...Archive for July 2011

Who are this ‘we’ of which you speak, Tyler Cowen?

Tyler Cowen has a tag line he’s been using for a while. Here’s the latest example:

Just to review briefly, I find the most plausible structural interpretations of the recent downturn to be based in the “we thought we were wealthier than we were” mechanism, leading to excess enthusiasm, excess leverage, and an eventual series of painful contractions, both AS and AD-driven, to correct the previous mistakes. I view this hypothesis as the intersection of Fischer Black, Hyman Minsky, and Michael Mandel.

In what sense is it true that “we thought we were wealthier than we were”? It is not obvious, for example, that we have encountered some unexpected scarcity in real factors that has forced us to downgrade our perception of our collective wealth. I don’t think that is what Cowen claims has happened, exactly. So what does he mean? We get some clues from his list of names. Fisher Black, as Cowen has interpreted him, suggests that since investors’ views over the short-term are not independent of one another, patterns of aggregate investment can be systematically mistaken for a while in ways that seem surprisingly obvious in retrospect. Hyman Minsky famously argued that the dynamics of financial capitalism encourage and even require ever more fragile and optimistic means of finance, leading inexorably to crisis. Michael Mandel claims that US productivity measures exaggerate domestic capabilities by failing to distinguish between domestic production efficiencies and gains due to outsourcing and production efficiencies elsewhere.

I’d like to add another name to the list, for Cowen’s consideration. Here’s John Kenneth Galbraith (grateful ht to commenter groucho, long ago):

To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in — or more precisely not in — the country’s businesses and banks. This inventory — it should perhaps be called the bezzle — amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times, people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always people who need more. Under the circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression, all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. The bezzle shrinks.

In any case, a common thread behind all of these stories is that our “overestimate” of wealth is not a random phenomenon. We did not just have a collective “oops!”. In Galbraith’s version, it is outright embezzlers who contrive to keep our accounts inflated. In Mandel’s, it is well-meaning but mistaken government economists (as well as those who unskeptically rely upon them). In Minsky, it is the interplay of competitive dynamics and financing arrangements. The Black/Cowen account is the least specific, but requires some common signal that causes investors’ judgments to be correlated, so their errors do not cancel.

What has been our actual, lived experience of the past decade or so? What were the common signals that rendered investors decisions to be both correlated and mistaken?

I don’t wish to denigrate Mandel’s work, which I consider useful and insightful. Certainly overestimates of domestic productivity contributed to a general sense of optimism, and as Mandel has argued, probably contributed to policy errors during the crisis as apparent high productivity helped policymakers to mistake a chronic economic crisis for a transient distortion in response to a financial shock. Robust apparent productivity growth might well have helped rationalize consumer and housing credit decisions that now seem questionable.

But I think we know something about the investors of the last decade. There was, as This American Life / Planet Money famously put it a “giant pool of money”, specifically sovereign and institutional money, that was seeking out ultra-safe, “Triple A” investment, and sometimes agitating for yield within that category. We really don’t need to look for subtle information cascades in order to explain investors’ “errors”. The investors in question weren’t, in fact, investors at all in an informational sense. To a first approximation, they paid no attention at all to the real projects in which they were investing. They were simply trying to put money in the bank, and competitively shopping for good rates on investments they could defend as broadly equivalent to a savings account.

But how did this “giant pool of money” come to be? The overestimate of wealth occurred prior to as well as during the investment process, a fact which can’t readily be explained by the Black/Cowen story. There was too much income to be invested, income which took the form not of speculative securities but of money, visible flows of central bank reserves and bank deposits. When ordinary investors make mistakes, however correlated, what we observe is a mere overpricing of questionable securities. Under current institutional arrangements, there is only one kind of investor who can convert investors’ mistakes into cash income growth (holding “velocity”, the reciprocal of peoples’ desire to hold income as cash or bank deposits, roughly constant). Only mistakes by banks can explain the increase of money income. (Note that the relevant income here, for the US, is not NGDP, but US dollar income worldwide, including e.g. income generated from exports by China and oil producers.)

