Do “net financial assets” matter?

I’ve just read Steve Waldman’s post on “net financial assets” and am connecting it up with Michael Pettis’ excellent discussion. (See also Cullen Roche’s comment on the issue.)

Steve discusses the decomposition of financial positions on which MMT is based. He points out that the term “net financial assets” is used for the “private sector domestic financial position” which refers exclusively to the aggregate netted financial position of both households and firms and explicitly excludes “real” savings such as any housing stock that is fully paid up. By definition, if the “private sector domestic financial position” is positive, then it must be the case that on net the private sector holds claims on either the government or on foreign entities. Of course, the value of such claims depends entirely on the credibility of the underlying promises — this is the essential characteristic that distinguishes a claim to a financial asset from a claim to a real asset.

For Steve, there is a tradeoff between holding financial claims and holding real claims, and a principal reason for holding financial claims is to offset the risk of the real claims. Thus, Steve goes on to claim that to the degree that such a positive private sector financial position is due to claims on government, the government is using its credibility to provide a kind of insurance against real economy risk.

This is where I think Steve both gets what happened in 2008 right, and gets the big picture of the relationship between the financial and the real, and between the private sector and the public sector wrong. Steve is completely correct that in 2008 the issue of public sector liabilities played a huge insurance and stabilization role.  But Steve extends his argument to the claim that: “The domestic private sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the state.”

The key point I want to make in this post is this: the financial and the real are so interdependent that they cannot actually be divorced. The same is true of the private and the public sectors. Financial activity and real activity, public sector activity and private sector activity are all just windows into a single, highly-integrated economy. Thus, I would argue that it is equally correct to state that: “The domestic public sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the private sector.”

That financial activity and real activity are two sides of the same coin is most obvious when one considers that the credibility of private sector financial liabilities depends fundamentally on the performance of the real economy. But it is equally true that the credibility of public sector liabilities (when measured in real terms) depends fundamentally on the robustness of the real economy as well. Those countries that have very highly rated debt did not achieve this status ex nihilo, but because of the historical performance of their economies and the robustness of their private sectors.

Thus, it is entirely correct that the public sector can temporarily step in to provide insurance for the private sector when it is struggling, but the view that it is the public sector that is the primary provider of insurance fails to capture the genuine interdependence that lies at the heart of a modern economy.

Indeed, Steve recognizes the danger of framing the financial and the real and the public and the private in this way in his last paragraph, where he acknowledges that this publicly-issued insurance is in fact provided in real terms at the expense of a segment of the private sector — the segment that does not hold the claims on government.

Michael Pettis on Creating Money out of Thin Air

Now let’s turn to Michael Pettis (whom I’ve never met, so I’ll call him by his last name). Pettis has long stood out as an economist with a uniquely strong understanding of the relationship between the financial and the real. He argues that “When banks or governments create demand, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other, equally easily specified, cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand out of thin air, as many analysts seem to think, because doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.”

His two cases are a full employment economy (without growth) and an economy with an output gap. He argues that it is only in the latter case that the funding provided by banks (or government) can have an effect on output. In a comment to Pettis’ post I observed that his first case fails to take into account Schumpeter’s theory of growth. An economy is at full employment only for a given technology. Once there is a technical innovation, the full employment level of output will increase. Schumpeter’s theory was that the role of banking in the economy was to fund such innovation. Thus, there is a third case in which bank finance in a full employment economy does not just transfer resources to a different activity, but transfers them to an innovative activity that fundamentally alters the full employment level of output. Thus, it is not only when the economy is performing below potential that bank funding can create the production that makes savings equal to investment. When banks fund fundamental technological innovation, it is “as if” the original economy were functioning below potential (which of course if we hold technology constant at the higher level, was in fact the case — but this deprives the concept of “potential GDP” of its meaning entirely.)

Schumpeter was well aware that the same bank funding mechanisms that finance fundamental technological innovation, also finance technological failures and a vast amount of other business activity. Indeed, he argued that even though the banking system was needed to finance innovation and growth, the consequences of the decision making process by which banks performed this role included both business cycles and — when banking system performed badly — depressions.

In short, there is very good reason to believe that even in a “full-employment” economy when banks create debt, some fraction of that process creates additional demand. The problem is that the fraction in question depends entirely on the institutional structure of the banking system and its ability to direct financing into genuine innovation. It’s far from clear that this fraction will exhibit any stability over time.

