Wednesday, April 16, 2014

Toward a run-free financial system

A new essay, expanding greatly on a previous WSJ oped and illustrated by a great comic. Here's the introduction, follow the link for the whole thing.

Toward a run-free financial system
John H. Cochrane
April 16 2014

Abstract

The financial crisis was a systemic run. Hence, the central regulatory response should be to eliminate run-prone securities from the financial system. By contrast, current regulation guarantees run-prone bank liabilities and instead tries to regulate bank assets and their values. I survey how a much simpler, rule-based, liability regulation could eliminate runs and crises, while allowing inevitable booms and busts. I show how modern communications, computation, and financial technology overcomes traditional arguments against narrow banking. I survey just how hopeless our current regulatory structure has become.

I suggest that Pigouvian taxes provide a better structure to control debt issue than capital ratios; that banks should be 100% funded by equity, allowing downstream easy-to-fail intermediaries to tranche that equity to debt if needed. Fixed-value debt should be provided by or 100% backed by Treasury or Fed securities.  


1. Introduction and overview  

    At its core, our financial crisis was a systemic run. The run started in the shadow banking system of overnight repurchase agreements, asset-backed securities, broker-dealer relationships, and investment banks. Arguably, it was about to spread to the large commercial banks when the Treasury Department and the Federal Reserve Board stepped in with a blanket debt guarantee and TARP (Troubled Asset Relief Program) recapitalization. But the basic economic structure of our financial crisis was the same as that of the panics and runs on demand deposits that we have seen many times before.  

    The run defines the event as a crisis. People lost a lot of money in the 2000 tech stock bust. But there was no run, there was no crisis, and only a mild recession.  Our financial system and economy could easily have handled the decline in home values and mortgage-backed security (MBS) values—which might also have been a lot smaller—had there not been a run.

    The central task for a regulatory response, then, should be to eliminate runs.

    Runs are a pathology of specific contracts, such as deposits and overnight debt, issued by specific kinds of intermediaries. Among other features, run-prone contracts promise fixed values and first-come first-served payment. There was no run in the tech stock bust because tech companies were funded by stock, and stock does not have these run-prone features.

    The central regulatory response to our crisis should therefore be to repair, where possible, run-prone contracts and to curtail severely those contracts that cannot be repaired. "Financial crises are everywhere and always due to problems of short-term debt" is a famous Doug Diamond (2008) aphorism, which we might amend to "and its modern cousins." Well, then, let us purge short-term debt from the system and base regulation on its remaining truly necessary uses.  

    When they failed, Bear Stearns and Lehman Brothers were financing portfolios of mortgage-backed securities with overnight debt at 30:1 leverage. For every thirty dollars of investment, every single day, they had to borrow a new twenty-nine dollars to pay back yesterday's lenders. It is not a surprise that this scheme fell apart. It is a surprise that our policy response consists of enhanced risk supervision, timid increases in bank capital ratios, fancier risk weighting, macroprudential risk regulation, security-price manipulation, a new resolution process in place of bankruptcy, tens of thousands of pages of regulations, and tens of thousands of new regulators.  Wouldn’t it be simpler and more effective to sharply reduce run-prone funding, at least by intermediaries likely to spark runs?

    In this vision, demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable. 

    Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund, stock index fund shares, or even the bank's own shares. A bank can originate and sell mortgages, if it does not want to finance those mortgages with equity or long-term debt. Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt. 

   If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in  an hour, without disrupting any of the operations or claims against the bank, and the government can credibly commit not to bail it out.

    I argue that Pigouvian taxes   provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests.  For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.

1.2 Technology

    The essence of this vision is not novel. Proposals for narrow banking or equity-based banking have been with us about as long as runs and crashes have been with us.  The "Chicago Plan," discarded in the 1930s, is only one of many such milestones  

    Here a second theme emerges: Modern financial, computational, and communication technology allows us to overcome the long-standing objections to narrow banking.  

    Most deeply, "liquidity" no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities. With today's technology, you could buy a cup of coffee by swiping a card or tapping a cell phone, selling two dollars and fifty cents of an S&P 500 fund, and crediting the coffee seller's two dollars and fifty cents mortgage-backed security fund. If money (reserves) are involved at all—if the transaction is not simply netted among intermediaries—reserves are held for milliseconds. In the 1930s, this was not possible. We could not instantly look up the value of the S&P 500 (communication). There was no such thing as an index fund, so stock sales faced informational illiquidity and large bid-ask spreads (financial innovation).  And transactions costs would have ruled out the whole project (computation, financial innovation). Closer to current institutions, electronic transactions can easily be made with treasury-backed or floating-value money-market fund shares, in which the vast majority of transactions are simply netted by the intermediary. When you buy something, your account loses an electronic dollar and the seller’s account gains one, and no security actually changes hands. 

    On the supply end, $18 trillion of government debt is enough to back any conceivable remaining need for fixed-value default-free assets. Three trillion dollars of interest-paying reserves can easily be $6 trillion of reserves. We can live Milton Friedman's (1969) optimal quantity of money, in which the economy is awash in liquidity. This optimal quantity will have financial stability benefit far beyond its traditional elimination of shoe-leather costs. Again, technology has fundamentally changed the game: instant communication means that interest-paying money is now a reality, so we can have the optimal quantity without deflation. Our government should take over its natural monopoly position in supplying interest-paying money, just as it took over a monopoly position in supplying nineteenth-century bank notes, and for the same reason: to eliminate crises, which have the same fundamental source.

    The quantification of credit risk, the invention of securitized debt, long-only floating-value mutual funds, and the size and liquidity of today's markets mean that financial flows needed to finance home and business investment can come from everyday saver/investors who bear risk rather than hold traditional deposits.

