Archive for May 2017


The problem with deposit insurance

I’ve always thought that the 2008 financial crisis was basically tight money plus moral hazard, with the latter factor playing the biggest role.  I’m no expert on banking, but I’d guess that these three factors increased moral hazard (in order of importance):

1.  FDIC (deposit insurance)

2.  The GSEs (Fannie and Freddie)

3.  Too Big to Fail

I’ve already spent a lot of time discussing the role of tight money, but I also believe that deposit insurance is a massively underrated problem.

A new NBER working paper by Charles W. Calomiris and Matthew S. Jaremski relied on rich set of panel data for banks in states with and without deposit insurance. They found that states that created deposit insurance during the early 1900s tended to see faster than normal rates of deposit growth, and then higher than average levels of bank failures after WWI:

First, we are able to show that deposit insurance increased insured banks’ deposits and loans, and lowered their cash to asset ratios and capital to asset ratios. Second, we find that deposits flowed from relatively stable banks to risky banks. Deposit insurance increased risk by removing the market discipline in the deposit market that had been constraining erstwhile uninsured banks.  .  .  .  Deposit insurance encouraged banks to increase their insolvency risk because doing so did not prevent them from competing aggressively for the deposits of uninsured banks operating nearby. In fact, increasing risk was necessary to fund the higher interest payments that presumably attracted depositors.

The extent to which insured banks attracted deposits away from uninsured banks, and used those funds to expand their lending, depended on the risk opportunities available in their local economic environment. Variation across in counties in the extent to which they produced commodities that appreciated during the World War I agricultural price boom explains between one-third and two-thirds of the observed effects of deposit insurance on deposit growth, loan growth and increased risk taking by insured banks. The fact that a large part of the moral hazard associated with deposit insurance is dependent on the time-varying and location-specific opportunities for risk taking has important implications for empirical analysis of the consequences of deposit insurance in other contexts. The potential costs of deposit insurance may appear low in environments that are relatively lacking in risk-taking opportunities, but those costs can appear much higher when greater risk taking opportunities present themselves.  (Emphasis added)

That’s final sentence is a warning not to become complacent.  Just because deposit insurance didn’t cause many problems in the decades after WWII (when borrowers were bailed out by higher than expected inflation), doesn’t mean that it could not do so in the 1980s or 2000s.

They also show that voluntary insurance systems were less destabilizing than mandatory insurance systems, presumably because they created less moral hazard.

Their paper ends with a warning:

The history of deposit insurance in the United States and internationally has been a process of increasing systemic risk in the name of reducing systemic risk. 

Thomas Raffinot on interest rate free monetary policy

I’ve always felt that the fundamental problem with conventional monetary policy is an excessive use of interest rates, as both an instrument and indicator of monetary policy.  The Mercatus Center has just published a new working paper by Thomas Raffinot entitled:

Interest-Rates-Free Monetary Policy Rule

which is music to my ears.  Here is the basic idea:

This paper’s objective is to elaborate a monetary policy rule assessing the stance of monetary policy without any reference to any interest rate. This rule should thus be able to measure the stance of monetary policy in conventional and unconventional environments without any distinction. To that end, this study develops a new monetary indicator based on the forward-looking generalization of the Taylor rule introduced by Koenig (2012).

Raffinot uses surveys of professional forecasters to derive his estimates of inflation and growth expectations.  Ideally we like to go one step further, and use market expectations.  He also constructs estimates of the stance of monetary policy “in retrospect”, that is, looking at how the actual inflation and growth played out over the next few years.  Interestingly, this is often quite different from the estimates using real time data.

Here are his estimates for the stance of monetary policy in the US, both using real time forecasts and actual ex post data:

A figure above zero represents an excessively expansionary monetary policy stance, and vice versa.  You can see that money became way too tight in 2008, using either approach.

I should note that the Lars Christensen newsletter that I discussed in my previous post provides these sorts of graphs from many key economies.  Of course his formula is not exactly the same.

Lars Christensen’s new market monetarist newsletter

Lars Christensen has a new newsletter called the Global Monetary Conditions Monitor, which I highly recommend for people interested in international monetary policy.  It is by subscription at this link, but Lars is allowing me to quote from the newsletter.  (There is a discount for academic users and think tanks.)

Lars has constructed a monetary conditions index for a wide range of currencies. This basically measures whether the current stance of monetary policy is too easy or too tight to hit the target.  (A value of zero means right on target.)

On pages 8 and 9 of the May issue there is a discussion of policy credibility:

The approach here is to evaluate a central bank’s credibility based on our monetary conditions indicators.

We consider a central bank to be credible if it succeeds over time in keeping the monetary indicator close to zero. This can be measured by how long each central bank keeps the indicator within a range between -0.25 and 0.25 over a rolling five year period. This also means a central bank’s credibility can and will change over time.

By this criterion, the central bank of New Zealand has the highest credibility:

This can be illustrated by looking at developments in New Zealand over the past five years.

If monetary policy is (highly) credible, we would expect monetary conditions to be ‘mean-reverting’ – meaning that if the monetary conditions indicator is above (below) zero, we should expect it to decline (increase) in the subsequent period.

This is precisely the case for New Zealand. The graph below shows monetary conditions in New Zealand six months ago and how they changed over the following six months.

