Kocherlakota on moral hazard

I found a kindred spirit. Narayana Kocherlakota, ex president of the Minneapolis Fed, shares my concerns over the current lending and bailout spree, in particular propping up the prices of corporate bonds.

In its last financial stability report of 2019, the Fed highlighted how many nonfinancial corporations were making use of highly risky debt. The report pointed out that “a number of contacts expressed concern that a U.S. recession would expose highly leveraged sectors … concerns related to nonfinancial corporate debt were cited most frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds.” 

The financial stability report, of course, made no mention of pandemics or social distancing. It didn't need to — the risk to the financial system and the economy is posed by any recessionary shock. The coronavirus just happened to be the first one that come along.

Bailout redux

The greatest financial bailout of all time is underway. It’s 2008 on steroids. Yet where is the outrage? The silence is deafening. Remember the Tea Party and occupy Wall Street? “Never again” they said in 2008. Now everyone just wants the Fed to print more money, faster. (Well, there are some free market economists left. But we're a small voice!)

Maybe the Fed is right that if any bondholder loses money, if bond prices fall, if companies reorganize in bankruptcy, the financial system and the economy will implode. I am not here today to criticize that judgement. But if so, we must ask ourselves how we got to this situation, again, so soon. Once is an expedient. Twice is a habit.  It is clear that going forward any serious shock will be met by bailouts, and the Fed printing reserves to buy vast quantities of any fixed-income asset whose price starts to fall.

Why does the Fed feel the need to jump in? Because once again America is loaded up with debt, because bankruptcy is messy, and because the Fed fears that debt holders losing money will stop the financial system from providing, well, more debt.

This crisis is a huge wealth shock. The income lost during shutdown is simply gone. The question is, who is going to take that loss? Borrowing to keep paying bills, the current solution, posits  that future profits will soak up today's losses. We'll see about that. The CARES act puts future taxpayers squarely on the hook to pay today's bills. But where do those bills go? To creditors -- property owners, bond holders, and so forth. If we're looking around for pots of wealth to absorb today's losses, why are bondholders not chipping in? The biggest wealth transfer in history is underway, from tomorrow's taxpayers to today's bondholders, on the theory that if they lose money the economy falls apart?

OK, but why did America load up with debt again, apparently all "systemically important?" Could the expectation of a bailout any time there is an economy wide shock happens have had something to do with it? Will we do anything when this is over to stop companies from once again loading up with debt -- especially short term debt -- and forcing the Fed's hand again?

Meantime, anyone who hoarded some savings in the hope of profiting from fire sales, in the hope of providing liquidity to "distressed markets" has once again been revealed as a chump. Will we do anything to encourage them? Will lots of debt, private gain, taxpayers take the losses,  be the perpetual character of our financial system.

"You can't worry about moral hazard in a crisis," they said, and they didn't. At least last time there was some recognition of moral hazard, and a promise to clean up the moral hazard with reform. Will there be any such effort this time? Is anyone even thinking about the enormous moral hazard we are creating with these precedents? Will  the financial system perpetually a four-year-old on a bicycle, a parent running closely behind with one hand on the seat? Will the "Powell put" on fixed income grow ever larger? Or will we, this time, finally cure the financial system so it can survive the next shock?

A bailout 

Small but symbolic: The federal government just bailed out the airlines -- or more precisely airline stockholders, bondholders, unions, airplane leaseholders and other creditors who would lose in bankruptcy.

 "big airlines will receive 70% of the money as grants—which won’t be paid back—and 30% as loans. The cash comes with strings attached: Airlines must give the government warrants amounting to 10% of a given loan’s value that can be swapped for stocks; they cannot lay off staff until September; and they face restrictions on dividends, buybacks and executive compensation."

Oh, and as the article makes clear, this only gets us maybe through the summer. Anyone want to take a bet that planes are full again by September?

The big banks got bailed out in 2008 — or more precisely, the stockholders, bondholders and creditors of the big banks got bailed out.  Never again, they said. Again.

Now, one can make a case that big banks are “systemic,” that if their bondholders lose money the financial system collapses. Just how are airline bondholders “systemic?” What calamity falls if airline bondholders don’t get paid in full?  Just why is a swift pre-packaged bankruptcy not the right answer for airlines? This seems like a great time to renegotiate airplane and gate leases, union contracts (some require the airlines to keep flying empty planes!) fixed-price fuel contracts and more.

If taxpayers have to give airlines cash grants don't we get some reassurance this doesn't have to happen again? Even I would say, no more debt financing. You can see the instinct in "restrictions on dividends, buybacks and executive compensation." Democrats in Congress wanted "stakeholder" board seats, carbon reporting, and more. Why not go full Dodd-Frank on them? Detailed regulation of their financial affairs, stress tests to make sure they can survive the next time? Like banks, the existing airlines might not end up minding so much a return to the 1970s status as regulated utilities. Or, more likely, like GM, we just forget about it, let them load up on debt again, and pretend there won't be a 2030 bailout?

The Fed's big artillery

The real action is at the Fed. The Fed is buying commercial paper, corporate bonds, municipal bonds. The Fed is explicitly propping up asset prices. The Fed is also lending directly to companies. The current guesstimate is $4 trillion, with $2 trillion already accomplished. More is coming.

It started "small" On March 17, the Fed bailed out money market fund investors, buying the “illiquid” assets of those funds so that the funds could continue to pay out dollar for dollar.  Recall that in 2008, the Fed and Treasury bailed out money market fund investors, buying assets to stop a run on money-market funds' promise that you can always cash out at $1. Never again, they said. Fixed dollar promises must be backed by Treasuries, other funds must let asset values float. Again.

On March 17 the Fed also announced it will buy commercial paper.  “Directly from eligible companies.” Yes, the Fed prints reserves to lend directly to companies that can issue A1/P1 commercial paper.

"By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. " 

Why are companies borrowing long term by rolling over commercial paper? Didn't we learn anything about rolling over short term debt in 2008? Are we going to follow up by putting a stop to that? Why don't companies have more equity financing, on which they can just stop paying dividends?

"Investors" you say, it's not all the Fed. Read carefully. "By eliminating much of the risk..." The Fed props up prices, and removes risk. Then private investors will come in. The markets won't ride that bike without the Fed's hand on the saddle, apparently. Why do we bother to have private markets?

On March 17 the Fed started to lend again to primary dealers. These are the traders, much maligned by the Volcker rule.

The PDCF will offer overnight and term funding with maturities up to 90 days...Credit extended to primary dealers under this facility may be collateralized by a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities. 

Let's translate. You're the trading desk at, say Goldman Sachs. You want to buy stocks, as you think people are dumping in a hurry. Great, that's what traders are supposed to do: "provide liquidity." But, sadly, you're in the habit of of funding trading activity by borrowing money, short term. And you can't do that right now. So the Fed will now lend you the money to buy stocks, and will take the stocks as collateral! It's almost as if the Fed is buying stocks -- except you get the gains, and if you go under, the Fed gets the stocks! (A friend in the securities industry say nobody is bothering to investigate and price high grade corporates. The Fed is setting the prices.)

