On “How the world economy shifted”

This is a commentary on Chapter 5 of Martin Wolf’s book, The Shifts and the Shocks.

Martin Wolf’s explanation of the euro zone crisis, and of the problems created for the currency union by countries that are determined to run a surplus is clear and convincing. (Indeed, if my memory serves me correctly, his reasoning echoes the initial rationale for the IMF, with its deliberate penalties for countries that run a surplus.)

The discussion of the savings glut is however less effective. The problem is that there are two aspects to this story: first the policies of emerging market countries that undervalue their currencies and make it easy for them to run current account surpluses and, second, the uncharacteristic movement of the U.S. business sector into surplus around the same time period.

Wolf makes it clear that the latter played an important role in the savings glut. The problem faced by Wolf and other advocates of the savings glut view is, however, that there is a coherent explanation for the surplus only in the case of the emerging market countries. Not surprisingly the text focuses on the explainable aspects of the glut and restricts its discussion of the U.S. business sector surplus mostly to remarks on the significance of its size.

This omission is extremely important, because Wolf makes it clear that an important factor in the crisis was the dysfunctional manner in which U.S. markets responded to both the savings glut and the subsequent reduction in the federal reserve’s policy rate which was designed to stimulate the U.S. economy and offset the adverse effects on U.S. employment of the combination of a huge trade imbalance and a deficit of business borrowing. U.S. financial markets responded to these two phenomena by creating unsustainable leverage and balance sheet deterioration in the household sector.

My concern is with the causality that Wolf assumes. Let me propose an alternative interpretation of the facts. We know that when a bubble pops there is a transfer of resources away from those who purchased at the peak and to those who buy at the nadir. One function of the massive extension of credit to households was to ensure that there was a lot of underinformed, “dumb” money buying into the peak of the bubble. To the degree that corporate decision-makers have access to investment funds where knowledgeable financiers either can navigate the bubble successfully or are just successful at convincing the decision-makers that they can do so, a profit maximizing corporate decision maker may prefer to invest in financial assets than to risk money on the production of products that need to be marketed to the already over-extended household sector. In short, the possibility that (i) the U.S. business sector was the important factor in the savings glut “at the margin,” and that (ii) the causality for the U.S. business sector’s participation in the savings glut runs from the overindebtedness of the U.S. household sector and a general tendency of the modern financial sector to misallocate resources to the financialization of the U.S. business sector’s use of funds, at least needs to be entertained and evaluated.

In short, I am uncomfortable with the assumption of causality implied by sentences like the following: “What the market demanded the innovative financial sector duly supplied . . . By creating instruments so opaque that they were perfectly designed to conceal (credit) risk.” (at 172). Given how difficult it is to establish causality, should we not be asking whether financial innovation, and in particular the ability of the financial sector to create assets that one side of the transaction did not understand, drove a demand to take the other side of transactions with such “dumb” money (of course, giving a substantial cut of the returns to the innovators and originators of these assets)?

Thus, while Wolf argues that household leverage and balance sheet deterioration were necessary to offset the massive demand deficiency created by the savings, he doesn’t really address the problem that a big chunk of this demand deficiency was endogenously created by the business sector itself. Blaming the crisis on foreign lenders who were only interested in riskless assets is too easy. Any genuine explanation of what was going on needs to include an explanation of the behavior of the U.S. business sector, and Martin Wolf does not offer such an explanation.

Overall, this chapter does a very good job of describing the trends that fed into the financial crisis. This careful description, however, is what made this reader see a gap in the explanation that made me question the causal story as it was presented. On the other hand, Wolf also draws the conclusion that a financial system capable of such extraordinary dysfunction is in need of serious reform. So perhaps my criticism of this chapter will turn out to be only a quibble with the full book. I’ll let you know.

A question for Martin Wolf: Was the crisis “unprecedented”?

