Monday, November 5, 2018

Kotlikoff on the Big Con

In preparing some talks on the financial crisis, 10 years later, I ran across a very nice article, The Big Con -- Reassessing the "Great" Recession and its "Fix" by Larry Kotlikoff. (Here, if the first link doesn't work.) 

Larry is also the author of Jimmy Stewart is Dead – Ending the World's Ongoing Financial Plague with Limited Purpose Banking, from 2010, which along with Anat Admati and Martin Hellwig's The Bankers' New Clothes is one of the central works outlining the possibility of equity-financed banking and narrow deposit-taking, and how it could end financial crises forever at essentially no cost.

Larry points out that the crisis was, centrally a run. He calls it a "multiple equilibrium."  Financial institutions have promised people they can have their money back in full, at any time, but they have invested that money in illiquid and risky assets. When people all do that at the same time, the system fails. Such a run is inherently unpredictable. If you know it's happening tomorrow, you run to get your money out and it happens today.

This is a common view echoed by many others, including Ben Bernanke. What's distinctive about Larry's essay is that he pursues the logical conclusion of this view. If the crisis was, centrally, a run, all the other things that are alluded to as causes of the crisis are not really central.  Short-term debt, run-prone liabilities are gas in the basement. Just what causes the spark, how big the firehouse is, are not central, as without gas in the basement the spark would not cause a fire.

Larry puts it all together nicely by starting with the 2011 Financial Crisis Inquiry Commission report:
"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. "
Larry then takes apart each of these non-culprits, as below.


In my view, the understanding that the crisis was a run, that without a run there would have been no crisis, somewhat like the 2000 tech stock bust, and that lots and lots more capital is the only real answer, has emerged slowly over the last 10 years. Larry's essay is good for putting all the others to rest.

The insight is also optimistic. It is possible to fix one clear simple thing -- too much short-term debt, not enough capital. If all the long list of vague maladies named by the crisis commission need to be fixed by super-powerful and financially clairvoyant regulators, the job is hopeless despite the immense government expansion that would entail.

In many of these items, I think Larry oversteps a bit. The argument only needs to be that "these things might have been problems, indeed, they might have caused a recession, but without a run, induced by short-term debt, there would have been no financial crisis." Larry goes on to cast doubt whether any of them are problems at all, which is fun and provocative but more than necessary. Moreover, Larry really goes on to view recessions themselves as multiple equilibria, which is an interesting and provocative idea, but not necessary.

Larry's essay is even more to the point today. I'm at the Financial Cycles and Regulation conference at the Bundesbank. Every paper so far takes it for granted that there is such a thing as a "financial cycle," a buildup of "excessive" or "imbalanced" debt that precedes an inevitable round of default and crisis. It is the regulator's job to manage such "debt cycles" actively. Larry's essay disagrees from the word go. It's nice to have two diametrically opposed ideas in mind.

Larry's List follows. If you get bored, skim to the bottom for his more provocative ideas on runs.

1) Liar Loans, No Doc Loans, NINJA Loans and Other Subprime Mortgages

There just weren't that many subprime defaults, especially before the crisis hit. (And, I would add, defaults not insured by fannie, freddie, etc.) 

2) The “Unsustainable” Rise in Housing Prices

House prices have risen and fallen before. And, I might add, many are sustained. If you're waiting for houses in Palo Alto or Manhattan to fall to, say Joliet IL levels, you may have a long wait ahead of you. 

