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Forcing frequent failures

I’m sympathetic to the view that financial regulation ought to strive not to prevent failures but to ensure that failures are frequent and tolerable. Rather than make that case, I’ll refer you to the oeuvre of the remarkable Ashwin Parameswaran, or macroresilience. Really, take a day and read every post. Learn why “micro-fragility leads to macro-resilience”.

Note that “micro-fragility” means that stuff really breaks. It’s not enough for the legal system to “permit” infrequent, hypothetical failures. Economic behavior is conditioned by people’s experience and expectations of actual events, not by notional legal regimes. As a matter of law, no bank has ever been “too big to fail” in the United States. In practice, risk-intolerant creditors have observed that some banks are not permitted to fail and invest accordingly. This behavior renders the political cost of tolerating creditor losses ever greater and helps these banks expand, which contributes to expectations of future bailouts, which further entices risk-intolerant creditors. [1] In order to change this dynamic, even big banks must actually fail. And they must fail with some frequency. Chalk it up to agency problems (“you’ll be gone, i’ll be gone“) or to human fallibility (“recency bias”), but market participants discount crises of the distant past or the indeterminate future. That might be an error, but as Minsky points out, the mistake becomes compulsory as more and more people make it. Cautious finance cannot survive competition with go-go finance over long “periods of tranquility”.

So we need a regime where banks of every stripe actually fail, even during periods when the economy is humming. If we want financial stability, we have to force frequent failures. An oft-cited analogy is the practice of setting occasional forest fires rather than trying to suppress burns. Over the short term, suppressing fires seems attractive. But this “stability” allows tinder to build on the forest floor at the same time as it engenders a fire-intolerant mix wildlife, creating a situation where the slightest spark would be catastrophic. Stability breeds instability. (See e.g. Parameswaran here and here. Also, David Merkel.) We must deliberately set financial forest fires to prevent accumulations of leverage and interconnectedness that, if unchecked, will eventually provoke either catastrophic crisis or socially costly transfers to creditors and financial insiders.

Squirrels don’t lobby Congress, when the ranger decides to burn down the bit of the forest where their acorns are buried. Banks and their creditors are unlikely to take “controlled burns” of their institutions so stoically. If we are going to periodically burn down banks, we need some sort of fair procedure for deciding who gets burned, when, and how badly. Let’s think about how we might do that.

First, let’s think about what it means for a financial institution, or any business really, to “fail”. Businesses can fail when they are perfectly solvent. They can survive for long periods of time even when they are desperately insolvent. Insolvency is philosophy, illiquidity is fact. Usually we say a business “fails” when it has scheduled obligations that it cannot meet — a creditor must be paid, the firm can’t come up with the money. The consequence of business failure is that creditors — the people to whom obligations were not timely met — become equityholders, often on terms that prior equityholders consider disadvantageous. The business may then be liquidated, so that involuntary equityholders can recover their investments quickly, or it may continue under new ownership, depending on its value as a going concern.

Forcing failure by rendering banks illiquid is not a good idea, for lots of different reasons. A better alternative is to jump straight to the consequence of illiquidity. We’ll say a bank has “failed” when some fraction of its debt is converted to equity on terms that affected creditors and incumbent equityholders would not have voluntarily arranged. [2] “Forced failure” will mean provoking unwelcome debt-to-equity conversions by regulatory fiat.

Failure isn’t supposed to be fun. Forced conversions to equity should be unpleasant both to creditors and incumbent equity. Upon failure, equityholders should experience unwelcome dilution, while creditors should find themselves shorn of predictable payments and bearing equity risk they do not want. Converted equity should not take the form of public shares, but restricted-sale instruments that are intentionally costly to hedge. Over the long-term, ex post as they say, there will be winners and losers from the conversions: If the “failed” bank was “hold-to-maturity” healthy, patient creditors will have received a transfer from equity holders via the dilutative conversion. If the bank turns out to have skeletons in its balance sheet, then converted creditors will lose, bearing a portion of losses that would have been borne entirely by incumbent equityholders. In either case, unconverted creditors (including depositors and public guarantors) will gain from a reduction of risk, as the debt-to-equity conversion improves the capital position of the “failed” bank. And in either case, both creditors and shareholders will be unhappy in the short-term.

One might think of these “forced failures” as what Garrett Jones has called speed bankruptcies. (See also Zingales, or me.) There are devils in details and lots of variations, but as Jones points out, “speed bankruptcy” needn’t be disruptive for people other than affected creditors and shareholders. Managed forest fires do suck for the squirrels, but we’d never be willing to adopt the policy if it weren’t reasonably safe for bystanders. Related ideas would be to frequently force “CoCos” (contingent convertible debt) to trigger or public injections of capital on terms that dilute existing equity.

But if we are going to “force” failures — if these failures are going to be regulatory events rather than outcomes provoked by market counterparties — how do we decide who must fail, and when? There is, um, some scope for preferential treatment and abuse if it becomes a matter of regulatory discretion whose balance sheets get painfully rearranged.

A frequent-forced-failure regime would have to be relative, rule-based, and stochastic. By “relative”, I mean that banks would get graded on a curve, and the “worst” banks would be at high risk of forced failure. That is very different from the present regime, whereunder there is little penalty for being an unusually risky bank as long as your balance sheet seems “strong” in an absolute sense. During good times, behaving like Bear Stearns just makes a bank seem unusually profitable. Given agency costs, recency bias, and the vast uncertainty surrounding outcomes for all banks should a crisis hit, penalizing banks only when they are in direct peril of regulatory insolvency is inadequate. We want to create incentives for firms to compete with one another for prudence as well as for profitability. Even during booms, creditors should have incentives to discriminate between cautious stewards of capital and firms capturing short-term upside by risking delayed catastrophe. The risk of forced conversions to illiquid equity would create those incentives for bank creditors.

Forced failures should obviously be rule-based. The current, discretionary system of bank regulation and enforcement is counterproductive and unjust. Smaller, less connected banks find themselves subject to punitive “prompt corrective action” when they get into trouble, while more dangerous “systemically important” banks get showered with loan guarantees, cheap public capital, and sneaky interventions to help them recover at the public’s expense. That’s absurd. Regulators should determine, in placid times and under public scrutiny, the attributes that render banks systemically dangerous and publish a formula that combines those attributes into rankable quantities. The probability that a bank would face a forced restructuring would increase with the estimated hazard of the bank, relative to its peers.

And “probability” is the right word. Whether a bank is forced to fail should be stochastic, not certain. Combining public sources of randomness, regulators should periodically “roll the dice” to determine whether a given bank should be forced to fail. Poorly ranked banks would have a relatively high probability of failure, very good banks would have a low (but still nonzero) probability of forced debt-to-equity conversion. The dice should be rolled often enough so that forced failures are normal events. For an average bank in any given year, the probability of a forced restructuring should be low. But in aggregate, forced restructurings should happen all the time, even (perhaps especially) to very large and famous banks. They should become routine occurrences that bank investors, whether creditors or shareholders, will have to price and prepare for.

Stochastic failures are desirable for a variety of reasons. If failures were not stochastic, if we simply chose the worst-ranked banks for restructuring, then we’d create perverse incentives for iffy banks to game the criteria, because very small changes in ones score would lead to very large changes in outcomes among tightly clustered banks. If restructuring is stochastic and the probability of restructuring is dependent upon a bank’s distance from the center rather than its relationship with its neighbor, there is little benefit to becoming slightly better than the next guy. It only makes sense to play for substantive change. Also, stochastic failure limits the ability for regulators to tailor criteria in order to favor some banks and disfavor others. (It doesn’t by a long shot eliminate regulators’ ability to play favorites, but it means that in order to fully immunize a favored future employer bank, a corrupt regulator would have to dramatically skew the ranking formula, whereas with deterministic failure, a regulator could reliably exempt or condemn a bank with a series of small tweaks.) It might make sense for the scale of debt/equity conversions to be stochastic as well, so that most forced failures would be manageable, but investors would still have to prepare for occasional, very disruptive reorganizations.

Banking regulation is hard, but in a way it is easier than forest management. As Parameswaran emphasizes, when a forest has been stabilized for too long, it becomes impossible to revert to the a priori smart strategy of managed burns. Too much tinder will have accumulated to control the flames, to permit any fire at all would be to risk absolute catastrophe. It is clear that regulators believe (or corruptly pretend to believe) that this is now the case with our long overstabilized financial system. Lehman, the story goes, was an attempt at a managed burn and it almost blew up the world. Therefore, we must not tolerate any sparks at all in the vicinity of “systemically important financial institutions”. No more Lehmans! [3]

However, unlike physical fire, with bank “failures” there are infinite gradations between quiescence and conflagration. A forced-frequent-failure regime could be phased in slowly, on a well-telegraphed schedule. Both the probability of forced failure and the expected fraction of liabilities converted could rise slowly from their status quo values of zero. Risk-intolerant creditors would, over time, abandon financing dangerous banks at low yields, but they would not flee all at once, and early “learning experiences” would provoke only modest, socially tolerable, losses. Over time, the cost of big-bank finance would rise. Of course, the banking community will cry catastrophe, and make its usual threat, “Nice macroeconomy you got there, ‘shame if something were to happen to the availability of credit.” As always, when bankers make this threat, the correct response is, “Good riddance, not a shame at all, we have tools to expand demand that don’t rely on mechanisms so unstable and combustible as bank credit.” We will never have a decent society until we develop macroeconomic alternatives to loose bank credit. Bankers will simply continue to entangle their own looting with credit provision, and blackmail us into accepting both.

There are a lot of details that would need to be hammered out, if we are to force frequent failures. Should debt/equity conversions strictly follow banks’ debt seniority hierarchy, or should more senior debt face get “bailed in” to haircuts? (Senior creditors would obviously take smaller haircuts than those experienced by junior lenders.) As a matter of policy, do we wish to encourage the over-the-counter derivatives business by exempting derivative counterparties from forced failures, or do we prefer that OTC counterparties monitor bank creditworthiness? (If so, “in the money” contracts with force-failed banks might be partially paid out in illiquid equity.) If risk of forced conversion is relative, banks may try (even more than they already do) to “herd”, to be indistinguishable from their peers so their managers cannot be blamed if anything goes wrong. Herding is already a huge problem in banking — “If everybody does it, nobody gets in trouble” ought to be the motto of the Financial Services Roundtable. (See also Keynes, and Tanta, on “sound bankers”.) Any decent regulatory regime would impose congestion taxes on bank exposures to ensure diversification of the aggregate banking sector portfolio.

These are all policy choices we can make, not barriers to imposing policy. We can, in fact, create a more loosely coupled financial system where risk-intolerant actors are driven to explicitly state-backed instruments and creditors of large private banks genuinely bear risk of losses. The hard part is choosing to do so, when so many of those who rail against “bailouts” and “too big to fail” are protected by, and profit handsomely from, those very things.


