Bad rhetoric

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

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

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

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

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

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

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

Is opacity an excuse?

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

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

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

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

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

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

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

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

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


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

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

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

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

Opaque and stinky logorrhea

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

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

Anyway here goes:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Update History:

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

Why is finance so complex?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

Update History:

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

The Eurozone’s policy breakthrough?

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

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

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

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

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

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

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

Cowen responds

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

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

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

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

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


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


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

Update History:

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

Yes, Virginia. The banks really were bailed out.

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

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

Bullshit.

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

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

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

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

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

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

Bullshit.

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

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

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

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

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

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

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

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

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

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

The banks were bailed out. Big time.

Update History:

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

Toy models of inequality, negative interest rates, revolutions, and trade deficits

Oddly, the toy model in the appendix of my previous post got a bit of attention. Megan McArdle is unimpressed. In the model, I posit a world in which abundant labor and scarce land yield an unstorable crop in great quantity. But because labor is so abundant (and so the marginal labor unproductive), wages are low and a vast surplus accrues to the landowners, far more than they can possibly consume. I posited that in this economy, the interest rate would be -100%. Laborers would be eager to “borrow” but would have no way to repay. Land owners would lose nothing to “lend”.

McArdle takes issue with this: “[A]t the limits of land scarcity and labor abundance..land-owners receive approximately all the bread and laborers receive approximately none of it.” She asks why laborers don’t die, but then answers her own question, and poses one for me.

[I]t’s a simplifying model. But…[o]nce you add in complications — the workers do need to eat, which means positive earnings — then it’s not clear you’re still in a model where persistent negative interest rates are possible. Once I am appropriating some subsistence amount of my marginal product, then, well, I can skip dinner today in order to enjoy two dinners tomorrow. Interest rates are positive.

She’s not entirely wrong and not entirely right here. Picking a nit, paying subsistence is not sufficient to generate an inter-worker lending market. You also have to sprinkle in some uncertainty or heterogeneity of circumstance. Identical laborers with identical wages never borrow or lend to one another. That’s a stupid point to a reader, since any realistic world has plenty of heterogeneity and uncertainty. But it’s a crucial point for the model writer, because, in the kind of models I tend to think about, the structure of uncertainties drives the results.

So, let’s posit idiosyncratic shocks to circumstance among our laborers. Then, as McArdle suggests, an inter-worker lending market with positive interest rates might arise. Or it might not. As I’ve sketched the model, land owners are indifferent between i) mocking the peasants’ hunger while bread rots; ii) “giv[ing] their excess bread to charity in return for a nice smile and tip of the hat” (Nick Rowe); or iii) participating in a lending market. If land owners don’t lend, McArdle is right — laborers face positive interest rates. If land owners do lend, we need to know more about laborers’ preferences and circumstances, but the market clearing interest rate might well remain negative -100% because the land owners will have flooded the market with bread. Loan demand will tell the tale:

So, even if the laborers have wages and can lend to one another, it’s perfectly possible for a wall of hot money from the rich to drive interest rates negative. Yay me.

(The shape of the supply curve is exaggerated, but I could use this diagram to summarize my view of the last decade. Pre-crisis, financial alchemists kept us on the high loan demand equilibrium. Post-crisis, effective loan demand has fallen, as people less likely to repay have been rationed out of the market. The result is a new equilibrium at a negative rate.)

My toy model is unsatisfying so long as we don’t understand why, as Nick Rowe wonders, the rich don’t simply give their surplus bread away. Rowe overprojects his own goodwill when he suggests the smiles of peasants would engender certain charity. But we’ve no reason to privilege sadistic withholding or ritualized lending either. Suppose the usual selfish homo economicus. Under what circumstances would the land owners be driven to lend of their own self-interest? It is not enough, as it would be among the peasants, to posit idiosyncratic, symmetric shocks for landlords that leave them sometimes hungry. That would lead to some kind of mutual insurance between lenders — I’ll give you my surplus this period if you give me yours when I have a drought. In order to drive lending to laborers, we need there to be some state of the world in which laborers as a group would have some wealth when landowners are short. If there is even a small probability of such a state, even if both the probability of that state and the expected recovery on loans is small, land owners will lend at negative formal rates rather than give charitably or horde sadistically.

