Financial reform video

Capital, more capital. I did a video interview for the Chicago Booth Review, summarizing a few talks I'm giving this fall. At some point I'll put the talks together in useful form for the blog. In the meantime, the Booth team did a nice job of cutting and splicing to make me sound coherent. 

Europe's Banks

My visit to Europe resulted in many interesting conversations. There was a stark contrast between the complex regulatory vision of formal presentations and papers, and the lunch and coffee discussion reflecting experience of people involved in actually regulating banks. They seemed to be quite frustrated by the state of things. Disclaimer: this is all completely unverified gossip, and remembered through a fog of jet lag. If commenters have better facts, I'm hungry to hear them.

Risk weights are ungodly complex, and not many people actually understand them, or the layers of buffers and how they are applied.

Risk weights are suspiciously low. Big banks are allowed to use their own models, calibrated on 10 years of data. That means the data have, now, 10 years of stable growth and very low default. Look, say the banks, our investments are nearly risk free.

"Micro" regulators who look at the specifics of an individual bank are prone to offset the "systemic" and "macro-prudential" efforts. Look, say the banks, we have to fulfill all these macro-prudential rules, give us a break. Regulators do.

The financial regulatory community has been preoccupied with writing reports about one thing after another. Meanwhile, the elephant remains in the room:  Italy may default or leave the euro.

Italian banks remain stuffed with Italian government bonds. I learned some new words for this: a "doom loop." If the government defaults, the banks go with it.  Some smaller foreign banks still have large investments in Italian bonds. Another new word: "Moral suasion," governments encouraging banks to buy a lot of their bonds.  I imagine the Godfather had more colorful words for it. On the other hand, Italian banks are reportedly happy for the moment, since as long as Italy doesn't actually default, they make a bundle from high interest rates. Government debt is still treated with low or no risk weights.

State of thought on financial regulation

I'm at a conference on "Financial cycles and regulation" at the Deutsche Bundesbank. Beyond the individual papers, I find the conversation interesting.

Groups of researchers develop a common language and a common set of assumptions. This is productive -- to push a research frontier we have to agree on a few basic ideas, rather than argue about basics all the time. I, as an outsider, parachute in, and learn as much what the shared assumptions are, as I do about particular points in elaboration of the program.

Here,  it is pretty much taken for granted that there is such a thing as a "financial cycle." It's in the conference title, after all! That means a "cycle" of credit expansion, usually "unwarranted," "excessive," or an "imbalanced," followed by a bust. It is also agreed that it is the job of financial regulators to manage this "cycle."

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.

Fed Nixes Narrow Bank

A narrow bank would be a great thing. A narrow bank takes deposits, and invests 100% of the money in interest-paying reserves at the Fed. (The Fed, in turn, mostly invests in US treasuries and agency securities.)

A narrow bank cannot fail*. It cannot lose money on its assets. A narrow bank cannot suffer a run. If people want their money back, they can all have it, instantly. A narrow bank needs essentially no asset risk regulation, stress tests, or anything else.

A narrow bank fills an important niche. Individuals can have federally insured bank accounts which are (mostly) safe. But large businesses need to handle cash way above the limits of deposit insurance. For that reason, they invest in repurchase agreements, short-term commercial paper, and all the other forms of short term debt that blew up in the 2008 financial crisis. These are safer than bank accounts, but, as we saw, not completely safe. A narrow bank is completely safe. And with the option of a narrow bank, the only reason for companies to invest in these other arrangements is to try to harvest a little more interest. Regulators can feel a lot more confident shutting down run-prone alternatives if a narrow bank is widely available.

The most common objection to equity-financed banking is that people and businesses need deposits. Well, narrow banks provide those deposits, and can do so in nearly unlimited amount. Narrow banking, providing completely safe deposits, opens the door to equity-financed banking, which can invest in risky assets and also be immune from financial crises.

Why not just start a a money market fund that invests in treasuries? Since deposit -> narrow bank -> Fed -> Treasuries, why not just deposit -> money market fund -> treasuries, and cut out the middle person? Well, a narrow bank is really a bank. A money market fund cannot access the full range of financial services that a bank can offer. If you're a business and you want to wire money to Germany this afternoon, you need a bank.

Suppose someone started a narrow bank. How would the Fed react? You would think they would welcome it with open arms. Not so.

TNB, for "The Narrow Bank" just tried, and the Fed is resisting in every possible way. TNB just filed a complaint against the New York Fed in District Court, which makes great reading. (The complaint is publicly available here, but behind a paywall, so I posted it on my webpage here.) Excerpts:

2. “TNB” stands for “the narrow bank”, and its business model is indeed narrow. TNB’s sole business will be to accept deposits only from the most financially secure institutions, and to place those deposits into TNB’s Master Account at the FRBNY, thus permitting depositors to earn higher rates of interest than are currently available to nonfinancial companies and consumers for such a safe, liquid form of deposit. 

3. TNB’s board of directors and management have devoted more than two years and substantial resources to preparing to open their business, including undergoing a rigorous review by the State of Connecticut Department of Banking (“CTDOB”). The CTDOB has now granted TNB a temporary Certificate of Authority (“CoA”) and is fully prepared to permit TNB to operate on a permanent basis. 

4. However, to carry out its business—indeed, to function at all—TNB needs access to the Federal Reserve payments system. 

5. In August 2017, therefore, TNB began the routine administrative process to open a Master Account with the FRBNY. Typically, the application procedure involves completing a one-page form agreement, followed by a brief wait of no more than one week. Indeed, the form agreement itself states that “[p]rocessing may take 5-7 business days” and that the applicant should “contact the Federal Reserve Bank to confirm the date that the master account will be established.” 

