and transparency are matters of degree, not binary categories. Questions of transparency cannot be resolved by legal formalism, but are matters of practice and expectation. Fannie Mae securities may have specified in big, bold text that they were not obligations of the United States government, but expectations of purchasers of those securities were not consistent with the formal disavowal, and those investors did not fully assent to bear the credit risk. The allocation of losses from Fannie Mae securities was determined ex post by a political process, not ex ante by informed acceptance of risk. So Fannie Mae securities were opaque investments. The degree to which an investment is transparent is contestable, a matter of judgment not a matter of fact. In the previous piece I argue that index funds are now opaque investments in the United States. I’m sure there are others who would dispute the point.

I think the degree to which investment in aggregate is mediated transparently vs opaquely is an important characteristic of a society.

P.P.S. It’s worth noting that, for now, in the US, savers are enthusiastically entrusting their resources to the state and opaque intermediaries. Deposit insurance and modest inflation expectations have been sufficient to prevent commodity hoarding and other nonintermediated, low return means of preserving wealth. For the moment, the bottlenecks to capital mobilization are at the interface of bankers, borrowers, and entrepreneurs, and in the reluctance of government to invest directly. (More fundamentally, perhaps the bottleneck is an absence of the security and demand that might inspire borrowers and entrepreneurs.)

Opaque and stinky logorrhea

My previous post on opacity in finance attracted a lot of discussion, both in an excellent comment thread and throughout the blogosphere. Thanks. As usual, your comments put my drivel to shame.

I thought I’d follow up (very belatedly, i’m sorry!) with some remarks on opacity in finance. This will be long and very poorly organized, a brain dump of responses I feel I owe people so I can move onto other things. If you actually read it, I am grateful. (I am always grateful that you read my words at all!)

Anyway here goes:

  • I, personally, detest opaque finance. I would prefer we eliminate whole sectors of status quo finance, replacing the existing skein of deceptive institutions with very simple arrangements that make it absolutely clear who bears what risks. Banks, money market funds, and pension funds are the first institutions we’d reform out of existence. They wouldn’t be the last. I became interested in financial systems as a large scale information system. It is with great unhappiness and reluctance that, after devoting years of my life to thinking about finance, I’ve concluded that financial systems are better characterized as large-scale disinformation systems and that disinformation is at the core of how they function, not some tumor that can be excised to restore the patient to good health.

  • I am still an idealist. I think we should try to develop financial systems that are honest and transparent, that do not combine kleptocracy and effectiveness into a bundle that’s both impossible to refuse and debilitating to accept. But that is a larger and very different project from, say, increasing capital and liquidity ratios at status quo banks.

  • We must give the devil her due. It pissed a lot of readers off and pisses me off too, but the argument I offered in the previous post is true. Over the broad scope of history, societies with financial systems that mobilize capital opaquely and at very large scale have completely dominated those that have relied only upon consenting risk assumption by well-informed individuals. Industrialization occurs in societies with corrupt and fragile big banks, or else in societies where the state coerces and obscures risk-bearing and reward-shifting on a large-scale, or (more usually) both. China is a great present day example. That does not mean it would be impossible to develop a set of institutions that would be both effective and transparent. But it does mean developing such a system is an ambitious and ahistorical project, not a mere matter of “fixing what’s broken”. Under present arrangements, transparency and what we perceive as effectiveness stand in opposition to one another. It is incoherent to demand transparency and expect “more” macroeconomically stimulative intermediation from our current financial system.

  • A lot of responses to the previous post were of the form, “You are wrong, and like, duh! Look around! Look at where opaque finance has gotten us! No one trusts anyone, we can’t mobilize risk capital at any scale, etc. etc.” That’s all true! But it’s the exception that proves the rule. The trouble with opaque finance is that the opaque and kleptocratic financial sector doesn’t con people into providing capital at scale only when it knows how to put it to good use (my first payoff matrix from the previous post), but tries to do so habitually, all the time. Financiers aren’t especially bright, and they are in the business of mobilizing capital, it’s what they get paid to do. As a group, they can’t distinguish periods with excellent real opportunities from periods in which they are shepherding capital into idiocy and waste. Financiers are first and foremost salesmen. Some of them do understand when they are selling poison. But many of them, like most good salesmen, persuade themselves of the amazingness of what they are selling in order to persuade the rest of us more effectively. So there are periods, as we’ve just seen, when financiers attract huge gobs of capital and confidently deploy it into an incinerator. They are then forced to break their promises to everyone. Since no one (most especially the financiers) believes themselves to have agreed to be the bagholder, we are left in an ocean of conflict over who must bear what costs. It’s awful! Where we are now is awful! So how can opaque finance possibly be good? Well, banking crises are not new. We’ve been at this for centuries. The US had depression-strength “banking panics” every decade or so during the 19th Century, with all the attendant conflict and recrimination when banks failed. Thailand had no banking panics. Which country developed? I’d wager that, over the course of history, the correlation between banking crises and long-term growth is strongly positive, not negative. Banking crises are evidence of banking, and banking is evidence of the recruitment of dispersed capital that enables industrialization and development. When disturbingly common crises destroy trust and render opaque finance ineffective, we don’t segue into prosperous periods of honest, transparent activity. As a general rule, our economies remain debilitated until con-men of both the private and public sector (a distinction without a difference) restore faith in some even more convoluted and cross-guaranteed variation on the same con.