Larry makes an interesting comparison of real house prices with real GDP, 
.. real house prices can rise for years, indeed, decades. They did so essentially every year for the 32 years between Q1 1975 and Q1 2007. The rise was both smooth and gradual with real house prices only 64 percent higher in Q1 2007 than they were in Q1 1975 – this despite real GDP rising by 170 percent over the same interval.  
...between Q1 2003 and Q1 2007 ... real house prices rose by 22 percent. But over this period real GDP rose by 14 percent. Hence, real house prices rose only 2 percent faster per year than did the economy during the period of “unsustainable” house price increases.
The comparison between real house price and real GDP is unusual. Larry writes
One can write down models with a fixed supply of housing in which house prices will rise pari passu with output, at least in the long run. One can also write down models in which there is a variable supply of housing and the price of housing stays fixed, while the quantity of housing rises with output.
In any case, it's not a financial crisis without short-term debt. 
Certainly, a temporary drop in house prices could have produced a contraction in construction.... Moreover, a decline in a given sector doesn’t augur an economy- wide recession. 
And, an important point
a drop in the price of homes does not adversely impact most homeowners. Yes, the value of their asset falls. ...
But you still get to live in the house. If you could pay the mortgage before, you still can. 
 if we’re talking about a nationwide decline in house prices, as we are with the GR, even those who moved experienced no economic harm because their ability to buy at a lower price offset their need to sell at a lower price.
The house price drop was great news for young people who live in apartments, as the stock price drop was great news for their retirement investment opportunities. Yes, there are theories in which the losers impact the economy asymmetrically, such as Mian and Sufi's, but we're straying away from the point here. A house price "bubble" and "burst" is not per se a reason for a financial crisis.  

As in many of these "causes" it's important to distinguish events before October 2008 from those afterwards. Yes, there was a huge recession, and that caused house price declines, job losses, mortgage defaults, and so forth. But causes of the crisis have to come first. 

3) Ratings Shopping
"overrating affected less than one half of one percent of the U.S. bond market. Furthermore, this small figure surely overstates the importance of ratings shopping as many of the downgrades were caused by the GR itself,"
4) Increased Bank Leverage
"Sky-high bank leverage is another part of the standard GR explanation....Bank leverage actually fell over the period 1988 through 2008.16 Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008."
Be careful here. Larry's point is that there was no voluntary increase in leverage, and especially as measured and monitored by regulators, and no such increase was a key cause of the crisis.  That doesn't mean the overall amount of leverage is fine. Larry's main point, as mine, is that the banking system has way too much leverage overall. 

5) Too Little [Regulatory] Capital  
"According to Cox [ Christopher Cox, Chairman of the U.S. Securities and Exchange Commission (SEC)..], Bear Stearns was well capitalized when it failed, with a capital ratio over 13 percent and a debt-equity ratio of 6 to 1. Indeed, it appears that Bear Stearns could have easily passed the current Dodd-Frank stress test immediately prior to its demise. Consider this statement from Chairman Cox. 
"The fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the weekend, the firm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard. "
Lehman was also well capitalized prior to its demise. It had tier-1 capital of 11 percent when its creditors pulled the plug. An 11 percent capital ratio is close to the current banking system’s tier-1 capital ratio of 12.3 percent, calculated based on the Federal Reserve’s recent stress tests. This indicates that today’s banking system is no safer than was Lehman Brothers when it was driven out of business."
Again, in this draft, Larry doesn't emphasize enough that the point is a decline in capital, a weakening of regulations, or a decline in regulatory capital. His and my overall point is that capital needs to be much, much larger overall, and that will stop runs. But the event of the crisis was a combustion of the regular old gas in the basement, not an addition of lots of new gas. 

6) Egregious and Predatory Lending

i.e. 
"adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages, piggy-back, and so-called pay-option ARM loans."
of these, 
"...in 2007, before the GR, the foreclosure rate was 5 percent. Its lowest value, between 2002 and 2007, was 3 percent, which was observed in Q3 2005.If one assumes that all of the 2 percentage-point increase in subprimes involved predatory lending, we’re still talking about predatory lending causing, at most, 0.3 percent more mortgages to definitely default, namely, enter foreclosure. This is simply too small a figure to matter to the overall economy. Indeed, given the size of the 2007 mortgage market, it represents just $32 billion. In 2007, U.S. GDP was $14.4 trillion. The economy’s 2007 total net wealth was $68 trillion."
The Dodd-Frank act piled every suggested fix to every perceived financial problem in one place. Even if one regards predatory lending as a problem, even if one does not regard competition as the best disinfectant and guarantor of good treatment, even if one thinks it needs fixing, Larry's point is that such a fix has nothing to do with stopping crises. 


