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July 13, 2009

Economist's View - 4 new articles

The Shadow Knows

Awhile back there was some controversy over the role of the shadow banking system in the financial crisis. Resetting the stage:

Much Ado About the Shadow Banking System, The Hearing: Occasionally, a blog post will flower into a wide-ranging debate in what is usually called the "economics blogosphere." Last Friday's guest post on regulation by Mark Thoma triggered just such a debate. I'll quote the controversial passage at some length:

Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.

The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.

We need to bring the shadow banking system – essentially any institution that takes deposits and makes loans either directly or indirectly – under the same regulatory umbrella as the traditional banking system.

Dr. Manhattan, an anonymous blogger at The Atlantic, focused on that middle paragraph in a post called "Sentences That Don't Compute," arguing that the crisis was due to problems at regulated financial institutions, such as AIG, not the shadow banking system.

Brad DeLong defended Thoma, drawing the line between commercial deposit-taking banks (heavily regulated) and other institutions (lightly regulated).

Thoma also responded on his own blog, pointing to the fact that AIG's problems, for example, were caused by the unregulated part if its business - the Financial Products derivatives-trading business.

Arnold Kling (who usually blogs here) responded to DeLong at The Atlantic, saying that failures of regulation of commercial banks were also a problem.

Finally, Rortybomb has a careful review of the issues, showing how different people mean different things by "shadow banking system." Ultimately he sides with Thoma on this point: money shifted into a sector of the financial system where there was no backstop against a liquidity crisis - unlike the regulated operations of the commercial banks, where deposit insurance plays that role. This is a problem that needs to be fixed.

Mike Rorty follows up today in The Atlantic's business blog with an interview with Perry Mehrling on shadow banking and its role in the crisis. Mehrling's bottom line for regulators is a "new Bagehot Rule" for modern markets: Insure freely but at a high premium.

Here's part of the interview:

Shadow Banking: What It Is, How it Broke, and How to Fix It, by Mike Rorty: We hear a lot of chatter about the shadow banking system and its crucial role in the financial crisis. But rarely do we find time to step back and ask the basic questions: What is shadow banking, where did it come from, how did it operate, what role did it play in this crisis and how do we deal with it going forward? I hope this Q&A with a very smart professor and economist at Barnard College Professor Perry Mehrling provides answers to each of those questions.

...[Mike Rorty:] So let's talk about shadow banks. What are they, where did they come from, and how did they operate?

We have to appreciate that we are writing history as it is being made so these are provisional theories. ... The shadow banking system was built up alongside the traditional banking system, using some of these tools of modern finance we were just talking about like interest rate swaps and credit default swaps. The idea was to make credit cheaper for the ultimate borrower and more available, but also to separate the credit system from the payment system. A lot of the regulation we have on the traditional banking system is there to protect the payment system, to make sure that when you write a check on your deposit account, that money actually gets transferred.

The idea of the shadow banking system was in some way, not only tolerated by regulators, but encouraged by regulators. They thought, "Let's get some of these risks off the balance sheet of the traditional banking system. Let's get interest rate risk off the balance sheet of the traditional banking system. Let's get credit risk off the balance sheet of the traditional banking system." They thought that would be a good thing. The traditional banks became an originator of loans which they packaged, securitized, and then sold to the shadow banking system, which then raised funds in the money market from mutual funds and asset-backed commercial paper that they issued to whomever. It was avoiding the traditional banking system entirely in this regard, and also avoiding all the regulation of the traditional banking system as well as all the regulatory support of the traditional banking system.

But of course it had the same risks. You aren't actually getting rid of liquidity risk or getting rid of solvency risk; you are just moving them into a different place. ...

So that explains how the shadow banks evolved. Now where did the weaknesses start to show up?

There's some controversy about this. It is certainly true that problems in subprime started to create some anxiety as to whether or not these assets were really AAA or not. But I don't think that this can be sustained, the notion that this was just a housing bubble that collapsed. Because if it was, we'd be done already. As many people said at the beginning of the crash, "oh [the problem is] just subprime, there's only, say, $400 billion of that stuff out there, it is not big enough to undermine the entire financial system." The fact that crisis continues shows that it isn't just a crisis of subprime, but a crisis of the whole securitization structure, that everything came into question.