  • Lots of responses were of the form. “Bankers don’t think that way!” No, of course they don’t. Most bankers don’t understand themselves to be con artists. Remember how finance enthusiasts used to like to gush about the power of “emergent systems”? If there’s any conspiracy in this story, it’s an emergent conspiracy, not some some self-conscious attempt to serve the greater good by pulling the greater wool over everyone’s eyes. Bankers just think about making money. They work to attract cheap finance via suggestions of clever risk-management and cross guarantees. They try to cover themselves in case it all goes wrong. They persuade themselves in some big-picture way that the “system” in which they are participating in does some good, they rationalize away practices that might seem to be a bit sketchy. Every industry has its sausage factories, right?

    It might be better if bankers actually were self-conscious conspirators. If they understood themselves to be the masters of sneakily pilfered resources, they might feel some kind of noblesse oblige to deploy those resources with care, and they might coordinate in the service of communal aims. Compare modern financial elites to their old-style WASP-dominated predecessors. Part of what makes an FDR different from a Mitt Romney is that an FDR understood his power to be derived from more or less arbitrary privilege, while a Mitt Romney imagines himself to have “eaten what he killed” in brutally efficient markets. The neoliberal revolution in finance and economics was not pap invented merely to enslave the plebes. As the value system of the first world grew more “open” and “meritocratic”, it became hard for those who achieved outsize influence in finance both to accurately understand their own roles and to consider themselves good people. Self-regard being more important to all of us than truth, financiers eagerly followed and encouraged an academic movement that described the conflicted institutions which had elevated them as “efficient” and tending inevitably towards “optimality”. They persuaded themselves, long before they persuaded the rest of us, that any games they played for their own enrichment would necessarily lead to social gain over the long term. It was because they were true believers, rather than mere deceivers, that they could evolve such rapacious forms of finance without the slightest hint of conscience. Their belief in an invisible hand so perfect it would be unrecognizable to Adam Smith led them to make mistakes that their chummy predecessors never would have. (The old WASP establishment would have responded to East Asian mercantilism instinctively. The neoliberals rationalized obvious strategic dangers as presumptively optimal market outcomes. Instead of resisting, they sought opportunities for self-enrichment and forged increasingly transnational identities.)

  • Many readers pointed out that, if the coordination problem I describe is real, there are lots of ways to overcome it, so opaque finance isn’t necessary. That’s absolutely true in theory, but questionable in practice. Governments could transparently tax resources away from citizens and, by some indeterminate intelligent means, directly invest those resources in order to maintain an efficient scale of activity. But as a matter if politics and practice, that doesn’t happen. Governments primarily contribute to the pace of investment in the most opaque manner possible, subsidizing a vast menagerie of not-at-all transparent financial intermediaries with a variety of often tacit guarantees. Sometimes a visible circumstance, like an immigration wave, can inspire a wave of direct investment by households, overcoming the coordination problem. Several readers pointed out that the 1990s tech boom I used as an example was itself financed rather transparently, by equity investors who dutifully accepted losses from risks they’d agreed to bear up front. That’s right, and a fair critique of my example. The tech boom was, to a very large degree, spontaneously coordinated by investor enthusiasm for a new technology. If animal spirits are a coordination problem, a game with multiple equilibria, lots of circumstances could put us into the good equilibrium. But then lots of circumstances could put us into the bad equilibrium too. Opaque finance isn’t needed to ensure that we occasionally find ourselves in a good equilibrium. Its function is to ensure that we reliably stay out of the bad equilibrium, or that if we fall into darkness, we don’t stay there for very long.

