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May 25, 2010

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"Rating the Raters"

Posted: 25 May 2010 01:08 AM PDT

Problems at the ratings agencies contributed to the crisis, and it's important for financial reform legislation to address the problems in this industry. The issues arise from the fact that the ratings agencies are paid by the firms whose assets are being rated. This gives the ratings agencies an incentive to issue pleasing ratings to encourage future business, and with enough money on the line, this can lead to large distortions in the risk assessments.

There are many ways to break the link between the ratings that are given and prospects for future business, e.g. the randomized selection of the agency that rates the assets that Dean Baker has been proposing, and the current proposal from the Senate takes a step in this direction. Lucian Bebchuk describes the Senate legislation, and explains how tying the profits that ratings firms earn to their actual performance breaks the link between issuing tough but accurate ratings and losing future business:

Rating the Raters, by Lucian Bebchuk, Commentary, Project Syndicate: In the new financial order being put in place by regulators around the world, reform of credit rating agencies should be a key element. Credit rating agencies, which play an important role in modern capital markets, completely failed in the years preceding the financial crisis. ...
What should be done? One proposed approach would reduce the significance of the raters' opinions. In many cases, the importance of ratings comes partly from legal requirements that oblige or encourage institutional investors and investment vehicles to maintain portfolios of assets that have received sufficiently high grades from the recognized agencies.
Disappointment about the raters' performance, and skepticism about the effectiveness of regulation, has led to calls to eliminate any regulatory reliance on ratings. If ratings are not backed by the force of law, so the argument goes, regulators ... can leave the monitoring of raters to the market.
Even if ratings were no longer required or encouraged by law, however, demand for ratings – and the need to improve their reliability – would remain. Many investors are unable to examine the extent to which a bond fund's high yield is due to risk-taking, and would thus benefit from a rating of the fund's holdings. Given past experience, we cannot rely on market reputation to ensure that such ratings will be reliable.
Another approach would be to unleash the liability system. ... But ... judicial scrutiny ... cannot ensure that raters do the right thing... There is thus no substitute for providing raters with incentives to provide as accurate a rating as they can. This can be done by making raters' profits depend not on satisfying the issuers that select them, but on performing well for investors. ...
The US Senate voted this month to incorporate such a mechanism into the financial reform bill that will now have to be reconciled by the bill passed by the US House of Representatives. Under the Senate's approach, regulators would create rules under which an independent regulatory board would choose raters. The board would be allowed to base its choices on raters' past performance.
For such a mechanism to work well, it must link the number of assignments won by raters, and thus their compensation, to appropriate measures of their performance. Such measures should focus on what makes ratings valuable for the investors who use them...
Predictably, the Senate's bill encountered stiff resistance from the dominant rating agencies. ... Rating agencies have been and should remain an important aspect of modern capital markets. But to make ratings work, the raters need to be rated.

At this point I'm not picky about how the incentive to issue higher than justified ratings is removed, there's more than one way to do this, the main thing is that a strong and effective mechanism along these lines is included in the final bill. [There also needs to be an entry and exit mechanism so that firm's that consistently give misleading risk assessments are driven from the set of authorized ratings agencies and replaced by new entrants to the industry.]

Who's Really Standing in the Way of Progress on Macroeconomic Theory?

Posted: 25 May 2010 12:33 AM PDT

I want to follow up on the post highlighting attempts to attack the messengers -- attempts to discredit Brad DeLong and Paul Krugman on macroeconomic policy in particular -- rather than engage academically with the message they are delivering (Krugman's response). The attacks have served to mislead people as to what macroeconomic theory has to say about monetary and fiscal policy interventions during severe recessions, fiscal policy in particular. So it's a bit mysterious as to why this group thinks that personal attacks on the messengers, attacks that mislead people about modern macroeconomic theory and what it says about policy, somehow advance the cause they purport to be interested in.

