How much do monetary and fiscal policy matter?

Paul Krugman:

The truth is that policy should be piling on, not looking for the exit. But central bankers can’t wait to pull away the punchbowl, even though the party hasn’t started, and shows no signs of starting for years to come.


We’ve got the president telling Fox News that he’s worried about a double-dip recession if he doesn’t reduce the deficit soon — as opposed to the concern I and other have that he’ll have a double dip if he doesn’t provide more support.

I’m not sure Krugman is asking the right questions.  The way I see things is this:  If we fix the financial system quickly — use the bankruptcy process to wipe out a lot of real economy debt and deal with the resulting bank failures via a resolution authority and by making sure that the remaining banks are well-capitalized — what Krugman calls a “liquidity trap” will disappear.  Only once consumers and firms feel that they no longer face a crushing debt burden will they be able to participate fully in the economy.

After the bankruptcies and bank closures have taken place, the Fed will no longer need to hold rates at ridiculously low levels to recapitalize the banking system and cause savings to move from Treasuries into CDs.  In this scenario the banking system can lead the recovery and government spending is of only secondary importance to the health of the economy.

On the other hand, if we fix the financial system, the spending that Krugman proposes won’t do any harm either, because we will be able to grow out of our debt.

I’m really just not sure whether or not government spending to support the economy matters very much.  In my view it is far, far, far more important to fix the financial infrastructure — by ending the policy of extend and pretend — so natural economic forces can drive a recovery.

On leverage and growth

Simon Johnson has found some research produced by Morgan Stanley that claims the following:

We think the regulators will balance the need for reducing systemic risk with the need for economic growth. … we think the demand for growth and access to credit will trump desire for unprofitable capital levels

The claim that maintaining the high levels of economic growth to which we have become accustomed requires that the financial system operate with minuscule levels of capital has sustained ever increasing leverage ratios in the financial system for decades.  I worried in this post that Morgan Stanley’s analysts are right and the crisis of the past year has indeed not been enough to dispell the idea that negligible levels of capital are the long term solution to our financial problems.

Lately I am often reminded of the fact that China’s experiment with fiat money lasted about 200 years — and I date  our current experiment with fiat money as starting in 1797.

On supporting Wall Street

In an excellent post on the problems the Fed is facing right now, Tim Duy writes

Fed officials see this a bit differently – they see supporting Wall Street as their mechanism for supporting Main Street

Does anybody else find something odd about this statement?  Supporting the commercial banking system as a means of supporting Main Street makes sense, but Wall Street?  How is it possible for Wall Street financiers to be such bad risk managers that they need support?  They don’t take bank deposits and carry illiquid loans.  How on earth did Wall Street get itself into a liquidity crisis — their standard business model should not involve carrying large quantities of high risk assets on their balance sheets.

If upstart companies want to make money making markets in junk bonds and other products of highly variable value that’s fine.  Let them enjoy their boom and bust cycle — making money in the good times and going bankrupt in the bad.  But why would companies that want to be around for the long-term ever get into these markets in a big way?

Yves Smith has the answer:  After Wall Street firms went public, they stopped being managed in a way that would allow them to be around for the long-term.  Prior to the 70s Wall Street firms were partnerships and every partners’ personal wealth was at risk in the event of failure.  Effectively financiers had professional liability exposure just like doctors — and the market was the arbiter of misconduct. For this reason, Wall Street firms didn’t fail.  They also didn’t make markets in junk bonds or other high risk assets.  They established the stock and commodities exchanges to reduce their exposure to loss from market making activities. In short, they understood the risks involved in market making and they were careful to minimize them.

Over the last quarter of the 20th century changes in the financial system allowed huge new markets in illiquid assets to develop.  As extraordinary levels of debt grew, this debt facilitated growth in the same way that increasing the money supply stimulates growth.  Unfortunately the foundations on which this debt was issued — and thus the foundations of this growth — were not sound.  Thus we find ourselves at the start of the 21st century trying to sort out how to maintain a functioning economy when the system of capital allocation (i.e. Wall Street) is completely broken.  The transition is sure to be difficult.  But if we recognize that the view that government has a duty to support investment banks has little or no historical support and that Wall Street functioned well in the past by treating the personal wealth of the financiers as the obvious source of funds for creditors of a bankrupt investment bank, then we can start to solve the problem.

Was TARP a failure?

