resilience, not stability

Archive for the ‘Moral Hazard’ Category

A Lesson From Lehman and Bear Stearns

with 5 comments

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:

Lehman CDS

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.

Bookmark and Share

Written by Ashwin Parameswaran

September 13th, 2013 at 12:34 pm

The Public Deposit Option: An Alternative To “Regulate and Insure” Banking

with 31 comments

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.

Bookmark and Share

Written by Ashwin Parameswaran

January 5th, 2012 at 12:18 pm

A Simple Solution to the Eurozone Sovereign Funding Crisis

with 14 comments

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.

Bookmark and Share

Written by Ashwin Parameswaran

December 10th, 2011 at 12:57 am

Financial Market Regulation and The Art of War

with 14 comments

“The interaction between the market participants, and for that matter between the market participants and the regulators, is not a game, but a war.”

Rick Bookstaber recently compared the complexity of the financial marketplace to that observed in military warfare. Bookstaber focuses primarily on the interaction between market participants but as he mentions, the same analogy also holds for the interaction between market participants and the regulator. In this post, I analyse the role of the financial market regulator within this context. Bookstaber primarily draws upon the work of John Boyd but I will focus on Sun Tzu’s ‘Art of War’.

Much like John Boyd, Sun Tzu emphasised the role of deception in war: “All warfare is based on deception”. In the context of regulation, “deception” is best understood as the need for the regulator to be unpredictable. This is not uncommon in other war-like economic domains. Google, for example, must maintain the secrecy and ambiguity of its search algorithms in order to stay one step ahead of the SEO firms’ attempts to game them. An unpredictable regulator may seem like a crazy idea but in fact it is a well-researched option in the central banking policy arsenal. In a paper for the Federal Reserve bank of Richmond in 1999, Jeffrey Lacker and Marvin Goodfriend analysed the merits of a regulator adopting a stance of ‘constructive ambiguity’. They concluded that a stance of constructive ambiguity was unworkable and could not prevent the moral hazard that arose from the central bank’s commitment to backstop banks in times of crisis. The reasoning was simple: constructive ambiguity is not time-consistent. As Lacker and Goodfriend note: “The problem with adding variability to central bank lending policy is that the central bank would have trouble sticking to it, for the same reason that central banks tend to overextend lending to begin with. An announced policy of constructive ambiguity does nothing to alter the ex post incentives that cause central banks to lend in the first place. In any particular instance the central bank would want to ignore the spin of the wheel.” Steve Waldman summed up the time-consistency problem in regulation well when he noted: “Given the discretion to do so, financial regulators will always do the wrong thing.” In fact, Lacker has argued that it was this stance of constructive ambiguity combined with the creditor bailouts since Continental Illinois that the market understood to be an implicit commitment to bailout TBTF banks.

As is clear from the war analogy, a predictable adversary is easily defeated. This of course is why Goodhart’s Law is such a big problem in regulation. Lacker’s suggestion that the regulator follow a “simple decision rule” is fatally flawed for the same reason. Lacker also suggests that “legal constraints limiting policymakers’ actions” could be imposed to mitigate the moral hazard problem. But attempting to lay out a comprehensive list of constraints suffers from the same problem i.e. they can be easily circumvented by a determined regulator. If the relationship between a regulator and the regulated is akin to war, then so is the relationship between the rule-making legislative body and the regulator. Bank bailouts can and have been carried out over the last thirty years under many different guises: explicit creditor bailouts, asset backstops a la Bear Stearns, “liquidity” support via expanded and lenient collateral standards, interest rate cuts as a bank recapitalisation mechanism etc.

Bookstaber asserts quite rightly that the military analogy stems from a view of human rationality that is at odds with both neoclassical and behavioural economics, a point that Gerd Gigerenzer has repeatedly emphasised. Homo economicus relies on a strangely simplistic version of the ‘computational theory of the mind’ that assumes man to be an optimising computer. Behavioural economics then compares the reality of human rationality to this computational ideal and finds man to be an inferior version of a computer, riddled with biases and errors. As Gigerenzer has argued, many heuristics and biases that appear to be irrational or illogical are entirely rational responses to an uncertain world. But clearly deception and unpredictability go beyond simply substituting the rationality of homo economicus with simple heuristics. In the ‘Art of War’, Sun Tzu insists that a successful general must “respond to circumstances in an infinite variety of ways”. Each battle must be fought in its unique context and “when victory is won, one’s tactics are not repeated”. To Sun Tzu, the expert general must be “serene and inscrutable”. In one of the most fascinating passages in the book, he describes the actions and decisions of the expert general: “How subtle and insubstantial, that the expert leaves no trace. How divinely mysterious, that he is inaudible.”