One of the objections often raised is that Krugman and DeLong are not, strictly speaking, macroeconomists. But if Krugman, DeLong, and others are expressing the theoretical and empirical results concerning macroeconomic policy accurately, does it really matter if we can strictly classify them as macroeconomists? Why is that important except as an attempt to discredit the message they are delivering? Same with all the nonsense about their not understanding modern theory beyond old style textbook IS-LM, that's nothing but a blatant attempt to discredit them. And it's not even true, both have a thorough understanding of New Keynesian model coupled with that rare ability to see through the mathematical formalities and highlight it's most important elements. In addition, does the advancement of economics that you are so worried about really depend upon whether you find them likable at a personal level? Of course not. Attacking people rather than discussing ideas avoids even engaging on the issues. And when it comes to the ideas -- here I am talking most about fiscal policy -- as I've already noted in the previous post, the types of policies Krugman, DeLong, and others have advocated (and I should include myself as well) can be fully supported using modern macroeconomic models. There's not much of an argument to be had when it comes to the ideas themselves.

One way to try to get around this is to cite empirical evidence from past recessions showing that fiscal policy multipliers are small. Eggertsson deals with this objection in his paper by noting that things are very different at the zero bound. Things don't work the same when the policy rate is already at the zero bound and the Fed cannot push it any lower. Multipliers that are small away from the zero bound can become large, they can even flip sign in some cases. Because of this, evidence gathered from periods when the economy was not at the zero bound tell us almost nothing about the size of multipliers we should expect in episodes like we are experiencing today. The problem is that we have almost no data for episodes such as the Great Depression when the economy was at the zero bound, certainly not enough evidence to say anything specific about the magnitude of fiscal policy multipliers. There are economists who ought to know better who are still acting as though evidence from, say, World War II or some other episode somehow matters, but if we take modern theory seriously that evidence ought to be heavily discounted. To quote Eggertsson (pg. 2):

This illustrates that empirical work on the effect of fiscal policy based on data from the post-WWII period, such as the much cited and important work of Romer and Romer (2008), may not be directly applicable for assessing the effect of fiscal policy on output today. Interest rates are always positive in their sample, as in most other empirical research on this topic. To infer the effects of fiscal policy at zero interest rates, then, we can rely on experience only to a limited extent. Reasonably grounded theory may be a better benchmark with all the obvious weaknesses such inference entails, since the inference will never be any more reliable than the model assumed.

On that note about model reliability, let me address one further criticism highlighted by Robert Waldmann:

Speaking for myself only, I don't care what modern macro models say. I don't think that New Keynesian models add anything much of value to the Keynesian cross. I certainly haven't noticed any great empirical success. Oh also speaking only for myself, I have never bothered to keep up with macro theory. It is entirely possible that people understand new Keynesian DSGE models and think they are worthless.

Since he is clear that he is only speaking for himself, and his point is a bit broader than mine, let me be clear that I am the one making the claim that the view that the standard macroeconomic model is useless is a more generally held sentiment.

I thought about addressing this point in the original post, but since the point I was making there does not depend upon whether modern macro theory is valid or not -- my point was that the policies Krugman, DeLong and others are advocating can, in fact, be justified using modern models contrary to what was being implicitly or explicitly suggested in attacks on them -- so I decided to leave this out and address it later if it came up.

I don't know that I'd go as far as Robert, but I agree that the current macroeconomic models are unsatisfactory. The question is whether they can be fixed, or if it will be necessary to abandon them altogether. I am OK with seeing if they can be fixed before moving on. It's a step that's necessary in any case. People will resist moving on until they know this framework is a dead end, so the sooner we come to a conclusion about that, the better.

As just one example, modern macroeconomic models do not generally connect the real and the financial sectors. That is, in standard versions of the modern model linkages between the disintegration of financial intermediation and the real economy are missing. Since these linkages provide an important transmission mechanism whereby shocks in the financial sector can affect the real economy, and these are absent from models such as Eggertsson and Woodford, how much credence should I give the results? Even the financial accelerator models (which were largely abandoned because they did not appear to be empirically powerful, and hence were not part of the standard model) do not fully link these sectors in a satisfactory way, yet these connections are crucial in understanding why the crash caused such large economic effects, and how policy can be used to offset them.

