Yes, speculators should respond more to interest rate hikes …

… in a negative real interest rate environment.

There’s an issue that Paul Krugman raises in “Strange Arguments for Higher Rates” that merits a response.  Krugman asks rhetorically:

Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators?

To which I can only respond:  Yes!  The speculators are often financial intermediaries and other financial players who exist on spreads.  The whole point of raising interest rates is to restrict the access of the financial system to free financing  and thereby reduce the quantity of punts taken on risk assets.  Furthermore, because a 1% increase is likely to affect the spread much more dramatically than the real economy’s debt payments, of course, speculators respond more dramatically than non-financial firms.

A critique of standard macro

I looked over Michael Woodford’s “Financial Intermediation and Macroeconomic Analysis” and the first thing I noticed was that his whole conception of financial intermediation is completely different from mine.  I think that Woodford’s approach to financial intermediation is fairly standard in macroeconomics, and thus that he is following well recognized norms when he avoids addressing the complex relationship between banks, money and the macroeconomy.  The habit of divorcing the study of banking and financial instruments from the analysis of monetary and macroeconomics seems to be so deeply ingrained that even in a paper that seeks explicitly to integrate the two, the bias in favor of the existing literature somehow manages to overwhelm the goal of taking financial intermediation seriously.

Unpleasant as this conclusion may be, I think much of modern macroeconomics needs to be understood as fair weather macroeconomics which produces accurate results only when the financial system is operating optimally;  genuinely integrating financial intermediation with macroeconomics will require reconsideration of the fundamentals of macroeconomics.  Afterall banks and money market funds issue liabilities that are counted in basic measures of the money supply, so it is a mistake to discuss “money” without first developing a thorough understanding of the relationship between financial institutions and money.

The biggest conceptual flaw in Woodford’s article comes from viewing the financial system as a place where trust-worthy intermediaries take in deposits and lend out the depositors’ funds.  This most definitely is not the traditional role of a bank in an economy.  Instead, because banks are trust-worthy – and their liabilities are accepted as a means of payment – banks originate loans to creditworthy borrowers as a means of creating liabilities to put into circulation.  That is, loans generate deposits, not vice versa.  In historical environments without capital requirements, banks potentially had unlimited leverage.  (Arguably this is the same conceptual error that Henry Thornton’ 1801 Paper Credit accused Adam Smith of making in the Wealth of Nations.)  In practice, of course, bank leverage was limited by the cost to the banker of failing – such costs usually included loss of all personal assets and sometimes the death penalty.

Once one understands that loans are the means by which banks put their liabilities into circulation, one also understands that banks for the most part are not constrained by some need to have funds flow into the bank before the bank can make loans.  That is, banks can be capital-constrained only to the degree that they face capital requirements on their lending, they are never capital constrained because they have yet to receive an inflow of funds from depositors.  (I will not discuss reserve requirements because the Fed’s interest rate target ensures that reserves can be borrowed at a rate well below the bank’s lending rate and therefore reserves are almost never a binding constraint on bank lending.)

I think that the best way to think about financial intermediaries is that in a modern economy there are public and private issuers of money.  Both the public and the private sector are able to issue money only because they are perceived by the public as trustworthy:  government is able to issue money because the general populace trusts that inflation will be kept within reasonable bounds, and financial intermediaries are able to issue money because the public views them as unlikely to default on their liabilities.

Because financial intermediaries are entrusted by the public with the job of issuing money, they have extraordinary access to leverage.  Their leverage is usually constrained by regulation in the form of capital requirements.