  • Some idealists suggest that the United States’ various twitches towards an “equity society”, or the popularity of the “Stocks For The Long Run” mantra, imply that there is no need for opaque finance. Americans, under this theory, have been successfully persuaded to willingly and informedly bear the risk of industrial development. So there is no need for any kind of a con. I’m afraid that’s terribly wrong. First, it’s wrong empirically. Despite the United States’ near obsession with its stock market, households have never held the majority of their financial wealth as direct claims on firms. Even if one defines holdings of index and mutual funds as “transparent” finance, transparent vehicles have never comprised the majority of US household financial wealth. Most household wealth is held as a mix of bank deposits, bonds, and pension fund reserves. (Just browse through table L.100 of the Fed’s Flow of Funds, even at the height of the dot com euphoria for equities.) Stocks are disproportionately held by high income households, so I suspect the bias towards opaque finance of the median household (rather than the average “household and nonprofit” tracked by the Fed) is overwhelming. An “equity society” in which individuals voluntary hold the preponderance of their wealth as claims against real-economy projects whose risks they are willing to bear is an ahistorical pipe dream. And it’s worse than it looks. Many mutual funds are money market funds, an institutional form which is a contrived masterpiece of opacity, explicitly structured to mimic “guaranteed” bank accounts, perceived by customers to be reputationally and now politically protected against “breaking the buck”. Index funds, in my view, should increasingly be grouped as opaque rather than transparent finance. Conventional financial wisdom now suggests that younger people should pay no attention to the underlying investments, but treat stock indices as long-term savings accounts. Inevitably, the growing popularity of that practice has coincided with political pressure for stabilization of “the market”, stabilization which is now widely and justifiably perceived to exist. People who invest in “the market” as a long-term savings vehicle do not really consent to accepting whatever outcomes the industrial firms they blindly fund happen to deliver. They consent to vertiginous short-term fluctuations in value, sure. But they expect, well, something to deliver the long-term stable growth that’s been promised, stocks for the long run. If things don’t work out that way, the political system is supposed to make it so. Indexers do not blithely consent to take a long-term loss, if that’s the way the cookie crumbles, and the political system, from the Fed to the US Congress to the President are increasingly geared toward ratifying expectations of things working out in the end. Remember all those emergency Fed interventions? Remember the pathetic frantic do-over when a market crash was attributed to an initial rejection of TARP? Would there be no bailout if a 401(k) catastrophe meant that a generation of “responsible, successful” people would have to retire in penury, people who did what experts advised, the kind of people who have a high propensity to vote? (Probably the bailout would take the form of interventions that reinflate the market, of course, so those responsible, successful people can pretend to have hung tough rather than to have been bailed out.) Index funds have become another form of opaque finance, with promises and justifications of safety delivered up front and conflict stored up ex post should things look not to work out. “Stocks for the long run” boosters, however sincere, serve the role of classic finance con-men: convincing large groups of people to bear risks they do not themselves evaluate, understand or fully accept; persuading people that some indeterminate force will ensure that they are safe; contributing on the one hand to the mobilization of capital for useful purposes, but also to inconsistent expectations about who will bear what costs should macroeconomic outcomes fail to work out.

  • Some readers misinterpreted the argument in the previous piece as being about bubbles. That’s my fault, since I used the 1990s tech boom as an example, but note that I dated those investments at 1997 rather than 1999 or 2000. Up until about 1997, there really was no tech bubble, just a boom. A long-term investor in a representative bundle of tech companies would have earned a decent, if not stratospheric, return, even though many of the companies in which they invested would eventually have failed. The success of the winners would have made up for the losers. 2000 was a bubble. An investor in a representative bundle of tech firms in that year would have been killed. In my story, the bubbles fanned by the financial sector are the price of the booms, a bug not a feature. One can make the case, à la Dan Gross, that the external benefits of (some) bubbles outweigh their costs to investors and others. But that is not the case I am making. I claim we would forego a lot of plain booms, the kind that ultimately enrich investors as well as society at large, if we didn’t have a financial sector skilled at getting people to assume risks they’d not directly consent to take. At its best, an opaque financial sector overcomes a coordination problem, makes bad risks (on average) good by getting everybody to jump at once, by ensuring a high baseline level of activity.

  • It is important to distinguish between the idiosyncratic and systematic functions of finance. The argument I’ve outlined is about the role of finance in managing systematic or aggregate outcomes, and has little to do with idiosyncratic risk and reward. Status quo finance is quite capable of helping individuals manage idiosyncratic risks, and largely performs as advertised. If you purchase fire insurance and your house burns down, your guaranteed and regulated insurer will probably pay the claim. If banks occasionally and sporadically fail, you gain a real benefit by putting your money in an FDIC insured bank, foregoing some potential deposit income in exchange for genuine safety. However, if there are systematic shocks to the banking system, premia from solvent banks will fail to cover the losses from failures. Cross guarantees can never protect against systematic shocks. If they are made to appear to do so, if FDIC-insured depositors are all made whole following a serious system-wide shock, it is because someone is covering FDIC’s losses. In aggregate, the payouts to the public are taken from the public, what we gain from deposit insurance we lose from additional taxes or higher bank fees. In reality, we are not an aggregate, so systematic shocks engender social conflict about to whom losses should be allocated. If we had not entrusted our resources to banks in the first place, our stashes of canned food and ammo would have remained safe.