As Robert Wilkinson notes, in order to make any sense of these comments, one needs to appreciate the Taoist underpinnings of the ‘Art of War’. The “infinite variety” of tactics is not the variety that comes from making decisions based on the “spin of a roulette wheel” that Goodfriend and Lacker take to provide constructive ambiguity. It comes from an appreciation of the unique context in which each situation is placed and the flexibility, adaptability and novelty required to succeed. The “inaudibility” refers to the inability to translate such expertise into rules, algorithms or even heuristics. The ‘Taoist adept’ relies on the same intuitive tacit understanding that lies at the heart of what Hubert and Stuart Dreyfus call “expert know-how”1. In fact, rules and algorithms may paralyse the expert rather than aid him. Hubert/Stuart Dreyfus noticed of expert pilots that “rather  than  being  aware  that  they are  flying  an  airplane,  they  have  the  experience  that  they  are flying.  The  magnitude  and  importance  of  this  change  from  analytic  thought  to  intuitive  response  is  evident  to  any  expert pilot  who  has  had  the  experience  of  suddenly  reflecting  upon  what he is  doing,  with  an  accompanying  degradation  of  his  performance and  the  disconcerting  realization  that  rather  than  simply  flying, he  is  controlling  a  complicated  mechanism.” The same sentiment was expressed rather more succinctly by Laozi when he said:

“Having some knowledge
When walking the Great Tao
Only brings fear.”

I’m not suggesting that financial markets regulation would work well if only we could hire “expert” regulators. The regulatory capture and the revolving door between the government and Wall Street that is typical of late-stage Olsonian demosclerosis means that the real relationship between the regulator and the regulated is anything but adversarial. I’m simply asserting that there is no magical regulatory recipe or formula that will prevent Wall Street from gaming and arbitraging the system. This is the unresolvable tension in financial markets regulation: Discretionary policy falls prey to the time-consistency problem. The alternative, a systematic and predictable set of rules, is the worst possible way to fight a war.

  1. This Taoist slant to Hubert Dreyfus’ work is not a coincidence. Dreyfus was deeply influenced by the philosophy of Martin Heidegger who, although he never acknowledged it, was almost certainly influenced by Taoist thought []
Bookmark and Share

Written by Ashwin Parameswaran

April 4th, 2011 at 10:29 am

Rent Extraction and Competition in Banking as an Ultimatum Game

with 9 comments

In two recent posts [1,2], Scott Sumner disputes the role of financial rent extraction in increasing inequality. His best argument is that due to competition, government subsidies by themselves cannot cause inequality. A few months ago, Russ Roberts asked a similar question: “If banking is a protected sector that the government coddles and rewards, why doesn’t competition for banking jobs reduce the returns to more normal levels?” This post tries to answer this question. To summarise the conclusion, synthetic rent extraction markets are closer to an ‘Ultimatum Game’ than they are to competitive “real economy” markets.

Scott brings up the example of farm subsidies and points out that they only reduce food prices without making farmers any richer – the reason of course being competitive food markets. In my post on inequality and rents, I used a similar rationale to explain how reduced borrowing costs for banks in Germany (due to state protection) simply results in reduced borrowing costs for the Mittelstand. So how is this any different from the rents that banks, hedge funds and others can extract from the central bank’s commitment to insure them and the economy from tail events? The answer lies in the synthetic and rent-contingent nature of markets for products such as CDOs. The absence of moral hazard rents doesn’t simply change the price and quantity of many financial products – it ensures that the market does not exist to start with. In other words, the very raison d’être of many financial products is their role in extracting rents from central bank commitments.

The process of distributing rents amongst financial market participants is closer to an ultimatum game than it is to a perfectly competitive product market. The rewards in this game are the rents on offer which are limited only by the willingness or ability of the central bank to insure against tail risk. To illustrate how this game may be played out, let us take the ubiquitous negatively-skewed product payoff that banks accumulated during the crisis – the super-senior CDO tranche1. In order to originate a synthetic super-senior tranche, a bank needs to find a willing counterparty (probably a hedge fund) to take the other side of the trade. The bank itself needs to negotiate an arrangement between its owners, creditors and employees as to how the rents will be shared. If the various parties cannot come to an agreement, there is no trade and no rents are extracted.  The central bank commitment provides an almost unlimited quantity of insurance/rents at a constant price. Therefore, there is no incentive for any of the above parties to risk failure to come to an agreement by insisting on a larger share of the pie.

In a world with unlimited potential bank stockholders, creditors and employees and unlimited potential hedge funds, the eventual result is unlimited rent extraction and state bankruptcy. The only way to avoid inequality in the presence of such a commitment is for every single person in the economy to extract rents in an equally efficient manner – simply increased competition between hedge funds or banks is not good enough. In reality of course, not all of us are bankers or hedge fund managers.  Nevertheless, it is troubling that the evolution of many financial product markets over the past 30 years can be viewed as a gradual expansion of such rent extraction.

Although I’ve focused on synthetic financial products, the above analysis is valid even for many of the “real” loans made during the housing boom. In the absence of the ability to extract rents, many of the worst loans would likely not have been made. The presence of rents of course meant that every party went out of their way to ensure that the loans were made. It is also worth noting that although I have explained the process of rent extraction as a calculated and intentional activity, it does not need to be. In fact, as I have argued before [1,2], rent extraction can easily arise with each party genuinely believing themselves to be blameless and well-intentioned. The road to inequality and state bankruptcy is paved with good intentions.

