...Archive for July 2008

Financial system failure and the paradox of thrift

Over the weekend, Paul McCulley offered a thought-provoking piece (ht Justin Fox, Brad DeLong), which starts with a discussion of the “paradox of thrift”:

For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

There’s a hidden assumption in the “paradox of thrift” that really ought to get teased out more often. It is true that one person’s spending is another person’s income. But it does not follow that an increase in saving translates to a decrease in aggregate income. There are two kinds of spending, consumption and investment. Laying a subway line adds to somebody’s income as surely as buying a Ferrari does. Ordinarily, nearly all savings are actually spent on investment goods, and there is no “paradox of thrift”. What is “saved” is really spent on current production of future capacity, and there are plenty of paychecks to go around. There is no “fallacy of composition“: individually and in aggregate, today’s thrift lays the groundwork for tomorrow’s abundant consumption.

However, for this to work out, two things must be true: Today’s savings must be invested in projects that will actually generate future wealth, and savers must believe they will retain a stake in the increased wealth commensurate with the size and wisdom of their investments. We have a financial system in order to make these facts true. If the investment industry is capable of finding or initiating projects likely to satisfy future wants, and if financial claims are predictable and stable stores of value, we need not trouble ourselves over the paradox of thrift. The issue only arises when the financial system breaks down. When investors lose faith in the quality of available investments or their ability to collect the proceeds (in real terms), they pull out savers’ Plan B: precautionary storage. They buy gold, or oil, or art, or whatever, and they keep it, generating scarcity rents for those who can offer perceived value stores, but very little in the way of general income and employment. Precautionary storage, not thrift itself, is the villain of the tale.

The vulgar Keynesian prescription is to encourage consumption, when a dynamic of precautionary storage takes hold. And in extremis that might be a good idea, because if all everyone does is hoard, it’s hard to figure what to invest in, except maybe storage tanks. But it’s much better to develop a financial system that actually performs, that identifies fruitful projects and allocates claims fairly. Storage eats wealth, while productive enterprise creates it. People know this. No one “invests” in gold or oil when a financial system is working. They do so when it is broken. Like now.

Encouraging people to go shopping in order to help the economy is not “second best” policy. It’s a desperate last resort. We’re not at a point where there’s so little economic activity that we can’t foresee future wants. We’re at a point where people are beginning to shift from investment to storage because of a well-deserved loss of confidence in the financial system. Encouraging consumption now is nihilistic. It feeds into a vibe (I feel it personally, do you?) that saving is so uncertain and money so volatile that one might as well spend, ‘cuz who knows what tomorrow might bring. The right way to sustain aggregate demand and maintain current income is to figure out what we should be investing in — not stocks, bonds, or CDOs, but factories, windmills, or schools — and then to put current resources to work. Our financial system is failing spectacularly because it erred grievously. It built homes and roads and sewers that oughtn’t have been built, it “invested” in vacations and plasma televisions, and it paid itself handsomely for doing so. That’s not a problem we can spend our way out of. To fix the financial system we have to change it, not rally to its support. We will know we’ve put things right when thrift is something we can celebrate, when we save because we are excited about what we are creating rather than frightened by what we might lose.

Covered by whom? Bonds on what?

When you’re abducted by aliens, there’s little cause to be cynical. The sucktitude of a painful probe is straightforward. There’s no sugarcoating to see past, things are exactly as bad as they seem. Between the screams you realize that, in a way, you have been offered a kind of innocence. When you are abducted by aliens, you savor the silver linings.

After such an ordeal it’s a bit depressing to be dropped off on the Planet of the Covered Bonds. Cynicism levels are off the tricorder here as, alas, they should be. [See Yves Smith, Michael Shedlock, Maxed Out Mama. Less cynically, David Merkel offers a very nice description of what covered bonds are and how they work.]

Covered bonds sound nifty. They’re designer drugs. They’re just like the mortgage-backed securities that gave us such a fine party, except the nasty hangover inducing components have been engineered away. They are on-balance sheet loans, look Ma, no Enron! (finally…) Covered bond issuers have “skin in the game”, skin, bone, and sinew actually, as they guarantee the loans. That problem of “misaligned incentives” is solved, ‘alleleujah! (…though intrafirm agency problems are not addressed.) These are old-fashioned, full recourse, secured and overcollateralized loans, just packaged into tradable securities. What could possibly go wrong?