In the acknowledgements to The Shifts and the Shocks (which I am currently reading) Martin Wolf has stated that friends like Mervyn King encouraged him to be more radical than initially intended, and I suspect, as I read Chapter 4, “How Finance Became Fragile,” that this was one of the chapters that was affected by such comments. In particular, I see a contradiction between the initial framing of financial fragility which focuses on Minsky-like inherent fragility, and the discussion of regulation. Was this a crisis like that in the U.K. in 1866 or in the U.S. in the 1930s, or was this an “unprecedented” crisis that was aggravated by the elimination of legal and regulatory infrastructure that limited the reach of the crisis in 1866 and the 1930s? I am troubled by Wolf’s failure to take a clear position on this question.

Because Martin Wolf understands that the government intervention due to the crisis was “unprecedented” (at 15), I had always assumed that he understood that the nature of the 2007-08 crisis was also unprecedented. He appears, however, to be of the opinion that this crisis was not of unprecedented severity. Martin Wolf really surprised me here by taking the position that: “The system is always fragile. From time to time it becomes extremely fragile. That is what happened this time.” And by continuing to treat the crisis as comparable to the 1930s in the U.S. or 1866 in the U.K. (at 123-24).

His treatment of how regulation played into the crisis could be more thorough. He concludes that “the role of regulation was principally one of omissions: policymakers assumed the system was far more stable, responsible, indeed honest, than it was. Moreover, it was because this assumption was so widely shared that so many countries were affected.” (at 141). Wolf is undoubtedly aware of the many changes to the legal framework that protected the U.K. financial system in 1866 and the U.S. financial system in the 1930s that were adopted at the behest of the financial industry in both the U.S. and the U.K. (Such changes include the exemption of derivatives from gambling laws, granting repurchase agreements and OTC derivatives special privileges in bankruptcy, and the functional separation of commercial banking from capital markets.) Is the argument that these changes were not important? or that these changes fall in the category of omission by regulators? Given the preceding section of this chapter, it would appear that he believes these changes were not important, but given the conclusion of the chapter, I am not so sure.

In the conclusion, Wolf takes a somewhat more aggressive stance than he does in the body of the chapter: “The crisis became so severe largely because so many people thought it impossible.” (at 147). So maybe the crisis is unprecedented compared to 1866 and the 1930s. (In 1866 at least the possibility of financial collapse seems to have been recognized.) He also adds two more points to the conclusion that I didn’t see in the body of the chapter: the origins of the crisis include “the ability of the financial industry to use its money and lobbying clout to obtain the lax regulations it wanted (and wants)” and the fact that “regulators will never keep up with” the ability of the financial industry to erode regulation (at 147).

Thus, once I reached the conclusion of the chapter, it was no longer clear that Wolf views this crisis as primarily an example of inherent fragility. He has laid out the argument for how the financial industry successfully removed the legal and regulatory protections that were in place in 1866 and the 1930s. So this is my question for Mr. Wolf: Was the crisis itself “unprecedented” in the course of the last two centuries of Anglo-American financial history, or was this just a Minsky moment like many that have come before?

Can central bank intervention prevent a depression?

Last week Mohamed El-Erian gave a speech at the St. Louis Fed explaining why continued extraordinary actions by the central banks risk creating more problems than they solve.  He does a good job of detailing why central bank actions can only buy time for policy makers to take the actions that will solve the crisis – and the dangers of continuously buying time, when policy makers decline to recognize the nature and seriousness of the problems they face.  I find some of his rhetoric dangerous however.

El-Erian repeats the mantra that “central banks succeeded in their overwhelming priority of avoiding economic depression.”  But this is precisely what they have not done, because a central bank’s toolkit does not enable it to address structural problems with the balance of trade.  Those must be addressed by policy makers – and thus policy makers are the only ones with the tools to avoid forced, sudden adjustments in such imbalances and economic depression.  Central banks can buy policy makers the time in which to act – but they can do no more than that.

By analogy with the Great Depression, we are currently somewhere in the late ’20s.  In 1925, after the Dawes plan had stabilized the European balance of payments situation via American lending to Germany, the central bankers got together and decided to work together to help Britain return to its pre-World War I peg to gold – expecting or hoping that policy makers would cooperate in this endeavor and facilitate the global rebalancing that needed to take place.  Instead French policy decisions, for example, ensured a steady inflow of gold, and capital flows were overall driven by disequilibrium exchange rates until in 1931 the system broke:  Britain finally acknowledged that the peg to gold could not be maintained and the international economy tumbled into Depression (though the move helped Britain put an end to a decade of stagnation).