    So, the most fundamental objection is met: that society "needs" a large stock of money-like assets, more than can be supplied by other means, so banks must try to "transform" maturity, liquidity, and risk, both to supply adequate assets for transaction-type needs and to provide adequate credit for real investment. I treat a wide range of additional common objections below.  

1.3 Current policy

    Our current regulatory response to financial crises is based on a different basic vision that evolved piecemeal over more than a century. In order to stop runs, our government guarantees debts, implicitly or explicitly, and often ex-post with credit guarantees, bailouts, last-resort lending, and other crisis-fighting efforts. But guaranteeing debts gives the borrowers (banks and similar institutions) an incentive to take on too much asset risk and an incentive to fund those risks by too much debt. It gives depositors an incentive to ignore bank risks when lending. So our government tries to regulate the riskiness of bank assets and imposes capital requirements to limit banks' debt funding. Then banks game their way around regulations, take on more risk, and skirt capital requirements; shadow banks grow up around regulations; and another crisis happens. The government guarantees more debts, expands its regulatory reach, and intensifies asset regulation.

    Less heralded, but no less important, this regulatory approach demands strong limits on competition and innovation, even before banks try to capture it. If regulators let new institutions circumvent regulated ones, the problems erupt again. Too big to fail means too big to lose money, and too big to lose money means too big to compete.

    Thus, Dodd-Frank regulation and its international cousins are not a radical new approach. They are just a natural expansion of a longstanding philosophy. Each new step follows naturally to clean up the unintended consequences of the last one. The expansion is nonetheless breathtaking.  Beyond massively ramping up the intensity, scope, and detail of financial institutions and markets regulation, central banks are now trying to control the underlying market prices of assets, to keep banks from losing money in the first place.

    The little old lady swallowed a fly, then a spider to catch the fly, a bird to catch the spider, and so on. Horse is on the menu. Will we eat?

1.4 Comparison

    The insight that the crisis was a systemic run, that we can fix runs by fixing and removing run-prone financial contracts, and that new financial and communication technology addresses the classic objections, liberates us from this Rube Goldbergian (or Orwellian?) regulatory project.

    We do not have to fix every actual and perceived fault of the financial system in order to protect against future crises.  We do not have to diagnose and correct the sources of the crisis, Fannie Mae and Freddie Mac, the community reinvestment act, so-called predatory lending, no-documentation loans, perceived global imbalances or  savings gluts, Wall Street "greed," executive compensation, perceived bubbles (whether thought to be caused by irrational speculation or too-low interest rates), and so on. We do not have to fix credit card fees, disparate-impact analysis, student loans, or hedge fund fees. We don't need to micromanage over-the-counter versus exchange-traded derivatives, swap margins, position limits, the bloated Basel bank regulation mess, the definition of risk-weighted assets, the internal process and regulatory designation of S&P and Moody ratings, the treatment of off-balance-sheet credit guarantees, and on and on and on. The thousand pages of the Volker rule alone can start a nice bonfire. If a crisis is a run, and we can remove or fix run-prone securities, none of these steps is either necessary (whew) or sufficient (ouch) to stop a future crisis. A narrower regulatory approach that can stop runs, and hence crises, without requiring these Herculean (or Sisyphean?) tasks, no matter how desirable each one might be, is much more likely to succeed.

    If financial institutions’ liabilities no longer can cause runs and crises, we don't have to try to micromanage institutions' asset choices or the market prices of those assets. Nor do we have to  stop entry by new and innovative institutions.   Rather than dream up a financial system so tightly controlled that no important institution ever loses money in the first place, we can simply ensure that inevitable booms and busts, losses and failures, transfer seamlessly to final investors without producing runs.

    Zero cost is not the standard. The financial crisis was, by most accounts, a hugely expensive event. Dodd-Frank regulation and its international cousins are not cheap, either. The challenge is only to show that my vision, which narrowly focuses on eliminating the poison in the well—run-prone assets—stops crises more effectively and costs less than these alternatives.


47 comments:

  1. Clarifying question from someone who doesn't know that much about banks: Currently, banks raise money by debt (short term) and equity, and then lend out long term and makes the spread, with a high leverage ratio. So, ignoring all the other stuff that banks do, start with 5MM in equity, collect 95MM in deposits, and lend out 100MM in long-term loans.
    Is your suggestion that we change this such that the 95MM goes into T-bills, and the bank needs to raise 100MM in equity to make the loans?

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    1. Of course John didn't "run" this by any bank shareholders. Federal government tells banks you can longer transform maturity by borrowing short from central bank and lending long to federal government. Shareholders from banks vote to suspend purchases of federal debt.

      Also, do open market sales by the FOMC constitute a run? If so, then how do Treasuries escape the "run prone" moniker that John has invoked?

      "In order to stop runs, our government guarantees debts, implicitly or explicitly, and often ex-post with credit guarantees, bailouts, last-resort lending, and other crisis-fighting efforts. But guaranteeing debts gives the borrowers (banks and similar institutions) an incentive to take on too much asset risk and an incentive to fund those risks by too much debt."

      There is already a resolution for companies that take on too much debt that does not involve bailouts - See:

      http://en.wikipedia.org/wiki/Chapter_11,_Title_11,_United_States_Code

      In many cases this involves converting existing debt to equity. What John fails to address is why many of the banks / financial institutions involved were not forced to go through Chapter 11 bankruptcy proceedings.

      This can be done by the individual company in bankruptcy court, or for systemic debt, this can be done by the federal government directly - federal government absorbs bank debt and replaces it with federal equity.

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    2. Frank,

      Your first paragraph claims that banks lend out reserves. I suggest you Google the phrase “banks do not lend reserves”. You’ll find plenty of explanations as to why your idea is flawed.