How Did We Get Here: The Fault Lies in Our Models

So why do economists fall into the trap of treating the financial and the real as separable phenomena? Why do macroeconomists of all persuasion look for solutions in the so-called public sector?

The answer to the first question is almost certainly the heavy reliance of the economics profession on “market-clearing” based models. In models with market-clearing everybody buys and sells at the same time and liquidity frictions are eliminated by assumption. Of course, one of the most important economic roles played by financial assets is to address the problem of liquidity frictions. As a result, economists are generally trained to be blind to the connections between the financial and the real. People like Michael Pettis and proponents of MMT are trying to remove the blindfold. They are, however, attempting to do so without the benefit of formal models of liquidity frictions. This is a mistake, because the economics profession now has models of liquidity frictions. The future lies in the marriage of Schumpeter and Minsky’s intuition with New Monetarist models.

The answer to the second question is that we have a whole generation of macroeconomic policy-makers who think that the principal macroeconomic economic debate lies between Keynesians and Monetarists, when in fact both of these schools assume that the government is the insurer of last resort. The only distinction between these schools is whether the insurance is provided by fiscal or by monetary means. (To understand why our economies are struggling right now one need only understand how the assumption that the government is the fundamental source of liquidity has completely undermined the quality of our financial regulation.)

The concept of liquidity as a fundamentally private sector phenomenon that both drives the process of growth and periodically requires a little support from the government (e.g. giving the private sector time to weather a financial panic without the government actually bearing a penny of the losses) has been entirely lost. Only the future can tell us the price of this intellectual amnesia.

On the “Low for Long” Report

Given that my preferred explanation for low real interest rates are the changes that have been wrought within the developed world’s financial markets — and in particular the growth in collateralized inter-bank lending, I read with interest the newly released report, Low for Long? Causes and Consequences of Persistently Low Interest Rates by Sir Charles Bean, Christian Broda, Takatoshi Ito, and Randall Kroszner.

The authors establish the basic facts:

the world long-term real risk-free rate has been drifting down remorselessly from around 4% in the late 1990s to just below zero today.


The very low level of long-term risk-free real interest rates in the advanced economies is historically most unusual. Real rates have rarely been so low; when they have been, it has almost invariably been during or after a war, when there was a degree of financial repression and/or inflation was elevated. The present configuration of low real rates with low inflation appears to be unprecedented.

In Chapter 2 the authors discuss the various explanations for why real interest rates have declined “remorselessly” from 1998 or 1999 on. While the authors do discuss shifts in preferences in favor of “safe assets,” they do not even mention what I would consider the most important explanation for such a demand shift: the increasing collateralization of financial exposures on the part of our biggest financial institutions. (As was noted in my previous post, data on this is available from the ISDA.) Indeed, the only source of an increase in demand for safe assets that the report cites which is consistent with the timing of the drop in rates is the increase in emerging market demand for foreign exchange buffers subsequent to the Asian financial crisis. All of the other explanations in this subsection refer to sources of increased demand subsequent to the crisis (post-crisis recognizing of the extent of possible bad outcomes, post-crisis regulatory requirements for banks to hold larger buffers of safe assets, and the demand for safe assets created by central bank quantitative easing policies.)

What is missing from the report is this: the latter stage of the Asian financial crisis coincided with the LTCM failure. The LTCM failure led to a significant increase in the collateralization of financial sector exposures. Collateralization ramped up continuously over the early years of the current millennium as laws supporting collateralization regimes were adopted in the US, the UK, and Europe. It is remarkable that this potential explanation of prolonged low rates on “safe assets” which has the same timing as the emerging markets savings glut explanation and therefore meets one of the most important criteria considered by the report has been entirely omitted from it.

This lapse strikes me as evidence that the financial sector is invisible to modern macroeconomists. I, of course, can’t help wondering whether this blindness is generated by the models they work with. In my view, we need to take a long and hard look at modern finance and how it has changed the way the real economy operates.

Economics, the big questions, and scoring opportunities

Barry Ritholtz sends us to Brad DeLong using a sports analogy to criticize the economics profession:

The first principle of success in practically any endeavor is to move not toward where the ball is, but where it is going to be. Economists, as a rule, ignore this principle, indulging in the likely-to-be-vain hope that policies that would have worked yesterday will still work tomorrow

The only sport I have much understanding of is soccer, and this principle is far from correct in soccer. I have long felt that economists are seriously handicapped by their failure to follow basic team sport principles, so here’s my sports analogy for economics.