To make my description of financial intermediation a little more concrete, let’s look at the constraints faced by JP Morgan when making a loan.  Currently JP Morgan’s tier 1 leverage ratio is 5.97%, while it is required to have a leverage ratio of at least either 3 or 4%.  Given that JP Morgan has total assets of $1.7 trillion, this implies that per regulatory requirements JP Morgan has somewhere in the realm of $800 billion of free lending capacity.  Now, JP Morgan probably wants to maintain a comfortable cushion of capital to ensure that the bank doesn’t need to worry about falling below regulatory capital requirements even in adverse circumstances, but we can be confident that if some entrepreneur walks in the door with an extremely strong business plan that just needs $1 million of funding, JP Morgan can write that entrepreneur a check today, simultaneously increasing both assets (the loan to the entrepreneur) and liabilities (the check) at the cost of an incremental decline in tier 1 capital.

So how do we reconcile this view of financial intermediation with what Woodford calls the “market-based financial system”?  The first thing to recognize is that the “market based financial system”, at least to the degree that the phrase is meant as a contrast with a “bank based financial system” is much smaller than it appears.  Although the bond market is a true non-bank financial market, in my view most asset backed securities markets, the commercial paper market and the repurchase agreement market – and the money market funds that invest in these assets – should actually be classed as sub-categories within the “bank based financial system”.  (I will not discuss mortgage backed security markets here, because these markets are complicated by the important role played by government-sponsored financial intermediaries like Fannie Mae, Freddie Mac and the Federal Housing Administration, and require detailed analysis that is far beyond the scope of this post.)

Let me illustrate how lending takes place in the asset backed securities market.  A bank originates an auto loan, just as JP Morgan originated the entrepreneur’s loan, by simultaneously creating an asset (the loan) and a liability (the check written to the dealer for the purchase of the car).  It packages this loan along with hundreds of others and sells it to an asset backed commercial paper conduit, replacing loans in the conduit that have matured.  The conduit raises the funds needed to buy the loans on the commercial paper market, so one might be inclined to say that this is market-based lending.  There is, however, a catch:  in order for the conduit to have an investment grade rating (which is required if it is to finance itself on the commercial paper market), a bank must provide the conduit with a liquidity backstop.  Because the conduit’s liabilities mature much earlier than the conduit’s assets, this liquidity backstop protects commercial paper buyers in the event that the conduit is unable to roll over its commercial paper issues.  Even though the bank provides a liquidity, not a credit, guarantee, as a practical matter the short maturities of commercial paper all but ensure that the conduit will experience a liquidity crisis months before its credit rating is downgraded so low that the bank is no longer obliged to honor the liquidity guarantee.  Thus, asset backed commercial paper (ABCP) should be viewed as bank lending with the ABCP conduit as an additional intermediary, that in theory can carry credit losses, but in practice serves to reduce the capital a bank must hold against the loans – since liquidity backstops have very small capital requirements.

The multi-tiered bank based financial system

Money market funds also play a role in this process, because they are important purchasers of asset backed commercial paper.  But the fraction of money market fund assets that do not carry a guarantee from either the federal government or the banking system is probably quite small.  According to the Investment Company Institute at the end of 2009, the funds in non-government money market funds were invested as follows:  14% government and agency issues, 39% certificates of deposit and bank notes, 27% commercial paper, 9% repurchase agreements. [1] Certificates of deposit are explicit bank liabilities.  The vast majority of commercial paper carries either an explicit (in the case of bank issued commercial paper) or implicit (in the case of a liquidity backstop) bank guarantee.  Data on repos is hard to find, but it seems highly unlikely that money market funds are deliberately choosing hedge funds and other risky firms as counterparties.  Most likely, a large majority of money market fund repos are repos with bank counterparties.

In short, it’s a mistake to look at lending by money market funds and assume that this lending can be classified as “market based” in contrast with “bank based” lending, because the vast majority of assets that money market funds choose to invest in are protected by a bank or government guarantee.  The role of money market funds is (i) to channel money into the banking system via financial commercial paper, certificates of deposit and repos and (ii) to reduce the capital banks are required to hold against their loans by removing loans from bank balance sheets via non-financial and asset backed commercial paper, protected by bank backstops.

