Archive for the Category Financial system


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. 

As expected, Ben is with Lars

Here’s Ben Bernanke on the idea of using monetary policy to address financial imbalances:

Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.

For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy.

One of the “unintended side effects” of the Fed’s 1928-29 attempt to pop the stock market bubble was the Great Contraction of 1929-33.  Another was Hitler taking power in Germany.  And another was WWII.  So if anything, Bernanke is being too polite to those who favor using monetary policy to prevent financial imbalances.

Now of course they’d insist that they also favored macroeconomic stabilization, and merely wish to use monetary policy at the margin.  But even those more reasonable proposals are highly questionable.  Bernanke cites one study (links further down) that does find that monetary policy might play a role, but not a very large one:

Although, in principle, the authors’ framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount (a basis point is one-hundredth of a percentage point). They show that a larger response would not meet the cost-benefit test in their estimated model. The intuition is that, based on historical relationships, higher rates do not much reduce the already low probability of a financial crisis in the future, but they have considerable costs in terms of higher unemployment and dangerously low inflation in the near- to intermediate terms.

And even this is doubtful, as it depends on the very dubious assumption that low interest rates imply easier money:

A new paper by Andrea Ajello, Thomas Laubach, David López-Salido, and Taisuke Nakata, recently presented at a conference at the San Francisco Fed, is among the first to evaluate this policy tradeoff quantitatively. The paper makes use of a model of the economy similar to those regularly employed for policy analysis at the Fed. In this model, monetary policy not only influences near-term job creation and inflation, but it also affects the probability of a future, job-destroying financial crisis. (Specifically, in the model, low interest rates are assumed to stimulate rapid credit growth, which makes a crisis more likely.)

Indeed a tighter monetary policy during the famous housing bubble of 2005-06 would have probably been associated with lower interest rates, not higher.  Thus in a counterfactual where in 2001-03 the Fed had cut rates to 3%, not 1%, the level of interest rates in the 2005-06 bubble would have had to be lower than the actual path of rates, as the economy would have been in depression.

What most caught my attention is that Bernanke comes down strongly in support of his former colleague Lars Svensson, who quit the Riksbank in disgust over its tightening of monetary policy around 2010-11:

Lars Svensson, who discussed the paper at the conference, explained, based on his own experience, why cost-benefit analysis of monetary policy decisions is important. Lars (who was also my colleague for a time at Princeton) served as a deputy governor of the Swedish central bank, the Sveriges Riksbank. In that role, Lars dissented against the Riksbank’s decisions to raise its policy rate in 2010 and 2011, from 25 basis points ultimately to 2 percent, even though inflation was forecast to remain below the Riksbank’s target and unemployment was forecast to remain well above the bank’s estimate of its long-run sustainable rate. Supporters justified the interest-rate increases as a response to financial stability concerns, particularly increased household borrowing and rising house prices. Lars argued at the time that the likely benefits of such actions were far less than the costs. (More recently, using estimates of the effects of monetary policy on the economy published by the Riksbank itself, he showed that the expected benefits of the increases were less than 1 percent of the expected costs). But Lars found little support for his position at the Riksbank and ultimately resigned. In the event, however, the rate increases were followed by declines in inflation and growth in Sweden, as well as continued high unemployment, which forced the Riksbank to bring rates back down. Recently, deflationary pressures have led the Swedish central bank to cut its policy rate to minus 0.25 percent and to begin purchasing small amounts of securities (quantitative easing). Ironically, the policies of the Swedish central bank did not even achieve the goal of reducing real household debt burdens.

When someone leaves an important policy position, where a person is not really free to speak their mind, to blogging, which is all about speaking one’s mind, you quickly learn a great deal about their views on controversial issues. Anyone want to wager with me on what Bernanke and Svensson think of the ECB’s decision to twice raise rates in 2011?

I was only disappointed by one aspect of the post—Bernanke continues to (implicitly) use a conventional measure for the stance of monetary policy.

Despite the substantial improvement in the economy, the Fed’s easy-money policies have been controversial. Initially, detractors focused on the supposed inflation risks of such policies. As time has passed with no sign of inflation, that critique now looks rather threadbare. More recently, opposition to accommodative monetary policy has mostly coalesced around the argument that persistently low nominal interest rates create risks to financial stability, for example, by promoting bubbles in asset prices or stimulating excessive credit creation.  (emphasis added)

In 2003, Bernanke correctly pointed out that conventional measures such as interest rates are highly flawed:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

.  .  .

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.

Of course by that criterion (averaging inflation and NGDP growth), money was tighter in 2008-2013 than in any 5 year period since Herbert Hoover was president.

