The recent discussion of secular stagnation has once again brought up the question of whether there is a “savings glut” that is aggravating our problems. To the degree that a savings glut exists, it generally has the property that it is focused on the safest assets. That is, for reasons that remain unclear, the collapse of returns on safe assets has not be sufficient to turn this “savings glut” into a vast flow of funds into real-economy risky assets.
I believe that there has been too little discussion of the possibility that the marginal “investors” who have created the savings glut are to be found in the financial industry itself. Although it is certainly true that after the Asian crisis developing countries became net savers — and I do not discount this factor in the flow of savings — at the same time there was a significant transformation of the financial industry. The growth of derivatives was accompanied by the growth of the collateralization of derivatives and the latter phenomenon accelerated after the LTCM crisis which took place one year after the Asian crisis. Thus a non-trivial component of the “savings glut” is likely to be the demand for collateral of the financial industry itself. This source of demand can also explain the strong preference for “safe” assets, since risky assets can easily become worthless as collateral in a liquidity crisis.
If my thesis is right, then Basel III is probably aggravating the “savings glut” problem by increasing the demand for collateral on the part of financial institutions. Thus there has recently been discussion of the existence of a collateral shortage, which sounds to me like the mirror view of a savings glut. (Note that the question of a collateral shortage is complicated by the fact that collateral circulates just like deposits in a banking system, but this issue goes beyond what I want to address in this post.)
One problem with a “savings glut” that is generated in significant part by a demand for assets to be used as collateral is that it is likely to create a segmented markets effect: that is, a significant demand for highly rated assets can coexist with very tepid demand for typical, real-economy, somewhat risky assets that don’t have good characteristics as collateral. This kind of demand for assets is unlikely to play a part in economic recovery by supporting an increase in lending.
The basic problem is this: If the role of the banking system in the economy is to manage and to bear risk for the rest of the economy, then trying to make the banking system “safe” by requiring it to hold vast amounts of collateral and by making it distribute to others the risk that it is supposed to be bearing may actually prevent it from performing its role in the economy. If our banking system is no longer capable of bearing good old-fashioned credit risk, but must find others upon whom to lay that risk, then we should not be surprised that the outcome is low levels of lending to the real economy, low investment, and poor growth. In short, we cannot make the financial system “safe,” by discouraging it from carrying real economy risk, because that undermines economic growth and the performance of all assets.
The Anglo-American universal banking experiment started in 1986 with Britain’s Big Bang which was quickly followed by regulatory policies in the US that would lead to the formal repeal of Glass Steagall a decade or so later. The question that needs to be asked is whether the 2007-2008 crisis is evidence of the failure of this quarter-century of experimenting with universal banking.
In Germany universal banking has been successful over the long-run, but Germany has a civil, not a common law legal system and a social structure that ensures that companies are managed in the interests of many participants in addition to those of shareholders/management. When universal banking is combined with Anglo-American law and social norms, it is possible that it generates pathological behavior that is not evidenced by the German economy.
A standard objection to the claim that universal banking is the underlying source of the crisis is that the only banks that were allowed to fail were not universal banks, but investment banks. This objection ignores that the whole investment banking industry had been reshaped over the decades preceding the crisis by the need to compete with the universal banks, so the fact that it was the investment banks that failed tells us nothing. Furthermore there is significant evidence that one or two of the universal banks did not fail only because the government considered them too big to fail.
John Quiggin recently argued that Wall Street isn’t worth it and that we should put an end to the universal banking experiment:
The only remaining option is to separate these markets entirely from the socially useful parts of the financial system, then let them fail. Publicly guaranteed banks should be banned from engaging in all but the most basic financial transactions, such as issuing loans and bonds and accepting deposits. In particular, banks should be prohibited from doing any business with institutions engaged in speculative finance such as trade in derivatives. Such institutions should be required to raise all their funds directly from investors, on a “buyer beware” basis, and should never be bailed out, directly or indirectly, when they get into trouble.
Matthew Yglesias critiques this view arguing that “it’s a very hard concept to operationalize.” And then limits his focus to derivatives regulation. He writes:
But while it’s easy to say ”we should allow derivatives trading for the purpose of hedging but not for the purpose of speculating” (certainly that’s what I think), it’s a lot harder to write precise legislative and regulatory language that accomplishes that goal. If you look at something like the Harvard interest-rate-swap fiasco, it’s difficult to say precisely where this crossed the line from a reasonable hedge to just gambling with endowment money.
Yglesias’ critique, however, misses Quiggen’s point: commercial banks shouldn’t be engaged in market making or in trading on financial markets at all. The difficulty of implementing the Volcker rule is that it’s trying to draw a line between trading that’s okay (e.g. market making) and trading that’s not okay (proprietary trading). Quiggen is stating that commercial banks should not be engaged in either of these activities. This is a much easier policy to implement (see Glass-Steagall).
