Simon Johnson on the Euro

Simon Johnson has a good blog post on the end of the euro. Digging in, the run is on, the end is near, and the chaos will be worse than you thought.T he ECB has also monetized a lot more than you thought.

Still, I do not understand why even Simon cannot imagine the idea of sovereign default while staying in – and firmly committing to stay in – the currency union. The picture Simon paints of the euro breakup is a catastrophe. So why not even talk about sovereign default (restructuring) without euro breakup?

It strikes me as really the only way out, and the longer Europe waits, the harder it will be. 

Texas Hedge

My first reaction to the JP Morgan loss was, if their “hedge operation” had become a “profit center” as reported, we know exactly what went wrong. (And, if they weren’t playing with a government guarantee, who would care if they lost $2 billion and some hedge funds gained $ 2 billion?)

Andy Lo put it beautifully:

Yes, we can tell the difference [between hedging and trading]….There is one very simple question that you can ask — which has a definitive answer — about the small number of individuals who were responsible for managing this group at JP Morgan and putting on the specific trades that lost these large amounts of money. That question is: How were they compensated on an annual basis? Were they paid a salary and a bonus, and was the bonus a function of the profitability of the group, or was the bonus a function of the hedging ability of the group? If you can answer this question — and it definitely has an answer to it; it’s not a metaphysical question — you will have your answer as to whether it was proprietary trading or hedging. I don’t know the answer, but I know the answer exists, and I know that certainly the government can get that answer with a single phone call. 

Hedging is supposed to lose money when everyone else makes money. That can be measured. The risks of the entire bank, which hedgers are supposed to minimize, can be measured.

I think Andy knows the answer to this question. I suspect I do too, but maybe I’m being too cynical.

(Thanks for pointer from Arnold Kling)

Why not thank the speculators?

 The price of oil. (Sent by a friend whose reputation I won’t besmirch by name, but thanks.)

Remember how the oil price rise was the work of evil speculators who had to be stopped? (My post here) Well, now that the speculators are driving prices down even faster,  shouldn’t they get a thank you? Ok, maybe not medal of honor, but a nice statue out on the Washington Mall would be thoughtful. Flowers are always nice.

Tongue in cheek of course, but the different treatment of price rises and declines by the usual economic and political pundits is interesting to note.

Good Comments

Reading through some of last weekend’s commentary  got me thinking about what I look for most – and try to emulate – in good economic commentary.

One of the first lessons we learn in econ 1 is that economics has a lot to say about incentives, which are usually ignored by popular discussions, and economists have a lot less to say about fairness, morality, or distributional questions, which is what popular discussions focus on. I don’t mean that fairness or distributional questions are unimportant, just that economists don’t have any special insight into those questions.


For example, an economist contributes best to the tax debate by pointing out margins that others have not noticed, such as the huge implicit marginal tax rates implied by phase-out provisions or the incentives for old people to save vs. consume when looking at confiscatory marginal estate taxes.

Economists need always to disinguish tax rates from taxes.  Whether “the rich” should pay more or less overall is really not that useful for us to comment on. Whether a code  attempts to raise revenue with high marginal rates and lots of deductions or low marginal rates and few deductions is something we can say a lot about. We need to remind people of econ 1, that who pays the tax and who bears the burden of a tax are often radically different. “Corporations” never pay taxes, they pass taxes on either to customers, workers, or investors.

Economists should focus on the things they know something about. Economists who pontificate on  the moral character of public figures are not saying anything about which they have any particular standing or expertise to analyze. It takes a lot of ego to think your political passions are that much more interesting than anyone else’s.

More deeply, seeing some people as good and others as evil really is not that useful as social science or as a contribution to policy debate. Our ancestors in the middle ages knew how to do that. If you want to understand why people do what they do, why policies are formed as they are, it is much more useful to view people who disagree with you as well intentioned but mistaken – we can’t all study economics all our lives – than as evil, or in the pay of dark powers.

Economic analysis is more believable when it is non-partisan. I like commentators who make an effort to find silliness (and there is plenty of it) attached to both parties. When I see an analyst that always seems to be plugging one of the political parties, I know he’ll be shading the truth at least half the time. Even people who are partisan function most usefully by holding their own party’s actions to scrutiny, rather than sanctifying any action on one side and demonizing any action on the other. Most hilarious are commentators who laud a policy action when their pet party does it, and demonize exactly the same action when undertaken by the other side. 

And economists should insist on precise language. When political discussion uses the word “drastic cut” to mean growing expenses by 5% where before the government was planning to grow expenses by 7%, our job is to remind them what “cut” means. So much economic discussion really belongs on my favorite game,  bullshit bingo.

By now you will probably guess that what set me off is Paul Krugman’s announcement in the New York Times that in his exalted opinion New Jersey Governor Chris Christie is a “big fiscal phony,” that Congressman Paul Ryan and candiate Mitt Romney are “fakers,” who are “willing to snatch food from the mouths of babes (literally, via cuts [sic] in crucial nutritional aid programs),” all to serve the dark conspiratorial interests of their “financial backers.”

This column illustrates just about every desirable principle by embodying its opposite.

Update:

There actually is a lot economists can add to the distribution debate. There are a lot of facts: the widening distribution comes from a skill premium, not inherited wealth. It’s new people getting rich, not the old rich keeping more money. It’s pretax income, not the rich keeping more money.  Consumption inequality is much less than income inequality. And so on. There’s a lot of good theory: Optimal redistribution with incentive and participation constraints is great stuff. And both theory and experience on how well tax-based redistribution works out. I just meant we don’t have much to add to the mostly normative questions. (Thanks to the “Lumpy Economist” Ruediger Bachmann for pointing this out.)