  1. In some cases, the super-senior itself was insured with counterparties such as AIG or the monolines making the payoff even more negatively skewed []
Bookmark and Share

Written by Ashwin Parameswaran

January 4th, 2011 at 10:45 am

The Cause and Impact of Crony Capitalism: the Great Stagnation and the Great Recession

with 23 comments


The core insight of the Minsky-Holling resilience framework is that stability and stabilisation breed fragility and loss of system resilience . TBTF protection and the moral hazard problem is best seen as a subset of the broader policy of stabilisation, of which policies such as the Greenspan Put are much more pervasive and dangerous.

By itself, stabilisation is not sufficient to cause cronyism and rent seeking. Once a system has undergone a period of stabilisation, the system manager is always tempted to prolong the stabilisation for fear of the short-term disruption or even collapse. However, not all crisis-mitigation strategies involve bailouts and transfers of wealth to the incumbent corporates. As Mancur Olson pointed out, society can confine its “distributional transfers to poor and unfortunate individuals” rather than bailing out incumbent firms and still hope to achieve the same results.

To fully explain the rise of crony capitalism, we need to combine the Minsky-Holling framework with Mancur Olson’s insight that extended periods of stability trigger a progressive increase in the power of special interests and rent-seeking activity. Olson also noted the self-preserving nature of this phenomenon.  Once rent-seeking has achieved sufficient scale, “distributional coalitions have the incentive and..the power to prevent changes that would deprive them of their enlarged share of the social output”.


Crony capitalism results in a homogenous, tightly coupled and fragile macroeconomy. The key question is: Via which channels does this systemic malformation occur? As I have touched upon in some earlier posts [1,2], the systemic implications of crony capitalism arise from its negative impact on new firm entry. In the context of the exploration vs exploitation framework, absence of new firm entry tilts the system towards over-exploitation1 .

Exploration vs Exploitation: The Importance of New Firm Entry in Sustaining Exploration

In a seminal article, James March distinguished between “the exploration of new possibilities and the exploitation of old certainties. Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” True innovation is an act of exploration under conditions of irreducible uncertainty whereas exploitation is an act of optimisation under a known distribution.

The assertion that dominant incumbent firms find it hard to sustain exploratory innovation is not a controversial one. I do not intend to reiterate the popular arguments in the management literature, many of which I explored in a previous post. Moreover, the argument presented here is more subtle: I do not claim that incumbents cannot explore effectively but simply that they can explore effectively only when pushed to do so by a constant stream of new entrants. This is of course the “invisible foot” argument of Joseph Berliner and Burton Klein for which the exploration-exploitation framework provides an intuitive and rigorous rationale.

Let us assume a scenario where the entry of new firms has slowed to a trickle, the sector is dominated by a few dominant incumbents and the S-curve of growth is about to enter its maturity/decline phase. To trigger off a new S-curve of growth, the incumbents need to explore. However, almost by definition, the odds that any given act of exploration will be successful is small. Moreover, the positive payoff from any exploratory search almost certainly lies far in the future. For an improbable shot at moving from a position of comfort to one of dominance in the distant future, an incumbent firm needs to divert resources from optimising and efficiency-increasing initiatives that will deliver predictable profits in the near future. Of course if a significant proportion of its competitors adopt an exploratory strategy, even an incumbent firm will be forced to follow suit for fear of loss of market share. But this critical mass of exploratory incumbents never comes about. In essence, the state where almost all incumbents are content to focus their energies on exploitation is a Nash equilibrium.

On the other hand, the incentives of any new entrant are almost entirely skewed in favour of exploratory strategies. Even an improbable shot at glory is enough to outweigh the minor consequences of failure2 . It cannot be emphasised enough that this argument does not depend upon the irrationality of the entrant. The same incremental payoff that represents a minor improvement for the incumbent is a life-changing event for the entrepreneur. When there exists a critical mass of exploratory new entrants, the dominant incumbents are compelled to follow suit and the Nash equilibrium of the industry shifts towards the appropriate mix of exploitation and exploration.

The Crony Capitalist Boom-Bust Cycle: A Tradeoff between System Resilience and Full Employment

Due to insufficient exploratory innovation, a crony capitalist economy is not diverse enough. But this does not imply that the system is fragile either at firm/micro level or at the level of the macroeconomy. In the absence of any risk of being displaced by new entrants, incumbent firms can simply maintain significant financial slack3. If incumbents do maintain significant financial slack, sustainable full employment is impossible almost by definition.  However, full employment can be achieved temporarily in two ways: Either incumbent corporates can gradually give up their financial slack and lever up as the period of stability extends as Minsky’s Financial Instability Hypothesis (FIH) would predict, or the household or government sector can lever up to compensate for the slack held by the corporate sector.

Most developed economies went down the route of increased household and corporate leverage with the process aided and abetted by monetary and regulatory policy. But it is instructive that developing economies such as India faced exactly the same problem in their “crony socialist” days. In keeping with its ideological leanings pre-1990, India tackled the unemployment problem via increased government spending. Whatever the chosen solution, full employment is unsustainable in the long run unless the core problem of cronyism is tackled. The current over-leveraged state of the consumer in the developed world can be papered over by increased government spending but in the face of increased cronyism, it only kicks the can further down the road. Restoring corporate animal spirits depends upon corporate slack being utilised in exploratory investment, which as discussed above is inconsistent with a cronyist economy.