      Next you suggest that “open market sales by the FOMC constitute a run”. Strange idea. A “run” is where ordinary depositors and similar withdraw money from banks and shadow banks. The FOMC has nothing to do with a standard bank run.

      In your last four paragraphs you make the strange suggestion that failing banks be put thru standard bankruptcy proceedings. The problem with that is that it involves ordinary depositors – households – losing a proportion of their money. And that just ain’t politically acceptable. They tried that in Cyprus a year or so ago and there were riots. Plus I suggest it is not morally acceptable: that is, I think that everyone is entitled to a 100% safe bank account, at least up to some maximum sum.

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    3. Ralph,

      My first paragraph was in reference to Federal Reserve as lender of last resort (banks borrow money from Fed at discount window). See:

      http://en.wikipedia.org/wiki/Discount_window

      Reserve requirements - deposits kept with central bank are a separate issue:

      http://en.wikipedia.org/wiki/Reserve_requirement

      "A run is where ordinary depositors and similar withdraw money from banks and shadow banks."

      Not according to John Cochrane's definition - "Runs are a pathology of specific contracts, such as deposits and overnight debt, issued by specific kinds of intermediaries. Among other features, run-prone contracts promise fixed values and first-come first-served payment."

      I believe that Treasuries bills fit the definition of a run prone contract in that they are predominantly short term, they promise fixed values, and they promise first-come first-served payment.

      "In your last four paragraphs you make the strange suggestion that failing banks be put thru standard bankruptcy proceedings. The problem with that is that it involves ordinary depositors – households – losing a proportion of their money. And that just ain’t politically acceptable."

      Wrong - Putting a bank through standard bankruptcy proceedings would involve depositors / lenders who are owed a debt by a bank becoming shareholders in that bank (preferably voting shareholders). The politically unacceptable part is for voting shareholders to refuse to lend the federal government money.

      "They tried that in Cyprus a year or so ago and there were riots."

      Really?!?! Banks in Cyprus went through Chapter 11 bankruptcy proceedings with deposits being converted to equity in the banks? That is what happened?

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    4. Ralph,

      Also,

      "Plus I suggest it is not morally acceptable: that is, I think that everyone is entitled to a 100% safe bank account, at least up to some maximum sum."

      Safe in what regard? My acceptable level of safety is that there are legal avenues to pursue when I am wronged (my deposits are taken without my permission). I realize that the federal government may not be able or willing to provide full restitution. If my deposits are taken, and through bankruptcy proceedings my deposits are converted to a voting equity stake in the financial institution that wronged me, then I consider that a reasonable resolution.

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    5. Frank,

      You claim that “Treasuries bills fit the definition of a run prone contract”. On the basis of JC’s definition which you cite in your preceding paragraph that is correct. But there is huge difference between a commercial bank on the one hand, and the central bank / treasury on the other. A central bank, unlike a commercial, can print money at will: the result might be inflation, but the central bank cannot go bust.

      Much the same goes for a Treasury: it can grab money at will off taxpayers. So there is not much point in taking part in a run on a central bank or treasury.

      Re destroying deposits with a book value of $X, and converting those to shares with a value of $0.8X or whatever, you personally might regard that as what you call a “reasonable resolution”, but it’s not what 99% of depositors expect or want. That is, the basic promise made by a bank is that when you deposit $X, you get $X back (maybe plus interest and maybe less bank charges).

      So why don’t we have a system like JC’s where there is a clear choice between two alternatives? First, for those who want to be GUARANTEED $X back for every $X deposited they can have 100% safe full reserve accounts, but they don’t get much interest. Alternatively, for those who want to take a bigger risk, there is the stock exchange or mutual funds that invest in stock exchange quoted securities.

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    6. Ralph,

      "Re destroying deposits with a book value of $X, and converting those to shares with a value of $0.8X or whatever, you personally might regard that as what you call a “reasonable resolution”, but it’s not what 99% of depositors expect or want."

      What depositors expect or want is immaterial to the argument. John has presented an argument that run prone contracts should be eliminated by having the banking system rely upon equity issuance to fund lending. In John's system there is no Fed as lender of last resort (and presumably no open market operations either). I am simply taking the next logical step, for a bank to remain a going concern it must maintain that full 100% equity capitalization. Meaning it must be able to convert its debt obligations (deposits) to equity in real time.

      "So why don’t we have a system like JC’s where there is a clear choice between two alternatives?"

      That second alternative already exists:

      http://www.gardall.com
      http://www.smith-wesson.com

      and the old standby

      www.serta.com

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    7. "Is your suggestion that we change this such that the 95MM goes into T-bills, and the bank needs to raise 100MM in equity to make the loans?"

      Yes. That is what Professor Cochrane is advocating.

      Delete
    8. Frank,

      It is nonsense to suggest that “for a bank to remain a going concern it must . . . . be able to convert its debt obligations (deposits) to equity”. You still haven’t got the point, clearly explained by JC, Milton Friedman, Lawrence Kotlikoff and other advocates of full reserve, namely under full reserve, the banking industry is split into TWO HALVES.

      The lending half, or the entities making up that half, just cannot get at the deposits accepted by the other half. Please study this subject before commenting on it.

      As to the idea that when the assets of one of the entities making up the lending half fall below the book value of the shares, that something has to be done (e.g. as you claim, nick depositor’s money) that is also nonsense. The entities making up the lending half of the industry are essentially mutual funds, as Kotlikoff explains. Now if the assets of such a fund fall below the book value of the original fund units what of it? Or in the case of shares, if a business starts up (funded by shares) and its assets fall below the book value of the shares, what of it? That does not, contrary to your suggestion, stop it being a “going concern”. There are thousands of businesses all over the country whose shares have fallen below book value. That does not, repeat not equal bankruptcy, insolvency or anything of that nature.