6. This treatment is consistent with the governing statutory framework. Concerned by preferential access to Federal Reserve services by large financial institutions, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (the “Act”). Under the applicable provision of the Act, 12 U.S.C. § 248a(c)(2), all FRBNY services “shall be available” on an equal, non-discriminatory basis to any qualified depository institution that, like TNB, is in the business of receiving deposits other than trust funds. 

7. TNB did not receive the standard treatment mandated by the governing law. Despite Connecticut’s approval of TNB—as TNB’s lawful chartering authority—and the language of the governing statute, the FRBNY undertook its own protracted internal review of TNB. TNB fully cooperated with that review, which ultimately concluded in TNB’s favor. At the same time, the FRBNY also apparently referred the matter to the Board of Governors of the Federal Reserve System (the “Board”) in Washington, D.C.  

8. In December 2017, TNB was informed orally by an FRBNY official that approval would be forthcoming—only to be called back later by the same official and told that the Board had countermanded that direction, based on alleged “policy concerns.” 

9. TNB’s principals thereafter met with staff representatives of the Board, as well as the President of the FRBNY, to explain that there was no lawful basis to reject TNB’s application for a Master Account. On information and belief, the FRBNY and its leadership agreed with TNB and were prepared to open a Master Account. 

10. Though TNB had satisfactorily completed the FRBNY’s diligence review, the Board continued to thwart any action by the FRBNY to open TNB’s Master Account, reportedly at the specific direction of the Board’s Chairman. 

11. Having delayed the process for nearly one year—effectively preventing TNB from doing business—the FRBNY has repeatedly refused either to permit TNB to open a Master Account or to state that the FRBNY will ultimately do so. 

12. The FRBNY’s conduct is in open defiance of the statutory framework, its own prior positions, and judicial authority. See Fourth Corner Credit Union v. Fed. Reserve Bank of Kan. City, 861 F.3d 1052, 1071 (10th Cir. 2017) (“The plain text of § 248a(c)(2) indicates that nonmember depository institutions are entitled to purchase services from Federal Reserve Banks. To purchase these services, a master account is required. Thus, nonmember depository institutions . . . are entitled to master accounts.”) (Bacharach, J.) (emphasis added). 

13. Further, the FRBNY’s actions, especially in the context of other recent conduct by the Board,1 have the effect of discriminating against small, innovative companies like TNB and privileging established, too-big-to-fail institutions—the very dynamic that led Congress to pass the Act in the first place. 

14. TNB therefore brings this action for a prompt declaratory judgment that it is entitled to a Master Account.

Why does the Fed object?

The Fed may worry about controlling the size of its balance sheet -- how many reserves banks have at the Fed, and how many treasuries the Fed correspondingly buys. If narrow banks get really popular, the Fed might have to buy more treasuries to meet the need. Alternatively, the Fed might have to discriminate, paying narrow banks less interest than it pays "real" banks, in order to keep down the size of the narrow banking industry. It would then face hard questions about why it is discriminating and paying traditional banks more than it pays everyone else. (It's already a bit of a puzzle that it often pays interest on reserves larger than what banks can get anywhere else, even treasuries.)

But why does the size of the balance sheet matter? Why does it matter whether people hold treasuries directly, hold them via a money market fund, or hold them via a narrow bank, which holds reserves at the Fed, which holds treasuries?

"Money" is no longer money. When the Fed pays interest on huge amounts of excess reserves, the size of the balance sheet no longer matters, especially in this regard. If people want to hold more treasuries indirectly through a narrow bank and the Fed, and correspondingly less directly, why should that have any stimulative or depressing effect at all? Even if you do think QE purchases -- supply-driven changes in the balance sheet -- matter, it is not at all clear why demand-driven changes should matter.

The Fed already allows a "reverse repo program,"  in which 160 institutions such as money market funds to hold reserves. It currently pays those 20 basis points (0.2%) less than it pays banks, to discourage participation.

The second argument, made during the discussion about reverse repos, is that narrow banks are a threat to financial stability, not a guarantor of it as I have described, because people will run to narrow banks away from repo and other short term financing in times of stress.

This is, in my view, completely misguided. Again, narrow banks are just an indirect way of holding treasuries. There is nothing now stopping people from "running" to treasuries directly, which is exactly what they did in the financial crisis.

Furthermore, the Fed does not, in a crisis, seek to force people to hold illiquid assets having a run. The Fed pours liquid assets into the system like Niagara falls, and buys illiquid assets from them, all in massive quantities.

Moreover, the whole point of the narrow bank is that large businesses don't hold fragile run-prone short term assets in the first place. By paying interest on reserves, and allowing more and more people to enjoy run-proof government money, there is less gasoline in the financial system to begin with. If the Fed is worried about financial crises, it ought to encourage narrow banks and give others a gold star for using them rather than shadier short-term assets in the first place.

The emptiness of both arguments is easy to see from this: Chase and Citi are narrow banks -- married to investment banks. Both take deposits, and invest them as interest paying reserves at the Fed. Right now there are more reserves than checking accounts in the banking system as a whole. If there were some threat to monetary policy or financial stability from banks being able to take deposits and funnel them in to reserves, we'd be there now. The only difference is that if Chase and City lose money on their risky investments, they drag down depositors too and the government bails out the depositors. The narrow banks are not separated from the investment banks in bankruptcy. A true narrow bank just separates these functions.

Shadier speculations are natural as well.

Banks are making a tidy profit on their current activities. JP Morgan Chase pays me 1 basis point on my deposits, as it has forever, and now earns 1.95% on excess reserves. The "pass through" from interest earned to interest paid to depositors is very slow. This is a clear sign of lack of competition in the banking system. The Fed's reverse RP program was put in place, in part, to pressure banks to act a bit more competitively, by allowing an almost-narrow bank to take investor money and put it in reserves. The Fed is now scaling that program back.

That the Fed, which is a banker's bank, protects the profits of the big banks system against competition, would be the natural public-choice speculation.

