Archive for the Category Financial system

 
 

Black swans

The Financial Times has a debate over recent Congressional attempts to loosen bank regulation.  Hal Scott supports looser regulation:

The Fed’s stress tests are effectively the binding constraint on bank capital and thus lending. They require banks to prove they could survive extreme adverse scenarios while still complying with global capital requirements. The process has two major deficiencies.

First, the Fed’s adverse scenarios are extreme to the point of incredulity. For example, the latest stress test assumes an increase of the unemployment rate from 4.1 to 10 per cent over seven quarters. That has not happened in the 70 years since today’s measure for unemployment was adopted. There is no open consultation with experts, industry or the general public as to whether these scenarios make sense.

Do we really want banks to hold enough capital to survive events that have no US historical precedent? If such an extreme economic event did occur, would any amount of capital be enough to withstand the panic it could trigger?

We absolutely do want to have banks be able to survive a recession that pushes unemployment up to 10%.  The unemployment rate hit 10% in 1982 and again in 2009 (albeit from a higher base than today.)  In the early 1930s, it rose from 3% to 25%.  After what happened in 2008, how can anyone seriously claim that we don’t want our banking system to be able to survive a recession that leads to 10% unemployment?  That makes no sense.

I don’t know enough about bank regulation to have an informed opinion on stress tests, but this argument actually makes me more likely to support the other side. I didn’t even have to read the arguments made by Lisa Donner, in opposition to loosening regulations.

Ideally we’d have a laissez faire banking regime.  But until we get rid of the GSEs, FDIC and TBTF, we probably need some sort of capital requirements and/or stress tests.  Since neither party favors removing moral hazard from banking, we are unfortunately stuck with regulation.

Off Topic:  The clown show continues:

Gary D. Cohn, the director of the National Economic Council, had been lobbying for months alongside others, including Defense Secretary James Mattis and Rob Porter, the staff secretary who recently resigned under pressure from the White House, to kill, postpone, or at least narrow the scope of the measures, people familiar with the discussions said.

But in recent weeks, a group of White House advisers who advocate a tougher posture on trade has been in ascendance, including Robert Lighthizer, the country’s top trade negotiator, and Peter Navarro, a trade skeptic who had been sidelined but is now in line for a promotion.

The departure of Mr. Porter, who organized weekly trade meetings and coordinated the trade advisers, and the breakdown of the typical trade advisory process has helped create a chaotic situation in which those opposing factions are no longer kept in check. The situation had descended into utter chaos and an all-out war between various trade factions, people close to the White House said.

Trump just stabbed US manufacturers in the back.

The only real solution to Too Big To Fail

In a recent post I suggested that higher capital requirements might be called for if policymakers were unwilling to bite the bullet and remove moral hazard from our financial system.

The FT has a new article discussing a Treasury proposal to end Too Big To Fail, by setting up a new type of bankruptcy for big banks.  I wish them well, but remain skeptical.  In my view, the only way we’ll ever be able to remove moral hazard is with monetary policy reform.  If we can get to a policy of NGDPLT, then policymakers will no longer have to worry about the consequences of the failure of a big bank.  Unfortunately, that’s likely to take many decades, as we first need to implement the policy, and then see how it does during a period of financial distress.  Only then would policymakers begin to feel comfortable rolling back TBTF.  (And even then, special interest groups will try to keep it in place.)

PS.  The NYT has a new post showing that historians view Trump as being the worst President in American history.  That’s also my view.  Some people judge presidential performance by how the country is doing.  That’s about like judging my blogging based on how monetary policy is doing.  A couple posts I’d recommend are Yuval Levin explaining why Trump is not actually the President, in the conventional sense of the term.  He’s not qualified to be President, so day-to-day decisions are made by others.  Thus the GOP “deep state” wisely vetoed his recent attempt at crony capitalism, which would have re-regulated the coal and nuclear industry as a backdoor way of bailing them out.  The outcome was good, but Trump’s specific input into the process was destructive.  Matt Yglesias also has a good post, explaining why Trump is much more corrupt that even lots of left-of-center reporters assume.

PPS.  I have a new post on budget and trade deficits, over at Econlog.

A very depressing interview

David Beckworth has an excellent interview with The President and VP of the Minneapolis Fed.  I did a post on the portion of the podcast that interviewed Neel Kashkari, over at Econlog.  Here I’ll address the part where David interviewed VP Ron Feldman, mostly on banking regulation.  I’ve always thought that eliminating moral hazard is the only way out of this mess.  Feldman says that’s politically impossible:

I think you just need to look at what happened with Fannie Mae and Freddie Mac. This was in a prior regime. People used to talk about what’s called subordinated debt, but it’s the same idea, that they would be forced to issue debt that would be very junior, so it would get converted, and there would be no problem.

