Archive for the ‘Financial Crisis’ Category
A strategy to maximise bonuses and avoid personal culpability:
- Don’t commit the fraud yourself.
- Minimise information received about the actions of your employees.
- Control employees through automated, algorithmic systems based on plausible metrics like Value at Risk.
- Pay high bonuses to employees linked to “stretch” revenue/profit targets.
- Fire employees when targets are not met.
CEOs and senior managers of modern corporations possess the ability to engineer fraud on an organisational scale and capture the upside without running the risk of doing any jail time. In other words, they can reliably commit fraud and get away with it.
Imagine that you are the newly hired CEO of a large bank and by some improbable miracle your bank is squeaky clean and free of fraudulent practises. But you are unhappy about this. Your competitors are making more profits than you are by embracing fraud and coming out ahead of you even after paying tens of billions of dollars in fines to the regulators. And you want a piece of the action. But you’re a risk-averse person and don’t want to risk spending any time in jail for committing fraud. So how can you achieve this outcome?
Obviously you should not commit any fraudulent acts yourself. You want your junior managers to commit fraud in the pursuit of higher profits. One way to incentivise this behaviour is to adopt what are known as ‘high-powered incentives’. Pay your employees high bonuses tied to revenue/profits and maintain hard-to-meet ‘stretch’ targets. Fire ruthlessly if these targets are not met. And finally, ensure that you minimise the flow of information up to you about how exactly how your employees meet these targets.
There is one problem with this approach. As a CEO, this allows you to use the “I knew nothing!” defense and claim ignorance about all the “deplorable” fraud taking place lower down the organisational food chain. But it may fall foul of another legal principle that has been tailored for such situations – the principle of ‘wilful blindness’ – “if there is information that you could have know, and should have known, but somehow managed not to know, the law treats you as though you did know it”. In a recent essay, Judge Rakoff uses exactly this principle to criticise the failure of regulators in the United States in prosecuting senior bankers.
But wait – all hope is not lost yet. There is one way by which you as a CEO can not only argue that adequate controls and supervision were in place and at the same time make it easier for your employees to commit fraud. Simply perform the monitoring and control function through an automated system and restrict your role to signing off on the risk metrics that are the output of this automated system.
It is hard to explain how this can be done in the abstract so let me take a hypothetical example from the mortgage origination and securitisation industry. As a CEO of a mortgage originator in 2005, you are under a lot of pressure from your shareholders to increase subprime originations. You realise that the task would be a lot easier if your salespeople originated fraudulent loans where ineligible borrowers are given loans they can’t afford. You’ve followed all the steps laid out above but as discussed this is not enough. You may be accused of not having any controls in the organisation. Even if you try hard to ensure that no information regarding fraud filters through to you, you can never be certain. At the first sign of something unusual, a mortgage approval officer may raise an exception to his supervisor. Given that every person in the management hierarchy wants to cover his own back, how can you ensure that nothing filters up to you whilst at the same time providing a plausible argument that you aren’t wilfully blind?
The answer is somewhat counterintuitive – you should codify and automate the mortgage approval process. Have your salespeople input potential borrower details into a system that approves or rejects the loan application based on an algorithm without any human intervention. The algorithm does not have to be naive. In fact it would ideally be a complex algorithm, maybe even ‘learned from data’. Why so? Because the more complex the algorithm, the more opportunities it provides to the salespeople to ‘game’ and arbitrage the system in order to commit fraud. And the more complex the algorithm, the easier it is for you, the CEO, to argue that your control systems were adequate and that you cannot be accused of wilful blindness or even the ‘failure to supervise’.
In complex domains, this argument is impossible to refute. No regulator/prosecutor is going to argue that you should have installed a more manual control system. And no regulator can argue that you, the CEO, should have micro-managed the mortgage approval process.
Let me take another example – the use of Value at Risk (VaR) as a risk measure for control purposes in banks. VaR is not ubiquitous because traders and CEOs are unaware of its flaws. It is ubiquitous because it allows senior managers to project the facade of effective supervision without taking on the trouble or the legal risks of actually monitoring what their traders are up to. It is sophisticated enough to protect against the charge of wilful blindness and it allows ample room for traders to load up on the tail risks that fund the senior managers’ bonuses during the good times. When the risk blows up, the senior manager can simply claim that he was deceived and fire the trader.
What makes this strategy so easy to implement today compared to even a decade ago is the ubiquitousness of fully algorithmic control systems. When the control function is performed by genuine human domain experts, then obvious gaming of the control mechanism is a lot harder to achieve. Let me take another example to illustrate this. One of the positions that lost UBS billions of dollars during the 2008 financial crisis was called ‘AMPS’ where billions of dollars in super-senior tranche bonds were hedged with a tiny sliver of equity tranche bonds so that the portfolio showed a zero VaR and delta-neutral risk position. Even the most novice of controllers could have identified the catastrophic tail risk embedded in hedging a position where one can lose billions, with another position where one could only gain millions.
There is nothing new in what I have laid out in this essay – for example, Kenneth Bamberger has made much the same point on the interaction between technology and regulatory compliance:
automated systems—systems that governed loan originations, measured institutional risk, prompted investment decisions, and calculated capital reserve levels—shielded irresponsible decisions, unreasonably risky speculation, and intentional manipulation, with a façade of regularity….
Invisibility by design, allows engineering of fraudulent outcomes without being held responsible for them – the “I knew nothing!” defense. of course, they are also self-deceived so this is really true.
But although the automation that enables this risk-free fraud is a recent phenomenon, the principle behind this strategy is one that is familiar to managers throughout the modern era – “How do I get things done the way I want to without being held responsible for them?”.
Just as the algorithmic revolution is simply a continuation of the control revolution, the ‘accountability gap’ due to automation is simply an acceleration of trends that have been with us throughout the modern era. Theodore Porter has shown how the rise of objectivity and bureaucracy were as much driven by the desire to avoid responsibility as they were driven by the desire for superior results. Many features of the modern corporate world only make sense when we understand that one of their primary aims is the avoidance of responsibility and culpability. Why are external consulting firms so popular even when the CEO knows exactly what he wants to do? So that the CEO can avoid responsibility if the ‘strategic restructuring’ goes badly. Why do so many firms delegate their critical control processes to a hotpotch of outsourced software contractors? So that they can blame any failures on external counter-parties who have explicitly been granted exemption from any liability1.