In fact, I find it odd when people claim that the fact that banks are financing themselves via commercial paper, repos and CDs is evidence of the growth of “market based” lending.  To me this is just evidence that money market funds should be viewed as an adjunct to the banking system.  It seems to me that the only reason money market funds are more successful than banks at raising money from the public is that they have lower costs, because they are not required to hold any capital whatsoever to protect against the possibility that they cannot repay account holders.  I have addressed the fundamental illogic of the regulation of money market funds elsewhere.

In my view the correct way to characterize the US financial system is to describe it as a multi-tiered bank based financial system.  In the 1950s the US had a simpler financial system where the circular flow of funds went from banks to firms to households and back to banks.  Now-a-days that channel still exists, but in addition there are a number of multi-tiered channels, for example:  from banks to firms to households to money market funds to asset backed commercial paper conduits to banks.

One of the reasons this multi-tiered structure has developed is because it is an effective means of circumventing bank capital requirements and thereby increasing the leverage in the economy and the availability of credit.  Minimizing capital has the effect of increasing the short-run profitability of financial intermediaries at the expense of their long-run solvency.  When the financial industry’s competitive forces are not restrained either by regulation or via punitive costs of failure, the profitability of undercapitalized intermediaries can easily force older well-capitalized firms to find a way to participate in undercapitalized lending.  It is important for regulators to understand that one consequence of an aggressively competitive financial market is likely to be undercapitalization and instability – as the bad banks drive out the good.

Why don’t those who lend to financial intermediaries constrain leverage to levels consistent with financial stability?  I can see two main reasons.  In some cases it is for the same reason that depositors cannot be relied on to discipline banks in an economy without deposit insurance:  the lenders have neither the information nor the sophistication necessary to evaluate the behavior of the intermediary.  They know there are dangers to maintaining a deposit account, but want to take advantage of the convenience of deposits as circulating currency. Knowing that what they do not know can hurt them, these depositors are apt to react strongly to rumors with the result that bank runs are endemic.

I would say that this is a fair description of what happened with investors in money market funds:  they were informed of the risks and chose to take them because of the convenience value of the accounts.  However, as soon as there was a hint of danger these same investors sought to withdraw from the accounts.

On the other hand, another reason for investors not to constrain leverage to levels consistent with financial stability is that there are explicit and implicit guarantees from the government to prevent instability in the banking system.  In the ABCP market, money fund managers relied on bank liquidity backstops to give them time to exit the commercial paper and transfer any losses to the banking system.  Government guarantees ensure that the money fund managers don’t need to worry about the failure of the bank-guarantor rendering those liquidity backstops valueless just when they are most needed.  As money fund managers generally choose to invest in bank guaranteed assets, it seems very likely that the government’s commitment to the stability of the banking system is an important driving force behind these decisions. Even the rating agencies take the government’s commitment to the stability of the banking system into account explicitly when they determine that an asset is investment grade.  In such an environment, it seems a bit odd to expect investors to constrain leverage.

Once one realizes that bank guarantees – and through the banks, government guarantees – are essential to most of the assets in the “market-based” financial system, one is forced to recognize that this nomenclature is misleading.  This is why I propose that our current system should be called a multi-tiered bank based financial system.

Financial capital is an endogenous variable

We have found that, because macroeconomists choose not to carefully evaluate financial instruments and their relationships to each other, they have failed to correctly characterize the type of financial system we have – and have effectively assumed that it is “market based” despite abundant  factual evidence to the contrary in the form of bank guarantees.  There is, however, another serious error that derives from a failure to carefully evaluate the role of financial intermediaries in the money supply.  By ignoring the fact that financial institutions issue money, macroeconomists generate capital constraints that do not in fact exist.

Woodford claims:  “Probably a more important limit on credit supply derives from the limited capital of intermediaries — or, more fundamentally, the limited capital of the “natural buyers” of the debt of the ultimate borrowers — together with limits on the degree to which these natural buyers are able to leverage their positions.”