Now, flash forward. You’re in a crisis, and what people are worried about is, am I going to lose my money? You’re in the middle of a crisis, and you’re telling me that the solution to making people feel comfortable, not freaking everybody out, is that you’re going to impose more losses on more people. It just seems implausible.

The only active creditor in the US where we have a record that we do impose losses on them is equity holders. We do treat equity holders differently from fixed income holders, depositors, or bond holders. I think CoCos and bail-in debt, it’s very elegant. If it worked, I think that would be great. But we have a record of it here.

I should just add, in Italy and other places, they’re using the same idea. Last year, they were confronted with this issue: what are they going to do about the bail-in debt of the Italian banks that are in trouble? They said, “We want a special exception. We’re going to need to protect those folks.”

I think that’s the history. We talked about, is the five-year delay credible? The thing that’s not credible is that in a crisis, a government is going to want to impose more losses on debt holders.

Just to be clear, I don’t think it would be a problem doing this in a technical sense.  Crisis or no crisis, there’s no reason why bonds can’t be converted to equity when a bank gets into trouble.  But I suspect he is right about the politics, at least in highly corrupt countries like Italy and the US.  (Perhaps it would work in the Nordic countries, or Canada.)

I find this to be profoundly depressing, and pushes me toward reluctantly supporting tighter bank regulation, especially higher capital requirements.  The Minneapolis Fed has developed a plan that calls for a 23.5% capital requirement for large banks:

We would require banks to fund themselves with equity that would be equal to 23.5 percent of their risk-weighted assets. Risk-weighted assets means there’s a bigger weight that’s put on something, an asset that’s risky, and a lower weight that’s put on something that’s safe, like a Treasury bill.

I actually think the main problem is reckless smaller banks.  That’s where our tax dollars go.  I’m much less worried about the bigger banks, where moral hazard is less of a problem.  Unfortunately, it seems like higher capital requirements are just as politically infeasible as reducing moral hazard through convertible bonds:

The capital ratio rose from 10.5% before the crisis to 12.7% after, but has since slipped back below 12%.  A 23.5% ratio sounds great, but only if applied to all banks, not just large banks.  Unfortunately there’s probably almost zero political support for doing some something like this.

As with healthcare reform, as with zoning reform, as with FAA privatization, as with a hundred other issues, there’s simply no interest in banking reform.  In either party.

 

Unsustainable?

I suppose I ought to say something about recent stock market turmoil, even though I don’t have any great insights.  (I recommend John Cochrane’s recent post.)

I generally divide shocks up into two types.  There are negative demand shocks, like 1929 and 2008.  Then there are real shocks, when the market crashes without any big drop in NGDP growth expectations.  That might have been the case in 1987 and 2000, although I’m not certain.

As far as I can tell, the recent market decline seems more like a real shock.  I don’t see any sign of slower NGDP growth expectations.  The Hypermind market is almost unchanged, and there’s not much change in nominal bond yields or TIPS spreads.  If anything, bond yields have risen, which is not reflective of declining NGDP growth expectations.

So if it’s a real shock, then what caused it?  Keep in mind that thus far the decline has been modest, less than 10%.  And that follows a huge stock price run-up.  So don’t look for a huge real shock, merely something that means investors are still quite optimistic, just a bit less optimistic than a week ago.  It’s all about levels.

One possible culprit is an increasing sense that things are “unsustainable”.  Here are a couple areas where that perception may be building:

1.  Perhaps RGDP growth is unsustainable.  Unemployment has fallen to 4.1%, the working age population is growing very slowly, immigration reform seems unlikely, and nominal wage growth is accelerating.  The recent 2.9% wage growth number seemed to hit stocks.

2. Perhaps fiscal policy is unsustainable.  The GOP passed a big tax cut (which will end up costing much more than estimated.)  After you do that, you are supposed to tighten up on spending if you are the small government party.  Instead they basically took off all the restraints on spending.  The deficit is about to get much worse.  And when the next recession hits?  Don’t even think about it.

[Remember when Blair and Brown enacted a big fiscal stimulus at a time when the UK was booming in the early 2000s?  And then there was no money for fiscal stimulus when the Great Recession hit.  That’s basically the current GOP.]

I don’t have a lot of confidence that fear of unsustainable trends is what caused the recent market setback, but I can’t see any other plausible culprits.  Have I missed anything?

The crybabies who blamed economists for not predicting the financial crisis

Back in 2008, it seems like everyone from the Queen of England on down was blaming economists for not predicting the financial crisis.  I seem to recall that Bob Lucas pointed out that economic theory explains why economists cannot predict financial crises, so our failure to do so was a feather in the cap of modern economic theory.  I also seem to recall that lots of people rolled their eyes at his seemingly too clever excuse.