This post was provoked by recent correspondence/conversation with Cassandra, The Epicurean Dealmaker, Dan Davies, Pascal-Emmanuel Gobry, Francis O’Sullivan, Ben Walsh and of course Ashwin Parameswaran. And whoever I’ve forgot. Unforgivably. The good stuff is almost certainly lifted from my correspondents. The bad stuff is my own contribution.


[1] Note that “too big to fail” has nothing to do with how Jamie Dimon talks to his cronies in the boardroom. It is a Nash equilibrium outcome in a game played between creditors, bank managers and shareholders, and government regulators. Legal exhortations that try to compel regulators to pursue a poor strategy, given the behavior of creditors and bankers, are not credible. If “the Constitution is not a suicide pact”, then neither was FDICIA with its “prompt corrective action”. Nor will Dodd-Frank be, despite its admirable resolution authority.

[2] Note that “creditors” here might include the state, which is the “creditor from a risk perspective” with respect to liabilities to insured depositors and other politically protected stakeholders.

[3] Some argue that Dodd-Frank’s “living wills” and resolution authority give regulators tools to safely play with fire “next time”, and so they will be more willing to do so. I’m very skeptical of claims they did not have sufficient tools last time around, and don’t believe their incentives have changed enough to alter their behavior next time. Perhaps you, dear reader, are less cynical.

Update History:

  • 20-Oct-2012, 11:35 p.m. EEST: “easier that than forest management”, “should be probabilistic stochastic, not certain”, “aggregate banking sector asset portfolio”

Rational astrologies

Suppose that you are transported back in time several hundred years. You start a new life in an old century, and memories of the future grow vague and dreamlike. You know you are from the future, but the details are chased away like morning mist by a scalding sun. You marry, have children. You get on with things.

Suddenly, your wife becomes ill. She may die. You consult the very best physicians. They discuss imbalances of her humors, and where and how she should be bled. You were never a doctor or a scientist. The men you consult seem knowledgeable and sincere. But all of a sudden you get a flash of memory from your forgotten future. The medicine of this era is really bad. Almost none of what they think they know is true. Some of their treatments do some good, but others are actively harmful. On average, outcomes are neither better nor worse with than without treatment.

You know your insight from the future is trustworthy. Do you let the doctors treat your wife, even pay them handsomely to do so?

Of course you do. With no special scientific or medical talent, you have no means of finding and evaluating an alternative treatment. You do have the option of turning the doctors away, letting nature take its course. From a narrowly rationalistic perspective, you understand that nontreatment would be “optimal”: Your wife’s chances would be just as good without treatment, and you would save a lot of coin. That doesn’t matter. You pay the most respected doctors you can find a great deal of money to do whatever they can do. And it is perfectly rational that you should do so. Let’s understand why.

You know that your wife’s expected medical outcome is unchanged by the treatment. But your “payoff” is not solely a function of that outcome. Whether your wife lives or dies, your future welfare turns crucially on how your actions are viewed by other people. First and foremost, you must consider the perceptions of your wife herself. Your life will be a living hell if your beloved dies and you think she had the slightest doubt that you did everything possible to help her. Your wife has no mad insights from the future. She is a creature of her time and its conventions. She will know your devotion if you hire the best doctors of the city to attend her day and night. She may be less sure of your love if you do nothing, or if you listen to the neighborhood madwoman who counsels feeding moldy bread to the ill.

Moreover, it is not only your wife’s regard to which you must attend. Your children and friends, patrons and colleagues, are observing your behavior. If you call in the respected doctors, you will have done everything you could have done. If you do nothing, or take a flyer on a madwoman, you will not have. Your behavior will have been indefensible. Perhaps you are a freethinker, an intellectual, a noncomformist. That makes for lively dinner conversation. But you are human, and when things get serious, you depend upon the regard of others, both to earn your keep and to shape and sustain your own sense of self. If your wife dies and it is the world’s judgment that you permitted her to die, rationalizations of your actions will ring hollow. You will be miserable in your own skin, and your position in your community will be compromised.

The mainstream medicine of several centuries ago was what I think of as a rational astrology. A rational astrology is a set of beliefs which one rationally behaves as if were true, regardless of whether they are in fact. Rational astrologies need not be entirely fake or false. Like bullshit, the essential characteristic of a rational astrology is the indifference to truth or falsehood of the factors that compel ones behavior. Some rational astrologies may turn out to be largely true, and that happy coincidence can be a great blessing. But they are still a rational astrologies to the degree the factors that persuade us to behave as though the beliefs are true are not closely related to the fact of their truth. The beliefs that undergird modern medicine may represent a well-founded characterizations of reality. But, now as centuries ago, most of us act as if those beliefs are true regardless of own judgments, especially when giving advice or making decisions for other people. Medicine remains a rational astrology. We hope that our truth-seeking institutions — universities and hospitals, the scientific method and peer review — have created convergence between the beliefs we behave as if are true and those that actually are true. But we behave as if they are true regardless.

There is nothing very exotic about all this. It is obvious there can be advantage in deferring to convention and authority. But rational astrologies are a bit more interesting, and a bit more insidious, than wearing a tie to get ahead in your career. When an aspiring banker puts on a suit, he may compromise his personal fashion sense, but his intellect and integrity are intact. He knows that he is conforming to a fairly arbitrary convention, because that is what is socially required of him. Rational astrologies refer to conventional beliefs adherence to which confers important benefits. In order to gain the benefits, an individual must persuade himself that the favored beliefs are in fact true, or else pretend to believe and know himself to be a cynical prevaricator. Either choice is problematic. If one embraces an orthodoxy as true regardless of the evidence, one contributes to what may be a misguided and destructive consensus. If one pretends whenever obeisance is socially required, it becomes hard to view oneself as a person of integrity, or else one must adopt a very sophisticated and contextualized notion of integrity. The vast majority of us, I think, avoid the cognitive dissonance and gin up a sincere deference to the conventional beliefs that it is in our interest to hold. When confronted with opposing evidence, we may toy with alternative viewpoints. But we stick with the consensus until the consensus shifts. And, after all, who could blame us?

After all, who could blame us? That is what drives rational astrologies, the fixative that seals them into place. In financial terms, behavior in accordance with conventional wisdom comes bundled with extremely valuable put options that are not available when we deviate. If, after an independent evaluation of the evidence, I make a medical decision considered “quack” and it doesn’t work out, I will bear the full cost of the tragedy. The world will blame me. I will blame myself, if I am an ordinarily sensitive human. If I do what authorities suggest, even if the expected outcome is in fact worse than with the “quack” treatment, then it will not be all my fault if things go bad. I will not be blamed by others, or put in jail for negligent homicide. The consolation of peers will help me to console myself that I did all that could and should have been done. If you understand how to value options, then you understand that the value of hewing to convention is increasing in uncertainty. If I am certain that the “quack” treatment will work, I will lose nothing by showing the imposing men in white coats an upraised middle finger. But even if I am quite sure the average outcome under the quack treatment is better than with the conventional treatment, if there is sufficient downside uncertainty surrounding the outcomes, the benefit of convention will come to exceed the cost.

If you knew with perfect certainty that a conventional cancer treatment had a 10% likelihood of success and a crazy unconventional “quack” treatment had a 10.1% likelihood, which one would you choose for a loved one? I’d like to think I’m good enough and courageous enough to choose door number two. But I like to think a lot of things. In the real world, of course, we never know with perfect certainty that conventional beliefs are wrong, and we can always console ourselves that we are imperfect judges and perhaps it is the best strategy to defer to social consensus. In any given case, that may be true or it may not be. But it is certainly convenient. It allows us to collect a lot of extremely valuable put options, and compels us to believe and behave in very conventional ways.

I see rational astrologies everywhere. I think they are the stuff that social reality is made of, bones of arbitrary belief that masquerade as truth and shape every aspect of our lives and institutions.

We crave rational astrologies very desperately, so much that we habitually and quite explicitly embed them into our laws. Regulations often provide “safe harbors”, practices that may or may not actually live up to the spirit and intent of the legislative requirement, but which if adhered to immunize the regulated parties from sanction. People grow quickly indifferent to the actual purpose of these law but very attentive to the prerequisites for safe harbor. Rational astrologies are conventional beliefs adherence to which elicits provision of safe harbor by the people around us, socially if not legally.

The inspiration for this post was a wonderful conversation (many moons ago now) between Bryan Caplan and Adam Ozimek on the value of “sheepskin”, a college degree. Caplan is a proponent of the “signalling model” of higher education, which suggests that rather than “educating” students in a traditional sense, college provides already able students with a means of signalling to employers preexisting valuable characteristics like diligence and conformity. Ozimek is sympathetic to the traditional “human capital” story, that we gain valuable skills through education and achievement of a college degree reflects that accomplishment. Both of them are trying to explain the wage premium that college graduates enjoy.

I’m pretty agnostic to this debate — I think people really do learn stuff in college, but I think attaining a degree also reflects and signals all kinds of preexisting characteristics about the sort of people who do it. I’d add the “social capital” story to the mix, that college students make connections, with peers, faculty, and institutions, that increase their likelihood of being placed in high-wage positions. (And, I’d argue, actual graduation is an important consummation of membership in “the club”, so post-college social and institutional connections are weaker for those who don’t collect their sheepskin.)

But even if none of those stories were true, “rational astrology” would be sufficient to explain a large college wage premium.

Suppose that it is merely conventional to believe that college graduates are better job candidates than non-graduates, and that graduates of high-prestige colleges are better than graduates of low prestige colleges. Suppose that in fact, the distribution of degrees is wholly orthogonal to the ability of job candidates to succeed, but that outcomes are uncertain and there is no sure predictor of employee success.

Consider the situation of a hiring decisionmaker at a large firm. She reads through a lot of resumés and interviews candidates. She develops hunches about who is and isn’t good. Our decisionmaker has real ability: the people she thinks are good are, on average, substantially better than the people she thinks are not so good. But there is huge uncertainty surrounding hiring outcomes. Often even people in her “good” group don’t work out, and each failed hire is an emotionally and financially costly event for the firm. How will our hiring agent behave? If she is rational, whenever possible, she will choose people from her “good” pile who also went to prestigious colleges. She will be entirely indifferent to the actual untruth of the claim that Harvard grads are “good”. She will choose the Harvard grad whenever possible, because if a Harvard graduate doesn’t work out, she will be partially immunized from blame for the failure. If she had chosen a person who, according to her judgment, was an equally promising or even better candidate but who had no college degree, and that candidate didn’t work out, her choice would be difficult to defend and her own employment might be called into question. Thus, whenever possible, hiring decisionmakers rationally choose the Harvard man over similar or even slightly more promising candidates without the credential, and would rationally do so even if she understands that a Harvard degree contains no information whatsoever about the quality of the candidate, but that it is conventional to pretend that it does. People hiring for more prestigious and lucrative positions attract larger pools of applicants, and have greater ability to find Harvard grads not very much less promising than other applicants, and so rationally hire them. People hiring for less remunerative positions attract fewer prestige candidates of acceptable quality, and so must do without the valuable protection a candidate’s nice degree might confer. Candidates with prestige degrees end up disproportionately holding higher paid jobs, for reasons that have nothing to do with what the degree says about them, and everything to do with what the degree offers to the person who hires them.