In soccer, the job of every player on the field is to move the ball to the position that maximizes the likelihood of scoring. The job of a coach at the developmental level is to teach the players to “see the field” before the ball is received in order to read where the ball needs to move next . Usually there are only one or two good answers to this maximization problem. Good players create danger by making the right choices of where to pass, and mediocre players don’t. (If you want to see a realization of this maximization process in action, watch Germany’s 2014 World Cup games.)

So “the first principle of success” in soccer is to create scoring opportunities by moving the ball effectively (and not always forward) on the field. (The second principle of success is to move when you don’t have the ball to a position that will make you the optimizing choice for the player receiving the ball. That is, contra DeLong, a good player creates the place where the ball will be next.) The problem with the economics profession is that it plays like Spain in the 2014 World Cup, it’s very good at passing side to side, but much weaker when it comes to creating and finishing scoring opportunities.

Thus, the economics profession must, first, define the scoring opportunities — or the big questions that economics must answer — and, second, the profession needs to play as a team always trying to move the ball into a position so that your teammate can score — except in the unusual case that you are best positioned to take the shot.

This, I think, is one way to understand Paul Romer’s critique of the economics profession. He is concerned that the current process promotes prima donna-like behavior, where the authors of articles set themselves the task of dribbling through four defenders and succeed only at losing possession of the ball entirely. And when there is team play it is wasted, dithering about, not even trying to answer important questions.

In short, the economics profession has an extraordinary wealth of formal analytic tools. Now that those tools have been developed, the challenge is to deploy them effectively to answer the big — mostly macroeconomic — questions. In order for this deployment to be effective, teamwork is necessary. The masters of the formal tools need to stop passing the ball laterally and start working on deploying them to answer the big questions. (The segment of the profession that seems to me to be making the greatest progress in the latter effort is “new monetarism.”) The proponents of big questions need to stop sniping at the formalists, acknowledge the weaknesses in their own economic toolbox, and, I would argue, set to work building models that take money and finance more seriously than New Keynesian models do.

I am optimistic that this challenge can be met. Teamwork was in evidence when the New Keynesian models were developed. And post-crisis, there is widespread acknowledgment of the need for better incorporation of finance into economic models, and many steps along this path have already been taken. But the economics profession needs to remember that the fastest way to progress is to act always with awareness of where the goal is, with a broad view of the entire field of players, and with each individual making careful decisions as to how to move the ball so that someone else can score.

Negative real rates signify a broken financial system

Noah Smith reviews the debate over negative real rates, and Brad DeLong remarks on “how profoundly strange and unexpected” is the current environment. While Noah covers all the most common explanations for real rates, I think that he — and most of econo-blogosphere — are missing a key factor that is probably driving this data.

First, recall that the problem of negative real rates is very much focused on the “safe” side of the market. That is, it is Treasuries (and similar assets like Bunds) that bear negative real rates. The market rates available to non-public borrowers are much higher than the rate on “safe assets.” (The distinction between these two rates is the premise behind Caballero and Farhi’s work.)

In my view the missing element of the discourse on the low yields of safe assets is the remarkable change in the structure of the financial system that started very slowly in the 1990s, accelerated at the end of that decade, and was a full-fledged financial revolution by the end of the next decade. This change is the collateralization of inter-bank lending, that previously was unsecured and funded on the basis of reputation-type mechanism.

ISDA data shows that with the growth of swaps starting in the early 1990s, collateralization of bilateral derivatives contracts become fairly common, though far from ubiquitous. Subsequent to the 1998 LTCM crisis, collateralization of derivatives contracts became much more widespread. The 2000 Commodities Futures Modernization Act pre-empted long-standing common law and state law constraints on derivatives markets, which subsequently grew dramatically — along with the use of collateral. The 2005 bankruptcy reform act dramatically changed markets for collateral, and in particular made it possible for the repos of just about any asset to trade on a par with derivatives collateral.

In addition in the early naughties, the growth of structured financial assets that made possible synthetic assets in which “investors” sold protection on bonds (instead of investing in actual bonds) and held the collateral that was used to guarantee payment on the protection contracts in “safe assets.” Finally, financial market participants have sometimes commented that the Basel rules for banks promoted collateralized interbank lending over unsecured interbank lending (though I’ve never really investigated this point).

