Is modern finance the source of secular stagnation?

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.

Does the 2007-2008 crisis show that the universal banking experiment has failed?

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.

Stabilizing the financial system: should banks carry long-term assets?

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 Problem with “Rational Expectations” is that it’s Usually Irrational

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.

Thoma concludes:

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.

Economic Theory does not Predict that Markets Produce Efficient Outcomes

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.