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    10. Ralph,

      "There are thousands of businesses all over the country whose shares have fallen below book value. That does not, repeat not equal bankruptcy, insolvency or anything of that nature."

      I never said it did. What I was describing was a banking system that had to maintain 100% equity financing in real time. JC doesn't make that distinction in his paper.

      And the question becomes should a bank whose shares have fallen below a certain threshold be permitted to continue to lend? Companies are routinely delisted from the equity indices once their share values fall below a certain value. You might say leave that decision up to the shareholders, and I would say as long as all shareholders hold voting equity, there is no problem with that solution.

      But neither you nor John will specify what type of equity should be sold to fund lending operations (preferred / common, voting / nonvoting).

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    11. Ralph,

      Simple question - once a banks assets (loans) fall below the value of its equity, should the bank be permitted by the federal government to continue to lend?

      I would argue - no it should not, for the same reason that a company that makes faulty goods should not be able to continue to make those faulty goods even if shareholders are willing to fund the production of those faulty goods.

      It would be different if a bank was forced to retain all the loans that it makes (no faulty goods are sold) - equity holders bear current and future risk.

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  2. You're proposing rather sweeping changes, trying to abolish some pretty long-standing economic institutions. You might think that modern options makes old-fashioned (broad?) banks obsolete, but until it's tried we really don't know if they can be so easily replaced. Scott Sumner's proposal, in contrast, does not involve trying to guarantee there are no runs (the same motivation behind deposit insurance and "too big to fail"), but trying to ensure the overall economy can withstand the failure of any particular institution which might fall victim to a run.

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    1. TGGP,

      You suggest that existing banks might not “be so easily replaced”. Well they already have been replaced in that full reserve or near 100% safe banks already exist: money market mutual funds (and in the UK, the government run savings bank “National Savings and Investments”).

      As to the “equity only funded” lending institutions that JC and others want, I completely fail to see the difficulty in an entity of that sort operating. Perhaps you can explain. Indeed in the 19th century, bank capital ratios of 50% were common (in contrast today’s laughable 3%). Far as I know, banks operated OK in the 19th century.

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    2. I think we could (and should) change the rules banks operate under to encourage a return to 19th century norms. That's not the same thing as prohibiting anything less than 100% safe banks (and even money market mutual funds are have fragile nominal obligations, hence "breaking the buck").

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  3. A lot to like here.

    For the public sphere, I always say, "Keep It Simple Stupid."

    From taxes to farm policy to bank regs, if I cannot understand it, then I suspect it is clogged up. I am an average citizen (my wife says I am below average, but if you discount that for the marriage factor...).

    Would it be so bad to demand simple, if heavy-handed but clear, solutions to bank fragility?

    After all, banks are intermediaries. They are supposed to funnel savings to productive uses, and not collapse. They should be simple. They are essential to our financial well-being, but it is not essential that they be indecipherable---if they want a public backstop.

    Another solution, of course, is to take away the public backstop, and just let the free markets handle it. It may be that savers demand greater transparency in banks and thus greater sturdiness. I would. I fear the public would not. The public trusts a brand and advertising also.

    AIG was an example of a private-sector financial guarantee.

    Certainly, any bank that wants to forego the public backstop should do as it pleases (excepting fraud). But a sign should say at the door, "You Can Lose All Your Money Inside."

    My only complaint about Cochrane's proposal is that it gets a little complicated. There are some judgement calls in there, ways to game the system.

    In English, what does it mean that banks are 100 percent funded by equity?

    Maybe FDIC-insured institutions should post equity at 15 percent of loans. There is a problem with the riskiness of the loans, so one bank could be iffy and the next rock-solid even at 15 percent equity. I would hope that shareholders would have a beneficial influence---which leads to another solution: Require 15 percent equity, and it must be privately held. No easy to dismiss public shareholders.

    And then apply the "Cochrane tax" to the flightiness of deposits.








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    1. Benjamin,

      "In English, what does it mean that banks are 100 percent funded by equity?"

      In English, it means there is no lender of last resort operation by the central bank. All lending operations by a bank must be funded by selling equity shares of that bank. And so if a bank wants to make $1 million in loans, it must sell $1 million in equity shares.

      Now what happens if the market value of that equity falls below the market value of the loans? Good question. Presumably, said bank would have to either cut costs or sell a portion of the loans that it holds to bring its equity capitalization back into line.

      Also, what happens if a bank decides to use deposits as a way to extend credit? Another good question. It must be able to get depositors to buy up the loans that it makes (certificates of deposit for example) or it must be willing to convert deposits into equity shares in the bank.

      John (and Ralph) have not discussed what type of equity stock would be issued to fund lending operations (Preferred / Common, Voting / Nonvoting, etc.). I would say that it should be preferred voting shares, but that is just my opinion.

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    2. “Now what happens if the market value of that equity falls below the market value of the loans?” What happens is the same as when the shares of any other corporation falls below their original book value: no need to panic, but the corporation is liable to be taken over, so management need to think about what they’re doing with a view to getting a better return on capital.

      “Also, what happens if a bank decides to use deposits as a way to extend credit?” That’s not allowed. It’s illegal. “Deposit money”, i.e. money which depositors want to be 100% safe cannot be loaned on to mortgagors or businesses: it can only be lodged at the central bank or perhaps invested in short term government debt. (I prefer the former).

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    3. Ralph,

      "What happens is the same as when the shares of any other corporation falls below their original book value: no need to panic, but the corporation is liable to be taken over..."

      And in the description I gave, the takeover would be orchestrated by the depositors - they would become the new shareholders.

      “Also, what happens if a bank decides to use deposits as a way to extend credit?”