Due to my experience in banking, my examples and illustrations are necessarily drawn from the world of finance. But it should be clear that nothing in what I’ve said is limited to banking. ‘Strategic ignorance’ is equally effective in many other domains. My arguments are also not a justification for not prosecuting bankers for fraud. It is an argument that CEOs of modern corporations can reap the benefits of fraud and get away with it. And they can do so very easily. Fraud is embedded within the very fabric of the modern economy.
Note: Venkat makes a similar point in his series on the ‘Gervais Principle’ on how sociopathic managers avoid responsibility for their actions. Much of what I have written above may make more sense if read in conjunction with his essay.
Five years on, what can we learn from the collapse of Lehman Brothers? The conventional opinion is that we should have saved Lehman Brothers just like we saved the rest of the financial sector in the immediate aftermath of the Lehman collapse. But some critics assert that the decision to save Bear Stearns convinced everybody that Lehman would be saved when push came to shove. When this expectation was not met, chaos ensued.
Market data from March 2008 to September 2008 supports the critics. Lehman’s credit spreads halved between March and June 2008. Even when Lehman’s stock price started falling in May and June, its credit spreads barely reacted. The below graph (courtesy the WSJ) captures just how dramatically Lehman credit spreads fell in the aftermath of the Bear Stearns bailout:
The Bear Stearns bailout convinced everybody that Lehman would be treated no differently as a Wall Street Journal article from June 2008 explains:
The ouster of two top executives at Lehman Brothers Holdings Inc., including the person responsible for keeping the company’s books, sent the bank’s share price tumbling to a new six-year low, but the normally jittery bond market shrugged off the move.
While Lehman’s stock price fell 4.4%, investors were bidding up some of Lehman’s bonds, and the price of protection against default on Lehman debt ultimately declined on the day. It costs an investor $280,000 annually to protect against default on $10 million of Lehman debt for five years – down from $285,000 Wednesday, according to Phoenix Partners Group.
The tempered reaction in the bond markets underscores investors’ conviction the Federal Reserve won’t let a major U.S. securities dealer collapse and that Lehman Brothers may be ripe for a takeover. In March, when Bear Stearns was collapsing, protection on Lehman’s bonds cost more than twice as much as it does now.
Of course allowing Bear Stearns’ creditors to take a loss may just have brought forward the chaos of September 2008 to March 2008. Given that bank creditors had been bailed out in the United States since Continental Illinois this is entirely plausible. Nevertheless, the policy actions of 2008 made things worse. If an evil genius had taken over the world in March 2008 with the sole aim of causing financial chaos, he could not have done any better – bail out Bear Stearns, convince everyone that no failures will be allowed and then renege on this implicit promise six months later.
As Tyler Cowen argues, there are many similarities between Hayek’s and Minsky’s views on business cycles. Fundamentally, they both describe the “fundamental impossibility in maintaining orderly credit relations over time”.
Minsky saw Keynes’ theory as an ‘investment theory of the business cycle’ and his contribution as being a ‘financial theory of investment’. This financial theory was based on the credit/financing-focused endogenous theory of money of Joseph Schumpeter, whom Minsky studied under. Schumpeter’s views are best described in Chapter 3 (’Credit and Capital’) of his book ‘Theory of Economic Development’. The gist of this view is that “investment, and expenditures more generally, require financing, not saving” (Borio and Disyatat).
Schumpeter viewed the ability of banks to create money ex nihilo as the differentia specifica of capitalism. He saw bankers as ‘capitalists par excellence’ and viewed this ‘elastic’ nature of credit as an unambiguously positive phenomenon. Many people see Schumpeter’s view of money and banking as the antithesis of the Austrian view. But as Agnes Festre has highlighted, Hayek had a very similar view on the empirical reality of the credit process. Hayek however saw this elasticity of the monetary supply as a negative phenomenon. The similarity between Hayek and Minksy comes from the fact that Minsky also focused on the downside of an elastic monetary system in which overextension of credit was inevitably brought back to a halt by the violent snapback of the Minsky Moment.
Where Hayek and Minsky differed was that Minsky favoured a comprehensive stabilisation of the financial and monetary system through fiscal and monetary intervention after the Minsky moment. Hayek only supported the prevention of secondary deflationary spirals. Minsky supported aggressive and early monetary interventions (e.g. lender-of-last-resort programs) as well as fiscal stimulus. However, although Minsky supported stabilisation he was well aware of the damaging long-run consequences of stabilising the economic system. He understood that such a system would inevitably deteriorate into crony capitalism if fundamental reforms did not follow the stabilisation. Minsky supported a “policy strategy that emphasizes high consumption, constraints upon income inequality, and limitations upon permissible liability structures”. He also advocated “an industrial-organization strategy that limits the power of institutionalized giant firms”. Minsky was under no illusions that a stabilised capitalist economy could carry on with business as usual.
I disagree with Minsky on two fundamental points – I believe that a capitalist economy with sufficient low-level instability is resilient. Allow small failures of banks and financial players, tolerate small recessions and we can dramatically reduce the impact and probability of large-scale catastrophic recessions such as the 2008 financial crisis. A little bit of chaos is an essential ingredient in a resilient capitalist economy. I also believe that we must avoid stamping out the disturbance at its source and instead focus our efforts on mitigating the wider impact of the disturbance on the masses. In other words, bail out the masses with helicopter drops rather than bailing out the banks.
But although I disagree with Minsky his ideas are coherent. The same cannot be said for the current popular interpretation of Minsky which believes that so long as we deal with sufficient force when the Minsky moment arrives, capitalism can carry on as usual. As Minsky has argued in his book ‘John Maynard Keynes’, and as I have argued based on experiences in stabilising other complex adaptive systems such as rivers, forest fires and our brain, stabilised capitalism is an oxymoron.
