...Archive for September 2011

An echo

I write, or at least I start to write, lots more blog posts than I ever publish. The paragraph below is from a post I began over the summer during the debt ceiling fracas. Intellectually, I did not consider gratuitous default on US debt to be wise policy. But throughout the period, I felt a strange sympathy for the people who were, very clearly, gunning for default. I was trying to articulate why.

For some reason, today seems like a good day to publish this.

I no longer trust my own government to be the provider of a civilized society. No government is perfect or without corruptions. But in 2007, I thought I lived in a remarkably well-governed nation that had gone off-kilter under a small and mean administration. In 2011, I view my government as the sharp edge of an entrenched kleptocracy, engaged in ever more expansive schemes of surveillance and arrogating powers of ever less restrained brutality. At a visceral level, I dislike President Obama more than I have disliked any politician in my lifetime, not because he is objectively worse than most of the others — he is not — but because he disproved my hypothesis that we are a country with basically good institutions brought low by poor quality leadership. Whenever I hear the President speak and am impressed by the quality of his intellect, by his instinct towards diplomacy and finding common ground and rising above petty struggles, I despair more deeply. Not just because a leader of high quality failed to restore passably clean and beneficient government. It is worse than that. The kleptocracy has harnassed this man’s most admirable qualities and made them a powerful weapon for its own ends. He has rebranded as “moderate”, “adult”, “reasonable”, practices such as unaccountable assassination lists and Orwellian nonhostilities. He has demostrated that the way grown-ups get things done in Washington is by continually paying off thieves in suits. Perhaps it is unfair to blame Barack Obama for all this. Maybe he has done the very best a person could do under our present institutions. But then it is not unfair to detest the institutions, to wish to see them clipped, contained, or starved.

FD: I am not an innocent. To my discredit, from September 11 until Abu Ghraib, I was a fellow traveler of the Bush administration, and actively supported the Iraq war.

The long bond does the limbo

Yields on long-term US bonds have been falling like a rock since August. On the demand side, there’s no great mystery to this. Stock markets have done poorly, which tends to support Treasuries as a “flight to safety” asset. Other “safe havens” have looked wobbly. European debt in general has been tarnished by the sovereign financial crisis. The Swiss Central Bank just made violently clear its discomfort with flight-to-safety investment flows. Gold and silver’s prices have seemed “bubblicious” for some time, and have duly lived up and down to that characterization by crashing. Only the US Treasury remains willing and able to bear the “exorbitant burden”, in Michael Pettis’ coinage, of providing sanctuary to refugee capital.

The latest collapse in long-term yields followed the announcement by the Federal Reserve of an “Operation Twist” intervention, under which it will sell short-term US debt and purchase long-term debt. At first blush, it is obvious why this might drive down long-term bond yields. Holding all else constant, if the Fed enters the long bond market as a large-scale buyer, it seems natural that it would bid up prices and push down yields on long-term bonds. But this account is unsatisfying. First, “operation twist” had been widely anticipated by market participants, so why the sudden earthquake? More importantly, “holding all else constant” is a ridiculous assumption when thinking about “operation twist”.

US Treasury bonds are issued by the US Treasury, which pays a great deal of attention to the structure of its liabilities, and has been working to lengthen their maturity. (See the discussion in this presentation, which is rather extraordinary in its candor, ht Bond Girl.) The US Treasury is the beneficial owner of the Federal Reserve. The Fed’s profits and losses eventually flow to the Treasury. If the Treasury wishes to manage its liability structure in order to manage future costs and risks, it will consolidate the Fed’s portfolio with its own as it targets a maturity structure. If the Fed sells short maturity and buys long maturity bonds, a rational Treasury will issue more long bonds and fewer short bonds than it otherwise would. (As indeed it has, see Jim Hamilton.) The central bank may “act last”, in Tyler Cowen’s quip, in the sense that monetary policy shifts can be made on a much higher frequency than acts of Congress that alter fiscal policy. But the Treasury issues and redeems debt continually. The Fed has no institutional advantage over the Treasury in determining the maturity structure of US debt. Unless there is a secret “Fed / Treasury” accord, the Treasury wins this fight. And Treasury seems resolute (and wise, in my opinion) in its intention to lengthen the maturity of its liabilities.

So I think “operation twist” is a side-show, perhaps a clever marketing scheme coordinated between the Fed and Treasury to help the US get high prices for the long-term debt it wants to issue. A more fundamental factor is the scale of issuance. And that has been interesting.