      Okay, I need to be a little more clear. What happens if people who deposit money with a bank want to earn a return on that money and a bank wants to offload it's credit risk? In that case either the bank would sell its claim on those loans to the people who will absorb it (think certificates of deposit) or the person with a deposit at the bank would purchase equity from the bank.

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    4. Ralph and Frank:

      Interesting questions.

      Funny thought: In the old days, depositors actually owned some S&L's, and one dollar of deposits was one share, or something to that effect. So, in that case, you could make out loans equal to deposits. People who wanted to own shares would make deposits.I guess you would attract shareholders if your return on deposits was high enough.

      I am still not sure what Cochrane means by 100 percent equity though. Even a Meltzer talks about 15 percent equity, in relation to outstanding loans.

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    5. "I am still not sure what Cochrane means by 100 percent equity though"

      I don't want to be rude to you Benjamin but what part of 100% equity don't you understand? Cochrane is saying that a bank should not be allowed to borrow money (by taking deposits or issuing paper) for the purpose of lending it to private borrowers. If a bank wants to lend money to anyone other than the US treasury they must fund the loan 100% from equity.

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    6. Absalon:

      Okay, but does Ccchrane's mean, in the entire country, and in every state, no group of people can pool their capital and lend it out, unless they are 100 percent equity funded?

      In other words, non-bank banks would be outlawed? We would substitute a prohibitive federal regulation for free markets?

      Why 100 percent? Why not 80 percent? Is there a chance that 80 percent of a bank's loans would fail?

      Then Cochrane also has this conflicting sentence: "For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well."

      Well, then, banks are not lending out only backed b 100 percent equity, but using some sort are sticky borrowed money too.

      That's the part I do not understand.

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    7. Benjamin,

      "Okay, but does Ccchrane's mean, in the entire country, and in every state, no group of people can pool their capital and lend it out, unless they are 100 percent equity funded?"

      No, I don't think that is what Cochrane means. What it means is that a bank cannot borrow money to turn around and lend it.

      Sure, a group of people who already have money could pool it together to form a firm that lends that money. This group of people could not go to a "bank" in John's world to borrow money and turn around and lend it (no credit intermediation).

      "We would substitute a prohibitive federal regulation for free markets?"

      No, the only thing that would be eliminated is the central bank as lender of last resort and open market operations by the central bank (in essence no central bank to speak of).

      Prior to the Federal Reserve Act of 1913 and Banking Act of 1933, the United States went through several banking panics:

      http://en.wikipedia.org/wiki/Panic_of_1907
      http://en.wikipedia.org/wiki/Panic_of_1893
      http://en.wikipedia.org/wiki/Panic_of_1873
      http://en.wikipedia.org/wiki/Panic_of_1857
      http://en.wikipedia.org/wiki/Panic_of_1837

      Those panics began about the same time as the expiration of the charter for the Second Bank of the United States:

      http://en.wikipedia.org/wiki/Second_Bank_of_the_United_States

      One final tidbit of interest that John makes mention of is the Chicago Plan for banking reform:

      http://en.wikipedia.org/wiki/Chicago_plan

      Mind you this plan for banking reform was put forth in 1933, 20 years after the establishment of the federal reserve.

      This was amended and represented as:

      http://home.comcast.net/~zthustra/pdf/a_program_for_monetary_reform.pdf


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    8. Thanks for your reply. But it strikes me that large lending organizations could evolve that borrow and re-lend but don't call themselves banks...

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    9. Benjamin,

      You are welcome.

      The presumption is that without a central bank to provide short term funding (overnight discount window) and without a deposit base, interest rate arbitrage (borrow short / lend long) cannot be realistically achieved.

      Of course, this type of banking arrangement would need to happen on a global scale to be truly effective. Can't get short term funding because there is no U. S. Central Bank? Go the the Central Bank of Europe or Japan.

      Less clear is whether central bank open market operations would continue. I presume that they would not (but that is just my presumption). A central bank that conducts only open market operations, but buys bonds at a premium and sells them at a discount, provides an interest spread (or rather a bond price spread).

      That spread is useless unless the central bank is permitted to buy and sell debt obligations other than U. S. Treasuries.

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    10. Frank-

      I was thinking the same thing, the international angle. The USA would would become dependent on foreign capital/lending.

      Okay, it is getting murkier and murkier.

      Dr. Cochrane:

      1. You say banks should be 100 percent funded by equity, but then we have the mystery sentence, "For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well."

      Okay, is this is just a flub, or do I have a deeper misunderstanding? Are we conflating commercial banks with investment banks?

      2. "I argue that Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax."

      Okay, I like the above idea, but I thought we had settled on 100 percent equity-financed banks. Now we seem to be saying banks can borrow money, but pay taxes based on the flightiness of borrowed money. The flightier a bank's source of funds, the higher the taxes.

      I am not sure I understand the somewhat oblique reference to "downstream easy-to-fail intermediaries to tranche that equity to debt if needed." In fact, I don't understand what that means.

      But all that said, I like the idea that financial intermediaries have a lot more skin in the game----much larger equity-to-loans ratios----and that they be taxed based on the flightiness of their sources of money to be lent out.

      These ideas are simple enough to fit under my KISS rubric, but also strike me as effective.

      Maybe banks should be required to have 15 percent equity to loans, and pay sliding scale of taxes on the days duration of their borrowed funds.


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    11. Ben,

      I could be wrong, but I think that John allows for bank debt to handle brick and mortar financing - for instance a bank opens a new office in Toledo.

      Normally fixed construction is financed with debt. The holders of that debt have a recovery mechanism (liquidation of fixed assets) that is not available to share holders.