What about Hayek’s views on credit elasticity? As I argued in an earlier post, “we live in a world where maturity transformation is no longer required to meet our investment needs. The evolution and malformation of the financial system means that Hayek’s analysis is more relevant now than it probably was during his own lifetime”. An elastic credit system is no longer beneficial to economic growth in the modern economy. This does not mean that we should ban the process of endogenous credit creation – it simply means that we must allow the maturity-transforming entities to collapse when they get in trouble1.
- Because we do not need an elastic, maturity-transforming financial system, we can firewall basic deposit banking from risky finance. This will enable us to allow the banks to fail when the next crisis hits us. The solution is not to ban casino banking but to suck the lifeblood out of it by constructing an alternative 100% reserve-like system. I have advocated that each resident should be given a deposit account with the central bank which can be backed by Treasuries, a ‘public option’ for basic deposit banking. John Cochrane has also argued for a similar system. In his words, “the Federal Reserve should continue to provide abundant reserves to banks, paying market interest. The Treasury could offer reserves to the rest of us—floating-rate, fixed-value, electronically-transferable debt. There is no reason that the Fed and Treasury should artificially starve the economy of completely safe, interest-paying cash”. ↩
In a previous post I argued that in the current environment, the Federal Reserve could buy up the entire stock of government bonds without triggering any incremental inflation. The argument for the ineffectiveness of conventional QE is fairly simple. Government bonds are already safe collateral both in the shadow banking system as well as with the central bank itself. The liquidity preference argument is redundant in differentiating between deposits and an asset that qualifies as safe collateral. Broad money supply is therefore unaffected when such an asset is purchased.
The monetarist objection to this argument is that QE increases the stock of high-powered money and increases the price level to the extent that this increase is perceived as permanent. But in an environment where interest is paid on reserves or deposits with the central bank, the very concept of high-powered money is meaningless and there is no hot potato effect to speak of. Some monetarists argue that we need to enforce a penalty rate on reserves to get rid of excess reserves but small negative rates make little difference to safe-haven flows and large negative rates will lead to people hoarding bank notes.
The other objection is as follows: if the central bank can buy up all the debt then why don’t we do just that and retire all that debt and make the state debt-free? Surely that can’t be right – isn’t such debt monetisation the road to Zimbabwe-like hyperinflation? Intuitively, many commentators interpret QE as a step on the slippery slope of fiscal deficit monetisation but this line of thought is fatally flawed. Inflation comes about from the expected and current monetisation of fiscal deficits, not from the central bank’s purchase of the stock of government debt that has arisen from past fiscal deficits. The persistent high inflation that many emerging market economies are so used to arises from money-printed deficits that are expected to continue well into the future.
So why do the present and future expected fiscal deficits in the US economy not trigger inflation today? One, the present deficits come at a time when the shadow money supply is still contracting. And two, the impact of expected future deficits in the future is muddied thanks to the status of the US Dollar as the reserve currency of the world, a status that has been embellished since the 90s thanks to reserves being used as capital flight and IMF-avoidance insurance by many EM countries (This post by Brett Fiebiger is an excellent explanation of the privileged status enjoyed by the US Dollar). The expectations channel has to deal with too much uncertainty and there are too many scenarios in which the USD may hold its value despite large deficits, especially if the global economy continues to be depressed and demand for safe assets remains elevated. There are no such uncertainties in the case of peripheral economy fiat currencies (e.g. Hungary). To the extent that there is any safe asset demand, it is mostly local and the fact that other global safe assets exist means that the fiscal leeway that peripheral economies possess is limited. In other words, the absence of inflation is not just a matter of the market trusting the US government to take care of its long-term structural deficit problems – uncertainty and the “safe asset” status of the USD greatly diminish the efficacy of the expectations channel.
Amidst the fog of uncertainty and imperfect commitments, concrete steps matter and they matter especially in the midst of a financial crisis. Monetary policy can almost always prevent deflation in the face of a contraction in shadow money supply via the central banks’ lender-of-last-resort facilities. In an economy like 2008-2009, no amount of open-market operations, asset purchases and monetary target commitments can prevent a sharp deflationary contraction in the private shadow money supply unless the lender-of-last-resort facility is utilised. Once the system is stabilised and the possibility of a deflationary contraction has been avoided, monetary policy has very little leeway to create incremental inflation in the absence of fiscal profligacy and shadow banking/private credit expansion except via essentially fiscal actions such as buying private assets, credit guarantees etc. In the present situation where the private household economy is excessively indebted and the private business economy suffers from a savings glut and a persistent investment deficit due to structural malformation, fiscal profligacy is the only short-term option. Correspondingly, no amount of monetary stimulus can prevent a sharp fiscal contraction from causing deflation in the current economic state.
Monetary policy is also not all-powerful in its contractionary role – it has significant but not unlimited leeway to tighten policy in the face of fiscal profligacy or shadow banking expansion. The Indian economy in 1995-1996 illustrates how the Reserve Bank of India (RBI) could control inflation in the face of fiscal profligacy only by crippling the private sector economy. The real rates faced by the private sector shot up and spending ground to a halt. The dilemma faced by the RBI today mirror the problems it faced then – if fiscal indiscipline by the Indian government persists, the RBI cannot possibly bring down inflation to acceptable levels without causing the private sector economy to keel over.
The current privileged status of the US Dollar and the low interest rates and inflation does not imply that long-term fiscal discipline is unimportant. Currently, the demand for safety reduces inflation and the low inflation renders the asset safer – this virtuous positive-feedback cycle can turn vicious if expectation of monetisation is sufficiently large and the mutual-feedback nature of the process means that any such transition will almost certainly be rapid. It is not even clear that the United States is better off than say Hungary in the long run. The United States has much leeway and flexibility than Hungary but if it abuses this privilege, any eventual break will be that much more violent. Borrowing from an old adage, give an economy too much rope and it will hang itself.
As I highlighted in my previous post, the honeymoon period for the SNB in its enforcement of the 1.20 floor on the EURCHF exchange rate is well and truly over. In May, the SNB needed to intervene to the tune of CHF 66 bn to defend the floor. There’s even speculation that the SNB may be forced to implement capital controls or negative interest rates on offshore deposits in the event of a disorderly Greek exit from the Eurozone.