And lots more principles for economics come to mind.

There’s always a supply curve and a demand curve. Most discussions assume one away.
Budget constraints.  The trade and capital account must balance.
Higher prices and interest rates can reflect good times not just signal bad times. 

Ok, too easy.

Local Regulation

A nice short video describing some of the trials and tribulations of an excellent Hyde Park cafe trying to navigate our city’s over-regulation:

A few things struck me about this story, which only scratches the surface of troubles small businesses have in Chicago.


We talk about “regulation,” but the real issue is rules vs. discretion. Regulating by simple clear rules is much better than regulation by discretion, or by rules so complex they amount to discretion. When a zoning inspector can come in after the fact and always find something wrong, it’s in invitation to corruption. We are increasingly a country in which “regulation” means that regulators can tell people what to do on a whim, not one in which clear objective rules are imposed.

The ill effects of this sort of over-regulation are hard to measure, so they tend to be forgotten. We talk about tax rates, spending and laws. But how do you quantify the far more important effects of this sort of thing? It’s far worse than an explicit tax, or on the books spending. But it just shows up as mysterious lack of business. We can find isolated anectdotes, but how do we add up the effects of regulatory harassment across the whole country?

I am reminded again of Greece. Pundits talk about how Greece needs its own currency so it can devalue its way to prosperity. But the kind of illness shown here in Chicago is multiplied a hundred fold there, and no exchange rate can solve it.

airline seats

You know the drill. They try to board us by groups, but people are smashing on the plane like it’s the New Delhi train station. When the plane is half full, the overhead bins fill up. Then people start dragging massive bags all the way upstream for gate checks. On and on it goes, tempers frazzling and  a few hundred million dollars of plane, costly crew, and my not so free time sitting idly on the ground.

So I have long wondered: why in the world do airlines charge $25 for checking bags, and not $25 for bringing huge bags on the plane? 

I finally found out the answer, here

Two years ago, [New York Senator Charles] Schumer got five big airlines to pledge that they wouldn’t charge passengers to stow carry-on bags in overhead bins. The promise came after Spirit Airlines became the first U.S. carrier to levy such a fee.

The article is actually about Sen. Schumer’s latest great idea, to force airlines to seat families together even if said families don’t want to pay the $25 fee for advance seat selection.

Next time you miss your connection because people took too long to stow their steamer trunks in the bins, you know who to thank.

Of course the larger picture is not the silliness of one individual, but the hubris of the Federal Government to try to regulate such things in the first place.

Update

As the comments point out, taking forever to stow your huge suitcase is a classic externality, deserving of a congestion tax.


Airline and cell phone pricing in general strikes me as price discrimination by needless complexity, a topic for another day.

Leaving the Euro again

Yesterday’s coverage of the latest European summit seems designed to reinforce my view of basic confusion expressed yesterday pretty clearly.

For example, the Wall Street Journal’s “Europe Girds for a Greek Exit” reports that the talk was all about eurobonds, stimulus, or bailout as a way to avoid Greek exit from the Eurozone, repeating the senseless mantra that sovereign default cannot occur in a currency union.

“We want Greece to remain in the euro zone,” German Chancellor Angela Merkel told reporters after nearly eight hours of talks. “But the precondition is that Greece upholds the commitments it has made.”

I salute Ms. Merkel for not giving in to the camp that wants endless wasted spending disguised as stimulus, to be followed by inflation. But really, why would Greece not “upholding its commitments” mean it has to “leave the eurozone?” Why is it impossible to turn off the bailout spigot, and let Greece default and stop running deficits, while it stays in the euro?


Actually, the article, quotes, and other coverage is deliberately vague on a central question: Are we preparing for Greece to decide to leave the Euro, or are we preparing that the rest of Europe will try to kick it out? The quote reads a lot like the latter!

How do you kick a country out of a currency union? Greece has every right to say “the euro is legal tender in Greece,” no matter what the rest of Europe does. Sure banking will be a bit harder if the ECB cuts off the Greek central bank, but unilateral use of another currency is an economic possibility. Kosovo and Montenegro do it.

The mantra continues,

…fears mount that Greece won’t be able to carry out the painful surgery to its public finances and its economy needed to stay in the currency zone.

 At least the fact is dawning that a currency switch is the same as default:

In addition, euro-zone members would likely have to take a large hit on governmental and central banks’ loans to Greece. There is a risk that some euro-zone commercial banks could face heavy losses on their exposure to the Greek economy. 

Eurobonds

A lot of coverage concerned “eurobonds,” an idea that has been stuck for years on just who is going to pay for them.

News flash: eurobonds have already been issued. They are called euros. ECB reserves are just particularly liquid floating-rate debt. The ECB issues reserves in return for sovereign debt and lends reserves to banks who load up on sovereign debt. This action is functionally the same as issuing Eurobonds to buy sovereign debts. What happens of the ECB’s holdings of sovereign debt or its bank loans turn out to be worthless? If the ECB needs to be “recapitalized,” it has the explicit right to call up the member states and demand funds, which means the member states have to kick in tax revenues. This is exactly a eurobond. For better, or, likely, worse. 