    The always excellent David Murphy objects to my characterization of finance as a placebo:

    Diversification, tranching, maturity transformation, and capital allocation are not sugar pills.
    Diversification and maturity transformation can protect us from idiosyncratic shocks, and Murphy is right to point that out. But they cannot protect us from systematic misfortunes. In aggregate we hold the aggregate portfolio, and the opportunity cost of transforming that portfolio into current consumption is whatever it is. Of the benefits Murphy lists, the only ones that could apply systematically are capital allocation and risk allocation (of which tranching is one technique). In aggregate, do we invest our resources is fruitful and beneficial projects? When things go wrong, are the costs allocated to those best able to bear them? It is always possible to imagine worse capital allocations than those we’ve experienced. We might have simply burned forests, rather than employing lumber to the construction of ghost suburbs in the desert. But I think it’s hard to make the case that our financial system as a whole, especially the largest and most opaque parts of it, does a very excellent job in allocating capital. Shifts in our aggregate portfolio seem to jerk around very faddishly, regulated by occasional crashes. It’s not obvious that Western quasiprivate capital allocation dominates equally opaque (and also terrible) “state capitalist” allocation.

    On capital allocation, status quo finance could do better and could do worse. Let’s call it a glass half full. But on systematic risk allocation, I think it unquestionable that status quo finance is completely terrible. When losses cease to be occasional, all that ex ante tranching turns out to be little more than prelude to continuing conflict, “tranche warfare”. In the recent crisis, the behavior of mortgage servicers — agents of banks working to avoid existentially threatening loss allocations — has been entirely perverse with respect to ex ante expectations that they would serve as agents of investors. Throughout the financial system, intermediaries and their erstwhile “clients” continue to struggle over who will bear costs. More broadly, the financial system, including its public and private elements, has by and large protected the nominal and real value of opaque “low risk” investments by shifting costs to the marginally employed (who relieve pressure on the price level by becoming unemployed) and to taxpayers (including people who hold few financial claims and those who are outright in debt). In other words, it is clear ex post that the risk of the aggregate portfolio has been borne by those who were least able to bear it (a circumstance that is unfortunately correlated with political weakness). In my view, there is no reasonable case that status quo finance did a remotely good job of allocating systemic risk to those best able to bear it in the recent crisis. And this shifting of costs to diffuse taxpayers and the marginally employed is hardly unusual. As allocators of systematic risk, opaque financial systems are very much worse than sugar pills. Opacity serves to delay and obscure conflicts, which are almost always resolved in favor of the powerful and at the expense of the weak.

    Status quo financial systems certainly do help us manage our idiosyncratic risks. And you can sum up the benefit of this insurance against idiosyncratic risks to argue they improve our aggregate welfare by some amount. But from a systematic perspective their main contribution is that they persuade us not to hold our wealth as canned goods and ammo. They embolden us to jump.

  • Though I acknowledge the important function opaque finance has served, I very much look forward to the day when we can euthanize whole swathes of our miserable financial system. But that will require institutional work. We have to create alternative means of overcoming coordination problems associated with the pace and scale of investment activity, while hopefully expanding the menu of investment options and improving the quality of investment decisions. As utopian as it sounds, I think we can work around compromised banking systems and gradually render them obsolete with a combination of “crowdfunding”, social insurance, and a shift of government support away from opaque debt guarantees and towards undiversified equity. But that’s a project still before us. We won’t be rid of all our vampire squids until we invent what will replace them.

Update History:

  • 22-Jan-2012, 4:50 p.m. EST: “coordinate in the service of perceived communal aims.”

Why is finance so complex?

Lisa Pollack at FT Alphaville mulls a question: “Why are we so good at creating complexity in finance?” The answer she comes up with is the “Flynn Effect“, basically the idea that there is an uptrend in human intelligence. Finance, in this view, gets more complex over time because financiers get smart enough to make it so.

That’s an interesting conjecture. But I don’t think it’s right at all.

Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway. A budding industrialist in an agrarian society who tries to build a car factory will fail. Her peers will be unable to supply the inputs required to make the thing work. If by some miracle she gets the factory up and running, her customer-base of low capital, low productivity farm workers will be unable to afford the end product. Successful real investment does not occur via isolated projects, but in waves, forward thrusts by cohorts of optimists, most of whom crash and burn, some of whom do great things for the world and make their investors wealthy. But the winners depend upon the existence of the losers: In a world where there was no Qwest overbuilding fiber, there would have been no Amazon losing a nickel on every sale and making it up on volume. Even in the context of an astonishing tech boom, Amazon was a pretty iffy investment in 1997. It would have been an absurd investment without the growth and momentum generated by thousands of peers, some of whom fared well but most of whom did not.