Increasingly, the SNB is caught between a rock and a hard place. Either it can continue to defend the peg and accumulate increasing amounts of foreign exchange reserves on which it faces the prospect of correspondingly increasing losses. Or it can abandon the peg, allow the CHF to appreciate 20-25% and risk deflation and a collapse in exports and GDP. It is not difficult to see why the SNB is being forced to defend the peg – the EUR in the current environment is a risky asset and the CHF is a safe asset. By committing to sell a safe asset at a below-market price, the SNB is subsidising the price of safety. It is no wonder then that this offer finds so many takers when there is a flight to safety.
Some argue that the continued deflation in the Swiss economy allows the SNB to maintain its peg but this argument ignores the fact that it is the continued deflation that also maintains the safe status of the Swiss Franc. Deflation provides the impetus for the safe-haven flows due to which the required intervention by the SNB and the SNB’s risk exposure are that much greater in magnitude. Therefore, if the SNB is eventually forced to abandon the floor, the earlier the better. A prolonged period of deflation punctuated by occasional flights to safety will compel the SNB to accumulate an unsustainable level of foreign exchange reserves to defend the floor. By the same logic, the SNB would obviously prefer that the Eurozone not implode but if it does implode, then it would rather that the Euro implodes sooner rather than later.
So what does the SNB need to do? It needs to engineer an outcome where the market price of the EURCHF moves up and the CHF devalues by itself. The only sustainable way to achieve this is to provide a significant dose of inflation to the Swiss economy and it needs to do so in a manner that does not provide an even larger subsidy to those running away from risk. For example, raising the EURCHF floor by itself only increases the temptation to buy the Franc and at best provides a one-time dose of inflation. The SNB could decide to buy CHF private sector assets but the safe-haven inflows and relatively strong performance of the Swiss economy mean that asset markets, especially housing, are already frothy.
The more sustainable and equitable solution is to simply make the safe asset unsafe by generating the requisite inflation for which money-financed helicopter drops are the best solution. Money-financed fiscal transfers will create inflation, deter the safe-haven inflow and shore up the balance sheet of the Swiss household sector. The robustness of this solution in creating sustainable inflation will not come as a shock to any emerging market central banker or finance minister. The crucial difference between this plan and that implemented by banana republics around the world is that instead of printing money and funnelling it to corrupt government officials we will distribute the money to the masses.
Many economists and commentators blame the Federal Reserve for the increasingly tepid economic recovery in the United States. For example, Ryan Avent calls the Fed’s unwillingness to further ease monetary policy a “dereliction of duty” and Felix Salmon claims that “we have low bond yields because the Fed has failed to do its job”. Most people assume that the adoption of a higher inflation target (or an NGDP target) and conventional quantitative easing (QE) via government bond purchases will suffice. Milton Friedman, for example, had argued that government bond purchases with “high-powered money” would have dragged Japan out of its recession. But how exactly is more QE supposed to work in an environment when treasury bonds are trading at all-time low yields and banks are awash in excess reserves?
If we analyse monetary policy as a threat strategy, then how do we make sure that the threat is credible? According to Nick Rowe, “The Fed needs to communicate its target clearly. And it needs to threaten to do unlimited amounts of QE for an unlimited amount of time until its target is hit. If that threat is communicated clearly, and believed, the actual amount of QE needed will be negative.” In essence, this is a view that market expectations are sufficient to do the job.
Expectations are a large component of how monetary policy works but expectations only work when there is a clear and credible set of actions that serve as the bazooka(s) to enforce these expectations. In other words, what is it exactly that the central bank threatens to do if the market refuses to react sufficiently to its changed targets? It is easy to identify the nature of the threat when the target variable is simply a market price, e.g. an exchange rate vs another currency (such as the SNB’s enforcement of a minimum EURCHF exchange rate) or an exchange rate vs a commodity (such as the abandoning of the gold standard). But when the target variable is not a market price, the transmission mechanism is nowhere near as simple.
Scott Sumner would implement an NGDP targeting regime in the following manner:
First create an explicit NGDP target. Use level targeting, which means you promise to make up for under- or overshooting. If excess reserves are a problem, get rid of most of them with a penalty rate. Commit to doing QE until various asset prices show (in the view of Fed officials) that NGDP is expected to hit the announced target one or two years out. If necessary buy up all of Planet Earth.
Interest on Reserves
Small negative rates on reserves or deposits held at the central bank are not unusual. But banks can and will pass on this cost to their deposit-holders in the form of negative deposit rates and given the absence of any better liquid and nominally safe investment options, most bank customers will pay this safety premium. For example, when the SNB charged negative rates on offshore deposits denominated in Swiss Franc in the mid-1970s, the move did very little to stem the inflow into the currency.
Significant negative rates are easily evaded as people possess the option to hold cash in the form of bank notes. As SNB Vice-Chairman Jean-Pierre Danthine notes:
With strongly negative interest rates, theory joins practice and seems to lead to a policy of holding onto bank notes (cash) rather than accounts, which destabilises the system.
Quantitative Easing: Government Bonds
Conventional QE can be deconstructed into two components: an exchange of money for treasury-bills and an exchange of treasury-bills for treasury-bonds. The first component has no impact on the market risk position of the T-bill holder for whom deposits and T-bills are synonymous in a zero-rates environment. But it is also irrelevant from the perspective of the banking system unless the rate paid on reserves is significantly negative (which can be evaded by holding bank notes as discussed above).
The second component obviously impacts the market risk position of the economy as a whole. It is widely assumed that by purchasing government bonds, the central bank reduces the duration risk exposure of the market as a whole thus freeing up risk capacity. But for most holders of government bonds (especially pension funds and insurers), duration is not a risk but a hedge. A nominal dollar receivable in 20 years is not always riskier than a nominal dollar receivable today – for those who hold the bond as a hedge for a liability of a nominal dollar payable in 20 years, the dollar receivable today is in fact the riskier holding. More generally the negative beta nature of government bonds means that the central bank increases the risk exposure of the economy when it buys them.