Again, the Fed is between a rock and hard place. Yes "balance sheets are constrained." Trading firms don't have enough equity to take on additional risk. The natural buyers at asset fire sales are constrained out of the market. Bail the Fed feels it must. But this is exactly what happened when the Fed first lent to broker/dealers in 2008! Why in the world are we in this position, 12 years after that crisis?

On March 20, the Fed expanded into state and municipal markets. The mechanism is the same: Fed lends to a financial institution, which buys the assets, and then gives the Fed the assets as collateral for the loan. Once again the point is  "enhance the liquidity and functioning of crucial state and municipal money markets."

On March 23, the Fed rolled out real artillery. Ominously, Treasury markets appeared "illiquid," so the Fed has stepped in buying $1.3 trillion in the first month -- more than the Treasury issued.  The Fed is funding Treasury borrowing with newly printed reserves.  The Fed now buys mortgage backed securities.

And now.. corporate bonds. This is well past 2008.

the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.

Translation: The Fed will buy new corporate bonds, thus directly lending to corporations. And it will buy  outstanding bonds.

Why would it do that? Well, to "provide liquidity." This is a word that ought to set off BS detectors. Yes, there is such a thing as an "illiquid" market. There is also such a thing as a market whose prices are dropping like a stone. Sell all you want but at 50 cents on the dollar. "I wish I had sold at yesterday's prices" is not illiquidity. You have to pay people a lot to take risk right now. Which is it? Hard to tell. There are ways to tell, of course. For example, illiquid markets have negative price autocorrelation -- a low price today bounces back. I am not aware of the Fed having applied this or any other test. (Research topic suggestion.)

Again, I don't want to criticize, but there sure is a danger of propping up prices under the guise of "illiquidity." The Fed's view that if the Fed takes all risk off the table "liquidity" will reappear is also pretty close to taking risk off the table so prices will rise.

The Fed is already buying new bonds from companies to finance their new expenditures. Propping up prices of existing bonds is a way to let old bondholders cash out at high prices, now before the deluge. Just why can't old bondholders even take mark-to-market losses?

And, if corporate bondholders need to be bailed out in this way, are we going to do anything about it going forward? Do you get to buy junk bonds, high interest municipal debt, and the Fed will let you out if anything bad happens?

Wrap up

OK, I haven't even gotten through March and the Fed is just getting going. Let's wrap up.

The Fed has felt the need to take over essentially all new lending in the economy. The Fed is also propping up most fixed-income prices. The Fed is deliberately removing risk from holding these assets.

Once again, I will be told, "this isn't the time to think about moral hazard." But having done this twice, the first time with huge protest, the second time as if it is perfectly normal, this is the pattern, and the moral hazard is there. The economy will load up on debt, especially short term debt. People will not keep stashes of savings around to provide liquidity or jump on buying opportunities. And the need for bailouts will be larger in the next crisis.

"But the Fed made money in 2008" you may retort. And it has a half chance of making money again. If the recession wraps up in September and these "loans" get paid back, it will do nicely. If the recession goes on a year and all these "loans" go sour, it will not look so pretty.

Yes, in 2008 the Fed and treasury successfully operated the world's largest hedge fund, printing money to buy low-price assets. But is this really the function of the Federal Reserve? Do we want it driving private hedge funds out of the liquidity provision business, by its ability to print rather than borrow money, and by the off-balance-sheet put that the US taxpayer will in the end take losses if this massively leveraged portfolio doesn't work out?

Where is the outrage? Where are the financial economists? Where is the reform plan so we don't do this again? At a minimum, can we say tha  the government could stop subsidizing debt, via tax deduction and regulatory preference for "safe" (ha!) debt as an asset?

Hello out there? In 2008, everyone was writing financial crisis papers. Now everyone is playing amateur epidemiologist.

Finance colleagues, you have a bigger crisis and intervention to study, and a deeper set of regulatory conundrums. Is everyone just too scared of sounding critical of the Fed? Get to work!

The Fed and Treasury's actions are telling us we are on the verge of financial apocalypse. Let's wake up and look at what's coming, especially if it doesn't all get better by September.

Some links 

This post continues from Financial Pandemic.

I had planned a longer post on the details of many of these programs, but this is long enough.


A great explanation by Robert McCauley in FT. Section heads include  1) Acting as a lender of last resort to securities firms, 2) acting as a lender of last resort to investment funds, 3) acting as a securities dealer of last resort, 4) acting as a securities underwriter of last resort and finally 5) acting as a securities buyer of last resort.

A simple tweet storm by Victoria Guida

Via the indefatigable Torsten Slok,

Financial Policy During the COVID-19 Crisis MIT opeds on financial affairs

A great list of policy trackers.

Financing Firms in Hibernation During the COVID-19 Pandemic

The Yale Financial Stability Tracker and especially the Finance Response Tracker are very useful list of what's going on.

Fed Intervention in the To-Be-Announced Market for Mortgage-Backed Securities
by Bruce Mizrach and Christopher J. Neely is a very nice description of what's going on there

The United States as a Global Financial Intermediary and Insurer by Alexander Monge-Naranjo. More contingent liabilities waiting for Uncle Sam bailouts.

A data set of international fiscal responses

Weisbach advice

Mike Weisbach is writing an excellent book of advice, A Field Guide to Economics: A Young Scholar’s Introduction to Research, Publishing, and Professional Development. As a good scholar he is circulating the manuscript. It's really half advice and half a meditation on how the profession works and how it should work.

There is a lot of good advice, and a lot of good questions. I'll highlight a few things I disagree with, but don't take that as criticism of the project, rather an invitation to read and think about the issues yourself.

Financial pandemic

The headlines are on the disease, the shutdown, and the hoped-for safe reopening. It's time to pay some attention to the financial side of the current situation, and the Federal Reserve's immense reaction to it.

Disclaimer: do not read in this post criticism of the Fed. Maybe the world would have ended if they had done things differently. But it is important for us who study such things to understand what they did, what beneficial and adverse consequences there are, and how the system might be set up better in  the future.

Big picture: We face an extremely severe economic downturn, of unknown duration -- it could be a V,  U, or L. If it is not a V shaped in months, there will be a wave of bankruptcies from personal to corporate, and huge losses all over the financial system. Well, earn returns in good times and take losses in bad times, you may say, and I do, more often than the Fed does, but for now this is simply a fact.

Our government's basic economic plan to confront this situation is simple: The Federal Reserve will print money to pay every bill, and guarantee every debt, for the duration. And, to a somewhat lesser approximation, to ensure that no fixed-income investor loses money. 

I reiterate, the point of this post is not to criticize. If you are reading economics blogs, you like me probably have a nice work-from-home job that still pays some money. This is not what's going on. From a combination of voluntary and imposed social distancing, the economy is collapsing. As I detailed in an earlier post  20 million people, more than 1 in 10 US workers, lost their jobs in the first month of this shutdown. That's more than the entire 2008 recession. In 3 weeks. 1/3 of US apartment renters didn't pay April rent. Run that up through the financial system. Most guesses say that companies have one to three months of cash on hand, and then fail. We'll look at signs of financial collapse in a bit, that the Fed reacted to. If you want to know why the Fed hit the panic button, it's because every alarm went off.