This may leave open some room to allow commercial banks to be end-users of financial contracts like interest rate swaps for hedging purposes, but drawing this distinction is much less difficult than Yglesias implies. The distinction between the use of derivatives for hedging or for speculating is precisely the same distinction that is drawn in insurance markets between an insurable interest and the absence of one. Given that we know that drawing the distinction is not an insuperable problem in insurance markets, it’s far from clear why the problem suddenly becomes insuperable when the label “derivative” is placed on the financial contract.
[In addition the whole point of Felix Salmon's post on the Harvard IRS fiasco is that it was clearly gambling at the time the swaps were entered into. Salmon states with barely veiled sarcasm "Larry was certain of two things: firstly that his beloved Allston project was a go — despite the fact that he hadn’t raised the funds for it, and secondly that interest rates would rise by the time construction started. Therefore, he decided to lock in funding costs by using forward swaps." In short Salmon is stating that the contracts represents two gambles, first, on the future need for the funds, and, second, on the future path of interests rates. While ex post we know that in 2008 Harvard would have been better off holding on to its side of the bet rather than buying itself out of the contracts, the post is crystal clear about the fact that these swaps were never a "reasonable hedge."]
While we can certainly debate whether or not the 2007-2008 crisis demonstrates that the Anglo-American experiment with universal banking has failed, arguments that it’s just too hard to reverse the experiment only play into the interests of the universal banks and probably should not be given much weight. If policies that were implemented at the tail end of the last century completely destabilized our financial system, it is clearly worth the effort to find a way to reverse those policies.
Viral Acharya and Bruce Tuckman write on the moral hazard of lender of last resort facilities and the adverse consequences they are likely to have on financial stability, and propose a variety of remedies. It’s high time this issue was carefully addressed by academics, so I’m very pleased to see this paper.
I do have one quibble with the paper, however. It presents the lender of last resort as designed to support banks through crises by supporting the value of long-term, illiquid assets. I think the constraints of the theory here are undermining our discussion of what a lender of last resort should do. Bagehot’s lender of last resort lent mostly against 3 month paper — it might have been possible for one-year paper to be discounted by the lender of last resort in 19th c. Britain, but lending against “long-term” assets was unthinkable at the time.
In my view, models should evaluate short-term, medium-term and long-term assets. And it is open to question whether the lender of last resort should be providing any support to assets that are truly long-term — that is, in excess of three or five years — with the exception of Treasuries. After all it’s from clear that financial intermediaries should be carrying long-term assets (other than Treasuries) on their balance sheets at all, except in the trading book — which should be managed so that the banks don’t need access to a lender of last resort under any circumstances.
This view is a very different model of the financial system than the one we have, but I’m not sure there’s any way to stabilize the one we have for the reasons presented in Acharya and Tuckman together with the fact that the longer one goes, the harder it is to establish the value of any asset.
The internet is still abuzz with the distinction between Fama and Shiller. E.g. from Mark Thoma:
Fama is a staunch defender of efficient markets and rationality, while Shiller argues, “The theory makes little sense, except in fairly trivial ways.” Shiller emphasizes “the enormous role played in markets by human error, as documented in a now-established literature called behavioral finance.”
These discussions, however, failure to state the basic problem with models that assume rational expectations: theorists long ago demonstrated that only in aberrant circumstances (i.e. when market participants are small relative to the market) is rational expectations rational. John Geanokoplos entry in the New Palgrave on Arrow Debreu Equilibrium makes this clear:
[The definition of a rational expectations equilibrium] is itself suspect; in particular, it may not be implementable. Even if rational expectations equilibrium were accepted as a viable notion of equilibrium, it could not come to grips with the most fundamental problems of asymmetric information. For like Arrow-Debreu equilibrium, in [rational expectations equilibrium] all trade is conducted anonymously through the market at given prices. Implicit in this definition is the assumption of large numbers of traders on both sides of every market
The short version of this quote is this: Rational expectations is not incentive compatible with the behavior of self-interested individuals in the typical market where at least one side of the market is likely to have either a small number of traders or a few traders who are large relative to the size of the market. When rational traders should take the effects of their actions on the price itself into account when making their decisions, the rational expectations approach will fail to be rational.
Rational expectations are important for two reasons. First, they serve as a “perfect case” benchmark. In order to understand departures from rationality such as those embraced by Shiller, we need to know how the economy will function if agents fully understand everything about the economy, and can process the information optimally.
Assuming rational expectations is like assuming a perfect vacuum in physics – it provides a baseline that can be augmented with real-world features. Second, there are cases – simple games and financial markets for example – where the assumption of rational expectations may be approximately satisfied. But it’s a mistake, I think, to assume that rational expectations apply in all other settings or to the economy as a whole.
I agree with Thoma’s first point. As a benchmark rational expectations is invaluable. It’s so difficult to discuss what’s going on in the economy that idealized models are very useful reference points.