Apart from the market risk impact of QE, we need to examine whether it has any impact on the liquidity position of the private economy. In this respect, neither the first or the second step has any impact for a simple reason – the assets being bought i.e. govt bonds are already safe collateral both in the shadow banking system as well as with the central bank itself. Therefore, any owner of government bonds can freely borrow cash against it. The liquidity preference argument is redundant in differentiating between deposits and an asset that qualifies as safe collateral. Broad money supply is therefore unaffected when such an asset is purchased.
If conventional QE were the only tool in the arsenal, announcing higher targets or NGDP targets achieves very little. The Bank of England and the Federal Reserve could buy up the entire outstanding stock of govt bonds and the impact on inflation or economic growth would be negligible in the current environment.
Credit Easing and More: Private Sector Assets
Many proponents of NGDP targeting would assert that limiting the arsenal of the central bank to simply treasury bonds is inappropriate and that the central bank must be able to purchase private sector assets (bonds, equities) or as Scott Sumner exhorts above “If necessary buy up all of Planet Earth”. There is no denying the fact that by buying up all of Planet Earth, any central bank can create inflation. But when the assets bought are already liquid and market conditions are not distressed, buying of private assets creates inflation only by increasing the price and reducing the yield of those assets i.e. a wealth transfer from the central bank to the chosen asset-holders. As with quantitative easing through government bond purchases, the inability to enforce adequate penalties on reserves nullifies any potential “hot potato” effect.
Bernanke himself has noted that the liquidity facility interventions during the 2008-2009 crisis and QE1 were focused on reducing private market credit spreads and improving the functioning of private credit markets at a time when the market for many private sector assets was under significant stress and liquidity premiums were high. The current situation is not even remotely comparable – yields on private credit instruments are at relatively elevated levels compared to historical median spreads but the difference in absolute terms is only about 50 bps on investment-grade credit (see table below) as compared to much higher levels (at least 300-40 bps on investment grade) during the 2008-2009 crisis.
A quantitative easing program focused on purchasing private sector assets is essentially a fiscal program in monetary disguise and is not even remotely neutral in its impact on income distribution and economic activity. Even if the central bank buys a broad index of bonds or equities, such a program is by definition a transfer of wealth towards asset-holders and regressive in nature (financial assets are largely held by the rich). The very act of making private sector assets “safe” is a transfer of wealth from the taxpayer to some of the richest people in our society. The explicit nature of the central banks’ stabilisation commitment means that the rent extracted from the commitment increases over time as more and more economic actors align their portfolios to hold the stabilised and protected assets.
Such a program is also biased towards incumbent firms and against new firms. The assumption that an increase in the price of incumbent firms’ stock/bond price will flow through to lending and investment in new businesses is unjustified due to the significantly more uncertain nature of new business lending/investment. This trend has been exacerbated since the crisis and the bond market is increasingly biased towards the largest, most liquid issuers. Even more damaging, any long-term macroeconomic stabilisation program that commits to purchasing and supporting macro-risky assets will incentivise economic actors to take on macro risk and shed idiosyncratic risk. Idiosyncratic risk-taking is the lifeblood of innovation in any economy.
In other words, QE is not sufficient to hit any desired inflation/NGDP target unless it is expanded to include private sector assets. If it is expanded to include private sector assets, it will exacerbate the descent into an unequal, crony capitalist, financialised and innovatively stagnant economy that started during the Greenspan/Bernanke put era.
Removing the zero-bound
One way of getting around the zero-bound on interest rates is to simply abolish or tax bank note holdings as Willem Buiter has recommended many times:
The existence of bank notes or currency, which is an irredeemable ‘liability’ of the central bank – bearer bonds with a zero nominal interest rate – sets a lower bound (probably at something just below 0%) on central banks’ official policy rates.
The obvious solutions are: (1) abolishing currency completely and moving to E-money on which negative interest rates can be paid as easily as zero or positive rates; (2) taxing holdings of bank notes (a solution first proposed by Gesell (1916) and also advocated by Irving Fisher (1933)) or (3) ending the fixed exchange rate between currency and central bank reserves (which, like all deposits, can carry negative nominal interest rates as easily as positive nominal interest rates, a solution due to Eisler (1932)).
I’ve advocated many times on this blog that monetary-fiscal hybrid policies such as money-financed helicopter drops to individuals should be established as the primary tool of macroeconomic stabilisation. In this manner, inflation/NGDP targets can be achieved in a close-to-neutral manner that minimises rent extraction. My preference for fiscal-monetary helicopter drops over negative interest-rates is primarily driven by financial stability considerations. There is ample evidence that even low interest rates contribute to financial instability.
There’s a deep hypocrisy at the heart of the macro-stabilised era. Every policy of stabilisation is implemented in a manner that only a select few (typically corporate entities) can access with an implicit assumption that the impact will trickle-down to the rest of the economy. Central-banking since the Great Moderation has suffered from an unwarranted focus on asset prices driven by an implicit assumption that changes in asset prices are the best way to influence the macroeconomy. Instead doctrines such as the Greenspan Put have exacerbated inequality and cronyism and promoted asset price inflation over wage inflation. The single biggest misconception about the macro policy debate is the notion that monetary policy is neutral or more consistent with a free market and fiscal policy is somehow socialist and interventionist. A program of simple fiscal transfers to individuals can be more neutral than any monetary policy instrument and realigns macroeconomic stabilisation away from the classes and towards the masses.
There are many similarities between a resilience approach to macroeconomics and the Minsky/Bagehot approach – the most significant being a common focus on macroeconomies as systems in permanent disequilibrium. Although both approaches largely agree on the descriptive characteristics of macroeconomic systems, there are some significant differences when it comes to the preferred policy prescriptions. In a nutshell, the difference boils down to the question of when and where to intervene.
A resilience approach focuses its interventions on severe disturbances, whilst allowing small and moderate disturbances to play themselves out. Even when the disturbance is severe, a resilience approach avoids stamping out the disturbance at source and focuses its efforts on mitigating the wider impact of the disturbance on the macroeconomy. The primary aim is the minimisation of the long-run fragilising consequences of the intervention which I have explored in detail in many previous posts(1, 2, 3). Just as small fires and floods are integral to ecological resilience, small disturbances are integral to macroeconomic resilience. Although it is difficult to identify ex-ante whether disturbances are moderate or not, the Greenspan-Bernanke era nevertheless contains some excellent examples of when not to intervene. The most obvious amongst all the follies of Greenspan-era monetary policy were the rate cuts during the LTCM collapse which were implemented with the sole purpose of “saving” financial markets at a time when the real economy showed no signs of stress1.