I believe that the fundamental misconception that deposits create loans rather than vice versa is leading Woodford astray here.  Once one accepts that financial intermediaries issue money, one realizes that there are no absolute constraints on the amount of capital in the system.  Just as the monetary authority can choose a helicopter drop of cash, so the financial intermediaries can create “capital”.  Think for a moment:  there is a borrower whose income for years was viewed as limiting him to a $200,000 mortgage, but in our competitive overleveraged financial system this borrower – and all his neighbors – is suddenly able to afford a $400,000 mortgage.  As one might expect house prices rise – for simplicity, let’s say that they double.  The seller of each house has twice as much “capital” as in the past (or even more if the house was not fully paid off).  Even though half of his capital was created by the fact that lending standards have collapsed, the seller still has the ability to invest the full amount as a “natural buyer” into whatever asset he chooses.

In short, a collapse in lending standards is inflationary, just like the government’s printing press.  It just so happens that our recent inflation showed up more in asset prices, than in goods (thanks most likely to the Chinese).  Thus the claim that financial intermediaries as a group are constrained by “the limited capital of the ‘natural buyers’” is incorrect, because it fails to take into account the fact that the amount of that capital is endogenous to the behavior of the intermediaries.  When credit is easy, “capital” will be relatively abundant and when credit is tight it will be relatively scarce.  This is part and parcel of an understanding that banks issue money.

For example, ABCP conduits and money market funds are intermediaries that hold no capital to protect investors in the event that assets go into default.  Because the loans that are funded by the interaction of money market funds and ABCP conduits go back into the system in the form of either money market deposits or bank deposits, there are very few constraints on the leverage these two financial intermediaries can jointly create.  The constraints enter in at the level of the underwriters:  In a world where nobody originates bad loans, the two intermediaries will probably facilitate very efficient allocation of credit.  However, in a world where lending is not sound, the fact that ABCP conduits buy bad assets and money market funds are indirect investors in these bad assets will mean that these two intermediaries are facilitating the growth of an overleveraged financial system.

Furthermore, the absence of capital means that the value of ABCP and money fund liabilities collapses much more easily than that of bank deposits, and these intermediaries are even more subject to runs than the uninsured banks of the 19th century.  It is far from clear that it makes sense for these financial intermediaries to exist in an environment where underwriting standards can break down – it is instead clear that if market forces had been allowed to operate both of these two intermediaries would have seen their market share plummet, and possibly even be extinguished entirely.

In short, I think that a careful analysis of the role of financial intermediaries in the macro economy will conclude that credit supply depends most importantly on the credibility of intermediaries, not on their capital.  As long as both money market funds and ABCP conduits were viewed as conservatively managed, safe investments, credit was abundant, but the moment that their management was doubted, credit evaporated.  In practice, it seems to be easy for the public to grant infinite leverage to intermediaries who are trusted with the issue of the circulating money supply, like banks and money funds – only to draw back in distrust when that easy access to leverage results in flawed lending policies.  Thus in order to understand what constrains credit supply, I think one must look towards (i) coordinated behavior by financial intermediaries who recognize that it is in their interests to avoid a collapse of credit, (ii) underwriting norms which depend on the penalties to intermediary failure and (iii) government regulation.

Update 7-1-10: I’ve been reading the comments on this post over at Interfluidity and wanted to mention that the idea that deposits come from loans is an idea that’s been around for a very long time.  I would source it back to Henry Thornton, but wouldn’t be surprised if earlier bankers turned theorists had also reached the same conclusion.  More recently it has been used as a tenet of Randall Wray’s endogenous money theory and of “Modern Monetary Theory”.


[1] For reference at the end of 2006 non-government money market funds were invested as follows:  3.5% government and agency, 20% CDs and bank notes, 39% commercial paper, 11% repurchase agreements and 21% corporate notes.  It is possible – though I do not in fact know what the norms were in this market – that some of the corporate notes were protected by bank liquidity guarantees.