This is not rocket science. It is a commonplace to point out that “no one ever got fired for going with [ Harvard / Microsoft / IBM / Goldman Sachs ]”. An obvious corollary of that is that it would be very valuable to become the thing that no one ever got fired for buying. One way of becoming the safe choice is by being really, really good, sure. But I don’t think it’s overly cynical to suggest that actual quality is not always well correlated with being the unimpeachable hire, and that once, somehow, an organization gains that cachet, a lot of hiring occurs that is somewhat insulated from the actual merit of the choice. [ Harvard / Microsoft / IBM / Goldman Sachs ] credentials may be informative of quality, or they may not, but they are very valuable regardless, once it becomes conventional to treat them as if they signify quality.

Rational astrologies are very difficult to dislodge. People who have relied upon them in the past have a stake in their persisting. More importantly, present and future decisionmakers require safe harbors and conventional choices, and unless it is clear what new convention is to be coordinated around, the old convention remains the obvious focal point. Very visible anomalies are insufficient to undo a rational astrology. There needs to be a clear alternative that is immune to the whatever called the old beliefs into question. The major US ratings agencies are a fantastic example. They could not have performed more poorly during last decade’s credit bubble. But regulators and asset managers require some conventional measure of quality around which to build safe harbors. Lacking a clearly superior alternative, we prefer to collectively ignore indisputable evidence of inadequacy and corruption, and have doubled down on the convention that ratings are informative markers of quality. Asset managers still find safety in purchasing AAA debt rather than unrated securities on which they’ve done their own due diligence. We invent and sustain astrologies because we require them, not because they are true.

The process by which rational astrologies are chosen is the process by which the world is ruled. The United States is the world’s financial power because it is conventional to pretend that the US dollar is a safe asset, and so long as it is conventional it is true and so the convention is very difficult to dislodge. Economics as a discipline has not performed very well from the perspective of commonsensical outside observers like the Queen of England. But the conventions of economic analysis are the rational astrology of technocratic government, and decisions that can’t be couched and justified according to those conventions cannot be safely taken by policy makers. Policy is largely a side effect of the risk-averse behavior of political careerists, who rationally parade their adherence to this moment’s conventions as enthusiastically as noblemen deferred to pronouncements of a court astrologer in an earlier time. We can only hope that the our era’s conventions engender better policy as a side-effect than attention to the movement of the stars. (As far as I am concerned, the jury is still out.) But it is not individuals’ independent judgment of the wisdom of these conventions that guides collective behavior. Our behavior, and often our sincere beliefs, are largely formed in reaction to the terrifying accountability that comes with making consequential choices unconventionally. Our rational astrologies are at the core of who we are, as individuals and as societies.

Trade-offs between inequality, productivity, and employment

I think there is a tradeoff between inequality and full employment that becomes exacerbated as technological productivity improves. This is driven by the fact that the marginal benefit humans gain from current consumption declines much more rapidly than the benefit we get from retaining claims against an uncertain future.

Wealth is about insurance much more than it is about consumption. As consumers, our requirements are limited. But the curve balls the universe might throw at us are infinite. If you are very wealthy, there is real value in purchasing yet another apartment in yet another country through yet another hopefully-but-not-certainly-trustworthy native intermediary. There is value in squirreling funds away in yet another undocumented account, and not just from avoiding taxes. Revolutions, expropriations, pogroms, these things do happen. These are real risks. Even putting aside such dramatic events, the greater the level of consumption to which you have grown accustomed, the greater the threat of reversion to the mean, unless you plan and squirrel very carefully. Extreme levels of consumption are either the tip of an iceberg or a transient condition. Most of what it means to be wealthy is having insured yourself well.

An important but sad reason why our requirement for wealth-as-insurance is insatiable is because insurance is often a zero-sum game. Consider a libertarian Titanic, whose insufficient number of lifeboat seats will be auctioned to the highest bidder in the event of a catastrophe. On such a boat, a passenger’s material needs might easily be satisfied — how many fancy meals and full-body spa massages can one endure in a day? But despite that, one could never be “rich enough”. Even if one’s wealth is millions of times more than would be required to satisfy every material whim for a lifetime of cruising, when the iceberg cometh, you must either be in a top wealth quantile or die a cold, salty death. The marginal consumption value of passenger wealth declines rapidly, but the marginal insurance value of an extra dollar remains high, because it represents a material advantage in a fierce zero-sum competition. It is not enough to be wealthy, you must be much wealthier than most of your shipmates in order to rest easy. Some individuals may achieve a safe lead, but, in aggregate, demand for wealth will remain high even if every passenger is so rich their consumption desires are fully sated forever.

Our lives are much more like this cruise ship than most of us care to admit. No, we don’t face the risk of drowning in the North Atlantic. But our habits and expectations are constantly under threat because the prerequisites to satisfying them may at any time become rationed by price. Just living in America you (or at least I) feel this palpably. So many of us are fighting for the right to live the kind of life we always thought was “normal”. When there is a drought, the ability to eat what you want becomes rationed by price. If there is drought so terrible that there simply isn’t enough for everyone, the right to live at all may be rationed by price, survival of the wealthiest. Whenever there is risk of overall scarcity, of systemic rather than idiosyncratic catastrophe, there is no possibility of positive-sum mutual-gain insurance. There is only a zero-sum competition for the right to be insured. The very rich live on the very same cruise ship as the very poor, and they understandably want to keep their lifeboat tickets.

If insurance were not so valuable, it would be perfectly possible to have very high levels of inequality and have full employment. The very rich might employ endless varieties of servants to cater to their tiniest whims. They’d get little value from the marginal new employee, but the money they’d lose by paying a salary would have very little value to them, so the new hire could be a good deal. But because of the not-so-diminishing insurance value of wealth, the value of hiring someone to scratch yet another trivial itch eventually declines below the insurance value of holding property or claims. There is a limit to how many people a rich person will employ, directly or indirectly.

In “middle class” societies, wealth is widely distributed and most peoples’ consumption desires are not nearly sated. We constantly trade-off a potential loss of insurance against a gain from consumption, and consumption often wins because we have important, unsatisfied wants. So we employ one another to provide the goods and services we wish to consume. This leads to “full employment” — however many we are, we find ways to please our peers, for which they pay us. They in turn please us for pay. There is a circular flow of claims, accompanied by real activity we call “production”.

In economically polarized societies, this dynamic breaks down. The very wealthy don’t employ everybody, because the marginal consumption value of a new hire falls below the insurance value of retaining wealth. The very poor consume, but only the most basic goods. In low productivity, highly polarized economies, we observe high-flying elites surrounded by populations improvising a subsistence. The wealthy retain their station by corruption, coercion, and extraction while the poor employ themselves and one another in order to satisfy these depredations and still survive. Unemployment is not a problem, exactly, but poverty is. (To be “unemployed” in such a society means not to be idle, but to be laboring for an improvised subsistence rather than working for pay in the service of the elite.)

Idle unemployment is a problem in societies that are highly productive but very unequal. Here basic goods (food, clothing) can be produced efficiently by the wealthy via capital-intensive production processes. The poor do not employ one another, because the necessities they require are produced and sold so cheaply by the rich. The rich are glad to sell to the poor, as long as the poor can come up with property or debt claims or other forms of insurance to offer as payment. [1] The rich produce and “get richer”, but often they don’t much feel richer. They feel like they are running in place, competing desperately to provide all the world’s goods and services in order to match their neighbors’ hoard of financial claims. However many claims they collectively earn, individually they remain locked in a zero-sum competition among peers that leaves most of them forever insecure.

It is the interaction of productivity and inequality that makes societies vulnerable to idle unemployment. The poor in technologically primitive societies hustle to live. In relatively equal, technologically advanced societies, people create plenty of demand for one another’s services. But when productivity and inequality are combined, we get a highly productive elite that cannot provide adequate employment, and a mass of people who preserve more value by remaining idle and cutting consumption than by attempting low-productivity work. (See “rentism” in Peter Frase’s amazing Four Futures.)

One explanation for our recent traumas is that “advanced economies” have cycled from middle-class to polarized societies. We had a kind of Wile E. Coyote moment in 2008, when, collectively, we could no longer deny that much of the debt the “middle class” was generating to fund purchases was, um, iffy. So long as the middle class could borrow, the “masses” could simultaneously pay high-productivity insiders for efficiently produced core goods and pay one another for yoga classes. If you didn’t look at incomes or balance sheets, but only at consumption, we appeared to have a growing middle class economy.

But then it became impossible for ordinary people to fund their consumption by issuing debt, and it became necessary for people to actually pay down debt. The remaining income of the erstwhile middle class was increasingly devoted to efficiently produced basic goods and away from the marginal, lower productivity services that enable full employment. This consumption shift has the effect of increasing inequality, so the dynamic feeds on itself.

We end up in a peculiar situation. There remains technological abundance: “we” are not in any real sense poorer. But, as Izabella Kaminska wonderfully points out, in a zero-sum contest for relative advantage among producers, abundance becomes a threat when it can no longer be sold for high quality claims. Any alternative basis of distribution would undermine the relationship between previously amassed financial claims and useful wealth, and thereby threaten the pecking order over which wealthier people devote their lives to stressing and striving. From the perspective of those near the top of the pecking order, it is better and it is fairer that potential abundance be withheld than that old claims be destroyed or devalued. Even schemes that preserve the wealth ordering (like Steve Keen’s “modern jubilee“) are unfair, because they would collapse the relative distance between competitors and devalue the insurance embedded in some people’s lead over others.

The zero-sum, positional nature of wealth-as-insurance is one of many reasons why there is no such thing as a “Pareto improvement”. Macroeconomic interventions that would increase real output while condensing wealth dispersion undo the hard-won, “hard-earned” insurance advantage of the wealthy. As polities, we have to trade-off extra consumption by the poor against a loss of insurance for the rich. There are costs and benefits, winners and losers. We face trade-offs between unequal distribution and full employment. If we want to maximize total output, we have to compress the wealth distribution. If inequality continues to grow (and we don’t reinvent some means of fudging unpayable claims), both real output and employment will continue to fall as the poor can serve one another only inefficiently, and the rich won’t deploy their capital to efficiently produce for nothing.

