Revaluing China

It’s odd that I’ve ended up something of a China dove. My entrée into the fin/econ blogosphere was as a commenter at Brad Setser’s website, where some of my rantings verged on sinophobic. But somewhere along the line, I came to the conclusion that faulting China for America’s problems is a bit pathetic. While the jury is still out on the long-term wisdom of its dash to wealth, there’s a solid case that the China’s economic policies have served it well. The United States was and remains the world’s most powerful nation, not a fainting virgin. If China’s economic choices were indirectly harmful to the United States (they were and are), it was within the United States’ power to craft a response that would neutralize those effects. It is not China’s fault that the US did not look after its own interests. The United States’ self-destructive tolerance of unbalanced trade was relentlessly pushed by domestic groups — Wall Street and Wal-Mart — and was given plenty of cover by the economic establishment prior to the “Great Recession”.

Although I hold the United States responsible for its imbalances, I have no patience at all for the argument that “profligate Americans” were the root of the problem. American families responded quite reasonably to the price signals they encountered in goods, credit, and housing markets under an assumption that markets are stable and reasonably efficient. In making those assumptions, they were following the endlessly repeated advice of “experts”. Sure, you can toss out anecdotes about ugly Americans buying Hummers and taking cruises with cash-out refis. America has its share of credit-loving conspicuous consumers. But most families put their cash-out refis to more ordinary and defensible uses, as a supplement stagnant incomes. Absurd and unsustainable price signals (ungodly cheap imports, incredibly easy credit, monotonically rising home prices) were the failure for which the US must take reponsibility, and the blame for those falls squarely on the shoulders of lobbyists, politicians, and economists. It was a technocratic elite that fucked up, not Jane and Joe Six-Pack.

All of a sudden, though, part of that elite wants to make amends by forcefully confronting China. I think that’s a mistake, see here and here, or read Ryan Avent. The United States needs a comprehensive, nondiscriminatory balanced trade policy, not a bilateral trade spat with China.

But suppose the China hawks are right, that China’s mercantilism is uniquely harmful and must be forcefully addressed. The usual demand is that China let its currency appreciate sharply against the dollar. A depressed exchange rate functions as both a tariff on foreign goods and an export subsidy. The (accurate) case against China is that its currency policy amounts to protectionism in disguise. However, it is the real, not nominal, exchange rate that matters in this story. Most China hawks are agitating for a change in the nominal exchange rate, so that instead of buying 6.8 Yuan, a dollar should only be able to purchase 6 or even 5.5 Yuan. That approach has advantages: it would be a clear, visible change that can be implemented quickly. Holding wages in the US and China constant, a nominal appreciation becomes a real appreciation. However, there is another way that China’s real exchange rate could adjust: Chinese wages could rise more quickly than American wages while the nominal exchange rate stays put.

The US should prefer real appreciation via wage growth in China to appreciation via a sharp change in nominal exchange rates. Economically, the two approaches are similar, but politically they are quite different. The danger that the US might try to “inflate away its debt” is a live issue in China. A big nominal appreciation of the CNY implies huge paper losses on China’s hoard of dollar assets. That might create resentments, as China’s relatively modest losses on other US investments have. If China were to engineer a real appreciation while keeping the nominal exchange rate stable, it could avoid an accounting loss on its enormous investment. Avoiding such a loss is in the interest of both China’s economic managers and the United States.

It’s uncomfortable to make a policy recommendation based on what a cynic might claim to be deceptive spin. The economic effects of a revaluation via rising Chinese wages or via a nominal appreciation are similar. One could argue my suggestion amounts to colluding with China’s leaders to hide the degree to which they and we have expropriated wealth from China’s underpaid workers. (China’s workers are underpaid in international terms, for work of comparable productivity.) A nominal revaluation would render transparent the cost of China’s past subsidies to Western consumers and its own export tycoons. A wage-based revaluation would hide it.

But there is also a sense in which the paper losses that a nominal reval would occasion are misleading. The wealth represented by China’s reserves might never have been earned without its policy of exchange rate management. China’s development, in a broad sense, is much more valuable than its stock of reserve assets. Despite suffering a direct expropriation of international purchasing power from the policy, most Chinese are arguably better off than they would have been in the absence of that “theft”. Outrage over paper losses on reserve assets would be like shareholders in a business getting mad over a phenomenally profitable promotion because it involved selling goods at a discount.

Further, the US has not — yet — “inflated away” the value of a dollar in terms of domestic purchasing power. China’s reserve assets can be traded for roughly the same American goods and services as they could have on the day that they were purchased. America has changed over the past decade much less than China has. China’s workers have grown dramatically, incredibly, more productive, thanks to structural changes in their economy. So perhaps the most accurate way of accounting for these changes is to let the wages of Chinese workers increase to match that productivity growth, rather than restraining wage-growth but cheapening internationally-traded goods.

I don’t think there’s a clear case that one story is “truer” than any other. But I do know that a future in which the US and China are warm friends looks far better than a new cold war based on avoidable grievance. My first-best prescription for the US is to avoid singling out China at all, while using nondiscriminatory capital controls (or else “import certificates“) to unilaterally enforce a balance of trade. But if we must single out China, we should prefer revaluation via higher wages to nominal appreciation. If we are not stupid about how we frame the issue — if we don’t throw around accusations of sweatshops and slave labor as an offensive sort of cudgel — we might find that China’s leadership is more open to wage appreciation than currency appreciation. Higher wages balance the cost of reduced international competitiveness with the benefit of increased domestic demand. Giving ordinary people more money always has a political upside. Rising wages don’t attract self-defeating flows of “hot money”, like gradual nominal appreciation does. And China’s leadership, with its laser-focus on stability, prefers gradual experiments to bold, dramatic adventures.

As Joseph Wang used to point out (see e.g. his comments here), ultimately, the stability of America’s middle class depends upon the emergence of a wealthier middle class in China and other emerging countries. That’s what we should all be working towards.

Capital can’t be measured

Simon Johnson and James Kwak are absolutely right. Sure, “hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.

Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 25 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

So Lehman misreported its net worth, right? Not according to the law. From the Valukas Report, Section III.A.2: Valuation — Executive Summary:

The Examiner did not find sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman’s valuations. In particular, in the third quarter of 2008 there is evidence that certain executives felt pressure to not take all of the write‐downs on real estate positions that they determined were appropriate; there is some evidence that the pressure actually resulted in unreasonable marks. But, as the evidence is in conflict, the Examiner determines that there is insufficient evidence to support a colorable claim that Lehman’s senior management imposed arbitrary limits on write‐downs of real estate positions during that quarter.

In other words, the definitive legal account of the Lehman bankruptcy has concluded that while executives may have shaded things a bit, from the perspective of what is actionable within the law, Lehman’s valuations were legally indistinguishable from accurate. Yet, the estimate of net worth computed from these valuations turned out to be off by 200% or more.

Advocates of the devil and Dick Fuld will demur here. Yes, Lehman’s “event of default” meant many derivatives contracts were terminated prematurely and collateral on those contracts was extracted from the firm. But closing a marked-to-market derivatives position does not affect a firm’s net worth, only its exposure. There may be short-term changes in reportable net worth as derivatives accounted as hedges and not marked-to-market are closed, but if the positions were in fact hedges, unreported gains on other not-marked-to-market assets should eventually offset those charges. Again, the long term change in firm net worth should be zero. There are transaction costs associated with managing a liquidation, but those would be minimal relative to the scale of these losses. Markets did very poorly after Lehman’s bankruptcy, but contrary to popular belief, Lehman was never forced into “fire sales” of its assets. It was and remains in orderly liquidation. Last July, more than 9 months after the bank fell, Lehman’s liquidator reported that only a “fraction” of the firm’s assets had been sold and the process would last at least two years. Perhaps the pessimistic estimates of Lehman’s value were made during last year’s nadir in asset prices, and Lehman’s claimed net worth looks more reasonable now that many assets have recovered. But if Lehman’s assets were so profoundly affected by last Spring’s turmoil that an accurate September capitalization of $28B shifted into the red by tens of billions of dollars, how is it plausible that Lehman’s competitors took much more modest hits during that period? Unless the sensitivity of Lehman’s assets to last year’s markets was much, much higher than all of its peers, Lehman’s assets were misvalued before the asset price collapse, or its competitors assets were misvalued during the collapse.