The way this played out is the following. Once there is any concern about the value of the collateral you are putting up in an overnight borrowing situation, the first thing the lender does is to alter the deal, to say "Ok, we'll continue to lend. But just to be on the safe side, instead of giving you 99 cents on the dollar we'll give you 95 cents on the dollar." That immediately creates a problem for the shadow bank that is borrowing. Where are they going to get that other 4%? The way that plays out is that ... collateral value was marked down. You couldn't borrow as much as you used to in order to carry the underlying security. This became a self-fulfilling prophesy on the way down, something I refer to as a "liquidity-solvency downward spiral."

I've told my students for a decade that this new system would inevitably get tested by a crisis. And when it got tested it was inevitable that it was going to break. We didn't know where it was going to break, and the important thing now is to identify where it broke and to fix it so it doesn't break there again. ...

So what can the Federal Reserve do going forward to try and regulate this shadow banking system?

I use the term "Credit Insurer of Last Resort." And here's the idea: The Bagehot Rule - lend freely, at a high rate, in a crisis - dates from 1873. That was a good enough rule for the 19th century British economy, an economy that ran on short term commercial bills of exchange, 90-day paper. You can see for the new capital markets banking system we have a problem. We have 30-year mortgages that are the underlying asset that are being turned into 90-day paper through asset-backed commercial paper, or a repurchasing agreement, or repo, but the underlying asset is still a 30-year mortgage. That is where the system broke, because those mortgages serve as collateral for the short term borrowing.

Floating the system with money market liquidity, which is what the Fed did, didn't solve the problem, because it wasn't getting to the capital markets. That's why we need a credit insurer of last resort, to put a floor on the value of the best collateral in the system. I say the new Bagehot Rule should be: Insure freely but at a high premium.

Why a high premium? If you insure an earthquake, you are not making earthquakes more likely. The insurance contract is a purely derivative contract, it isn't influencing earthquakes. That is not true of insurance of financial risk. When AIG is selling you systemic risk insurance for 15 basis points, that price is too low. People said: "If I can get rid of the whole tail risk that cheaply, I should load up. I should take more systemic risk." So the prices were wrong. So the important thing for government intervention here is to get that price closer to a reasonable rate to prevent people from creating earthquakes.

Mike also notes:

Mehrling has a fantastic paper, The Global Credit Crisis, and Policy Response, about the shadow banks and their role in the current crisis. It's very accessible to a general reader with an interest in the subject matter and just a bit of background knowledge and by far the best explanation of this part of the crisis; I highly encourage you to read it before or after tackling the interview. He also has a video of him presenting the paper, as well as a webpage full of relevant papers and editorials. Check it out.

Update: Arnold Kling disagrees based upon the idea that the market will always be one step ahead:

Merhling's solution is for the government to be a risk insurer of last resort. That sounds to me like Freddie Mac and Fannie Mae, which did not work well at all. But Merhling says,

the important thing for government intervention here is to get that price closer to a reasonable rate...
Thus, the insurer of last resort has to charge a very high premium.

With all due respect to Professor Mehrling, I think that this is unworkable. The market will figure out a way to make the insurer of last resort take much more risk than it thinks it is taking. That is what the market did to AIG, as Merhling points out. I see no reason to expect that the government insurer will always be able to outsmart the market.

Whether that's true or not, to me it says nothing about whether we should add regulation to close the holes we already know exist - we should - though I suppose one could counter with an unintended consequences argument. And we should also close any holes we are able to anticipate. We won't always stay one step ahead, that's true, but at least we won't fall further behind.

Update: James Kwak adds:

Merhling's takeaway point is that there needs to be a "credit insurer of last resort," who will insure any asset against a fall in value – for a sufficiently high premium. This would make it possible for financial institutions to unload the risk of their asset portfolios in a crisis, if they are willing to pay enough to do so. The only institution that would have the credibility to play this role in a real crisis would be the federal government; as we saw, AIG – the world's largest insurance company, remember – was not up to the task. Still, though, I'm not sure this would do the trick. If I'm a large bank with a balance sheet full of toxic assets, and I don't want to pay the premium that the insurer of last resort is charging, then I go to the government, say the price is too high, and ask for a bailout. The credit insurer of last resort would need to be coupled with a commitment not to provide an alternative form of government support, or we would end up where we are today.