Distribution is the core of the problem we face. I’m tired of arguments about tools. Both monetary and fiscal policy can be used in ways that magnify or diminish existing dispersions of wealth. On the fiscal side, income tax rate reductions tend to magnify wealth and income dispersion while transfers or broadly targeted expenditures diminish it. On the monetary side, inflationary monetary policy diminishes dispersion by transferring wealth from creditors to debtors, while disinflationary policy has the opposite effect. Interventions that diminish wealth and income dispersion are the ones that contribute most directly to employment and total output. But they impose risks on current winners in the race for insurance.

Why did World War II, one of the most destructive events in the history of world, engender an era of near-full employment and broad-based prosperity, both in the US where capital and infrastructure were mostly preserved, and in Europe where resources were obliterated? People have lots of explanations, and I’m sure there’s truth in many of them. But I think an underrated factor is the degree to which the war “reset” the inequalities that had developed over prior decades. Suddenly nearly everyone was poor in much of Europe. In the US, income inequality declined during the war. Military pay and the GI Bill and rationing and war bonds helped shore up the broad public’s balance sheet, reducing indebtedness and overall wealth dispersion. World War II was so large an event, organized and motivated by concerns so far from economic calculation, that squabbles between rich and poor, creditor and debtor, were put aside. The financial effect of the war, in terms of the distribution of claims in the US, was not very different from what would occur under Keen’s jubilee.

Although in a narrow sense, the very wealthy lost some insurance against zero-sum scarcities, the post-war boom made such scarcities less likely. It’s not clear, on net (in the US), that even the very wealthy were “losers”. A priori, it would have been difficult to persuade wealthy people that a loss of relative advantage would be made up after the war by a gain in absolute circumstance for everyone. There is no guarantee, if we tried the jubilee without the gigantic war, that a rising tide would lift even shrinking yachts. But it might very well. That’s a case I think we have to make, before some awful circumstance comes along to force our hand.

[1] It is interesting that even in very unequal, high productivity societies, one rarely sees the very poor reverting to low-tech, low productivity craft production of goods the wealthy can manufacture efficiently. One way or another, the poor in these societies get the basic goods they need to survive, and they mostly don’t do it by spinning their own yarn or employing one another to sew shirts. One might imagine that once people have no money or claims to offer, they’d be as cut off from manufactures as subsistence farmers in a low productivity society. But that isn’t so. Perhaps this is simply a matter of charity: rich people are human and manufactured goods are cheap and useful gifts. Perhaps it is just entropy: in a society that mass produces goods, it would take a lot of work to prevent some degree of diffusion to the poor.

However, another way to think about it is that the poor collectively sell insurance against riot and revolution, which the rich are happy to pay for with modest quantities of efficiently produced goods. “Social insurance” is usually thought of as a safety net that protects the poor from risk. But in very polarized societies, transfer programs provide an insurance benefit to the rich, by ensuring poorer people’s dependence on production processes that only the rich know how to manage. This diminishes the probability the poor will agitate for change, via politics or other means. Inequality may be more stable in technologically advanced countries, where inexpensive goods substitute for the human capital that every third-world slum dweller acquires, the capacity and confidence to improvise and get by with next to nothing.

Update History:

  • 4-Aug-2012, 6:10 p.m. EEST: Thanks to @EpicureanDeal for calling attention to my abysmal use of prepositions. Modified: “we have to trade-off extra consumption for by the poor against a loss of insurance by for the rich.” Also, eliminated a superfluous “the”: “The zero-sum, positional nature of the wealth-as-insurance is..”
  • 8-Oct-2012, 1:20 a.m. EEST: “If there is drought terrible so terrible”; “Perhaps this is simply a matter of the charity”

Michal Kalecki on the Great Moderation

So, it is to my great discredit that I had not read Kalecki’s Political Aspects of Full Employment (html, pdf) before clicking through from a (characteristically excellent) Chris Dillow post. There is little I have ever said or thought about economics that Kalecki hadn’t said or thought better in this short and very readable essay.

Here is Kalecki describing with preternatural precision the so-called “Great Moderation”, and its limits:

The rate of interest or income tax [might be] reduced in a slump but not increased in the subsequent boom. In this case the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy. The same would arise if it were attempted to maintain full employment by stimulating private investment: the rate of interest and income tax would have to be reduced continuously.

Dude wrote that in 1943.

Let’s check out what FRED has to say about interest rates during the era of the lionized, self-congratulatory central banker:

Yeah, those central bankers with their Taylor Rules and DSGE models were frigging brilliant. New Keynesian monetary policy was, like, totally a science. Who could have predicted that engineering a secular collapse of interest rates and incomes tax rates (matched, of course, by an explosion of debt) might, for a while, moderate business and employment cycles in a manner unusually palatable to business and other elites? Lots of equations were necessary. No one would have guessed that, like, 70 years ago.

The bit I’ve quoted is perhaps the least interesting part of the essay. I’ve chosen to highlight it because I hold a churlish grudge against the “Great Moderation”.

Bloggers say this all the time, but really, if you have not, you should read the whole thing.

Time and interest are not so interesting

I wanted to add a quick follow-up to the previous post, inspired by its very excellent comment thread. (If you do not read the comments, I’ve no idea what you are doing at this site; I am always pwned by brilliant commenters.)

Cribbing Minsky, I defined the core of what a bank does as providing a guarantee. Bill Woolsey and Brito wonder whatever happened to maturity transformation, the traditional account of banks’ purpose? Nemo and Alex ask about interest, which I rather oddly left out of my story.

Banks do a great many things. They certainly do charge interest, as well as a wide variety of fees, both related and unrelated to time. Banks do borrow short and lend long, and so might be expected to bear and be compensated for liquidity, duration, and refinancing risk. Banks also purchase office supplies, manage real estate, and buy advertising spots. Banks do a lot of things.

But none of those are things that banks do uniquely. Banks compete with nonbank finance companies and bond markets for the business of lending at interest, and nearly every sort of firm can and occasionally does borrow short to finance long-lived assets. There is no obvious reason why any special sort of intermediary is needed to mediate exchanges across time of the right to use real resources. As Ashwin Parameswaran points out, there is no great mismatch between individuals’ willingness to save long-term and requirements by households and firms for long-term funds. Banks themselves largely hedge the maturity mismatch in their portfolios, outsourcing much of the whatever risks arise from any aggregate mismatch to other parties. Once upon a time, before we could swap interest rate exposures and sell bonds to pension funds, perhaps there was a special need for banks as maturity transformers. But if that was banks’ raison d’être, we should expect their obsolescence any time now.

But that is not and never was banks’ raison d’être, however conventional that story might be. Banks’ role in enabling transactions is and has always been much more fundamental than their role in lending at interest over long periods of time. It is not for nothing that we sometimes refer to cash money as “bank notes”. In some times and places, paper bills issued by private banks served as the primary means of commercial exchange. Here and now, the volume of exchange of bank IOUs to conduct transactions entirely dwarfs the scale of loans intended to survive for an extended length of time. When we buy and sell with credit and debit cards, merchants pay a fee for nothing more than a banks’ guarantee of a customers’ payment. Banks issue deposits to merchants with varying degrees of immediacy for these purchases, but charge no interest at all to debit and nonrevolving credit card customers.

Interest over time is, of course, at the center of how banks make money. But the question is why banks have any advantage over bond investors and nonbank finance companies in earning an interest spread. One traditional story has to do with relationship banking: local banks know local businesses (in part by having access to the history of their deposit accounts, in part because of social and community connections), and are able to lend profitably and consistently to firms whose creditworthiness other lenders could not evaluate, and can helpfully smooth over time variations in lending interest rates due to changes in the firm’s financial situation over time because the ongoing relationship prevents firms from jumping during periods when they are “overcharged”. I think there is something to this story historically, but fear it’s growing less and less relevant as the business consolidates into megabanks that require “hard” centrally verifiable statistics rather than “soft” local information to justify making credit decisions. In any case, if managing relationships actually is banks’ special advantage, note that it has nothing to do with maturity transformation and everything to do with evaluating creditworthiness and providing a guarantee.

Even if there’s something to the relationship banking story, it’s not sufficient to explain the resilient centrality of banks. Why can’t local nonbank finance companies couldn’t enter into persistent relationships with firms, evaluate creditworthiness, and earn the same smoothed interest rates as banks? Banks’ advantage in earning an interest rate spread comes ultimately not from anything special about their portfolio of assets, but from what is special about their liabilities. Banks pay no interest at all or very low interest rates on a significant fraction of their liabilities, low-balance checkable demand deposits. The class of bank creditors called “depositors” accepts these low rates because 1) they deem the bank to be highly creditworthy, and so don’t demand a credit spread; and 2) they gain an in-kind liquidity benefit because “bank deposits” serve as near perfect substitutes for money.

To me, a bank is any entity that can issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered. Bill Gates can issue liabilities that will be accepted as near-perfect substitutes for money, but Gates is not a bank: his liabilities are viewed as creditworthy precisely because he is rich. The value of his assets far exceed his liabilities; he is not a highly levered entity. Goldman Sachs, on the other hand, was a bank even before it received its emergency bank charter from the Federal Reserve. Prior to the financial crisis, despite being exorbitantly levered and having no FDIC guarantee, market participants accepted Goldman Sachs’ liabilities as near substitutes for money and were willing to leave “cash” inexpensively in the firms care. The so-called “shadow banks”, the conduits and SIVs and asset-backed securities, were banks before the financial crisis, because their highly rated paper was treated and traded as a close substitute for cash despite the high leverage of the issuing entities. Shadow banks wrapped guarantees around a wide variety of promises that, after a while, we wished they hadn’t.

Maturity transformation, issuing inexpensive liquid promises today in exchange for promises that pay a high rate of interest over a period of time, is one strategy that banks use to exploit the advantages conferred by the resilient moneyness of their liabilities. Issuing guarantees for a fee — swapping their money-like liabilities in exchange for some other party’s less money-like IOUs — is another way that banks exploit their special advantage. These activities are not mutually exclusive: lending at interest over time and bundling the price of the guarantee into a “credit spread” embedded in the interest rate combines these two strategies.

But maturity transformation is really nothing special for banks: depositors’ willingness to hold the liabilities of highly levered banks at low interest means banks can invest at scale in almost anything and earn a better spread than other institutions. Whether that spread comes from bearing maturity risk or credit risk or currency risk or whatever doesn’t matter. What is uniquely the province of banks is their ability to issue, in very large quantities relative to their capital, money-like liabilities in exchange for the illiquid and decidedly unmoneylike promises of other parties, and thereby effectively guarantee those promises. It is this capability that makes banks special and so central in enabling commerce at scale among mistrustful strangers.