In theory, it is enough to posit kitchen gardens among the peasants whose three-radish harvests are independent of land-owner droughts. That would break the indifference and tip the scale to lending. But it feels like a cheap modeling trick. What kind of shocks could make land owners really prefer lending at an expected loss over other uses?

An obvious possibility is political risk, or in extremis revolution. Suppose there is mobility between peasants and landowners, so that they must sometimes trade places (the king elevates a peasant to a lord, and demotes the old lord to a peasant). If loan contracts might survive the demotions, so that a new lord would honor a debt to his predecessor, that would be a strong reason for land owners to prefer lending over charity or waste, even if the lending rates are negative and the likelihood of demotion is small.

In the modern real world, we don’t have kings and nobles, but we do have billionaires who face some risk of expropriation. After their expected consumption needs are seen to, it is perfectly rational for these investors to accept sharply negative rates on loans whose repayment would resist such misfortune. Unfortunately, billionaires’ recovery of loans to their own nations’ poor might be negatively correlated with revolution. So they should prefer to supply loans externally rather than domestically, even at low or negative interest rates. The increased likelihood of surviving a revolution would offset the cost of any price concession.

This model would predict a positive correlation between within-country inequality and gross capital outflows. If nations are homogeneously unequal and unstable, there might be symmetrical diversification and little net imbalance of flows. But if some nations less unequal or are viewed as unusually reliable loan destinations, they’d experience net inflows. Price-insensitive capital flows would engender trade deficits, as risk-averse foreign elites accept low returns from safe countries despite much better returns elsewhere on a conventionally risk-adjusted basis. To very wealthy investors, the correlation structure of tail risk would be the primary driver of investment behavior, far outweighing questions of price.

Paul Krugman argues that if there’s a savings glut exerting a downward pull on US real interest rates, it must be driven by foreign saving rather than domestic inequality, as net saving by US households was on a secular decline prior to the current crisis. I’d need more evidence, because, as Kevin Drum points out, low net household saving could include accelerating saving by the very wealthy masked by debt-financed consumption of the less affluent. Domestic inequality may yet be an important part of the story. But I agree with Krugman that price insensitive foreign capital has been the clearest source of interest rate gravity. The secular decline in US real interest rates since the 1980s has been matched by a secular deterioration in the US balance of payments. Ben Bernanke’s famous 2005 speech on a “global savings glut” was all about foreign capital inflows. As a long-time Brad Setser groupie, I would never downplay the scale or role of financial imbalance in reshaping the world economy.

But financial imbalance is at least in part an inequality story, and may be only the tip of an iceberg of gross cross-border capital flows from sources willing to pay for insurance or other goods rather than seek return in units of consumption. The supply of capital, like any other good, reflects the opportunity cost of its providers. The quantities we observe are effects more than causes. For a Chinese government purchasing development and domestic stability, or a Saudi prince exchanging appreciating oil for depreciating London bank deposits, or an American oligarch overpaying for apartments in far flung countries, the opportunity cost of capital has little to do with units of CPI foregone. As the marginal supplier of capital, domestically and internationally, comes to look less like an individual balancing present vs future consumption and more like a billionaire or a state, models of capital allocation that focus on investors seeking “real return” fade into irrelevance.

I don’t think we have any sense of how a “market economy” behaves under this form of capital allocation. Unfortunately, I think we are a long way down the road towards finding out. Even wealth allegedly invested on behalf of modest savers is increasingly centralized and managed by agents whose choices are dominated by professional trends, regulatory safe harbors, and front-loaded asymmetric payouts. It’s a brave new world, unless we find some way to restore investment decisionmaking to people whose trade-offs of current for uncertain future wealth more closely resemble those faced by ordinary, nonsatiated consumers.

The negative unnatural rate of interest

David Andolfatto points out that US five-year real interest rates are now negative. Nick Rowe discusses the possibility that the so-called “natural” real interest rate could be negative, referring us to Frances Woolley’s discussion of the drag demographics might exert on real returns. (I’ll respond to Rowe and Woolley specifically in a little appendix to this post, but I want to start more generally.)

When we observe negative real rates, they are often attributed to something abnormal. Perhaps it is “depression economics” which has driven interest rates underground, or, as Andolfatto rather charitably considers, a misguided tax and regulatory regime.