Money Monopoly

Marshall Auerback says California is challenging the federal monopoly on money creation:

Schwarznegger to Obama: Watch and Learn, by Marshall Auerback: According to the San Diego Union-Tribune, Republicans and Democrats alike embraced legislation last Friday that would make California IOUs legal tender for all taxes, fees and other payments owed to the state.

Effectively, California is using its IOUs to create a currency. If this bill passes it would allow California to deficit spend just like the Federal Government and with the IOU's acceptable as payment of state taxes, it instantly imparts value to them. In effect, what you have is a state of the union creating a sovereign currency right under the noses of Treasury, Fed. They are stumbling their way into it... It will be viewed as a stop gap measure at first, and then could very well become entrenched as states realize they have a way to escape balanced budget requirements. ...

The ... Federal government retains this monopoly under our existing monetary arrangements. If California is successful here in allowing its IOUs to pay tax, it has profound constitutional ramifications. ...

It will be interesting to see what the exchange rate is between California IOU and US currency - the IOUs do offer a yield, so should be less than par by design. I wonder if NY is next.

This is like some sort of return to the 13 colonies with all kinds of ersatz currency floating about. It's hard to believe the Rubinite wing of the Democrats will just let it be, given the threat it represents to Wall Street's prevailing economic interests, but it is an understandable response...

There are political benefits for Obama...: If the Federal government allows this proposal of the state of California to go unchallenged, it would relieve the President of a major political quandary, which is, does he help California and then open himself to aid requests from other states?..., or, does he let California go and lose 56 electoral votes in the next election?

By allowing them to "solve" their own problem in the manner proposed by the legislation he avoids the quandary. And ... they just might let them do it until the import is fully understood.

It is true that this legislation represents a profound break from all federal laws. It is almost bound to incur some sort of constitutional challenge, representing as it does, a profound threat to the Federal government's currency monopoly powers. But this is another instance where Obama's inattentiveness to the ramifications of the states' respective fiscal crises has come back to haunt him. This situation would not have arisen had Obama embraced a simple revenue sharing plan with the states (so that the states' respective fiscal policies would be working in harmony with his proposals, rather than mitigating the impact of the Federal fiscal stimulus), as recommended by any number of prominent economists...

It will be interesting to see how this plays out. As California goes, will the nation follow? ...

Setting aside the particulars of the California case and whether or not the IOUs are actually functioning as money - that's debatable - very, very generally, the federal government has a budget constraint just like everyone else, well sort of like everyone else anyway -- most of us can't levy taxes or print money. Federal government finances must satisfy

G - T = ΔM + ΔB,

where Δ means "change in," G is government spending, T is taxes, M is the money supply, and B is bonds. The left-hand side is the deficit, and the right-hand is how it is financed. Thus, when G is greater than T so that there is a deficit in a given budget period, it must be financed by printing new money (ΔM) or issuing new bonds (ΔB). (If it helps, think of G as being 100 and T being 70 so that the deficit is 30. The deficit can be financed by printing 30 new dollars, by borrowing 30 dollars from the public, or some combination of the two)

Now, for states, ΔM is zero since that would be money creation, and they are not allowed to do that. Thus, a state's budget constraint is:

G - T = ΔB

This must be satisfied each budget period. Because this constraint must hold each budget period, notice what happens if there is a legal or political debt limit -- in some states it is effectively B=0 -- and B is already at the limit (which means ΔB cannot be positive since that would add to the debt). If the state's budget deficit rises in a recession due to decreased tax revenue and increased spending on social services, then G must fall to eliminate the deficit, or new taxes must be levied, and the cutback in spending and/or increase in taxes makes the recession worse.