I disagree with Thoma’s second point. Why on earth would financial markets, where there are almost always market participants who are large either in terms of their inventories or in terms of the information they have about the market, be composed of people who don’t take into account the effects of their actions on prices. In fact, is there anyone who actually thinks that the large banks that dominate our financial market trade as “price-takers”? As long as rational behavior on a market includes significant effort to affect the movement of the price, then deviations from the rational expectations model will be as important to understanding the behavior of prices on these market as the benchmark model itself.
To avoid the possibility that the foregoing discussion generates confusion, Fama deserves his Nobel. But as this year’s award clearly shows he doesn’t deserve it because he got the theory of financial markets right. Nobody can do that. He deserves it because the efficient markets hypothesis is an extremely important benchmark and he showed us its importance.
Note: Toned down the text a little.
Ingrid Robeyns (h/t Steve Waldman) in Economics as a Moral Science questions economists’ use of Pareto efficiency arguing that it is not value-neutral, but I actually think that adding normative analysis to economics is of distinctly secondary importance to simply insisting that economists and those who make policy on the basis of economic principles get their positive analysis of economics right.
First, in most real-world economic environments economic theory very clearly fails to predict that market trade will produce efficient outcomes. The prediction of efficient prices as a market outcome relies fundamentally on the assumption that all participants in the market are “price-takers” — in other words, all market participants must honestly reveal their private information about the their inventories and their desires, or economics does not predict efficient prices. As soon as the issue was clearly framed, economic theorists determined that efficient market equilibria are incentive compatible for the participants in the market when there are very many (technically infinite) market participants on both sides of every single market, but in general makes no predictions about efficiency in other circumstances. (See, e.g., John Geanokoplos “Arrow-Debreu Model of General Equilibrium” p. 122.) In short, because there is no reason to believe that efficient market equilibria are likely to be incentive compatible with real-world behavior except when all market participants are very small relative to the size of the market, game theory is extremely popular among economic theorists.
Second, the concept of Pareto efficiency divides social states into only two categories: states where the allocation is efficient and states where it is not. Thus, once we have reason to believe that the market is unlikely to produce an efficient outcome, the whole set of Pareto efficient outcomes comprises an appropriate target for government intervention. For this reason, Pareto efficiency states that if we can design a policy that takes everything (or something or nothing) away from the rich, but ends up at an allocation where nobody’s welfare can be improved without reducing the welfare of someone else, then the government policy is an improvement over the market. In short, the second theorem of welfare economics makes it crystal clear that government policies that have redistributive aspects are entirely consistent with economic efficiency.
Overall, the problem with economics is not the use of Pareto efficiency, but the failure to acknowledge the implications of economic theory for the importance of the structure of our markets. Economics predicts efficient prices only when markets are carefully structured to make the revelation of private information incentive compatible. (See Mechanism design and Auction theory.) An ill-defined concept of a “market” is not predicted to produce the same result, but instead to induce strategic behavior about when and how to reveal information. When market participants are behaving strategically in an environment not designed like an auction to induce the revelation of truthful information, economic theory does not predict that the outcome will be efficient.
The fundamental problem with modern economics does not lie in the use of Pareto efficiency, but in the failure of both the broader economics profession and policy-makers to incorporate the implications of economic theorists’ formal economic analysis into their intuition about how the economy works.
Brad DeLong’s recent post on “Where was China?” [in the history of modern growth] calls to mind an essay I wrote many years ago on a financial explanation for modern growth which I thought I’d post. For good measure, I’ve tacked another essay onto this post that addresses the problem of method in economics and was written, I believe, in May 2006.
The Wealth of Nations: A Financial Approach
By Carolyn Sissoko
First Draft: 5/1/03
Current Draft: 3/13/06
“Why are some countries rich while others remain poor?” is the question that lies at the heart of economic growth theory. Here I argue that to find the answer, one must first reframe the question and ask: How is it that some countries managed to become so very rich in such a short period of time?
To illustrate the miracle of growth that has changed the lives of a select segment of the globe over the past century or two, one need only picture a woman squatting by a riverside washing her family’s clothes by hand. For how many millennia have this and innumerable other mundane and laborious tasks defined life for the vast majority of the world’s population? And yet in the United States in the 21st century life without the miracle that is a washing machine is unimaginable. There is not a family in any developing country that cannot understand the value of a washing machine. By the same token a few centuries ago in North America the value of a washing machine, if it could have been imagined, was always evident. The demand for technological innovation has always existed, it is the means that were lacking – until recently. During the past two centuries in some countries the economy changed dramatically leading to a sustained path of technological advance, but in some countries it did not change. Until we gain an understanding of the foundations of growth in developed countries, we can not hope to understand lack of growth in less developed countries.