7) Dramatic Increases in Household Mortgage Debt
Surely, the addition of over $750 billion in mortgage debt in the course of 6 short years must represent a priori evidence that a massive recession was in the works. Not so. ... The increase in borrowing to purchase homes was not associated with a massive spending spree on the part of the American public. Indeed, the share of GDP consumed by the public remained fixed at roughly 67 percent between early 2002 and late 2007.
What about household debt payment service as a share of disposable personal income? There was an increase prior to the GR, but nothing extraordinary. Between Q4 2001 and Q4 2007, the ratio troughed at 12.1 percent in Q2 2004 and peaked in Q4 2007 at 13.2 percent. A 13.2 percent ratio is small and the increase from trough to peak is only 9 percent
As with houses, your debt is my asset. Larry is verging here into causes of the recession rather than the crisis. There is a case for asymmetries, but the first-order mistake is to think that just because I am in debt we all are in debt.

8) Exponential Growth in Trading Activity by Financial Firms
Here, again, we have a supposed reason for the Great Recession that has no counterpart in economic theory. If Joe and Sally sell the same share of stock back and forth to each other an infinite number of times in, say, a second, nothing real will happen to Joe and Sally or the economy.
9) Unregulated Derivatives and the Repo Market
The reigning narrative – that derivatives were misunderstood and over rated by compliant rating companies – has been questioned in a recent study by economists Juan Ospinal and Harald Uhlig. They examined 8,615 residential mortgage-backed securities (RMBS) over the period 2007-2013, almost all of which were rated AAA. Through 2013, the cumulative loss on these “toxic” securities was only 2.3 percent. Some three quarters of the AAA-rated RMBS had essentially zero losses through 2013. On a principal-weighted basis, the average loss rate was only 0.42 percent. 
Yes, losses were far higher for non-AAA rated segments of the RMBS market. But that’s what one would expect from a “great” recession. However, these securities represented a small fraction of the RMBS market.
I think the logic here is that if securities were overpriced, then they should have fallen. That they did not is interesting. Of course, if they had fallen that is not necessarily evidence of overpricing, as there was a huge recession after the run! 
What about REPOs? Did they cause the GR? Well, they certainly increased in the run up to the GR. But short-term financial-company borrowing has been growing far faster than the economy for decades. The fact that some economic variable rose rapidly prior to the GR is not evidence that it caused the GR. Smart phone sales tripled between 2005 and 2008, but no one would link that to the GR. Of course, Repos would be implicated in causing the GR had they been part of excessive leveraging by financial intermediaries. But, as discussed above, overall financial- company leverage fell, not rose prior to the GR.
Here again I think a big qualification is in order. The run on repo was a central part of the crisis, and I think Larry and I agree that way too much such run-prone financing was the key cause of the crisis. Again, I think the point Larry is making is that the financial system as constructed is always vulnerable, that the crisis was not brought on by some sudden and preventable increase in debt. 