      A bank floats a loan for $100 million and says it will use this money to build a new building. At the same time a bank sells $100 million in equity and says it will use it to fund lending operations. How does a government regulator who is enforcing the 100% equity rule decipher which funds are being used where?

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    12. Benjamin,

      "I am not sure I understand the somewhat oblique reference to downstream easy-to-fail intermediaries to tranche that equity to debt if needed. In fact, I don't understand what that means. "

      It means that an intermediate firm can exist between the firm that issues equity and the borrower that receives a loan. In essence, the "senior" firm issuing equity would turn around and buy equity in the "junior" intermediate firm. That intermediate firm would then originate a loan - hence the term "tranched" equity.

      Tranching debt involves create senior and junior levels of credit claims. Tranching equity involves the same thing.

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  4. John,

    This last paragraph intrigued me:

    "Constructing a financial and monetary system which is immune both to private and to public default is an interesting question. Rather than pursue a fundamentally different monetary standard—substitute bitcoins, gold, or SDR (special drawing rights) for short-term nominal Treasury debt—I think fairly simple innovations in government debt would suffice. If the government were to issue long-term, ideally perpetual, debt that comes with an option to temporarily lower or eliminate coupons, without triggering a legal or formal default, then government financial problems could be transferred to bondholders without crisis or inflation."

    I thought you didn't like discretionary actions by the federal government? "...comes with an option to temporarily lower or eliminate coupons" sounds a lot like discretionary policy to me.

    Instead, if the government switched from debt financing to equity financing (return on investment is only realized against a future tax liability), then a government does not have to do coupon maintenance (raising / lowering / eliminating payments) based upon discretion. Government has a sold risk asset. Realized returns on government equity increase during periods of high economic activity and decline during periods of falling economic activity.

    Government's financial position is unchanged with equity issuance no matter the economic situation. Which means that tax and spending policy can remain unchanged no matter the economic situation.

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  5. Excellent! Favorite sentence (regarding the way things are currently done):

    "Each new step follows naturally to clean up the unintended consequences of the last one."

    So much truth in one short sentence!

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  6. Mr. Cochrane:

    Several issues with the essay. For starters, since equity capital has a much higher cost associated with it, banks will have to charge a much higher rate of interest on loans they make in order to generate a reasonable economic profit.

    This is likely to reduce accessibility of credit and make credit much less affordable. New businesses or those still in their infancy will see their profit margins squeezed and may have to close down. New home purchases are likely to go down considerably or the rate of new home sales could decelerate sharply. Bottomline, I would like to know why we shouldn't expect a sharp economic slowdown if we go from an "FDIC deposit-funding" regime to "Equity-funding" regime.

    If your argument is going to be that a reduction in leverage will result in a drop in the bank's cost of equity then my questions would be: 1) who can say a priori what the cost of equity will be under the new regime, and 2) even if one could provide an estimate of cost of equity how do we know it will be sufficiently low to maintain economic activity at current levels?

    I am not sure these issues are addressed in your essay.

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    Replies
    1. See the section titled "modigliani and miller"

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    2. Not so fast Mr. Cochrane. You are talking about a 50 bps increase in the bank's cost of equity. Firstly, how do you get to 50 bps?

      If I look at the period 1996 to 2006 (both years inclusive), I find that the rate of interest on conventional mortgages was about 6.84% (data from the Fed). If we assume that an equity-funded bank has $100 in equity that is lends out to home-owners at (say) 7% then:

      1) Interest income = $7
      2) Interest expense = $0 (since funding is all equity)
      3) Non-interest expense = $1 (it cannot be zero, so I am making a guess here)
      4) Pre-tax income = $6
      5) After-tax income = $4 (assuming a 33.33% tax for ease)

      Therefore ROE = 4%. If banks are making an economic profit, then cost of equity is probably 3% (again, no a priori way to know this). But we do know that there is a certain absurdity about the 3% number:

      a) the yield on the 10-year constant maturity treasury bond during 1996-2006 was 5.15% (again, courtesy The Fed). So if the risk free asset has a cost of 5%, how can a bank's cost of funds be 3%?

      b) Post-financial crisis, banks are struggling to post ROEs in excess of 10%. By your logic, these stocks should have behaved like superstars. In fact, the stocks have done nothing of the kind.

      Things just don't add up.

      And oh by the way, I did read the MM piece is your essay.

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    3. Anonymous,

      If you think “equity capital has a much higher cost” perhaps you can explain the reverse yield gap. I.e. the REALITY (contrary to what you or I might expect) is that the return on equity just ain’t too impressive compared to the return on bonds. Of course bonds are not EXACTLY THE SAME as bank deposits, nevertheless, and quite apart from Modigliani Miller, the reverse yield gap casts doubt on the idea that equity holders demand a particularly large return on their investment.

      Second, even if funding loans just from equity did raise the cost of loans (and I think it would to a finite extent), that increased cost comes about as a result of the removal of bank subsidies. Remember that banks enjoy HUGE SUBSIDIES under the existing system: that’s because the existing and chronic banking system (fractional reserve) needs periodic injections of trillions from the taxpayer to stop it collapsing. In contrast, JC’s system (i.e. full reserve banking) cannot suddenly collapse, ergo it needs no subsidy.

      And it’s a cardinal rule in economics that subsidies do not make sense (unless there are very good social reasons for a subsidy).

      Next, you claim the switch to JC’s system would bring a “sharp economic downturn”. Certainly if the cost of loans rises, then all else equal, the effect is deflationary. But loans are only as cheap as they currently are because banks are subsidised. And subsidies, to repeat, do not make sense. And as to how to deal with that downturn, that’s easily done: just have the central bank and government do a bit of stimulus. My preferred form of stimulus (also favored by Milton Friedman) is simply to create and spend new money into the economy: up to the point that brings full employment without exacerbating inflation too much.