One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis. In the context of an investment boom, individuals can be persuaded to take direct stakes in transparently risky projects. But absent such a boom, risk-averse individuals will rationally abstain. Each project in isolation will be deemed risky and unlikely to succeed. Savers will prefer low risk projects with modest but certain returns, like storing goods and commodities. Even taking stakes in a diversified basket of risky projects will be unattractive, unless an investor believes that many other investors will simultaneously do the same.

We might describe this as a game with two Nash Equilibria (“ROW” means “rest of world”):

If only everyone would invest, there’s a pretty good chance that we’d all be better off, on average our investments would succeed. But if an individual invests while the rest of the world does not, the expected outcome is a loss. (Colored values wearing tilde hats represent stochastic payoffs whose expected value is the number shown.) There are two equilibria, a good one in the upper left corner where everyone invests and, on average, succeeds, and a bad one in the bottom right where everybody hoards and stays poor. If everyone is pessimistic, we can get stuck in the bad equilibrium. Animal spirits are game theory.

This is a core problem that finance in general and banks in particular have evolved to solve. A banking system is a superposition of fraud and genius that interposes itself between investors and entrepreneurs. It offers an alternative to risky direct investment and low return hoarding. Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty, without regard to whether other investors buy in or not. They create a new payoff matrix that looks like this:

Under this new set of payoffs, there is only one equillibrium, the good one on the upper left. Basically, the bankers promise everyone a return of 2 if they invest, so everyone invests in the banks. Since everyone has invested, the bankers can invest in real projects at sufficient scale to generate the good expected payoff of 3. The bankers keep 1 for themselves, pay their investors the promised 2, and everyone is made better off than if the bad equilibrium had obtained. Bankers make the world a more prosperous place precisely by making promises they may be unable to keep. (They’ll be unable to honor their guarantee if they fail to raise investment in sufficient scale, or if, despite sufficient scale, projects perform more poorly than expected.)

Suppose we start out in the bad equillibrium. It’s easy to overpromise, but harder to make your promises believed. Investors know that bankers don’t have a magic wealth machine, that resources put in bankers’ care are ultimately invested in the same menu of projects that each of them individually would reject. Those risk-less returns cannot, in fact, be riskless, and that’s no secret. So why is this little white fraud sometimes effective? Why do investors’ believe empty promises, and invest through banks what they would have hoarded in a world without?

Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. You’re in on the con. If something goes wrong, each and every investor is assured, there will be a bagholder, but it won’t be you. Bankers assure us of this in a bunch of different ways. First and foremost, they offer an ironclad, moneyback guarantee. You can have your money back any time you want, on demand. At the first hint of a problem, you’ll be able to get out. They tell that to everyone, without blushing at all. Second, they point to all the other people standing in front of you to take the hit if anything goes wrong. It will be the bank shareholders, or it will be the government, or bondholders, the “bank holding company”, the “stabilization fund”, whatever. There are so many deep pockets guaranteeing our bank! There will always be someone out there to take the loss. We’re not sure exactly who, but it will not be you! They tell this to everyone as well. Without blushing.

If the trail of tears were truly clear, if it were as obvious as it is in textbooks who takes what losses, banking systems would simply fail in their core task of attracting risk-averse investment to deploy in risky projects. Almost everyone who invests in a major bank believes themselves to be investing in a safe enterprise. Even the shareholders who are formally first-in-line for a loss view themselves as considerably protected. The government would never let it happen, right? Banks innovate and interconnect, swap and reinsure, guarantee and hedge, precisely so that it is not clear where losses will fall, so that each and every stakeholder of each and every entity can hold an image in their minds of some guarantor or affiliate or patsy who will take a hit before they do.

Opacity and interconnectedness among major banks is nothing new. Banks and sovereigns have always mixed it up. When there has not been public deposit insurance there have been private deposit insurers as solid and reliable as our own recent “monolines”. “Shadow banks” are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.

This is the business of banking. Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk. Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats.

A lamentable side effect of opacity, of course, is that it enables a great deal of theft by those placed at the center of the shell game. But surely that is a small price to pay for civilization itself. No?

Nick Rowe memorably described finance as magic. The analogy I would choose is finance as placebo. Financial systems are sugar pills by which we collectively embolden ourselves to bear economic risk. As with any good placebo, we must never understand that it is just a bit of sugar. We must believe the concoction we are taking to be the product of brilliant science, the details of which we could never understand. The financial placebo peddlers make it so.