Thus 2008 looks very like 1925.  Our efforts to muddle through may have been more effective than in the late twenties, because many understand that the underlying problem of trade and capital flow imbalances must be addressed.  On the other hand, policy makers’ actions have definitely been insufficient to date and there is good reason to fear that the vast challenge of international policy coordination will prove too great and that our system too will break under the stress of ongoing imbalances sometime over the next decade.

This concern was clearly expressed by El-Erian.  But he chose not to call it by its name.  What El-Erian is worried about is a second Great Depression.  And, as he states clearly, the only people with the tools to stave off such a crisis are the policy makers.  The question is whether they will fail as their 20th century forebears did before them.

Comparing bankers past and present

Even after verifying that banking was indeed an unlimited liability enterprise in the 19th century, TED appears to struggle with the idea that anybody with wealth would be willing to take on such risks — especially for a measly return of 5% or less on assets.  TED writes:

My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard.

What this sounds like to me is that the employees of our financial institutions are so habituated to making outrageously large risk-free (i.e. government guaranteed) returns, that the idea of risking one’s own assets in order to make a profit seems patently ridiculous — which of course it is — if you happen to be one of the few privileged enough to be able to spend your life sucking at the government’s teat.

(My apologies to TED, Alea, Sonic Charmer and all the other financiers looking for a better system, but this bit of hyperbole seems close enough to the truth to me that I couldn’t bring myself to edit it out of existence.)

Given the growth of unlimited liability banking in the past and the plethora of Americans living lives of quiet desperation in the present, I suspect that the risks of unlimited liability banking could in fact attract many, many small lenders whose initial capital may be little more than significant equity in their own home — if it were not the case that the whole industry is overshadowed by government sponsored mega-lenders.  After all, how many small businessmen and women in this country have already signed up to be personally liable for their business debts?  Putting all of one’s assets at risk to start a business is hardly an unknown or rare phenomenon in this country.

To support the view that unlimited liability banking operates as a constraint on the economy, TED writes:

The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

Given that Britain spent the 19th c. growing economically into its role as a premier world power (“the sun never sets …” etc.) and by the late 19th c. was exporting capital around the world, it’s hard to understand the foundation for TED’s argument that the supply of capital must have been “artificially limited,” since banks were lending at 5%.  If banks in Britain were “overequitized,” there’s little or no evidence that this had an adverse effect on the economy.  As long as banks could be operated profitably, to the degree that existing lenders were at the limit of their ability/willingness to lend, new entrants into the industry — or new partners — could probably be found to expand the business and take advantage of good lending opportunities.

The data on the United States indicates that banks subject to double liability were not “overequitized.”  In 1919 the ratio of the aggregate total capital account for all Federal Reserve member banks to total assets was 11%. (See column 1 of Chart No. 57 here.  This ratio rose to 15% at the depths of the Depression and then dropped with the advent of deposit insurance.)  At the start of the recent financial crisis the Fred database indicates that this ratio was hovering around 10%.  Thus, it’s far from clear that double liability in the US resulted in “overequitized” banks.

I believe that the claim that “the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century,” is just an explanation for the growth of stock markets and limited liability non-financial companies.  It is widely recognized – and I do not dispute this claim – that certain industries with extremely high fixed costs but significant risks in the form of aggressive competition to take advantage of recent technological developments, like railroads or fiber optic cables, can, more or less, only be financed via a limited liability shareholder structure.  Since banking developed as a successful industry before the rise of stock markets, and as Andrew Haldane notes the banking industry was very slow to embrace limited liability, it is far from clear that limited liability is an essential element of a efficient banking system.

Mr. Haldane appears to argue that because systems of extended liability did not protect depositors in the Depression, such systems were rejected.  While this may be a historical explanation for the growth of limited liability banking, it is far from clear that Depression-era problems should be taken as conclusive evidence against extended liability.  It’s doubtful that any banking system could have survived Depression-like events, marked most notably by the world’s reserve currency delinking itself from gold and setting off a reserve currency transition, without significant losses.