My preferred explanation for the growth that underlies the wealth of rich countries is based on institutional change and I tend to focus on change in monetary and financial institutions. The collapse of the bronze monetary system in China created a demand for precious metals with which to build a new money supply.  This was possibly the most important driving force in world trade during the latter half of the Middle Ages and into the modern era. The famous silk and spice trade was paid for by the export of precious metals from Europe. Precious metals were, however, also the basis of Europe’s money supply during this period. I argue that the difficulties created by the export of her money supply pushed Europe onto a path of monetary and financial innovation that would completely change the nature of economic relations.
The European ports that exported silver and gold coin to the Levant where caravans would carry it East had a problem. Storms meant that sailing eastwards on the Mediterranean was a seasonal activity. Since silver and gold ships could only sail on a seasonal basis, the coin available for use in local trade would be increasing for months and then all but disappear when the ships departed. These cities had a money supply that fluctuated dramatically and predictably. To smooth the money supply (and indeed make trade possible when specie was scarce) both Venice and Barcelona developed deposit banking systems which allowed trade to take place on the basis of what were effectively checking accounts. Not surprisingly the reserves of these banks were at their lowest when the specie ships left port, with the result that the amount of bank money increased when coin was particularly scarce. Together with the development of “checking” accounts came the development of clearing of claims on the banks and this meant that a lot of trade could take place without any underlying coin whatsoever.
The rest of Europe had a problem too. While there was quite a bit of intra-European trade, specie had a tendency to flow from mines to ports. In order to keep the flow of European trade moving, Italian merchant-bankers developed the bill of exchange. A bill could be purchased from a merchant-bank in one city and would be repaid after a few weeks by another branch of the bank in a different city. If we take the example of an English woolens merchant selling his wares in the Low Countries, we can see that by purchasing a bill of exchange in Bruges for payment to his correspondent in London, the English merchant can remit his earnings home and possibly finance another shipment of woolens. Of course, if the merchant-banker actually had to pay every bill in specie, the bill of exchange wouldn’t have solved the problem of drainage of specie to the ports. In practice, first at the fairs in Champagne and then through deposit banking systems in all the major trading centers, most of the bills were cleared rather than paid in cash. At the same time and in the same centers, money markets (that carefully skirted usury laws) developed so that a merchant banker who didn’t have the cash to pay his balance after clearing could borrow from someone who did have cash. These financial innovations allowed intra-European trade to take place with minimal use of specie.
In the process of re-organizing their trade to operate on the basis of paper claims rather than on the basis of commodity money, Europeans built up a plethora of institutions to support long-distance trade that took place on the basis of reputation. Both merchant and deposit bankers had to be trusted to pay according to contract. To promote a city as a trading center rulers often had to cede jurisdiction over commercial matters to Merchant Law, which was a kind of common law based on usage and judged by a jury of peers carefully balanced in terms of nationality. For a long time any default, fraudulent or not, was likely to result in exclusion from the local merchant community. Of course, the high profits of banking gave value to a reputation for repayment – names like Medici, Fugger and Rothschild belong to merchant bankers.
Before the modern era begins around 1500, the institutional structures that allowed international trade to take place on the basis of clearing in trade centers rather than via cash settlement were well established in Europe. By 1700 an innovation in the form of the endorsement of the bill of exchange, allowing it to be passed from one merchant to another before redemption, would revolutionize European financial markets. Endorsement allowed clearing to take place outside a banking system. Merchants were using bills drawn on the major Dutch banking houses to make purchases in the Americas, in Russia and in India. All over the world, merchants who would never set foot in Europe were using claims on the Dutch banking system to finance international trade.
Endorsement also revolutionized local trade. Since bills were easily transferable, deposit banks began to discount them. This led to a situation where a merchant or tradesman who maintained a good relationship with a reputable local banker could write an IOU to anyone and the recipient would be able to take it to the local bank and get cash on it (at a discount based on the maturity date of the bill or note). Amsterdam was the first city to successfully exploit this system of secondary markets in commercial paper, and interests rates paid by local merchants fell as low as 3% per year. The low costs of finance allowed Dutch merchants to offer generous credit terms to their trading partners and helped them out-compete the English through the first half of the 18th century.
Unfortunately the complex credit networks that Europe had developed could prove extremely unstable. The Dutch came face to face with this problem first in 1763 and then in 1773. In both cases the short-term credit on which the economy operated evaporated. In 1763 the end of the Seven Years War came with tight money in Germany that would have caused major merchant banking houses involved in the finance of the war to collapse. Because the fall of the Dutch houses would have caused problems for London banks which had funneled money into Germany for the war, the Bank of England allowed London bankers to draw gold out of the Bank to support their correspondents in Amsterdam. At this juncture the Bank of England’s reserves fell below 5%. In 1773 the cause of the crisis was speculation and the Dutch received no support from the English with the result that two of the three largest banking houses in Amsterdam collapsed. A secondary result was that Amsterdam lost its position in the finance of international trade and London took the position over.