Micro-Fragility as the Key to a Resilient Macroeconomy and Sustainable Full Employment

At the appropriate mix of exploration and exploitation, individual incumbent and new entrant firms are both incredibly vulnerable. Most exploratory investments are destined to fail as are most firms, sooner or later. Yet due to the diversity of firm-level strategies, the macroeconomy of vulnerable firms is incredibly resilient. At the same time, the transfer of wealth from incumbent corporates to the household sector via reduced corporate slack and increased investment means that sustainable full employment can be achieved without undue leverage. The only question is whether we can break out of the Olsonian special interest trap without having to suffer a systemic collapse in the process.

  1. It cannot be emphasized enough that absence of new firm entry is simply the channel through which crony capitalism malforms the macroeconomy. Therefore, attempts to artificially boost new firm entry are likely to fail unless they tackle the ultimate cause of the problem which is stabilisation []
  2. It is critical that the personal consequences of firm failure are minor for the entrepreneur – this is not the case for cultural and legal reasons in many countries around the world but is largely still true in the United States. []
  3. It could be argued that incumbents could follow this strategy even when new entrants threaten them. This strategy however has its limits – an extended period of standing on the sidelines of exploratory activity can degrade the ability of the incumbent to rejoin the fray. As Brian Loasby remarked : “For many years, Arnold Weinberg chose to build up GEC’s reserves against an uncertain technological future in the form of cash rather than by investing in the creation of technological capabilities of unknown value. This policy, one might suggest, appears much more attractive in a financial environment where technology can often be bought by buying companies than in one where the market for corporate control is more tightly constrained; but it must be remembered that some, perhaps substantial, technological capability is likely to be needed in order to judge what companies are worth acquiring, and to make effective use of the acquisitions. As so often, substitutes are also in part complements.” []
Bookmark and Share

Written by Ashwin Parameswaran

November 24th, 2010 at 6:01 pm

Derivatives: The Negative Skewness in Dynamic Hedging and the Moral Hazard Problem

without comments

In a recent article, John Kay discovered the temptations of negative skewness, even for non-bank investors. Although some may label this irrational or even a scam, seeking out negative skewness may be entirely rational in the presence of policies such as the Greenspan/Bernanke Put that seek to avoid tail outcomes at all costs. The product that John Kay describes is a equity reverse convertible bond with an auto-call feature and European barriers. A cursory internet search shows that atleast in Europe, these products are not uncommon and most are not dissimilar to the specific bond that he describes:

“If the FTSE index is higher in a year’s time than it is today, you receive a 10 per cent return and your money back (no doubt with an invitation to apply for a new kickout bond). If the FTSE has fallen, the bond runs for another year. If the index has then risen above its initial level, you receive your money back with a 20 per cent return. Otherwise the bond runs for another year. And so on. The race ends – sorry, the investment matures – after five years. If the FTSE index, having been below its initial level at the end of years one, two, three and four, now lies above it, then bingo! you get a 50 per cent bonus.

There is, of course, a catch. If you miss out on the five-year jackpot the manager will review whether or not the FTSE index ever closed at more than 50 per cent below its starting level. If it hasn’t, then you will get back your initial stake, without bonus or interest. If the index breached that 50 per cent barrier your capital will be scaled down, perhaps substantially.”

The distribution of returns of this bond is negatively skewed: In return for taking on a small probability of a significant loss (if equities fall by 50%), the investor is compensated via a highly probable but likely modest profit – it is probable that the investor only gets his principal back and the most probable profitable scenario is redemption in one year with a return of 10%.

But if the investor takes on a negatively skewed payoff, doesn’t the bank by definition take on a positively skewed payoff? And does that not invalidate my entire thesis on moral hazard? No – In fact, structured products which provide negatively skewed payoffs to bank clients frequently allow banks to take on negative skewness. Banks do not simply hold the other side of the bond – they dynamically hedge the risk exposure of the bond and it is this dynamically hedged exposure that has a negatively skewed payoff.

Dynamic hedging differs from static hedging in that the hedges put in place need to be continuously rebalanced throughout the life of the transaction. Most banks restrict their hedging to first-order and second-order risks such as delta, gamma, vega etc and only rarely hedge higher order risks. How often this rebalancing needs to be done depends on the stability of the risks themselves (how stable the risks are with regards to movements in the market and movements in time) and the realised movements in the market itself. At the extremes, a product with stable risks in a stable market environment will require only infrequent rebalancing of the hedge and a product with unstable risks in an unstable market environment will need to be rebalanced often. In a world without transaction costs and slippage, none of this matters. But in the real world, increased slippage costs dramatically reduce the profitability of a dynamically hedged structured product when markets are unstable and/or the tenor of the product increases.