It would be plausible to argue that banks were not at the vanguard of the error, that they were only caught up in a general zeitgeist of malinvestment, if other classes of investors were making the same misjudgment. That roughly describes what happened during the dot-com boom. But during second boom, other classes of investors were, to a first approximation, making no judgments at all. Institutional investors were simply buying the securities that banks were willing to treat as “money good” and reaching nihilistically for yield without a care in the world about how it might be generated.

Even the most careful and independent population of investors is likely to have its aggregate expectation disappointed if those investors’ incomes correspond to a lower quality of real resources than is suggested by the number of dollars that alight in their bank accounts. And any rational investor will choose to forego direct participation in risky real projects if intermediaries offer sufficient yield on securities that banks are willing to monetize at will. The primary mistake of non-bank investors was to fail to foresee that banks would change their willingness to accept as “money good” securities that core institutions were designing for precisely that acceptance. The “overestimate” of wealth from which we are now suffering occurred first as an exaggeration of value within the core financial system and then as a willingness of institutional investors to take values given by core financial intermediaries as durably sound. “We” did not decide we were wealthier than we are. Two groups of people whose economic role is precisely to evaluate the quality of our wealth misjudged, one directly by neglecting risk, the other indirectly by trusting the first when it should have known better. The broad public or taxpayers or the polity erred only and precisely by trusting these professionals.

Why were banks so easily persuaded that, via the magicks of tranching and diversification, lending into obviously questionable real projects was so safe that any downside risk could safely be socialized? The banking sector’s job is to convert a portfolio of real investment into money that is ultimately backed by the state, and its responsibility is to do so in a manner such that the likelihood realized values will in aggregate undershoot funds advanced is negligible, without recourse, directly or indirectly, to any heroic government stabilization. “Mistake” is not a remotely sufficient characterization of what occurred. There were discernible incentives behind the banking sector’s misbehavior. Throughout the securitization chain, conservative valuation practices were entirely inconsistent with maximizing employee and shareholder wealth. And why did institutional money trust bank and rating agency valuations when money managers were not too stupid to understand that high yield and low risk make for a fishy combination? Again, the answer is not some kind of sunspot. Agents were well paid not to question “money center banks”, for whose misjudgments and misrepresentations they could never reasonably be blamed.

The broad public did err, by accepting an absurdly and dangerously arranged financial system. If we want to prevent a recurrence going forward, if (qua Black/Cowen) we want to enter a world where it would even be possible for investors’ judgments to be reasonably independent, we have to undo a financial system designed around the delegation of investment decisions from the broad public through several tiers of professionals to a semi-socialized “money center” core. Yes, we also have to attend to the public sector’s role in generating “money good” securities not-necessarily-backed by reliable value. But that’s an implausible account of the lead-up to 2008, and we should be cognizant of the fact that, absent debt-ceiling own goals, public sector securities fail more gracefully than bank advances against private assets. (The costs of public sector over-issue would be experienced either as inflation or economic depression due to tight monetary policy required to avoid inflation even in the face of underemployment and not, at least initially, as a banking crisis.)

Despite all these errors, we have no reason to believe that, in real terms, we are unable to consume or produce today at levels suggested by the pre-2008 trendline. Yes, we’ve recently experienced price spikes that might suggest scarcity of some commodities. But we experienced large spikes prior to the crisis and kept on growing. Over the longer haul, we may be able to grow around emerging scarcities via technological ingenuity or we might have to redefine growth so that we value less resource-intensive consumption more highly in order to sustain the almighty trendline. But at this moment, we are not discouraged by a physical bottleneck, but by increased uncertainty about the future value of our resources, skills, organizations, and political arrangements. The only coherent way to understand Cowen’s tag line is that we currently believe the future to be less bright than we believed it to be in 2007, and this change in collective expectation has altered our behavior. We are not, today, forced to produce or consume less than we expected to in 2007. We are choosing to do so, perhaps pathologically as a Keynesian output gap, perhaps wisely in order to conserve and regroup given diminished expectations going forward. (Even if you buy the latter story, conservation of human resources implies providing education or employment. No true Austrian would characterize involuntary idleness, misery, and decay as desirable no matter how badly we discover we have malinvested.)