Pay every bill? Yes, pretty much. This is not "stimulus." It is get-through-it-us. People who lost jobs and businesses that have no income can't pay their bills. When people run out of cash they stop paying rent, mortgages, utilities, and consumer debts. In turn the people who lent them money are in trouble. Businesses with zero income can't pay debts (just why debts are so large is a good question to keep track of), employees, rent, mortgages, utilities. When they stop, paying they go through bankruptcy and their creditors get in to trouble. If you want to stop a financial crisis, you have to pay all the bills, not just some extra spending cash.

And that's pretty much the plan. There will be unemployment insurance, with 100% replacement of wages, for people who lose jobs, so they can pay rent, mortgages, utilities, and consumer debts. The Small Business Administration will make forgivable loans to businesses. Bailout plans are in place to make sure industrial companies like Arlines do not file for bankruptcy. (Much of this money is stuck in snafu, but that's the plan if not the execution.) And, where the big money is, the Fed is propping up corporate bond, municipal bond, treasury, money market funds, and other markets. I'll survey the programs below, this is big picture for now.

Printed money? Yes. Start with the Treasury. The Treasury wants to spend $2 trillion in the first stimulus bill. Where is that money coming from? In normal times, that would mean selling $2 trillion of treasury bond and bills. But who has $2 trillion of extra income lying around that they want to use to buy treasury debt right now? Yes, the new treasury debt has to come from a new flow of savings. Well, you can argue if that's there or not, but you don't have to. The Fed is buying more debt than the Treasury is selling. 

When the Fed buys Treasury debt, it prints up new money, and gives it to the holder of the Treasury debt. (I will say "printing money" as that is clearer. The Fed actually creates new reserves, accounts banks have at the Fed, by flip of an electronic switch. Banks can convert reserves to cash and back at will.)  On net, if the Treasury borrows and spends the money, and the Fed buys the Treasury debt, the government as a whole has printed up new money to spend. That's what's going on now. 

From the March 4 and April 8 Fed H.1 data, we learn that the Fed held $2,502 billion and $3,634 billion Treasury securities on those dates, an increase of $1,132 billion.  From the Treasury debt to the minute page, we learn that debt held by the public (including the Fed) rose from $17,469 billion to $18,231 billion -- a (huge) rise of $762 billion. $9 trillion at an annual rate. The Fed bought all the Treasury debt, printing new money to do it, and then some. On net, the government financed the entire $762 billion by printing new money and printed up another $370 billion to buy back that much existing treasury debt. 

The UK is abandoning pretenses. Bank of England to directly finance UK government’s extra spending writes the FT. Rather than have the government sell to the market, and then the bank buy it, the bank will now print money for the government to spend, and the government will print treasury debt to give to the bank in return.

(Who cares you may ask? The US Fed is not legally allowed to buy from the Treasury. The Treasury must sell in private markets to establish the interest rate, i.e. the price of the debt. If not, there is an inevitable temptation to say that markets are "impaired" or "illiquid" requiring too high rates, and thus the Fed buys at artificially low rates and high prices. The laws against inflationary finance are pretty thoughtful.)

The new lending programs are explicitly financed by the Fed printing up new money to do so.

The Fed and Treasury are teaming up to provide trillions to lend money to businesses and banks, and to buy assets including  money market funds, corporate bonds, municipal bonds, mortgages,

Now where do these trillions come from? Answer, in short, the Fed simply prints them up. It prints up the new money, and gives it to a business or bank or uses it to buy assets. 

A bit longer explanation 

In normal times, the Fed creates money (reserves) by buying Treasury bills. It has an asset -- the Treasury -- and a liability -- the money. The money is backed by Treasurys, a good principle of non-inflationary policy. That's the simple version of which  the Fed just did a trillion. 

When the Fed lends money to a bank or a company, the Fed likewise prints up money, gives it to a company, and counts the company's promise to pay back the loan as the corresponding asset. You can see the danger. The Fed is supposed to make only safe loans, to guard against inflationary finance, and to keep the Fed politically independent. Printing money to hand gifts to well connected firms and politically powerful interest groups is dynamite, and an independent agency will not stay independent long if it does so. 

For this reason the Fed and Treasury work together. The Treasury agrees to take the first tranche of losses, so the Fed can say this is a safe loan. Jay Powell was, as usual, clear on this. 

I would stress that these are lending powers, not spending powers. The Fed is not authorized to grant money to particular beneficiaries. The Fed can only make secured loans to solvent entities with the expectation that the loans will be fully repaid

What happens if the loans are not paid back? Well, in the first 5 to 10%, the Treasury takes the loss.  But right now, the Treasury gets its money from the Fed. So it really comes back to printed money anyway. If losses are so severe that the Fed loses a lot of money, the Treasury will have to recapitalize the Fed with a gift of Treasury bills. 

So, if the loans are not paid back, one way or another, we end up with that much more outstanding Treasury debt, either owned by the Fed and money outstanding, or owned by people. 

But this Fed vs treasury business, while important inside baseball for Fed independence and a bunch of issues on how the plumbing works, is really beside the point. The Fed and Treasury right now are, together, printing up trillions of dollars -- $4 -$6 trillion is the current guesstimate, which assumes a short sharp recession -- and handing them out. Most of it is "loans" which the Fed and Treasury hope to recoup. Then they can reduce the amount of money left outstanding. 

Is this really lending? 

As Jay Powell emphasized, the current vision is that most of the current support is lending, not spending. The Treasury kicks in something like $400 billion which really is spending, the anticipated loan losses (companies that don't survive) and forgiveness (programs that promise to forgive the loan if the company meets employment or other goals). The Fed lends $4 trillion on top of that, and gets its money back. The government as a whole has only spent $400 billion when its over, and the new debt (money) is soaked up again by repayment. 

But is this really lending or just spending?  Well, in the short run it's lending, but if the recession lasts more than a few months it will turn in to spending.

Companies have no income but must pay rent, debts, (interest on their corporate bonds and bank loans used to purchase now idle plant and equipment), utilities, skeleton staff, etc. Local governments are in a similar bind. They borrow to cover this cost. What's wrong with that? 

Well, borrowing usually corresponds to a productive asset, to an increase in value. If a bakery borrows to buy an oven, the bakery will make more bread, and use the additional profits on the extra bread to pay off the loan. If it doesn't work out, the oven is a real asset, collateral that the bank can sell to get some of its money back. A city borrowing to build a highway gets more tax revenue from greater activity to pay off the loan. 

But there is no economic value to these loans. These are consumption loans, stay-afloat loans, preserve-the-business loans. They are loans against future profits, but not additional future profits. They are a transfer of the franchise value of the firm to the lender. 