I think this aberrationist view is quite wrong. I don’t think you can make sense of the last decade without understanding that the so-called real interest rate has been trying to fall through zero for years. Only tireless innovation by the men and women of Wall Street prevented negative rates long before the traumas of 2008. A deep cause of the financial crisis was a simple expectation: That lenders ought to earn a “decent” real, risk-free yield even while a variety of trends — skyrocketing incomes for the 0.1%, the professionalization of investing, leverage-induced risk aversion, China — were creating Ben Bernanke’s famous savings glut. The market response to a global savings glut ought to have been sharply negative real interest rates for low risk savers. But as a society, we resent and resist that capitalist outcome. It is well and good for markets to drive the price of undifferentiated labor asymptotically towards zero. But God forbid that “savers” not be paid for supplying a factor that turns out not to be scarce. Instead, an alphabet soup of financial innovations was conjured to transform bad lending into demand for low risk money, and thereby support its price. Now those innovations have failed, and the fact of negative real interest rates is plainly before us. But we are still, desperately, resisting it.

There is no such thing as a “natural” anything in economics. Economic behavior is human artifact and artifice. When economists call anything “natural” — the natural rate of interest, or of unemployment — you should recall Joan Robinson’s famous quip:

The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.

The word natural is always used to hide the constructed context in which an outcome occurs, to disguise human institutions as immutable facts and thereby exclude them from controversy. What was the “natural” real rate of interest in 2006? According to TIPS yields, 5-year real interest rates were about 2.5%. But those rates were observed under the institutional context of a structured finance boom which transformed a lot of loose credit into allegedly risk-free lending demand. Was that rate “artificial” then? Today those same rates are -1%. Is this “natural”?

Ultimately, the words are meaningless. The level of interest rates that prevails in the market will be the result of a mix of institutional choices and economic circumstances. For now, we are in a bit of a pickle, because if we are “conservative” — if we stick with familiar institutional arrangements — we end up with outcomes that are violently disagreeable to our cultural prejudices. In social terms, a negative real rate of interest means that prudence is a cost, not a virtue. Caution is a greater vice than spending what you have and hoping for the best. Savers must be punished for their thrift.

In a sense, this is perfectly “natural”. Current spenders assume risks of future deprivation that current savers are unwilling to accept. Why shouldn’t spenders be paid to bear that burden? Transforming present resources into future wealth is uncertain and difficult work. Savers’ expectation of a positive real interest rate amounts to a demand for time travel cheaper-than-free. Why should such unreason be accommodated? The sense of entitlement carried by savers in our society would put any welfare queen to shame.

So, are negative real rates the way to go? Should we just tell savers exactly what we tell laborers? The price of the factor you supply has fallen. This is capitalism, quit whining and deal with it!

Maybe. But maybe not. In theory, a sufficiently negative rate of interest could restore a full employment, noninflationary equilibrium. I think that’s the market monetarist solution.

But it might not work out so well. Debt is a particular and problematic institution. If savers must pay borrowers for the privilege of carrying forward wealth, it matters in the real world whom they pay and how well those people do their jobs. Borrowers can always default, even after they have contracted loans at negative interest rates. If we try to restrict lending to only very creditworthy borrowers, we’ll find that real interest rates have to fall sharply negative to induce spending by people who would otherwise be inclined to save. If we allow more liberal credit standards, we’ll observe higher notional interest rates, but only as prelude to widespread defaults. We’ve seen that movie and it isn’t entertaining.

Ideally, a special class of borrowers, entrepreneurs, would invest borrowed funds in projects precisely designed to meet savers’ future consumption requirements. But in a sufficiently unequal society, the marginal saver may have vastly more wealth than is necessary to endow her own future consumption (including proximate bequests). There may be lots of ways to turn today’s resources into “future wealth” in a general sense, but goods and services in excess of what today’s lenders will be able to consume or reinvest in future periods are worthless to the people who set the price of money. The marginal productivity of investment may remain high technologically even as its marginal productivity to existing lenders turns sharply negative. (More accurately, both the marginal present and future dollar may have no consumption value to a lender, but in a accounting terms the value of a present dollar is fixed, while the relative value of a future dollar is flexible as long as there is inflation or some other means of circumventing the nominal zero bound.) It is the marginal productivity of investment to existing lenders that sets a floor beneath market interest rates. If we posit satiable consumption and sufficient inequality, market interest rates can approach -100% even while technologically fruitful projects go unfunded, because the projects would be of benefit only to people with little to offer the marginal lender.