10) Investors Mispriced/Ignored Risk

11) Unaligned CEO Incentives
Yet another explanation for the GR is that CEOs of financial institutions had too little “skin in the game.” Jimmy Cayne, former head of Bears Stern, would surely disagree. Cayne lost close to $1 billion as his bank collapsed. Ken Lewis, CEO of the Bank of America, had $190 million to lose by making wrong decisions and succeeded in losing $142 million. Lehman Brothers’ Dick Fuld received most of his 2007 compensation in the form of Lehman Brothers’ stock.
12) Democratization of Finance
Under this theory, government sponsored enterprises (Fanny and Freddie) and government regulators were too permissive with banks in their quest to help the poor get into affordable housing. ...if this were the chief or even a major cause of the GR, subprime mortgages would need to have played a much larger role than they did.
13) The Federal Reserve Kept Interest Rates Too Low
Thirty-year mortgage interest rates were certainly lower between 2000 and 2007 than in the prior quarter century. But they weren’t that low especially adjusted for inflation. In the 1990s, the real 30-year mortgage rate averaged 7.91 percent. It averaged 6.27 between January 2000 and December 2007. This decline is hardly something to write home about, let alone pretend is the underlying GR culprit.
Runs
..the foundational bank-run models --- Bryant (1980), Diamond-Dybvig (1983), Pech and Shell (2003) and related models – admit multiple equilibrium in which financial-market collapse arises absent any fundamental financial- or real-sector problem...  from the perspective of these models, the question is not whether the banking system will fail, but when. Hence, it’s passing strange that the FCIC report makes no mention whatsoever of either paper, let alone the theory underlying bank runs. 
In completely ignoring the theory of bank runs... the FCIC pretended that what happened wasn’t intrinsic to how the financial market is structured. Instead, the commission, for whatever reasons, appears to have rounded up the usual suspects and held a sham trial.
(My emphasis.) Larry goes on for several pages documenting spreading panic. An earlier quote is good here
SEC Chairman, Mary Schapiro’s, 2010 testimony to the House Financial Services Committee...includes this statement.
 The immediate cause of Lehman's bankruptcy filing on September 15, 2008 stemmed from a loss of confidence in the firm's continued viability resulting from concerns regarding its significant holdings of illiquid assets and questions regarding the valuation of those assets. The loss of confidence resulted in counterparties and clearing entities demanding increasing amounts of collateral and margin, such that eventually Lehman was unable to obtain routine financing from certain of its lenders and counterparties
Unsafe at Any Speed, and the limits on bailouts
The banks failed because they could. And they could fail because they were leveraged. They falsely promised to make repayments regardless of the circumstances. 
The overall level of leverage is way too high. This reinforces my earlier interpretation of Larry's comment about leverage not being the problem -- there was way too much leverage, but its increase did not directly cause a crisis. 

The next part is really interesting. 
The Federal Reserve is also leveraged. In the aftermath of Lehman’s collapse, the Fed effectively insured not just checking and saving accounts, but also money market funds. These obligations were officially and, respectively, FDIC and Treasury obligations. They ran to some $6 trillion. But neither institution had $6 trillion in ready cash to make good on its insurance. Hence, the Fed would have been on the hook. Indeed, had things gotten worse, there would surely have been a run on the life insurance industry’s cash-surrender value policies, which, at the time, also totaled roughly $6 trillion.
Now imagine, as discussed in Kotlikoff (2010), that the government’s explicit and implicit pledges of insurance had been called by the public. I.e., suppose the public had, despite the promises of government insurance, headed straight to the banks, money market funds, and insurance companies to empty out their accounts and cash out their cash-surrender value policies. In this case, the Fed would have had to print $12 trillion virtually overnight. The M1 money supply at the time was just $1.5 trillion. Hence, this would have produced fully-justified fears of hyperinflation leading everyone to run for their money before prices soared
The U.S. has yet to experience a run on its central bank. But this is common in countries like Argentina, ...
Larry is, of course, an expert on all the explicit and implicit credit guarantees our government offers. I was unaware that $6 trillion of "cash surrender value policies" existed, and given the bailouts of other insurance policies we would certainly have seen them bailed out too. Fannie and Freddie guarantee most mortgages. 

Though it does represent promises of payment, I don't think this really is "leverage" of the Federal Reserve. The government has, in essence, written a lot of put options, which is a different thing. 

What happens in an even more massive run, with more massive bailouts is an interesting question. It's not as simple as "print [ing] $12 trillion overnight." The Fed issues reserves, convertible to cash, but always in return for something else. So, this would have put a big strain on the Fed's legal limitations of what collateral it can accept and from who. 

The Fed mostly deals with commercial banks. Imagine a massive run on commercial banks, perhaps stemming from a rumored cyberattack that emptied one of them out. The Fed would have to lend against the entire portfolio of bank assets, not just liquid securities. Goodbye Badgehot.

As Larry points out, really the FDIC and Treasury are the ones guaranteeing non-bank debts.  The Treasury would have to borrow $12 billion overnight, sell it to the Fed, and then use it to bail out here and there. The ban on direct Fed-Treasury purchases would make this very hard, and would probably have to be scrapped. 