But what if a state was suddenly granted the power to print money? Then it could pay for that year's deficit without increasing bonds (i.e. debt) any further, i.e. G - T could be financed solely by ΔM if it so chooses. That is, the state now has the constraint

G - T = ΔM + ΔB

If B is maxed out politically or legally so that ΔB must equal zero (or be negative), then a deficit, G - T, could still be financed with ΔM.

Having fifty different currencies isn't necessarily bad, there are pros and cons to having a single currency across all fifty states, i.e. to forming currency union. With a currency union, individual members lose the ability to conduct independent monetary policy - there is one money and one policy so everyone in the group gets the same treatment - but that is less costly when the the economic differences among the members of the union is small and the same policy is generally applicable. There are many advantages to having a single currency (no exchange rate uncertainty and lower transactions costs to name just two), and for countries considering forming a currency union, there is a list of factors that are cited as working for or against unification. Many of these factors involve social, political, economic, and geographic factors, and generally, though not always, the more similar the countries are, the more likely it is that a currency union will be beneficial (e.g. similar levels of development, a similar mix of products, similar legal institutions, same language). In the case of the fifty states within the U.S., I believe the advantages of a single currency far outweigh the disadvantages, and states should not be allowed to create their own currencies.

"Boiling the Frog"

What are we waiting for?:

Boiling the Frog, by Paul Krugman, Commentary, NY Times: Is America on its way to becoming a boiled frog?

I'm referring, of course, to the proverbial frog that, placed in a pot of cold water that is gradually heated, never realizes the danger it's in and is boiled alive. Real frogs will, in fact, jump out of the pot — but never mind. The hypothetical boiled frog is a useful metaphor for a very real problem: the difficulty of responding to disasters that creep up on you a bit at a time. ...

I started thinking about boiled frogs recently as I watched the depressing state of debate over both economic and environmental policy. These are both areas in which ... it's very hard to get people to do what it takes to head off a catastrophe foretold. ...

Start with economics: ...Most economic forecasters now expect gross domestic product to start growing soon, if it hasn't already. But all the signs point to a "jobless recovery"...

Now, it's bad enough to be jobless for a few weeks; it's much worse being unemployed for months or years. Yet that's exactly what will happen to millions of Americans if the average forecast is right — which means that many of the unemployed will lose their savings, their homes and more.

To head off this outcome — and remember, this isn't what economic Cassandras are saying; it's the forecasting consensus — we'd need to get another round of fiscal stimulus under way very soon. But neither Congress nor, alas, the Obama administration is showing any inclination to act. Now that the free fall is over, all sense of urgency seems to have vanished.

This will probably change once the reality of the jobless recovery becomes all too apparent. But by then it will be too late to avoid a slow-motion human and social disaster.

Still, the boiled-frog problem on the economy is nothing compared with the problem of ... climate change. ... At this point, the central forecast of leading climate models — not the worst-case scenario but the most likely outcome — is utter catastrophe, a rise in temperatures that will totally disrupt life as we know it... How to head off that catastrophe should be the dominant policy issue of our time.

But it isn't, because climate change is a creeping threat rather than an attention-grabbing crisis. The full dimensions of the catastrophe won't be apparent for decades, perhaps generations. ... Unfortunately, if we wait to act until the climate crisis is ... obvious, catastrophe will already have become inevitable.

And while a major environmental bill has passed the House, which was an amazing and inspiring political achievement, the bill fell well short of what the planet really needs — and despite this faces steep odds in the Senate.

What makes the apparent paralysis of policy especially alarming is that so little is happening when the political situation seems, on the surface, to be so favorable...

After all, supply-siders and climate-change-deniers no longer control the White House and key Congressional committees. Democrats have a popular president to lead them, a large majority in the House of Representatives and 60 votes in the Senate. And this isn't the old Democratic majority, which was an awkward coalition between Northern liberals and Southern conservatives; this is, by historical standards, a relatively solid progressive bloc.

And let's be clear: both the president and the party's Congressional leadership understand the economic and environmental issues perfectly well. So if we can't get action to head off disaster now, what would it take?

I don't know the answer. And that's why I keep thinking about boiling frogs.

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