Over the first three quarters of 2011 (through last week), the net issuance of Treasury debt to the public has been very small, once you take into account purchases by the Fed. The US government has run a large deficit. In round numbers, total US debt increased by $700B over the period. Yet there was only a $40B increase in US Treasury debt to nongovernment entities. The rest of the deficit was financed by the Fed, which purchased roughly $440B of Treasury debt; by the Treasury itself, which spent down deposits it had at the Fed (as part of the crisis-related “supplementary financing program”) by about $200B; and ~$20B by other “intragovernment” lenders (like Social Security). The Federal government ran a sizable deficit, yet almost no net new issuance found its way to the public. Instead, most of the new debt was monetized as part of QE2. And interest rates, long-term as well as short-term, are lower than they’ve ever been.

One theory of long-term interest rates is, I think, definitively refuted. This is the joint hypothesis that 1) long-term real rates include a mostly stable real yield plus a premium for expected inflation; and 2) expected inflation is a function of the growth of the monetary base. If you believe in a stable real yield, then you’ve got to concede that investors’ now expect deflation despite an explosion of the monetary base.

The facts strike me as consistent with two different views. In one account, long rates are pinned by arbitrage to the expected path of short-rates plus a risk premium, and market participants have become increasingly certain that nominal interest rates will be very low for a very extended period. In a second account, important clienteles of investors do not consider money issued by the Fed and debt issued by the Treasury, particularly long-term debt, to be close substitutes. These investors have basically been starved of new Treasury supply, and so have bid up bond prices, in order to draw supply from the inventory of investors less wedded to maturity. [*]

These two stories are not contradictory: they might both be true to some degree. But they have different implications. Under the arbitrage-pinned expectations account, the only thing that could cause long yields to rise are changes in the expected path of short yields (or the uncertainty surrounding that expectation). Expected short yields might increase because of good economic news, or they might increase because the Fed is expected to fight inflationary pressures even in the absence of good news. Under the flow-to-clienteles story, yields would be expected to rise as Treasury issuance to the non-Fed public increases in the absence of quantitative easing, regardless of any change in economic outlook.

Expectations or flow? We still don’t know. But we might have a natural experiment pretty soon, as the net, unmonetized issue of Treasury securities to the public ramps back up after a restrained nine months.

Update: Browsing around, I’ve just noticed a headline very similar to mine on a Reuters article published Friday: “Operation Twist to make Treasuries do limbo”, by Emily Fitter. My apologies to Ms. Fitter or her headline writer for unintentionally stealing the line.


[*] Note: long maturity bond clienteles have had some net new supply, as the Treasury has been lengthening the maturity of its existing indebtedness via the Treasury’s operation anti-twist. But there would be substantially more supply, if the Treasury had been issuing more debt.

FD: I have a longstanding short futures position in 30-year Treasuries, which I maintain both as a portfolio diversifier and for speculative reasons. I frequently purchase hedges against large adverse moves, which have been helpful lately.

Update History:

  • 26-Sep-2011, 3:55 a.m. EDT: Added bold update, apology re similar Reuters headline.
  • 27-Sep-2011, 2:40 a.m. EDT: Changed “nongovernmental institutions” to “to nongovernmental entities”. Changed “in the Treasury’s operation anti-twist” to “via the Treasury’s operation anti-twist”.

Rogue traders and stated-income borrowers

The financial scandal du jour is a $2 billion dollar loss at UBS blamed on a “rogue trader”. You’d think the whole “rogue trader” problem would have been solved by giant, sophisticated investment banks. After all, it was way back in 1995 that Nick Leeson brought down a 233 year-old global institution. Since then we’ve had John Rusnak at my hometown bank, Jérôme Kerviel at Société Générale, and others.

Kid Dynamite, a former trader himself, notes that “losing $2B without anyone knowing about it is much harder than you think“. To generate a $2 billion dollar loss in a short period, a trading position has to be gargantuan. Some dude on a trading desk can’t just put on that kind of trade. He’d have to get buy-in from superiors and risk managers, which probably means making up justifications or falsifying hedged positions. Derivatives trades require collateral posting, and securities trades settle in cash. You’d think the bean counters would take note when large sums come and go through the accounts. Perhaps these “rogue traders” are supergeniuses who reroute the accounting ledgers through the lavatory plumbing at the exact critical moment. Otherwise you’d think that detecting unauthorized positions of $10B-ish would be the sort of thing that masters of the universe would be capable of doing.