In short, while unlimited or extended liability banking would almost certainly mean that the economy was populated with a greater number of smaller banks, it’s far from clear that credit itself would be constrained.  Nor should one assume that interest rates would rise.  After all the risk premium portion of interest rates depends as much on the quality of bank underwriting and social enforcement mechanisms as on the characteristics of the borrower, so incentivizing banks to screen borrowers and lend carefully may actually reduce the interest rates available to most borrowers.

Related posts:
What banks do
The problem of collateral
What is capital?

A little fear is a good thing

TED, whose beautifully written posts are always stimulating, challenges me on my last post:

I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

and I’m first to admit that a wholesale return to unlimited liability in banking by congressional fiat is — shall we say — unrealistic.  But I also think some of TED’s concerns about insufficiency of capital and excessive interest rates in a system with unlimited liability are overblown.

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum.  Market rates often fell as low as 2%.  It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).

Furthermore, from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit).  If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises.  Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

One of the most worrisome aspects of our current financial evolution is the shift to ever-increasing use of collateral, which to me is testimony to the fact that the institutional structures supporting a financial system with cheap capital are disappearing before our eyes.  Collateral adds expenses that are unnecessary when the unsecured financial system works well.  One of the first policies I would propose is a (phased-in) prohibition on the posting of collateral by our largest financial institutions.

I’d be more optimistic about the future of our financial system if certain aspects of banking were understood.

(i)  Total collapse of the financial system is possible.  I’m talking about the kind of event that will cast a shadow over the Great Depression.  I am reminded of the fact that China had a fiat money system that lasted for about 200 years before it imploded, creating a vast demand for silver that fueled the silk and spice trade of the middle ages, and arguably set off the development of European finance.

(ii)   “Safe assets” like deposits and bills of exchange were created by a merchant class subject to common law (i.e. law for the commoners) at a time when the idea of a government guarantee of a financial asset was somewhat ridiculous.  (Kings have a habit of taking property — with or without your leave — and failing to return it.)  That is, when assets were “safe,” they were safe because of a complex web of social characteristics including law, social norms, property rights, etc.  Such safety cannot be recreated by a myth of governmental infallibility — all that will be demonstrated by seeking refuge in government guarantees is the weakness of the governance structures.  To recreate an environment with relatively “safe” assets will require reworking of the institutional structure of the financial system, so that it can provide these assets on its own with little reliance on government.

(iii)  It would be helpful if the members of our financial elite could take a long enough break from their rent extraction activities to take a look at the path we’re on — and whether they’re sure the world they’re leaving to their children is the one they want to leave behind.  And, maybe, throw their weight behind some wholesale reform themselves.  (Pace, TED, I don’t mean you, because you do worry and you are speaking up.  You give me hope.)

With a little fear of total financial collapse, maybe we can manage to change the the system enough to keep it running for another few decades.

In defense of banking …

… but not the banks we have.

Opacity is absolutely essential to modern finance.” “Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.” Steve Waldman

This is a response to three posts at Interfluidity that argue that banking is essentially a con job.   The quotes here are from those posts except as noted.

While I agree on the issue of “opacity” (bankers lend money and it is difficult or impossible for depositors and creditors to monitor bank assets), I also think that Waldman is confusing two things:  modern finance and the financial systems that facilitated economic development.  They have/had very different characteristics:

  • Modern banking:  limited liability, government-guaranteed deposits, high risk of loss to bank creditors (in the absence of government intervention).
  • Before 1930:  at least double liability, deposit “contracts” that were always implicitly conditional, and comparatively low risk of loss to bank creditors (in the absence of government intervention).

In short, prior to the 1930s the assets of the bank-owners themselves were very much at stake with the result that their leverage ratios were much, much lower than in modern times.  (Econometric analysis indicates that  in the late 1800s neither the leverage ratio nor the size of banks was a predictor of either bank profitability or stability of profits.   Lamoreaux, Insider Lending, pp. 97-98.)