We get lost in details and petty arguments. The bottom line is simple. The capital positions reported by “large complex financial institutions” are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank “conservatively” levered at 11× tier one capital.

Errors in reported capital are almost guaranteed to be overstatements. Complex, highly leveraged financial firms are different from other kinds of firm in that optimistically shading asset values enhances long-term firm value. Yes, managers of all sorts of firms manage earnings and valuations to flatter themselves and maximize performance-based compensation. And short-term shareholders of any firm enjoy optimistic misstatements coincident with their planned sales. But long-term shareholders of nonfinancial firms prefer conservative accounts, because in the event of a liquidity crunch, firms must rely upon external funders who will independently examine the books. The cost to shareholders of failing to raise liquidity when bills come due is very high. There is, in the lingo, an “asymmetric loss function”. Long-term shareholders are better off with accounts that understate strength, because conservative accounting reduces the likelihood that shareholder wealth will be expropriated by usurious liquidity providers or a bankruptcy, and conservative accounts do not impair the real earnings stream that will be generated by nonfinancial operations.

This logic inverts for complex financials. Financial firms raise and generate liquidity routinely. Many of their assets are suitable as collateral in repo markets. Large commercial banks borrow freely in the Federal Funds market and satisfy liquidity demands in part simply by issuing deposits that are not immediately withdrawn. For large financial firms, access to liquidity is rarely contingent upon a detailed audit by a potential liquidity provider. Instead, access to liquidity, and the ability to continue as an operating firm, is contingent upon the “confidence” of peer firms and of regulators. Further, the earnings of a financial firm derive from the spread between its funding cost and asset yields. Funding costs are a function of market confidence, so the value of a financial firm’s real future earnings increases with optimistic valuation. For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the “option value” of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.

So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?

Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we’ll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank’s capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.

Regulation by formal capital has a proud and reasonably successful history, but has been rendered obsolete by the complexity of modern financial institutions. The assets and liabilities of a traditional commercial bank had straightforward, widely acceptable book values. For the corner bank, discretionary modeling mattered only in setting credit loss reserves, and the range of estimates that bank officers, external auditors, and regulators would produce for those reserves was usually pretty narrow (except when all three colluded to fake and forbear in a general crisis). But model complexity overwhelms and destroys regulatory capital as a useful measure for large complex financial institutions. We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.


Some sources: Yves Smith has been phenomenal on the Lehman bankruptcy. Regarding estimates of the hole that appeared in Lehman’s balance sheet, see “$75 Billion Needlessly Lost in Hasty Lehman Bankruptcy Filing?” and “So Where, Exactly, Did Lehman’s $130 Billion Go?“. Neither Yves nor I remotely buy the “hasty bankruptcy” explanation, see my comments above, the previously cited article, and the always acerbic Independent Accountant. Comments on the pacing of the Lehman liquidation are from the CNBC video embedded in Yves’ piece. The $24B estimated tangible for Lehman is computed by taking its September 10, 2008 shareholder equity and subtracting intangible assets reported on Lehman’s last available balance sheet.

My discussion of financial firms’ incentive to lie was informed by the investor/blogger/super-cop John Hempton, see “Don’t believe what they say” and “Bank solvency and the ‘Geithner Plan’“.

This essay also owes something to Frank Partnoy’s excellent “Make Markets Be Markets” presentation.

Update: Somehow I managed to get the date of Lehman’s bankruptcy wrong. Takes talent, I know. Thanks to commenter mindbender for setting me straight!

A different perspective on interest rates

In the endless debates over stimulus and deficits, more “dovish” commentators frequently point out that debt markets appear sanguine about US borrowing. Despite some recent upward jitters, the Federal Government currently pays less than 4% to borrow for 10 years, and under 5% to borrow for 30 years. Those are bargain rates in historical terms, the argument goes, so investors must not be terribly concerned about inflation or default or any other bogeyman of “deficit terrorists”.

To make the point, Paul Krugman recently published a graph very similar to this one:

Since the financial crisis began, the US government’s cost of long-term borrowing has dramatically fallen, not risen. If we graph a longer series of 10-year Treasury yields, the case looks even more compelling. The United States government can borrow very, very cheaply relative to its historical experience.

However, there is another way to think about those rates. The US government’s cost of long-term borrowing can be decomposed into a short-term rate plus a term premium which investors demand to cover the interest-rate and inflation risks of holding long-term bonds. The short-term rate is substantially a function of monetary policy: the Federal Reserve sets an overnight rate that very short-term Treasury rates must generally follow. Since the Federal Reserve has reduced its policy rate to historic lows, the short-term anchor of Treasury borrowing costs has mechanically fallen. But this drop is a function of monetary policy only. It tells us nothing about the market’s concern or lack thereof with the risks of holding Treasuries.

But the term premium (or “steepness of the yield curve”) is a market outcome (except while the Fed is engaged in “quantitative easing”). How do things look when we graph the term premium since the crisis began?

The graph below shows the conventional barometer of the term premium, the 2-year / 10-year spread (blue), and a longer measure, the spread between the yield on 3-month T-bills and 30-year Treasury bonds (red), since the beginning of the financial crisis:

Since the financial crisis began, the market determined part of the Treasury’s cost of borrowing has steadily risen, except for a brief, sharp flight to safety around the fall of 2008. Investors have been demanding greater compensation for bearing interest rate and inflation risk, but that has been masked by the monetary-policy induced drop in short-term rates.

Taking a longer view, we can see that the current term premium is at, but has not exceeded, a historical extreme:

Note: There’s a gap in the 30-year rate series, probably because it became impossible to compute a “constant maturity” 30-year Treasury yield during the period when the Treasury stopped issuing 30-year bonds.

The present term premium is quite similar to those that vexed President Clinton during the heyday of the “bond vigilantes”. A glass half full story says that, despite all the stresses of the financial crisis and the sharp spike in Treasury issuance, the term premium has not become unmoored from its historical range. A glass half empty story says that the term premium is toying with the boundary of that range, and could break loose in an instant. I have no idea which tale is truer.

My politics on the deficit are centrist to dovish. I think that deficit spending is always an option, and that the Federal Government should absolutely spend on forward-looking, high-return investment projects. I also favor generous “safety net” benefits and would like to see a guaranteed income program in the United States. However, the only form of “stimulus” I support is very broad based transfers (e.g. I would support a payroll tax subsidy). I agree with many left-ish commentators that the deficits we’ve experienced are more an effect than a cause of our economic problems, and will take care of themselves if we create a strong economy and a broadly legitimate political system (neither of which I think we have right now). A nation as large and wealthy in natural resources and human capital as the United States need never be constrained by the vicissitudes of financial markets, if its government is capable of mobilizing its citizens’ risk-bearing capacity on behalf of the polity. [*]

But whatever my politics, I think there is a fair probability that the US will experience the thrilling uncertainty that attends a loss of confidence in its currency and debt. The argument that “markets don’t seem troubled by our deficits” is less persuasive than it first appears.

Full disclosure: Although my views are sincerely held, sincerity is cheap. Perhaps I am just talking my book! I am one of those people long gold and short Treasuries (although I am not a proponent of the gold standard).


[*] Remember, economic capital has nothing to do with money. Supplying capital is nothing more or less than assuming the burden of economic risks. Where do you think China’s ever-expanding capital base comes from, when it has been the world’s largest exporter of financial capital? China’s citizens assume great risk, in the form of below-world-market wages and social safety benefits, in exchange for the promise of a wealthier and more powerful nation. To some degree that capital is extracted involuntarily, but China’s government has had remarkable success at maintaining legitimacy and the consent of the governed despite the extraordinary costs citizens have borne in the service of an uncertain future. So far, citizens have seen consistent returns on their investment: the big question is how China fares in a persistent “bear market”, when it comes to seem as though much of their sacrifice has been wasted or stolen.

In defense of incivility

Hooh, boy.

There’s a nice spat a-brewing between two people I hardly know, but nevertheless consider friends. The Epicurean Dealmaker offered some thoughts on financial reform, and in particular “resolution authority”. Yves Smith took exception. TED took exception to her exception taking. I suspect the sparks have just begun.