This is the Green Room has a delightfully wry take on the affair:

The revelation that yet another rogue trader has been pulling the levers at a major bank…makes me wonder about all the rogue traders we’re not hearing about — the ones who aren’t big, stupid or aggressive enough to get caught… Perhaps banks should start reporting “income from rogue trading” in their financial statements. It would seem naive to presume that it isn’t contributing to the bottom line.

It is a commonplace now to talk about troubled banks’ incentives to “gamble for redemption”. It has also become cliché to talk about how traders’ asymmetrical incentives encourage risk taking: If we take a big risk and make a lot of money, we get huge bonuses. If it doesn’t work out, worst case scenario is we lose our jobs. Of course, regulators discourage gambling for redemption, at least in theory. And all else equal, nobody wants to lose their job, not to mention the deferred compensation that is supposed to discourage this sort of thing. Still, there is a sense in which the bank “wants” big risks to be taken, as do a variety of employees with exposure to the upside in their bonuses. But it would be better if the risks were taken in some manner that, if things go south, no one could be blamed. Well, almost no one.

I am reminded of a wonderful post by Tanta at Calculated Risk, on stated-income loans:

I have said before that stated income is a way of letting borrowers be underwriters, instead of making lenders be underwriters… What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they’re taking risky loans, but instead of doing so with eyes open and docs on the table, they’re putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they’re doing. This practice is not only unsafe and unsound, it’s contemptible.

We use the term “bagholder” all the time, and it seems to me we’ve forgotten where that metaphor comes from. It didn’t used to be considered acceptable to find some naive rube you could manipulate into holding the bag when the cops showed up, while the seasoned robbers scarpered. I’m really amazed by all these self-employed folks who keep popping up in our comments to defend stated income lending. It is a way for you to get a loan on terms that mean you potentially face prosecution if something goes wrong. Your enthusiasm for taking this risk is making a lot of marginal lenders happy, because you’re helping them hide the true risk in their loan portfolios from auditors, examiners, and counterparties. You aren’t getting those stated income loans because lenders like to do business with entrepreneurs, “the backbone of America.” You’re not getting an “exception” from a lender who puts it in writing and takes the responsibility for its own decision. You’re getting stated income loans because you’re willing to be the bagholder.

Maybe “rogue traders” aren’t devious supergeniuses after all. Maybe they’re just the stated-income borrowers of high finance, people willing to indemnify their quietly enthusiastic “victims” by being the one to tell a lie.

Saving Europe with sovereign equity

One way to think about the European financial crisis is that it is a matter of capital structure. Countries like the United States and Great Britain are equity-financed, while countries like Greece, France, and Germany are debt-financed. [1] There is no question that some European countries have very real problems. But there is also no question that no matter how badly a country may be arranged, nations cannot be “liquidated”. A “bankrupt” state must be reorganized. If Greece were a firm, a bankruptcy court would not sell critical assets at fire-sale prices, as Greece’s creditors sometimes idiotically demand. Instead, a bankruptcy court would convert debt claims that are unpayable, or whose payment would impair the long-term value of the enterprise, into equity claims whose value would depend upon restoring the underlying enterprise to health.

Greece’s problems are extreme, but by no means unique. European states in general are crippled by overleveraged, fragile capital structures. What Europe requires, in financial terms, is a means of converting some part of member states’ sovereign debt into equity. One solution would be to redenominate the debt of European sovereigns into unredeemable fiat currencies. But that is a particularly extreme solution, and would represent a large setback to the European project. What follows is a more modest proposal to equitize part of European states’ capital structures. The proposal is not original. It is an elaboration of a suggestion by Warren Mosler. It seems politically impossible. But very recently, so did outright default and/or exit of a Eurozone sovereign, yet that political impossibility suddenly looks very likely. The boundaries of the possible are very much in flux. European governance, to its deep discredit, tends to disparage populism in favor of elite technocracy. This proposal intentionally includes a strong populist element.