Subprime vs subprime

The financial industry’s way with words — that is, the industry’s way of making sure that words never mean what you think they mean — has tripped up the academics once again.  The recent debate between Raghuram Rajan and Paul Krugman over the role played by Fannie Mae and Freddie Mac seems to hinge on the fact that they are talking at cross purposes.

The commonly understood meaning of “subprime” when referring to securitized mortgages is to be found in wikipedia:

Varieties of underlying mortgages in the pool:

  • Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
  • Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
  • Subprime: weaker credit scores, no verification of income or assets, etc.

There are also jumbo mortgages, when the size is bigger than the “conforming loan amount” as set by Fannie Mae.

Since a “conforming mortgage” is one that meets the criteria set by Fannie Mae and Freddie Mac, the traditional meaning of subprime is a loan that does not meet Fannie Mae and Freddie Mac’s criteria for a reason other than loan amount.  (Alt-A came much later than sub-prime.)  For this reason it is common to see the words “prime” and “conforming” used interchangeably in mortgage articles.

Thus using the traditional approach, any MBS issued by Fannie or Freddie is, by definition, not a sub-prime MBS.  When Fannie and Freddie invested in sub-prime they did so by buying up privately issued sub-prime MBS.  It seems obvious that in this market Fannie and Freddie were two of many, many guilty parties.

What makes the whole discussion complicated is that (I think) the GSE’s loan criteria became less discriminating over time.  Thus, if one wants to fix the definition of sub-prime based on the GSE’s standards in, for example, 1998, one can claim that the GSEs themselves were issuing “non-conforming” MBS.  On the other hand, it is unarguable that even when the GSEs were issuing “non-conforming” MBS, the loan criteria were always noticeably stricter than those in the privately issued subprime MBS market.  The bottom line is that the lending behavior of the GSEs is not well suited to a casual assertion that they started issuing subprime MBS, but instead deserves a carefully researched dissertation that breaks loans into far more granular categories than prime, subprime and Alt-A.

Tanta is of course the go-to source for anyone who wants to understand the nitty-gritty details of the mortgage market.  For an extremely thorough discussion of what precisely it means for a loan to be sub-prime or Alt-A see here, and here for a thorough discussion of what precisely the GSEs were doing when they securitized loans — see in particular the paragraph that starts:  “Propaganda from certain other market participants aside, you cannot just put any old loan in a GSE MBS.”

The problem with negative real interest rates

The “Taylor rule” is representative of a large school of macroeconomic thought which takes the view that monetary policy-makers should set the policy rate as a function of the inflation rate and the unemployment rate (or an alternate measure of economic slack).  Those who have been schooled in this framework have difficulty understanding why anyone would recommend raising the policy rate when inflation is extremely low and the economy is weak.

Monetary policy is viewed as a “neutral” policy because it works through interest rates.  As long as the big banks pass changes in the policy rate on to borrowers, then all participants in the economy are able to benefit from any decreases in the policy rate and to face the costs of any increases.  Fiscal policy by contrast will always favor some beneficiaries of the government’s largess over others, and thus cannot be considered “neutral”.  It should be noted, however, that the neutrality of monetary policy depends on the competitive structure of the monetary transmission mechanism and if the banks that trade in the federal funds market, where policy rates are set, do not always pass on changes in the policy rate, monetary policy will act as a subsidy to the big banks.  In fact, it is my view that when the policy rate approaches the zero lower bound — and real interest rates are negative — the incentive for financial intermediaries to arbitrage their negative cost of funds distorts lending markets and the monetary transmission mechanism.