For many structured products such as the auto-call reverse convertible, the risk exposure of the dynamically hedged position is as follows: a high probability of a stable and/or short lifespan combined with a small probability of an extremely unstable and long lifespan. Typically, the bank would hedge the delta and vega of the bond  sometimes utilising out-of-the-money puts and calls to replicate the skew exposure. In most probable scenarios, the risk exposure of the dynamically hedged position is fairly stable. If the market simply goes up and stays there, the bond redeems with a 10% return after one year and the hedge would have to be rebalanced very few times in a smooth manner. If the market simply goes down significantly, the risk exposure simplifies into one resembling a put option owned by a bank. But what if the market goes down a little bit and stays there? Or even worse, what if the market goes down dramatically and then reverses course in an equally swift manner but stops short of the redemption level? It is not difficult to visualise that in some scenarios, the losses due to slippage can quite easily swamp the profits and fees made at inception.

The losses are exacerbated as it is precisely in these unstable market conditions when hedges need to be rebalanced frequently that transactions costs and slippage spiral out of control – the bank then faces the option of running the risk of an unhedged position or locking in a certain and significant loss. Although many traders would argue that remaining unhedged is the more profitable strategy (sometimes correctly), senior managers almost always choose the option of locking in a known loss even if it wipes out the past profits of the business. Moreover, the oligopolistic nature of the market and the homogeneous “same-way” exposure of the banks implies that all market participants will need to hedge at the same time in the same manner. The execution of such hedging itself may also affect the fragile fundamentals of the related market in a reflexive feedback loop.

The simplistic argument against TBTF banks owning a derivatives business is as follows:  bankers accumulate large positions of a long tenor yet get paid bonuses based on annual performance. If the positions accumulated in this manner blow up afterwards, the bank and often the taxpayer is left holding the can. Banks counter this argument by pointing out that these positions are typically hedged. In a world of static hedging, this may be an acceptable argument. But in a derivative book that needs to be dynamically hedged, the argument falls apart. Most existing books of dynamically hedged derivative positions are a negative NPV asset if the likely slippage in future market disruptions is incorporated into their valuation, especially if these slippages are computed over the “real” distribution rather than a “normal” one. Warren Buffett found this out the hard way when Berkshire Hathaway lost $400 mio in the process of unwinding General Re’s derivatives book even though the unwind was executed in the benign market conditions of 2004-2005 and Gen Re was only a minor player in the derivatives market.

Even in a calm market environment, most long-tenor dynamically hedged positions are marked significantly above their true NPV net of expected future slippage. In the good times, this dynamic is hidden by the profits that flow in from new business. But sooner or later, the negative dynamics of the book (the “stock”) overwhelm the profits on the new business (the “flow”) especially as the flow of new deals dries up. And when the bank in question is too big to fail, it is not the stockholder or the retail investor but the taxpayer who will ultimately foot the bill.

Bookmark and Share

Written by Ashwin Parameswaran

November 18th, 2010 at 1:17 pm

The Resilience Stability Tradeoff: Drawing Analogies between River Flood Management and Macroeconomic Management

with 9 comments

In an earlier post, I drew an analogy between Minsky’s Financial Instability Hypothesis (FIH) and the ecologist Buzz Holling’s work on the resilience-stability tradeoff in ecosystems. Extended periods of stability reduce system resilience in complex adaptive systems such as ecologies and economies. By extension, policies that focus on stabilisation cause a loss of system resilience. Holling and Meffe called this the Pathology of Natural Resource Management which they described as follows: “when the range of natural variation in a system is reduced, the system loses resilience.That is, a system in which natural levels of variation have been reduced through command-and-control activities will be less resilient than an unaltered system when subsequently faced with external perturbations.” This pathology is as relevant to macroeconomic systems as it is to ecosystems and I briefly drew an analogy between forest fire management and economic management in the earlier post. In this post, I analyse the dilemmas faced in river flood management and their relevance to macroeconomic management.

A Case Study of River Flood Management: River Kosi

The Kosi is one of the most flood-prone rivers in India. The brunt of its fury is borne by the northern Indian state of Bihar and the Kosi is aptly also known as the “Sorrow of Bihar”. Like many other flood-prone rivers, the root cause lies in the extraordinary amount of silt that the Kosi carries from the Himalayas to the plains of Bihar. The silt deposition raises the river bed and gravity causes the river to seek out a new course – in this manner, it has been estimated that the river Kosi may have moved westwards by an incredible 210 km in the last 250 years. During the 1950s, in an effort to provide “permanent salvation from floods” the Indian government embarked on a program of building embankments on the river to curb the periodic shifting of the Kosi’s course – the embankments were aimed at converting the unpredictable behaviour of the river into something more predictable and by extension, more manageable. It was assumed that the people of Bihar would benefit from a stabilised and predictable river.

Unfortunately, the reality of the flood management program on the river Kosi has turned out to be anything but beneficial. The culmination of the failure of the program was the 2008 Bihar flood which was one of the most disastrous floods in the history of the state. So what went wrong? Was this just a result of an extraordinary natural event? Most certainly not – As Dinesh Mishra notes, in 2008 the Kosi carried only  1/7th of the capacity of the embankments and at various points of time since the 50s, the river had carried far greater quantities of water without causing anywhere near the damage it caused in 2008. This was a disaster caused by the loss of system resilience, highlighted by the inability of the system to “withstand even modest adverse shocks” after prolonged periods of stability.