Perhaps also my vision of a run-proof essentially unregulated banking system isn't as attractive to the Fed as it should be. If deposits are handled by narrow banks, which don't need asset risk regulation, and risky investment is handled by equity-financed banks, which don't need asset risk regulation, a lot of regulators and "macro-prudential" policy makers, who want to use regulatory tools to control the economy, are going to be out of work.

To be clear, I have no evidence for either motivation. But the facts fit, and large institutions are not always self-aware of their motivations.

Whatever the reason, it is sad to see the Fed handed such an obvious boon to financial stability and efficiency, and to slow walk it to regulatory death, despite, apparently, clear legal rights of the Narrow Bank to serve its customers.


*Well, almost. For the Fed to fail, there would have to be a large-scale US default on treasury debt. Even so, Congress could exempt the Fed by recapitalizing it, making good its losses. So Congress would have to decide that it won't even recapitalize the Fed, so that reserves also default. If there is one bank that really is too big to fail, it's the Fed, as its failure would bring down the entire monetary system. Literally, all of the ATMs and credit card machines go dark. This is a pretty improbable event.

Update: Endi below asks "Why do you say that with the existence of narrow banks, equity-financed banks would be immune from a financial crisis?" See "A Blueprint for Effective Financial Reform", "Equity-financed banking and a run-free financial system," "Toward a run-free financial system",  All here.

Update 2: Matt Levine at Bloomberg has excellent coverage.   Michael Derby at WSJ too. As Matt and a commenter below explain,  I got ahead of myself on TNB. This particular company is not planning to offer banking services or retail deposits. They won't even wire money for you. The reason: if they were to do so, they would face lots of anti-money-laundering regulations. This particular business is focused on giving money market funds and other large institutions access to the 1.95% that the Fed pays on reserves, which is more than the 1.75% that money market funds can get via reverse repo at the same Fed, or (paradoxically) the rate that short term treasuries have been offering lately.

Update 3: an excellent WSJ editorial. The Fed remains silent. My forecast: The Fed will remain silent, fight the lawsuit with obfuscation and delay.  It can surely let this rot in the courts for a decade or more. By that time the TNB folks will be out of money and have to give up, and any potential copycats will get the message.

Who will pay unfunded state pensions?

Homeowners. So says a nice WSJ op-ed by Rob Arnott and Lisa Meulbroek, and a proposal by Chicago Fed Economists Thomas Haasl, Rick Matton, and Thomas Walstrum.

The latter was a modest proposal, in the Jonathan Swift tradition. Despite Crain's Chicago Business instantly labeling it "foolish," "inhumane," and "the dumbest solution yet, the first article points out its inevitability. If indeed courts will insist that benefits may not be cut, then state governments must raise taxes, and this is the only one that can do the trick.

States can try to raise income taxes. And people will move. States can try to raise business taxes. And  businesses will move. What can states tax that can't move? Only real estate. If the state drastically raises the property tax, there is no choice but to pay it. You can sell, but the new buyer will be willing to pay much less. Pay the tax slowly over time, or lose the value of the property right away in a lower price.  Either way, the owner of the property on the day the tax is announced bears the burden of paying off the pensions.

There is a an economic principle here, the "capital levy." A government in trouble has an incentive to grab existing capital, once, and promise never to do it again. The promise is important, because if people know that a capital levy is coming they won't invest (build houses). If the government can pull it off, it is a tax that does not distort decisions going forward. Of course, getting people to believe the promise and invest again after the capital levy is... well, let's say a tricky business. Governments that do it once have a tendency to do it again.

In sum, a property tax is essentially the same thing as the government grabbing half the houses and selling them off to make pension obligations. And unless a miracle happens, it is the only way out.

Update: We're there already, say Orphe Divounguy, Bryce Hill, and Joe Tabor at Illinois Policy. The bulk of recent increases in property taxes have gone to pay for pensions, not more teachers, police, etc.

Update 2: I should clarify, that I found this an interesting piece of economics more than anything else. I do not think this is the right solution, nor is it the only one. Most other countries around the world, having made unsustainable pension promises, find some way around them and reduce pensions. It happens. Some sort of federal bailout is not unthinkable either. Moreover, the suddenly announced surprise once and for all property tax increase is unlikely, see update 1. So the states are likely to reap many disincentive effects of expected increases in property and other taxes.

Finally, most importantly property tax payers vote! They are unlikely to sit still for such a mass expropriation of their wealth.

Nobel Symposium on Money and Banking Day 2

Day 2 of the Nobel Symposium on Money and Banking focused on monetary policy. (My last post covered Day 1 on banking.)

Bernanke

Sadly Ben Bernanke's video and slides are not up on the website. Ben showed some very interesting evidence that the crisis was an unpredictable run, rather than the usual story about predictable defaults resulting from too much credit. Things really did get suddenly a lot worse in September and October 2008. Yes, it's easy to say this is defense against the charge that he should have done more ahead of time. But evidence is evidence, and I find it quite plausible that the relatively small losses in subprime need not have caused such a massive crisis and recession absent a run. Ben says the material is part of a paper he will release soon, so look for it. One can understand that Bernanke is careful about releasing less than perfect drafts of papers and videos.

History

Barry Eichengreen gave a scholarly account of why history matters, especially the great depression, and we should pay more attention to it. (Paper, video.) He aimed squarely at typical economists whose knowledge stopped at Friedman and Schwartz, or perhaps Ben Bernanke's famous non-monetary channels paper, in which bank failures propagated the depression. He emphasized the role of the gold standard and international cooperation or non-cooperation, and warned against facile comparisons of the gold standard experience to today's events and the euro in particular.