Me, I’m a lovah not a fightah, so I’ll split the difference. TED is right that constructive ambiguity and discretionary power are prerequisite to an effective, non-public-raping resolution regime. But Yves is right to take him to task for leaving things there, because whatever gets writ in the ex post memoirs, there are predictable and repeatedly observed incentive problems that prevent regulators from using discretionary authority until it’s too late (and then they whine to stenographers about how powerless they were). Read Michael Pomerleano and Andrew Sheng, or watch Richard Carnell, or check out l’il ol me. To be fair to TED, I know he is cognizant of these incentives; elsewhere he has offered ideas on how to change them. (See e.g. his reformist manifesto. I believe TED has also proposed adopting the Singapore model, conjuring an extraordinarily well-paid, independent regulatory caste that would be structurally resistant to capture and could recruit talent competitive with Wall Street’s finest. But I can’t find that link.)

TED is right on here:

Ms. Smith appears to advocate “root and branch reform” of the system, which makes her, by definition, more radical than me. As befits my nature as an investment banker, I am a pragmatist and an incrementalist. I think the prospect of true root and branch reform of the domestic financial system—not to mention the global one with which it is inseparably interconnected—is such a vast and daunting task to undertake in our current sociopolitical environment as to be unlikely at best. Notwithstanding the theoretical attractions of radical reform—which I personally would favor, by the way—I would much rather cobble together a partially effective, imperfect resolution authority today than wait the ten or twenty years serious reform might take… Sympathetic or not, however, I would also like to caution Ms. Smith. Like many radical reformers, I suspect she would be surprised how little common ground she has with other would-be radical reformers. It is always a revelation to discover, as revolutionaries always have, just how little agreement you have with your peers when it comes to deciding just exactly which roots and branches of the ancien régime need to be trimmed.

As, um, a proponent of root-and-branch reform, these are the questions that keep me up at night. For the record, I think we will end up with root-and-branch reform, but I fear we’ll get it hard and painful following a much more serious crisis that we have already failed to avert. I think the Great Financial “Panic” of 2008 has shrunk into another LTCM or Enron, a moment we will someday look back upon and wonder why we failed to deal with problems that were so fucking obvious, but for now all we hear is “It worked!” I’m a middle-aged Jewish guy who thinks and writes about finance, makes much of his living as a speculator, and avoids honest work. The tail risk I worry about is that I’ll get to see the sort of financial reform I advocate from a wonderful vantage high atop a lamppost.

But that is precisely why I want to take issue with TED here:

Like many other econobloggers opining on the state of affairs in the world of finance, Ms. Smith has gotten into the nasty habit of using the term “banksters” to refer to members of the financial services industry. (It is in the title of yet another post of hers today.) The overarching metaphor behind this coinage—which, I emphasize again, is neither original nor limited to Ms. Smith—is that commercial bankers, investment bankers, insurance company employees, and presumably everyone else in the financial industry are uniformly engaged in a vast, intentional, and irredeemably criminal enterprise. Ms. Smith reinforces this metaphor often, including in the post dissected herein (with the crack of “financiers [looting] taxpayers”), and implicitly in the title of her new book, ECONNED.

Now, I am all for the charms of expedient exaggeration. (Although mine tend to be limited to sarcastic and humorous uses, rather than bitter and humorless character assassination.) It can be funny, and it can emphasize important points. But uniformly and universally excoriating millions of people who work in finance as gangsters, thieves, looters, and con men is just fucking dumb. It’s like saying all management consultants are morons, or everyone from Iowa is a hick. While there certainly must be examples of moronic management consultants and hayseed Iowans among the myriad constituents of each of those groups, no honest or intelligent person would believe all of them are that way. Why, then, do so many bloggers writing today tar the entire finance industry with the same tired, thoughtless old brush?

These casual, unthinking insults would not bother me if I did not think they lower and coarsen the important conversation we are having in society and the blogosphere about financial reform. Sure, investment banking has its fair share of crooks, but we are no different than the rest of society. Some of us, closer to the top and more successful, perhaps, probably do have a more highly developed sense of entitlement and aggressiveness than your average bear. But we are not criminals. We work the system, hard, to advance our own and our families’ personal and professional interests, but 99.9% of us are not out to rape and pillage the commonfolk of their daily bread. To think otherwise is just plain stupid.

I myself don’t use the term “banksters”. And I sympathize with TED. I like financial industry professionals, personally. I enjoy meeting bankers. They are usually smart, interested in the arcane crap I’m interested in, and assholes of the sort that I enjoy sparring with. Bankers are great fun, and they are not bad people.

But we are who we are collectively as well as individually. Large organizations can and do evolve to do evil things while isolating people individually from illegal or morally uncomfortable acts. That capacity can confer tremendous advantages over smaller, more personal and accountable, collectives. It’s harsh, but we don’t get a pass just because the particular lever we are paid to pull only shifts a cog in a vast machine whose overall function we don’t control. As moral agents, it is not enough to follow the law and let pecuniary incentives guide us. We have to take responsibility for the behavior of the collectives to which we belong.

We are all dirty. Seven years ago I supported a war that has been responsible for hundreds of thousands of deaths, and that has not achieved any of the positive ends I thought it would achieve. That was a moral error I’m not sure I deserve to have survived, and I’m a terrible hypocrite, because I don’t live like Mother Theresa to atone, but carry on as a comfortable American. I won’t point a finger at anyone and claim moral superiority.

But I am responsible, and it’s important that I know I am responsible. We all have an obligation, not to self-flagellate like monks, but to be aware of the systems in which we are situated, and to work a bit, at the margin, to correct them. Obviously, so long as there are badly skewed incentives, a bit at the margin won’t be enough. I won’t hold a grudge against some mid-level banker who put together crap CDOs because everyone was doing it, and who knew housing would collapse?, and it was very lucrative. But neither will I abstain from using words like “fraud” and “looting” to describe organized practices which, innocuous act by innocuous act, do in fact serve to extract wealth from many and distribute it to a well-organized, well-placed few. And if you work in the industry and that makes you uncomfortable, it should make you uncomfortable, even if your accuser is a hypocrite and morally reprehensible himself. We can and should make better rules and fix perverse incentives in the financial system. But we won’t be able to design a game so perfect that self-interested amoral agents plus an invisible hand ensure decent outcomes. We need industry participants to take responsibility for the organizations and practices in which they participate, and to take an active, serious role in policing those practices. That will require a cultural shift, an understanding that actions that are legal and profitable can be illegitimate and disreputable, and should be avoided even if competitors will profit from your scruples. If context makes that impossible, if behaving well implies that you’ll be fired or your firm will go bust, you (like Chuck Prince!) must try to alter that context.

Calling out misdeeds by hard names helps. Words like “looting”, “theft”, “fraud”, and “scam” are fair descriptions of a lot of common practices, even if some of the perpetrators worked 18 hour days putting together pages 120 through 237 of mind-numbing prospecti and meant only to earn a living.

Yves and TED and I all derive sustenance, one way or another, from the financial industry. Many, perhaps most, people with significant savings in the US, nearly all workers whose pension will support a financially comfortable retirement, are beneficiaries of practices that involved shifting wealth from others to us by means of questionable legitimacy. Many of us profited from asset bubbles; we extracted rewards from price signals that harmed the real economy rather than guiding smart decisions. This is not just about “them”. It is about us. We, the savers, the affluent, educated, hard-working “core” of American society have become thieves, or at best unwitting beneficiaries of theft. We ought to be uncivil to ourselves for that, and we ought to be trying to ensure it never happens again. Both Yves and TED are doing a good job, doing more than their parts to make sense of what’s happened and agitate for something better. But as for the people watering down derivatives reform, defending bank gigantism, shoving the CFPA into a cubicle six sub-basements beneath Ben Bernanke’s ass, well, I’m glad as hell to have people like Yves calling them out as “banksters”.

Rooseveltian reflections

Wednesday morning, I attended a Roosevelt Institute conference, on the theme “Make Markets Be Markets“. It was an enjoyable affair, with a bunch of smart, well-known speakers saying things I broadly agree with, mostly on financial reform. A wrinkle I had not really expected was how frequently, and rather charmingly, the name of the gentleman after whom the Institute is named would be invoked. FDR, and the 1930s generally, were very much with us that morning.