There are many technical difficulties with connecting the real and the financial sectors. Again, to highlight just one aspect of a much, much larger list of issues that will need to be addressed, modern models assume a representative agent. This assumption overcomes difficult problems associated with aggregating individual agents into macroeconomic aggregates. When this assumption is dropped it becomes very difficult to maintain adequate microeconomic foundations for macroeconomic models (setting aside the debate over the importance of doing this). But representative (single) agent models don't work very well as models of financial markets. Identical agents with identical information and identical outlooks have no motivation to trade financial assets (I sell because I think the price is going down, you buy because you think it's going up; with identical forecasts, the motivation to trade disappears). There needs to be some type of heterogeneity in the model, even if just over information sets, and that causes the technical difficulties associated with aggregation. However, with that said, there have already been important inroads into constructing these models (e.g.). So while I'm pessimistic, it's possible this and other problems will be overcome.

But there's no reason to wait until we know for sure if the current framework can be salvaged before starting the attempt to build a better model within an entirely different framework. Both can go on at the same time. What I hope will happen is that some macroeconomists will show more humility they've they've shown to date. That they will finally accept that the present model has large shortcomings that will need to be overcome before it will be as useful as we'd like. I hope that they will admit that it's not at all clear that we can fix the model's problems, and realize that some people have good reason to investigate alternatives to the standard model. The advancement of economics is best served when alternatives are developed and issued as challenges to the dominant theoretical framework, and there's no reason to deride those who choose to do this important work.

So, in answer to those who objected to my defending modern macro, you are partly right. I do think the tools and techniques macroeconomists use have value, and that the standard macro model in use today represents progress. But I also think the standard macro model used for policy analysis, the New Keynesian model, is unsatisfactory in many ways and I'm not sure it can be fixed. Maybe it can, but that's not at all clear to me. In any case, in my opinion the people who have strong, knee-jerk reactions whenever someone challenges the standard model in use today are the ones standing in the way of progress. It's fine to respond academically, a contest between the old and the new is exactly what we need to have, but the debate needs to be over ideas rather than an attack on the people issuing the challenges.

links for 2010-05-24

Posted: 24 May 2010 11:05 PM PDT

Reich: Obama’s Regulatory Brain

Posted: 24 May 2010 02:07 PM PDT

I don't fully agree with Robert Reich's view expressed below and elsewhere that breaking up the big banks is the key to solving the too big too fail problem. It does mean that the failure of an individual firm would be less worrisome, and hence less likely to get help from the government, but that assumes shocks are idiosyncratic rather than common. However, the shocks we should worry about are common -- systemic to use another term. The shocks that are capable of bringing down large institutions would, if the large banks had been broken up into smaller pieces, bring down all the smaller banks just as easily. Collectively they would still be too big too fail and still require a bailout. And it's certainly true that there are historical episodes where the failure of a large number of small banks was the problem.

But there is another reason to worry about big banks, the economic and political power that comes with size. Even if it's true that breaking banks into smaller pieces doesn't help much, if at all, to make the system safer, all else equal, it does make it much less likely that banks will capture regulators and legislators. And it makes it harder for banks to use their economic power in the marketplace to increase profits at the expense of consumers, or to maintain a financial marketplace where high risk, high reward, taxpayers pay the bill it things go sour strategies are allowed.

So yes, break up the big banks if for no other reason than to curtail economic and political power. And if I'm wrong and this also makes the system substantially safer, so much the better. But what I was really interested in here is the distinction Reich makes between the regulatory and structural approaches, a distinction I think is important:

Obama's Regulatory Brain, by Robert Reich: The most important thing to know about the 1,500 page financial reform bill passed by the Senate last week — now on he way to being reconciled with the House bill — is that it's regulatory. If does nothing to change the structure of Wall Street. The bill omits two critical ideas for changing the structure of Wall Street's biggest banks so they won't cause more trouble in the future, and leaves a third idea in limbo. The White House doesn't support any of them. 
First, although the Senate bill seeks to avoid the "too big to fail" problem by pushing failing banks into an "orderly" bankruptcy-type process, this regulatory approach isn't enough. The Senate roundly rejected an amendment that would have broken up the biggest banks... You do not have to be an algorithm-wielding Wall Street whizz-kid to understand that the best way to prevent a bank from becoming too big to fail is preventing it from becoming too big in the first place. ... Because traders and investors know they are too big to fail, these banks have a huge competitive advantage over smaller banks.
Another crucial provision left out of the Senate bill would be to change the structure of banking by resurrecting the Depression-era Glass-Steagall Act and force banks to separate commercial banking ... from investment banking. Here, too, the bill takes a regulatory approach..., it would not erode the giant banks' monopoly over derivatives trading, adding to their power and inevitable "too big to fail" status.
Which brings us to the third structural idea, advanced by Senator Blanche Lincoln. She would force the banks to do their derivative trades in entities separate from their commercial banking. This measure is still in the bill, but is on life-support after Paul Volcker, Tim Geithner, and Fed chair Ben Bernanke came out against it. Republicans hate it. The biggest banks detest it. ... Almost no one in Washington believes it will survive the upcoming conference committee. But it's critical. ...
Wall Street's lobbyists have fought tooth and nail against these three ideas because all would change the structure of America's biggest banks. The lobbyists won on the first two, and the Street has signaled its willingness to accept the Dodd bill, without Lincoln's measure. The interesting question is why the president, who says he wants to get "tough" on banks, has also turned his back on changing the structure of American banks — opting for a regulatory approach instead.
It's almost exactly like health care reform. Ideas for changing the structure of the health-care industry — a single payer, Medicare for all, even a so-called "public option" — were all jettisoned by the White House in favor of a complex set of regulations that left the old system of private for-profit health insurers in place. The final health care act doesn't even remove the exemption of private insurers from the nation's antitrust laws. 
Regulations don't work if the underlying structure of an industry — be it banking or health care — got us into trouble in the first place. ... A regulatory rather than structural approach to deep-seated problems in complex industries like banking and health care is also vulnerable to the inevitable erosion that occurs when industry lobbyists insert themselves into the regulatory process. Tiny loopholes get larger. Delays get longer. Legislative words are warped and distorted to mean what industry wants them to mean. ...
Inevitably, top regulators move into the industry they're putatively trying to regulate, while top guns in the industry move temporarily into regulatory positions. This revolving door of regulation also serves over time to erode all serious attempt at overseeing an industry.
The only way to have a lasting effect on industries as large and intransigent as banking and health care is to alter their structure. That was the approach taken to finance by Franklin D. Roosevelt in the 1930s, and by Lyndon Johnson to health care (Medicare) in the 1960s. 
So why has Obama consistently chosen regulation over restructuring? Because restructuring Wall Street or health care would surely elicit firestorms from these industries. Both are politically powerful, and Obama did not want to take them on directly.
A regulatory approach allows for more bargaining, not only in the legislative process but also, over time, in the rule-making process as legislation is put into effect. It's always possible to placate an industry with a carefully-chosen loophole or vague legislative language that will allow the industry to continue to go on much as before. 
And that's precisely the problem. 

The line between structural and regulatory intervention is a bit vague in some cases, but it's still conceptually useful to categorize the types of intervention in this way. As I've said many times, we should try as hard as we can to make the system safe, but we'll never be able to guarantee that the financial system is immune to sudden collapse. Thus, as we think about the structural and regulatory changes that are needed, we should be sure to make changes that minimize the fallout when another collapse occurs, as it eventually will. Much of the change that is needed is structural in nature, but not all, e.g. I'd categorize leverage limits, which I view as critical to minimizing the fallout when problems occur, as regulatory.

However, as noted above structural change is harder than imposing new regulations. The fact that legislators are shying away from the harder to impose types of change out of fear of losing reelection support from the financial industry points to the political power the industry still has, and to the need for structural change to reduce this political (and economic) power. If we cannot muster the political will to make such changes in light of the most devastating financial collapse since the Great Depression, that does not bode well for the future.

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