Formally, the only way anything could go wrong would be if the issuing bank fails and the pledged assets turn out to be worth less than originally estimated. Do you think those two events might be correlated? Covered bonds can certainly be no worse, from an investor standpoint, than the nonrecourse asset pools they are intended to replace. A guarantee by the issuing bank has gotta be worth something. If it were 2002 again and the banking industry had adopted this originate and guarantee model (rather than the originate and forget model they chose), perhaps we wouldn’t be in the current mess. But it is not 2002. These bonds will be offered by banks that would already have collapsed without vast support to the financial system by the Fed and the US Treasury. Guarantees by money-center banks are no longer bonds of confidence in the prudence or skill of bank managers. The value of such guarantees comes from a different place, from the notion that it is unthinkable the state would permit these banks to fail. A covered bond offered by Citi or Bank of America would only default if a titan collapsed. Investors might reasonably believe that would not be permitted to happen. If they are right, then these bonds are indeed covered. They are covered by you, dear taxpayer.

The great credit crisis of 2007-2008 is slouching towards its Bethlehem, a full faith and credit crisis for the United States of America. This die was cast at the first TAF auction, when the Fed chose to pull private credit risk onto taxpayers’ already strained balance sheet, rather than endure any unpleasantness. Covered bonds may prove to be a success with investors. But, careful what you wish for. The more banks sell, the more we’re all on the hook, if the loans go bad. Covered bonds issued by “too big to fail” banks are basically equivalent to mortgage backed securities guaranteed by Fannie and Freddie. It’s just another way of putting private-sector bells and whistles on a public sector assumption of risk.

These bonds are seen as a way of “unfreezing the housing market”. The housing market seems frozen because in many areas, relationships between home prices, rents, and incomes are still out of whack. Assuming relatively stable rents and incomes (bad assumption, I know), mortgages in “stuck” markets made at or near current asking prices are likely bad investments. That suggests the implicit taxpayer guarantee won’t expire unused. The more covered bonds are sold, the more extreme measures or hidden subsidies will be required to prevent household names from failing.

The committee to save the world is you, and we will be grateful for your contribution, although we will never thank you, or admit that anything other than the skill of our red knuckled, fabulously wealthy financiers had anything to do with the eventual recovery. That period of commodity inflation and steep yield curves was just a market outcome, a fact of nature. Of course our proud financial institutions were always going to weather the storm. They are the best and most sophisticated in the world. Thank goodness for private enterprise.


[HT Yves Smith on the slouching towards Bethlehem thing. BTW, my use of the term "taxpayer" is imprecise, state guarantees are really backed by "taxpayers and/or those most vulnerable to inflation (low bargaining power workers and those on fixed incomes)". My guess is that we will use tradables inflation more than outright taxation to save the whales. FD, I'm short long-term Treasury futures and long precious metals, going with that whole full faith and credit crisis scenario. As always, this ain't investment advice, I frequently lose my shirt so go copy Warren Buffett or something.]


Update: Felix Salmon directs us to an excellent new blog on which John Hempton writes:

[I]f you have lent to people in a currency where interest rates suddenly go to 50 percent (as happens in some devaluation crises), your funding cost (deposits) will rapidly go to 50%. However if you pass that on to your borrowers they will fail. You will suffer credit risk and possibly go insolvent. If however you have offered fixed loans to your borrowers you will wind up with huge funding mismatches – and possibly go insolvent. For small moves there is a difference between credit risk and interest rate risk. For large moves there is no effective difference. The same analysis applies to currency and credit risks.

This goes some way towards adressing Tyler Cowen’s demurral

I cannot see that the credit of the United States government is in danger. There is a) the printing press, and b) our location on the left side of the Laffer Curve.

I agree with Tyler that the US government is more likely to print than default outrught, if those are the alternatives (though do recall this from the generally levelheaded Accrued Interest). But, for large moves, I think the distinction between credit risk, inflation risk, and currency risk is largely academic. (Regarding Tyler’s second point, Robert Olson hits the nail on the head in a Marginal Revolution comment, “Being on the left-side of the Laffer Curve doesn’t matter much if the political situation makes it impossible to raise taxes.”)