Brad DeLong is arguing that the government’s actions since the Lehman failure have been good — and thus that TARP was not a failure because it saved the financial system.  I think the issue is this:

If we ask the question:  Given that passing a resolution authority was impossible, was TARP a failure?  Then I think the answer is no.  If you take the best solution out of the set of possibilities, then the Treasury and the Fed did what they could given the constraints they faced.  In other words TARP was better than using the bankruptcy process as it is currently structured to resolve the crisis.  (Note:  Steve Lubben is proposing that a modified Chapter 11 process would be a superior alternative to a resolution authority.)

However, if you simply ask the question:  Was TARP a failure?  Then you have to take into account the fact that passing a resolution authority in September/October 2008 was a possibility. The sense in which TARP was a failure was that a conscious decision was made to transfer funds from the taxpayer to the financial system in a way that all but ensured that a large chunk of the money would be lost (see CIT bankruptcy).  This was necessary because there was no resolution authority and no way for the government to provide DIP financing (as it did for the GM and Chrysler).  Thus, the responsibility for TARP’s “failure” lies with whoever took the possibility of passing a resolution authority off the table.

We need a MFPA too

As one hears about all the municipalities that have gotten over their heads in derivatives, it becomes clear that we need a Municipal Financial Protection Agency too.  The MFPA can define the terms of plain vanilla products that are designed for municipalities.  Each state or local government can then decide to what degree employees are allowed to enter into products that are not plain vanilla muni products.

Which comes first democracy or rule of law?

My point is that respect for the rule of law does not necessarily result from free and open elections.  Respect for the role played by the rule of law in the general welfare may need to exist before democratic institutions can establish strong foundations.

Daron Acemoglu argues that “if you wish to fix institutions, you have to fix governments” and I’m not sure that I agree that governments are the starting point for reform.  On the other hand, his view that we should push non-democratic regimes to be more transparent and democratic and encourage foreign citizens to use technological tools to organize themselves can be supported on first principles without an appeal to economic growth.

In short, only after the value of the rule of law in common affairs was well established were democracies able to flourish in Europe.  Thus, if the goal is to “fix institutions”, it is possible that supporting economic growth in non-democratic regimes by pursuing goals like those of Paul Romer’s charter cities may be more effective than pushing democracy on countries that lack the economic foundations to maintain their democracies.

On banks and the provision of liquidity

William Dudley wants to permanently expand the role of the lender of last resort well beyond the commercial banking system.  He argues that most financial firms can face runs and that it is the role of the central bank to eliminate the possibility that a solvent financial firm faces a run.

I think this view is founded on a misunderstanding of the nature of liquidity and thus of the role of the lender of last resort. Liquidity is created when creditworthy borrowers have access to loans.  While a well functioning economy requires a government that is creditworthy and will protect the value of its currency, a well functioning economy also requires ample access to credit on the part of the populace.  Both public and private liquidity are essential to the operation of a dynamic economy.

Banks provide liquidity to the private sector.  Private sector liquidity exists because banks know how to evaluate and monitor the credit of borrowers.  When banks make loans, they create money.  That is why bank deposits are an important component of the money supply.

The value of bank money depends fundamentally on the quality of the banking system’s lending process.  If the banks make enough bad loans to drive them into bankruptcy, their depositors will lose money and there will be a loss of confidence in the banking system.  In a worst case scenario depositors lose all faith in the banking system and the private provision of liquidity collapses — and the well-functioning economy along with it.  For this reason a banking system must be sound:  banks must on the whole make profitable loans.

Because in a normal banking system some banks fail every year and some depositors lose money every year, there is a risk that depositors will overreact to normal events and lose faith in the banking system even though the banking system is making good loans and is fundamentally sound.  In this environment the private provision of liquidity can be protected by a central bank policy of lending to solvent banks against sound collateral.  These loans allow the solvent banks to honor their obligations to depositors, even though the loans they made are still outstanding.  In this situation the central bank acts as a pressure valve to prevent the natural vagaries of a system of private liquidity provision from destroying the system.

Thus the government has several important roles to play in the provision of liquidity.  By maintaining fiscal and monetary discipline the government ensures that the value of money is reasonably stable and that the government is not extracting (too much) value from the private provision of liquidity.  It also protects the system of private liquidity provision by protecting well-managed banks from a run by depositors.

This public-private partnership in the provision of liquidity is delicately balanced. It requires the central bank to have the discipline to refuse to provide liquidity to any banks that do not have sound lending practices.  Supporting a bad bank is one of the most dangerous actions a central bank can take, because it makes bad lending profitable and thus undermines financial stability.  In short the central bank must act with the understanding that short term instability is the price that must be paid for long-term financial stability.  The lender of last resort is a crucial pressure valve that protects the system, but it cannot be relied on too heavily — or just as in a physical system where the pressure valve is always open — it will stop playing the role of a safety mechanism and will instead act to permit the buildup of destabilizing forces.