In the past I’ve argued that Lucas was exactly right, but in this post I’ll assume he was wrong.  I’ll assume the EMH is wrong.  Even in that case I’m going to argue the complaints were silly, just a bunch of crybabies.

So how do I respond to those people who are moaning that we didn’t warn them that a crisis was coming?  One answer is that some economists, such as Nouriel Roubini, did issue warnings.  But then the crybabies might respond, “But most economists didn’t warn us.  How were we to know that he was the one to listen to? The economics profession as a whole should have issued a warning, so that it was unambiguously clear to the public that a financial crisis was coming.”

To summarize, a few economists did warn the public, so the crybabies’ lament only makes sense if you assume that these people wanted the profession as a whole to offer a clear credible warning to the public.  Something that would be believed.

Were you the sort of person who believed in Santa Claus, and thought he would bring you a fairytale castle floating on a cloud, with unicorns prancing about in front?  If not, why would you make such a patently unrealistic demand of the economics profession?

You wanted us to warn you that a big financial crisis was coming so that you could sell all your stocks before they went down?  I ask this because a prediction of a severe financial crisis is implicitly also a prediction of a massive asset price collapse.  So the people complaining that economists didn’t predict the financial crisis are (whether they know this or not) effectively complaining that economists didn’t warn them that their 401k plan was about to lose a few hundred thousand dollars.

Let’s suppose we have a time machine and economists from October 2008 can go back 6 months in time, to April 2008.  They are told to warn the public that a massive financial crisis is coming in the fall.  They warn the public that Lehman won’t be bailed out, and its failure will trigger a rush for liquidity and a Great Recession.  What exactly would that warning have done, other than move those events up 6 months in time?  Then the crybabies would have asked why we didn’t warn them in October 2007 (assuming they didn’t lynch the economists for causing the crash.)

And as for those stocks you were going to sell if economists had warned you of the crash—just who did you plan to sell them to?  And at what price?

A better argument is that the economics profession didn’t warn the public that public policy was creating excessive lending, as Fannie and Freddie and FDIC and TBTF were creating moral hazard.  In fact, I did warn people I met about this problem (but I completely failed to forecast the financial crisis.)  Some other economists also warned about moral hazard, but not all.  But no one wants to listen to a bunch of killjoy economists on public policy questions.  It would be like blaming economists for tariffs, or rent controls.

When I explain to non-economist commenters what economic theory tells us about some public policy, they almost universally blow off my advice, unless it coincides with their pre-existing view on that particular public policy.  No one cares what economists think, so don’t blame us for areas where we have no control.  (Monetary policy is a different case; there the economics profession actually deserves far more blame than it’s gotten from the public.)

PS.  I see that Trump threw a temper tantrum when his aides told him that Iran had been adhering to the nuclear agreement.  We now have an administration with no ability to negotiate because no one trusts them to keep their word.  The focus of his top aides is not dealing with foreign crises but rather managing unnecessary crises created by an out of control and mentally ill president.  North Korea knows we’ll renege on any agreement we sign with them, and so a nuclear deterrent is their only option.  Meanwhile they show their population images of Trump threatening to destroy their country.

Meanwhile Trump has abandoned the utilitarian approach of the Obama administration and the slaughter of innocent civilians has been skyrocketing:

Airwars reports that under Obama’s leadership, the fight against ISIS led to approximately 2,300 to 3,400 civilian deaths. Through the first seven months of the Trump administration, they estimate that coalition air strikes have killed between 2,800 and 4,500 civilians.

Trump seems like excellent black comedy to me, but unfortunately there are lots of dead women and children for whom he is no joke.

PPS:  New Flash:  Americans horrified to discover Hollywood producer behaving like a President of the United States.  Hillary and Fox News particularly disgusted by this behavior.

PPPS:  Another gem:

Speaking over the phone, Mr Reich said he asked his friend whether other Republican senators were preparing to follow Senator Bob Corker and “call it quits with Trump”.

His source told him: “Others are thinking about doing what Bob did. Sounding the alarm. They think Trump’s nuts. Unfit. Dangerous.” . . .

“Tillerson would leave tomorrow if he wasn’t so worried Trump would go nuclear, literally,” he added.

“Who knows what’s in his head? But I can tell you this. He’s not listening to anyone. Not a soul.

“He’s got the nuclear codes and, well, it scares the hell out of me. It’s starting to scare all of them. That’s really why Bob spoke up.”

Trump ran for President as a crazy man, and we are shocked to discover he is governing as a crazy man?