The Fed wants banks to be able to survive epic Fed incompetence

A commenter named Steve sent me this puzzling article on stress tests:

The Federal Reserve plans to stress test six large U.S. banks against a hypothetical market shock, including a deterioration of the European debt crisis, as part of an annual review of bank health.

The Fed said it will publish next year the results of the tests for six banks that have large trading operations: Bank of America (BAC.N), Citigroup (C.N), Goldman Sachs (GS.N), JPMorgan Chase (JPM.N), Morgan Stanley (MS.N) and Wells Fargo (WFC.N).

“They are clearly worried about the issue of Europe,” said Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial. “In a time of risk aversion and concern, you need transparency.”

The Fed said its global market shock test for those banks will be generally based on price and rate movements that occurred in the second half of 2008, and also on “potential sharp market price movements in European sovereign and financial sectors.”

In the Fed’s hypothetical stress scenario, unemployment would spike as high as 13 percent while U.S. gross domestic product would fall by as much as 8 percent.

I’d rather the Fed stress test their own policies.  Can they keep US NGDP rising at a 5% rate as Europe goes to pieces?  If not, what sort of policy regime might be able to do that?

An intriguing new idea to address moral hazard

The recent crisis exposed a fundamental flaw with our banking system (actually it’s been there since 1934, but this was the worst manifestation of the problem.)  Because of various government backstops (FDIC, F&F, TBTF, etc) our financial system takes excessive risks.

Tim Congdon has an intriguing proposal to address this problem.  His plan would not eliminate moral hazard, but it just might reduce it:

Suppose that banks are short of capital because of bad asset selection and heavy losses, and that there is a risk of deposits not being covered by banks’ remaining assets-the situation allegedly facing Britain’s banks and economy in late 2008. Surely everyone ought to agree that, ideally, the job of replenishing banks’ capital should fall on the private sector, not the state, and that as far as possible accountability must lie in only one place. How might that be achieved?

I propose a structure which is almost the polar opposite of Buiter’s. In a 2009 monograph, Central Banking in a Free Society, I argued that the capital of the Bank of England should be provided by the leading banks, and that the functions of the central bank and deposit insurance agency should be amalgamated. Whereas Buiter wants, in effect, to nationalise the arrangements (and the costs) of cleaning up a banking system fiasco, I would privatise them.

My proposal is much less radical than it may seem. Recall that at present the banking industry as a whole can in fact be levied by the FSCS if its funds are exhausted as a result of losses at one or a handful of banks. So, making the commercial banks the shareholders in the central bank and giving the central bank an explicit responsibility to protect deposits, has two consequences. First, the central bank would extend loans only if confident they would be repaid. The well-behaved, risk-avoiding and profitable banks have a strong interest in preventing their risk-prone competitors from incurring losses and ruining the system. Secondly, if the system nevertheless ran into trouble, the first line of defence would lie in the private sector, via the capital-levying power of the Bank of England. If the government did have to come in, it would be only after the bankers had decided that they could not help themselves. It would indeed be a last resort.

I’d like to separate two questions:  Should there be a unified institution to handle deposit insurance and emergency capital provision, which is owned and financed by the banking sector?  And should this institution be the central bank?  I agree with Congdon on the first point, but don’t see the second as being essential, or even politically feasible (at least in the US.)  In America, banks already have partial ownership of the Fed (albeit less than people imagine) and that’s highly controversial.  So let’s look at the first question.

The beauty of Congdon’s idea is that decisions on bank rescue will be made by those with the right set of incentives.  Suppose a bank gets into trouble, but is not a systemic threat.  The socially optimal solution is bankruptcy, that’s how markets should work.  That sends a signal to the banks that they should take fewer risks.  It sends a signal to creditors that they should carefully monitor bank behavior.  It would be nice to send a signal to depositors, but that doesn’t seem politically feasible—at best we might be able to trim the maximum coverage a bit.

But what if the bank failure was a systemic threat?  In that case the institution would have an incentive to provide emergency capital injections–in order to prevent contagion that would threaten the rest of the banking system.  This institution basically internalizes externalities.  The money belongs to the banks, who would be shareholders (in some proportion to bank size.)  If funds were paid out, banks would have to chip in to re-capitalize the institution.

In once in 100 year disasters the Treasury might have to backstop the institution with Federal loans.  But as we saw with the TARP loans, the Treasury could simply require that these loans be repaid by the institution, once the banks got back on their feet.

In theory, taxpayers should monitor Washington regulators, so that they wouldn’t show favoritism to politically important special interests.  But we know from public choice theory that that doesn’t work very well.  The banks themselves are the best monitor, or perhaps a Board of Directors that is directly answerable to the banks.