      The net result would be less lending based economic activity and more non-lending based activity. Given that private debts are at record levels relative to GDP, I fail to see the problem there. Also in the UK, the banking industry is now TEN TIMES AS LARGE relative to GDP as compared to the 1960s. If you can think of any benefits we’ve derived from that, I can’t. Certainly economic growth is no better now than in the 60s.


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    4. Ralph,

      Milton Friedman lived in a time when there were two forms of U. S. currency:

      1. Federal Reserve notes (lent into existence by the central bank)
      2. United States notes (printed into existence by the U. S. Treasury)
      See: http://en.wikipedia.org/wiki/United_States_Note

      Are you advocating the return of US Notes?

      "Certainly if the cost of loans rises, then all else equal, the effect is deflationary."

      If all else is equal (supply of goods is unchanged, demand for goods is unchanged) then why would raising the nominal cost of loans be deflationary?

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    5. Mr. Musgrave

      Several things:

      1) Let us allow Mr. Cochrane to respond instead of engaging in dialog on "his" blog

      2) There is no inconsistency at all. Equity does have a higher cost and if companies are not generating returns in excess of this cost of equity i.e. they are not making sufficient economic profit, stockholder returns are bound to be anemic. So there is no inconsistency between your "claim" that equity returns have lagged returns on bonds.

      3) You contradict yourself. First you say that the "REALITY" is that return on equity is just ain't too impressive. OK. If that is the case, then why do you say in the very next sentence that "casts doubt on the idea that equity holders demand a particularly large return on their investment". Well if they didn't demand a high return on their investment, why has their performance lagged vs. bonds? Can't have your cake and eat it too you know. You have to choose what it is that your proposition is.

      4) What I see in all your responses to other comments is a lot of words a very little data to support anything. Can we have some data next time you say something please?

      5) Let me reiterate again, this is Mr. Cochrane's blog and after this I don't wish to engage in any further dialog with commenters. Let us allow Mr. Cochrane to respond - assuming he wants to.

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    6. You've already answered your question(s) when you applied a 33% rate to the $6 theoretic income.

      As MM tell us, in many ways it's not so much that equity costs are higher, but rather that debt costs are lower (debt's privilege at the expense of equity). Further, debt payments are deducted from income. If dividends weren't discriminated against and a bank were 100% equity your sums above would add up just fine. (And JC clearly outlines in his vision that these distorting accounting / taxation policies need to go.)

      The core issue that JC is getting at is that we must purge, as far as possible, the notion that commercial entities (banks) can use demand deposits (or any other "fixed-value, pay-on-demand, and hence run-prone securities" to finance lending. Lending means risk and such inventions like demand deposits are (guaranteed) risk-free. At the moment the (sometimes very large) risk gap gets picked up by the government and where it's not is run-prone; why not short circuit all this and just require demand deposits to be fully backed by government bonds?

      In such a world, the saver/lender cannot live in blissful ignorance that his money is risk-free and will be paid back in full tomorrow - not if he wants to earn a return on it that is. Banks' lending funded by 100% equity may or may not look attractive to invest in depending on what they do with their funds. But if depositors want a return on their money, then they must accept risk. No more of this everybody-wins-all-the-time and the government will bail us (them) out if it all goes wrong. Prefer a completely risk-free deposit? Then you will de-facto be buying treasury bonds.

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    7. Anonymous,

      "why not short circuit all this and just require demand deposits to be fully backed by government bonds?"

      Why do you believe that treasury bonds are risk free?

      For that to work and for deposits to maintain their liquidity, all government bonds would need to be short term (probably six months or less). That puts huge interest rate rollover risk ($16 trillion and counting) on the federal government and its ability / willingness to collect tax revenue to make the payments on those bonds.

      Want to bet the federal government wouldn't suspend interest payments if they could not agree on other fiscal (tax / spending) policy?

      JC advocates just such a thing with his reference to perpetual debt:

      "If the government were to issue long-term, ideally perpetual, debt that comes with an option to temporarily lower or eliminate coupons, without triggering a legal or formal default, then government financial problems could be transferred to bondholders without crisis or inflation."

      Notice how John suddenly favors temporary government measures here, and yet favors rules based government policy here:

      http://johnhcochrane.blogspot.com/2014/03/hello-discretion.html

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  7. Professor Cochrane:

    Allow me to make a tangential, possibly unrelated, but topical comment, away from the obvious financial theory/policy lines of inquiry. It occurs to me that an integral part of delivering in practice your vision would greatly benefit from further advances in an area that has now been declared "non-socially productive" by many "thought leaders" -- algorithmic-based HFT. We may or we may not be there yet in being able to liquify equities and a few government securities to the degree that your proposal may need, but clearly as this practice deepens, those miliseconds and micro cents people laught at will provide real areas for improved efficiencies on a much larger scale of trading. Moreover, as the practice broadens and more and more securities are brough into the liquification blender -- think the entire family of risky debt -- it will become obvious that what our securities markets need is more, not less, investment in liquidity enhancement technologies.

    So, perhaps those who are currently working in algorithmic and HFT, may soon have a greater incentive to broaden their software and hardware investments with aims not just to squezze out a micro bp off the S&P flow, but off the entire money supply!.

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    Replies
    1. I've been thinking along similar lines. Prof. Cochrane seems willing to constrain the money stock to government debt, in the belief that $18 trillion is sufficient both for transactional needs as well as the demand for safe assets. He suggests that transactions can also be made by liquidating risky assets, when needed. But this allows HFT to tax such transactions, and why should we allow that?

      For liquidity enhancement, we need more money, and a safe way to generate it is for the government to issue more treasury securities. In addition to safe assets, they can produce an information insensitive risky asset, which would be usable as money without needing HFT for liquidity.