The ECB has propped up Greek banks for months through its lending operations and, increasingly, its emergency-lending program, known as ELA.

Under ELA, banks borrow from their national central bank, in this case the Bank of Greece, with approval of the ECB’s governing council. The default risk resides with the Greek central bank and, ultimately, the Greek government.

This is a great case of wishful thinking, I’d say. Oh sure, the ECB doesn’t have credit risk…if the banks collapse because the Greek government defaults on its debt, the Greek government will pay us back!

To ease the fallout on Spain and others, the ECB could issue more three-year loans to banks, analysts say. More than €1 trillion in these loans have been doled out since late last year. 

A trillion here, a trillion there, and pretty soon you’re talking real money – real debt. 

Devaluation

A quick response to some emails and comments. Yes, I understand that devaluation can change a trade balance towards exports. (I try to avoid the mercantilist implications of writing “improve the current account” or “raise competitiveness.”) 

If the US Fed were to say “we buy and sell Euros at $2 per Euro,” US prices and wages would not instantly adjust; our exports would become cheaper and imports more expensive, and we would import less and export more for a while.

The reason is superficially clear: prices and wages are a bit sticky. The precise mechanism of such stickiness is the subject of a huge academic investigation and is, I opine, still a little unclear. But it’s not really controversial what would happen in the US.

But nominal prices are not always sticky. For example, when countries joined the euro, nominal prices changed by orders of magnitude, overnight, with no output or trade effects whatsoever.

The challenge for theory – and for predicting what would happen to Greece if it left the euro – is to figure out which kind of experience applies.

For a small country to suddenly leave a currency union, adopt its own currency, and instantly devalue that currency,  along with likely capital, exchange, trade, and other controls, is a quite different experiment than for a large country, with a well-established currency to devalue.

Does the price and wage stickiness that applies to a US company with longstanding contracts in dollars apply to Greek contracts that expect 10 euros, suddenly told that’s going to be 10 drachmas, which are now worth 5 euros? Or do people in that circumstance focus on the euro value and treat the event exactly as they would being told that they are going to get 5 euros? Just how “sticky” will Greek nominal prices and wages be? Will the political constituencies be who don’t want explicit euro cuts be mollified if they are paid in Drachma instead?  It’s not obvious!

Here I’m willing to offer my Keynesian colleagues a friendly wager: Let’s look at Greece 6 months after Drachma introduction and swift devaluation. I bet it will be a continuing basket case, and that Greece won’t be exporting lots of Porsches back to Germany. If return to the Drachma and devaluation produce a swiftly growing Greece based on a hot export sector, well, I’ll at least say I was wrong. No, you don’t get to say it’s awful but it would have been worse otherwise.

Leaving the Euro

I find all the reporting of the Greek (and following Spanish, Italian, etc.) debt crisis unbelievably frustrating.

Why does everyone equate Greece defaulting on its debt with Greece leaving or being kicked out of the euro? The two steps are completely separate. If Illinois defaults on its bonds, it does not have to leave the dollar zone – and it would be an obvious disaster for it to do so. 

It is precisely the doublespeak confusion of sovereign default with breaking up a currency union which is causing a lot of the run.

It’s pretty clear that if Greece leaves the Euro and reintroduces the Drachma, that event will come with capital controls, swift devaluation, effective expropriation of savings, and a disastrous and chaotic rewriting of all private contracts (do I have to pay this bill in Euros or Drachmas? Every contract ends up in court. Greek court.) 

Quiz: If your politicians are even talking about this sort of thing (together with “austerity” which is heavy on higher capital taxation) what do you do? Answer: take your money out of the banks, now.  Take everything that is not bolted down and leave.

Just talking about leaving the Euro is How To Start a Bank Run 101.

The right step is the opposite: firmly announce and commit as much as possible that Greece (and Italy, Spain, etc.) will not leave the euro.

Precommitment is hard, but a good first step is to make it clear you know the action you’re trying to commit not to do will hurt you.  Communicating a commitment not to have dessert is hard. Communicating a commitment not to shoot yourself in the foot should be easier. Start by not saying  that shooting yourself in the foot will taste good.

Politicians need to repeat over and over again that they understand a default does not mean euro exit – that the two steps are completely separate decisions; that a currency union with sovereign default is perfectly possible.

Them they need to articulate just what a disaster leaving the Euro will be. They need to say they will tolerate sovereign default, bank failures, and drastic cuts in government payments rather than breakup.

Yes, cuts. The question for Greece is not whether it will cut payments. Stimulus is off the table, unless the Germans feel like paying for it, which they don’t. The question for Greece is whether, having promised 10 euros, it will pay 10 devalued drachmas or 5 actual euros. The supposed benefit of euro exit and swift devaluation is the belief that  people will  be fooled that the 10 Drachmas are not a “cut” like the 5 euros would be. Good luck with that.

Think what would happen if, in order for Illinois or California to solve their debt,  pension and benefits debacles, they decided to leave the dollar zone, institute capital controls, redenominate all bank accounts and private contracts in their borders, and devalue. Plus big wealth taxes. Now they can tell their pensioners, “see, we didn’t cut your benefits after all.” Would the pensioners be fooled? Would this set of steps make them more competitive? And if Illinois or California politicians started talking about this sort of thing, how fast would the bank run start?

A Greek departure would also be disastrous for the rest of Euroland. Yes, Greece is small. But  people with bank accounts in Spain or Italy would see clearly that their leaders do not understand sovereign default can coexist with a currency union. The run starts. Sorry, intensifies.  Greece is a huge precedent.  