I have much to spout on the subject of financial reform; I am several posts in arrears on that. But by the end of the conference, I was fascinating myself with a little thought experiment.

Suppose the good guys win. Better yet, suppose they had never lost. Suppose banks had never ventured beyond conservatively prudent lending; that there had been no housing, internet, or credit bubble. Forlorn cul-de-sacs surrounded by mouldering homes were never cut from the Arizona desert. Webvan and pets.com were rejected straight off by investors rather than soaring against all reason then dying in an unreasonably sudden collapse.

In a world without bubbles and, let’s not mince words, in a world without fraud in substance if not in law, would we, or how could we, have enjoyed two decades of near “full employment” and apparent growth? Without all the internet companies that were forseeably destined to fail, without all the housing construction, without all the spending by employees whom we know now and should have known then were not actually participating in economic production, without all the spending by people feeling rich on stock or housing gains that would eventually collapse in their or someone else’s arms, what kind of economy would we have built?

These are not questions that answer themselves. They are unknowable counterfactuals.

But we do know something about the 1930s. In 1930, Keynes famously proclaimed “we have magneto trouble”, with the implication that the then incipient depression was due to a kind of remediable, technical failure. Less famously, Keynes was wrong. The post-war economy that finally put paid to the Great Depression was an economy different in kind from that of the go-go 1920s. One piece of that was financial sector reform: there were the securities acts and the FDIC and an astonishing forty years without major banking crises. But there was also a new age of mass production and mass unionization in the US (the so-called “Fordist era“), and the vast existential project of reconstruction in Europe. The Bretton Woods system fixed exchange rates and was intended explicitly to prevent the sort of unbalanced international capital flows that preceded the Great Depression. The postwar United States had an agricultural sector that was largely centrally planned, Fannie Mae and Social Security, and especially the Wagner Act which put the coercive power of the state behind exclusionary labor cartels, but which more than any other single thing made possible mass affluence based on income rather than credit. These were radical, inconceivable changes, combining “socialist” central-planning and redistribution with “fascist” collusion between the state and large corporations in support of national aims. Keynes was right, of course, that the “resources of nature and men’s devices [were] just as fertile and productive” in 1945 as they had been in 1929. But the “delicate machine” we had “blundered in control of” was replaced, not repaired. The new model mixed the technologies of the original gizmo with very novel and foreign elements in a design influenced both by the history of the Depression and an emerging great-power conflict. (See this excellent piece by the Roosevelt Institute’s Mike Konczal.)

It is entirely unclear that, absent these changes, the US economy would have “recovered”, even with financial sector reform and the deleveraging of household balance sheets. Sure, depressions never last forever, but it is plausible that the US would have fallen into a spiral of booms and busts and class warfare absent the political choices that defined the postwar economy. And note that they were political choices — a “free market” never would have delivered and sustained for decades a pervasively unionized workforce. They were, for better and for worse, the work of Franklin Delano Roosevelt.

I don’t mean to underplay the importance of financial sector reform. A continually malfunctioning financial sector has brought the American economy to underappreciated ruin and left us with an overhang of unfulfillable promises that may engender conflict for decades. Further, the financial sector has generated the rump of a crony capitalist class which threatens to set us on the Argentine path. We have to fix the financial sector.

But we cannot fix the financial sector without addressing the problems and contradictions which we depend upon financiers to paper over. This never was just a financial crisis. It was, and is, an economic and political crisis, and we are only a very short way down the path towards resolving it.


p.s. While I do favor restrictions on international capital flows, I don’t favor (I’m actually quite hostile to) unionization as a means of delivering widespread affluence. I am not arguing that we should rehearse the political bargains of the mid-20th century. I am arguing that we had better come up with new bargains, that excising the tumors of parasitic finance is necessary but nowhere near sufficient to getting us out of the trouble we’re in.

Can we handle the truth?

Both globally and within most nations, the patterns of consumption required to sustain existing social arrangements are inconsistent with the distribution of the fruits of production. Social and economic stability, therefore, depend upon redistribution for which there is no overt legal framework or political consensus. To square this circle, the financial and government sectors have evolved means of hiding redistribution in complex, continually improvised arrangements. Unsurprisingly, massive wealth distributions arranged in this way leave much to be desired, in terms of straight corruption (the financial and government sectors redistribute a lot of wealth to themselves), justice (e.g. wealth is redistributed to those who happen to speculate early in bubbles), and sustainability (the illusion of value behind the claims of those from whom wealth is taken may prove fragile, but “loss realizations” are socially disruptive if they are not carefully paced and allocated).

Neither financial nor political reform can succeed unless we overcome the social and economic contradictions we have relied upon the financial sector to literally paper over. Off-balance-sheet liabilities that hide the impairment of savers’ claims, whether in subprime mortgage-backed securities or sovereign entitlement programs are not aberrations. They are essential tools in the arsenal of social stability, the economic equivalent of military “black-ops”, things that must be done but must always be denied in order to protect the American (and European, and Chinese) way of life. Unless we define overt arrangements that overcome the contradictions between the organization of production and socially desirable patterns of consumption, each scandal and reform will necessarily be followed by some new technique or trick that delivers, however unjustly or corruptly, the wealth transfers upon which our societies depend. Our choices are to overtly align the fruits of production with patterns of consumption, to continue to employ accounting fictions and magic to pretend away the contradictions, or to undergo some form of collapse.

Fixing “global imbalances” in three easy steps

Some problems are hard.

Some problems are not, except when we blind ourselves to pretty obvious solutions. Addressing “global financial imbalances”, or, more specifically, the fact that some countries are running persistent current account deficits that they (correctly) perceive not to be in their interest, falls into the second class of problems. It is flawed ideology, nothing more, that makes this problem seem difficult. If you want something to stop, stop it. Let me break it down for you into three easy steps.

  1. Stop blaming China!

    Yes, China’s success at limiting its currency’s real appreciation against the dollar amounts to a combination export subsidy / import tariff, turbocharging China’s tradables sector by making Chinese goods cheap abroad and foreign goods costly to Chinese consumers. The policy has, in some formal sense, robbed Chinese consumers of purchasing power, and shared the loot between Chinese elites and Western consumers.

    But it has also been profoundly good development policy. (See Dani Rodrik.) China’s rise has been miraculous, something that the planet as a whole, and Americans in particular, ought to celebrate. Literally hundreds of millions of people have transitioned from poverty to comfortable modernity. China’s abrupt rise most resembles that of the United States, which went from a civil-war-riven backwater to a dominant world power in only eighty years time.

    I don’t mean to gloss China’s problems or excuse its sins. China’s rise presents huge environmental challenges, to its own people and to the world. I dislike many aspects of its political system. Economically, I’m pretty sympathetic to Tyler Cowen’s China skepticism, and expect that during the continuing economic crisis, a parade of Brobdingnagian boondoggles will come to be revealed.

    Despite all that, in any nondystopian future, China’s gains will be consolidated, not reversed. We should all be rooting for its success. During whatever turbulence lies ahead, we should do everything we can to help.

    I agree with many critics that the combination of China’s currency peg and America’s economic dogma has been harmful to the US. But it is an odd sort of petulance to blame China for acting in its national interest because of consequences that US policymakers have always had the power to prevent. The blame for America’s (very serious) predicament rests squarely with a policy establishment that remained willfully blind to obvious problems for years, and that still refuses to consider effective remedies.

  2. Recognize that a nation’s balance of payments is a legitimate object of public policy.

    Yes, you can write models in which no agent transacts except when doing so is in her infinite-horizon self-interest, in which case policy that restricts or discourages any trade is Pareto destructive, QED. But those models bear little resemblance to the real world.