Randy Kroszner has a great set of slides and an engaging presentation. He also started on parallels with the great depression, and told well the story of the US default on gold clauses. He closed with a warning about fighting the last war -- particularly apt given the exclusive focus of most of this conference on the events of 2008 -- and on how to start a crisis. In his view when Bank of England Gov Mervyn King said: “We will support Northern Rock." People hear "Northern Rock's in trouble? Run!" Likewise, in my view, speeches by President Bush and Treasury Secretary Paulson did a lot to spark the run in the US.

DSGE

A highlight for me, was the session on DSGE models.

Marty Eichenbaum (video, slides, subsequent paper) gave a nice review of the current status of new Keynesian DSGE models, and how they are developing in reaction to the financial crisis and recession, and the zero bound episode.

Harald Uhlig

Critiques, or more precisely lists of outstanding puzzles and challenges, are often more memorable and novel than positive summaries, and Harald Uhlig delivered a clear and memorable one. (Video, Slides)

Asset prices are a longstanding problem in DSGE models. In typical linearized form, the quantity dynamics are governed by intertemporal substitution, and the asset prices by risk aversion, and neither has much influence on the other. (I learned this from Tom Tallarini.) Rather obviously, our recent recession was all about risk aversion -- people stopped consuming and investing, and tried to move from private to government bonds because they were scared to death, not a sudden attack of thriftiness. There is a lot of current work going on to try to repair this deficiency, but it still lives in the land of extensions of the model rather than the mainstream. Harald also points out a frequently ignored implication of Epstein-Zin utility, the utility index reflects all consumption and anything that enters utility

Financial frictions are blossoming in DSGE models, in two forms: First, HANK or "heterogenous agent" models, which add things like borrowing constraints and uninsurable risks so that the distribution of income matters, and in an eternal quest to make the models work more like static ISLM. Second, in response to the financial crisis (see first day!) stylized models of banking and intermediary finance are showing up. I'm still a little puzzled that the more standard time-varying risk aversion part of macro-finance got ignored, (a plea here) but that is indeed what's going on.

The conundrum, here as elsewhere in DSGE, is that the more people play with the models, the further they get from their founding philosophy: macro models that do talk about monetary policy, (now) financial crises, but that obey the Lucas rules: Optimization, budget constraints, markets, or, more deeply, structures that have some hope of being policy invariant and therefore predictions that will survive the Lucas critique. Already, many ingredients such as Calvo pricing are convenient parables, but questionably realistic as policy-invariant.

Harald points out that since most of the frictions are imposed in a rather ad-hoc manner, neither will they be policy-invariant. This is a deeper and more realistic point than commonly realized. Every time market participants hit a "friction," they tend to innovate a way around that friction so it doesn't hurt them next time. Regulation Q on interest rates was once a "friction," and then the money market fund was invented. The result is too often "chicken papers:"

The understandable trouble is, if you try to microfound every single friction from Deep Theory -- just why it is that credit card companies put a limit on how much you can borrow, in terms of asymmetric information, moral hazard, and so forth -- the audience will be asleep long before you get to the data. Also, as we saw in day 1, there is (to put it charitably) a lot of uncertainty in just how contract or banking theory maps to actual frictions. I think we're stuck with ad-hoc frictions, if you want to go that route.

Harald's next point is, I think, his most devastating, as it describes a huge hole in current models that is not (unlike the last two) a point of immense current research effort. The Phillips curve and inflation are the central point of the New Keynesian DSGE model -- and a disaster. 

The Phillips curve is central. The point of the model is for monetary policy to have output effects. Money itself has (rightly) disappeared in the model, so the only channel for monetary policy to work is via the Phillips curve. Interest rates change inflation, and inflation causes output changes. No surprise, it is very hard for that model to produce anything like the last recession out of small changes in inflation. (I have to agree here with the premise of the financial frictions view -- if you want your model to produce the last recession, other than by one huge shock, the model needs something like a financial crisis.)

The Phillips curve in the data is well known

Less well known, but worth lots of attention, is how the now standard DSGE models completely fail to capture inflation. Harald's slide:

The point of the slide, in simpler form: The standard Phillips curve is

inflation today = beta x expected inflation next year + kappa x output gap  + shock

Essentially all inflation is accounted for by the shock. The model is basically silent about the source of inflation. Looking at the model as a whole, not just one equation, Neither monetary policy shocks nor changes in rules accounts for any significant amount of inflation. 

I made a similar graph recently. Use the standard three equation model

Now, use actual data on output y, inflation pi, and interest rate i, to back out the shocks v. Turn off the monetary policy shock vi = 0. Solve the model and plot the data -- what would have happened if the Fed had exactly followed the Taylor rule? 

Answer: Inflation and output would have been virtually the same. The inflation of the 1970s and its conquest in the 1980s had nothing to do with monetary policy mistakes. It is entirely the fault, and then fortunate consequence, of "marginal cost" shocks that come from out of the model. This is a pretty uncomfortable prediction of a model designed to be about monetary policy! Or, as Harald put it

• Data: no Phillips-Curve tradeoff.
• QDSGE: don’t account for inflation with monetary policy shocks.
• The NK / Phillips-Curve-based NK QDSGE models may thus provide a poor guide for monetary policy.

Wait, you ask, what about Marty Eichenbaum's pretty graphs, such as this one, showing the effects of a monetary policy shock?

The answer: After a lot of work, the effects of a monetary policy shock look (at last) about like what Milton Friedman said they should look like in 1968. But monetary policy shocks don't account for any but a tiny part of output and inflation variation, quite contra Friedman (and Taylor, and many others') view.

Last, standard new Keyensian DSGE models have strong "Fisherian" properties. In response to long lasting or expected interest rate rises, inflation goes up. More on this later.

Ellen McGrattan

Ellen stole the show. (Slides.) Take a break, and watch the video. She manages to be hilarious and incisive. And unlike the rest of us, she didn't try to sheohorn a two hour lecture into her 15 minutes.