Models that support the use of a Taylor rule rarely specify the structure of the financial system explicitly.  And I think that the best way to understand them is that they express a very simple view of financial intermediation along these lines:  A vast number of the transactions that underlie economic activity are dependent on the extension of credit — many firms depend on short-term credit to finance working capital and on long-term finance to make large scale projects possible and most consumers are dependent on credit to finance large purchases like homes and automobiles and other consumer durables.  For this reason a decrease in the interest rate tends to reduce the cost of financing transactions and by reducing their cost increase the number of transactions — and it is of course these transactions that are used to calculate GDP.  The role of financial intermediaries in this process is to hold as deposits the income received by the consumers (who also staff the firms) and sales receipts of the firms and recycle those deposits into the loans — at an interest rate sensitive to the policy rate — that allow this economic activity to take place.  In short, the model is based on old-fashioned banks that (i) hold loans on their balance sheet — and because they carry long-term exposure to these loans underwrite them very carefully and (ii) set interest rates on the loans they offer in a competitive market.

There are many historical time periods in which this simple model of financial intermediation is accurate enough.  However, the drive towards profitability in the financial system has a tendency to generate a process of financialization in the economy.  A multi-tiered financial system is created in which banks lend to other financial intermediaries who in turn lend to other financial intermediaries or the real economy.  One of the most common consequences of this process is a reduction in the capital supporting the issue of loans.  In fact the profitability of the multi-tiered system is generally driven by the fact that more loans can be issued with a given capital base.  (It is precisely because there are norms for bank capital requirements that a new kind of intermediary has to be created.)

Some examples of this process are the bill-brokers of mid-19th century England, who are discussed in detail by Walter Bagehot, and whose role in the financial system was greatly reduced after the failure of Overend and Gurney in 1866.  In the early 20th c US, trust companies and investment trusts were important vehicles for financialization — until the reforms of the ’30s forced a return to “plain vanilla” banking.

Of course another wave of financialization has taken place over the past few decades and it is this multi-tiered financial structure that interferes with the simple operation of the Taylor Rule.  Modern banks don’t hold the loans they originate, but instead either sell them off — to for example an asset backed commercial paper conduit — or finance them on the repo market.
(i)  Because the loans are not carried on the balance sheet, but instead have their value realized at the date of origination, the immediate value of the loan becomes more important than the life-long value of the loan.  This is an environment which is primed to issue as many loans as possible.  Furthermore,
(ii) Each tier of the financial system is profiting from an interest rate spread and when nominal interest rates are below the rate of inflation, economic incentives push these intermediaries to borrow as much as possible and finance as many loans as possible.  While, in theory, these should all be “good” loans with little risk of credit loss, (i) ensures that the incentives are not necessarily aligned to guarantee the quality of the loans.

Another aspect of modern financialization is that financial intermediaries are able to use their borrowed funds to trade on secondary markets — an act that has traditionally been prohibited for banks.  Thus, the unlimited demand for funds created by negative real interest rates is easily channeled into purchases on secondary markets.  The natural consequence of this process is that negative real interest rates tend to drive up the value of risk assets like stocks and junk bonds.  Of course, to the degree that the demand for these assets is driven by the negative cost of borrowing, normalization of interest rate policy will necessarily have the effect of reducing demand for these assets and the value of risk assets.  Thus, negative real interest rates will tend to create increases in the prices of risk assets that are unsustainable over the long-run.

In short, in an environment where new financial intermediaries have been created that attenuate the relationship between deposits and loans, negative real interest rates create an unlimited demand for funds by the financial sector which can easily flow into loans of dubious quality and markets for risky assets as intermediaries gamble on their ability to successfully arbitrage the negative cost of funds.  This view implies that in an economy with a multi-tiered financial system the Taylor rule needs to be adjusted for the additional economic costs created by a policy rate that falls below the rate of inflation — and that as we near the zero bound the optimal policy rate will be significantly higher than that implied by the Taylor rule.  On the other hand these concerns will not necessarily apply to an environment where a law like Glass-Steagall (i) restricts the activities of financial intermediaries in a way that protects the profitability of simple commercial banks, while at the same time allowing for interbank competition, and (ii) precludes the flow of funds borrowed by intermediaries into secondary markets.