Rajan on the world's troubles

My colleague Raghu Rajan wrote a very thoughtful essay in Foreign Affairs. Though titled “The True Lessons of the Recession” it’s really more a grand view of the last 50 years and prospects for growth ahead. The subtitle “The West Can’t Borrow and Spend Its Way to Recovery” is worth repeating.

Raghu reminds us that growth, in the end, comes from productivity. Keynesians have stolen the term to mean a few years of caffeinated stimulus, but to everyone else, growth means better living standards for decades. And the lesson of modern growth theory is that such growth comes only from greater from productivity – people able to produce more valuable goods and services per hour that they work.

Raghu reminds us that growth is not a given. There is no stone tablet saying GDP per capita will rise 2% per year forever. Every drop of growth is hard-won. It comes from people investing in ideas, in the human capital that produces ideas, in better skills, and able to start businesses, displace ossified incumbents, make new and better products and services.

He offers a thoughtful capsule view of the last 50 years; the strong postwar growth, how it petered out, and how the US responded with deregulation. Now it’s petering out again, and the question for us is whether we will be able to remove the sand in the gears. 

Raghu reminds us what economists know but seems forgotten in policy circles: The global rise in inequality over the last 30 years comes from the rising returns to skill, not from lower taxes, “greed” or malfaisance. The rich didn’t get richer; new people came in and got rich. As he put it, starting in the 1980s, 

It was no longer as important to belong to the right country club to reach the top; what mattered was having a good education and the right skills.

Raghu goes on to a long list of disastrous policies our government has followed which are greatly to blame for the current mess.  

While I agree these policies are disastrous, I’m less convinced of Raghu’s political narrative: that our government subsidized houses and credit as a benevolent but ham-handed attempt to address rising inequality.  There is more to an overarching theory of the political determinants of US economic policy than this. 

In part, I think Raghu’s own analysis proves the point,

Outside the United States, other governments responded differently to slowing growth in the 1990s. Some countries focused on making themselves more competitive.

OK, so if other governments such as Germany chose different policies, then our particularly damaging policies were not simply an inevitable reaction to the skill premium.

I part company even more as Raghu describes what to do about it. Raghu’s analysis emphasizes  America’s disastrous inability to provide its middle-class citizens with decent education. You would think a stunning denunciation of teacher’s unions and associated public-school bureaucracy would follow, but it doesn’t.

Raghu offers instead:     

The United States must improve the capabilities of its work force, preserve an environment for innovation, and regulate finance better so as to prevent excess.

This kind of sentence drives me a bit batty. Who is the subject of this sentence, really? You smell a new set of programs, but to be put in place by the same government that Raghu so skewers for the last 20 years?

Admittedly, Raghu adds, 

None of this will be easy,… Government programs aimed at skill building have a checkered history. Even government attempts to help students finance their educations have not always worked; some predatory private colleges have lured students with access to government financing into expensive degrees that have little value in the job market. 

OK, but he’s still apologizing for not layering new programs on top of the old failed programs. And with this little caveat the start-new-programs instinct takes over full-force,

That is not to say that Washington should be passive. Although educational reform and universal health care are long overdue, …

Wait a minute, Raghu! You just diagnosed the disasters of America’s public education system, and how desire to subsidize the middle class led to policy disasters. You want the same genius system to run health care too?

[Washington] can do more on other fronts. More information on job prospects in various career tracks, along with better counseling about educational and training programs, can help people make better decisions before they enroll in expensive but useless programs. 

Again, that indefinite tense. Who is going to provide this “more information?” and “counseling?” What about that “checkered history” of such efforts in the past?   

…subsidies for firms to hire first-time young workers may get youth into the labor force and help them understand what it takes to hold a job. 

Rajan offers brillant analysis of the global skill premium, and we’re back to tinkering with the tax code to overcome the disincentives offered by the minimum wage?

As finance professors, both Raghu and I pay extra attention to financial regulation.

Finally, even though the country should never forget that financial excess tipped the world over into crisis, politicians must not lobotomize banking through regulation to make it boring again. 

Amen, brother Rajan. But continuing,

At the same time, legislation such as the Dodd-Frank act, which overhauled financial regulation, although much derided for the burdens it imposes, needs to be given the chance to do its job of channeling the private sector’s energies away from excess risk taking. As the experience with these new regulations builds, they can be altered if they are too onerous.

What? The Dodd-Frank act is a monster compared to Fannie and Freddie, which Raghu just skwered. He surely would not write

At the same time, agencies such as Fannie and Freddie, although much derided for the subsidies and distortions they impose, need to be given the chance to do their job of channeling funds to housing, small business and student loans. As the experience with these agencies builds, they can be altered if their side-effects are too onerous.

 He does write

Americans should remain alert to the reality that regulations are shaped by incumbents to benefit themselves. They should also remember the role political mandates and Federal Reserve policies played in the crisis and watch out for a repeat.

Yes. Exactly why hoping that a complex monster like Dodd-Frank can work is sure to lead to more trouble.  Dodd Frank is designed and destined to lobotomize, monopolize and politicize the financial system. 

In sum, I think Raghu’s soft tinker-at-the-edges solutions just don’t match the eloquence of his diagnosis. We have a disastrous public education system that is leaving the middle class and poor behind, and a shattered middle-class family structure that renders education even more difficult. Accept his diagnosis that our political system drove us to financial disaster by patching up the resulting inequality.  Is not the answer much more far reaching, and much more of the stop-banging-our-head-against the wall variety?