Without further ado, the proposal:

  1. European governments would define a new class of security: European Sovereign Equity Shares. Governments would issue and sell these securities at par. Dividends would accrue at the Eurozone inflation rate (and negative accruals could occur in the event of outright deflation). However, these would be true equity securities. The timing of any redemptions, whether of principal or accrued dividends, in part or in full, would be at the discretion of the issuing sovereign.
  2. Under certain circumstances (like the current circumstances), member states and the ECB would agree that issuance of sovereign equity would serve the economic interest of the Union. The ECB would agree to purchase up to a certain quantity of each states’ equity shares, which it would carry on its books at par. With any purchase offer, the Bank would announce a maximum balance that the ECB would be willing to accept from each state. This limit would be equal for all states in per capita terms. For example, the ECB might set the maximum equity balance might at €20000 per capita. If that announcement were made today, it would mean that Greece could issue roughly €226 billion of shares, while Germany could issue roughly €1.6T. The maximum balance per country would be set at the time of an offer, and would not automatically change with population shifts. However, up to that balance, the policy would amount to a standing offer to purchase shares. Even if a sovereign has redeemed shares, should it have the need, it may issue new shares, and the ECB would purchase them, up to the ECB’s current limit for that country.
  3. Purchase of equity by the ECB would be contingent upon member states agreeing to use the proceeds precisely as follows:
    1. First and foremost, any proceeds must be used to retire or repurchase the sovereign’s debt.
    2. Should the proceeds of any sale exceed the sovereign’s outstanding debt, the excess must be distributed directly to citizens in equal amounts.
    3. Distributions to citizens would be under analogous terms. Before receiving any cash benefit, citizens would be required to apply their allotments to retiring or defeasing outstanding debts. Only once all debts are retired would citizens receive a check, with which they could do as they please.

That’s basically it. This sounds opaque and technocratic. Why do I claim that it’s a good idea and also populist?

The reason it’s a good idea is because it does what obviously needs to be done in Europe, which is to eliminate the tyranny of zero. Suppose that Germany’s net financial position (however you want to compute that) is €30000 per capita while Greece’s is €5000 per capita, because Greeks have consistently consumed a greater fraction of their income than Germans. That’s fine and right: for whatever reason, the Greeks have saved less than the Germans, and therefore have a lesser claim on future consumption. But now suppose Germany’s net financial position is €10000 per capita while Greece’s is negative €15000. The difference in wealth, in absolute terms, is identical, but around and beneath zero all kinds of “distress costs” kick in. Loans go unpaid, interest rates spike, politics get ugly, etc. etc. (You don’t have to imagine. Just read the news.) The effect of this proposal, in practical terms, would be to shift the zero point. If Greece and Germany both issue €20000 per capita of sovereign equity, the non-equity financial position of both states shifts upwards, reproducing the first hypothetical. The operation keeps the absolute wealth difference intact but eliminates distress costs. Of course, a sovereign’s issued equity represents a liability to the ECB, so each sovereign’s overall financial position has not changed at all. But equity, redeemable at the discretion of the issuer, does not provoke distress costs, while a debt position very much does. For sovereigns as for corporates, capital structure matters in the real world. The long-term value of a distressed enterprise can increase dramatically if it is able to convert an unserviceable debt position to equity.

But why is this a populist proposal? What pisses off ordinary humans, quite legitimately, about bailouts is that they undermine the moral environment, the “karma” if you will, that we try to construct in our communities in order to preserve and sustain the social norms that is the “secret sauce” of every good society. It is corrosive if policy interventions render those who are industrious and prudent no better off than those who are reckless, indolent, or predatory. However, we needn’t (and ordinary humans don’t) demand that people who are reckless or disorganized be condemned to starvation or misery. What matters is that the industrious fare significantly better than the indolent. If an ordinary German citizen gets a €15000 check (or €15000 of burdensome personal debt forgiven) while an ordinary Greek gets nothing other than the vague knowledge that politicians have squirmed out of the debt they have accrued, that sustains the difference in reward. Ordinary people in rich countries are likely to be more open to a proposal that involves their receiving a nice check (while their counterparts in less disciplined countries get nothing at all) than they would be to a “transfers union” that implies their cutting a check to those who behaved poorly while seeming to get nothing in return.

But what about inflation? Does this just amount to a scheme to hide transfers from rich countries to poor behind a money veil? No, or not entirely. First off, many of the distress costs associated with insolvency are deadweight losses, not transfers. The benefit of preventing the burning of Athens does not impose any offsetting cost on Berliners. Shifting the zero point is just a good idea. Second, for the Eurozone as a whole, inflation need not rise at all. The ECB has the tools to combat a general inflation, if it wishes to. When inflationary pressures arise, the ECB can raise interest rates. In terms of Eurozone-wide consumption, the value of Germans’ new Euros can be sustained. The distribution of inflation rates across the Eurozone would likely be affected, in a way that disadvantages citizens of rich countries. Status quo inflation targeting across the Eurozone tends to distribute inflation towards current-account deficit countries, reducing their relative competitiveness and exacerbating the imbalance. Cash grants to citizens in rich countries reverse the maldistribution of inflation, raising income and prices in countries that are generating unsustainable current-accunt surpluses. If Germans but not Greeks receive €15000 grants, prices of German goods will rise relative to prices of Greek goods. At the margin, this will increase Germans’ propensity to spend their newfound wealth in Greece and help restore financial balance.