So what caused this loss of system resilience? As Dinesh Mishra explains: “By building embankments on either side of a river and trying to confine it to its channel, its heavy silt and sand load is made to settle within the embanked area itself, raising the river bed and the flood water level. The embankments too are therefore raised progressively until a limit is reached when it is no longer possible to do so. The population of the surrounding areas is then at the mercy of an unstable river with a dangerous flood water level , which could any day flow over or make a disastrous breach.” As expected, the eventual breach was catastrophic – the course of the Kosi moved more than 120 kilometres eastwards in a matter of weeks. In the absence of the embankments, such a dramatic shift would have taken decades. With the passage of time, a progressively greater degree of resources were required to maintain system stability and the eventual failure was a catastrophic one rather than a moderate one.

As the above analysis highlights, the stabilisation did not merely substitute a series of regular moderately damaging outcomes for an occasional catastrophic outcome (although this alone would be a cause for concern if a catastrophic outcome was capable of triggering systemic collapse). In fact, the stabilisation transformed the system into a state where eventually even minor and frequently observed disturbances would trigger a catastrophic outcome. As Jon Stewart put it, even “regular storms” would topple a fragile boat. When faced with the possibility of a catastrophic outcome, the managing agency has two choices, neither of which are attractive.

Either it can continue to stabilise the system using ever-increasing resources in an effort to avoid the catastrophic outcome. But this option must only be followed if the managing agency has infinite resources or if there is some absolute limit to this vicious cycle of cost escalation that is within the resource capabilities of the agency. Or it can allow the catastrophic outcome to occur in an effort to restore the system to its unstabilised state. But this option risks systemic collapse – it is not just the unprecedented nature of the outcome that we have to fear from, but the very fact that the adaptive agents of the complex system may have lost the ability to deal with even the occasional moderate failures that the unstabilised system would throw up. In other words, once the system has lost resilience, managing it is akin to choosing between the frying pan and the fire.

For example, in the pre-embankment era when the Kosi was allowed to meander and change course in a natural manner, the villagers on its banks had a deep understanding of the river’s patterns and its vagaries. The floods sustained the fertility of the soil and ensured that groundwater resources were plentiful. This is not to deny that the Kosi caused damage but because the people had adapted to its regular flooding patterns, systemic damage only occured during the proverbial 100-year flood. This highlights an important lesson in complex adaptive systems: The impact of disturbances cannot be analysed in isolation to the adaptive capacities of the agents in the system. If disturbances are regular and predictable, agents will likely be adapted to them and conversely, prolonged periods of stability will render agents vulnerable to even the smallest disturbance.

The problems of managing floods on the river Kosi are not unique – many rivers around the world pose similar challenges. For example, the Yellow River, aptly named the “Sorrow of China” and the Mississippi river basin, the story of which was captured so well by John McPhee. So is there any way to avoid this evolutionary arms race against nature? Are we to conclude that the only sustainable strategy is to avoid any intervention in the complex adaptive system? Not necessarily – interventions on the system must avoid tampering with the fundamental patterns and evolutionary dynamics of the system. Indeed the best example of river management that works with the natural flow of the river rather than against it is the Dutch government’s aptly named “Room for the River” project in the Rhine river valley. Instead of building higher dikes, the Dutch have chosen to build lower dikes that allow the Rhine to flood over a larger area thus easing the pressure on the dike system as a whole. This program has been adopted despite the fact that many farmers need to be relocated out of the newly expanded flood zones of the river.

Macroeconomic Parallels

Axel Leijonhufvud’s “Corridor Hypothesis” postulates that a macroeconomy will adapt well to small shocks but “outside of a certain zone or “corridor” around its long-run growth path, it will only very sluggishly react to sufficiently large, infrequent shocks.” The adaptive nature of the macroeconomy implies that stability and by extension stabilisation reduces the width of the corridor to the point where even a small shock is enough to push the system outside the corridor. Just as embankments induced fragility in the river Kosi, bailouts and other economic transfers to specific firms and industries induce fragility into the macroeconomic system. Economic policy must allow the “river” of the macroeconomy to flow in a natural manner and restrict its interventions to insuring individual economic agents against the occasional severe flood.

This sentiment was also expressed by that great evolutionary macroeconomist of our time, Mancur Olson. In his final work “Power and Prosperity”, Olson notes: “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.” Olson understood the damage inflicted by rent-seeking not only from a systemic perspective but from a perspective of social justice. The logical consequence of micro-stabilisation is a crony capitalist economy – rents invariably flow to the strong and the result is a sluggish and an inegalitarian economic system, not unlike many developing economies. Contrary to popular opinion, it is not limiting handouts to the poor that defines a free and dynamic economy but limiting rents that flow to the privileged.