The horizons of the future are broad, and lenders can invest in speculative future consumption like traveling to outer space rather than throw away money on nonproductive, low risk projects. People who seem now to have little to offer potential lenders might come up with new goods and services that savers will desire in the future. But debt is not the right instrument to fund speculative outlays, most of which will not be repaid. It would be an answer to the problem of negative real interest rates, if today’s risk-averse lenders would finance an exuberance of uncertain ventures. The majority would fail, but rare successes might be more valuable to lenders than certain negative returns on risk-free loans. This would require big changes on the part of current lenders and the institutions through which their funds are channeled. Rather than regulate a risk-free interest rate or scalar cost of capital, we’d need to find ways to encourage exploration, idiosyncratic judgment calls, and equity finance. It is foolish to presume that negative real interest rates alone will inspire a golden age of speculative investing.

If we rely too heavily on negative real interest rates to spur the economic activity, my prediction is that we will see a lot of false dawns and social strife. Savers of modest means are harmed and outraged by low market interest rates and use the political system to try to raise them. Regardless of macro models or market outcomes, we have a cultural bias against negative real rates. We hold prudence dearer than profligacy. We don’t work to teach our children to spend their allowances. We work to teach them to save. More people are willing to spend incautiously than are able to husband savings carefully. If we were to cast away the norm that saving is praiseworthy and spending decadent, rather than getting contingent, market-price-regulated spending/savings behavior, we might end up with a culture incapable of saving. We want most people to face a positive real interest rate, not because that is the price that equilibrates a market, but because positive real interest rates reward behavior we wish to uphold as a virtuous.

Our current negative real interest rates are not an aberration, but a product of longstanding and continuing trends. However, since neither those trends nor the negative rates are conducive a decent and prosperous society, it is foolish to refer to them as “natural”. We need to alter the circumstances under which full-employment requires that lenders pay borrowers to spend. We need to reshape “nature” until the new natural rate is positive. We need to understand the circumstances that lead investors to accept negative real returns rather than finance new ventures. We have to think about issues like income and wealth inequality, the structure of labor markets, institutional investor incentives, financial risk-aversion and deleveraging. We need to transform existing institutions, or invent new ones.


Appendix: Persistently negative real interest rates might have many causes. Nick Rowe and Frances Woolley tell stories that are essentially technological: Suppose we can bake a lot of bread today, but no so much bread thirty years from now. But we’ll need bread thirty years from now, and bread cannot be stored. Then no matter what we do with our surplus of bread, no matter who consumes and who saves, we’ll end up with a shortfall of bread in the future. Whatever we try to save, we’ll not recover. Institutional innovation can’t help us out very much, other than to arrange an allocation future pain.

But technological incapacity is not the only possible cause of negative real interest rates, nor I think the relevant cause at the moment. Unequal distribution can drive interest rates negative as well.

Suppose that land to grow wheat is scarce but labor to farm and bake it into bread is abundant. Land-owners and laborers are paid their marginal products, which at the limits of land scarcity and labor abundance means that land-owners receive approximately all the bread and laborers receive approximately none of it. Suppose that people prefer a bite of bread now to a bite of bread later, but that in each period, no individual can eat more than twice what their share of total output would be if total output were evenly divided. Land owners at full gluttony can eat no more than a small fraction of potential output, and they cannot store the surplus. Technology and population are stable, but land owners face negative real interest rate. There are laborers who would be glad to borrow the surplus bread, but they have no capacity to repay. The real interest rate on the bread lending market would be -100%.

In this economy, if a government were to tax land owners in every period and redistribute total production by lottery, so that each individual receives a per capita share of production in expectation, but variable amounts in practice, a wheat lending market would arise in which people receiving lower-than-average shares borrow from lend to people receiving greater than average shares at a positive real interest rate determined by agents’ time preference. Technology and population remain perfectly stable, but positive real interest rates arise as a function of institutional choices.