If Cowen is right, it has caused us a great deal of misery that “we thought we were wealthier than we were”. We should attend very carefully to the details of how we came to think what we thought, of who told us we were wealthy when we weren’t. (Shades of Galbraith…) More importantly, if we cannot evaluate the quality of our wealth going forward, we are unlikely to make decisions conducive to sustaining and expanding that wealth. There is something in the tone of Cowen’s tagline that suggests an “oops!”, a shrug of the shoulders. Whether he intends that or not, it’s precisely the wrong response to the events of the last decade. “Our” misjudgments were not some random perturbation spiraled out of control. They were the result of a set of arrangements that systematically bribed gatekeepers to make and accept incautious estimates, and to circumvent control systems intended to keep valuations in check. As of this writing, those arrangements remain largely in place.

Update History:

  • 1-Aug-2011, 1:01 a.m. EEST: Changed misspelling, “hos” to “his”, in Galbraith quote. Changed “specifically seeking” to “seeking out” in order to avoid awkward repetition of “specifically”. Changed “are” to “is” to agree with “population”, the actual subject of the sentence. Removed a superfluous “the”. Changed “really can’t” to “can’t readily”. No substantive changes.

Accounting is destiny

So, unusually, Felix Salmon is wrong:

In order for banks to offer principal reductions, two criteria need to have been met: (a) they came into the mortgages via acquisition, rather than writing them themselves; and (b) they bought the mortgages at a discount… Economically speaking…what the banks are doing here does not make sense. Either writing down option-ARM loans makes sense, from a P&L perspective, or it doesn’t. If it does, then the banks should do so on all their toxic loans, not just the ones they bought at a discount. And if it doesn’t, then they shouldn’t be doing so at all.

It makes perfect sense for banks to reduce principal on loans valued at less than par on their books, and to refuse to do so for other loans.

Let’s suppose we have a loan whose direct value will increase if we offer to reduce the principal owed. That’s not a rare situation. As Salmon writes, “a sensibly modified mortgage is likely to be much more profitable for a bank than forcing a homeowner into a short sale or foreclosure and trying to sell off the home in the current market.” Under these circumstances, one effect of a principal reduction is to increase the expected present value of the cash flows associated with the loan. Ka-ching!

However, there are two offsetting effects. The most widely discussed is moral hazard. Banks worry that borrowers for whom a principal reduction would impair rather than enhance the economic value of the loan will find ways of getting reductions too, by strategic mimicry or due to changing norms and public pressure. That helps to explain why (Salmon again), “principal reductions were being done on many mortgages which were actually current and in good standing, rather than on mortgages which were careening towards foreclosure.” Keeping principal modifications something that is offered only to “our best customers” keeps the practice voluntary. It preserves banks’ freedom to discriminate between profit-making and loss-making modifications.

The second offsetting effect of an otherwise desirable principal reduction is a matter of accounting. If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity.

Of course this is a matter of mere accounting. Whether or not a bank takes a capital hit has no bearing on whether a principal reduction will increase the realizable cash-flow value of the loan.

But accounting is destiny. The economic value of a bank franchise, both to shareholders and managers, is intimately wound up with its accounting position. A bank whose books are healthy may distribute cash to shareholders and managers, while a bank whose capital position has deteriorated will find itself constrained. A well-capitalized bank is free to take on lucrative, speculative new business, while a troubled bank must remain boringly and unprofitably vanilla. The option to distribute and the option to speculate have extraordinary economic value to bank shareholders and managers.

You cannot understand banking at all unless you understand that banks must be valued as portfolios of options. You can value some businesses by estimating the present value of cash flows from firm assets, and then subtracting liabilities. But banks are more complicated than that. The value of a bank is a function not only of expected cash flows, but of the shape of the probability distribution of those cash flows, and of the diverse arrangements that determine how different cash flow realizations will be split among a bank’s many stakeholders. A hit to a bank’s capital position narrows the distribution of future cash flows (by attracting regulatory scrutiny) and diminishes the degree to which cash flows can be appropriated by shareholders and managers rather than other parties. To say that a bank should only be concerned with maximizing the long-horizon value of its loan book is like arguing that the holder of a call option ought not object if her contract is rewritten at a higher strike price, because, after all, changing the strike price doesn’t reduce the economic value of the underlying. A bank’s accounting situation and regulatory environment define the terms of the options that are the main source of value for big-bank shareholders. Accounting changes imply real transfers of wealth.