One sentence on “educational reform” isn’t enough, let’s talk about the deep reforms that need to be taken, now. How can he  hope that the same political system will act more wisely, though it has much greater arbitrary power with the health law and Dodd-Frank?  Take his reading of the 1980s deregulation and how it solved the stagnation of the 1970s and gave us a new round of growth. Is the answer not the same sort, get out of the way rather than a spate of new Federal “competitiveness” programs?

Raghu regains his eloquence on the idea that a touch more stimulus is all we need, that growth is just a short-run “demand” problems not deep “supply” problems. 

Countries that don’t have the option of running higher deficits, such as Greece, Italy, and Spain, should shrink the size of their governments and improve their tax collection. They must allow freer entry into such professions as accounting, law, and pharmaceuticals, while exposing sectors such as transportation to more competition, and they should reduce employment protections…

Yes, but why does the same advice not hold for the US as well? Certainly not because we have the option (for a while) of running higher deficits.

But he really comes in to focus with this gorgeous paragraph: 

The industrial countries have a choice. They can act as if all is well except that their consumers are in a funk and so what John Maynard Keynes called “animal spirits” must be revived through stimulus measures. Or they can treat the crisis as a wake-up call and move to fix all that has been papered over in the last few decades and thus put themselves in a better position to take advantage of coming opportunities. For better or worse, the narrative that persuades these countries’ governments and publics will determine their futures— and that of the global economy

Yes!

Anyway, go read the original – provocative, thoughtful, and refreshingly well-written.

FDA for Financial Innovation?

Eric Posner and Glen Weyl are making a big splash with their proposal for An FDA for Financial Innovation. 

As you might guess, I think it’s a terrible idea. But let me try not to be predictable. I do think there are financial products that need to be regulated if not banned. Interestingly, Posner and Weyl completely miss these elephants in the room. (What are the dangerous products? I’m going to make you wait so you’ll read more of the post.) That observation alone seems like a good argument against their FDA as a structure for financial regulation. 

That’s the real question. The question is not, “should there be some financial regulation?” The question is, “what form should it take?"  "What institutional structure should it follow?” For example, see a previous blog post distinguishing law, rules-based regulation, and regulatory discretion. The question is, “does it make sense to legislate an FDA-like structure, in which all products are presumed guilty until proved safe to the satisfaction of a regulatory agency’s discretionary judgement?" 

The two missing ingredients

Though the FDA is not immune from criticism, the real FDA has two things going for it that the Financial FDA can only dream of: A clear and objective definition, and an objective method for testing products against that definition. Drugs either help patients to get better, with few side effects, or they don’t. And we can evaluate that ability with randomized clinical trials. The Financial FDA has neither.

Posner and Weyl want the financial FDA to separate products that are used for "investment” or “hedging” from those used only for “speculation,” and ban the latter.

The agency’s fundamental standard would be whether the welfare gains from insurance allowed by a new product exceeded the likely costs created by the speculation it facilitates.

But there is no consensus on “hedging” vs. “speculation” for  existing securities like stocks and options, after 400 years of actual experience!  And, not having that experience, or an objective method like  clinical trials, Posner and Weyl propose that panels of experts can make the call and decide how much “speculation” vs. “hedging” a new untried security will give rise to.

Posner and Weyl aren’t really able to express what’s so terrible about “speculation” anyway.  OK, some people lose money.  For example, they decry “heuristic arbitrage-based speculation”. 

A large literature establishes that people’s trading strategies often reflect simple heuristics (buy a stock that has recently increased in price) that can be easily exploited by hedge funds. By considering such heuristics and how they interact with the product’s characteristics, the agency could project demand based on heuristic arbitrage.

“Easily?” I know a lot of hedge funds that are losing money. About 1 in 5 goes bust every year. They (and our endowments that invest in them) only wish it were so easy to “project demand.” And even if so, where is the social problem here? It’s a zero sum game played among grownups.

Yes, some people think “speculation” makes prices too volatile. The puzzle is,  by definition “excess volatility” provide opportunities for others to speculate against them and make money. Another 400 year argument with no consensus, at least not one ready to be written into Federal Law after selectively citing only one side of the debate. 

Speculation

I’ve got bad news for Posner and Weyl. Almost all stock and option trading is “speculative.” Exchanges exist to facilitate “speculative” trading.  Options were designed and invented purely for “speculation.” Their use for “hedging” was a much later discovery, and remains a minor part of trading.

Let me explain. A call option gives you the right to buy a stock at a given price, but not the obligation to do so. For example, you might buy for 5 pounds the right to buy East India Company stock for 100 pounds. (A deliberately 1700s example to emphasize how long this has been with us.) Now, if East India company stock goes up to 120, the value of your option will increase dramatically, maybe to 22 pounds.

So, suppose your spies see the latest boat floating up the Thames, deep in the water with spices. What do you do? You want to buy lots of stock. But you only have 5 pounds. You could try to borrow 100 pounds to buy the stock, but the lender doesn’t want to do that, because if the stock goes down you won’t pay back the loan. Buying the option lets you speculate on the stock as if you borrowed 100 pounds, but you can only lose the 5 pounds. The trader on the other side (whose spies say the boat is just leaking) is perfectly happy to enter that contract. It is a perfectly designed security… for speculation. 