To be clear, I don’t think that the bread economy I’ve described is a remotely useful model of our actual economy, or that stochastically equal redistribution is remotely desirable public policy. But in response to Rowe and Woolley, while it is certainly true that technological limits can force real interest rates negative, it does not follow that observed negative real interest rates reflect technological limits. Observed interest rates are a function of distributions and institutions as well as technology, and it is perfectly possible that institutional innovation could cure observed negative real rates, if in fact we want them to be cured.

Update History:

  • 8-Nov-2011, 2:25 p.m. EST: Changed “loose lending” to “loose credit” to avoid repetition of the world “lending”.
  • 11-Nov-2011, 1:35 a.m. EST: With respect to who borrows from whom. See scratch-and-update in second to last paragraph. Many thanks to commenter ferd for pointing out the error.

Expectations can be frustrated

As the previous post suggests, I support targeting an NGDP path. I think an NGDP path target is superior in nearly every respect to an inflation target, and so would represent a clear improvement over current practice. [1]

But, unlike the “market monetarists”, I do not believe that central banks can sustainably track their target, whether NGDP or inflation, given the set of tools currently at their disposal. If those tools are (misguidedly) expanded to permit central banks to lend more freely or purchase a wider range of debt instruments, “success” might prove counterproductive. Although Scott Sumner and Bill Woolsey and Matt Rognlie hate the idea, I think we need to add direct-to-household “helicopter drops” to our menu of instruments. Ultimately, I have a different theory of depressions than the market monetarists do.

Self-fulfilling expectations lie at the heart of the market monetarist theory. A depression occurs when people come to believe that income will be scarce relative to prior expectations and debts. They nervously scale back expenditures and hoard cash, fulfilling their expectations of income scarcity. However, if everybody could suddenly be made to believe that income would be plentiful, everyone would spend freely and fulfill the expectations of plenty. The world is a much more pleasant place under the second set of expectations than the first. And to switch between the two scenarios, all that is required is persuasion. The market-monetarist central bank is nothing more than a great persuader: when “shocks happen”, it persuades us all to maintain our optimism about the path of nominal income. As long as we all keep the faith, our faith will be rewarded. This is not a religion, but a Nash equilibrium.

If the market monetarists’ theory of depressions is correct, then their position is correct. They are famously vague and prickly on the question of what instruments or “concrete steps” central banks will use to achieve their objective. That is because it doesn’t matter one bit, as long as those instruments are persuasive. Whether police wield pistols or tanks or tear gas or nightsticks to keep the peace really doesn’t matter, as long as their choice is sufficiently intimidating that people are deterred from resisting their authority. We only care about the weapon they’ve chosen when deterrence has failed and they are forced to act. Then we are faced with damage from the violence required to sustain their credibility. Even then, if we are certain they will restore order quickly and that incidents of disorder will be rare, we might not worry so much over means. But if conditions are such that lawlessness will not be deterred, there will be no general peace but frequent mêlées on the streets, then it matters very much how the police fight their battles. We start to ask whether the medicine is better than the side effects, whether police tactics are well tailored to improve the underlying conditions and restore a durable peace.

I have a Minsky/Mankiw theory of depressions. The economy is divided into two kinds of people, spenders and savers. Perhaps some people lack impulse control and have bad character, while others are patient and provident. Perhaps structural inequality renders some people hungry but cash-constrained, while others have income in excess of satiable consumption. Let’s put those questions aside and just posit two different and reasonably stable groups of people. Variation in aggregate expenditure is due mostly to changes in the behavior of the spenders. Savers spend at a relatively constant rate and save the rest. Spenders spend whatever they can earn or borrow, which varies with the level of wages, the cost of servicing debt they’ve accrued in the past, and the availability of new credit.

In this world, a central bank that targets something — NGDP, inflation, whatever — doesn’t regulate behavior via expectations. Instead, the central bank regulates access to credit and wages. When the economy is “overheating”, the central bank raises interest rates to increase debt servicing costs, tightens credit standards to diminish new borrowing, and if absolutely necessary squeezes so hard that a recession reduces spenders’ wages via unemployment. When the economy is below potential, the central bank reduces interest rates and relaxes credit standards, encouraging spenders to borrow and leaving them with higher wages net of interest payments.