Some notes: I do think there are alternatives to goat-herding and kleptocratically opaque semi-fraudulent banking. But adopting those would require not “reform” but a wholesale reimagining of status quo finance.

Sovereign finance should be viewed simply as a form of banking. Sovereigns raise funds for unspecified purposes and promise risk-free returns they may be unable to provide in real terms. When things go wrong, bondholders think taxpayers should be on the hook, and taxpayers think bondholders should pay. As usual, everyone has a patsy, someone else was supposed to take the hit. Ex ante everyone was assured they have nothing to fear.

I have presented an overly flattering case for the status quo here. The (real!) benefits to opacity that I’ve described must be weighed against the profound, even apocalyptic social costs that obtain when the placebo fails, especially given the likelihood that placebo peddlars will continue their con long after good opportunities for investment at scale have been exhausted. By hiding real economic risks from those who ultimately bear them, status quo financial systems blunt incentives for high-quality capital allocation. We get capital allocation in bulk, but of low quality.

Update History:

  • 26-Dec-2011, 10:15 a.m. EST: Flipped around a sentence: “You can have transparency and herd goats, or you can have opacity and an industrial economy.” becomes “You can have opacity and an industrial economy, or you can have transparency and herd goats.”

The Eurozone’s policy breakthrough?

Today’s money quote, obviously, is this, from Fitch:

a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach.

Fitch’s view reflects the clear consensus of Anglo-American commentators. But Anglo-American commentators aren’t always right. Ezra Klein writes that the German policy establishment “remain[s] serenely confident that they will save [the Eurozone].” Note that Klein attributes this to no one in particular. He characterizes it as a view drawn from “members of Angela Merkel’s government, members of the opposition Social Democrats, industrialists, and bankers.” In other words, Klein heard this in private conversations, not market-moving public statements. Jean-Claude Junker’s famous when-it-becomes-serious-you-have-to-lie rule doesn’t apply. These are smart people who know everything we know, and they think they’ve got the situation covered.

Tyler Cowen has been emphasizing the possibility that the ECB will quietly fund sovereigns via the banking system. The ECB would lend to banks at very low rates, accepting sovereign debt as collateral. Banks would earn the spread between the yield on sovereign debt (which is currently distressed and very yieldy) and the sliver of interest demanded by the ECB. As a matter of mechanics, this plan could work. It’s the same as direct ECB lending to sovereigns, except ECB gets added security (in theory) by interposing banks as guarantors, and pays a fee for the privilege.

The Anglo-American punditosphere is unimpressed. After all, European banks are already in deep trouble because of their sovereign holdings. An article by Gareth Gore (ht Felix Salmon) quotes a senior banker:

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen responds

My view is not that banks will find the arbitrage opportunity overwhelming (that is unclear), rather my view is that public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not.

I’m not sure that bank-mediated ECB finance is the plan, but if there is any plan at all, it is the only one I can find. And, as Cowen points out, markets seem to perceive some cause for optimism. But if this is the plan, I think Cowen is a shade off on the politics. Desperate governments can commandeer domestic banks all they want, but it is the ECB who decides to whom it will lend and against what collateral. Further, bankers’ objections are entirely irrelevant. That major banks may be, from an admittedly archaic perspective, “insolvent” is an argument for rather than against the practicality of the plan.

European banks, especially in the troubled periphery, are mortally dependent upon the ECB for liquidity and finance. These banks will acquire whatever collateral the ECB prefers to lend against. It is not a matter of trying to profit from a spread. A spread would be nice for banks, a subsidy that will help them recapitalize over time. But holding collateral the ECB wants is a matter of life-or-death for them, every day. If the ECB wants Italian bonds, they will be supplied. If the ECB prefers that Italy “face market discipline”, it can quietly hint its concern and steepen the haircuts it imposes when the country’s bonds are offered as collateral. Banks will start to divest, replacing them with whatever the ECB favors.

A lot of commentators have derided Europe’s “policy breakthrough” as just a restatement of the old stability and growth pact with some institutional changes at the margin. Talk of automatic consequences and qualified majorities may just be blah blah blah. But if European states become dependent on bank finance, they become dependent on ECB finance. The ECB would have the power to manufacture fiscal crises for a misbehaving state at will, and with marvelous deniability. Laundered through banks and then through capital markets, ECB actions would be attributed to nameless bond vigilantes rather than unelected technocrats. ECB haircuts would very quickly be self-justifying, and disentangling cause from effect would be nearly impossible as officials might privately telegraph changes before anything is put in writing. Control would be hidden as a market outcome, a fact of nature.