Her central points. First, like Harald, she points out that the models are driven by large shocks with less and less plausible structural interpretation, and thus further from the Lucas critique solution than once appeared to be the case. The shocks are really "wedges," deviations from equilibrium conditions of the model with unknown sources

What to do? Focus on rules and institutions. This is a deep point. Even DSGE modelers, in the desire to speak to policy makers, often adopt the static ISLM presumption that policy is about actions, about decisions, whether to raise or lower the funds rate. The other big Lucas point is that we should think about policy in terms of rules and institutions, not just actions.

Monetary policy and ELB

Stephanie Schmitt-Grohé (slides, video)  talked about the Fisherian possibility -- that raising interest rates raises inflation. New-Keynesian DSGE models, with rational expectations, have this property, especially for permanent or preannounced interest rate increases, and when at zero interest rates or otherwise in a passive regime where interest rates do not react more than one for one with inflation. She and Martin Uribe have been advocating this possibility as a serious proposal for Europe and Japan that want to raise inflation.

She presented some nice evidence that permanent increases in interest rates do increase inflation -- and right away, not just in the long run.

Mike Woodford. (slides, video)  gave a dense talk (37 slides, 20 minutes) on policy at the lower bound. During the ELB, central banks moved from interest rates to asset purchases and forward guidance. Mike asks,

To what extent does this mean that the entire conceptual framework of monetary stabilization policy needs to be reconsidered, for a world in which ELB might well continue periodically to bind? 

In classic form, Mike sets the question up as a Ramsey problem. Given a DSGE model, what is the optimal policy, given that interest rates are occasionally constrained? He derives from that problem a price level target. The price level target works, intuitively, by committing the central bank to a period of extra inflation after the zero bound ends. It is a popular form of forward guidance. The innovation here is to derive that formally as an optimal policy problem.

Mike's price level target is stochastic, changing optimally over time to respond to shocks. I'm a little skeptical that the central bank can observe and understand such shocks, especially given the above Uhlig-McGrattan discussion about the nature of shocks. Also, as I emphasize in comments, I'm dubious about the great power of promises of what the central bank will do in the far future to stimulate output today. I'm a fan of price level targets, but on both sides, not just as stimulus, but for utterly different reasons.

Mike takes on rather skeptically the common alternative -- quantitative easing, asset purchases during the time of the bound. He points out that to work, people have to believe that the increase in money is permanent, and won't be quickly withdrawn when the zero bound is over. As evidence, he points to Japan:

Similarly, he likes the price level target over forward guidance -- speeches in place of action -- as it is a more credible commitment to do things ex-post that the bank may not wish to do ex-post.

Finally, he addresses the puzzles of new Keynesian models at the zero bound -- forward guidance has stronger effects the further in the future is the promise; effects get larger as prices get less sticky, and so on. He argues that models should replace rational expectations with a complex k-step iterated expectations rule.

Me.

Video, slides from Sweden, slides from my webpage, written version. I covered this in a previous blog post, so won't repeat it all. I put a lot of effort in to it, and it summarizes a lot of what I've been doing in 15 minutes flat, so I recommend it (of course). It also offers more perspective on above points by Mike and Stephanie. My favorite line, referring to Mike's push for irrational expectations is something close to

"I never thought we would come to Sweden, that I would be defending the basic new-Keynesian program, and that Mike Woodford would be trying to tear it down. Yet here we are. Promote the fiscal equation from the footnotes and you can save the rest." 

Emi Nakamura

Poor Emi had to go last in an exhausting conference of jet-lagged participants. She did a great job (video, slides) covering a century of monetary history and monetary ideas clearly and transparently. These are great slides to use for an undergraduate or MBA class on monetary policy, as well. An abbreviated list:

• Gold standard
• Seasonal variation in interest rates under the gold standard; money demand shocks
• Money demand shocks in the 1980s -- how the supposedly "stable" V in MV=PY fell apart when the Fed pushed on M.
  
  
  
• Theoretical instability / indeterminacy of interest rate targets
• The switch to interest rate targets and corridors in operating procedures
• The (near-miraculous) success of inflation targets
  
• Taylor rules and other theory of determinate inflation under interest rate targets
• How is it "monetary economics" without money?
• Why did immense QE not cause inflation? 

The overarching theme is the grand story of a move, intellectual and practical, from money supply targets (of which gold is one) to interest rate targets.

Postlude

Monday featured two panels, Macroeconomic research and the financial crisis: A critical assessment, with Annette Vissing-Jørgensen, Luigi Zingales, Nancy Stokey, and  Robert Barro ; and Banking and finance research and the financial crisis: A critical assessment with Kristin Forbes, Ricardo Reis, Amir Sufi, and Antoinette Schoar.

Perhaps it's in the nature of panels, but I found these a disappointment, especially compared to the stellar presentations in the main conference. Also I think it would have been better to allow more (any, really) audience questions; the whole conference was a bit disappointing for lack of general discussion, especially with such a stellar group.

In particular, Luigi led by excoriating the profession for not paying attention to housing problems and financial crises. I thought this a bit unfair and simultaneously short-sighted. He singled out monetary economics textbooks, including Mike Woodford's, for omitting financial crises. Well, Mike omitted asteroid impacts too. It isn't a book about financial crises. And, after lamabasting all of us, he said not one word about events since 2009. What are we missing now? I had to stand up and ask that rude question, again suggesting that perhaps we are all not listening to Ken Rogoff this time. Annette went on to ask something like "don't you Chicago people believe in any regulation at all," and the respondents were too polite to say what an unproductive question that is and just move on.

Again, I offer apologies to authors and discussants I didn't get to. The whole thing was memorable, but there is only so much I can blog! Do go to the site and look at the other sessions, according to your interests.