Earlier banking collapses had punctuated the European experience of trading on the basis of paper money, and the founders of the Bank of England appear to have had these problems in mind at its birth in 1694. When they offered cash to the British government in exchange for a perpetual debt, regular interest payments and a Bank charter, they wanted to establish a bank “without the hazard of bankruptcies.” Within half a century the Bank had become the sole manager of the nation’s debt, and indeed the government could not afford for the Bank to go bankrupt. In the meanwhile the Bank of England note became the high-powered money of the London merchant community, which relied on the Bank’s discount facilities when in need of cash. In 1797 the Bank of England suspended the convertibility of its notes into gold, and the British economy shifted smoothly onto an inflationary fiat money standard. Thus, in 1797 the Bank of England demonstrated that it was in fact a bank that could not go bankrupt. The fiat money standard lasted for over a quarter of a century, before the economy was put through a deflation-driven recession and the Bank resumed convertibility at the 1797 level, its reputation untarnished.
But what in the end does all this institutional development have to do with growth, you may ask? Right around 1763 when the Bank of England was letting the world know that it could not go bankrupt, by emptying its vaults to support the Dutch through their financial crisis, domestic banking in England took off. Banks in the towns of England went from less than 12 in 1750 to over 100 in 1775 to well over 300 in 1800. These banks were opened throughout the length and breadth of England, so that by 1800 only one county was without a bank. These were discount banks that, when they were illiquid could turn for support to their London correspondents, which could in turn use the discount facilities of the Bank of England when need be. The role played by the Bank of England in the late 18th and 19th centuries would demonstrate that a source of funds that could not go bankrupt was indeed a stabilizing mechanism for the domestic banking system.
Important to growth, however, is what the banks in the English countryside were doing. By offering discounts (or credit lines) to merchants and tradesmen in country towns, the banks for the first time made access to working capital fairly easy for them. By strictly enforced usury laws the maximal interest rate a bank could charge was 5% per annum, so working capital was not just accessible, but also cheap. This was possible because country bank connections with London meant that the bills issued by tradesmen in the countryside could be discounted in London, so small town producers were connected with the deep secondary markets of the capital. The banks often had small capital bases themselves and were able to keep their need for specie to a minimum by clearing the trade of the local economy on their books.
The terms of a discount were not dissimilar to those of a modern credit card (except at much lower interest). An individual with no credit history could get only a small line of credit, but as a good history of repayment was built up the credit line could grow quite large. Anyone who overdrew his credit line or did not make timely payments would face a penalty, and repeated infractions would result in the loss of the credit line. The credit offered was short-term, but sufficient for a firm to cover wages and rent while readying a product for sale. None of the firms that grew up during England’s Industrial Revolution failed to make use of these facilities. Boulton and Watts, the inventors of the steam engine, relied heavily on bank finance, as did the woolens industry, and the import and export trades.
The crux of my argument is this: countries that are rich have environments in which a banking system uses its clearing facilities to make working capital cheap and accessible, so an individual with a good idea can implement it. This environment breeds a dynamic economy with innovative firms and technological development. In countries that are poor working capital is much less accessible. Middle income countries may offer credit facilities to firms in large urban centers, but rarely extend banking services to the countryside – and therefore to the general populace. In the poorest countries even in the capital city medium and small size firms can not raise working capital through banks.
This brief review of European history tells us that even an ideal form of globalization, in which developed country subsidies to agriculture and other distortions of free trade are absent, is unlikely to result in high levels of growth in the less developed countries without domestic institutional reform. The history of England indicates that a stable banking system relies on a central bank that the people of the country trust to practice a conservative and non-inflationary monetary policy. Trust in the central bank gives it the flexibility to “overissue” either to support the banking system or to finance a welfare-improving government policy (like a defensive war). Because rich countries have trustworthy central banks, they can “suspend convertibility” or, in other words, float their currencies. When we see that a country has difficulty maintaining a floating currency, we have evidence that the country’s central bank is considered unreliable. Until low income countries find a way to establish trustworthy central banks, or find a substitute for them, their banking systems will be too unstable to support the growth we associate with developed countries.
 Legal institutions and in particular the definition of property rights tend to change along with monetary and financial institutions. I don’t find it productive to take a stand on the importance of legal versus financial institutions. They accompany each other and their effects can not be easily distinguished. My story, however, focuses on financial institutions.
 India had a similar and possibly equally important demand for precious metals at this time. On money in China during this period see Richard von Glahn’s Fountain of Fortune, 1996, University of California Press.
 See Reinhold Mueller’s The Venetian Money Market: Banks, Panics and the Public Debt, 1200-1500, 1997, Johns Hopkins University Press for Venice and Abbott Usher’s “Deposit Banking in Barcelona, 1300-1700,” Journal of Economic and Business History, 1931 for Barcelona.