But the huge increase in money would clearly be a temporary increase in money demand, and not obviously inflationary. Moreover, the Treasury, Fed, FDIC, etc. would take on assets. If these operations could be reversed after the panic passes -- if there is not a tremendous amount of actual lost value, as there was not last time, the money could be soaked up again. Even if not, the operation would not be inflationary if people thought the government could retire the debt and soak up the interest-paying reserves by future surpluses. We get inflation -- and Argentina gets inflation -- if and only if this nightmare involves a large fiscal transfer, that the US government cannot or will not pay off, that is financed by a permanent increase in non-interest-paying money.  

US Federal debt is about $10 trillion larger than in 2008, and we're running $1 trillion deficits, with no end in sight. The reliability of the fiscal resources to make good on all these put options is, I think, a serious problem, and the heart of the potential inflation Larry describes. 

The Role of Opacity
Bear Stearns was among the first to be picked off by those who stood to gain by a financial collapse because it was viewed as particularly opaque
The fact that Bear’s stock was valued at $60 per share one week before JP Morgan bought it for $2 per share (less a $29 billion sale of Bear’s troubled assets to the Fed valued at far less than $29 billion) tells us that no one knew anything about Bear’s assets, either before it died or when it died. Its valuation was, it seems, purely a matter of conjecture. Before it didn’t, the market apparently though Bear’s assets were worth something because everyone else thought its assets were worth something. This too is the stuff of multiple equilibria
Gary Gorton likens financial crises to a salad bar, where someone says "there's a news report of e-coli in the (inaudible)". So what do you do? Absent information on which ingredient has the e-coli, and the time or inclination to investigate, you go order a hamburger. 

Now ask yourself, where is there a mountain of debt that can't be repaid, much of it very short term, phoney-baloney accounting, and opaque off-balance-sheet exposures (put options)? Sovereigns. 

Bottom line 
Bad/greedy/lazy/irresponsible actors, we’re told, engaged in all manner of financial malfeasance, risk taking, negligence, theft and greed. And what we’re told is true. There were plenty of bad actors... But the story of these bad actors is not the real story of the Great Recession. The real story is that both the economy and the banking system are inherently unstable. ... If enough people think enough people think a bank is going down, that bank will go down regardless of its true condition. If enough people think the economy is going down, the economy will go down, also regardless of its true condition.
The first conclusion seems to me spot on. The second one is more provocative. Here Larry signs up with multiple-equilibrium theories of recessions, as well as simple multiple equilibria associated with run-prone assets like overnight debt. It's verbally plausible. If you think there will be a recession tomorrow, you fire workers and do not invest, and there is a recession today. But you can see a crucial derivative needs to be greater than 1.0 for that to work. Lots of formal models have multiple equilibria, but I've spent 10 years putting nominal multiple equilibria back in the new-Keynesian model, and real multiple equilibria are harder to get going. 
One approach to addressing the problem of financial multiple equilibrium is to replace Dodd- Frank with more fundamental financial reform, such as Kotlikoff (2010)’s Limited Purpose Banking (LPB). LPB would transform all financial corporations into 100 percent equity-financed mutual fund holding companies subject to full and real-time disclosure supervised by the government.


Choose your equity-financed banking flavor, and we can end financial crises forever. Just why we don't do it seems an important -- and sadly forgotten -- question.

21 comments:

  1. Kotlikoff link is broken - but easy enough to find if one is curious.

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  2. Not a fan of multiple equilibrium explanations/stories. I could not link to Larry's paper. The multiple eq vs fundamentals comes down to : " A lotta people went broke so it was a crisis (fundamentals) vs it was a crisis so people went broke (ME)." Hard to distinguish w/o looking a lots and lots of balance. Maybe Larry did the work. I surely did not.

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  3. I tried to follow the first link and it went to "page not found"

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    1. The 2nd link works. It will take you to https://www.kotlikoff.net/sites/default/files/The%20Big%20Con%20NBER%20Version.pdf which is the NBER version of K's paper.

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  4. Interesting article and post, but #7 is the weak link in LK's thesis - none of his metrics get to the reasons why big credit cycles correspond to big business cycles and small credit cycles correspond to small business cycles.

    Credit booms push up every measure of activity and wealth, so his ratios (he looks at consumption to GDP, debt to wealth, and debt service to income) tell us virtually nothing.