A final point about banks as I’ve defined them is that they simultaneously ought not exist and must exist. In financial theory, the interest demanded of an entity by its liability holders should increase in the leverage of the institution. There ought not to be entities that can “lever up” dramatically, often against opaque and illiquid assets, without creditors demanding a large premium to hold its deposits. Yet banks exist, and existed long before deposit insurance immunized some creditors from some of the risks of bank leverage. They existed in spite of financial theory, with the help of marble columns and good salesmanship and perhaps the small assurance that came from knowing that if depositors were ruined, the banker would be too. Under a wide range of political and institutional settings, banks come into the world and gain people’s trust despite their inherent fragility, because humans are susceptible to elevating gods, because commerce requires scalable and trustworthy guarantors. People require commerce enough to collectively hope for the best and overlook the inherent contradiction between leverage and trustworthiness. Nowadays, we mostly rely on the state to overcome this contradiction. But recall that no one thought that AAA tranches of structured vehicles had a state guarantee, yet they were often treated as near-money assets. It was just unthinkable that the rating agencies could be so wrong on so vast a scale. If you think about it, you’ll come up with other examples of entities that became able to act as banks, to issue near-money paper despite high leverage, because failure became conventionally unthinkable, even in the absence of any state guarantee or ability to extract one via the knock-on costs of failure. Our propensity to anoint banks is ultimately a social phenomenon, not a product of economic rationality.

Then the state itself is a special kind of bank. Like any bank, the state is perfectly creditworthy in its own banknotes. But unlike other banks, many states make no promise that their notes should be redeemable for anything in particular. “Currency-issuer” states (as the MMTers put it) are highly creditworthy because they don’t make clear promises they might be ostentatiously forced to break. That the failure of states is conventionally unthinkable lends another layer of resilience to the state-as-bank. Successful states use their capacity to intervene in economies — both gently through good stewardship and roughly via taxation — to ensure that the liabilities they issue remain valuable and liquid in commerce. This capacity to intervene renders states and state-guaranteed banks somewhat more resilient than private banks, although not infinitely so. Ultimately the value of any state’s irredeemable notes depends on its capacity to organize and tax valuable real production.

Addendum: Note that the subsidy to sellers described in the previous post depends specifically on the notion of banking systems organized and guaranteed by the state, rather than the more general definition of banks used in this piece. A person who surrendered some real good or service directly for the AAA paper of some CDO bore risk and probably got screwed. But if the same vendor surrendered a real resource for Citibank deposits which had been issued to the buyer against that same AAA paper as collateral, the seller was protected from the risk engendered by her semi-transaction. (“Semi”, because she surrendered something real, but received nothing real in return, creating a risk of nonreciprcation that did not exist before, see e.g. Graeber). It is the state guarantee of bank IOUs, whether explicit or tacit, that effectively socializes the risk of a sale, rather than merely obscuring it or rendering it conventionally unthinkable.

Update History:

  • 15-Jul-2012, 8:15 p.m. EEST: Added addendum re importance of state guarantee to the engineering of a subsidy to sellers.
  • 16-Jul-2012, 4:55 a.m. EEST: Fixed an ambiguously phrased sentence, many thanks to Ritwik for pointing out the issue: “requirements by households and firms for long-term savings funds.”
  • 16-Jul-2012, 5:05 a.m. EEST: “somewhat more resilient than more circumscribed private banks”, “against the that same AAA paper as collateral”

What is a bank loan?

When a bank makes a loan, does it create money “from thin air“? Are banks merely intermediaries, where “if people are borrowing, other people must be lending“? I consider these sorts of questions less and less helpful. Let’s just understand what a bank loan is, in terms of real resources and risk.

Suppose I go to my local bank and ask for a loan. The bank says yes, and suddenly there is “money in my account” where there was not before. Am I now a “borrower” and the bank a “creditor”?

No. Not at all. The transaction that has occurred is fully symmetrical. It is as accurate to say that the bank is in my debt as it is is to say that I am in debt to the bank. The most important thing one must understand about banking is that “money in the bank” also known as “deposits” are nothing more or less than bank IOUs. When a bank “makes a loan”, all it does is issue some IOUs to a borrower. The borrower, for her part, issues some IOUs to the bank, a promise to repay the loan. A “bank loan” is simply a liability swap: I promise something to you, you promise something of equal value to me. Neither party is in any meaningful sense a creditor or a borrower when a loan is initiated.

Now suppose that after accepting a loan, I “make a purchase” from someone who happens to hold an account at my bank. That person supplies to me some real good or service. In exchange, I transfer to her my “deposits”, my IOUs from the bank. Suddenly, it is meaningful to talk about creditors and debtors. I am surely in somebody’s debt: someone has transferred a real resource to me, and I have done nothing for anyone but mess around with financial accounts. Conversely, the seller is surely a creditor: they have supplied a real service and are owed some real service in exchange. It would be natural to say, therefore, that the seller is the creditor and I, the purchaser, am the debtor, and the bank is just a facilitating intermediary. That is one perspective, a real resources perspective.

But it is an incomplete perspective. Because in fact, the seller would not accept my debt in exchange for the goods and services she supplies. If I wrote her a promise to perform for her some service of equal value in the future (which might include surrendering crisp dollar bills), she would not accept that promise as a means of payment. I circumvent her fear by writing to the bank precisely the promise that the vendor would not accept and having the bank “wrap” my promise beneath its own. The bank’s job is not to “lend” anything in any meaningful sense. The bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants to borrow. The bank’s role is to transform questionable promises into sound promises. It is a kind of adapter of promises, or alternatively, a guarantor. [*]

Let’s suppose for a moment that the bank’s promises are in fact ironclad. With 100% certainty, the bank will deliver to holders of its IOUs the capacity to purchase real goods and services as valuable as those that were surrendered to acquire the IOUs. Now, when I transfer to a seller IOUs the bank has issued to me in exchange for my somewhat sketchy promises, is it still meaningful to refer to the seller as a “creditor”? After all, she has already received something that is unquestionably as valuable as the goods and services she has surrendered. So her situation is flat, “even-steven”. In exchange for her real resources, she has “money in the bank” whose purchasing power is guaranteed. She bears no risk. But the bank still bears the risk that I will fail to honor my promise while it will be required to honor its own without fail. Which is the creditor then, the seller or the bank? It becomes a matter if definition.

So let’s define. A party that has supplied real goods and services in exchange for a promise of future reciprocation is a “creditor from a real resources perspective”. A “creditor from a risk perspective” is a party that bears the risk that a transfer of resources will fail to be reciprocated. When I have taken a bank loan and “spent the money”, the seller becomes a creditor from a real resources perspective, while the bank becomes a creditor from a risk perspective. The role of creditor becomes bifurcated.

More accurately, the role of creditor becomes “multifurcated”. It cannot be true that “the bank” is a creditor from a risk perspective. Remember: the bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants. The risk that we claim sits with “the bank” must in fact fall on people who control or have controlled or might control real resources. We need to consider the “incidence” of the bank’s risk. It might be the case, for example, that the bank’s IOUs, its “deposits”, are in fact not solid at all, such that if I fail to repay the loan, the bank will fail to make good on its promises to people who supplied real goods and services in exchange for bank IOUs. In this case, the “creditors from a risk perspective” are the depositors, people who have delivered real goods and services in exchange for promises from the bank. When depositors are on the hook — and only when depositors are on the hook — there is no divergence of identity between creditors from a risk perspective and creditors from a real resources perspective. Only when depositors absorb losses it is fair to describe a bank as a mere intermediary between groups of borrowers and lenders, perhaps performing credit analysis and pooling risk to facilitate transactions, but otherwise just a pass-thru entity.

That is not how modern banking systems work. Bank depositors are almost entirely protected. The actual incidence of bank risk is, um, complicated. In theory, the risk of loan nonpayment falls first on bank shareholders, then on bank bondholders, then on uninsured depositors, and then on the complicated skein of taxpayers and other-bank stakeholders who back a deposit insurance fund, and then finally on holders of inflation-susceptible liabilities (which include bank depositors). In practice, we have learned that this not-so-simple account of the incidence of bank risk is inadequate, it cannot be relied upon, that the incidence of bank risk will in extremis be determined ex post and ad hoc by a political process which favors some claimants over others when the promises that a bank has guaranteed prove less than valuable.

This may all sound confusing, but one thing should be absolutely clear. Under existing institutions, there is little coincidence in the roles of creditor from a real resource perspective and creditor from a risk perspective. Our banks are machines that permit vendors to surrender real resources in exchange for promises the risks of which they do not bear. The risks associated with those promises do not go away. They may be mitigated to some degree by diversification and pooling. They might be modest, in the counterfactual that banks were devoted to careful credit analysis. But these risks must be borne by someone. The function and (I would argue) purpose of a banking system is to sever the socially useful practice of production-and-exchange-for-promises from the individually costly requirement of assuming the risk that promises will be broken, in order to encourage the former. The essence of modern banking is a redistribution of costs and risks away from people who disproportionately surrender real resources in exchange for promises. Under the most positive spin, modern banking systems engineer an opaque subsidy to those who produce and surrender more real resources than they acquire and consume by externalizing and ultimately socializing the costs and risks of holding questionable claims.

Unfortunately, there are a lot of ways of acquiring protected claims on banks besides producing and surrendering valuable real resources. This divergence of “creditor from a real resources perspective” and “creditor from a risk perspective”, between the party to whom real resources are owed and the party who bears the cost of nonperformance, creates incredible opportunities for those capable of encouraging loans that will be spent carelessly in their direction. Incautiously spent loans are unlikely to be repaid, but the recipients of the money never need to care. Industries like housing and education and of course finance depend heavily on this fact. When industries succeed at encouraging leverage that will be recklessly spent or gambled in their direction, they create certain gains for themselves while shifting risks and costs to borrowers and the general public.

Banks are not financial intermediaries in any simple sense of the word. When they “make a loan”, they serve as guarantors, not creditors. The borrower does not meaningfully become a debtor until the loan is spent. Only then do creditors emerge, but the role of creditor is bifurcated. The people to whom resources are owed are not the same as the people bearing the risk of nonperformance. The question of who actually bears the risk of nonperformance has grown difficult to answer, and concomitantly, incentives among bank decisionmakers for caution in creating that risk have weakened, especially relative to the benefits of cutting themselves in on some share of borrowers’ protected expenditures. This bifurcation of the role of creditor also explains why creditors as a political class are relatively indifferent to the upside of a good economy but extremely intolerant of inflation. A good economy means better higher values and better performance on outstanding loans, but creditors who are owed resources but are absolved from risk do not care about the performance of the loans that have become their assets. Those fluctuations, like fluctuations of the stock market, are somebody else’s problem or somebody else’s gain. Protected claimants, people who are owed money by banks or the state (which is itself a bank), can only lose via inflation. They understandably work within the political system to oppose inflation, which would force them to bear some of the cost of the bad loans whose misexpenditures were, in aggregate, the source of much of their wealth.