    In reality, financial flows — trades of promises rather than current goods or services — are subject to unusual uncertainty, and individuals have great difficulty distinguishing advantageous from disadvantageous exchanges. Aggregate financial flows affect both real and financial economies in ways no competent government can afford to ignore. There are reasons why a country might prefer to run a current account surplus or deficit for a while, but that ought to be a considered policy choice. It is rarely sensible for a large, mature, and diverse economy, like that of the United States (or Germany), to run either a deficit or surplus. Persistent trade deficits are a problem for human aggregations of any scale, from family to city to nation-state and beyond. Surpluses are okay at small scales, but become dangerous as they grow. Some groups have reason to oscillate between deficit and surplus, but no sustainable arrangement involves capital flows that never reverse, and whose reversion is not planned for in advance. (This is slightly overstated: a growing economy can sustain persistent small flows indefinitely and maintain a stable net financial position with the rest of the world. For a growing economy, “balance” is a modest range surrounding zero, not a single point. You can also write models — I just did — under which capital flows would never reverse, but the assumptions you need to make are, to say the least, dangerously unreliable.)

    I know of very many arguments that try to justify persistent imbalance, especially persistent deficits. After all, the United States has run very large current account deficits, but its net international position has been relatively stable, because foreigners’ return on their US investments has been abysmal compared to Americans’ return on their gross foreign investment. Also, when a country like the United States, whose debts are incurred in its own currency, runs a trade deficit, it exchanges claims on tokens it can produce indefinitely at zero cost for real goods and services. Why shouldn’t it take the deal?

    These arguments are both ways of saying that some countries, either intentionally or inadvertently, are willing to offer other countries real subsidies mediated and often hidden by complex financial arrangements. But perpetual subsidy is often harmful to the recipient, even if it is willingly offered by the donor. And usually the subsidy is not explicit, so that the donor retains a claim that it expects (however implausibly) to be payable in future goods and services. Arrangements that rely upon systematically reneging on that promise, by perpetually offering poor real returns on creditors,cannot endure, and are likely to be harmful to the spirit of trust and cooperation upon which trade ultimately depends. All financial claims are mere paper, or “spreadsheet entries”. But our ability to sustain economic arrangements that extend over time and geography depend upon our continually giving meaning to that paper by backing our accounts with sweat and treasure. To the degree that we are unable to do so, to the degree that we issue claims that we find ourselves incapable or unwilling to back, we corrode the scaffolding upon which cooperative prosperity depends.

    To be clear, this does not mean that issuers of financial claims should be bound, come what may, to deliver on those claims. Promises, including bad promises, are always joint projects of a promisor and promisee. There may be times and places where the burden of trying to make good on bad paper exceeds the costs, particular and general, of reneging. We are living through those times in very many places, and we are witnessing the consequences — a corrosion of trust, a diminishment of enterprise. The point here is to recognize that promises are fragile but essential. An environment in which promises made are generally kept, in letter and in spirit and without duress, is crucial to organizing the vast collaborations without which we are naked and cold. Persistent net capital flows imply some group of people accepting a flow of current goods and services in exchange for ever more expansive promises to reciprocate at some time in the future. That may occasionally be justifiable, but it is always dangerous, and ought to be subject to very careful scrutiny. When bad promises are made and broken, the consequences are rarely limited to the foolish transactors. The “externalities” can be severe.

  3. Gradually impose nondiscriminatory capital controls to regulate ones own balance of payments

    Fundamentally, there are two ways a country can regulate its international balance. It can target the “current account” or the “capital account”. Managing one takes care of the other as a matter of course. The current account is dominated by the trade balance — the gap, if any between the value of a nation’s imports and exports. The capital account is equal and opposite: if a nation has imported more than it has exported, it has “paid for” the difference with promises. To accept a promise in exchange for present value is to supply capital. Simplifying a bit, a nation receives capital to the degree that it accepts imports in excess of exports, and offers financial claims to cover the difference. A current account deficit implies a capital account surplus, which sounds nice but is nothing more than a windfall of promises yet to keep.

    Traditional protectionism — trade restrictions like tariffs and duties — target the current account. They alter the price of foreign goods and services relative to domestic goods and services, usually making foreign goods more expensive in order to encourage domestic consumption. However, these policies have a deservedly bad reputation. Attaching duties to imported goods and services implies that choices have to be made about how large the duties should be, and to which goods and services they should attach. That discretion generally proves very attractive to politicians, who may reward political supporters with protection of specific industries, skewing consumer choices far beyond the small home bias that might be necessary to manage the balance of payments. In theory, countries might adapt small, perfectly uniform tariffs. But in practice, this never happens, both because the political temptation to pick winners is impossible to overcome, and definitional questions of what ought and ought not be viewed as imports become fraught. (If I buy advertising on a foreign website, is a duty owed?)

    A much better approach is “capital account protectionism”. Rather than getting into the messy business of interfering with the trade in goods and services, manage capital flows directly. The simplest way to do this is to tax (or subsidize) the purchase of domestic financial assets other than zero-interest cash by nonresidents. There need be no interference in Ricardian free trade, the exchange of present goods and services. But the cross-border trade in promises would be taxed and regulated.

    I can already hear the cacophony of objections, and many of them are valid. Yes, clever people would quickly find ways to circumvent a financial asset tax, especially if implemented unilaterally by a single government. (Mutual enforcement would be preferable, but not essential.) Off-balance-sheet arrangements, clever swaps, would have to be controlled (but we have a lot of good reasons to want to do that). Transactions that multinationals now consider “internal” would become more costly and subject to scrutiny (but again, there are lots of reasons to think that supervising “internal” but international corporate flows might be a good idea, given how often these flows are tax motivated). A good regulatory regime combines tactical flexibility with clear goals to which regulators will be held accountable, creating incentives for regulatory innovation to counter circumvention. Those who think capital controls are always futile and doomed to failure are simply wrong. Sometimes they fail, and sometimes they work very well. That capital controls inevitably “leak” is besides the point. Evading controls entails costs and risks that discourage flows at the margin. The point is never to stop flows, but to modulate them. Capital controls that are intended to maintain balanced accounts are more likely to succeed than controls intended to sustain or enlarge imbalances. Also, in a world where disruptive financial flows are increasingly due to the official sector, capital controls are less likely to be actively evaded. A private speculator might hide capital flows in overpayments for current goods (and bear a huge risk of whether her partner will honor her legally unenforceable claim). A foreign government would hesitate to play such games for fear of provoking conflict with the government whose laws it would be flouting.

    Speaking personally, I don’t “like” the idea of capital controls any more than I like trade protectionism. I enjoy the freedom to think globally and invest wherever I choose. But the experience of the developing world for half a century and of the developed world over the last decade ought to have convinced all but the most ideological observers that balance of payment matters; that we cannot expect balance to naturally emerge in global markets; and that relying only on self-correction means tolerating massive-scale waste of real resources while flows persist, then indiscriminate destruction and human misery when flows reverse, or when the poor quality of earlier investment decisions becomes revealed. Our choices are to simply accept these costs as the price of freedom, to use the tools of trade protection, or to add a layer of regulation to the financial economy. In a world of bad alternatives, normalizing capital controls is by far the least awful. Capital controls aren’t perfect, but they are much more resistant to corrupt micromanagement than trade controls.

    The process of going from liberal to more managed capital flows won’t be easy, but it needn’t be that hard either. First and foremost, it can be done without sparking trade wars. If a country imposes capital controls to manage its own balance of payments, it needn’t discriminate against any particular foreign power. China (its government or private investors) could continue to buy US Treasuries on precisely the same terms as European investors. The market would determine which flows (of both goods and capital, they are inextricably linked) would continue and which would be blunted based on demand and comparative advantage. In public relations and in fact, managing ones balance of payments wouldn’t be “about” or any particular trade partner, but simply a matter of national prudence. In order to minimize disruption to other economies, a nation could announce a several year timetable over which it would gradually increase controls as necessary to bring its accounts into balance. Rather than the heated rhetoric of trade protection (which usually involves somebody accusing somebody else of cheating or dumping or poisoning), capital account protectors can focus on the hazards of their own financial position, and adopt an apologetic rather than accusatory tone to help trade partners to save face as they find ways to accommodate the adjustment.