This is a pretty good gig, it works pretty well, especially when the marginal dollar of expenditure is borrowed and easily regulated by the central bank. But if there are lower bounds on interest rates and credit standards, the scheme is not indefinitely sustainable. Even when spenders hold consistent, reasonably optimistic expectations about the economy, it becomes continually more difficult to persuade them to maintain their level of spending. The cost of debt service grows as their indebtedness grows, reducing their ability to spend. New borrowing becomes more difficult as wages are dwarfed by liabilities. Individuals become more nervous that some blip in their complicated lives will leave them unable to meet their obligations. In order to hold expenditure constant, interest rates must fall, credit standards must loosen, the value of spenders’ one consumption good that survives as pledgeable collateral — their homes — must be made to rise. Stabilizing expenditure requires continual easing. Any sort of lower bound provokes a “Minsky moment”, as expenditures that can no longer be sustained unexpectedly contract, rendering maxed-out spenders unable to service their debts.

All of this is just a theory, but I think it fits the facts better than a theory that takes stable demand and depression as arbitrary “sunspot” equilibria, selected by expectations. If the demand-stable “great moderation” had been an equilibrium, one might expect parameters like interest rates and aggregate indebtedness to be stable or to mean-revert around their long-term values. They were not. Interest rates were in secular decline throughout the period, and the indebtedness of some households to others was consistently rising as a fraction of GDP. Credit standards declined.

If my theory is right, absent significant structural change, attempting to restore demand merely by shocking expectations would be like trying to defibrillate a corpse. Yes, NGDP expectations absolutely did collapse over the course of 2008, but that was not due to a transient shock but a secular change which made the prior stabilization regime untenable. The housing collapse and credit crisis made it impossible to sustain expenditure by loosening credit standards. That left interest rates as the only tool by which to encourage spenders, but the zero nominal bound and rising credit spreads rendered that lever insufficient. Since 2008, whenever expectations have begun to perk up — and they have, several times — yet another “shock” has come along and returned us to pessimism (“OMG, Europe!”). Eventually you have to wonder whether there isn’t something more than arbitrary about these negative expectations.

The market monetarists might retort that a sufficiently determined central bank, if given license to lend and purchase assets as it sees fit, can always meet a nominal spending target, and therefore can always set expectations of nominal demand. That may be true. But in the context of an economy structurally resistant to increasing expenditure, expectations of stable nominal income become equivalent to expectations of continual central bank expansion. NGDP expectations can be maintained, if and only if the central bank demonstrates its willingness to continually intervene.

If intervention will be frequent and chronic, precisely what instruments the central bank intends to use becomes a matter of great public concern, rather than a technocratic detail best left to professionals. Central banks may significantly shape patterns of consumption and investment by choosing to whom they are willing to lend and on what terms. They may pick winners and losers, not for a brief Paul Volcker Chuck Norris moment but for the indefinite future.

So, I am all for targeting an NGDP path. I think it’s a great idea, and have more nice things to say about it. I hope the market monetarists are right, that merely by announcing an NGDP target and showing resolve in a one-time wrestling match with skeptics, central banks can restore a high-demand equilibrium. But if we adopt an NGDP target and are serious about it, there is significant risk that we will be committing to chronic intervention. The market monetarists owe us a more serious conversation than they’ve offered so far about how monetary policy would be conducted if resetting expectations turns out not to be enough. Would the interventions they propose be fair, if pursued cumulatively over many years? Would they be wise? Would they help resolve the structural problems that have rendered it so difficult to sustain demand, or would they exacerbate those problems?


[1] Yes, the US Federal Reserve has its murky triple mandate. But in practice tracking a tacit inflation target seems to dominate. Other central banks are at least explicit in their poor choice of a target.

Update History:

  • 29-Oct-2011, 7:10 p.m. EDT: Changed “a more durable peace” to “a durable peace”. “there is a significant risk” to “there is significant risk”.