The Minsky/Bagehot approach focuses on tackling all disturbances with debt-deflationary consequences at their source. Bagehot asserted in ‘Lombard Street’ that “in wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them”. Minsky emphasised the role of both the lender-of-last-resort (LOLR) mechanism as well as fiscal stabilisers in tackling such “failures”. However Minsky was not ignorant of the long-term damage inflicted by a regime where all disturbances were snuffed out at source – the build-up of financial “innovation” designed to take advantage of this implicit protection, the descent into crony capitalism and the growing fragility of a private-investment driven economy2, an understanding that was also reflected in his fundamental reform proposals3. Minsky also appreciated that the short-run cycle from hedge finance to Ponzi finance does not repeat itself in the same manner. The long-arc of stabilised cycles is itself a disequilibrium process (a sort of disequilibrium super-cycle) where performance in each cycle deteriorates compared to the last one – an increasing amount of stabilisation needs to be applied in each short-run cycle to achieve poorer results compared to the previous cycle.
Resilience Approach: Policy Implications
As I have outlined in an earlier post, an approach that focuses on minimising the adaptive consequences of macroeconomic interventions implies that macroeconomic policy must allow the “river” of the macroeconomy to flow in a natural manner and restrict its interventions to insuring individual economic agents rather than corporate entities against the occasional severe flood. In practise, this involves:
- De-emphasising the role of conventional and unconventional monetary policy (interest-rate cuts, LOLR, quantitative easing, LTRO) in tackling debt-deflationary disturbances.
- De-emphasising the role of industrial policy and explicit bailouts of banks and other firms4.
- Establishing neutral monetary-fiscal hybrid policies such as money-financed helicopter drops as the primary tool of macroeconomic stabilisation. Minsky’s insistence on the importance of LOLR operations was partly driven by his concerns that alternative policy options could not be implemented quickly enough5. This concern is less relevant with regards to helicopter drops in today’s environment where they can be implemented almost instantaneously6.
Needless to say, the policies we have followed throughout the ‘Great Moderation’ and continue to follow are anything but resilient. Nowhere is the farce of orthodox policy more apparent than in Europe where countries such as Spain are compelled to enforce austerity on the masses whilst at the same time being forced to spend tens of billions of dollars in bailing out incumbent banks. Even within the structurally flawed construct of the Eurozone, a resilient strategy would take exactly the opposite approach which will not only drag us out of the ‘Great Stagnation’ but it will do so in a manner that delivers social justice and reduced inequality.
- Of course this “success” also put Greenspan, Rubin and Summers onto the cover of TIME magazine, which goes to show just how biased political incentives are in favour of stabilisation and against resilience. ↩
- From pages 163-165 of Minsky’s book ‘John Maynard Keynes’:
“The success of a high-private-investment strategy depends upon the continued growth of relative needs to validate private investment. It also requires that policy be directed to maintain and increase the quasi-rents earned by capital – i.e.,rentier and entrepreneurial income. But such high and increasing quasi-rents are particularly conducive to speculation, especially as these profits are presumably guaranteed by policy. The result is experimentation with liability structures that not only hypothecate increasing proportions of cash receipts but that also depend upon continuous refinancing of asset positions. A high-investment, high-profit strategy for full employment – even with the underpinning of an active fiscal policy and an aware Federal Reserve system – leads to an increasingly unstable financial system, and an increasingly unstable economic performance. Within a short span of time, the policy problem cycles among preventing a deep depression, getting a stagnant economy moving again, reining in an inflation, and offsetting a credit squeeze or crunch…….
In a sense, the measures undertaken to prevent unemployment and sustain output “fix” the game that is economic life; if such a system is to survive, there must be a consensus that the game has not been unfairly fixed…….
As high investment and high profits depend upon and induce speculation with respect to liability structures, the expansions become increasingly difficult to control; the choice seems to become whether to accomodate to an increasing inflation or to induce a debt-deflation process that can lead to a serious depression……
The high-investment, high-profits policy synthesis is associated with giant firms and giant financial institutions, for such an organization of finance and industry seemingly makes large-scale external finance easier to achieve. However, enterprises on the scale of the American giant firms tend to become stagnant and inefficient. A policy strategy that emphasizes high consumption, constraints upon income inequality, and limitations upon permissible liability structures, if wedded to an industrial-organization strategy that limits the power of institutionalized giant firms, should be more conducive to individual initiative and individual enterprise than is the current synthesis.
As it is now, without controls on how investment is to be financed and without a high-consumption, low private-investment strategy, sustained full employment apparently leads to treadmill affluence, accelerating inflation, and recurring threats of financial crisis.” ↩
- Just like Keynes, Minsky understood completely the dynamic of stabilisation and its long-term strategic implications. Given the malformation of private investment by the interventions needed to preserve the financial system, Keynes preferred the socialisation of investment and Minsky a shift to a high-consumption, low-investment system. But the conventional wisdom, which takes Minsky’s tactical advice on stabilisation and ignores his strategic advice on the need to abandon the private-investment led model of growth, is incoherent. ↩
- In his final work ‘Power and Prosperity’, Mancur Olson expressed a similar sentiment: “subsidizing industries, firms and localities that lose money…at the expense of those that make money…is typically disastrous for the efficiency and dynamism of the economy, in a way that transfers unnecessarily to poor individuals…A society that does not shift resources from the losing activities to those that generate a social surplus is irrational, since it is throwing away useful resources in a way that ruins economic performance without the least assurance that it is helping individuals with low incomes. A rational and humane society, then, will confine its distributional transfers to poor and unfortunate individuals.” ↩
- From pg 44 of ‘Stabilising an Unstable Economy’: “The need for lender-of-Iast-resort operations will often occur before income falls steeply and before the well nigh automatic income and financial stabilizing effects of Big Government come into play. If the institutions responsible for the lender-of-Iast-resort function stand aside and allow market forces to operate, then the decline in asset values relative to current output prices will be larger than with intervention; investment and debt- financed consumption will fall by larger amounts; and the decline in income, employment, and profits will be greater. If allowed to gain momentum, the financial crisis and the subsequent debt deflation may, for a time, overwhelm the income and financial stabilizing capacity of Big Government. Even in the absence of effective lender-of-Iast-resort action, Big Government will eventually produce a recovery, but, in the interval, a high price will be paid in the form of lost income and collapsing asset values.” ↩
- As Charlie Bean of the BoE suggests, helicopter drops could be implemented in the UK via the PAYE system. ↩
Many economists want to turn back the clock on the American economic system to that of the 50s and 60s. This is understandable – the ‘Golden Age’ of the 50s and 60s was characterised by healthy productivity growth, significant real wage growth and financial stability. Similarly, many commentators see the banking system during that time as the ideal state. In this vein, Amar Bhide offers his solution for the chronic fragility of the financial system:
governments should fully guarantee all bank deposits — and impose much tighter restrictions on risk-taking by banks. Banks should be forced to shed activities like derivatives trading that regulators cannot easily examine…..Banks must therefore be restricted to those activities, like making traditional loans and simple hedging operations, that a regulator of average education and intelligence can monitor.