Insure depositors, not banks

Raghuram Rajan offers a thoughtful comment on regulating big banks (hat tip Mark Thoma). The upshot is that bigness, interconnectedness, and proprietary trading are difficult to define, and hard caps are likely to be gamed and evaded. Rajan advocates more subtle strategies “such as prohibiting mergers of large banks or encouraging the break-up of large banks that seem to have a propensity for getting into trouble.” That strikes me as weak tea. I’d prefer that regulators explicitly target a diffuse market structure under which any bank can be let to fail, and that they impose graduated-to-prohibitive taxes on a wide variety of markers of bigness and badness in order to meet that target. Successful banks should grow by division rather than accumulation.

Like Ezra Klein, I was especially intrigued by Rajan’s concluding paragraph:

In reality, proposing limits on size and activity is just an attempt to diminish the deleterious effects of another previous and now anachronistic intervention — deposit insurance. When households did not have access to safe deposits, deposit insurance made sense. With the advent of money-market funds, households gained access to near riskless deposits. Money-market runs can be eliminated by marking them to market daily; they do not need deposit insurance. To encourage community-based banks, deposit insurance may still make sense because small banks are poorly diversified and subject to bank runs. But for large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way? Why not phase out deposit insurance as domestic deposits grow beyond a certain size? That would be far more effective in reducing risk than size or activity limits, and far easier to implement.

I’ve a bunch of nits to pick with this: money-market funds are not perfect substitutes for state-guaranteed assets, mark-to-market doesn’t limit aggregate risk or prevent runs (it just makes the race to the exit a bit fairer, and the collapse a bit sharper, as everyone learns when to get nervous at the same time). If large numbers of ordinary households, swayed by yield or convenience, hold funds at an uninsured Chase, Citi, or BoA (cue the television commercials claiming “large, well-diversified banks” to be solid as Gibraltar), that fact would make each of those banks individually too big to fail even in the absence of a “general panic”. No system that expects sales clerks and schoolteachers to monitor financial firms is reasonable or politically sustainable. (If ordinary households can’t be persuaded to do without FDIC insurance, Rajan’s proposal would amount to an end of large depository institutions, which wouldn’t be a bad thing. Depositors would migrate to smaller banks, and large institutions would fund themselves as pure-play investment banks, unless regulated by other means.)

Of course I have a better idea. Rather than insuring banks, the government should insure depositors individually for losses they suffer on deposits at any FDIC-approved bank, up to a pretty high limit (say $1 million, indexed to inflation). Ordinary households would be unaffected by this change, as most families hold balances far less than the insurance cap. They could continue to deposit funds at the FDIC-approved bank of their choice without fear. Affluent households would no longer be able to play the wasteful game of evading insurance limits by splitting funds among different types of accounts and institutions. The affluent would be expected to monitor and help discipline the firms in which they invest. This is both fair and politically credible. It’s fair, because pushing wealth forward in time requires hard information work, and those who wish to push a lot of wealth forward (and earn interest on top!) should contribute to the effort. It’s credible, because ex post facto bailouts for underinsured depositors would be a hard sell when the underinsured include only wealthier depositors, who would not be reduced to penury but, at worst, to a level of affluence most households never achieve, simply by maxing out their government insurance.

Insuring depositors rather than banks wouldn’t, and doesn’t purport to, resolve the too-big/bad/sexy-to-fail problem. It would be a modest change that would eliminate some of the gaming that permits affluent investors to shirk their duty of discipline, and that would improve incentives to monitor by reducing the likelihood that notionally uninsured depositors get bailed out. But all of this matters very little in a world where even junior, unsecured creditors of some banks enjoy an implicit state guarantee.

Update History:

  • 27-January-2010, 5:15 a.m. EST: Touched up the text a bit, fixing some awkward sentences. No substantive changes.

A toy model of money, growth, and inequality

I’ve been trying to develop my intuitions about how inequality might affect aggregate growth. It’s not like this is a new question. Theoretical arguments have been made both ways, and an empirical literature found a consensus in the 1990s (inequality looked bad for growth), then squinted harder to find little relationship in the 2000s. For some careful theorizing about how inequality might harm growth, take a look at this paper by Philippe Aghion, Eve Caroli, and Cecelia Garcia-Penalosa (“ACG”). They tell three stories, with very careful models: i) when capital markets are imperfect, inequality might reduce the efficiency of investment, as the less productive opportunities of the wealthy are funded in preference to the more productive opportunities of the poor; ii) the borrowing required to fund investment under inequality impose agency costs, because entrepreneurs expend less effort when the benefits and costs of their labors are shared with financiers; and iii) unequal access to investment opportunities may combine with financial market imperfections to create macroeconomic downcycles during which savings cannot be efficiently invested.

Those are good stories, and there are others. The oldest story has to do with incentives. The traditional notion of a trade-off between efficiency and equity comes from the idea that redistribution blunts incentives to invest and produce. In almost any model, reducing after-tax returns on investment will reduce investment, ceteris paribus. It is worth pointing out that inequality and redistribution are separate questions. Inequality may be harmful (or helpful) to growth regardless of whether redistribution by the state would would be good policy. That lower after-tax investment returns reduce growth doesn’t really tell us all that much about the effect of inequality. Also, incentives swing both ways: see ACG story (ii) above, or models of effort in tournaments (e.g. Freeman & Gelber via Benign Brodowicz and commenter Indy).

Anyway, there are lots of stories. I want to add one more, and illustrate it with a very simple model. My intuition goes like this: when people are relatively poor, they spend nearly all their income on real goods and services with care, in ways that yield positive returns in present and future consumption. As people grow wealthy, they spend an increasing fraction of their wealth on financial assets, purchases of which only imperfectly translate to productive mobilization of real goods and services. To make my life as a modeler easier, I conjecture that financial assets are phenomenally inefficient — not only do they fail to yield any positive return, but the net expenditure of real goods and services for financial assets is “thrown into the sea”. We’ll see that despite this, under not-entirely-outrageous assumptions, it might be optimal for wealthy agents to purchase an ever larger “stock” of financial assets, but that by doing so rather than mobilizing real resources, they exert a drag on aggregate growth. We’ll find that transfers (or zero-interest loans) of real resources from the issuers of financial assets to the relatively poor can restore growth, and be Pareto optimal if no deductions are made from the claims of the wealthy when real resources are transfered to the poor. In other words, printing money and giving it to poor people (who then buy real resources from the rich, who prefer the insurance value of money to the use value of their marginal goods) can be optimal and noninflationary. We’ll also find that if there is a monopoly issuer of conventionally “safe” financial assets, the value of those assets can be kept stable even if the issuer totally wastes the real resources it receives in exchange for them, and even if the waste and “insolvency” of the issuer is widely known. Effectively, an arbitrarily insolvent Ponzi scheme can be sustained indefinitely due to the usefulness of having a conventional financial claim that agents can use to pool idiosyncratic risks which they cannot contract to diversify. However, if the economy suffers a shock deep enough not only to halt but to reverse the steady state net positive flow of real goods and services from the economy, a devaluation (inflation) or collapse might occur.

This is a shitty little model, not anything an economist would take seriously. Like most models, it’s tendentious — I set out to confirm my intuition that inequality dampens growth via a financial channel, and I’ve done so. Nevertheless, this what I’ve been thinking about lately, and it’s led me to some unexpected conjectures about money. Please read it, if you must read it at all, as a sketchy first draft. (i know, i am such a girl i’ll never change the world.)


Here’s the setup. There’s a population of rational, risk-averse, agents. At any point in time, each agent can exchange goods and services with other agents, or surrender some of their stuff to a monetary authority (government/banking system) to build a stock of money. (When agents trade amongst themselves, it doesn’t matter whether they use money as a medium of exchange, any money holdings are transient.) The exchange and use of real stuff yields a positive instantaneous return on average, but is risky: sometimes real activity works out, but sometimes it fails. The exchange rate between money and real goods and services — the price level — is notionally fixed. We’ll return to the question of whether this presumption of price stability is credible (without state coercion), since monetary claims will be backed by nothing. We simply assume that, as our story begins, agents believe the price level to be stable. Therefore, they view money as a risk-free asset (that pays no interest; the risk-free rate in our economy is zero). Money is the only financial asset: agents can’t buy or sell claims on one another’s production. So agents cannot diversify their exposure to the risk of their real projects. They must decide at each point in time how much of their wealth to plow into risky real stuff, and how much to allocate to safe money. By assumption, there is no systematic risk: individual project returns are uncorrelated. Agents seek to maximize return while managing undiversifiable idiosyncratic risk.