 See John Monroe, “The international Law Merchant and the evolution of negotiable credit in late-medieval England and the Low Countries,” in Banchi pubblici, banchi privati e monti di pietà nell’Europa preindustriale, 1990, Atti del convegno, Genoa.
 On endorsement see Herman van der Wee, “The influence of banking on the rise of capitalism in north-west Europe, fourteenth to nineteenth century,” in Alice Teichova, Ginette Hentenryk and Dieter Ziegler ed. Banking, Trade and Industry: Europe, America and Asia from the thirteenth to the twentieth century, 1997, Cambridge University Press.
 Endorsement actually was developed in Antwerp, but shortly after the development war between France and Spain interfered with Antwerp’s role as a center of trade and finance with the result that many merchants moved to Amsterdam, which became the new center of trade in the Low Countries.
 On Dutch interest rates and their effect on commerce see Violet Barbour, Capitalism in Amsterdam in the 17th Century, 1963, reprint University of Michigan Press, Ann Arbor, in particular p. 85.
 On the crises in Amsterdam see Charles Wilson, Anglo-Dutch Commerce and Finance in the Eighteenth Century, 1977 reprint of 1941 edition, Arno Press, New York.
 Adam Anderson, An Historical and Chronological Deduction of the Origin of Commerce, 1801, reprint of 1764 edition, London, volume 2 p. 602.
 On the domestic role of the Bank of England see John Clapham, The Bank of England: A History, volumes I and II, 1945, Cambridge University Press, Cambridge. For the details of this argument see Carolyn Sissoko, “The political economy of private paper money: Institutional development in Europe up to 1800,” UCLA mimeo.
 On the role of country banks in the 18th and 19th century English economy see L.P. Pressnell, Country Banking in the Industrial Revolution, 1956, Oxford University Press.
Economics: A challenge for the profession
Where did all the economists go?
There are probably more economists – in the sense of individuals who have earned PhDs in economics – now than at any time in the past. However, it is no longer clear that those who call themselves economists actually feel that it is their job to try to understand the economy.
Why do some economies hum along with extraordinary consistency, while others roar for a few years only to come suddenly to a complete stop, and some never seem to get the engine running at all? Outsiders assume that economists spend their time mastering the mechanics of the economic engine and are invariably surprised to discover that most economists don’t consider the economy per se to be their field of study.
Economics is a field of both extraordinary importance and extraordinary difficulty. Like the sciences where breakthroughs can lead to the development of antibiotics and nuclear fusion, economics is a field where advances have the ability to transform the very nature of the world we live in. (For anyone who has difficulty coming up with examples, consider the progress made in central banking over the past two centuries.) Unlike the sciences, however, economics is a field where controlled experimentation is impossible, drawing firm conclusions is often difficult and applying economic knowledge to a particular problem is consequently even harder.
Thus the nature of economics itself generates a form of uncertainty principle: the closer one approaches the fundamental questions of economics, the harder it is to reach concrete and well-defined answers to the questions. The closer one comes to a solid answer to an economic question, the farther the question is from the core economic issues.
In response to their dilemma the profession has chosen to pursue the answers at the expense of the questions. A good research topic is composed of a very narrow question and a concrete, provable conclusion. The focus of current research in economics is on the methodology by which narrow questions can be addressed. Economics is increasingly a field composed of career-oriented technicians, not professional intellectuals.
In short economists have failed to come to terms with the fact that the mechanics of the economic engine will never be understood with scientific precision. Uncertainty and subjectivity lie at the very heart of the profession and cannot be escaped. For each question there is a whole series of answers consistent with the data. To fathom the full spectrum of these answers requires skills which are not taught in economics departments.
It is the humanities that face unblinkingly the problems of uncertainty and subjectivity in research. Students of literature and history are taught to take an episode and rotate it, looking at it from many vantage points, before sitting down to write. They must be cognizant of the paths not taken and of the existence of paths not even considered. Into this nebula of potential meaning, the researcher shines a light that carefully picks out selected regions in a process, subjective though it is, that can illuminate a form with a clarity and unexpectedness that astounds.
The cost to the economics profession of the effort to escape the intrinsic nature of the field is huge. The mechanics of the economic engine are not well understood and the two main theories of its function are both more than half a century old. Keynes’ seventy-year old view is now considered out of date. When modern economic theory attempts to explain the mechanics of the engine, it refurbishes 19th century models of competition and general equilibrium. Far from recognizing a need to generate new theories, many economists identify the field itself with its 19th c. antecedents.
Unfortunately 19th c. economics is like 18th century physics. The competitive general equilibrium model is a theory of gravity without a theory of friction. Just as it is obvious that an object in motion most definitely does not stay in motion, so it is obvious that a price system does not effortlessly move goods – even those that don’t generate externalities – to their highest value use.