The moral case for NGDP targeting

The last few weeks have seen high-profile endorsements of having the Federal Reserve target a nominal GDP path. (See Paul Krugman, Brad DeLong, Jan Hatzius and colleagues at Goldman Sachs.) This is a huge victory for the “market monetarists”, a group that includes Scott Sumner, Nick Rowe, David Beckworth, Josh Hendrickson, Bill Woolsey, Marcus Nunes, Niklas Blanchard, David Glasner, Kantoos, and Lars Christensen. Sumner in particular deserves congratulations. He has been on a mission from God for several years now, and has worked tirelessly to persuade us all that central banks should target NGDP, and that they have to ability to do so even after interest rates fall to zero.

I have reservations about the market monetarists’ project. I’m not certain that the Fed has the tools to meet an NGDP target, or if it does have the tools, that the costs of deploying them to establish its credibility are supportable. Moreover, I don’t think that the market monetarists have sufficiently thought through the consequences of success, in accounting terms, if they restrict themselves to lending to the private sector (or, equivalently, purchasing debt instruments from the private sector). The market monetarists have grown in parallel with another fringe monetary theory, MMT. The two groups don’t consider themselves aligned, but I think they are two sides of the same coin. It would be great if they would combine their insights — the market monetarists with their NGDP-targeting central bank, the MMT-ers with their concern for balance sheet health and their understanding that transfers-to-be-taxed deleverage private sector balance sheets while advances-to-be-repaid do not.

But such quibbles are for another time. Here I want to join the market monetarists’ happy dance, and point out several moral benefits of NGDP targeting.

  • The most plain moral benefit of NGDP targeting is that it is activist. Relative to the status quo, it demands a serious effort to combat the miseries of depression. This is a big improvement over our current strategy, which is to shrug off and rationalize mass deprivation and idleness.

  • A second moral benefit is that under (successful) NGDP targeting, any depressions that occur will be inflationary depressions. Ideally, we’ll find that once we stabilize the path of NGDP, the business cycle is conquered and there will be no more depressions ever again. But that probably won’t happen. If depressions occur even while the NGDP path is stabilized, then they will reflect some failure of supply or technology. Our aggregate investment choices will have proved misguided, or we will have encountered insuperable obstacles to carrying wealth forward in time. It is creditors, not debtors, whom we must hold accountable for patterns of aggregate investment. There always have been and always will be foolish or predatory borrowers willing to accept loans that they will not repay. We rely upon discriminating creditors to ensure that funds and resources will be placed in hands that will use them well. Creditors allocate capital by selecting the worthy from innumerable unworthy petitioners. An economic downturn reflects a failure of selection by creditors as a group. It is essential, if we want the high-quality real investment in good times, that creditors bear losses when they allocate funds poorly. When creditors in aggregate have misjudged, we must have some means of imposing losses without the logistical hell of endless bankruptcies. Our least disruptive means of doing so is via inflation.

    I do not relish inflation for its own sake, or advocate punishing creditors because they are rich and the tall poppies must be cut. But if, despite NGDP stabilization, real GDP cannot be sustained, someone has to bear real losses. There are only two choices: current producers can be taxed in order to make creditors whole in real terms, or past claims can be devalued so that losses are borne at least in part by creditors. In my view, the latter is the only moral choice, and the only choice that creates incentives for investors to maximize real-economic return rather than, say, hide behind guaranteed debt and press politicians to ensure the purchasing power of that debt is sustained regardless of the cost to aggregate wealth. (Sumner makes a similar point in his excellent National Affairs piece.)

    Note that NGDP targeting doesn’t prevent the honorable Austrian remedy to credit misallocation: having creditors individually to bear losses via default and/or bankruptcy of borrowers. When it is possible to equitize or liquidate particular claims quickly and without creating terrible costs for the rest of the economy, we should do so. Every completed restructuring promotes real activity by reducing valuation uncertainty and debt overhang, and so reduces the degree to which an NGDP targeting central bank will need to tolerate inflation and spread losses to creditors generally. We should try internalize the costs of credit decisions via default and bankruptcy as much as possible, as doing so keeps investment incentives sharp. (On a stable NGDP path, we don’t have to worry so much that loans that should have been good turned bad because of a scarcity of aggregate income.) But whether it is particular bad lenders who suffer or creditors in aggregate, current producers should not be forced to bail out the bad or unlucky investment decisions of earlier claimants.