    He would need to explain away the GDP growth contributions from residential investment (-0.5% in 2006, -1.13% in 2007, -1.14% in 2008 and -0.74% in 2009) and the fact that res. investment still hasn't recovered halfway to its 2005 peak.

    The total res. investment drag on GDP from 2006-9 is the largest on record and it worked its way through the rest of the economy through all the usual pathways (construction and fin. sector employment, furniture & furnishings, appliances, ancillary services such as title and home insurance, etc.) - it was easily large enough on its own to explain a severe recession.

    And the fact that res. investment hasn't even approached its 2005 peak tells us that the mortgage boom (and lax lending standards) brought so much demand forward that it was always going to end in a recession once house prices peaked (with or without a banking crisis).

    So it's one thing to argue that different banking regs could have prevented the banking crisis, but LK goes way beyond that under #7 - he argues that the GR had little to do with the mortgage boom when the data seem to show that the GR had everything to do with the mortgage boom.

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  5. ".between Q1 2003 and Q1 2007 ... real house prices rose by 22 percent. But over this period real GDP rose by 14 percent. Hence, real house prices rose only 2 percent faster per year than did the economy during the period of “unsustainable” house price increases."

    ""Sky-high bank leverage is another part of the standard GR explanation....Bank leverage actually fell over the period 1988 through 2008.16 Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008.""

    These sound like end point selection, Case-Shiller has housing prices peaking in 2006, and AIG (iirc) was raising captial in the summer of 2007. Q1 2008 is an odd time to use for demonstrating that there was sufficient capital as it came after several quarters of the market demanding that the investment banks raise more capital.

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  6. The proposed remedy "Kotlikoff (2010)’s Limited Purpose Banking (LPB)" would be worse than the disease it seeks to cure.

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  7. In Gennaioli and Shleifer's new book, A Crisis of Beliefs, the bank run model is described as putting the cart before the horse (page 72).

    What's your comment on that, John?


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  8. Fascinating post.

    I agree all financial institutions should probably have higher required levels of capital or a fat layer of convertible bonds.

    Still, it is interesting that the financial institutions that failed are Bear Stearns, Lehman, and AIG. These are not commercial banks.

    Indeed, if S&L's and banks sell off their portfolios of mortgages into the secondary market, they then go back to matching assets to liabilities. They sell off the risk of homeowner default on mortgages.

    In mainland China there has been a policy of the People's Bank of China buying bonds that are in default, or recapitalizing banks basically by printing money. This has prevented the financial system from seizing up, and China today is below its inflation target.

    Adding to the confusion, the Bank of Japan has purchased 45% of that nation's huge mountain of sovereigns. Japan is below its 2% inflation target, and may slip back into deflation.

    The interesting thing about macroeconomics is that no one is ever wrong.

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  9. Your link to Koltikoff's paper didn't work. Try this one:

    https://www.kotlikoff.net/node/661

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  10. Two points:

    I do not believe there is any real systemic risk in life insurance cash surrender values. They are not like checking or money market accounts. They are very slow money. Typically, the cycle to liquidate them is months not days. And, regulators can, and do, throw weak companies into receivership where things get even slower. Further, a large chunk of those values are pledged to the issuers to secure policy loans that were used to pay for the policies. The value numbers may or may not net those loans out.

    Second, the real Fed leverage is on the face of its balance sheet. The latest H.4.1 Report shows total assets of $4.1 Trillion being carried by capital of $39 Billion. This is a leverage ratio of 104. If the Fed were a commercial bank, the Fed would put it into receivership. 10 years after the crisis, there is no excuse for not unwinding this monstrosity.

    https://www.federalreserve.gov/releases/h41/current/

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  11. The new link is

    https://www.kotlikoff.net/sites/default/files/The%20Big%20Con%20NBER%20Version.pdf

    John, Thanks for writing up my paper. We're on the same page except for a couple minor points. Really happy you liked the piece. All best, Larry

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  12. "Moreover, Larry really goes on to view recessions themselves as multiple equilibria, which is an interesting and provocative idea..."