“Speculation” has important social functions, as everyone since Adam Smith has recognized. Suppose you want to sell some stock in a hurry. If “speculators” are banned, it becomes much harder to find a willing buyer. It is “speculation” that provides “price discovery” and “liquid markets” for the rest of us.

Posner and Weyl recognize this, to some extent: 

An investor who buys Facebook stock is making a bet as to how much money Facebook will earn by providing a service in the real economy. If people could not buy stock in this “speculative” manner (or make loans, etc.), then businesses with good ideas would have a great deal of trouble implementing those ideas and thus providing benefits to consumers, while companies with poor ideas might receive capital because no one would ensure that the price of their stocks or bonds remained low. Thus, financial market activity that helps prices adjust to their true value can influence the allocation of capital among potential
products and thus improve economic efficiency.

So far so good. But then they go on…

However, improving the informational efficiency of prices is only useful to the extent that it reflects the fundamental (social) value of the asset and affects the allocation of capital in the real economy. When fluctuations are too unpredictable, too driven by expectations of other traders’ behavior or shifts in prices over too short time-scales to have any impact on the real economy, they cannot have value under this argument.

Very nice. But which commissar can tell the line between “fundamental (social) value of the asset” and excesses?  Given we can’t do it for existing assets, with 400 years of data, how is a panel of experts supposed to figure this out, ahead of time, for new products that we have not seen yet? 

The hopeless task for the panel of experts  

You really need to read the paper, not just the opeds, to get a sense of how pie-in-the-sky this faith in experts is. Remember, we are talking here about evaluating categories of new products, like “stock” or “call options,” products that don’t exist yet.

The crucial step would be to determine the speculative costs of the new instruments, based on how many individuals would be interested in speculating on them and at what volume. The key to a careful analysis is to break down speculative demand itself into several categories: disagreement-based, regulatory arbitrage-based, tax arbitrage-based, and heuristic-exploiting.

That is indeed the “crucial step.” Sort of like “Here is where the magic happens.” “The crucial step would be where the Easter Bunny comes in the middle of the night and gives the children chocolates.”

Continuing, they offer a taxonomy of speculation to be forecast:

Pure disagreement-based speculation. This is perhaps the hardest of all the forms of speculation to project demand on, as so much depends on what catches the imagination of potential participants. Luckily, a large historical track record of past products offers a rich data set on which regressions using ex-ante characteristics of products can be run to project ex-post speculation, which can be measured fairly easily based on observed volumes compared to the demand accounted for by the other sources demand (both hedging and other speculative forms discussed below).

Nobody has ever done this for existing products.

For example, one natural predictor of speculative demand, proposed by Simsek is to survey professional forecasters for their estimates of the value of the security. If, for example, the forecasters agree on the value of the security, then it cannot be used to speculate. If the distribution of estimates is sufficiently wide, however, it can be used to speculate.

Give 100 analysts all the company data you want but not the stock price, and see how many of them can come within a factor of 10 of the actual price.

 Other predictive factors may relate to how prominent the phenomenon that the derivative is based on is in  the public mind or in commonly used financial models. These can be quantified using new tools of automated text analysis, such as Google’s nGrams Viewer.41 By harnessing data on past products and the speculative demand they generated, indicators like this could be used to form clearer expectations of likely speculative demand, in conjunction with documents that the proposer will submit about the sources of demand they anticipate and projections by similar but disinterested market players.

OK, this went on a bit, but is the pie in the sky nature of this clear? Nobody has ever credibly run even one of these regressions for existing securities, let alone proposed securities.

Let me try to be positive. The main thing Posner and Weyl could do is to actually produce one such evaluation, that survives widespread scrutiny and determines the amount of “speculation” vs. “hedging” in even an existing security, to the level of certainty required for us to bring down the heavy power of the Federal Government to ban it. 

Regulatory and tax arbitrage: Catch 22

Posner and Weyl make one good point: some financial innovation is undertaken for regulatory or tax arbitrage. Mortgage backed securities were bundled into special purpose vehicles with off-balance sheet guarantees as a dandy way to get around capital requirements. Institutions required to hold AAA securities found ways to construct such securities to hold more risk than regulators wanted.

Alas, a Financial FDA blessing new securities would be hopeless to stop this sort of thing. In these cases, as well as Posner and Weyl’s other examples, the securities had perfectly valid other uses. They were invented for other uses. Securitized debt also goes back hundreds of years. (When you get bored here, go explore Geert Rouwenhorst’s History of Financial Innovation website)

Most of all: Catch 22. Posner and Weyl’s complaint is that financial engineers are one step ahead of regulators, who can’t see how they’re using financial products to get around regulations and taxes. Well, if the bank regulators and tax authorities can’t figure out, often for 10 years or more after the fact, how a product is used to avoid regulation and taxes, how in the world is the Financial FDA’s panel of experts supposed to figure it out ahead of time? If that were possible, the regulators themselves would be able to stop the practices! This is an airtight logical proof that the idea can’t work.

Junk bonds are another good example. Poser and Weyl write of them approvingly, 

A financial instrument may lower the cost of capital to firms and individuals. Such reductions in the cost of capital result from the ability to spread the risk more evenly. For example, prior to the securitization of “junk bonds” in the 1980s, many small  firms could draw only on very wealthy investors for financing.