[*] Update: JW Mason of the remarkable Slack Wire gently chides that I ought to have attributed this point to Minsky. And indeed I should have! From Stabilizing an Unstable Economy (Nook edition, p. 227):

[E]veryone can create money; the problem is to get it accepted.

Banking is not money lending; to lend, a money lender must have money. The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, by accepting a debt instrument, agrees to make specified payments if the debtor will not or cannot. Such an accepted or endorsed note can then be sold in the open market.

Update History:

  • 8-Jul-2012, 8:10 p.m. EEST: Added update/footnote with attribution to Minsky, many thanks to JW Mason.

Stabilizing prices is immoral

The first thing to recognize is that a policy of enforced “price stability”, whether implemented in terms of levels or rates, is a form of goverment-provided social insurance, just like unemployment or disability benefits. For all of these programs, there are states of the world in which some individuals might suffer misfortune. The government acts to counteract that misfortune, imposing costs on other individuals in order to fund a transfer of resources. With unemployment insurance, business owners and employed workers pay unemployment premiums, which fund benefits for workers who lose their jobs. A similar dynamic holds for stabilizing prices.

Consider an adverse supply shock. Absent government action, the effect of a reduction of the supply of goods and services would be higher prices. The only way to prevent higher prices is to concomitantly reduce aggregate demand. The reduction might be implemented by raising interest rates or other monetary operations, or it might be effected via taxation. In either case, some people will pay a cost, which will show up as a reduction of demand. Other people will enjoy a benefit from the absence of price inflation.

Who are these people? Can we identify them? Sure. People who benefit from nonincreasing prices are people who hold nominal-dollar assets. That includes most obviously creditors — people with money in the bank, bondholders, etc. — but also people with stable employment but little bargaining power to pursue raises. These groups would see their purchasing power fall in an inflation. If the government restrains prices by reducing aggregate demand, it helps these groups by shifting costs to others. If prices are stabilized via monetary policy, debtors pay: both the increase in interest rates and the reduction of aggregate demand increase the burden of repaying debts. If prices are stabilized via increased taxation, then obviously whoever bears the incidence of the new tax pays. In both cases, marginal workers pay, by enduring an increased likelihood of becoming unemployed or a diminished likelihood of finding a job. [1]

It is fairly obvious, then, that restraining prices in the face of a supply shock effects a transfer from debtors, taxpayers, and marginal workers to creditors and secure workers. A policy of price restraint is a form of insurance for creditors and secure workers, who are absolved of the risk that the purchasing power of their nominal assets will suffer an unforeseen decay. It is financed with a guarantee written by debtors, taxpayers, and marginal workers, who are put at risk by the policy. [2]

So far, we have considered an asymmetric policy, price restraint. But suppose that the state targets a price level or an inflation rate symmetrically? Then don’t the losers from potential price restraint become the winners from potential price support when the state acts to prevent deflation? Absolutely! Under a symmetric price targeting regime, if by monetary policy, debtors enjoy the benefit of a positive supply shock in terms of lower interest rates and increased aggregate demand from which to draw income. If by fiscal policy, the benefit of the happy shock is distributed to whoever captures tax cuts and to recipients of government transfers and expenditures. Whether monetary or fiscal, an antideflationary response to a supply shock implies an increase in aggregate demand which helps keep marginal workers employed. Creditors and secure-but-stagnant job-holders lose out, as the increase in purchasing power they otherwise might have enjoyed via deflation is distributed to other parties.

So is a symmetric price targeting regime “fair”? Absolutely not. Sure, it involves an exchange of risk and benefits, rather than distributing only risks to some and benefits to others. But for this sort of swap to create value, benefits must be matched to losses. Risk-averse individuals seek insurance that pays off in bad times. All groups are at greater risk when an economy is poor following a supply shock. Under any policy of price restraint, creditors and the securely employed enjoy an insurance benefit. Under an asymmetrical policy, that insurance is free, the premiums are paid by other people. Under a symmetric policy, creditors and the securely employed purchase their insurance against bad times by foregoing some benefit during good times. That’s still a fine deal. Their overall risk is reduced.

But the opposite is true for debtors, taxpayers, and marginal workers. Just when these groups need a break, when the economy is bad due to an adverse supply shock, they are hit with additional costs in the name of price stability. Sure, when things are good all over, they get some frosting on their cake. Their highs are higher, but their lows are lower. Symmetrical price targeting turns debtors, taxpayers, and marginal workers into high-beta speculators on the state of the broad economy, while reducing the risk exposure of creditors and secure workers. It represents a vast subsidy, a transfer paid in risk-bearing, from debtors, taxpayers, and marginal workers to creditors and secure workers. A symmetric price target is a better deal than asymmetric price restraint for debtors, taxpayers, and marginal workers — better to have some benefit than no benefit for the burden of guaranteeing other peoples’ purchasing power! But a symmetric price target is still a raw deal. Debtors, taxpayers, and marginal workers are forced to bear costs when they are most burdensome and receive payoffs when they are least valuable.

In the real world, of course, we usually see something between a policy of pure price restraint and a symmetrical price targeting regime. And usually, price stabilization is implemented via monetary policy. We assiduously provide insurance to creditors and the securely employed, but haphazardly reward debtors and the marginally employed when they least need help. Price stabilization is social insurance we provide to the most secure members of our society, while the bill is paid in lost purchasing power and increased risk by the least secure. Further, the benefits of price stabilization accrue disproportionately to the largest creditors and to holders of high-salary secure jobs. Preserving the purchasing power of a billion dollar stash is a lot more valuable than preserving the value of fifty bucks in a bank account. Price stabilization is an incredibly regressive form of social insurance, a program whose distributional ghastliness would be abhorrent to most people if it were not conveniently submerged. But the transfers engendered by price stabilization are invisible, obscured by the money veil. Since they benefit the most influential and harm the most marginal in our society, this ghastly policy is politically untouchable.

It is certainly true that there are groups in our society whose purchasing power we ought to collectively insure: retirees on fixed incomes, savers with moderate nest eggs. It is great that Social Security payouts are indexed, so that retirees enjoy some protection of purchasing power. But indexing is a visible, and visibly costly, form of social insurance. Because it is visible, we transparently ration its provision and allocate its costs. I do not argue that purchasing power insurance is immoral. On the contrary, we need purchasing power insurance and the state should invent explicit means to provide it. What is immoral is to hide what is arguably the government’s largest social insurance program behind the technocratic phrase “price stability”. This a scheme that forces the most precarious members of our society to insure the purchasing power of the most secure, without any limit or even any accounting of the scale of the transfer.


  1. In the argument above, I have considered only the effect of supply shocks, not of shocks to aggregate demand. Price stabilization, in the counterfactual that it were fully symmetric, would seem less awful if we considered demand shocks. But it is silly to do so. The tools that we use to stabilize the price level all work through aggregate demand. To the degree that it is possible to stabilize prices, it is possible to stabilize aggregate demand directly. I am not opposed to macro stabilization in general. Aggregate demand stabilization is a great idea, although I have preferences with respect to means that might differ from those of the market monetarists who most famously advocate the policy. But since aggregate demand manipulation is our instrument, it is simpler to stabilize that variable than to stabilize prices. Causing aggregate demand to deviate from a planned growth path in order to stabilize prices is what is immoral. The price level should have no weight whatsoever in macro policy, which should simply target an NGDP path.

  2. I’m aware of New Keynesian models that predict “divine coincidence”, where stabilizing prices would stabilize real production as if by an invisible hand. The conditions under which we might rely on “divine coincidence” even in theory are unlikely to hold in practice. The models that predict divine coincidence posit one “representative household”, and so are blind by construction to the distributional concerns discussed here. I consider “divine coincidence”, in almost any forward-looking context, to be another name for “error”.

  3. I’ve neglected term effects when discussing the effect of interest rate changes on creditors. For creditors holding long-maturity debt, raising interests rates to restrain prices helps by supporting the purchasing power of the principal lent and by increasing the interest they might earn on reinvestment. But it also harms by provoking a capital loss should they need to liquidate and spend their term debt prior to maturity. For long-term savers, the reinvestment effect compensates the capital loss. Creditors as a group are clearly made better off by a policy of price restraint, but some long-term creditors do get burned by rising interest rates.


[1] Unemployment contributes to price restraint by reducing worker bargaining power and therefore the cost of a major factor of production, and by diminishing consumption of goods that might be in scarce supply, as people without jobs sharply curtail consumption. In theory, unemployment might also lead to price increases due to a reduction in supply from goods and services not produced by idle workers. But if the unemployment is caused by restraint of aggregate demand (rather than, say, destruction of a productive factory), the effect of reduced consumption will dominate, as the people fired will be people who provide more exchange value by refraining to consume than by producing, after consumption baskets shift under tighter budget constraints. What the unemployed do not eat is the basis of everyday low prices for the rest of us. Note that these workers are “zero marginal product“, but only in a narrow and artificial sense. The marginal product of workers as reflected in hiring and firing patterns is clearly sensitive to aggregate demand policy, demonstrably over the short-term and almost certainly over the long-term. Those who appear to offer “zero marginal product” when nominal income is scarce and prices stable might provide a high marginal product when income is plentiful and prices are flexible. Ones marginal product today is a function of policy as well as intrinsic qualities, and economic activity is very path dependent.

[2] Of course, these various groups are not exclusive. One can be both a debtor and have a stable job, both a creditor and a taxpayer. Each individual enjoys some benefit, and bears some burden, from a policy of enforced price stability. But on net, there are winners and losers from such a policy. If price restraint will be implemented via monetary policy, large creditors and secure non-indebted workers enjoy the largest net benefit while marginally employed debtors bear the largest risk. Securely employed debtors would experience a mix of risk and benefit, depending on the scale of their salaries and debts.

Update History:

  • 24-Jun-2012, 12:40 a.m. EEST: Shifted what was originally the last paragraph of the piece into the Addenda section; it is now the first addendum — makes for a punchier ending.
  • 24-Jun-2012, 1:00 a.m. EEST: The ending is too punchy now. Removed last sentence, “It is detestable.” I think my disdain comes through well enough without so artlessly overpunctuating it.
  • 24-Jun-2012, 1:20 a.m. EEST: “are politically invisible”

Great Britain as a case study: which sticky price?

Richard Williamson offers a report from the UK. Combining bits via Tyler Cowen and Williamson’s own excellent blog:

I think there has been a lot missing from the discussion of the UK in the blogosphere. We are a bit of a puzzle on a purely AD-based explanation of the recession.