On the Damage Done by the Greenspan Put Variant of Monetary Policy

Clearly, some fiscal policies aimed at firm and industry stabilisation harm the economic system. But what about monetary policy? Isn’t monetary policy close-to-neutral and therefore exempt from the above criticism? On the contrary – the Greenspan Put variant of monetary policy damages macroeconomic resilience as well as being inegalitarian and unjust. Monetary policy during the Greenspan-Bernanke era has focused on stabilising incumbent banks and helping them shore up their capital in response to every economic shock, as well as a focus on asset prices as a transmission channel of monetary policy i.e. the Greenspan Put. Unlike a river system where the buildup of silt is a clear indicator of growing fragility, there are no clear signs of loss of system resilience in a macroeconomy. However, we can infer loss of macroeconomic resilience from the ever-increasing resources that are required to maintain system stability. Just as the embankments of the Kosi were raised higher and higher to combat even a minor flood, the resources needed to stabilise the financial system have grown over the last 25 years. In the early 90s, bank capital could be rebuilt by a few years of low rates but now we need a panoply of “liquidity” facilities, near-zero rates and quantitative easing aimed at compressing the entire yield curve to achieve the same result.

As I mentioned earlier, such a stabilisation policy may be credible if there is a limit to the costs of stabilisation. For example, the rents that can be extracted by any small, isolated sector of the economy are limited. Unfortunately, and this is a point that cannot be emphasised enough, there is no limit to the rents that can be extracted by the financial sector. Every commitment by the Central Bank to insure the financial sector against bad outcomes will be arbitraged for all its worth until the cost of maintaining the commitment becomes so prohibitive that it is no longer tenable. Of course, as long as the stabilising policy is in operation it appears to be a “free lunch” – the costs of programs such as the TARP appear to be limited and well worth their macroeconomic benefits just like flood protection appears to be a successful choice in the long period of calm before the eventual disaster. The loss of resilience and rent extraction is exacerbated as other financial market players are encouraged to mimic banks and take on similarly negatively skewed bets such as investing the proceeds from securities lending in “safe” assets.

In my last post, I noted the connection between inequality and rents emanating from the moral hazard subsidy but the larger culprit is the toxic combination of Greenspan Put monetary policy and a dynamically uncompetitive cronyist financial sector. Even if the sector were more competitive it is inevitable that monetary policy focused on shoring up asset prices will benefit the primary asset-holders in the economy, which in itself is a regressive transfer of wealth to the rich. The idea that supporting asset prices is the best way to support the wider economy is not far away from the notion of trickle-down economics (or as Will Rogers put it: “money was all appropriated for the top in hopes that it would trickle down to the needy.”).

Finally, although it goes without saying that even a fiat currency-issuing central bank does not have infinite resources, the move over the last century from a gold standard to a fiat money regime does have some important implications for system resilience. In evolving from a decentralised gold standard monetary system to a fiat-currency issuing central bank regime, the flexibility and resources at the monetary authority’s disposal have increased significantly. In the hands of a responsible central bank the ability to issue a fiat currency is beneficial, but in an excessively stabilised economy, it allows the process of stabilisation to be maintained for far longer than it would otherwise be. And just like in the case of the river Kosi, the longer the period of the stabilisation the more catastrophic are the results of the inevitable normal disturbance.

Bookmark and Share

Written by Ashwin Parameswaran

October 18th, 2010 at 11:35 am

Inequality and Moral Hazard Rents in the Financial Sector

with 12 comments

A recent study by Kaplan and Rauh (h/t Tyler Cowen) confirms what a lot of us suspected anyway: the dominance of Wall Street (bankers, hedge fund managers etc) at the very top end of the income distribution. The presence of bankers at the top end of the income distribution is not surprising – A large portion of this blog has been devoted to the subject of how banks extract significant rents from the implicit and explicit support provided to them by the central bank. It is not surprising then that a significant proportion of these rents flows directly to bank employees. But as Megan McArdle notes, this does not explain the significant presence of hedge fund managers in this list. After all, hedge fund managers do not directly benefit from any state guarantees, implicit or explicit.

The SuperStar Effect?

It is clearly possible that there are many “superstars” in the hedge fund universe who generate genuine alpha and deserve their fat paychecks. But then the question arises as to why the prevalence of such superstars has increased so dramatically in recent times. One explanation may be the increased completeness of markets in the last quarter century which enables hedge fund managers to express a much more diverse range of market views in an efficient and low-cost manner. But this must surely be negated by the reduced supply of easy arbitrage opportunities and the increased competition amongst hedge funds.

Hedge Funds as an Indirect Beneficiary of Moral Hazard “Rents”

Megan McArdle rightly dismisses the role of tax policy on pre-tax compensation of hedge fund managers. But just because hedge funds do not directly benefit from a state guarantee doesn’t mean that central bank policy towards the banking sector is irrelevant in determining their returns. For example, in my post analysing the possible strategy that Magnetar followed in its CDO investments, I observed that Magnetar essentially chose a trade with a positively skewed distribution. As I noted then, it is not a coincidence that Magnetar chose the other side of the trade that was preferred and executed in significant size by bank traders i.e. severely negatively skewed bets such as the super-senior tranche. As I have discussed many times, this demand for negative skewness is driven by the specific dynamics of the moral hazard problem in banking, often exacerbated by the principal-agent problems that exist even between different levels in banks. Therefore, the “alpha” that Magnetar generated would likely not have existed if it were not for the skewed incentives faced by bankers which in turn were driven by the rents they could extract from the state guarantees provided to them.