Here’s another way of looking at the plan.  It’s politically difficult to get the big banks to hold enough capital to overcome the TBTF problem.  They’ll whine about picking up and leaving New York, London, or Zurich.  But it’s also unlikely that all big banks will get into trouble at exactly the same time.  This institution would pool capital in a way the could nip a potential financial panic in the bud, without requiring taxpayer money.

Of course the cost of this insurance fund will ultimately be borne by customers, so in that sense it is a tax.  But it has two advantages over a bailout using income taxes.  The tax reflects the external costs imposed by fractional reserve banking.  And second, the banks would have much more incentive than government bureaucrats to use the funds wisely.

OK, I’m not a banking expert—tell me what’s wrong with this plan?

It made good sense for America to build lots of homes around 2002-06

Follow-up to previous post (read that first.)

When the tech bubble burst the Wicksellian equilibrium real rate fell to very low levels.  In that situation, the Fed must cut interest rates sharply to prevent a sharp fall in NGDP and a depression.  They did so.  Whether they then raised them fast enough in the middle of the decade is a harder issue, and there are good arguments on both sides.  But I’d like to focus on arguments for a housing boom in 2002.

In a classical world (on the PPF) less business investment should lead to more residential investment.  Some commenters object when I call housing construction “investment.”  Just like real men eat steak and not sushi, real investment is supposed to be factories and infrastructure, not houses.  They see houses as a sort of consumption.  America consumes too much, and houses are exhibit A.  I think this is totally wrong; there is almost no entity that is more “capital-like” than houses.

A can of beer is a capital good that depreciates rapidly as you drink it.  Hence we call it a “consumption good.”  The longer-lived an asset, the more capital-like it is.  In a recent comment section Mark Sadowski made this point:

Isn’t the real consumption of useful capital taking place right now? Menzie Chinn recently alluded to the fact that growth in potential RGDP has probably slowed in the face of a persistent and massive output gap. And I keep reading local news stories about well maintained manufacturing facilities that were highly profitable until just three years ago being torn down because no one expects sufficient demand to come back anytime soon.

This reminded me of just how short the useful life of many so-called “capital goods” really is.  Think computers.  Or factories.  Or even stadiums and basketball arenas.  They actually tear down perfectly good arenas that I recall being touted as new and modernistic in the 1970s.  (Meanwhile the Roman Coliseum is still standing.)  In contrast, my house is 90 years old and perfectly fine.  Around me are many houses 100, 150 even 250 years old.  All still in good shape.  All still producing housing service “output.”

Suppose you were a central planner, deciding what America should do in 2002 to keep people busy (idle hands are the devil’s workshop.)  Business investment is out because of the tech crash.  Two percent of Americans can feed us all.  It used to take 30 percent to make manufactured goods, but even without imports we’d need a far lower number today due to technology.  Soon only about 5% of Americans will be able to produce all the manufactured stuff we need.  Most Americans already have the refrigerators and washers and cars they want.  If I were a central planner, I suggest two uses of labor; more houses and more fun.  People love nice houses with granite countertops (when I remodeled in 1997 I put in formica, and I bitterly regret it every day of my life.)  We all see pictures of dream houses we’d love.  And if we have the things we need, then more services.  Restaurants, hotels and hospitality.  Service jobs.  More houses and more services would seem to have been the best way to keep people busy and boost living standards after business investment crashed in 2002.

It boggles my mind that so many people wring their hands that we might have built a couple of million too many houses over a few years, in a country with 120 million units.  In the grand scheme of this does it really matter all that much if a house built in Phoenix is only occupied for 145 years of its 150 year life, instead of 150 years of its 150 year life?

Some would say “what about the banking crisis, the recession?”  What about them?  Yes, those are the big problems we should worry about.  But they have little to do with building a few too many houses.  Those failed mortgages were mostly re-fis, as people used their houses as ATMs.  Or mortgages on the purchase of existing homes.  The losses to the financial system from people not paying back their mortgage on a newly-built house are way too small to explain the great financial crisis of 2008.  And I already showed the housing slump doesn’t explain the recession, as it occurred way too soon.

It seems like the misallocation of capital into housing construction was a disaster.  Actually it was a minor problem that was correlated with two major disasters, horrible mis-regulation of our financial system that allowed risky loans with tax-insured dollars, and really bad monetary policy that allowed NGDP expectations to fall sharply in 2008.

Those are some really nice new houses out there.  Now let’s print some money so that people can enjoy them.  (But only enough money to get proper NGDP growth, not enough to bail out all the bad investments.)