  1. We didn’t have deflation (on annual basis at least), and even stripping out the effect of the VAT rise in 2011 should still show persistent inflation over 3% since 2010 http://www.tradingeconomics.com/united-kingdom/inflation-cpi

  2. UK inflation expectations seem to be significantly higher here (if falling away a little recently) http://www.bondvigilantes.com/2012/03/19/markets-start-to-think-about-inflation-again/ http://uk.finance.yahoo.com/news/uk-inflation-expectations-drop-1-093038319.html

I’m not really sure what is going on… If we were to just look at inflation (at expectations thereof), the country that ought to be having an AD-driven double-dip recession would appear to be the US…

I am becoming steadily less convinced that [an aggregate demand deficiency] is the whole story, at least for the UK. Back in November, Karl Smith made the clearest statement I have ever read of the New Keynesian explanation of a recession:

I can’t hammer this home enough. A recession is not when something bad happens. A recession is not when people are poor.

A recession is when markets fail to clear. We have workers without factories and factories without workers. We have cars without drivers and drivers without cars. We have homes without families and families without their own home.

Prices clear markets. If there is a recession, something is wrong with prices.

Right now, unemployment remains at over 8% in the UK while real wages are lower than they were 7 years ago and are continuing to fall. Yes, you read that correctly. Which immediately leads one to ask: on this explanation of a recession as expounded by Karl, how much further do real wages have to fall to eliminate disequilibrium unemployment?

There are two broad stories having to do with “sticky prices”. One, the mainstream New Keynesian story, emphasizes rigidity in the price of goods and services, most especially “sticky wages”. The other, emphasized by post-Keynesians and sometimes by monetarists, has to do with the sticky price of satisfying debts.

In the standard New Keynesian story, a depression is caused by the relative prices of goods and services falling out of whack. This is the basis for much of the mainstream policy consensus. The source of macroeconomic problems is sluggish adjustment of some goods and service prices, and stabilizing the price level should diminish the need for such adjustments. Macro policy can’t prevent relative prices in the real economy from needing to change sometimes. But it can prevent difficult-to-adjust prices from requiring frequent updates due to fluctuations in the overall price level. Because some important prices — the price of labor especially — are thought to be “sticky downward” (meaning they can “ratchet” upwards but can’t adjust down), targeting a positive inflation rate is recommended. The gradual, predictable movement of prices allows slow updates, preventing misalignments due to sluggish adjustment. The upward-slope permits “sticky downward” prices to fall in real terms relative to other goods and services by simply not rising with other prices. A recession, in the New Keynesian telling, occurs when this stabilization policy is not sufficient. If changes in supply and demand are so great that “sticky downward” prices must fall faster than the targeted rise in the price level, markets won’t clear. If the “sticky downward” price is workers’ wages, then it is employment markets that won’t clear, and we will experience mass joblessness. If this occurs, a cure would be to increase the targeted rate of inflation until real wages fall relative to other goods and services. When real wages fall enough, employment markets will clear again and the recession will end.

In the post-Keynesian story, a depression is driven by an decrease in agents’ willingness or ability to carry debt. Agents “pay for” decreased indebtedness by devoting their income to the purchase of safe assets (including especially their own outstanding debt) rather than spending on real goods and services. Unfortunately, money spent on financial asset purchases does not create income (they are asset swaps), and may not be cycled back into income for producers of real goods and services. So, in aggregate the attempt to reduce indebtedness can lead to a reduction of income that sabotages the attempt to pay down debt. This is the famous “paradox of thrift”. We simultaneously experience unemployment (reduced spending and income to real goods and service providers plus sticky wages means that people get canned) and financial distress (reduced income and fixed debt makes prior debt ever more burdensome). In this story, reducing real wages is not a solution. Real wage reductions might mitigate unemployment temporarily, but they also engender financial distress. Financial distress then causes agents to redouble their efforts to satisfy debts, reducing aggregate income and requiring further reductions in real wages ad infinitum. The only way out of a post-Keynesian depression is to increase real wages relative to the real burden of debt. In the post-Keynesian story, inflation is helpful only if real incomes hold steady, or, at very least, fall more slowly than the real value of prior debt.

One data point is not dispositive. But Williamson’s account of the UK experience is not consistent with the New Keynesian story, while it is perfectly consistent with the post-Keynesian account. There has been inflation in the UK. The real price of labor has not been sticky. The real burden of debt has fallen, sure, but real wages and incomes have fallen even farther, leaving people less able than ever to satisfy debts they’ve contracted and so purchase financial security.

There is a lesson here. If we mean to pursue reflationary policy, the goal should not be to reduce real wages, but to reduce the real value of debt relative to incomes. One way to do this, which the post-Keynesians’ closest frenemies suggest, is to stabilize the nominal income path at its prior trend while tolerating whatever inflation that engenders. This implies a large increase in nominal income from current levels. Going forward, if we hold nominal income to a gently rising path, the burden of aggregate debt relative to income will never unexpectedly rise. (Unfortunately, predictable distress may not prevent debtors in aggregate from taking on more debt than they can service, due to the competitive dynamic of a boom. I think NGDP targeting would be a big improvement, but not sufficient: We must always be mindful of leverage and debt.)

Pace the very brilliant Chris Dillow, the UK has not stabilized the path of NGDP:

Even if, as Dillow suggests, policymakers could not have held NGDP on path in 2009 due to forecast error, after the collapse they certainly could have restored total income to its prior trend with some combination of monetary and fiscal policy. They have not, and so the burden of debt relative to incomes in the UK has increased.

The UK has just entered a “double-dip” recession, and remains, in my view, in a depression, despite occasional thaws and recoveries. That this has happened, despite the plummeting real wages that Williamson reports, tells a tale. It is not “sticky wages” that should concern us, but the sticky burden of precontracted nominal debt.

Afterward: David Andolfatto wonders whether debt dynamics could play so large a role more than three years after a collapse in nominal income. Yes it can, I argue in his comments.

Karl Smith responds to Williamson here.

Update History:

  • 28-Apr-2012, 6:00 a.m. EDT: Had mistakenly used a FRED graph that I thought was NGDP, but was really RGDP. I’ve replaced it with a proper NGDP graph. Removed the word “remotely”, as the proper graph shows a less dramatic picture: “the UK has not remotely stabilized the path of NGDP.

Two quick responses on choosing depression

  • Scott Sumner and Marcus Nunes suggest that our policy failures are in some sense just an “oops!”, that they result from a mix of mistaken theory, institutional frictions, personal quirks, and political forces rather than being, as I argue, a choice. I’d be more sympathetic if these “mistakes” were unique to the United States. Broadly similar choices have been made in Europe, and Japan.

    You can tell idiosyncratic stories of political and institutional failure for each of these countries individually. But ex ante, you’d not have expected similar policy responses. From an international balance perspective, for example, it’s not surprising that Japan did not inflate, but you might expect the United States to jump at a policy response that would reduce the burden of its considerable debt to foreigners. Yet the US and Japan seem to be on broadly parallel tracks.

    There is supposed to be a constituency for stimulative policy. The conventional story is that, during a downturn, election-seeking politicians will be recklessly pro-expansion, in conflict with and checked by an independent central bank. But, at least in the United States and Europe, there is surprisingly little appetite among politicians from “mainstream” parties to emphasize either fiscal or monetary expansion. On the contrary, the political conversation revolves around restraining deficits and “being responsible”, which is code for ensuring that the demands of creditors (public and private) are fully satisfied. This may change. In Greece, Portugal, Ireland, and Spain, parties now viewed as “fringe” may gain influence. But despite a years-long downturn of Great Depression severity, so far elected politicians in all these countries have emphasized a narrative of necessary adjustment and responsibility, and have almost never agitated for monetary policy better tailored to Southern Europe or threatened disorderly default. The behavior of politicians, in Europe as in the United States, suggests that the people to which they are accountable are not primarily the fraction of their labor force that is out of work. This is different from the 1970s, when elected officials did seem to behave as though they were accountable to unemployed people, and put central bankers under intense pressure to be accommodative. Something has changed. In status quo democracies, politicians tend to respond to groups that are numerous, rich, or organized. Since the 1970s, in all the depression democracies, retirees and near-retirees have grown both more numerous (as a fraction of voters) and more rich, while workers have grown less organized. Emerging markets like China have responded to the downturn quite differently. I think this pattern is too systematic to chalk up to idiosyncratic mistakes. [1]

  • Kevin Drum writes:

    [The problem is] Steve’s claim that the median influencer — whoever it is — “is panicked by the prospect of becoming poorer,” which explains our financial system’s rabid opposition to inflation higher than 2%. This claim might have made sense 50 years ago, when many of the affluent elderly were coupon clippers. But today it doesn’t make sense even for them, and it certainly doesn’t make sense for anyone else. Hardly anybody literally lives on a fixed income these days. The elderly middle class lives on Social Security, which is indexed to inflation. The broad middle class has its retirement savings invested in 401(k) funds, which do better when the economy does better. The wealthy have their money invested in a variety of sophisticated vehicles, all of which are hedged against inflation in one way or another. We simply don’t live in a world of fixed returns anymore. Unless you’re a hedge fund quant making some specific kind of inflation play, there are very few people today who have any reason to fear higher inflation, especially of the moderate, temporary sort that the Paul Krugmans and Scott Sumners of the world advocate.

    Drum is right that there are no more coupon clippers. There is very little coupon to clip, because interest rates have been in secular decline for the last 30 years. But he is wrong to jump from that to imagine that upper-middle-class retirees and near retirees are immune to inflation. Affluent retirees depend heavily on asset wealth; Social Security cannot cover the lifestyles to which they’ve grown accustomed, and the expenses and commitments they’ve accumulated.

    Affluent older Americans hold a large proportion of their wealth in bonds and cash-like instruments (bank CDs, money market accounts). They also maintain significant positions in stock funds that might “do better when the economy does better”. But, unsurprisingly, retirees keep the wealth they most depend upon in safer, fixed income vehicles. The proportion they keep in stock funds tends to increase with wealth. [2] Since they can’t clip coupons, retirees rely upon asset sales and redemptions for income. They try to manage the pace of sales so they don’t outlive their capacity to maintain their lifestyles.