Update History:
  • 29-July-2008, 11:09 a.m. EDT: Fixed misspelling of Warren Buffett’s name. Thx Nemo.
  • 31-July-2008, 3:03 a.m. EDT: Added the word “by” somewhere where it was needed. Added the update regarding credit risk vs inflation/currency risk.

hello?

Err… is this thing on? Am I back?

I think I’m back.

I am periodically abducted by aliens, who do unspeakable things the details of which I can only guess from various aches and irritations.

In my absence, the comments on the previous more-than-a-month-ago post were remarkably good. The blog is better, actually, when I disappear. Smarter voices chatter.

The whole oil thing seems so, like, last month, although I notice there was some kind of deadhead revival in SoCal a couple of days ago. Some quick, crude thoughts: the whole “fundamental” vs “speculative” debate is terribly miscast, as emphasized most recently by Jeff Frankel (via Mark Thoma), but also by Tyler Cowen, and me too. What I liked best about the Thoma / Krugman model is that it gave us four lines to think about, two kinds of demanders (people who want to burn oil vs people who want to store it) and two kinds of suppliers (people who suck oil from the ground vs people who drain their tanks). An imbalance of speculation on futures (more longs than shorts) creates incentives for people with tanks to fill them, potentially shoving up one of the two demand lines (the one on the left-hand panel of the Thoma/Krugman graphs). But four lines iz a lot of moving parts. I think the really interesting line is the right-panel supply line. Rather than “speculation” vs “fundamentals”, I wonder whether discretionary oil producers are flat-out producing as much as they are able, given the infrastructure currently in place, and whether over the past few years they have held back on developing capacity, or whether they are in fact eager to pump but hitting “peak oil” limits. Either story is consistent with James Hamilton’s fundamentals, although one might call unenthusiastic production “speculative” in a certain sense. In the end, I think Paul Krugman wins the debate he started, if it was the left-panel demand line driving prices, the only piece futures-buyers can influence, we should observe storage in tanks. As both Robert Waldmann and Alea’s jck (in a comment) point out, paper speculators only persuade oil producers to leave the stuff in the ground when they drive futures into something close to strict contango, because producers enjoy less of a convenience yield than people with tanks. Inventory should build in tanks before it builds underground, if increased stock demand is driving the story.

It’s important to note that, just because futures buying / speculative storage probably did not drive the great oil price boom of early 2008, doesn’t mean it could not affect prices. Imagine, in Mark Thoma’s discussion, that rather than a parallel outward shift in demand, the slope of the stock demand curve flattens as well. The “flatness” of stock demand maps to speculators’ conviction that prices will rise. If speculators are absolutely certain that (the present value of) future prices will be higher than the current price, then they would persistently buy as much as would be necessary to pull the flow market price to the expected future price. In Mark’s scenario, speculators effectively choose a quantity they are willing to buy at above the spot clearing price, and prices revert once their appetite has been sated. But speculators might choose price rather than quantity. (Still, if they do, we should see inventory build.)

Of course, explaining the rise in oil prices is passé. Now it’s all about explaining the fall. Is it demand destruction? an incipient long run? declining inventories? increased production? a speculative bubble going “pop”? I dunno. Do you? (Maybe it’s those evil short-sellers.)

In the month-ago discussion, Arnold Kling was the first to point out the connection between option values and the convenience yield. That theme was developed quite extensively by commenters, especially anon and MG, and is common in the academic literature as well. The kind of option a convenience yield represents is fun to think about. It is an option whose underlying is fluctuating calendar spreads, rather than prices. There is a lovely symmetry, in that there is a positive convenience yield both on having the commodity available, and on not having the commodity (but having an place to efficiently store it). If that seems weird, recall how same-strike call and put options both have positive value, even though when one is in the money, the other cannot be. We can even derive a relationship between the expected value of these two convenience yields somewhat analogous to put/call parity.

This all seems very retro now, a month is a long time, in the blogosphere and in financial markets. If I can avoid the lights in the sky, perhaps I’ll come up with something more exciting to write about soon.

Oh! Speaking of exciting, welcome Gabriel!