History:  Unlimited liability and the nature of the deposit “contract”: 

“A banking system is a superposition of fraud and genius”  “Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty,”  “First and foremost, they offer an ironclad, moneyback guarantee.”

Waldman’s model of banking has these properties, perhaps, because he’s referencing a world with deposit insurance instead of bank failures – that is, a world with explicitly government backed deposits:  this form of banking has been around for just three quarters of a century.  Historically banking is built on a conditional promise to depositors to return the money unless the bank closes its doors.  When the bank closes its doors, “time” is lost, but because nobody would entrust his money to a banker who wasn’t wealthy and subject to liability (either unlimited or capital calls on stock owners to pay debts), once the banker’s horses, etc. are sold, you get your money back.  Depositors understood that “time” could be lost and that only a fool would leave his money with someone who wasn’t wealthy.  The contract was conditional on the risk of temporary illiquidity and, in practice, conditioned on the assets of the banker.

To the degree that Waldman’s concept of banking is based on the Diamond and Dybvig model, even they acknowledge that the 19th century solution to the problem of bank runs, suspension (i.e. closing the bank and liquidating) also solved the problem.  It is only dominated by deposit insurance if the insurer has the ability to target a tax to those who withdrew money during a run (or to achieve the same result via inflation).

History:  Bank losses were put to the owners of the bank:  While crises and bank failures were common, there are many historical examples of major bank crises that didn’t result in losses to depositors’ principal.  (See for example the failure of Overend and Gurney in England, which was the Lehman’s of 1866.)

“Second, they point to all the other people standing in front of you to take the hit if anything goes wrong.”

This is a pure invention of modern “limited liability” banking.  Even through the early years of the 20th century, bank shareowners were subject to capital calls in the event the bank failed.  In Britain bank stock was usually purchased by paying only a fraction of par, leaving stockholders subject to a capital call that could be a multiple of the original payment.  In the US the norm was double liability, so stockholders who bought shares with a par value x, were liable for a “second” capital call of x. (Double liability was part of the National Bank Act of 1864 and also enacted by most state legislatures.  It was the law in Massachussets even earlier.)  It’s not clear that losses of principal (i.e. excluding “time”) to depositors due to bank failures were either common or large.  It’s my understanding that there were no such losses in England from 1850 through 1900 – and probably very few between 1800 and 1850.  In the US there were most likely some losses, but how significant were they after the whole legal process was complete?

 “ ‘Shadow banks’ are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.  This is the business of banking.”  “Since no one (most especially the financiers) believes themselves to have agreed to be the bagholder, we are left in an ocean of conflict over who must bear what costs.”

I disagree.  This is the modern business of banking.  When our financial system developed the ones who were most at risk were the bankers themselves.

Bagehot’s Lombard Street is in many ways about the growth and contraction of a shadow banking system.  The “bill-brokers” — of which Overend was by far the largest — grew up as undercapitalized shadow banks that relied extremely heavily on the lender of last resort facilities of the Bank of England in crisis.  The Bank objected to the quantity of Overend bills it had discounted and told Overend/the bill-brokers that they would have to find their own source of capital in the next crisis.  In 1866 the Bank of England kept its word and Overend failed.  As noted above, the Overends had to sell their personal assets (and there was a capital call on shareowners), but every penny was repaid to creditors.

After this crisis, British finance continued to flourish.   The lesson I draw from this is that the key to central banking and a strong financial system is knowing when to close the liquidity spigot.

In fact, it is possible that the problem created by bank failures in the depression may not have been losses to depositors (although they were certainly the more visible), but the wiping out of the stratum of society that had the reputational and financial assets to be bankers or invest as shareholders in banks (i.e. the capacity to answer and the willingness to risk a capital call).

Opacity, confused creditors and growth

“Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.”
“Industrialization occurs in societies with corrupt and fragile big banks.”