Some technical points (you can skip this paragraph!): Because it makes the math easy, I’ll model returns as normal, and individual agents as having “constant absolute risk aversion (CARA / negative exponential) utility”. I don’t think the assumption of normal returns hurts us much. (This isn’t like a pricing model where fat tails can kill us — fatter tails would just make our agents look more risk-averse and hold more money.) The CARA assumption is less defensible for the very reason it makes the math easy: Under CARA utility, an agent choosing between a high-return risky and low-return risk-free asset always wants to hold a fixed quantity of the risky asset. That’s unrealistic — even at high levels of wealth, I think people typically expand their holdings of risky assets in absolute terms as they grow richer, although they diminish risky holdings as a proportion of their overall portfolio. That is, it’d be more realistic to use a DARA/IRRA utility function, but with the ones I’ve tried, the math is too hard. Qualitatively, though, this doesn’t matter very much. If agents increase their risky holdings in fixed proportion with their wealth or faster (CRRA or DRRA preferences) my story on inequality breaks down (or reverses under DRRA). But as long as agents put an ever greater fraction of their wealth into money-like assets as they grow rich (and I think they do, for informational as well as risk-management reasons), the basic results holds. The curves below with “kinks” would be smoother under a more realistic DARA/IRRA utility function, but the qualitative implications would not change.

Without further ado, here are some pictures.

The top graph displays several initial wealth distributions. Imagine a large population of individuals lined up from poorest to richest, with wealth rising from left to right. The flat, red line represents perfect equality. The purple line represents a highly unequal distribution. The bottom graph displays the expected evolution of GDP for each of those distributions. (Curves are matched to income distributions by color throughout.) Eventually the economy reaches a steady state, in this case at GDP of 10 (an arbitrary quantity). But the more equal distributions reach the steady state more quickly than the unequal distributions, because wealthier people exchange part of their wealth for money rather than putting it to productive use in the real economy.

It might seem odd and unrealistic to imagine an economy that just “tops out” and stops growing. This happens because I haven’t modeled technological change. We can easily augment the model with exogenous growth in technology. The easiest way to do that would be to let both investment returns and absolute risk tolerance grow with technology (that is, to let the numeraire be technology adjusted), and set the risk-free rate to the rate of technology growth. Then we get the more comforting graphs below. We could make other choices about how to model technology, “endogenize” it or rethink how technology affects agent preferences, but that’s not what we’re after right now.

Let’s return to the simple, constant-technology model, and see what happens to money. In the graph below, the solid line represents the aggregate perceived wealth of agents in the economy. The dashed line represents real income, GDP, the goods and services that the economy is actually producing. The gap between the solid and dashed line is the stock of money, backed by nothing but nevertheless part of the perceived wealth of agents in the economy.

Note that the money stock grows earlier in less equal economies. This is the “leakage” that slows their growth. But for all economies, money growth is unbounded, while (technology-adjusted) GDP approaches a steady state. That is, for all economies, eventually the stock of money gets to be much, much larger than the capacity of the economy to produce goods and services. Is it rational, then, for agents to keep adding to their money stock? Can this be a stable arrangement?

The surprising answer is yes, as long as there is no other risk-free asset in the economy. By assumption, agents who choose not to hold money bear idiosyncratic risk: the value of their holdings, while expected to increase, fluctuates in a manner that they dislike. As long as all agents treat money — backed by nothing at all — as a risk-free asset, and there are many agents whose risks are uncorrelated, each agent knows with almost-certainty that whenever their real projects fail, others will have succeeded more than enough so that the flow of goods and services to the monetary authority will be more more than sufficient to accommodate their idiosyncratic withdrawals. As long as the net flow into money is positive at all times, the aggregate stock money is irrelevant. Each agent values her own stock of money, and wants more, because the greater her stock, the greater her entitlement to make withdrawals should she encounter a string of bad events. The growing illusion of wealth produces real benefits, by leaving agents less insecure than they otherwise would have been. The economy is effectively a Ponzi scheme that, under our assumptions, never fails. More formally, it is a Nash equilibrium: each agent’s best strategy, under the assumption that other agents treat money as a stable risk-free asset, is to treat money as a stable risk-free asset. This is true even when all agents are fully aware of the Ponzi-ish nature of the arrangement.

Of course, this benign result depends upon several assumptions, some of them not so realistic. We’ve assumed that all real investments are uncorrelated and money is the only financial asset. If real investment returns are correlated — if there is systematic risk — it is possible there would be a period during which there would be more losses than gains on real investments. Then, rather than happily exchanging goods and services for money, agents in aggregate would try to redeem money for stuff that financial asset issuers don’t actually have. What then? Our model can’t help us — its assumptions are violated at this point, money is no longer a risk-free asset. The value of financial assets could simply collapse à la Bernie Madoff. But qualitatively, if agents can be made to believe that money will continue to offer some insurance value (and if the expected return on unplanned real investment is low and/or the risks are high), then real goods and services could become more expensive in terms of money until the net flow into financial assets matched the net flow out. Rather than a collapse, there would be an inflation. Here the stock of money matters: under almost any circumstance, dollars offer diminishing marginal insurance value. If there is a large stock of dollar claims, then the devaluation required to match inflows and outflows would have to be larger, as people would surrender dollars more easily. Fundamentally, the degree of devaluation would depend upon the demand curve for real goods in suddenly uncertain dollars. If confidence is shaken just a bit, or people hold few dollars, then demand might be price elastic, and a small revaluation might lead to zero net redemptions. If confidence is shaken a lot, if people hold large stocks of dollars, if some shock creates inelastic demand for real goods ad services, then the devaluation (inflation) could be large. In ordinary times, the stock of money is mostly irrelevant, and in fact large stocks of unbacked money creates real benefits. But in extraordinary times, when the flow into money fails, the stock of outstanding money contributes to the likelihood that an inflation will be violent. (Unmodeled demographic changes, rather than investment losses, could also lead to net outflows and valuation crises.)

If a monetary authority has taxing power, could it overcome a shortfall of inflows of real goods and services relative to desired redemptions by taxing? Under our framework, that’d be a tricky thing to try to do. Taxing the money balances of the wealthy doesn’t much affect the flow of resources, except for agents who would have sufficient balances to cover idiosyncratic losses other than for the taxation. So taxing the very rich does nothing, except alter notional insurance balances, while taxing those with little savings does reduce some flows out of money by forcing people to bear losses as hits to consumption rather than drawdowns of money balances. The most effective form of taxation, however, would be to force the poor to exchange goods and services for money, and then surrender the money to the state. Tax receipts from the poor are all real — they cannot be satisfied by drawdowns of notional money balances, and they reduce the net imbalance between flows into money and redemptions very directly. In other words, taxes are effective at preventing a monetary crisis only to the degree the are regressive and harmful to growth. Taxes on rich people with large money balances are only effective if they are confiscatory, bringing those money balances to near zero.

What if we reimpose our “no systematic risk” assumption, so we don’t have to worry about shortfalls, but allow there to be more than one notionally risk-free asset? Then our Nash equilibrium becomes potentially unstable. So long as agents expect some net positive flow to all monetary assets, they are indifferent among them. But that indifference means that no barrier prevents agents from withdrawing claims from one monetary asset and exchanging it for another. If agent behavior is not random, if trends or “sunspots” might affect financial asset choices, and each agent would try to choose whatever asset they expect other agents would predominantly choose. There could be inexplicable runs to and from assets, similar to banks runs, except under our assumptions all agents already know that all monies are in some sense equally insolvent. Runs might be random (or based on unmodeled markers of “confidence”), unless and until only one survived.