There are a couple of problems with his idea – for one it may not be possible to effectively regulate bank risk-taking. On many previous occasions, I have asserted that regulations cannot restrain banks from extracting moral hazard rents from the guarantee provided by the state/central bank to bank creditors and depositors. The primary reason for this is the spread of financial innovation during the last fifty years that has given banks an almost infinite variety of ways in which it can construct an opaque and precisely tailored payoff that provides a steady stream of profits in good times in exchange for a catastrophic loss in bad times. As I have shown, the moral hazard trade is not a “riskier” trade but a combination of high leverage and a severely negatively skewed payoff with a catastrophic tail risk.
Minsky himself understood the essentially ephemeral nature of the financial system of the 50s from his work on the early stages of the process of financial innovation that allowed the financial system to unshackle itself from the effective control of the central bank and the regulator. As he observes:
The banking system came out of the war with a portfolio heavily weighted with government debt, and it was not until the 1960s that banks began to speculate actively with respect to their liabilities. It was a unique period in which finance mattered relatively little; at least, finance did not interpose its destabilizing ways……The apparent stability and robustness of the financial system of the 1950s and early 1960s can now be viewed as an accident of history, which was due to the financial residue of World War 2 following fast upon a great depression.
Amar Bhide’s idea essentially seeks to turn back the clock and forbid much of the innovation that has taken place in the last few decades. In particular, derivatives businesses will be forbidden for deposit-taking banks. This is a radical idea and one that is a significant improvement on the current status quo. But it is not enough to mitigate the moral hazard problem. To illustrate why this is the case, let me take an example of how as a banker, I would construct such a payoff within a “narrow banking”-like mandate. Let us assume that banks can only take deposits and make loans to corporations and households. They cannot hedge their loans or engage in any activities related to financial market positions even as market makers, and they cannot carry any off balance-sheet exposures, commitments etc. Although this would seem to be a sufficiently narrow mandate to prevent rent extraction, it is not. Banks can simply lend to other firms that take on negatively skewed bets. You may counter that banks should only be allowed to lend to real economy firms. But do we expect regulators to audit not only the banks under their watch but also the firms to whom they lend money? In the first post on this blog, I outlined how the synthetic super-senior CDO tranche was the quintessential rent-extraction product of the derivatives revolution. But at its core, the super-senior tranche is simply a severely negatively skewed bond – a product that pays a small positive spread in good times and loses you all your money in bad times. There is no shortage of ways in which such a negatively skewed payoff can be constructed by simple structured bank loans.
What the synthetic OTC derivatives revolution made possible was for the banking system to structure such payoffs in an essentially infinite amount without even going through the trouble of making new loans or mortgages – all that was needed was a derivatives counterparty. Without derivatives, banks would have to lend money to generate such a payoff – this only makes it a little harder to extract rents but it still does not change the essence of the problem. Even more crucially, the potential for such rent extraction is unlimited compared to other avenues for extracting rent. If the state pays a higher price for an agricultural crop compared to the market, at least the losses suffered by the taxpayer are limited by physical constraints such as arable land available. But when the rent extraction opportunity goes hand in hand with the very process that creates credit and broad money, the potential for rent extraction is virtually unlimited.
Even if we assume that rent extraction can be controlled by more stringent regulations, there remains one problem. There is simply no way that incumbent large banks, especially those with a large OTC derivatives franchise, can shed their derivatives business and still remain solvent. The best indication of how hard it is to unwind complex derivatives portfolios was the experience of Warren Buffett in unwinding the derivatives portfolio which he inherited from the General Re acquisition. As Buffett notes, unwinding the portfolio of a relatively minor player in the derivative market under benign market conditions and no internal financial pressure took years and cost him $404 million. If we asked any of the large banks, let alone all of them at once, to do the same in the current fragile market conditions the cost of doing so will comfortably bankrupt the entire banking sector. The modern TBTF bank with its huge OTC derivatives business is akin to a suicide bomber with his finger on the button that is holding us hostage – this is the reason why regulators handle them with kid gloves.
In other words, even if our dream of limited and safe banking is viable we have a ‘can’t get there from here’ problem. This does not mean that there are no viable solutions but we need to be more creative. Amar Bhide makes a valid point when he argues that “Why not also make all short-term deposits, which function much like currency, the explicit liability of the government?” But the solution is not to allow private banks to reap the rents from cheap deposit financing but to allow each citizen and corporation access to a public deposit account. The simplest implementation of this would be a system similar to the postal savings system where all deposits are necessarily backed by short-term treasury bills. If the current stock of T-bills is not sufficient to back the demand for such deposits, the Treasury should shift the maturity profile of its debt until the demand is met. In such a system, there would be no deposit insurance i.e. all investment/deposit alternatives except for the state system will be explicitly risky and unprotected.
One criticism of such a system would be that the benefits of maturity transformation would be lost to the economy i.e. unless short-term deposits are deployed to match long-term investment projects, such projects would not find adequate funding. But as I have argued and the data shows, household long-term savings (which includes pensions and life insurance) is more than sufficient to meet the long-term borrowing needs of the corporate and the household sector in both the United States and Europe.