Operationally, I don’t see why the plan can’t work. I dislike it, both because I dislike the policies I suspect ECB would enforce (austerity and internal devaluation) and because it is profoundly undemocratic. Democracy is really the main obstacle, though the plan gains some immunity from the fact that politicians who try to call it out would quickly be labeled conspiracy nuts.


p.s. If you haven’t seen Ashwin Parameswaran’s democratic twist on the putative Euroarbitrage, do check that out.


FD: I hold a short position in long-term US Treasuries, and via that, I attribute some personal discomfort to Euro-uncertainty. I’m not sure how or whether this affects my views, but I thought I’d confess that my holdings have focused my mind.

Update History:

  • 17-Dec-2011, 3:15 a.m. EST: Minor edits: “hint that its concern“, “Banks will start to divest, and purchase replacing them with whatever the ECB favors.”, “imposes when Italian the country’s bonds” Italicized “blah blah blah”.

Yes, Virginia. The banks really were bailed out.

I find it really depressing that I have to write this. But it seems I have to write it.

Substantially all of the TARP funds advanced to banks have been paid back, with interest and sometimes even with a profit from sales of warrants. Most of the (much larger) extraordinary liquidity facilities advanced by the Fed have also been wound down without credit losses. So there really was no bailout, right? The banks took loans and paid them back.

Bullshit.

Suppose you buy fire insurance from Inflammable Insurance. You pay $1000 for a year of insurance. There is no fire, so you make no claim. Next year, you find a different provider offering a better price, and you switch.

Soon after your relationship has ended, you discover that Inflammable failed to pay any claims at all during the year you were insured, because all customer premiums were diverted to the Cayman Islands and then spent on kiddy porn and Pez. Were you defrauded? Do you have any cause for complaint? After all, ex post your cash flows turned out to be the same as if you had been dealt with fairly.

Of course you have been defrauded. You did not get what you had paid for. You had paid for Inflammable to bear risk on your behalf. It did not do so. The money you paid was simply stolen.

In financial markets, risk-bearing is the ultimate commodity. It is what financial market participants buy and sell. As a financial speculator, I spend exorbitant amounts of money buying out-of-the-money options to limit my downside risk. The vast majority of those options expire worthless, just like the vast majority of fire insurance policies end with no claims paid. If only someone would give me all those options for free, or sell them to me for half the market price, or reimburse the cost of the options that I never end up using, I would be rich. Seriously, given the years I’ve been in this game, I’d be pretty set if I had my option premiums back. It doesn’t seem fair at all that I am confined to a modest middle-class life because I had to buy all this insurance I never used.

Cash is not king in financial markets. Risk is. The government bailed out major banks by assuming the downside risk of major banks when those risks were very large, for minimal compensation. In particular, the government 1) offered regulatory forbearance and tolerated generous valuations; 2) lent to financial institutions at or near risk-free interest rates against sketchy collateral (directly or via guarantee); 3) purchased preferred shares at modest dividend rates under TARP; 4) publicly certified the banks with stress tests and stated “no new Lehmans”. By these actions, the state assumed substantially all of the downside risk of the banking system. The market value of this risk-assumption by the government was more than the entire value of the major banks to their “private shareholders”. On commercial terms, the government paid for and ought to have owned several large banks lock, stock, and barrel. Instead, officials carefully engineered deals to avoid ownership and control.

But still. Everything worked out, right? It turns out that banks didn’t need to use the government’s giant insurance policy. It was just a panic after all!

Bullshit.

Suppose my kid’s meth habit got the best of him. He needs to come up with $100K quick or his dealer’s gonna whack him. But he’s a good kid, really! Coulda happened to anyone. So I “lend” him the money, even though he has no visible means of support and the sketchiest loan sharks in town wouldn’t give him the time of day. Now I believe in bootstraps and hard work, individualism and self-reliance. So I tell my son. “Son, you are going to pay me back every penny of that loan. You are going to work it off. I have arranged with one of my golf buddies, a guy who owes me a favor or three, a job that pays $200K a year. You’d better show up every day at 9 a.m. and sit behind that desk, and get me back my money!” And he does! After a year, he’s made me whole. What a good kid.

No bail out, right? He paid me back every penny! Worked it off!

Bullshit. The opportunity I provided him, the $200K job that he would not have received without my intercession, was a huge grant. On the open market, if I were to accept bribes from the highest bidder to wangle the job from my friend, that opportunity would be worth more than the $100K advanced. I paid my son’s loan with my own money. I just obscured the cash flows, so my son and I can pretend and sustain our mutual self-regard and our righteous disdain for the moochers and the hippies and the riff-raff.