In short, the same data the Ben Bernanke explained in terms of a “savings glut” can also be explained by the financial industry’s massive increase in demand for safe assets that serve as high quality collateral over the same time period. The financial industry’s demand is a demand for safety and cannot be met by risky assets, so it is an excellent explanation for the 21st divergence between the behavior of “safe” interest rates and risky interest rates.

Furthermore, since the 2008 crisis the financial industry’s demand for collateral has only increased. In 2008 the unsecured interbank markets, including both the Federal Funds market and the Libor market, collapsed. They have not recovered. Interbank lending has shifted almost entirely to a collateralized basis. While it is true that the demand for collateral that was created by structured finance products has largely disappeared, this is most likely offset by regulatory changes that increase the demand for collateral.

In short, the best explanation for why private markets are forcing interest rates to zero is that the banking system is broken. The system which functioned for centuries on the basis of unsecured, reputation-based, inter bank lending no longer exists. ZIRP is just evidence that the financial industry is turning to government as a source of the liquidity that the financial industry is no longer capable of creating on its own.

Models, Depressions, and “Natural” Economics

My recent work has led me to study classical banking theory, which informed both Wicksell’s and Schumpeter’s understanding of the economy. Classical banking theory views bank liabilities as the primary form of money and argues that, given a well-structured financial system, the quantity of money is endogenously determined by the demands of the business community for the finance of accounts receivable and similar short-term loans.

This theory of money views the role of banks and supply of money as passively responding the needs of the real economy. And this view was, probably correctly, targeted as one of the reasons U.S. officials failed to act aggressively during the Great Depression in he 1930s. Certainly both the Monetarists and the Keynesians who would develop what is now known as macroeconomics saw classical banking theory as a school of thought that was best exterminated. And these days extraordinarily sophisticated works that took a banking theory approach in the mid-20th century are now relegated to the moth-balled “depository” shelves of university book stacks (e.g. the work of R.S. Sayers).

In short, in the 1930s there was a predominant model of the money and banking system. This model when it was applied to circumstances far beyond the realm of its usual operation failed. When it failed, proponents could not recognize that failure and instead used the model to justify the view that real economic performance was a “natural” phenomenon about which there was nothing they could do. They were firmly convinced there was no need to act.

Reading David Beckwith and Paul Krugman today, I couldn’t help wondering whether history is beginning to rhyme. After describing the views of those who doubt the continued efficacy of policy rates that are held at zero, Beckwith writes:

What I wish George Will, Bill Gross, and other free market advocates would consider is the possibility that the Fed itself is not the source of the low rates, but simply is a follower of where market forces have pushed interest rates. That is, the Great Recession and the prolonged slump that followed  caused interest rates to be depressed and the Fed did its best to keep short-term interest rates near this low market-clearing level.

Krugman, discussing Beckwith’s post, gives a very clear description of how this view is the output of the current predominant model of the macroeconomy:

He’s completely right about the economics. . . . we have a very clear model that tells us what interest rates would be in the absence of distortions and rigidities, the Wicksellian natural rate — the rate of interest consistent with an economy subject neither to inflationary overheating nor deflationary excess supply. And with inflation consistently below the generally accepted 2 percent target, this model says that the actual interest rate, at zero, is above the natural rate, not below.

And all I can hear reading this is the rhyme of history. We have a model and we rely on it to be right. That model tells us that low rates are “natural.” There is nothing more to be done. We must keep rates at zero until the economy improves. But just as in the 1930s the model is being applied far beyond the region of the data in which we have knowledge that it works.

And my guess is that just as in the 1930s we will find that we need to develop a completely different model, built on completely different premises in order to develop policy recommendations for our current problems. My own view is that this a good time to revive classical banking theory and relearn what it has to say about central bank policy and what makes the economy tick.

David Andalfatto has given a very simple explanation of why such new models are needed: the data can be explained by debt-constraints just as well as it can be explained by a negative real interest rate. This accords very closely with Schumpeter’s view that every economic “catastrophe” can be attributed to dysfunction in the banking sector. Perhaps it will be only after we have relearned how to model the monetary role of the banking system that we will be able to escape the tragedy of ZIRP.