Now let’s consider alternatives to the assumption that real goods and services exchanged for money are “thrown into the sea”. We won’t relax the deep (and important) assumption that aggregate wealth is not storable: it must continually reproduce itself via investment. So the monetary authority doesn’t have the option of simply holding the “stock” of goods and services it collects to back the stock of money. So what if, instead of throwing the stuff into the sea, the monetary authority just gives it away? Let’s consider two cases. First, suppose the monetary authority disburses the goods and services it receives to “poor” people. Under our assumptions that would be a Pareto improvement over ocean disposal. Aggregate growth is maximized, as in the perfect equality case (as all real resources would be continually reinvested until all agents reach their desired risky asset portfolio). Suppose the monetary authority transfers the real goods and services it receives back to the wealthy people who surrendered them? Under our assumptions, this sets up an endless loop. Wealthy people would rather have money than real goods and services, so they’d just sell the subsidy back for money. (Despite the apparent absurdity of this, wealthy people would prefer to receive transfers than have them go to the poor, as they gain insurance value from the notional money stock they build by continually receiving and selling back goods.) Transfers to wealthy people yield potentially unbounded growth in the stock of (still unbacked) financial assets, while transfers to those poor enough to invest in the real economy yield growth. Once the economy reaches its steady state, there are no growth-enhancing transfer possibilities left; all agents can maintain their desired level of real investment without transfers, and transfers just increase the notional money stock. Assuming that the monetary authority can’t invest on its own account, it has little to do with the stuff it receives other than to throw it into the sea.

Instead of making transfers, the monetary authority could lend the goods and services it receives from the rich to the poor. Under my assumptions, those sufficiently the poor would borrow and profitably invest if the interest rate charged is less than the expected return, and if resources are lent at the risk-free rate of zero, all those who hadn’t saturated their risky portfolio would be willing to borrow, and the growth rate could be maximized. This corresponds to people’s intuition about how a perfect or transparent financial system would behave. (Interestingly, if the monetary authority lends rather than transfers, growth might last a bit longer than in the perfect equality or transfers-to-the-poor cases, as agents would have to generate somewhat more than their own desired wealth, because some real wealth would continually belong to the monetary authority during the growth phase. Once the economy reaches the steady state, if the monetary authority cannot invest on its own account, the real wealth it holds is surplus and can no longer be reproduced, and so must be thrown into the sea.

If we imagine that the monetary authority can and does invest on its own account as well as private agents, then inequality doesn’t matter and the economy grows indefinitely at the rate of expected return on investment. If we imagine that the monetary authority can and does invest on its own account, and earns higher returns than economic agents, then inequality would be positive for aggregate growth. If we imagine that the monetary authority does things that yield no return but enhance private returns on investment (for example, creating public goods with the resources it purchases by issuing money), we can’t make any prediction about the effect of inequality without modeling the details.

Some observations: The true heart of this model is the idea that, beyond a certain level of wealth, people prefer the security of saving to expanding personal consumption. In real life, I think this is true of most, but not all, people. It’s a condition that I used to characterize, back in the optimistic 1990s, as “post-affluence” or “post-materialism”. In the steady state of this model, there is wealth inequality but consumption equality. The formerly rich are somewhat better insured than the formerly poor, and savvy investment choices can further increase agents’ degree of security (or position in status competitions), but people are satisfied with their level of consumption and don’t much alter it. Changes in consumption patterns result from changes in technology rather than idiosyncratic improvements in economic circumstance. I think this is a state of affairs worth thinking about. Again, in reality, people are not identical, both in terms of levels of consumption at which they’d be content and propensity to switch from consumption to savings at high levels of wealth. But in the 1990s, in my little bubble of opportunity-rich tech types, I did wonder whether we might become a “post-affluent” society, something like what the steady state of this model suggests.

One interesting characteristic of this model is that poor immigrants are good for aggregate growth. As the economy grows, agents become rich and content and cease contributing to growth. Importing poor people who are still striving creates growth and increases steady state GDP, but not GDP per capita (although one could posit indirect spillovers from aggregate growth to technological change, public goods provision, or somesuch). I think there’s something to that.


Some semi-technical miscellany

  • For simplicity, we’ve assumed (unrealistically) that all agents have identical preferences and opportunities. They only differ in their level of wealth. In the real world, peoples’ opportunities and risks vary. In the real world, there are a wide variety of financial assets, some financial asset purchases do affect real investment, and people choose to purchase financial assets rather than real assets in order to capture return, not just to hedge the risks of their own real lives. People may choose financial assets over real assets due to informational problems: high return projects may be available, but it may be difficult or costly to discover them. This model assumes all that away. Agents always know the return distribution they face for real investment; both risk and return are constant. In reality you’d expect diminishing marginal returns to risk (for any given search cost). These effects work in different directions: the fact that financial investment does affect growth-producing real investment by business and government means we are likely to overstate the cost of inequality in the model, but the model excludes many reasons for purchasing financial assets, so it potentially underestimates the scale of inefficient financial asset purchases.

  • We haven’t drawn a distinction between wealth and income inequality, because under the assumptions of our model, real income is always proportional to real wealth. However, perceived wealth includes monetary holdings. Under our assumptions, income eventually decreases as a proportion of perceived wealth, as agents invest in nonyielding money. In the steady state, there is perfect income equality, although the rank order of perceived wealth is preserved (in expectation) from the starting distribution.

  • We haven’t drawn a distinction between “consumption” and “investment”. If agents are rational and have time-consistent preferences, the distinction is immaterial: agents make purchasing decisions that yield a stream of consumption over time, and there’s no reason to treat the enabling of consumption at time zero any differently from consumption at time seven as long as the allocation is optimal. We concern ourselves only with “real expenditure”, and the returns thereon. Our intuitions about the distinction between consumption and investment have to do with lived knowledge that people’s preferences are not time-consistent, that it is hard to defer consumption however “rational” that might be. But even intuitively the distinction between consumption and investment is murky. Is eating consumption or investment? On the one hand, to eat is literally to consume. On the other hand, failing to eat reliably leads to reduced future returns on labor. Maybe some minimal “necessary eating” is investment, and the rest consumption? But we have a notion of poor investment for other goods. Why is it better to consider eating dessert “consumption” rather than superfluous and foolish investment?

  • I’ve been very vague throughout about the distinction between “financial assets” and “money”. That’s intentional but sloppy. Money is the purest example of a financial asset arguably backed by nothing, whose issuers (both governments and banks) may waste, lend, or transfer the real goods and services they receive in exchange for the funds they issue. But other financial assets may be similar, if people purchase them because they seem safer than forward-looking personal spending, and if net issuance results in transfers, loans, or manager perqs rather than direct productive investment. Financial assets whose issuance funds the purchase of real capital goods would count as risky investment rather than money in our model. I also need to think about how purchasing appreciated assets in secondary markets fits in: I think there should be something of an equivalence between assets like money whose increase in aggregate value takes the form of new issue under nominal price stability, and less supply-elastic financial assets which see price appreciation rather than new issue.

Read Scott Winship and Mike Konczal on inequality

Check out the very high quality debate on inequality and middle class living standards between Scott Winship and Mike Konczal. Winship (in two posts) suggests that complaints about middle-class living standards over the past three decades are overdone. Konczal rejoins that even if so, during the last decade something changed, with middle-class income stagnating entirely and debt growth accelerating. Plus, he reminds us, many of the gains in middle class household income prior to the millennium were due to women working more rather than increased wages. Finally, he notes that it’s pretty hard to accentuate the positive for the middle class just now, given the impact of the housing bust and recession. Another piece of the puzzle that Konczal doesn’t address here (but has addressed fabulously elsewhere) is Elizabeth Warren’s point that the operating leverage of middle class households — the proportion of their wealth devoted to fixed necessary expenses — has dramatically increased, leaving families more vulnerable to shocks and worse off in risk-adjusted terms than their (modest) income growth suggests. (Hat tip to Rortybomb commenter RW.)

For the point I’d like to get at about the tension between inequality and stable growth, Kumbaya!, I don’t have to take sides. Winship points out that

what has likely happened is that the very top—the top one-half of one percent—has pulled away from everyone else, though the increase from 1980 to 2009 has probably been fairly modest.

The hypothesis I’m playing around with is that income at the top end of the scale, for a variety of reasons, has a harder time reproducing itself than income going to people whose consumption wants are less completely satiated. (Econogeeks — nonsatiation may not mean what you think it means in a monetary economy under uncertainty.) So even “pareto improving” gains at the top may create a problem for sustaining overall GDP growth. Microeconomics and macroeconomics, alas, need not go together in perfect harmony. Things don’t compose.

I still haven’t made that case — I want to stew on it a bit. More soon, I hope.