Nobel Symposium on Money and Banking Day 1

I attended the Nobel Symposium on Money and Banking in May, hosted by the Swedish House of Finance and Stockholm School of Economics.   It was a very interesting event. Follow the link for all the presentations and videos. (Click on "program." )

This review is  idiosyncratic, focusing on presentations that blog readers might find interesting. My apologies to authors I leave out or treat briefly -- all the presentations were action-packed and even my verbose blogging style can't cover everything.

"Nobel" in the title has a great convening power! The list of famous economists attending is impressive. And each presenter put great effort into explaining what they were doing, in part on wise invitation from the organizers to keep it accessible.  As a result I  understood far more than I do from usual 20 minute conference presentations and 15 minute discussions.

The first day was really "banking day," giving a whirlwind tour of the financial economics of banking.

Trading liquidity

Darrell Duffie gave (as always) a super presentation on the effects regulation is having on arbitrage in markets. (Slides, video)

DB warns of US debt crisis.

"A coming debt crisis in the US?" warns a Deutsche Bank report* by Quinn Brody and Torsten Slok.

Source: DB

This graph is gorgeous. US deficits have, historically, been driven overwhelmingly by the state of the business cycle, and have very little to do with tax policies and spending decisions that dominate press coverage. In booms, income rises, so tax rate times income rises. In busts, the opposite, plus "automatic stabilizer" spending kicks in.

Until now.

There is a good reason past deficits did not really spook markets. They understood the deficit was a temporary phenomenon, due to temporary poor demand-side economic performance. We do not have that excuse now.

In case you thought this was some alarmist crank sheet, the report starts by quoting the latest CBO
report:

the CBO argues that, assuming current policies and trends are not changed, “the likelihood of a fiscal crisis in the United States would increase. There would be a greater risk that investors would become unwilling to finance the government’s borrowing unless they were compensated with very high interest rates.” 

Basecoin

Cryptocurrencies like bitcoin have to solve two and a half important problems if they are to become currencies: 1) Unstable values 2) High transactions costs 2.5) Anonymity.

I recently ran across Basis and its Basecoin, an interesting initiative to avoid unstable values. (White paper here.)

Basecoin's idea is to expand and contract the supply so as to maintain a stable value. If the value of the basecoin starts to rise, more will be issued. If it falls, the number will be reduced.

So far so good. But who gets the seignorage when basecoins are increased? And just what do you get for your basecoins if the algorithm is reducing the numbers? From the white paper:

If Basis is trading for more than $1, the blockchain creates and distributes new Basis. These Basis are given by protocol-determined priority to holders of bond tokens and Base Shares, two separate classes of tokens that we’ll detail later. 

If Basis is trading for less than $1, the blockchain creates and sells bond tokens in an open auction to take coins out of circulation. Bond tokens cost less than 1 Basis, and they have the potential to be redeemed for exactly 1 Basis when Basis is created to expand supply.

Aha, basecoins get traded for ... claims to future basecoins?

You should be able to see instantly how this will unwind. Suppose the algorithm wants to reduce basecoins. It then trades basecoins for "basecoin bonds" which are first-inline promises to receive future basecoin expansions. But those bonds will only have value during temporary drops of demand. If there is a permanent drop in demand, the bonds will never be redeemed and have no value.  They are at best claims to future seignorage. Any peg collapses in a run, and the run threshold is mighty close here.

But it gets worse.

Bear Stearns Anniversary

Justin Baer and Ryan Tracy have an excellent article in the Wall Street Journal commemorating the tenth anniversary of the Bear Stearns bailout.

The Federal Reserve tried to limit the damage with extraordinary actions, first extending the firm credit before forcing it into a hasty weekend shotgun marriage to JPMorgan Chase with $29 billion in assistance.

More specifically,

Ten years ago, Bear’s crisis week began with rumors of liquidity problems following steep losses from mortgage bonds. Mr. Schwartz, the CEO, phoned JPMorgan Chief Executive James Dimon to ask for a simple overnight loan. By that Thursday, Bear’s lenders and clients had backed away, and the firm was running out of cash. Mr. Schwartz called Mr. Geithner for more help.

Fearing a Bear-induced panic could spread throughout the banking system, the Fed arranged a $12.9 billion emergency loan routed through JPMorgan. It ultimately agreed to purchase $29.97 billion in toxic Bear assets.

First, Bear lost a lot of money in mortgage backed securities. Second, like Lehman to follow, Bear was mostly financing that investment with borrowed money, and short-term borrowed money at that, not with its own money, i.e. equity capital. Small losses then made it more likely Bear would not be able to pay back its debtors. Third, there was a run.  Short term creditors ran out the doors just like Jimmy Stewart's depositors in a Wonderful Life. More interestingly, Bear's broker-dealer clients started running too. Just how investment banks like Bear were using their broker-dealer clients to fund investments is a great lesson of the event.  Darrell Duffie lays this out beautifully in The failure mechanics of dealer banks and later How big banks fail.

Bitcoin and Bubbles

Source: Wall Street Journal

So, what's up with Bitcoin? Is it a "bubble?'' A mania of irrational crowds?

It strikes me as a fairly pure instance of a regularly occurring phenomenon in financial markets, one that encompasses some "excess valuations" in stock markets, gold and commodities, and money itself.

Let's put the pieces together. The first equation of asset pricing is that price = expected present value of dividends. Bitcoin has no cash dividends, and never will. So right off the bat we have a problem -- and a case that suggests how other assets might have value above and beyond their cash dividends.

Well, if the price is greater than zero, either people see some "dividend," some value in holding the asset, beyond its cash payments; equivalently they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two are called "convenience yield," the latter is a "rational bubble."

"Rational bubbles" are intriguing, but I think fundamentally flawed. If a price goes up forever, eventually the value of bitcoin must exceed all of US wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. The "greater fool" or Ponzi scheme theory must break down at some point, or rely on an irrational belief in the next fool. The rational bubbles theory also does not account for the association of price surges with high volatility and high trading volume.