Now the value of a bank to shareholders and managers is very different from the social value of a bank. If we aggregate the interests of all of a banks’ claimants — shareholders, managers, bondholders, depositors, counterparties, guarantors — there is far less optionality. From a “social perspective”, what we want banks to do is to lend into enterprises whose interest payments reflect real value generation and then maximize the expected value of those cash flows, irrespective of who gets what among bank claimants. If we were serious about that, we would force banks to write down their loan portfolios aggressively, so that going forward shareholders and managers have nothing to lose by offering principal modifications when doing so would maximize the cash flow value of their loans. But if we did force banks to write their loan portfolios down aggressively, the shareholders and managers with nothing to lose would be different people than the current shareholders and managers of large banks, via some resolution process or restructuring. Which is much of why we didn’t do that, when we had the chance, and why bank mismanagement of past loans continues to exert a drag on the real economy as we try and fail to go forward. This very minute, there are homeowners who are nervously hoarding cash, who are leaving factories idle and neighbors unemployed, in order to maximize the option value of the bank franchise to incumbent shareholders, managers, and uninsured creditors.

The debt ceiling and the end of QE2

This is a trivial point, but I haven’t seen it made.

It will be very difficult to tell whether the expiration of QE2 was the end of the world, or whether it will matter very much at all, until the debt ceiling standoff is resolved.

Quantitative easing alarmists tend to take a “flow” view of Treasury bond prices. During QE2, the Federal Reserve was purchasing a substantial fraction of the debt issued by the Treasury, reducing the flow of securities that the private sector was required to absorb. Without the Fed as a megapurchaser, the private sector will have to absorb a larger quantity of debt, and may demand concessions on price (or, equivalently, higher yields) in order to do so.

QE2 has ended, but the net flow of Treasury securities to the private sector has not increased. On the contrary, since mid-May net issuance has ground to a halt, as the Treasury has juggled intragovernmental accounts to fund itself without violating the debt ceiling.

I have no idea whether the QE2 Cassandras are correct or not. But we won’t have a reasonable test of their hypothesis, even by the rough and ready evidentiary standards of a blogfight, until the US Treasury resumes funding its deficit by selling securities to the public at large.

FD: I’m short long-term US Treasuries, and have been for years, for reasons that are in part speculative and in part related to hedging other positions. I have no strong view on the degree to which QE2 or its expiration might affect Treasury prices.

Update History:

  • 6-July-2011, 8:25 p.m. EDT: Added parenthetical “(or, equivalently, higher yields)”.

A question for Greece and elsewhere

Suppose that Greece had never adopted the Euro and the terms of its external borrowing had remained subject to “market discipline”, as it had been in the 1990s. Would Greece today be better off or worse off, in real terms, looking forward?

This does not seem to me an easy question to answer. On the one hand, Greece’s borrowing on easy terms inspired a great deal of real activity, including valuable development in a variety of sectors. On the other hand, it is now clear that indiscriminate credit enabled patterns of behavior that were unsustainable, the adjustment from which will be costly and painful. If foreign capital had been available but discriminating, perhaps some of the real activity and development of the 2000s would have not have occurred. But perhaps the activity that would have occurred would have been channeled in different directions, forming patterns more sustainable and profitable, and less corrupt.

This question isn’t really about the Euro per se. Several Central and Eastern European members of the EU also enjoyed indiscriminate credit booms without formally adopting the common currency. Ultimately, the question is whether market discipline, and the restriction of choice that it implies, is a long-term benefit or a long-term cost to the nations that face it. Does active monitoring by foreign creditors ever actually help nations develop well? Or is that a kind of capitalist pipe dream? And if useful market discipline is an old wives tale, is it better for countries to take whatever money is cheaply on offer in spite of the likelihood of inefficient use, or to restrict external borrowing on the theory that undisciplined cash promotes corruption and boondoggles and ultimately leaves nations hobbled?

These sound like “emerging markets” questions, and they are, but they are more broadly applicable. I find myself asking the same set of questions about the United States, whose external borrowing seems famously immune from market discipline. On net, is that fact a blessing or a curse?

Update History:

  • 3-July-2011, 8:25 p.m. EDT: Removed an unnecessary “the” and an ungrammatical “that would”. No substantive changes.