By focusing the profession’s efforts on narrow questions with concrete answers, the profession has reneged on its responsibility to develop a set of theories that provide a context explaining how general equilibrium theory applies to real world phenomena. Is it a good model of the economic engine? If so, then what are the conditions that differentiate economies that run smoothly from those that start and stop and from those that never get started at all? A good understanding of the frictions that can interfere with the operation of the engine is essential, and the study of these frictions will in all likelihood neither validate nor invalidate classical theory. Instead, the proper study of economics will allow us to see more clearly under what conditions we can expect the theory to be a good predictor of observed economic behavior and under what conditions we can expect it to fail.
In the process of developing a context for competitive theory, the profession will have to develop a set of theories explaining economic frictions. And in the process of developing these theories the profession will refine them. And, maybe, just maybe, the profession will succeed in making a nonsense of this essay by fully and definitively explaining the mechanics of the economic engine. But one thing is certain: the profession has a lot of work to do before it proves me wrong.
 All right, it’s true: I am overemphasizing the lack of progress in the profession. Game theory has done wonders for expanding the horizons of economic theory, and a big segment of the profession is confident that it will play an important role in the development of new theories. On the other hand, you and I both know plenty of economists who don’t think game theory is all that important. And, of course, this essay is really about the big macroeconomic questions. These have only just begun to be addressed using game theory.
I think Krugman’s problem is that he doesn’t have a formal model that can help him understand what makes banks so important. Instead he refers to Diamond-Dybvig and Tobin-Brainard. Diamond-Dybvig is an excellent workhorse model, but it’s a model of why banks face runs and doesn’t really attempt to take a close look at the role banks play in the broader economy. Since I’m not very familiar with Tobin-Brainard, I’m going to discuss Krugman’s description of it:
if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent.
But this discussion abstracts from the fact that the funds the public is able to deposit in banks depend fundamentally on whether or not the bank is willing to lend those funds. A classic example is the difficulty of borrowing against one’s future wage income. For purposes of consumption smoothing members of the public would often like to hold as deposits cash representing future wage income that was posted to a checking accounts against a loan that has to be paid back to the bank. However, when the banks refuse to provide this form of lending, the public doesn’t get to hold these deposits in banks or take advantage of the consumption smoothing opportunities that such deposits would allow. In short, the criteria that banks use for making lending decisions are (rather obviously) crucial inputs determining the size of the deposit base. Because of these dynamics, it appears that “the answer is ‘Yes’” only as long as the banks’ lending criteria are held constant. This, of course, is a unexceptional modelling decision, but it is incumbent on Krugman to understand that Tobin-Brainard depends fundamentally on not modelling the details of bank lending. [Note that Steve Waldman gives a more general explanation of the problem with Tobin-Brainard: "it must be reasonable to model the nonbank private sector as if it were a unified actor with preferences independent of the behavior of the banking system."]
For a better understanding of the central role that banks play in the monetary system, I suggest that Krugman take a look at a paper I wrote half a decade ago, An Idealized View of Financial Intermediation. This paper looks only at the role banks play in facilitating payments and abstracts entirely from portfolios and the banking system’s role in long-term investment. All banks have is creditworthiness, but by adding this to the economy banks are able to offer credit lines and make it possible for everybody’s debts to be accounted for and made enforceable.
(More specifically, I introduce a monetary friction into a general equilibrium model of a repeated endowment economy and demonstrate that credit lines underwritten by banks are a better solution to the monetary problem than cash: as long as loss of access to bank lending is a sufficient penalty to induce bank customers to repay debt, banks need only set a credit limit for everyone that’s high enough for the richest person to overcome the monetary friction and then everyone will choose to use the right amount of credit. The model also shows why bank customers will choose not to default: loss of access to bank services restricts your ability to participate in the broader economy, and leaves you with a very bad set of choices. Because there is no investment in this environment the only role played by the infinite horizon is to provide for a future punishment for bank customers who do not repay debt.)
This is a formal model, so I abstract from issues like investment, portfolios, and bank default. On the other hand, since Krugman seems to need a model to explain to him in what way banks add something both unique and extraordinarily important to the economy, this paper provides an answer: banks make credit and credit-based transactions possible, because they are trustworthy. In short, banks are the cornerstones of the economy’s circulatory system, which is, I think, also Cullen Roche’s point.
Matt Levine argues that complexity in the financial world “has arisen over time because it responds to actual needs.” The heart of his argument is this:
But many of the main flavors of derivatives, from an economic importance perspective, grew out of traditional banking. Evil credit default swaps were invented by JPMorgan in the Glass-Steagall era, when it was a commercial bank and wanted to hedge its commercial loan book. Interest-rate swaps also have a mostly traditional-banking history, starting as a way to let banks and borrowers hedge the interest rate risks of their loans. These were not risky investment-banking activities that mingled uneasily with good old-fashioned safe banking. They were attempts to make old-fashioned banking safer.