Furthermore, banking like all industries is constantly in flux with new products and new practices appearing all the time.  For this reason it is the bankers who have enough information to evaluate their business practices and it may be impossible for the central bank to gather enough information to determine whether a particular bank is solvent in the midst of a crisis.

My concern with William Dudley’s view of the role of the lender of last resort is that his policy would turn a safety valve that ideally is almost never used and was designed to protect the commercial banking system into a reliable path of travel for the whole financial system.  Unless he wishes to propose some alternate backup mechanism that can fill the traditional role of the lender of last resort, I view the proposal as destabilizing over the long term.

Dudley explains why TBTF firms need to shrink

William Dudley claims that there are two sources of instability inherent to financial intermediation.  The first is universally recognized: maturity transformation.  The second is not:

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent as shown in Figure 1. But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line, as shown in Figure 2, because the liquidation value is lower than the firm’s value as a going concern.

In his analysis Dudley fails to ask one very important question:  When is there a big difference between the liquidation and the “going concern” value of financial firms?

I would posit that for old-fashioned banks that hold loans on the balance sheet and take deposits the difference between the liquidation and the “going concern” value of the bank is not necessarily large.  Simple loans are relatively easy to value.  Branches can be sold off.  Key employees who know the borrowers and have relationships with large depositors can be kept on by the firm that purchases a branch.

Almost certainly too big to fail firms have much higher liquidation costs than old-fashioned banks.  Complex asset portfolios are harder to liquidate than simple loan portfolios and are likely to be particularly hard-hit when markets are unstable.  Furthermore too big to fail firms are frequently too large to be managed well even when they are going concerns and thus must be split in many, many pieces in liquidation.  The process of selling off divisions will inevitably lead to some loss of information as employees with broad experience must go in one direction or another.

I read Dudley’s second source of instability as a reason to protect the financial system from oversized financial supermarkets.

Does Caballero support a convertible bank debt policy?

Ricardo Caballero is once again proposing that the government insure private financial institutions against risk.  His theory is that there are no solvency crises, only liquidity crises, and therefore public insurance is needed to support asset prices.  (“Once the crisis sets in, insurance acquires great value and leads to more risk-taking and speculative capital injections into the financial system, but by then this is mostly desirable since the main economy-wide problem during a financial panic is too little, not too much, risk-taking.”)

Caballero is opposed to the resolution of failed financial firms, because decisions made during the resolution would be based on panic prices and therefore error-prone.  Thus resolution, he believes, would only fuel the panic.

I would like to know what Caballero thinks of the idea that whole debt structure (excluding deposits) of financial firms should be convertible in tiers.  By insuring that banks have ample access to capital when they need it, a convertible debt structure guarantees that resolution will occur only when bank assets fall so low that they can’t even support the bank’s deposits.  As long as Caballero’s theory that all crises are liquidity crises is correct, conversion into equity will be in the interests of bank creditors because they will earn spectacular gains as the economy recovers from the crisis that triggered the conversion.  And if Caballero is wrong and there are solvency crises, then the policy insures that it is the creditors of the firm — instead of the government — that bear the cost of the crisis.

On the role of CDS in the Bear Stearns collapse

In William Dudley‘s very informative speech on the what and why of the investment bank failures, there is a very interesting footnote:

One final factor that was important in exacerbating the funding crises was the novation of over-the-counter (OTC) derivative exposures away from a troubled dealer. In a novation, a customer asks a different dealer to stand in between the customer and the distressed dealer. This process results in the outflow of cash collateral from the distressed dealer. The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.

Dudley cites three sources of the failure:
(i)  withdrawal of repo credit backed by illiquid assets
(ii) loss of primary dealer accounts, and
(iii) drain on cash collateral via novation of OTC derivatives

Given the aggressive action in the credit default swap (CDS) market that was demanded by the NYFed after the Bear Stearns failure, I think that it is safe to conclude that the novation of CDS was an important source of cash outflow for Bear Stearns.  This is worth noting because one periodically runs into claims by financial market participants that CDS markets operated effectively throughout the crisis and that CDS are being unfairly targeted by people who don’t understand them.

I suspect that when the full history of the Bear Stearns collapse is written, CDS will play a non-trivial role in the story.