Economic Rents flow to the Strong

The example of Magnetar merely illustrates a more general principle that is often ignored: the ultimate beneficiary of any economic rent may be far removed from its initial beneficiary. The final distribution of rents is determined by many factors, most critically the competitive dynamics of the industry in question. In the context of our financial sector, the rents flow initially to the banks but are ultimately distributed between bank shareholders, employees, creditors and their clients/counterparties. The specifics of this distribution depends upon the bargaining power of each group and crucially the bargaining power of each group is uncertain and dynamic. So at the height of the economic boom when both equity and debt capital were cheap and plentiful, it is likely that a large portion of the rents was captured by employees, clients and counterparties such as Magnetar. Correspondingly, during the comparatively uncompetitive banking environment that emerged post the bankruptcy of Bear Stearns and Lehman, more of the rents could flow to the capital holders.

It is instructive to examine a couple of instances where the differing competitive dynamics result in dramatically different distributions of the rents flowing from socialized finance. The same moral hazard argument that I have made repeatedly for the banking systems in the United States and the United Kingdom applies in an even stronger fashion to the banking system in Germany which is dominated by a multitude of state-backed institutions. Yet Germany is one of the most unprofitable banking markets in the world – the ultra-competitive nature of the market means that almost all the rents flow out of the banking sector to their clients (depositors and borrowers such as the formidable Mittelstand).

Fix the System, Don’t Blame The Individuals

I have used the language of games and intentional agent adaptation above but the same outcome could easily arise simply via the various groups reacting to local incentives or even via selection mechanisms arising from principal-agent dynamics – Indeed I have argued that active deception on the part of economic agents is unlikely to be selected for. All of which which implies something that I have repeatedly emphasised on this blog: Fix the system, don’t blame the individuals.

The increased completeness of markets means that banks and hedge funds can implement almost any payoff they desire. Attempts to make markets less complete are futile and any attempts to do so can and will be subverted by economic agents. In such an environment, the system will evolve to a state  which maximises the rent extracted from “insurance commitments” by the central bank or other state agencies. To deny this is to assume that economic agents are omniscient as well as angelic. Even angelic agents who only possess knowledge of their local incentives rather than the bigger picture will act no differently from what I’ve sketched out above – An economic system that demands such omniscience on the part of its agents contradicts the very essence of a decentralised market economy.

Bookmark and Share

Written by Ashwin Parameswaran

September 23rd, 2010 at 11:48 am

Raghuram Rajan on Monetary Policy and Macroeconomic Resilience

with 16 comments

Amongst economic commentators, Raghuram Rajan has stood out recently for his consistent calls to raise interest rates from “ultra-low to the merely low”. Predictably, this suggestion has been met with outright condemnation by many economists, both of Keynesian and monetarist persuasion. Rajan’s case against ultra-low rates utilises many arguments but this post will focus on just one of these arguments that is straight out of the “resilience” playbook. In 2008, Raghu Rajan and Doug Diamond co-authored a paper, the conclusion of which Rajan summarises in his FT article: “the pattern of Fed policy over time builds expectations. The market now thinks that whenever the financial sector’s actions result in unemployment, the Fed will respond with ultra-low rates and easy liquidity. So even as the Fed has maintained credibility as an inflation fighter, it has lost credibility in fighting financial adventurism. This cannot augur well for the future.”

Much like he accused the Austrians, Paul Krugman accuses Rajan of being a “liquidationist”. This is not a coincidence – Rajan and Diamond’s thesis is quite explicit about its connections to Austrian Business Cycle Theory: “a central bank that promises to cut interest rates conditional on stress, or that is biased towards low interest rates favouring entrepreneurs, will induce banks to promise higher payouts or take more illiquid projects. This in turn can make the illiquidity crisis more severe and require a greater degree of intervention, a view reminiscent of the Austrian theory of cycles.” But as the summary hints, Rajan and Diamond’s thesis is fundamentally different from ABCT. The conventional Austrian story identifies excessive credit inflation and interest rates below the “natural” rate of interest as the driver of the boom/bust cycle but Rajan and Diamond’s thesis identifies the anticipation by economic agents of low rates and “liquidity” facilities every time there is an economic downturn as the driver of systemic fragility. The adaptation of banks and other market players to this regime makes the eventual bust all the more likely. As Rajan and Diamond note: “If the authorities are expected to reduce interest rates when liquidity is at a premium, banks will take on more short-term leverage or illiquid loans, thus bringing about the very states where intervention is needed.”

Rajan and Diamond’s thesis is limited to the impact of such policies on banks but as I noted in a previous post, market players also adapt to this implicit commitment from the central bank to follow easy money policies at the first hint of economic trouble. This thesis is essentially a story of the Greenspan-Bernanke era and the damage that the Greenspan Put has caused. It also explains the dramatically diminishing returns inherent in the Greenspan Put strategy as the stabilising policies of the central bank become entrenched in the expectations of market players and crucially banks – in each subsequent cycle, the central bank has to do more and more (lower rates, larger liquidity facilities) to achieve less and less.

Bookmark and Share

Written by Ashwin Parameswaran

August 3rd, 2010 at 6:30 am