So, first, the firm clearly at some point is better off shutting down than promising its entire profit stream to a lender just for the right to reopen someday. Second, the government, already inclined to forgive, say, student debt, has every reason to forgive these "loans" as well. The business "loans" explicitly promise forgiveness if the government keeps workers on board. When we are in a sluggish recovery, and businesses are saying "well, I would hire more people, but we have all this extra debt because we took Fed loans to keep our employees fed while we were shut down," let's see just how tough the government is going to be on repayment. 

So, in a matter of months, these loans turn to gifts. The $4 trillion Fed lending package winds up as $4 trillion permanently added to Treasury debt. 

Does this mean inflation? 

You would think that, if the Fed and Treasury are going to print up something like $1 trillion a month of money to pay everyone's bills and prop up markets for the duration, we would be heading for inflation, soon. 

No, or at least not immediately. Reserves pay interest. Reserves are just another form of Treasury debt. (Reserves that pay interest is one of the best innovations of recent decades, and Kudos to Ben Bernanke and everyone else involved.) 

So why does it matter? Couldn't the Treasury just print up Treasury bills, sell them for reserves, hand out the reserves, collect loans in due time and retire the Treasurys? In the short run it does matter, which should send a few shivers up our spine. Apparently the Treasury had a hard time finding willing buyers. So printing up the reserves directly made a difference. So, the Fed ends up with a loan "asset" on its balance sheet against reserves, rather than the Treasury with that loan as an asset on its balance sheet against Treasury bills. Conveniently, also, reserves though equivalent to Treasury debt are not counted in the debt limit along with many other contingent liabilities. 

In the long run it does not matter. The Fed and Treasury print up reserves, lend it to Joe's Laundry; Joe pays his mortgage; the mortgage company pays its investors. If those investors are happy sitting on reserves (bank accounts backed 1:1 with reserves on the margin), it sits. If they are not, which would be the beginning of the inflationary process, the Fed can just raise the interest rate on reserves until they are, really really transforming reserves to Treasury debt. Or the Fed can give them some of its stock of Treasurys and so on up the reserves. 

With abundant interest-paying reserves, reserves and Treasury debt are almost exactly the same thing, and in roughly functional markets, what matters is their total supply, not reserves alone. Inflation is a danger, but from the total quantity of government debt, not its split between reserves and  bills. Inflation comes basically if the US hits a debt crisis. 

(That is, so long as the Fed pays market interest on reserves, and lets the market basically have as much or as few reserves as it wants. If the Fed, and Treasury, start worrying about interest costs of the debt, and do not pay interest on reserves and do not allow people to convert to Treasurys, then inflation comes sooner. )

But we're looking for sure at raising US debt from $22 trillion to $27 trillion, likely hitting 150% of GDP if this is a short and swift recession. It could be much larger if the recession goes on a year or more. Is there a demand for that much more treasury debt in the long run? Is there a flow of that much new saving that people are willing to park with Uncle Sam? How much more can markets take? So the chance of a global sovereign debt crisis and inflation is not zero -- but not centrally from the fact that it's currently financed by printing money. I'll come back to this issue in detail later. 

Questions. 

First, how long can this go on?

As you can see, the viability of this whole plan depends on a short recession. The Fed is printing up something like $1 trillion per month. If the recession ends up being L shaped, those numbers will ramp up as reservoirs of private cash dry up. A few large company bailouts, a few more "dysfunctional" markets turn to the Fed to buy everything, and so on. The  IMF wants  $1.2 trillion to bail out emerging market economies. After 3 weeks. That will get worse. State and local governments, already facing pension crises, are gong to be toast when sales and income tax receipts collapse. Bear Stearns, Fannie and Freddy, AIG...

Where is the limit? Perhaps the peasants with pitchforks, remarkably absent so far, will revolt. Perhaps the willingness to hold interest-bearing reserves or US Treasury debt will find its limit after $10 trillion. Or $20 trillion.

At some point, people who bought risky, high return debt, and earned nice returns on the way up, will have to bear some of the genuine economic losses. There is no magic. Government debt is paid back by taxes. (If you think that law has been repealed by MMT or r<g, I'll disabuse you of that in an upcoming post.) Trillions will be spent. Either taxpayers pay it, or creditors pay it. 

Second, isn't there a bit of moral hazard here? Now, you may say, nobody asks about moral hazard in a foxhole. But at some point we have to address the moral hazard. Half of these interventions were things done in 2008, and we said no, never again, we'll pass a mountain of regulations to control moral hazard. Remember "no more bailouts?" Especially money market funds? And here were are, one week into it and airlines are too big to fail and money market funds need the Fed to stop from breaking the buck. At a minimum we can look at what the Fed has done, remark on how the post 2008 controls on moral hazard failed, and at least think about how we might avoid being in exactly the same  pickle in 2032.  We can also once again Monday morning quarterback and suggest how things might be done in a way to diminish the moral hazard. At least we can get a better playbook for next time.

I will look at both these issues in detail in upcoming blog posts.

Strategic Review and Beyond: Rethinking Monetary Policy and Independence

March 4, I was honored to give the Homer Jones lecture at the St. Louis Federal Reserve. Link here

Strategic Review and Beyond: Rethinking Monetary Policy and Independence.

I used the opportunity to put lots of thoughts together in condensed form, on how the Fed and other central banks should approach monetary policy, financial regulation, and ever-expanding mandates.  The link is to the html version. It will appear in prettier form in the April St. Louis Fed Review.

The conclusion

Should, and can, the Fed stimulate with strongly negative rates, immense QE asset purchases, and an arsenal of forward guidance speeches? I think not. What sort of target should it follow? A price-level target. The Fed should get out of the business of setting the level of nominal rates and target the price level directly. Price-level control will be much more effective with fiscal policy coordination. The Fed should offer a flat supply curve of interest-paying reserves, open basically to anyone, though the Treasury should take up much of that role directly. 

Going forward, the Fed and its international counterparts should disavow the temptation toward ever-expanding mandates and economic and financial dirigisme that would take them to "macroprudential" policy, discretionary credit cycle management, asset price targeting, and exploiting regulatory power to embrace social and political goals… today on climate change and inequality, perhaps tomorrow on immigration, trade restriction, China-isolation, or whatever the smart set at Davos wants to see. Only limited scope of action to areas of agreed technocratic competence will salvage the Fed's, other central banks', and international institutions' useful independence.

Of course this effort arrives with spectacularly bad timing, as nobody is talking about anything but the Covid-19 virus. Still, life does go on, and I don't see anything that is directly contradicted by current events. And perhaps you want to read and think about something other than virus crisis, and issues we will go back to thinking about when it's all over.

In the final section (see the footnotes too) I discovered that our international institutions, BIS, IMF, FSB, and so forth were busy dragging banks into the partisan warfare over green new deal style climate policy and forced redistribution. I took a dim view of that. First of all, the idea that climate and inequality present financial risks is just fanciful. Most importantly these are political minefields that will doom independence.

I think this section holds up well. That the worthies who look in to the future and spot risks to the financial system, and drag banks into accounting for them via stress tests and regulatory accounting, found climate change and inequality the biggest run-provoking risks they could think of, not even mentioning pandemic, tells you volumes about the whole technocratic project.

