...Archive for December 2008

Krugman’s “hangover theory”, revisited.

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

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

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

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

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

Krugman also points out that the hangover theory…

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Here’s Bloomberg:

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

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

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

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

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

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

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

Expenditure vs investment — thinking clearly

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

I am sad.