From a historical perspective this is unsupported by the evidence.  Societies that develop and prosper have banks that pay their depositors back from the assets of the owners of the bank, should the bank fail.  This is the reason bankers were trusted with “other people’s money” in Venice, in Amsterdam (each, the center of world trade in its time), in 18th and 19th c. England and in the US through the 1920s.  Only in modern times did anyone imagine it is possible to have financial system populated by entities with complete limited liability.  (Observe that banking systems will full liability also can collapse – usually because the flourishing economic activity that made it worthwhile for bankers to take the risk of losing all their property evaporates for external reasons.)

I think the truth that underlies Waldman’s argument is that it’s impossible to have a truly competitive financial system, without destroying the financial system itself – and this is one of the greatest errors of modern finance. Why?  Historically, bankers must take risks and their assets must be at risk; bankers will only do this if they make a hefty return.  In modern times, they must be highly compensated simply to keep them from taking advantage of their access to other people’s money and their abundant opportunities to profit from activities that tend towards fraud.  They will be wealthy, they will control the payments system, and they will favor policies that are in their own interests, not those of the general public.  They will be the target of populist complaints.  If you try to address these complaints by introducing too much competition, you will compete away the profits that will compensate them for their risk (or their access to pilferable funds).  Theory tells us that given too much competition, bankers will decide they’re better off stealing people’s money.

(cf. “Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. …  insiders’ privileged position and knowledge enable them to extract rents.”  http://epicureandealmaker.blogspot.com/2012/01/all-together-now.html  )

Banking and capitalism

Bankers have historically been the “capitalists” of their time, but only if one understands “capitalism” in the Marxist sense of the word.  Bankers are the wealthy making profits off their wealth.  In modern times where non-wealthy individuals enter the banking profession, the bankers are profiting from their position in a company that has vast amounts of money at its command.  Because these companies have limited liability — and abundant government support systems — however, society, not the owners of the bank are the true sources of their capital.  When profits are being made off of capital provided by the public, a better word for what the bankers are doing is probably best characterized as socialism.  (cf.  Prof. Varma on safe assets, h/t Ashwin Parameswaran)

“Part of what makes an FDR different from a Mitt Romney is that an FDR understood his power to be derived from more or less arbitrary privilege, while a Mitt Romney imagines himself to have “eaten what he killed” in brutally efficient markets.”  Yes.

“They persuaded themselves, long before they persuaded the rest of us, that any games they played for their own enrichment would necessarily lead to social gain over the long term.”  This is very true too.  One thing I’ve learned from blog discussions is that traders think it’s socially efficient for them to make money off of the sorry, uninformed creature who thinks that asset is worth what he’s paying for it.  (They  obviously missed the Econ 101 class on asymmetric information and efficiency.)

“What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities.

I’m not sure that the right approach to this problem is to place “obligations” on bankers.  I’d opt for incentives.  Jamie Dimon’s houses and financial assets should go on the block to pay creditors if J.P. Morgan fails.

Would this reduce risk-taking?  Absolutely.  But in a good way.  Bankers need to be incentivized to take reasonable risks, not unreasonable ones.  Keep in mind that industrialization and modern banking was born in an environment with precisely these characteristics.

Does (financially-supported) growth require misinformed bank creditors? No

“I claim we would forego a lot of plain booms, the kind that ultimately enrich investors as well as society at large, if we didn’t have a financial sector skilled at getting people to assume risks they’d not directly consent to take.”

I think that what Waldman is missing here is that historically bank accounts in industrial regions start out as loans.  That is they are discounts not accounts.  So no bank creditor is putting their savings at risk, instead the bank (as noted above most likely the wealthiest person in town) is lending to the local entrepreneurs and tradesman, but avoiding having to maintain much of a stock of gold by clearing the whole town’s transactions on his books.  In a well functioning financial system, the town banker can send those debts to the big city and sell them off if he happens to need cash.  There ends up being a large network so that long-distance transactions can be cleared in the big city.  Basically finance is a debt clearing system that requires, in theory, no capital or actual savings at risk at all — but only a bunch of entrepreneurs/tradesmen who are willing to lend to each other because an entity with reputation (the bank) is underwriting the loans. In practice, people with money to lose have to guarantee that the system is sound.  These bank-guarantors make it possible for the system of unsecured trade credit that makes the economic world go round to operate.