If you like to watch videos, here is the actual lecture somewhat shorter than the written version.

WSJ oped on virus policy

Why is the market going nuts? What should policy do? I put some of my recent thoughts in a Wall Street Journal Op-ed, here. As usual I can't post the whole thing for 30 days, but if you're clever you can find it.

This is not a "demand" recession needing "stimulus." The economic policy challenge is to allow the economy to shut down, but make sure it doesn't die in the process. The problem is -- once again -- debt.

Had everyone kept a few months of cash around, things would be fine. But many did not. Now we are seeing the beginnings of a scramble for cash, as people and businesses try to sell assets or borrow. But who is buying? And who is lending? Banks can’t make new loans to companies and people with no income.

If there is a wave of firing and bankruptcy,

A pandemic can turn quickly to a financial crash and a long recession, not a V-shaped pause. That’s the scenario spooking markets, and it should spook all of us.

What to do? Clearly the central goal of policy should be to keep businesses alive so they are ready to turn back on again.  

The main focus of economic policy should be

Lending is better than transfers. Since loans must be paid back, larger amounts can go where needed. ...

Forbearance is important. Banks and creditors should not immediately shut down a nonpayer. But they have to be allowed to forbear by their regulators, their own creditors, and their own fiduciary responsibility, and to borrow or pass forbearance up the line....

Rather than give each of us $1,000, allow us to borrow a fraction of last year’s income from the Internal Revenue Service and repay when we file our taxes. That provides more money to those who need it, and helps those even with large debts not to default. Allow penalty-free withdrawals from retirement accounts. Social-program rules must be stretched. If people have to lose a job to get help, we tempt the employer to needlessly fire them, and they and the employer are not ready to start up again fast.

This is all really hard. Economists blogging from home are full of good and creative ideas. But changing rules for who banks can lend to, to create pandemic exemptions, is much much harder than writing checks. It would be awfully nice if anyone in government had put the slightest thought into this ahead of time.

We are headed to the second huge creditor bailout. When it's over, we need to start taking seriously that if you're too big to fail, you're too big to borrow. Airlines, this means you.

The Oped summarizes many ideas in condensed form. To see more, use the "pandemic" label below, or this link

Tesla Bubble?

Paul Vigna in the Wall Street Journal

Source: Wall Street Journal

"Tesla TSLA -18.51% Inc.’s shares rose 14% Tuesday to $887.06. They have surged 56% in the past week and have nearly quadrupled since early October.  Those outsize gains don’t match Tesla’s more modest fundamentals, which include annual losses."

"They do, however, resemble any number of other assets that have experienced prolonged bubbles, including shares of Qualcomm Inc. and other tech stocks of the dot-com era; oil in 2008 and bitcoin in 2017."

At these prices, Tesla is worth more than Ford and GM combined.

Holman Jenkins:

Tesla can earn a lot more profit per car, and can sell a lot more cars than it does now, and still its stock is priced as if its future profits will be coming from some unnamed something that is not the car-making business.

A correspondent:

I just looked at the minute by minute data for TSLA.  In the last 12 minutes of trading volume was 4.5 million shares, high price was 967, low price (in the last 12 minutes not the day) came 5 minutes later at 860, closed at 887.06.  

Shares outstanding is 180 million so the move from 969 to 860 erased 20 billion of market cap, in five minutes, on no news.  These numbers are so crazy they seem almost meaningless but they make for a good sound byte in a video.

And implicitly (he's more polite)

So Mr. Efficient Market, what do you make of that? 

I can't resist the temptation to plug an old paper, that I have long wanted to return to, "Stocks as Money." I wrote it in response to the internet boom and bust, and the excellent Owen Lamont -Richard Thaler "Can the market add and subtract" in particular. 

This pattern happens over and over (and over and over) again in financial markets. Surely we can do better as an "explanation" than "people are dumb." Or, as Lamont and Thaler put it so nicely,

one needs investors who are (in our specific case) irrational, woefully uninformed, endowed with strange preferences, or for some other reason willing to hold over-priced assets.

Patterns that are repeated over and over again need ether irredeemable human folly -- not much of an "explanation" as it can explain anything -- or economics, a model by which rules of the game produce a strange outcome despite people in the game understanding the game and where it ends. That's what "stocks as money" suggested.

Stocks as money points out these events do not happen in isolation. High prices are only one symptom. They always occur with 1) huge price volatility (check) 2) huge share turnover (check) 3) impediments to short-selling, especially at a longer horizon (check, more below)  4) in an asset where there is a lot of disagreement, a lot of potential news, a lot of different opinions about long run value. Bubbles do not happen in regulated public utility stocks.

"People are dumb and will pay too much for flashy stuff" does not explain why they should, a week later, change their minds and sell. It does not explain why high prices only happen with the other four.

So why would anyone buy Tesla?

Boot Camp

The Hoover Institution will host another "Policy Boot Camp" August 16-22. See here for details and how to apply. It's a one-week survey of serious policy analysis.

The program includes  economists such as John Taylor, Ed Lazear, Amit Seru, Caroline Hoxby, Erik Hurst, and yours truly. Learn about international affairs from H.R. McMaster, Jim Mattis and  Condoleezza Rice. Niall Ferguson on Nationalism vs. Globalism and Bjorn Lomborg on climate should be worth it all on their own. And many more.

It's designed for "college students and recent graduates," but I think that is a bit elastic. Food and lodging free.

Update: in response to a commenter. Yes, PhD students and even those a year or two out are welcome. 

Online Asset Pricing back again!

My online Asset Pricing course is back again, after one more software/administrative change once again threatened its demise.  It's still on Canvas, but you have to ask to sign on.

The course is here, University of Chicago Canvas course 23303. To log in and use it, you need to email  instructional.design@chicagobooth.edu.  The course is open to anyone, not just University of Chicago students. If that doesn't work, email me john dot cochrane at stanford dot edu, and I'll see what's wrong.

The videos, notes, and other materials are still available ungated on my website, here, under the "Asset Pricing" tab.

If all goes well you see this:

Economic note: It's interesting how software depreciates so rapidly, though its physical being depreciates not at all. Perfectly good software stops working as operating systems and machines get "upgraded," as IT departments seem to latch on to new "solutions" every three years, and so forth. Most of my email from before the mid 2000s is gone due to an "upgrade." My website is in the midst of an "upgrade" crisis, and I can't seem to keep the online class going for more than two or three years. There is an interesting economics paper in this. As son of a historian, I feel for the historians of a few hundred years from now who, looking back on our interesting era, will find a blank void, as all of our records are unreadable.

More on low long-term interest rates

In an environment with stable inflation, the yield curve should typically be inverted.

Long term investors care about money when they retire, not next month. Most investors are long-term.

If inflation is steady, long-term bonds are a safer way to save money for the long run. If you roll over short-term bonds, then you do better when interest rates rise, and do worse when interest rates fall, adding risk to your eventual wealth. The long-term bond has more mark-to-market gains and losses, but you don't care about that. You care about the long term payout, which is less risky. (Throw out the statements and stop worrying.) So, in an environment with varying real rates and steady inflation, we expect long rates to be less than short rates, because short rates have to compensate investors for extra risk.