  • In fact, NGDP targeting, despite the stench of sugar-high money games that Austrians perceive in it, might actually increase our ability to impose losses on foolish creditors via default and bankruptcy. This would pay a huge moral dividend, in terms of our ability to avoid the unfairness of arbitrary bail-outs. Both Nick Rowe and Scott Sumner have suggested to me that if we had sufficiently aggressive monetary stabilization, we could avoid acquiescing to “emergency” rescues that flamboyantly reward bad actors, because allowing bad actors to collapse would no longer threaten the rest of us. Rajiv Sethi has made a similar point:

    The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed’s intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries. While I do not subscribe to Baker’s view that Ben Bernanke “deliberately misled” Congress in order to gain approval for TARP, his main point still stands: if the Fed can increase credit availability to non-financial businesses and households by direct purchases of commercial paper, than why is any financial institution too big to fail?

    Perhaps we ought to think of “liquidationism” and stimulus as complementary rather than pin them to bitterly opposed camps. The palliative of stimulus might enable the medicine of consequences to work its pain without killing the rest of us. Obviously, fiscal and monetary interventions can be used to bail out failing incumbents, and as a matter of political economy, we might find ourselves unable to prevent this misuse. But precommitting to aggressive macro stabilization via tools that don’t discriminate in favor of particular firms or sectors might allow for more liquidation of bad claims than pretending we will be laissez-faire when the consequences of nonintervention would prove catastrophic.

  • In constrast to an inflation-targeting central bank, an NGDP-targeting central bank need not distort the division of income between capital and labor. Under current practice, the Fed tends to encourage asset price inflation but worries frenetically over any growth in unit labor costs, or, equivalently, labor’s share of income. Labor share of income has been collapsing since about 1970. I don’t mean to claim that the Fed has caused the collapse of labor share: globalization, automation, and deunionization would have put pressure on wages regardless of Fed action. But the credibility of the Fed’s consumer-inflation targeting regime is closely tied to moderation of wage growth. Managers, union leaders, and policymakers know that bargains whose effect would be to increase labor share might provoke contractionary monetary policy and even recession. This undoubtedly has had some effect. I don’t want to overattribute, but it seems more than coincidental that Rubinism and Clintonesque hypersensitivity to bond-market concerns arose after George H.W. Bush’s reelection was thought to have been crippled by cautious monetary policy and the jobless recovery it engendered. I think many labor-sympathetic observers view the Federal Reserve as an organization which tilts the scales against workers in subtle and unaccountable ways. I know that I do.

    An NGDP-targeting central bank trying to contract would be indifferent between restraining wage and capital income. Wage income growth puts more pressure on consumer prices than capital income growth, but under NGDP targeting it’s all nominal income. In practice, devils live in details, and how the Fed actually works to achieve its target might or might not be neutral. But labor has a better shot of being treated equitably under an NGDP-targeting regime than under an inflation target that is inherently threatened by wage growth.

It’s a bit ironic that the “market monetarists” are gaining prominence at the same time as “End the Fed” is a rallying cry of social movements across the political spectrum. It is a mistake to associate “End the Fed” solely with Ron Paul’s unpersuasive sound-money fetish. (Unpersuasive, because the Fed over its history has preserved the purchasing power of a dollar held in any financial instrument other than a mattress.) Many Americans, including me, feel a strong antipathy towards the Fed, not because of it has debauched the currency, but because we believe that it has played favorites in the economy and in politics, usually in the shadows but brazenly over the course of the financial crisis. We think the Fed behaves immorally and unfairly. An NGDP-targeting Fed could be a better Fed, in a moral as well as technocratic sense. I wish the market monetarists luck in trying to make it so.

Update History:

  • 25-Oct-2011, 3:30 a.m. EDT: Changed “Clintonesque hypersensitivity to deficits and bond-market concerns” to “Clintonesque hypersensitivity to bond-market concerns” in order to make an awkward sentence slightly less awkward.
  • 25-Oct-2011, 4:30 a.m. EDT: Changed “a loan” to “loans” to match plural subjects…
  • 25-Oct-2011, 11:45 p.m. EDT: Corrected misattribution of Sumner article to “Nation Interest”. The piece appeared in “National Affairs”. Many thanks to commenter Matt for calling attention to the error!