The “regulate and insure” model ignores the ability of banks to arbitrage any regulatory framework. But the status quo is also unacceptable. However the system is sufficiently levered and fragile that allowing market forces to operate or simply forcing a drastic structural change upon incumbent banks by regulatory fiat implies an almost certain collapse of the incumbent banks. Creating a public deposit option is the first step in implementing a sustainable transition to a resilient financial system, one in which instead of shackling incumbent banks we separate them from the risk-free depository system.
Note: My views on this topic and some other related topics which I hope to explore soon have been significantly influenced by uber-commenter K. For a taste of his broader ideas which are similar to mine, try this comment which he made in response to a Nick Rowe post.
In response to the sovereign funding crisis sweeping across the Eurozone, the ECB decided to “conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months”. Combined with the commitment of the members of the Eurozone excluding the possibility of any more haircuts on private sector holders of Euro sovereign bonds, the aim of the current exercise is clear. As Nicholas Sarkozy put it rather bluntly,
Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6–7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.
In other words, the ECB will not finance fiscal deficits directly but will be more than happy to do so via the Eurozone banking system. But this plan still has a few critical flaws:
- As Sony Kapoor notes, “By doing this, you are strengthening the link between banks and sovereigns, which has proven so dangerous in this crisis. Even if useful in the short term, it would seriously increase the vulnerability of both banks and sovereigns to future shocks.” In other words, if the promise to exclude the possibility of inflicting losses on sovereign debt-holders is broken at any point of time in the future, then sovereign default will coincide with a complete decimation of the incumbent banks in Europe.
- European banks are desperately capital-constrained as the latest EBA estimates on the capital shortfall faced by European banks shows. In such a condition, banks will almost certainly take on increased sovereign debt exposures only at the expense of lending to the private sector and households. This can only exacerbate the recession in the Eurozone.
- Sarkozy’s comment also hints at the deep unfairness of the current proposal. If default and haircuts are not on the table, then allowing banks to finance their sovereign debt holdings at a lower rate than the yield they earn on the sovereign bonds (at the same tenor) is simply a transfer of wealth from the Eurozone taxpayer to the banks. Such a privilege may only be extended to the banks if banking is a “perfectly competitive” sector which it is far from being even in a boom economy. In the midst of an economic crisis when so many banks are tottering, it is even further away from the ideal of perfect competition.
There is a simple solution that tackles all three of the above problems – extend the generous terms of refinancing sovereign debt to the entire populace of the Eurozone such that the market for the “support of sovereign debt” is transformed into something close to perfectly competitive. In practise, this simply requires undertaking a program of fast-track banking licenses to new banks with low minimum size requirements on the condition that they restrict their activities to a narrow mandate of buying sovereign debt. This plan can correct all the flaws of the current proposal:
- Instead of being concentrated within the incumbent failing banks, the sovereign debt exposure of the Eurozone would be spread in a diversified manner within the population. This will also help in making the “no more haircuts” commitment more time-consistent. The wider base of sovereign debt holders will reduce the possibility that the commitment will be reversed by democratic means. The only argument against this plan is that such a concentrated new bank is too risky but that assumes that there is still default risk on Eurozone sovereign debt and that the commitment is not credible.
- The plan effectively injects new capital into the banking sector allowing incumbent bank capital to be deployed towards lending to the private sector and households. If sovereign debt spreads collapse, then the plan will also shore up the financial position of the incumbent banks thus injecting further capital available to be deployed.
- The plan is fair. If the current crisis is indeed just a problem of high interest rates fuelling an increased risk of default, then interest rates will rapidly fall to a level much closer to the refinancing rate. To the extent that rates stay elevated and spreads do not converge, it will provide a much more accurate reflection of the real risk of default. No one will earn a supra-normal rate of return.
On this blog, I have criticised the indiscriminate provision of “liquidity” backstops by central banks on many occasions. I have also asserted that key economic functions must be preserved, not the incumbent entities that provide such functions. In times of crisis, central banking interventions are only fair when they are effectively accessible to the masses. At this critical juncture, the socially just policy may also be the only option that can save the single currency project.
The Borio-Disyatat paper is especially recommended. It explains best why the savings glut thesis itself is a product of a faulty ‘Loanable Funds’ view of money. Much more appropriate is the credit/financing view of money that Borio and Disyatat take. The best explanation of this credit view is Chapter 3 (’Credit and Capital’) in Joseph Schumpeter’s book ‘Theory of Economic Development’. As Agnès Festré notes, Hayek had a very similar theory of credit but a very different opinion as to its implications:
both Hayek and Schumpeter make use of the mechanism of forced saving in their analyses of the cyclical upswing in order to describe the real effects of credit creation. In Schumpeter’s framework, the relevant redistribution of purchasing power is from traditional producers to innovators with banks playing a crucial complementary role in meeting demand for finance by innovating firms. The dynamic process thus set into motion then leads to a new quasi-equilibrium position characterised by higher productivity and an improved utilisation of resources. For Hayek, however, forced saving is equivalent to a redistribution from consumers to investing producers as credit not backed by voluntary savings is channelled towards investment activities, in the course of which more roundabout methods of production are being implemented. In this setting, expansion does not lead to a new equilibrium position but is equivalent to a deviation from the equilibrium path, that is to an economically harmful distortion of the relative (intertemporal) price system. The eventual return to equilibrium then takes place via an inevitable economic crisis.
Schumpeter viewed this elasticity of credit as the ‘differentia specifica’ of capitalism. Although this view combined with his vision of the banker as a ‘capitalist par excellence’ may have been true in an unstabilised financial system, it is not accurate in the stabilised financial system that his student Hyman Minsky identified as the reality of the modern capitalist economy. Successive rounds of stabilisation mean that the modern banker is more focused on seeking out bets that will be validated by central bank interventions than funding disruptive entrepreneurial activity. Moreover, we live in a world where maturity transformation is no longer required to meet our investment needs. The evolution and malformation of the financial system means that Hayek’s analysis is more relevant now than it probably was during his own lifetime.