If, by contrast, inflation is volatile and real rates are steady, then long-term bonds are riskier. When inflation goes up, the short term rate will go up too, and preserve the real value of the investment, and vice versa. The long-term bond just suffers the cumulative inflation uncertainty. In that environment we expect a rising yield curve, to compensate long bond holders for the risk of inflation.

So, another possible reason for the emergence of a downward sloping yield curve is that the 1970s and early 1980s were a period of large inflation volatility. Now we are in a period of much less inflation volatility, so most interest rate variation is variation in real rates. Markets are figuring that out.

Most of the late 19th century had an inverted yield curve. UK perpetuities were the "safe asset," and short term lending was risky. It also lived under the gold standard which gave very long-run price stability.

(Yes, this argument is about portfolio variance, not beta, and assumes that the bond portfolio is a substantial part of the investor's wealth, or that inflation happens in bad times, at least over the investor's long horizon.)

***

This is a follow-up to low bond yields. That post has several good comments with links to the literature.

On that point, Uri Carl and Anthony Dierks send along this lovely graph from their note which makes the same point as my earlier blog post. The plot is different measures of the time-varying "covariance between Real Activity and Nominal Measures." The covariance changes sign, as I suspected.

Low bond yields

Why are interest rates so low?

Here is the 10 year bond yield, by itself and subtracting the previous year's inflation (CPI less food and energy). The 10 year yield has basically been on a downward trend since 1987.  One should subtract expected 10 year future inflation, not past inflation, and you can see the extra volatility that past inflation induces. But you can also see that real yields have fallen with the same pattern.

There is lots of discussion. A falling marginal product of capital, due to falling innovation, less need for new capital, a "savings glut," and so forth are common ideas. The use of government bonds in finance, the money-like nature of government debt among other institutional investors and liquidity stories are strong too. And most of the press is consumed with QE and central bank purchases holding down long term rates. I hope the steadiness of the trend cures that promptly.

Along the way in another project, though, I made the following graph:

The blue line is 10 times the growth rate of nondurable + services per capita (quarterly data, growth from a year ago). The red line is the negative of an approximate measure of the real return on 10 year government bonds. I took 10 x (yield - yield a year ago), and subtracted off the CPI.

Look at the last recession. Consumption fell like a rock, while the real return on long-term bonds was great. That real return came from a double whammy: long term bonds had great nominal returns as interest rates fell, and there was a big decline in inflation.  No shock, there is a "flight to quality" in recessions, along with a sharp decline in nominal rates. From a foreign perspective, the rise in the dollar added to the return of long-term bonds. The graph suggests this is a regular pattern going back to the almost-recession of 1987. In every recession, consumption falls, interest rates fall, inflation falls, so the real ex post return on government bonds rises.

Government bonds are negative beta securities. At least measured by consumption or recession betas.  Negative beta securities should have low expected returns. They should be less even than real risk free rates. I haven't seen that simple thought anywhere in the discussion of low long-term interest rates.  

Making the graph, I noticed it was not always thus. 1975, 1980, and 1982 have precisely the opposite sign. These were stagflations, times when bad economic times coincided with higher inflation and higher interest rates. Likewise, countries such as Argentina which go through periodic currency crises, devaluations, and inflations, flights to the dollar, all associated with bad economic times, should have the opposite sign. There is a hint that 1970 was of the current variety.

One could easily make a story for the sign flip, involving recessions caused by monetary policy and attempts to control inflation, vs. recessions involving financial problems in which people run to, rather than from, money in the recession.

In any case, the period of high yields was associated with government bonds that do worse in recessions, and the period of low yields is associated with government bonds that do better in recessions and have a negative beta. I haven't really seen that point made, though I am not fully up on the literature on time-varying betas in bond markets.

In any case, if we want to understand risk premiums in bond markets, this sort of simple macro story might be a good starting point before layering on institutional complexities.

Letter from Argentina

My friend Alejandro Rodriguez, at Universidad del CEMA, sends the following report:

Oops we did it again. Macri (the current president) lost in the open primary elections (all parties present their candidates in an open  general election so it is like a very big poll). The formula Alberto Fernandez- Cristina Fernandez (the ex president who ruled between 2007 and 2015 is the candidate to vice president) is expected to win in October. 

The peso is falling like a rock (down 25%) and interest rates are up by 1000 bps. The Central Bank has to 1.3 trillion ARS (22 billion USD at the current FX) in short term debt (all expires in the next 5 days). Today it has to roll 250 billion ARS and in the first round it only managed to roll 14 billion ARS. Argentine. 

Argentina stocks in NY are down 50% to 60% and President Macri will adress the nation at 16:30 local time. The Central Bank has a lot of internatinal reserves (over 60 billion USD) but nearly 1/4 are the counterpart of dollar deposits at commercial banks. The remaining reserves are mostly borrowed from the IMF and China... We can surely screw over the IMF but I don't think that messing up with the Chinese is a smart move... so nobody knows how much fire power the Central Bank has to hold the FX. I don't know what can be done to stop a major currency crisis which might in turn into a debt crisis (if we are not in one already).

Perpetually wrong forecasts

Torsten Slok of Deutsche Bank sends along the following fascinating graphs

The titles seem a little off. Yes, the market is expecting rate cuts (forward rate) but the market has been exactly wrong about everything for 10 years (and longer) first forecasting the recovery that never came, then forecasting much slower interest rate rises than actually happened.  Survey expectations seem to match the forward curves well except perhaps at the very end.

Mechanically, a rising forward curve and rates that never rise means you earn a lot of money in long term bonds. It's a "risk premium" Monika Piazzesi and Eric Swanson point out this pattern is common. The same pattern holds in longer term bonds, as well known since Fama and Bliss. An upward sloping term structure indicates higher expected returns on long term bonds, and vice versa. And it makes some sense. In recessions, people don't want to hold risks, so we expect a premium for riskier assets. In booms, as interest rates rise, people are more willing to take risks.

Still it's unsettling for lots of reasons. Why did the forward curve suddenly flatten exactly when interest rates finally took off? Another interpretation is something like a Poisson process in the end of recessions, in which the chance of fast recovery is independent of how long you've been in a recession, rather than arriving slowly and predictably. That makes it rational to continue these expectations persist despite continual disappointment, and to change forecast quickly once the long-awaited fast growth arrives.

Less listing

Torsten Slok at DB sent along this lovely graph. The underlying paper "Eclipse of the Public Corporation or Eclipse of the Public Markets?" by  Craig Doidge, Kathleen M. Kahle, G. Andrew Karolyi, and René M. Stulz,  has a lot more.

Stocks are fleeing the exchanges in the US. Small and young stocks are disappearing most, with older larger stocks dominating. Less public means more private, not less companies. Companies are more and more financed by private equity, groups of large investors, debt, venture capital and so forth.