Can finance solve the problem of systemic risk?  No, and neither can government.

“Diversification and maturity transformation can protect us from idiosyncratic shocks, and Murphy is right to point that out. But they cannot protect us from systematic misfortunes.”

Finance is unstable, so if a basic precept upon which most banker’s decisions have been based (e.g. the Bank of England will maintain its peg to gold) a lot of bankers can fail and lose their fortunes, taking the economy down with the bankers. (The worst of the bank failures in the Depression took place around the same time or after the Bank of England went off gold in Sept 1931 — causing a big hit to balance sheets around the world.)  Bagehot recognized that banking is a system of credit, so by definition its always within the realm of possibility that the whole system collapses.  There’s no reason the system can’t be born again – as long as there’s someone with assets to lose who recognizes trading activities he’s willing to finance.  But, of course, the process is excruciating.

But on systematic risk allocation, I think it unquestionable that status quo finance is completely terrible.”  Agreed.  But this is not a problem with banking.  It’s a problem with limited liability banking where the people making the lending decisions can put the ultimate losses to someone else.


If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles.

I’m not convinced there is an alternative to the threat of personal losses to keep managers of “other people’s money” honest.  The banks have too much incentive to infiltrate whatever regulatory system is put in place, so it’s probably close to impossible to keep it from being captured in one way or another.

Have we reached the apotheosis of finance?  That is, did we once have a functional (though always changing) financial system that evolved to the degree that it is now on the path to implosion?  Far from Waldman’s view that finance has always been this way and this is the way it must be for growth to take place, I think that finance once had very different characteristics from that which it has today and that the loss of those characteristics significantly increases the likelihood of the total collapse of which  Bagehot warned.

The questions, for me, are:  Is the financial system dying from the effort to turn it into a competitive industry?  And can we save it?

Note: I edited  a phrase that was too strongly worded, and tweaked the text.

The Central Bank is not a Deus ex Machina 2

Brad DeLong muddles his history of central banking.  First he starts by discussing central bank support of government debt and then he supports his argument with evidence that the central bank was lender of last resort to the private sector.

The Bank of England was founded in the 1690s to fund the British debt.  In 1711 the Bank was required by law to discount exchequer bills on demand.  As North and Weingast observed in their seminal paper, the Bank’s support of government debt (e.g. through discounting exchequer bills) was crucial to the British ability to finance (and win) the Napoleonic Wars.  This is indubitably an important role of a central bank — but then every British county wasn’t issuing its own debt and the Bank certainly wasn’t buying the debt of the counties.   The modern European situation is more complicated than the early British case.

The lender of last resort role that DeLong claims “got its start” in 1825 was played by the bank in 1763 at end of the Seven Years War, in 1772 not altogether willingly after causing the collapse of the speculative activities of Alexander Fordyce’s bank, in 1783 at the end of the American Revolution (anticipating the normalization of trade the Bank in fact conserved gold reserves that fell to 8% by favoring private credit and restricting discounts of exchequer bills) and of course in 1797 when the strains of financing the wars led the Bank to seek authority for an emergency suspension of gold payments from the Privy Council (later confirmed by Parliament).  (See Clapham’s history of the Bank of England and Jacob Price’s articles on the Bank.)

Finally, once again we see that DeLong grossly misinterprets the point of Lombard Street.  Bagehot most definitely did not support lending against assets independent of the quality of their origination.  He states explicitly:

The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

It happens, however, that in 19th century England the combination of personal liability of the banker and capital calls on shareholders to honor the debts of bankrupt joint banks was sufficient to ensure that origination practices were extremely careful.  Needless to say when origination practices are sound, a central bank’s practices do not need to be “over-nice.”  However, when rot has been allowed to grow in the financial system to the degree that the largest banks are being sued for fraud over their origination practices of their loans, central bank practices will have to be more careful than those of the19th c. Bank of England — at least if the goal of the central bank is to preserve financial stability (and not simply to bail out the banks).

Does anyone really believe that this is a liquidity crisis?