After assuming the banking system’s downside risk, the US government engineered a wide variety of favorable circumstances that helped banks “earn” their way back to quasi-health. The government provided famous and obvious transfers like unwinding AIG swaps at 100¢ on the dollar. It forced short-term yields to zero and created an environment in which medium-term interest rates would be capped for several years, granting banks a near-risk-free arbitrage for a while. It emitted trillions in excess reserves on which it continues to pay interest. It forewent investigations and prosecutions that by law it should actively pursue, and settled what enforcement it could not avoid for token fees. Then there are the things conspiracy theorists and cranks like me suspect but cannot prove: that the government and the Fed have been less than aggressive in minimizing their costs when they or entities they control (AIG, Fannie, Freddie) transact with large banks, that they have left money on the table where doing so could be hidden in arcane accounts or justified as ordinary transaction expenses and trading losses. Large banks have enjoyed some rather extraordinary results for allegedly efficient markets, quarters with large trading profits and no or very few losing days. Government housing policy is pretty overtly subject to a constraint that interventions must not provoke loss realizations for banks carrying bad loans at inflated values, or interfere with servicing revenues. (If you think I am overconspiratorial, I’m still waiting for an innocent explanation of this, from 1991.)

Pulling back from a shell game whose details are, by design, labyrinthine, check out the big picture. Since the beginning of the 3rd quarter of 2008 (Lehman quarter), US debt held by the public increased by 84%, from $5.28T to $9.75T (as of the end of Q2 2011). Depending on where you start, the growth rate of publicly held US debt prior to Q3 2008 had been ~8% per year (starting in 1970 or 1980) or ~4.5% (starting in 1990 or 2000). The growth rate since Q3-2008 has been 22.6% per year. The United States has issued between $3T and $4T more debt than would have been predicted by any reasonable estimate prior to the financial crisis. So far.

Hyman Minsky famously described crisis stabilization as a two-step process: First, the state/central-bank steps in as lender of last resort to halt the panic. Then the state must underwrite a program of massive deficit spending in order to “validate” — Minsky’s word — the fragile capital structures and the “innovative” business practices that proliferate during periods of tranquility.

Translating into current buzzwords, when the trouble begins there is a solvency crisis. It is converted into a liquidity crisis ex post by a firehose of net spending by the state. The current crisis has followed Minsky’s script perfectly. Banks’ ability to “pay back” bailouts has depended upon continued regulatory forbearance, tacit expectations of support if shit hits the fan again, and massive government debt issuance which resuscitated assets that would otherwise be worthless.

But who has lost anything from the bailouts? Wasn’t it a win-win? This all sounds very abstract. Where are the transfers?

If the government borrowed or printed a trillion dollars and gave the money to me, would there be any losers? If you don’t think there has been a wealth transfer, if you don’t think ordinary people have lost, please call your Congressperson and ask her to cut me a trillion dollar check. In some abstract sense, this policy of giving me money would push government debt higher. But that is so very vague a cost! I promise I’d do great things with a trillion dollars. My ideas are so much cooler than Goldman Sachs’, despite all the wholesome commercials they are running.

During the run-up to the financial crisis, bank managers, shareholders, and creditors paid themselves hundreds of billions of dollars in dividends, buybacks, bonuses and interest. Had the state intervened less generously, a substantial fraction of those payouts might have been recovered (albeit from different cohorts of stakeholders, as many recipients of past payouts had already taken their money and ran). The market cap of the 19 TARP banks that received more than a billion dollars each in assistance is about 550B dollars today (even after several of those banks’ share prices have collapsed over fears of Eurocontagion). The uninsured debt of those banks is and was a large multiple of their market caps. Had the government resolved the weakest of the banks, writing off equity and haircutting creditors, had it insisted on retaining upside commensurate with the fraction of risk it was bearing on behalf of stronger banks, the taxpayer savings would have run from hundreds of billions to a trillion dollars. We can get into all kinds of arguments over what would have been practical and legal. Regardless of whether the government could or could not have abstained from making the transfers that it made, it did make huge transfers. Bank stakeholders retain hundreds of billions of dollars against taxpayer losses of the same, relative to any scenario in which the government received remotely adequate compensation first for the risk it assumed, and then for quietly moving Heaven and Earth to obscure and (partially) neutralize that risk.

The banks were bailed out. Big time.

Update History:

  • 1-Dec-2011, 7:20 a.m. EST: Light edits: “received more than a billion dollars each in assistance”; “weakest of those the banks”; “that he would not otherwise have received without my intercession,“; “like paying unwinding AIG swaps”; “entities they controls control”
  • 10-Jun-2014, 3:25 p.m. PDT: “He’s He needs to come up with $100K”