This is largely a US phenomenon, which is important for us to figure out what's going on:

What's going on? Doidge,  Kahle, Karolyi, and Stulz have some intriguing hypotheses. US business is more and more invested in intellectual capital rather than physical capital -- software, organizational improvements, know-how, not blast furnaces. These, they speculate, are less well financed by issuing shares on the open market, and better by private owners and debt.

This shift from physical investment to R&D -- investment in intellectual capital -- is an important story for many changes in the US economy.

Improvements in financial technology such as derivatives allow companies to offload risks without the "agency costs" of equity, and then keep a narrower group of equity investors and more debt financing.

"We argue that the importance of intangible investment has grown but that public markets are not well-suited for young, R&D-intensive companies. Since there is abundant capital available to such firms without going public, they have little incentive to do so until they reach the point in their lifecycle where they focus more on payouts than on raising capital."

I.e. the only reason to go public is for the founders to cash out, and to offer a basically bond-like security for investors. But not to raise capital.

They leave out the obvious question -- to what extent is this driven by regulation? Sarbanes Oxley, SEC, and other regulations and political interference make being a public company in the US a more and more costly, and dangerous, proposition.  This helps to answer the question, why in the US.

The move of young, entrepreneurial companies who need financing to grow to private markets, limited to small numbers of qualified investors, has all sorts of downsides. If you worry about inequality, regulations that only rich people may invest in non-traded stocks should look scandalous, however cloaked in consumer protection. But if you can only have 500 investors, they will have to be wealthy. Moving financing from equity to debt and derivatives does not look great from a financial stability point of view.

Our financial system has become remarkably democratized in recent years. Once upon a time only wealthy individuals held stocks, and had access to the superior investment returns they provide. Now index funds, 4501(k) plans are open to everyone, and their pension funds. What will they invest in as listed equity disappears?

A wealth tax, easy to assess on publicly traded stock and much harder to assess on private companies with complex share structures -- especially structures designed to avoid the tax -- will only exacerbate the problem. More moves to regulate the boards and activities of public companies will only exacerbate the problem.

Volalitily, now the whole thing

An essay at The Hill on what to make of market volatility, from Dec 31. Now that two weeks have passed, I can post the whole thing. I add some graphs too.  (Though at the rate things are going any forecast will have been proved wrong in two weeks!)

What’s causing the big drop in the stock market, and the bout of enormous volatility we’re seeing at the end of the year?

The biggest worry is that this is The Beginning of The End — a recession is on its way, with a consequent big stock market rout. Is this early 2008 all over again, a signal of the big drop to come? 

Maybe. But maybe not. Maybe it’s 2010, 2011, 2016, or the greatest of all, 1987. “The stock market forecast 9 of the last 5 recessions,” Paul Samuelson once said, and rightly. The stock market does fall in recessions, but it also corrects occasionally during expansions. Each of these drops was accompanied by similar bouts of volatility.  Each is likely a period in which people worried about a recession or crash to come, but in the end it did not come.

Still, is this at last the time? A few guideposts are handy. 

There is no momentum in index returns. None. A few bad months, or days, of stock returns are exactly as likely to be continued as to be reversed. The fact is well established, and the reason is simple: If one could tell reliably that stocks would fall next month, we would all try to sell, and the market would fall instantly to that level.

Twenty percent volatility is normal. Twenty percent volatility on top of a 5 percent average return, means that every other year is likely to see a 15 percent drop.

Big market declines come with a recession, as in 2008. But recessions are almost as hard to forecast as stock prices, and for much the same reason. If we knew with confidence that a recession would happen next year, businesses would not invest or hire, and people would not spend, and we’d have a recession now.

Recessions do have some momentum. But the cyclical indicators of the real economy are strong, much stronger than they were in 2007-2008. Unemployment is 3.7%. There is no slowdown in real GDP growth or industrial production, or business investment in the most recent data. Inflation is close to the Fed’s target, so there is little reason to fear the Fed will quickly raise rates and cause a recession. Now, the market aggregates more information and faster than the rest of us. Still, the lack of any slowdown adds weight to the suspicion that this correction may pass as well.

In thinking about the economy, remember that it has passed from “demand” to “supply.” At 3.9% unemployment, we cannot get greater growth from simply putting unemployed people and machines to work.

The stages of the business cycle

As we complete the transition from a demand-limited economy to a supply-limited economy, it is perfectly natural for interest rates to rise. One or two percent above the inflation rate is perfectly normal. As interest rates rise, it is perfectly natural for interest-sensitive sectors like housing and autos to decline a bit – but other sectors do better. Demand shifts between products, and auto or housing slowdowns do not mean an overall slowdown.

The economy no longer needs or can use monetary or fiscal “stimulus.” Now growth must come more productivity. Growth-oriented policy requires efficiency, “structural reform,” better incentives, not just money in pockets. In my view, the US has gotten an extra percent of growth, mostly from deregulation and a bit from the incentive effects of the tax cuts. But these are over, and further reform is unlikely. So a growth slowdown is certainly in the cards.

What about the yield curve? It is flattening – the difference between long-term rates and short term rates is narrowing. And an inverted yield curve has, historically, been a good forecast of a recession to come.

But we are not yet at inversion, as the graph shows. Moreover, there have been long periods of nearly flat yield curves in the past, when the “supply” economy kept growing before the next recession, most notably the mid 1990s. In fact, if inflation remains contained, it is possible that the world starts to resemble earlier eras with permanently inverted yield curves. In a non-inflationary environment, long-term bonds are safer for long-term investors. Last, the form of inversion matters as well as the fact. An inversion that comes from the Fed quickly pushing up short rates to cause a slowdown, fighting inflation, is likely to, well, cause a slowdown. An inversion that comes when long-term rates plummet, seeing trouble ahead, is likely to be followed by trouble ahead. We have neither of those circumstances.

So what is going on? I hazard a guess.

Volatility occurs when there is great uncertainty. Investors are worried big events are on the horizon, and can’t quite figure out what is going to happen. Prices aggregate information, so seeing a price decline can make you think other people know something you don’t in a time of great uncertainty. We see this clearly in studies of high frequency data, when bond markets are adapting and digesting Fed statements, and we know there is no other news to react to.

We are, no doubt, in a time of high uncertainty about policy and politics. Volatility broke out almost coincident with the November election, and I think the markets are trying to digest just what the political chaos of the next two years means for the economy.

Surely no major growth-oriented economic reforms will come out of Congress. Congressional democrats will bring the full weight of the legal system against the Administration. Cabinet secretaries trying to clean up regulation will have a hard time when being constantly subpoenaed.

The government shutdown over 1/10 of 1% of the Federal budget devoted to a border wall is emblematic. It is, of course, entirely symbolic as any border wall will be stuck in the courts for decades. But it is precisely when issues are symbolic that compromise is impossible.

So the best economic news that markets can hope for is two years of complete government paralysis, and therefore a return to 2 percent or so growth.

Things could be much worse, and markets know it. A large policy blunder in the next two years, such as a big trade shock could well happen.

