Wednesday, October 31, 2012

Misunderstanding the Financial Crises

I forget where I found this link, I think it was on an MMT blog and it was supportive towards the article. Having good MMT info on the Financial Times would be great, and I had not heard of Gary Gorton, so I was interested in reading what it said. Unfortunately, I don't agree with Gary.

The specifics. Gary has some interesting points about the role collateral plays in repo and other overnight interbank lending markets. Essentially, Gary says, these are not credit decisions most of the time. I agree. I would go farther and say these should never be credit decisions because when the credit of the institution comes under question, it generates a negative feedback expectations loop and the bank finds itself cut off from the rest of the financial system, and needs to go to the Fed (with the stigma attached to that). More robust, then, to have everyone always go to the Fed directly. The Government is the best source of "secret-less and information-insensitive collateral" to use Gary's phrase.

He adds a second good point:
As I mentioned above, the private sector cannot create riskless collateral. This is because the backing assets are longer-term than the bank money; the backing assets are claims on real output. An inherent feature of a market economy is that private money is useful over shorter time intervals than the backing collateral. This “maturity transformation” is not a choice, but inherent in the economy.
Also interesting. This is the first time I've heard this argument to support maturity transformation as an inherent element in the economy. But then he seems to contradict himself:
Privately-produced safe debt can be created without being vulnerable to bank runs with the right regulation. It would be better for the government to oversee the creation of privately-produced safe debt than to try to create enough government debt to meet the demand.
 Why? It's easy for the US to create enough government debt to meet demand by simply taxing less. Having the Government work with the private sector to create safe debt through implicitly backing private actors seems needlessly complicated and more open to corruption. It gets worse.
Yes, there are limits to a government’s ability to create safe debt. We have seen this recently in Europe where the debt of some governments has become information-sensitive – it is no longer viewed as safe.
Individual Euro nations are closer to currency users than issuers, and therefore are more similar to private actors than monetary sovereigns. So, "Governments" are not the same, and a currency sovereign that maintains its ability to tax also has no limit to its ability to create safe debt -- aside from inflation risk if it exceeds the private sector's demand. But, the misunderstanding's continue:
This history has been lost because financial crises are misunderstood. Crises are now attributed to government actions rather than to the inherent features of bank money. The government tries to prevent bank runs, but then—when the bank run is not observed—the government is blamed for the crisis. The run on repo was not observed by regulators, academics, journalists, or the public. So instead of the Livingston and Blaisdell logic of saving the banking system and providing mortgage relief, there have been proposals to efficiently liquidate banks during crises. Realistically, this would mean liquidating the banking system.
I don't believe this is true. Depositors could be protected while actual bank investors (equity and bond) could be wiped out. So long as the Fed continues to provide liquidity, a bank in any degree of capital insolvency can continue to operate, regardless of how that capital insolvency impacts the bank's investors.
It seems like mandating more prudential lending standards would help — if not prevent future bank runs, then make them less frequent or less severe.
I don’t think that will help. It is an inherent feature of private economies that they cannot create riskless debt. What is the proposed lending standard, that banks are only allowed to make riskless loans?
How about keeping banks on the hook for the credit quality of the loans they make, by requiring them to keep all loans on their books?

And finally, a non-solution to a non-problem:
These new banks would essentially create private safe assets and short-term bank debt subject to regulatory oversight. Essentially, these banks would hold asset-backed securities and finance their portfolios with short-term debt, repo. We want to avoid another run so we want to address the problem head-on. Furthermore, we recognize that this new banking system—shadow banking– is real banking. The economy needs this banking system. Prior to the crisis the issuance of non-mortgage asset-backed securities was larger than the issuance of U.S. corporate bonds.
I don't think we need narrow banking, I think we need unlimited FDIC coverage. I also think we need to question whether we need that Gary calls "real banking". Prior to 1970s, there was no housing shortage in the US. Mortgage backed securities appeared in 1970. Why real benefit did this generate?

Monday, October 22, 2012

Analogy by Reason

SRW, whom I am fond of, has a long piece here about how there should be small, frequent financial failures so we can avoid large, systemic financial failures. The reasons for this are 1) we cannot beleive the law, since it is inevitably suspended when things go pear-shaped and 2) this is how forest fires are best managed.

On board with 1. But I don't think arboreal analogies are the best way to think about robust regulation.