So, let's think about "convenience yield." Why might someone be willing to hold bitcoins even though their price is above "fundamental value" -- equivalently even though their expected return over a decently long horizon is lower than that of stocks and bonds? Even though we know pretty much for sure that within our lifetimes bitcoin will become worthless? (If you're not sure on that, more later)

The real questions the Fed should ask itself

The real questions the Fed should ask itself.  This is a cleaned up and edited version of a previous blog post, commenting among other things on Janet Yellen's Jackson Hole speech in favor of most of Dodd Frank, that appeared in the Chicago Booth Review. When you think of the Fed, think more of the giant regulator than about where interest rates go.

Taylor for Fed

I might as well share with blog readers my favorite for the Fed: John Taylor.

A preface is in order though.

Monetary policy is not, right now, the flaming hot mess that characterizes so much of the Federal Government. And all the candidates are good.

The Fed's official mandate is low interest rates, low inflation, and maximum employment -- as large as monetary policy can make it. Interest, inflation, and unemployment are each lower than they have been in living memory. The stock market is high yet surprisingly quiet (low volatility).

One may question whether this is because or despite the Fed. (My view, largely despite.) One may quibble about low growth and labor force participation. One may worry about over-regulation, though Congress mandated most of it. But by the standards of the Fed's mandate, we must admit that the outcomes we see are fine. In any other branch of the Federal government, performance like this relative to mandates, together with a tradition of reappointment, would argue for Ms. Yellen's swift reappointment.

Ms. Yellen's critics, such as the Wall Street Journal editorial page, are forced to argue that she might fall short faced with future challenges. She might keep interest rates too low for too long, and let inflation pick up. (Inflation is still nowhere in sight.) She might raise interest rates too fast if the economy does start to grow more, in fear of inflation, and choke off supply side growth. (Yes, the two criticisms are inconsistent.) She might not handle the next crisis well.

Indeed. And taking the measure of people and trying to figure out how they will deal with future challenges is just what this process is supposed to be about. One can also complain that the process of monetary policy has too much discretion, too many speeches, and needs a more stable rules based approach. I have complained that the Fed is massively over-regulating finance, and this will cause a less competitive and efficient financial system in the future.

But recognize that all this is hypothetical, and there is little to complain right now about in the outcomes we tasked the Fed to achieve.

Still, let us suppose Mr. Trump decides he wants a new person at the Fed. Why John?

John is, quite simply, the top monetary economist of his generation. He understands the theory, he understands the empirical work, he deeply knows the history. He took the baton from Milton Friedman.

Tyler: Equity financed banking is possible!

Tyler Cowen wrote an extended blog post on bank leverage, regulation and economic growth on Marginal Revolution. Tyler thinks the "liquidity transformation" of banks is essential, and that we will not be able to avoid a highly levered banking system, despite the regulatory bloat this requires, and the occasional financial crisis. As blog readers may know, I disagree.

A few choice quotes from Tyler, though I encourage you to read his entire argument:

I think of the liquidity transformation of banks in terms of...Transforming otherwise somewhat illiquid activities into liquid deposits. That boosts risk-taking capacities, boosts aggregate investment, and makes depositors more liquid in real terms.  

Requiring significantly less bank leverage, at any status quo margin, probably will bring a recession. 

...many economies are stuck with the levels of leverage they have, for better or worse. 

I fear ... that we will have to rely on the LOLR function more and more often. 

I don’t find the idea of 40% capital requirements, combined with an absolute minimum of regulation, absurd on the face of it. But I don’t see how we can get there, even for the future generations.

Depressing words for a libertarian, usually optimistic about markets.

This is a good context to briefly summarize why "narrow", or (my preferred) equity-financed banking is in fact reasonable, and could happen relatively quickly.

Tyler's main concern is that people need a lot of "liquidity" -- think money-like bank accounts -- and that unless banks can issue a lot of deposits, backed by mortgages and similar assets, bad things will happen -- people won't have the "liquidity" they need, and businesses can't get the investment they need.

Here are a few capsule counter arguments.  In particular, they are reasons why the economy of, say 1935 or even 1965 might have required highly levered banks, but we do not.

1) We're awash in government debt.

Yellen at Jackson Hole

Fed Chair Janet Yellen gave a thoughtful speech at the Jackson Hole conference.

The choice of topic, financial stability and the Fed's role in financial regulation and supervision, says a lot. Financial regulation, supervision, and other tinkering, is much more centrally a part of what the Fed is and does these days than standard monetary policy. Whether overnight interest rates go up or down a quarter of a percentage point may be the subject with the greatest ratio of talk to action, and of commentary to actual effect, in all of economics. Interest rates are likely to stay around 1% for the foreseeable future. Get used to it. But the Fed is deeply involved in running the financial system, and all the talk points to more. 

Rather unsurprisingly, she did not give the speech I might have given, or that some of the others campaigning for her job have given, bemoaning the current state of affairs. She's been in charge, after all. If she viewed the Dodd-Frank act as a grossly complex Rube Goldberg contraption, and the Fed only following silly rule-making dictates to comply with the law, she would have said so loudly long before this. Whether with an eye to reappointment, to write the first draft of history, or -- my sense of Ms. Yellen -- out of forthright Jon Snow-like irrepressible honesty, one should not have expected a stunning critique.  Moreover, her speech is dead-center of the world in which she lives, that of international policy and regulatory organizations. It would be a lot to expect a Fed chair to lead intellectually and to strike out far from the consensus of the bubble.

Still, I am disappointed. Even accepting her view of the crisis, and the current slow growth era, there are far more "Remaining Challenges" than her three paragraphs. There are far more questions to be asked, paths to choose, and fundamental choices to be made.

Which deregulation? 