More deeply, the US is now unable to respond to any genuine crisis — economic, financial, military. Imagine that another banking crisis hits, and President Trump asks Congress, again, for a trillion bucks to bail out banks, and another trillion for fiscal stimulus. Or imagine if he does not, and whether the Administration can implement better ideas to fight a new and different crisis. Imagine what happens if China invades Taiwan, or a big bomb goes off in the middle east.

Europe is not in much better shape. It has followed the Augustinian approach to structural reform – Dear Lord, give me reform, but not quite yet. Italian banks, and too many German banks, are still stuffed with Italian government debt. Brexit, Cinque Stelle, and Gilets Jaunes mean that pro-market, free trade, growth-oriented structural reform not likely, and there is a limit to what even the ECB can do. China is as usual obscure, and more fragile than they want us to believe.

Throughout the world, government debt remains the big danger. Where is there a lot of debt, no plan to repay it, shady accounting, extend-and-pretend, off-balance sheet guarantees, and the debt is mostly short term and prone to runs? Government debt. If a serious recession comes, in a time of dysfunctional government, it may well provoke a government debt crisis, which would be an economic conflagration beyond anything we have seen.

So, we live in a time of great uncertainty, brought about by great political uncertainty. Great uncertainty leads to volatility. Volatility means that stocks are more risky, and thus must pay a greater expected return to get people to hold them. The only way for the expected future return to rise, is for today’s price to go down. So we see a correction – mild so far, to compensate for the mild risk of holding stocks through a few months of ups and downs.

There is a silver lining to this story. If prices are low because required returns have risen, then if nothing bad happens, long-term investors will do fine. Bond prices go down when yields go up, and the larger yields eventually make up for the price loss.

But greater uncertainty means a greater chance that something truly terrible will happen. As well as a greater chance that it won’t. The big message of the moment is that risk is higher. Managing risk, not following some sage’s directional bet, is the best investment advice anyone should start with.

(I also wrote here "The Jitters" related thoughts about the spring 2018 bout of volatility.)

Volatility

An essay at The Hill on what to make of market volatility:

What’s causing the big drop in the stock market, and the bout of enormous volatility we’re seeing at the end of the year?

The biggest worry is that this is The Beginning of The End — a recession is on its way, with a consequent big stock market rout. Is this early 2008 all over again, a signal of the big drop to come? 

Maybe. But maybe not. Maybe it’s 2010, 2011, 2016, or the greatest of all, 1987. “The stock market forecast 9 of the last 5 recessions,” Paul Samuelson once said, and rightly. The stock market does fall in recessions, but it also corrects occasionally during expansions. Each of these drops was accompanied by similar bouts of volatility.  Each is likely a period in which people worried about a recession or crash to come, but in the end it did not come. 

Still, is this at last the time? A few guideposts are handy. 

There is no momentum in index returns. None. A few bad months, or days, of stock returns are exactly as likely to be continued as to be reversed. The fact is well established, and the reason is simple: If one could tell reliably that stocks would fall next month, we would all try to sell, and the market would fall instantly to that level.

Twenty percent volatility is normal. Twenty percent volatility on top of a 5 percent average return, means that every other year is likely to see a 15 percent drop. 

Big market declines come with a recession, as in 2008. But recessions are almost as hard to forecast as stock prices, and for much the same reason.

...

They asked me to hold off a few weeks before posting the whole thing. So either wait two weeks or head over to The Hill. I also wrote here "The Jitters" related thoughts about the spring 2018 bout of volatility. 

Series on recession and financial crisis

Over the last few weeks we have had a series of discussions at Hoover on the 10th anniversary of the financial crisis and recession. This all happened mostly due to the energy of John Taylor.

The final event on Friday Dec 7 was a Panel Discussion Summary, including Taylor, Shultz, Ferguson, Hoxby, Duffie, and myself, with question and answer. Click the above video.

This was preceded by four smaller discussions. We did not video them, but there are transcripts and presentation materials.

October 19, The causes.  (Follow links to a transcript and to the presentation slides.)  John Taylor and Monika Piazzesi present and learn discussion on the causes of the financial crisis, emphasizing monetary policy, regulation, and housing.

November 9 The Panic What happened on in the panic of August through November (or so) 2018? Did the actions of government officials help or hurt? Or both? George Shultz and Niall Ferguson present their views and lead the discussion.

December 7 The Recession. Why was the recession so deep? Why wasn't it deeper, repeating the Great Recession? Why did it last so long? Did fiscal stimulus help or hurt? Caroline Hoxby and John Taylor led, focusing on labor markets and stimulus. I added some comments on QE and the lessons of the long zero bound for monetary economics; Bob Hall comments on labor markets and unemployment, Mike Boskin comments on stimulus, and much more

December 7 also, Lessons for Financial Regulation. Darrell Duffie and me. Darrell summarizes his excellent "Prone to Fail." I expound on the need for more capital.

What's distinctive about this series, given all the other conferences and retrospectives?

First, we decided not to have retrospectives from people in power at the time. Many other such meetings are descending into memoirs of how we saved the world. Maybe they did, maybe they didn't. And maybe that's not so interesting, except of course to the parties involved who would like to go down nicely in history.

Second, you will find an effort to trace the intellectual lessons of the last 10 years of thought, not just whether certain actions were right or wrong in context of some eternal truth. We all have learned a great deal in the last 10 years, and opinions are shifting. For example, I discuss how capital, once thought immensely costly and regulation much prefereable, has slowly emerged as not at all costly and the best salve for financial crises. Similar lessons have emerged throughout.

Third, and perhaps most importantly, you will find here many disagreements with the standard narrative and what is becoming the first draft of history, as Ferguson nicely described. No, maybe it wasn't just "greed" and "deregulation." No, maybe our officials contributed to panic as much as they helped to stop it. No, maybe fiscal stimulus and QE did not save the world. No, maybe our super-confident regulators armed with an immensely larger rule book are not ready to save the world again next time. And in each case you will hear contrary views buttressed with facts and thoughtful analysis. Perhaps when the second draft of history is ready to be written this will be a starting place.

Canadian non-QE

Friday at Hoover we will have a series of events reexamining the lessons of the financial crisis and recession. (There is a public event here, in case you're interested. Presenters include George Schultz, John Taylor, Niall Ferguson, Caroline Hoxby and Darrell Duffie.)

In preparing a presentation on QE, I stumbled across the following fact.

1) Canada did not do QE, quantitative easing. (Kjell Nyborg showed us this fact in a very interesting finance seminar on a different topic -- European banks are borrowing from the ECB using rotten collateral)

2) Use vs. Canadian 10 year government bond rates were nearly identical in the QE period.

Conventional wisdom states that US QE lowered interest rates by 1%. I am a skeptic, and this graph reinforces my skepticism.

One might say that the US exports its monetary policy effects to Canada. But the Canadian Dollar is its own currency, so exchange rates, not interest rates should soak up that difference.

One can complain in many ways, but this seems to me to add to the view that QE didn't even change interest rates.

Financing innovation

I went to the Financing of Innovation summit at Stanford GSB last Thursday. (Sorry, I can't seem to find a full program online.) Here is a sample of two interesting papers, presented by Amit Seru and Steve Kaplan:

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.