One needs to look more carefully at the function of a bank, and see that they are at the intersection of two distinct activities. Muddling the actors in these two activites, and ignoring the correct role of Government, leaves you in a horrible pickle where you curse FDIC insurance and argue that Grannie should pay for Blankfein's sins. I exaggerate, but not by that much.

The two activities are 1) payment clearance and 2) credit decisions.

When I write a check to you, I want that check to clear if I have money in the account. My depositing money in a bank is not an investment decision where I am, or should, consider the credit worthiness of the institution. If I were buying stocks or commercial paper it's a different story, but depositors are fundamentally not bank creditors (even though the deposits themselves are held as liabilities) and should not bear the burden that falls on investment. Aside from this being true, it is also good policy. If we can separate picking stocks from being able to use a safe, reliable payment clearance system, we should, just as we should separate drinking water from sewage. This is half-done by FDIC insurance today, which insulates depositors, but not infinitely. Depositors should get unlimited coverage.

A bank makes a credit decision when it decides to make a loan. It does not use depositor's deposits to make that loan, it just prints the money by expanding both sides of its balance sheet, leveraging the capital cushion of its equity. If the loan goes well, it enriches those capital holders. If the loan goes badly, it should punish those capital holders. When capital holders decide to invest in a credit making institution, they are explicitly making a judgement call on the ability of that institution to make good credit decisions. These folks should be in first loss positions when a bank needs to write down its portfolio.

Monday, October 08, 2012

Deficits and Growth

An outstanding question I've been thinking about is whether ever larger deficits are a requirements for economic growth. On the one hand, you can certainly have larger deficits without growth. On the other hand, as an economy increases its real assets, does it demand a larger quantity of net financial assets (equity), and if that demand is not met, does the economy begin to contract and save in the form of unemployment and unwanted inventory stockpiles? As there is only one source of NFA(e), it would follow that if the last statement is true, then we need ever larger deficits.

A different approach to this question via Sankowski:
...should an economy ever reach stationary equilibrium, all stock variables as well as all flow variables would be constant; and that if all stock variables, including government debt, were constant, government receipts would have to equal government payments. It would then follow that if the economy were moving toward stock-flow equilibrium and if taxes were levied as a proportion of income, the GDP of a (closed) economy would always be tracking, perhaps with a long lag, government outlays divided by the average tax rate – the very same concept that we call fiscal stance. Therefore, a necessary condition for the expansion of the economy, at least in the long term, is that the fiscal stance should rise: Government expenditure must rise relative to the average tax rate. If the tax rate were held constant, government expenditure would have to rise absolutely for output to grow; if government expenditure were held constant, the tax rate would have to fall.
Some important notes. First, it is obvious that real wealth can increase with no deficits at all, and this note does not seem to make a hard real/nominal distinction. The question is, in a fiat economy where there is demand for NFA(e), if that happens. Second, the model above has taxes (NFA drains) as a % of income -- for obvious reasons -- but NFA drains can be levied in other ways that make the particular dynamic this argument relies on moot.  Third, the model assumes demand for NFA(e) is constant, which begs the question I raised initially.

Still, interesting, and interesting to see a critique of Steve Keen outside the standard one of not including vertical money at all.

Monday, October 01, 2012

Why Angel Investors don't make money

A very nice (and kind) article on why Angel's don't make money.
I make those few angel investments because I want to help my best students achieve their goals, and because I like being involved in startups. That’s the ultimate lesson from the fish stories in Silicon Valley. True fishermen cast their lines not because they want the fish, but because they like fishing. It’s fine to be an angel investor – just don’t do it for the money.
Also, a nice perspective on our current bubble:
The premier venture capital firms know the best investments have high technical risk and low market risk. Market risk causes companies to fail. In other words, you want companies that are highly likely to succeed if they can really deliver what they say they will. Unfortunately, consumer Internet companies don’t follow that pattern. They usually have low technical risk and high market risk. There is very little chance they can’t deliver their product. The big issue is whether the startup’s product is of value to a large enough audience. Most people see angels as taking market share from venture capitalists. I think that is the wrong perspective: The premier venture capital firms have consciously outsourced consumer Internet companies’ bad market risk onto the angels, maintaining their returns as a result.
I think this ascribes a little more concious agency to VCs than is true. What VC would not want to have a piece of the next Twitter, Facebook, or Pinterest? Certainly we've seen lots of funding pour into hot consumer segments. Nevertheless, I can see VCs wanting to avoid high market-uncertainty sectors and I can see Angel's step in where they fear to tread.