Let’s get some basic facts clear here. Glass-Steagall was formally repealed in 1999. But the Glass-Steagall era ended much earlier. I would argue that it ended in December 1986, when the Fed responded to Britain’s Big Bang by permitting banks to have subsidiaries that underwrite non-government securities.
So both CDS and IRS can easily be viewed as products of the post-Glass-Steagall era. Furthermore, while IRS were indeed attempts to make old-fashioned banking “safer,” it far from clear that those who created them were actually thinking through the consequences of their actions from a macro-economic (rather than a micro-economic) perspective. How the financial world addresses the economy’s “actual needs” is a profound question that merits careful discussion. Not the financial industry’s “whatever is, is right” approach that assumes that financial innovation can only take place to address “actual needs.”
Updated: I altered the language a little for some statements that were phrased too strongly.
Ryan Avent seeks to rebut Matt Klein on the issue of whether a popped real estate bubble must have adverse consequences on the economy as a whole. Afterall, as Avent points out the houses are built and in the worst case we can just let them rot and turn our efforts to gainful production. He ”dreams of a day when the only people who suffer from money-losing investments are the money-losing investors.”
The problem with our reaction to the real estate bubble is that the “money-losing investors” haven’t lost their money (yet). The houses were built on debt and there are vast losses on that debt that have not yet been realized. There’s no issue of morality here. Someone has to take the losses. It should have been the banks (who had vast exposure on second liens) and the mortgage investors. Instead, we’ve been protecting the financial sector by convincing people to continue making payments at bubble prices on their houses. That’s the point of HAMP, the government modification program.
The “wages of sin” language is unfortunate, but the point that nothing good can come of prolonging the financial sector’s realization of its losses over a decade or more remains. The nature of debt means that losses must be realized — and this truth remains with or without moralistic framing.
Vast numbers of mortgagees still owe twice as much as their homes are worth are are continuing to make payments (in December 2012 30% of mortgagees in the crisis states were underwater, 4.7% of all mortgagees owed twice as much as their homes were worth) — in part because the payments have been temporarily reduced through HAMP and HAMP-like mods. These payments are going to support the banks and mortgage investors, who are currently accounting for these loans as though there are no losses (i.e. because payments are current). Instead of these individuals’ income being freed to circulate in the economy productively, this income is spent on preventing the realization of losses in the financial sector.
People who know economics generally assume that what is happening can’t happen, because it doesn’t make sense. Any rational homeowner would walk away from a mortgage that’s the double the value of the home — and indeed sometime over the course of the 40 to 50 years that this debt is to be paid most likely the homeowners will choose to walk away. However, currently large chunks of U.S. income are being spent on preventing the realization of financial sector losses. I would say that it’s no coincidence that the overall economy is simultaneously remarkably weak.
Given how poorly our financial system is functioning when it comes to simply recognizing losses and moving on, Matt Klein may be right to ask: “Wouldn’t it be ironic if our unwillingness to punish reckless lenders for their sins crippled our economy for a generation?”
Finance and economics are difficult. Understanding how and why the financial system or the economy works are deeply impenetrable questions that are best answered by healthy, aggressive debate, not by a consensus that we know what the answers are. In my view financial regulation will only be successful when we have competing schools of thought that are constantly pushing back against each other.
It’s normal for people who work together to settle into a consensus view, in part because it’s stressful to be butting heads on a daily basis, so it’s common for people who feel that their views cannot be expressed without generating conflict or ridicule to go elsewhere. In the best working environments everybody’s view is given weight, so the consensus view is something of a truce — as long as you frame your view in this way, I won’t challenge you. In other working environments, a single group or even individual manages to define the consensus, largely because of that entity’s reaction to other views.
It’s also normal for any industry to develop a consensus view that’s conducive to its interests. While there will certainly be sub-cultures within the industry, the variation is likely to lie within a very narrow range, because the interests within industry will tend to be aligned.
Thus, it seems to me that the principal source of the counterweight that’s necessary to promote healthy debate about the nature of the financial system and the economy is the regulators. We need these regulators to have their own view of how finance and the economy work that should look bat-shit insane when viewed from the perspective of industry. When the regulators take industry to court, it should be common for a war of ideas to be taking place.
Thus, the problem with the revolving door is really one of cultural cross-contamination. If industry and the regulators together settle into a single consensus view of how finance and the economy function, then the result will be destabilizing, because whatever flaws exist in that consensus view will become deeply entrenched in the way finance and the economy function.
We don’t our regulators to agree with industry on what is a prosecutable offense. We don’t want our regulators to agree with industry on the most efficient microstructure of exchanges. We don’t want our regulators to agree with industry on when financial innovation is good.
We do want our regulators to have their own view of the financial system, of the economy, and of what constitutes legal behavior that should be so different from the industry view, that they appear to be generated by people born on different planets. Thus, the real problem with the revolving door is that a collegial consensus on how the financial system and economy function and on what financiers can and cannot legally do is destablizing to the financial system and the economy.