The line should go through zero, with most of the points being in the upper left and lower right quadrants.  To give you a sense of what a lack of credibility looks like—consider Turkey, one of the least credible central banks:

Maybe Lars will eventually incorporate the Hypermind NGDP forecast into his analysis.

One by one, the anti-EMH arguments collapse

When I started blogging in early 2009, the anti-EMH forces were riding high.  The previous decade had seen tech and housing “bubbles”, there were studies showing that hedge founds and elite college endowments outperformed the broader markets, there was the absurdly high price of Bitcoins, and there were academic studies finding market “anomalies”.  In the eight years since, all of these arguments have either mostly or entirely collapsed.

1. Remember those people who told you not to buy Bitcoin at $30 because it was a wildly inflated bubble?  They stopped you from becoming filthy rich, as it’s now at over $2400.  Yes, it could collapse by 90%, but it would still be 8 times higher than when anti-EMH pundits were calling it a bubble.  Alternatively, if 98% of Bitcoin-type investments fell in value to zero, it would still be a good idea to invest in all of them as long as one in 50 went from $30 to $2400.  Yes, the anti-EMH argument is that weak—even if they were right 98% of the time on bubbles bursting, they’d be wrong in their broader argument that markets are not efficient.

2.  Hedge funds have done poorly since I started blogging (Buffett won his bet that they would not continue outperforming the S&P500.)  College endowments haven’t even been able to beat index funds.

3.  House prices are back up to the peak, and NASDAQ is almost 24% above the 2000 peak.  In fairness, in both cases the real price remains below peak levels.  But there is no longer a serious argument that these markets were “obviously” ridiculously overvalued, especially given that so many other foreign housing markets are now far above 2006 levels. Back in 2002, when NASDAQ was at roughly 1100, people were claiming that 5000, and even 4000, had been an absurdly overvalued level.  Now it’s over 6200.  And yet most of these pundits seemed to have no problem with a NASDAQ of 1120 in October 2002.  Don’t let anti-EMH people tell you how to invest.

4.  Alex Tabarrok linked to a recent academic study by Kewei Hou, Chen Xue and Lu Zhang, which looked at a large number of market “anomaly” studies, and found that the results were heavily influenced by data mining (aka p-hacking):

The anomalies literature is infested with widespread p-hacking. We replicate the entire anomalies literature in finance and accounting by compiling a largest-to-date data library that contains 447 anomaly variables. With microcaps alleviated via New York Stock Exchange breakpoints and value-weighted returns, 286 anomalies (64%) including 95 out of 102 liquidity variables (93%) are insignificant at the conventional 5% level. Imposing the cutoff t-value of three raises the number of insignificance to 380 (85%). Even for the 161 significant anomalies, their magnitudes are often much lower than originally reported. Out of the 161, the q-factor model leaves 115 alphas insignificant (150 with t < 3). In all, capital markets are more efficient than previously recognized.

In retrospect, 2009 was “peak anti-EMH”, and it’s been all downhill from there.

PS.  Just when you think the GOP and its fake news co-conspirators can’t get any further down into the gutter, they hit a new low.  Remember the saying; “The fish rots from the head down”?  A pro-Trump Republican assaulted a reporter in Montana, while running for Congress.  There was a Fox News reporter standing three feet away.  But during the next few hours, Fox News reported the candidate’s pathetic lie (notice how these bullies don’t even have the courage to stand up for their beliefs?), but failed to report its own reporter’s eyewitness account–which contradicted the candidate.  Perhaps Fox is spending too much time trying to find the real killer of Seth Rich.

And of course GOP politicians just run and hide when asked to comment.

Update:  The editors of Bloomberg want the Bank of Canada to stop trying to stabilize the economy and shift over to trying to control asset prices:

Canada Must Deflate Its Housing Bubble

A major donation to boost the Hypermind NGDP market

I am very pleased to announce that Kenneth and Jennifer Duda have agreed to donate $50,000 to the Mercatus Center to help support the Hypermind NGDP prediction market project.  Ken Duda is the CTO of Arista Networks, a major Silicon Valley tech company.  Back in 2014, the Dudas supported the original NGDP prediction market, and more importantly were very generous donors to the Mercatus Center, which allowed for the creation of the Program on Monetary Policy. This is the program that supports the work that David Beckworth and I are engaged in.

As far as I know, Ken and Jennifer are the world’s leading philanthropists in promoting research on monetary policy reform–an area where technical improvements could be worth trillions of dollars (just watch how global stocks react to bad monetary policy decisions), as well as millions of jobs.

The earlier post initially left out some necessary information as to where to donate–apologies for that.  We have added options such as Bitcoin and PayPal, which were requested in the comment section.

I am very excited about this market.  The Dudas’ donation will eventually result in a big jump in the prize level, which should motivate more trading.  (If not, the few people who do trade will be very lucky.)  I anticipate more donations are coming in as well—I’ll keep you posted.  I’ll provide more specifics on prize money when the donation process is completed.

Relatively soon, there should be lots more $100 bills lying on Hypermind’s sidewalk. I don’t think I need to tell you guys what to do.  Pick them up!

PS.  I have a new Econlog post that responds to questions raised in the comment section of the previous request for donations post.