    Retirees living on asset wealth are very exposed to inflation. It’s an error, a fallacy of composition, to assume that the existence of hedges and “sophisticated vehicles” means that somehow everybody can be protected. Every debt contract imposes inflation risk that some party must bear. Stock markets get the press, but most financial claims on capital are structured as debt, all of which must be held, directly or indirectly, by some human (usually an old or rich human). [3] Any individual retiree can shed inflation risk by switching from, say, municipal bonds or bank CDs into TIPS. But retirees and near-retirees in aggregate can’t do this: there aren’t enough TIPS to go ’round, and somebody has to be persuaded to hold the unprotected bonds. TIPS already pay negative yields. If creditors grow nervous and try to herd into protected assets, TIPS yields would be driven even more sharply negative and prices of ordinary bonds would collapse. Somebody, some creditor, will bear the loss of value imposed on bondholders by inflation. It’s a game of musical chairs. No matter how sophisticated your vehicle, evading inflation risk is and must be costly if markets are remotely efficient. (If markets are not efficient and it is cheap to slough off inflation risk, then someone — quite possibly a gullible retiree — has been made a patsy and persuaded to offer underpriced insurance. “Sophisticated vehicles” tend to benefit those who structure them more reliably than those who purchase them.) [4]

    Affluent retirees do hold some of their wealth in corporate stock, and it is obviously true that the US political system and the Federal Reserve are extremely loss-averse when it comes to the stock market. Note that some equity claims (think banks) are indirect claims on debt, and so are themselves conduits for inflation risk. And there is no necessary relationship between asset inflation and goods inflation. The interests of affluent retirees are best served when financial assets in general (both stocks and bonds) are inflating but goods prices are not. And for the most part, that is what the US political system works to deliver. [5] If you could promise that stimulating the economy would lead to a stock boom, much of the opposition to expansionary macro policy would dissolve. But you can’t promise that. Even if the policy “works” from an employment perspective, stocks may fall. Corporate profits are near all-time highs as a fraction of GDP, and stock markets are priced with optimistic growth assumptions already. Sharing more of the wealth with wage earners may cost more than the benefit to shareholders of incremental sales. Today’s affluent retirees lived through the most stock-market-focused era in human history. They remember the 1970s stagflation, during which the influx of women into the labor force was successfully absorbed but stocks languished. They know that stock wealth is fickle.

    So people who intend to live off their nest eggs rely first and foremost on the “safety” of bonds. Expansionary policy is a hazard for them.

    Consider NGDP targeting. Under this policy rule, Treasury securities would become risk assets, whose real return would be geared to the health of the economy. (NGDP path targeting implies that shortfalls in real growth must be matched by increases in inflation.) Treasuries become low-beta index funds, diversified claims on the real production. Nominal yields would be more stable, but the real value of a future payment becomes as uncertain and volatile as the business cycle.

    More conventionally, an increase of the de facto inflation target from 2% to 4% would be a “tax” on whoever holds fixed income securities at the moment the change is announced. Holders of long-term bonds would lose no matter what. If the inflation target is raised in order to enable steeper negative real yields (and that is the point), then people holding short-term bills and deposits would also face a new 2% per year cost, for as long as the low rates persist. And that’s not the worst of it. Ben Bernanke is speaking in the voice of older affluent Americans when he argues that adjusting the inflation target is bad because it might disturb “anchored” expectations. What people who rely upon asset wealth really fear is a sharp, unexpected increase in inflation. And much as that may not be what dovish economists have in mind, there is no guarantee that higher inflation and lower real rates will succeed at reviving growth and employment. If the new target fails, will the Fed double down and try 6% inflation? Even if the Fed says it won’t, will nervous markets require the bank to prove its credibility at 4%? Will the Fed be willing to hike interest rates into a still depressed economy, to prove it will hold its new 4% inflation target? Should it? All bets are off.

    Affluent retirees and near-retirees have very good reason to fear inflation.


[1] In Japan, Germany, and France, more than 50% of the total population is over 40 years old. (56.5%, 57.2%, and 50.2% respectively.) They do have children in these countries, so there are many more retirees and working-age people over 40 than there are younger workers. In the US, “only” 45.5% of the population is over 40, but I think as a polity, the United States behaves as though it is substantially older, because its unusual fecundity (for a developed economy) comes from relatively poor and disenfranchised immigrants. By comparison, China’s over-40 share is 40.3%, Brazil’s is 32.8%, and India’s is 27.1%. In the 1970s, when the US policy was, um, plainly inflationary, the over-40 share of the population was 36.1%.

Using 40-years-old as a cut-off age is arbitrary. “Retirees and near-retirees” is a vague formulation, and 40+ is admittedly a stretch. But people do not turn suddenly into zombie-like asset hoarders. As cohorts of workers age, they accumulate financial assets and become less likely to face unemployment. When they retire, their fear of unemployment disappears entirely, and their dependence upon saved assets increases. There is a continuum between the young and poor, who should prefer the risk of stimulus, and the old and rich who should not. It’d probably be best to modify my story to declare “affluent retirees and older workers” the “median influencer”.

By the way, I am guilty of data mining the cutoff age to support my case. (I examined the population pyramids.) Add whatever grain of salt you like, but I think the point stands. The data are via Wolfram Alpha, e.g. “age distribution US 1975“, then “Show Details”.

[2] As of 2001, people over 65 with assets of $1M or less held substantially more in cash and bonds than stock. Richer people held a greater share in stock. See Curcuru et al, Table 6.

[3] Remember Karl Smith’s point that capital is mostly stuff like buildings and cars. In the US, the bond market is roughly twice as large as the public equity market, and that excludes debt held indirectly via ordinary bank deposits.

[4] Throughout this piece, I’m using “inflation risk” to encompass both the risk that inflation will diminish the real value of precontracted payments from long-term, fixed coupon securities and the risk that inflation will enable sharply negative real yields, affecting the real value of floating rate debt and short-term claims.

[5] This lends credence to Matt Yglesias’ view that central banks would use negative nominal rates where they do not use inflation to generate negative real yields. Negative nominal yields would deliver windfall gains to people holding stock and longer-term bonds, while negative yields engineered via inflation would have uncertain effects on stock and reduce the real value of longer term bonds (with or without capital losses, depending on whether yields follow inflation). If the American political system is geared to paying off asset holders, it’s no wonder that reducing nominal yields became “conventional” monetary stimulus.

Depression is a choice

I enjoyed Matt Yglesias’ suggestion that depressions are merely a technical problem that will go away once the obsolescence of cash eliminates the zero lower bound on interest rates, and Ryan Avent’s rejoinder. Although I’ve toyed with Yglesias’ view myself, I think that Avent has the better of the argument when he characterizes our current policy impotence as reflecting behavioral rather than technical constraints. We don’t lack for technical means to counter people’s self-defeating impulse to hoard cash and safe financial assets. On the contrary, we have a whole cornucopia of options! The squabbling that has preoccupied me lately, between market monetarists and post-Keynesians and mainstream saltwater economists, is an argument over which of many not-necessarily-mutually-exclusive options would most perfectly address address this not-really-challenging problem.

We are in a depression, but not because we don’t know how to remedy the problem. We are in a depression because it is our revealed preference, as a polity, not to remedy the problem. We are choosing continued depression because we prefer it to the alternatives.

Usually, economists are admirably catholic about the preferences of the objects they study. They infer desire by observing behavior, listening to what people do more than to what they say. But with respect to national polities, macroeconomists presume the existence of an overwhelming preference for GDP growth and full employment that simply does not exist. They act as though any other set of preferences would be unreasonable, unthinkable.

But the preferences of developed, aging polities — first Japan, now the United States and Europe — are obvious to a dispassionate observer. Their overwhelming priority is to protect the purchasing power of incumbent creditors. That’s it. That’s everything. All other considerations are secondary. These preferences are reflected in what the polities do, how they behave. They swoop in with incredible speed and force to bail out the financial sectors in which creditors are invested, trampling over prior norms and laws as necessary. The same preferences are reflected in what the polities omit to do. They do not pursue monetary policy with sufficient force to ensure expenditure growth even at risk of inflation. They do not purse fiscal policy with sufficient force to ensure employment even at risk of inflation. They remain forever vigilant that neither monetary ease nor fiscal profligacy engender inflation. The tepid policy experiments that are occasionally embarked upon they sabotage at the very first hint of inflation. The purchasing power of holders of nominal debt must not be put at risk. That is the overriding preference, in context of which observed behavior is rational.

I am often told that this is absurd because, after all, wouldn’t creditors be better off in a booming economy than in a depressed one? In a depression, creditors may not face unexpected inflation, sure. But they also earn next to nothing on their money, sometimes even a bit less than nothing in real terms. “Financial repression! Savers are being squeezed!” In a boom, they would enjoy positive interest rates.

That’s true. But the revealed preference of the polity is not balanced. It is not some cartoonish capitalist-class conspiracy story, where the goal is to maximize the wealth of exploiters. The revealed preference of the polity is to resist losses for incumbent creditors much more than it is to seek gains. In a world of perfect certainty, given a choice between recession and boom, the polity would choose boom. But in the real world, the polity faces great uncertainty. The policies that might engender a boom are not guaranteed to succeed. They carry with them a short-to-medium-term risk of inflation, perhaps even a significant inflation if things don’t go as planned. The polity prefers inaction to bearing this risk.

This preference is not at all difficult to understand. The ailing developed economies are plutocratic democracies. “The people” do have power, but influence is weighted in a manner correlated with wealth. The median influencer in these economies is not a billionaire, but an older citizen of some affluence who has mostly endowed her own future consumption. She would like to be richer, of course. But she is content with her present wealth, and is panicked by the prospect of becoming poorer. For such a person, the depression status quo is unfortunate but tolerable. The risks associated with expansionary policy, on the other hand, are absolutely terrifying.

The revealed preference of my polity is not my personal preference. Perhaps that is because I’m an idealist, and I actually care about the misery provoked by precarity and unemployment. Perhaps it’s simply because I’ve not yet endowed my own future consumption, and I’m scared. Regardless, I object. Although I understand where it comes from, I detest the preference for depression revealed by my polity. Perhaps you do too.

But if we want to change the behavior of the polity, it’s not enough to argue over clever policies that, if implemented, might do the trick. We’ve got to change its preferences, which means either buying off the median influencer, or changing her identity via political struggle. Alternatively, we can wait until what are now problems of aggregate demand morph into supply problems (after people become unemployable and capital decays), or into threats of political and social unrest. The median influencer may change her views if tight supply makes goods costly despite fiscomonetary conservatism. Or if her neighborhood is on fire. But I’d prefer we avoid all that, and take a more proactive route.

In the meantime, we have to recognize that what we are experiencing is not a technical failure. It is not “magneto trouble”. We, collectively, are making a choice. The task before us is to change our mind.

Update History:

  • 17-Apr-2012, 9:20 p.m. EDT: Small edits to eliminate wordiness and word repetition: “In the meantime, what we have to recognize is that what we are experiencing is not a technical failure.”; “and is terrified frightened of becoming poorer”
  • 17-Apr-2012, 11:50 p.m. EDT: Changed my change above; “frightened” is too weak: “and is frightened panicked by the prospect of becoming poorer”