      Lately, we have seen the government buying risky assets in exchange for bonds, which does not enhance the government's portfolio. I advocate the reverse trade: the government should retire some debt in exchange for standardized equity that would act as macroeconomic insurance, and this does not need to decrease the money stock. Banks could do the same trade for the same portfolio benefits, while producing a second form of money.

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  8. There's an article in today's Financial Times by Martin Wolf which is sympathetic towards the sort of system Grumpy wants. See:

    http://www.ft.com/cms/s/0/7f000b18-ca44-11e3-bb92-00144feabdc0.html?siteedition=uk#axzz2zoqbkZES

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    Replies
    1. Ralph,

      The link is subscription only. Curious - What role does Mr. Wolf envision for the central bank? Currently, private banks must create money for the government to be able to borrow money (the central bank may not directly loan money to the federal government).

      JC briefly touches on the fiscal angle at the end of his article, but does not elaborate on what changes would happen with the central bank under the arrangement he imagines.

      You seem to prefer the U. S. going back to the federal government printing money into existence (no central bank required) - See:

      http://en.wikipedia.org/wiki/United_States_Note

      Which would make the whole notion of government debt a mute point. The only question that remains would be whether the government would go back to some metallic standard - from the article on U. S. notes:

      "Soon after private ownership of gold was banned in 1933, all of the remaining types of circulating currency, National Bank Notes, Silver Certificates, Federal Reserve Notes, and United States Notes, were redeemable by individuals only for silver."

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    2. Frank,

      Wolf does not set out any specific role for central banks. He just sets out the basics of full reserve banking (which comes to much the same as Grumpy’s system). Plus he quotes some advocates of full reserve, e.g. Laurence Kotlikoff. He might also have quoted Milton Friedman: see Friedman’s “Program for Monetary Stability” 2nd half of Ch3 if you’re interested.

      You’ll find a number of long quotes from Wolf’s article here which may be of some help:

      http://www.positivemoney.org/2014/04/strip-private-banks-power-create-money-financial-times-martin-wolf-endorses-positive-moneys-proposals-reform/

      “You seem to prefer the U. S. going back to the federal government printing money into existence (no central bank required)”. Quite right. Advocates of Modern Monetary Theory, of which I am one, tend to regard the distinction between central banks and governments as very artificial. Milton Friedman suggested scrubbing the distinction. See p.247, item No1 under the heading “The Proposal” here:

      http://nb.vse.cz/~BARTONP/mae911/friedman.pdf

      As to how to actually merge government and central bank, while barring politicians access to the printing press, Positive Money advocates that the AMOUNT of stimulus (or extra money created and spent into the economy) be decided by a committee of economists, while the split of that as between extra spending and tax cuts, and how the money is spent is left to the democratic process and politicians.

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    3. Ralph,

      "while barring politicians access to the printing press"
      "decided by a committee of economists"

      And there are no economist politicians?

      http://en.wikipedia.org/wiki/Paul_Douglas
      http://en.wikipedia.org/wiki/Phil_Gramm

      Ever foresee the possibility that an economist is on both the finance committee of Congress AND the spending committee of Congress? Are economists precluded from running for office now?

      Delete
    4. Frank,

      You COULD have “economist / politicians” deciding how much stimulus to implement, but the temptation to organise pre-election booms is just too big I think.

      Delete
    5. Ralph,

      "but the temptation to organize pre-election booms is just too big I think"

      Which is the reason the federal government either taxes to fund spending or sells securities to fund spending (as opposed to printing money).

      Taxing creates a relative demand change - I was going to spend money on a new car, government would rather spend that money on a new tank. Government taxes me - demand for cars goes down, demand for tanks goes up.

      When the federal government sells a security, it creates an incentive for the private individual to save while the government spends. For instance, I buy bond with a rate of return while government spends borrowed money. That works as long as the bond is accrual type (not coupon type) and the central bank does not try to monetize the government's debt.

      The only issue (that I see) is whether the government should sell securities with a guaranteed rate of return (bonds) or a non-guaranteed rate of return (equity).

      John prefers banks to issue equity when funding loans, but then digresses into perpetual bonds when addressing fiscal issues.

      Why not government equity? It eliminates the discretionary aspect of perpetual bonds (Congress suspending / re-instating interest payments) while still preserving the risk / reward profile of non-guaranteed securities. It also eliminates the possibility of monetary policy interference - central bank can't buy equity issued by federal government. It may be permitted to buy and sell perpetual bonds.

      Robert Shiller makes a similar case for "Trills" here:

      http://cowles.econ.yale.edu/P/cd/d17a/d1717.pdf

      "We make the case for the U.S. government to issue a new security with a coupon tied to the United States’ current dollar GDP. This security might pay, for example, a coupon of one-trillionth of the GDP, and we propose the name Trill be used to refer to this new security."

      "This security would be long term in maturity, ideally even perpetual."

      The only problems that I have with Trills are:

      1. Federal expenditures tied to Trills rise and fall with GDP when federal expenditures should be countercyclical, Trills tied to the output gap would make more sense - remember Trills are coupon securities and the coupon payments can be spent as soon as they are received. Shiller makes the mistake of assuming that only pension / retirement funds would be buyers.

      2. Trills do not change the incentives of the buyers of those securities - I think that is the crucial aspect that is missing from both perpetual bonds (recommended by JC) and from Trills (recommend by Shiller).

      Better would be a security where the return on investment can only be realized against a future tax liability. Potential return on investment is set by government / Treasury relative to the output gap. Higher output gap = higher potential return on investment. Realized return on investment is left to the owner of the security.

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  9. Thank you. It's a good article.

    ReplyDelete

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