    Can we NOT use the term multiple equilibria when we are describing a single observed realized path in a dynamic economy? :-) A model can have multiple equilibria, but you can only observe one of them on a path. Different equilibria live in isolation. If you want a dynamic model of expansions and recessions in which people sometimes coordinate on a good outcome (and we have an expansion) and sometimes on a bad outcome (and we have a recession), then it has to happen in one particular equilibrium (perhaps driven by a sunspot, which becomes part of the characterization). And such outcomes are even harder to generate than just multiple equilibria, because, as you point out ("If you think there will be a recession tomorrow, you fire workers and do not invest, and there is a recession today."), if agents understand that tomorrow, there is a chance we will coordinate on a bad outcome, they will start responding today and a lot of the interesting cycle-like dynamics are undone.

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    1. Excellent point! I think there is a general idea that with multiple equilibria we jump from one to another, but that's another model altogether. Multiple equilibria, sunspot coordinated equilibria, off-equilibrium vs. alternatie-equilibrium behaviors... we need some equations here!

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  13. Well...this is my semi-uneducated stab at it all.

    To me, the Fed unfroze credit via unconventional monetary policy. 4.5T balance sheet doesn't lie.

    *Zero bound with QE for how long?
    *Buying long term treasury bonds to keep the long term rates low, perhaps artificially.
    *Sterilization to prevent inflation.
    *Intervention to prevent asset deflation.

    So, these are reactive measures, and they were extraordinary. The issue of transparency is always a hot button after the fact. It's great to talk about, but, given the bad behavior of banks and using asymmetric information to their advantage (imagine how surprised AIG was), this whole business of transparency is kind of hollow. When the perception itself is enough to induce panic, doesn't matter what the facts are.

    Will capital requirements really be enough to prevent bad risk taking? If so, maybe we just do that with permanent sterilization so the Fed can capitalize banks until the end of time, mitigating risk through incentives from the Fed to have banks hold on to ER, instead of inventing reasons to do dumb things. Transparency can be substituted for better enforcement and incentives? More carrots and big sticks? Enforcement on transparency maybe? Tough sell.

    Maybe the reason the banking sector is considered unstable is because, oh, I don't know...people lie to gain an economic benefit and advantage? Sure, there's the eventual misallocation/overallocation that leads to debt bubbles, and some of that is just due to invisible hands thumb wrestling. No investment is ever a sure thing. Things can go sideways. Not sure how transparency can mitigate perceptions -- might even make them worse!

    Modeling this stuff has always been fascinating to me, as a side note. Trying to model what is essentially a chaotic system is a challenge.

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  14. Didn't I just read that the Fed was lowering capital requirements? Hello moral hazard!

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  15. I'm puzzled by #2. Using GDP as a measure of comparison house prices were rising on the order of 5 times faster than normal, and he cites that as evidence that nothing was amiss? After reading that I'm *more* likely if anything to think house prices were a key ingredient.

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  16. A great discussion. One minor typo down near the end where Cochrane writes:

    "As Larry points out, really the FDIC and Treasury are the ones guaranteeing non-bank debts. The Treasury would have to borrow $12 billion"

    Should be "trillion"

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  17. We don't do equity banking because too many banksters think they'll be the ones getting $60 assets for $2 in a crises -- and in the meantime, they can speculate to get above average returns from investing the leveraged money.

    And the Big Banks want to be Too Big To Fail.

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  18. Put me down as another person thinking the housing bubble was a big factor in triggering the financial crisis. Very surprised not to see a reference to Gjerstad and Smith's detailed work on this.

    As for the solution to liquidity panics, I am skeptical that there is any way to stop entities from levering up in vulnerable ways through all sorts of indirect contracts, given that in non-run periods levering up amplifies earnings. My tentative solution is to embed in common law the rule that during systemic crises (defined by some non-manipulable national rate spread between safe and risky assets) debt payments can be suspended without triggering default. That will make "crises" somewhat more frequent but vastly less consequential, more like a temporary circuit breaker. Run-vulnerable borrowers in such a regime would also be able to embed "don't-run" incentives into their contracts that rewarded people with higher returns if they went to the back of the line as the crisis eased.

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