Further, the proposal creates a new policy tool by which countries can individually take some control over their own price level, helping remedy the “one size fits all” limitation of European monetary policy. Remember, the German government would have the right, but not the obligation, to issue sovereign equity in excess of its debt and distribute the proceeds to its citizens. To whatever degree the German polity values price stability over access to wealth on very easy terms, the German polity can choose not to issue. It loses nothing by doing this: it retains the right to issue equity and distribute the proceeds whenever it judges that its domestic economy would be helped more than harmed by a bit of “helicopter drop”. As a matter of political economy, when the ECB’s equity limits are raised due to a crisis in some corner of the Eurozone, solvent countries might wish to issue some equity and distribute the proceeds, to buy the support of citizens and sustain the sense of reward for collective prudence. But they could leave much of their capacity in reserve for a future domestic slump.

One genuine downside of this scheme is that it fails to distribute losses to foolish rich-country lenders, and therefore might encourage reckless lending to and borrowing from spendthrift countries going forward. Persistent current account imbalance is, I think, very dangerous and corrosive, and should absolutely be discouraged. Very few proposals credibly address this. Under current arrangements, trying to punish foolish lenders generates a crisis that threatens the existence of the Euro. The leading maybe-reform, a European stabilization fund financed by “Eurobonds”, would bail out creditors and impose deadweight austerity costs on debtors. It is naive to think that imposing harsh austerity on debtors will prevent intra-European debt crises going forward. In human affairs at every level, it is creditors, not debtors, who provide or fail to provide practical limits on bad lending. An individual person or government may be prudent and refuse to borrow funds they’ll be unable to invest and repay. But in any population of humans, and in most countries as governments change over time, there will always be people willing to take loans and consume the proceeds recklessly. The only way to prevent that behavior from causing systemic problems is to insist that creditors take responsibility for their loans. (Note that the roles of creditor and debtor are asymmetrical. Many humans have an innate impulse to spend recklessly that is not matched by an innate impulse to lend recklessly. Trying to punish foolish borrowing is fighting human nature in a way that insisting reckless creditors bear losses is not.)

The current proposal punishes creditors insufficiently. But it does punish them some, by reducing their relative advantage over debtors. Going forward, if it were up to me, I’d insist that bank loans to sovereigns other than a bank’s “home” sovereign carry the same risk weighting as corporate equity, and I’d tax cross-border fixed-income investment. But those are topics for another time.

This proposal would defuse the current crisis. And it would create a permanent mechanism for dealing with future crises. It does not pretend (absurdly) that interventions are “one-offs” that absolutely, positively, will never be repeated. The ECB can purchase sovereign equity whenever a systemic debt crisis threatens the Eurozone.

Enabling sovereign equity issuance would enlarge the space of macroeconomic policy options, both at the level of the Union and at the level of individual member states. Distributing the proceeds of equity sales (after debt retirement) directly to citizens means that crises get resolved in a manner that is comprehensible and fair to ordinary people. Nothing explodes. Citizens of countries that adequately discipline their governments and banks occasionally receive large checks. Citizens of less careful countries do not, and look across their borders with envy.

[1] If you don’t get this, think about it. The sine qua non distinction between debt and equity is involuntary redemption. The issuer of a debt security must redeem it for something else, either on a fixed schedule or on demand. Equity securities are redeemable only at the issuer’s discretion. Great Britain and the US finance themselves by issuing 1) fiat currency, which is plainly a form of equity; and 2) securities that convert to fiat currency on a fixed timetable, or “mandatory convertibles” to equity. In both cases, bearers have no right to demand redemption of the issuer’s paper for anything other than, well, the issuer’s paper. Just as firms that issue equity work to maintain the value of their equity despite the absence of any right to redeem, Great Britain and the US work to ensure that their paper is valuable in secondary markets by a wide variety of techniques, including taxation and the payment of interest. But all of those manipulations are at the discretion of the issuing sovereign. Great Britain and the United States have all-equity capital structures. Greece, France, and Germany finance themselves by issuing securities that are redeemable on a fixed time table for Euros, an asset which those states cannot issue at will. Greece’s sovereign debt is in fact debt, while the United States’ “sovereign debt” is a form of equity.