But junk bonds were also used for regulatory arbitrage. In the 1980s, savings and loans wanted to add a lot of risk. Regulation said they could only buy “bonds” but the S&Ls wanted to double or nothing by taking on the risk and return profile of “stocks.” Junk bonds fit the bill perfectly, and let the S&Ls evade risk regulation. Posner and Weyl didn’t notice this after the fact. Good luck to their Financial FDA to notice it ahead of time.

More regulatory arbitrage just gets around silly regulations. We subsidize debt by making interest payments tax deductible to companies while dividends are not. No surprise, companies do a lot of engineering to take advantage of this tax deduction. Big banks want huge leverage, then engineer their way around capital ratios. But it would be a whole lot easier to remove the subsidy for debt in the first place.  

The Nature of Innovation

 Who is going to run all these regressions?

This information should be available from the firm seeking approval; after all, it should be incorporated in the demand analysis the firm uses to decide whether to market the financial product in the first place.

This quote reveals a deep confusion on how markets work and how new products are invented. New products typically start as one-on-one agreements. Company A calls Goldman Sachs asking for a new kind of swap contract. Others find it useful, over the counter trading increases, some contracts get standardized and traded on exchanges, then clever ducks figure out how to use them to get around regulation, and traders start “speculating.”

Stocks, bonds, credit default swaps, catastrophe bonds, insurance itself, reinsurance, mortgage backed securities, securitized debt  all started this way. They did not start with some big “firm” planning to “market” some new security like an iphone. Some consumer financial products start that way, but there’s no “speculation” in credit cards.

Trading vs. Products

Posner and Weyl go on a bit on the evils of high freqeuency trading. This is particularly curious. Their FDA is supposed to analyze products. But high frequency trading is a practice, for a product that’s been around 400 years.   Or is the Financial FDA supposed to preemptively approve or disapprove every “trading practice” whatever that could mean?

 Assuming all transactions that only occur when possible at sufficiently low cost are wasteful, one can combine this “elasticity” with the expected reduction in cost created by the new instrument to estimate the number of harmful transactions likely to be created

That’s an interesting assumption to be written in to the Federal Register. 
 
A Reflection on Law.

A financial contract is a contract. It’s just an agreement between two parties: if X happens, I pay you money. If Y happens, you pay me money. That’s the most basic kind of contract there is.

In essence, Posner and Weyl are advocating a dramatic change to contract law as we’ve understood it for hundreds of years. (OK, I’m not a legal historian,  but you know what I mean.)

At heart, their proposal is to declare that any private contract involving money is illegal until the Federal Government authorizes it. As you see in their discussion of high speed trading, financial practices are  illegal if Posner and Weyl can’t understand their social function.

And the determination of “social utility” comes from a politically-appointed regulatory body with wide discretion, no clear definitions, no clear procedure, and thus essentially no recourse. (If the panel says no, how can you prove your security is useful?)

Aside the issue of basic liberties, constitutional limitations, and all that old-fashioned stuff, it doesn’t take much to imagine how quickly such an operation would become politicized, captured, or corrupt. Even the FDA doesn’t do so well when big political interests are involved.

That’s rather astonishing, especially coming from across the Midway at the University of Chicago


(The dangerous contracts? Short term debt, demand deposits, and now broker-dealer relationships. Contracts which induce runs. These have plain externalities: if I run, it makes the institution less liquid, so you have an incentive to run. We just had a big run in the shadow banking system. That is the problem to be fixed, not “heuristic-exploitative” hedge funds, no?)

Slow recoveries after financial crises?

Are recoveries always slower for recessions that follow financial crises? This factoid has become sort of a mantra, or excuse, depending how you look at it.

Former President Bill Clinton chimed in, repeating the factoid thus: “If you go back 500 years, whenever a country’s financial system collapses, it takes between 5 and 10 years to get back to full employment.”

I. Facts

I’m not aware of the study Clinton is  referencing, nor of any comprehensive international database on employment and financial crises going back 500 years. But only a nerdy academic would footnote an introduction at a Presidential fund-raiser, and one might excuse a little exaggeration in that circumstance anyway. (I don’t mean to pick on Clinton. Lots of people have passed around this factoid. They just don’t get written up in the newspapers!)

Reinhart and Rogoff’s “Aftermath of Financial Crises” is, I think, the source. Their work actually reflected a fairly recent sample of countries. For example, here is their unemployment graph.

Which they summarize thus:

the aftermath of banking crises is associated with profound declines in output and employment… The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years.

(The paper doesn’t offer a comparison with “regular” business cycles, but I presume they have one somewhere.)  In a recent Bloomberg oped, Reinhart and Rogoff repeat that summarizing all their evidence, they think recessions following financial crises are longer and deeper.

As I look at the facts, the wide disparity in outcomes in the picture is more striking to me than the average. Financial certainly don’t always and inevitably lead to long recessions, as the factoid suggests.

This is interesting but leaves one hungry for evidence from the United States – maybe we are different from  Colombia – and for a longer time period. Recently several authors are picking up this challenge.

In a  nice article for the Atlanta Fed, Gerald Dwyer and James Lothian went back to the 1800s, and find no difference between recessions with financial crises and those without. Some, like the Great depression and now, last a long time. The others don’t. 