Xavier Gabaix argues that restrained business investment is a natural — and healthy and problematic — reaction to macroeconomic tail risk.  And Brad DeLong responds:

The macroeconomic tail risk that businesses today fear is not a Great Forgetting of technology and organisation or a Great Vacation on the part of the North Atlantic labour force … [These] are the only two “macroeconomic tail risk” shocks I can think of that would make it socially and collectively rational for businesses as a group to refuse to invest in new capacity right now

DeLong’s references make it clear that he persists in viewing our current problems as a liquidity, rather than an solvency crisis.  [Say explains that the Bank of England’s tight monetary policy in 1825 triggered a sharp recession by curtailing the supply of credit firms and causing them to hoard cash.  Mill explains that it was only after the Bank reversed its policy and loosened the money supply that the economy recovered.  And the Kindleberger reference makes the liquidity interpretation entirely clear because a “lender of last resort” only functions because it lends to solvent firms — a condition that Mill also emphasizes.  For more on the crisis of 1825 see here.]

In short, Prof DeLong appears to imagine that if we continue to treat the crisis of 2007 as a liquidity rather than a solvency crisis — eventually the solvency crisis will disappear.  The theoretic foundations of this view are hard to fathom — especially given that our financial institutions have been relying heavily on “liquidity support” for almost three full years — could there be any stronger evidence that we are facing a solvency crisis, not a “panic”?

[The timeline of the 1825 crisis is as follows:  March 1825 Bank of England starts to tighten, December 1825 full blown bank crisis with money center bank failures, met with aggressive lender of last resort action, by June 1826 lender of last resort activities have wound down and by December 1826 monetary measures and bankruptcies have normalized.  See Chart 11 here and Chart 1 here.]

In my view business investment is restrained not because of macroeconomic tail risk, but based on elementary macroeconomic analysis:  As long as policymakers are determined to prevent the bankruptcy of insolvent firms, necessary economic adjustments will be delayed and valuable assets will be entombed in firms without the balance sheet capacity to borrow the funds necessary to realize the value of those assets.  This policy will have the effect of preventing the economy from growing at its natural rate over the next decade and render investment a very dubious prospect indeed.

In short, what’s holding corporate investment back may be uncertainty over future policy and the nature of the institutional structure of the economy.  That is, firms may fear that bad economic policy in the form of using liquidity tools to support insolvent firms until they become solvent — in the next decade or two if ever — (similar to the Japanese “solution” of avoiding the restructuring of banks and firms) is going to cost the economy so much that it really doesn’t make sense to invest in a future without economic growth.

Update 7-7-10: Gabaix points out that it is possible that the future policy that firms are worried about may be a failure to bailout in the next crisis.  Is this the same point I am making or a different one?  Hmm.

And Krugman argues that there’s no need to interject “future government policies” into the discussion at all — a review of data suggests that investment is higher than one would predict in an environment where we simply don’t need that much new construction, etc.

I am happy to acknowledge that I have no way of determining the true source of concerns about the future economic performance, but I hope everyone can agree that too much government intervention, too little government intervention and misdirected government intervention are all on the list of  possibilities.  For which reason the decision-makers who are actually navigating these shoals have all my sympathy.

A lesson from the Great Depression

Central bankers have to be realistic about the political environment in which they operate.  All the central bank cooperation in the world can’t solve a problem of imbalances, if the politicians don’t decide to cooperate too.  And betting the economy on the theory that the politicians just *have* to cooperate is not good central banking.

Central bank policy needs to take into account the possibly of political failure — even when that failure is “unthinkable”.

Elvin, money and technological change

Saw this title “More empires have fallen because of reckless finances than invasion” just after reading DeLong’s links to Mark Elvin on the bewildering end to China’s 12th century technological advance.  And assumed they were related.  Not.

It’s always been my opinion that technological advance is closely tied to paper monetary systems.  And that when a paper monetary system collapses, so does the capacity of the economy to support the kind of growth that makes technological advance possible.  So I’m guessing it was the collapse of China’s monetary system (in the 14th century) that put an end to technological advance.

Is there a lesson in here somewhere?