Pollyanna

In case you stay up at night worrying about the next financial crisis, the good folks at the Financial Stability Board have produced a nice soothing little video (original link in case the embed doesn't work, and so you can see that no, I'm not making this up),

The short summary:

Safer, Simpler, Fairer 

3 July 2017 

A decade on since the start of the global financial crisis, G20 countries have rebuilt the financial system so that it serves society, not the other way round. 

By fixing the fault lines that caused the crisis, the financial system is now safer, simpler and fairer than before.   

View and share our videos that explain the G20's work to reform the financial system.

As cheery propaganda, it's not quite up to the Chinese "belt and road" video standard, but pretty good. It needs more puppies and singing children. As unintentional humor, it scores highly. I mean, wasn't "safer" enough, questionable as it is? Did they really have to stretch for simpler and fairer? I don't think Dodd and Frank themselves buy that one.  As a good link to have around for the next financial crisis, better still. As an insight into the wisdom of the Financial Stability Board... well, sometimes I find things that leave even me sputtering to find a pithy summary. You'll have to enjoy it on your own, and try to come up with something good in the comments.

Update: Look at the "capital" bucket. What capital ratio is in the video? What capital ratio is in real life?

The Treasury Portfolio

Charlie Plosser makes the case that the Federal Reserve should hold only Treasuries in its asset portfolio, at Hoover's "Defining Ideas"

Background: The Fed is essentially a giant money-market fund. Its liabilities are cash and bank reserves. Its assets are .. well, they used to be entirely short term Treasury securities, but now include mortgage-backed securities. In the crisis, the Fed bought a lot of other securities. Other central banks buy stocks, and it's pretty clear if there were a recession tomorrow, after interest rates hit zero the next day, the Fed would go on a buying binge. The Fed is a government agency, but it is "independent," enjoying a lot of freedom to do what it wants no matter what Congress or the Administration want it to do.

Plosser's proposal,

 1.        The Federal Reserve should be required to maintain a Treasuries-only policy as it pertains to the conduct of monetary policy. 

2.         The Federal Reserve should be prohibited from purchasing non-Treasury securities, private sector securities or lending against private collateral except through traditional discount window operations with depository institutions. 

3.         Emergency lending under Section 13(3) of the FRA should be eliminated and replaced with a new Fed-Treasury accord...

The Fed may buy other securities, but basically has to swap them back to the Treasury or sell them within 60 days. If the government is going to subsidize credit to various industries, voters, and constituencies, then the politically accountable Treasury should do it, not the independent Federal Reserve. Charlie allows here that the Fed may be able to move faster in a crisis.

Why only Treasuries? Why should the Fed not always have greater power to guide the economy more forcefully by buying whatever assets it thinks need propping up? Because,

Living Trusts for Banking

One of the core problems of financial reform is how to "resolve," AKA bankrupt, a big bank -- how can equity holders be wiped out, and debt holders carve up the remaining assets. Big banks are supposed to craft “living wills,” really living vivisection guides, but that effort is clearly in trouble. This blog post expands on a different idea for bank resolution; let’s call it “living trusts” by a similar analogy to estates.

Here's the idea: Let a bank fund its risky investments 100% by issuing equity. The bank then simply cannot fail — it cannot go bankrupt, it cannot suffer a run.  As I've argued elsewhere, I think this is entirely practical.

But suppose it really is important for some reason to carve up bank liabilities into a small amount of highly leveraged equity and a large amount of run-prone short-term debt. Suppose it really is important for banks to "create money," and to take deposits, and to funnel those into risky, illiquid, and otherwise hard-to-resolve assets. Suppose that equity holders really demand highly leveraged high return high risk bank equity, not super-safe low return low risk bank equity, that the return on equity not its Sharpe ratio is a constant of nature.

OK. For $100 of assets, and $100 of bank equity, let, say, $10 of that equity be traded — enough to establish a liquid market. Then, let $90 of that equity is held by a downstream entity or entities— a fund, special purpose vehicle, holding company or other money bucket. I’ll call it a holding company, and return to legal structures below. The holding company, in turn, issues $10 of holding company equity and $80 of debt.

There you have it — $100 of bank assets are “transformed” into $10 of very safe bank equity, $10 of risky and high return holding-company equity, and $80 of short-term debt.

Now if the bank loses money, the value of the bank equity falls. But the bank is failure-proof and run-proof. Shareholders get mad, may throw out management, may even break up the company. But they cannot run, demand their money now, and force bankruptcy.

The holding company can fail however! Suppose he bank loses $20. The holding company owes $80 of short term debt. Its assets are worth .9 x $80 = $72. It’s insolvent. It fails. Holding-company equity holders are wiped out. Holding-company creditors get the assets, common stock in the original bank, worth $72/$80 = 90 cents on their original dollar.

It need not be that drastic. Its likely the previous short-term debt holders don’t want stock, and would want to sell it in a hurry. Dumping 90 shares on the market might be tough.

The holding company could do a 5-minute recapitalization instead. Holders of the $80 of debt get $60 of debt and $12 of new holding-company equity. The holding company is recapitalized by the flip of a switch.

The key: this resolution/recapitalization can happen in about 5 minutes.

Fintech and Shadow Banks

"Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks" is an interesting new paper by  Greg Buchak, Gregor Matvos, Tomasz Piskorski, and Amit Seru

1. Shadow banks and fintech have grown a lot.

the market share of shadow banks in the mortgage market has nearly tripled from 14% to 38% from 2007-2015. In the Federal Housing Administration (FHA) mortgage market, which serves less creditworthy borrowers, the market share of shadow banks increased...from 20% to 75% of the market. In the mortgage market, “fintech” lenders, have increased their market share from about 5% to 15% in conforming mortgages and to 20% in FHA mortgages during the same period

2. Where are they expanding? They seem to be doing particularly well in serving lower income borrowers -- FHA loans.  They also can charge higher rates than conventional lenders, apparently a premium for convenience of not having to sit in the bank for hours and fill out forms,