Michael Bordo and Joseph Haubrich wrote a somewhat more detailed study of US history, (which I found through John Taylor’s blog) concluding

recessions associated with financial crises are generally followed by rapid recoveries. We find three exceptions to this pattern: the recovery from the Great Contraction in the 1930s; the recovery after the recession of the early 1990s and the present recovery. …

In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength

This had pretty much been the “stylized facts” when I went to grad school: US output has (so far) returned to trend after recessions. The further it falls, the quicker it rises (growth). Financial crises give sharper and deeper recessions, followed by sharper recoveries, but not, on average, longer ones. This “recovery” is in fact quite unusual, looking more like the Great Depression but unlike the usual pattern.

As I did minor searches for the facts however, it’s clear there is an explosion of work on this subject, so it’s hardly the last word. 

 2. Explanations

Historical averages are not explanations. We are not doomed to repeat history. Clinton echoed a common interpretation: something is written in stone that financial crises lead to long recessions, so don’t blame us. But I haven’t read much convincing economics about why a financial or banking crisis must inevitably lead to a long recession.

A logical possibility of course is that drawn-out recessions following financial crises (whether the average or just isolated incidents) reflect particularly ham-handed policies followed by governments after financial crises.  Financial crises are followed by  bailouts, propping up zombie banks, stimulus, heavy regulation, generous unemployment and disability benefits, mortgage interventions, debt crises and high distortionary taxation (European “Austerity” consists largely of taxes that say “don’t start a business here”) and so on. These policies do have their critics as well as their fans. It is certainly possible that these, rather than “financial crisis” are the cause of slow recovery, and thus that slow recovery is a self-inflicted wound rather than an inevitable fate. 

The similar policy mix in the Great Depression is now accused by a strand of scholarship as the prime cause of that depression’s extraordinary length, not valiant but sadly insufficient fixes. (For example, see Lee Ohanian; for some more popular summaries see Jim Powell or Amity Shlaes.)

Bordo and Haubrich include capsule histories. I don’t agree with them entirely, but they’re worth reading for one big reason: We recovered quickly from many financial crises in the 19th and early 20th century, when there was no Fed at all, no stimulus spending, no unemployment insurance, none of the usual “fixes” being applied to this crisis. To read most lefty comment these days on the need for “stimulus,” you’d predict that one recession in the 1800s would have led to permanent stagnation.

The wide variation across countries shown above, as well as the wide variation in US financial recessions is really intriguing from this aspect. The question we should be asking is not “how long are financial crisis recessions on average” but “what accounts for the huge variation across time and countries?”

Just a quick Google search will show you that an enormous amount of work is underway on “why is this recovery so slow?” (Sorry, I can’t begin to post useful links, just too many to sort through.) Explanations from poor policy, job mismatch, sticky labor markets, housing overhang, and so on abound. The interesting thing is that almost nobody seems to be taking the view that all financial-crisis recessions are the same, or that a long recovery is inevitable. 

Even Reinhart and Rogoff write this way:

 It is interesting to note in Figure 3 that when it comes to banking crises, the emerging markets, particularly those in Asia, seem to do better in terms of unemployment than do the advanced economies. While there are well-known data issues in comparing unemployment rates across countries, the relatively poor performance in advanced countries suggests the possibility that greater (downward) wage flexibility in emerging markets may help cushion employment during periods of severe economic distress. The gaps in the social safety net in emerging market economies, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.

Lots of others (such as Casey Mulligan) also think that high and persistent unemployment is a result of government policies that discourage moving or a return to work. 

On my reading list: In the meantime, Jim Stock and Mark Watson do very careful econometric analysis and conclude that this recession really didn’t have much to do with the financial crisis: “no new “financial crisis” factor is needed."  They continue,

More ominously,  we estimate that slightly less than half of the slow recovery in employment growth since 2009Q2, compared topre-1984 recoveries, is attributable to cyclical factors (the shocks, or factors, during the recession), but that most of the slow recovery is attributable to a long-term slowdown in trend employment growth

3. What next?

”Aftermath of Financial Crises“ continues,

Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies in advanced economies aimed at mitigating the downturn.

And in  From Financial Crisis to Debt Crisis,

..banking crises (both domestic and those emanating from international financial centers) often precede or accompany sovereign debt crises. Indeed, we find they help predict them.

The same crowd that likes to quote Reinhart and Rogoff for the inevitability of long recessions after financial crises should read their work here. It seems like a potent warning for view that we need just a little more borrowed-money stimulus, or that such spending reliably pays for itself by magically generating higher tax revenues.

Update

Oscar Jorda sent along a link to two papers  here and here  covering 14 countries over 140 years. They find episodes of "global instability” – notice how many of the above graph are 1997 or 1998 – which is important to digesting just how much information we have. Crises lead to deeper recessions and stronger recoveries. And they look at predictors. I haven’t read them yet, but they are on top of the stack.

Floating-rate debt update

As reported in the WSJ, the Treasury delayed it’s decision on floating rate notes.

I was interested to note in the article that the Treasury seems to be struggling with the same issue that occupied my post on the subject yesterday – just how will the “floating” rate be set?

The Treasury is searching for an index, and considering the overnight Federal Funds rate, Libor, the general collateral Repo rate, or an index based on treasury bill rates. All of these have various problems outlined in the article.

A second indication of the problem with any index shows up in the article: The unsettled debate whether to let floating rate debt auction at a price greater than face value. That means Treasury also envisions the security trading less than face value.


I’m interested that what’s missing is the most obvious mechanism: The price is exactly $100 every single day, and an auction mechanism sets the rate daily at whatever it takes to maintain that price. Any other mechanism means the security is not protected from capital losses, which makes it much less useful as an asset.