Tuesday, August 27, 2013

Summers to Fed?

The fact that Summers to Fed has even been discussed is a sign of complete economic illiteracy by the administration. It's genuinely shocking that there isn't a single person in the administration either smart enough or brave enough to say so. 

First, the positive. I think he'll do a better job than his critics suggest on bank regulation. He doesn't like the complex regulatory schemes that others within the administration have favored because he thinks complex rules are too easy to be gamed. On this, I agree. 

However, to anybody who thinks this role is primary (like, clearly, Obama), have you been paying no attention at all to anything happening in stock or credit markets? The stance of monetary policy - QE, tapering, IOR, *interest rates*.... That literally shapes the path of the US economy, and Summers is simply not qualified to carry that out in two important ways. Content wise, I agree with Scott Sumner - he has zero knowledge of monetary policy at the zero bound. His "paper trail" suggests he believes monetary policy is ineffective at the zero bound. This is an absolutely archaic notion, and this belief outweighs any potential role as a financial regulator. It's like asking your pediatrician to be your dentist because he's generally smart and great with kids when he has never worked on teeth before. 

Speaking of great with kids, the other qualification for Fed chair is temperament with the media. Every time you speak, six billion people hang on your every word. Thousands of people make a living interpreting what you say and how it will affect monetary policy over the short, medium and long run. It is a position for somebody who doesn't speak thoughtlessly, who understands the importance of every word they say. Watch one Bernanke press conference and you'll see exactly what I mean - the man is extremely careful to preserve 100% the credibility of every word  coming from both the institution and the position. And should be! Larry Summers is notoriously thoughtless and blunt in his opinions. Has everyone forgotten how he got himself fired from Harvard? How he alienated people there, how he alienated people in the government working there, his style in every meeting?

I believe Larry Summers would have made an excellent Treasury Secretary- better in his little finger than Jack Lew could ever hope to be with his whole body. Summers WAS a good treasury secretary under Clinton and would handle the increased importance of the position with aplomb. But Fed Chair? Is Obama completely incompetent?

I hate the perception, looking at my opinions, that I've moved rightward. I'm as difficult to place as always. I just think this administration is being run by an (economic/managerial) idiot. 

Thursday, May 9, 2013

Fixing the Financial System

This is a draft of something I've been thinking about for the last week. Unfortunately, I don't have time to look at it for a minute longer, so I'm posting it as is. please forgive the slightly less-than-perfect organization

There seem to me to be two fundamental ways of protecting the financial system. The first is to restrict what financial institutions can do (let's call this "activity fencing") and the second is to restrict the amount they can do it (which is basically deleveraging).

Activity fencing has been a common cry, but I suspect it is far inferior as a method. A number of reasons come to mind. 

Firstly, most of the activities that banks would be restricted from doing are services that banks provide to clients to assist them in reducing their own risk. For example, much of the widely-disparaged prop trading is the bank helping a client de-risk and holding the other side of the deal on its own balance sheet. In many, though not all, cases, this is simply until the bank can find an appropriate counterparty. 

Hedging in this manner can be a big win-win for clients. Think quickly about upside-downside risk of an airline and a refinery hedging the price of jet fuel. Both firms, highly capital intensive and often themselves quite levered, face far more existential risk from an unfavorable move in jet fuel than they benefit from a favorable one. Hedging is by no means zero sum in impact, even if it is in cash flow. 

Thus, banks providing these services is a form of risk pooling, no different from and in many ways superior to that found in a health insurance company. If we aggregate all the risks together, many will cancel out, so that the net remainder of risk is far less. A lot of this remainder ends up on financial institution balance sheets as prop trades. 

Another analogy is inventory management. It is fundamental in operations management that the total amount of inventory you need to hold is lower for a pool of inventory serving lots of outlets than it would need to be on an aggregate basis if each outlet kept its own inventory. This is because each outlet risks over- or underpurchasing relative to inventory levels but must keep a safety stock of extra inventory to handle high demand periods. Aggregating up reduces the standard deviation in demand (outlets that are oversubscribed can cancel out those that are undersubscribed) and allows that safety stock to be significantly smaller. We can think of risk at banks in a similar fashion. 

The true problem of these activities, which legitimately reduce risk on their own, is that it is not easy to measure how much you have actually reduced risk, and if you overestimate how much risk you've reduced, you take on too much additional risk and end up with an institution that is too risky. I hope it is clear in this framework that the issue is not one of "useless" activity but instead one of measurement of just how much that activity is helping. 

Addressing this fundamentally must happen by restricting legitimately helpful activity where it is very hard to measure the amount of help it provides on the margin. The question is whether this should be done more by restricting types of activity (activity fencing) or restricting amounts of activity (leverage). 

Restricting types of activity leaves a lot of risk to corporations. Corporations are generally not too bad at knowing the risks they're going to face, and they tend to be pretty efficient in identifying the risks they want to fix.  Restricting bank activities thus brings down significantly the corporate activity level by limiting them to the risk they can handle unhedged. This sounds nice, but insurance would get significantly more expensive and harder to get, anything commodities-based (airplane flights, food, etc) would be more expensive and harder to get, etc. 

In fact, thinking about returns to scale, it is very likely that the first credit in a hard-to-measure activity is still a much better one to have societally than the marginal (last) credit in an easy-to-measure one. In fact, that marginal credit in an easy-to-measure area is still probably hard to measure when levered up. Would you rather hedge Berkshire Hathaway's fixed/floating interest with a swap (hard to measure but clearly safe) or a subprime mortgage (much easier to measure but not deterministically so, and risky!)

Given this, it seems far more logical to focus on deleveraging, because by deleveraging you prevent banks from taking on too much additional risk regardless of whether they think they can handle it on a measurement basis. It also eliminates the marginal credits that would be the sources of the most problems in a given financial product if that product were to get hit. 

Now, it's important to note here that banks need a return on equity capital to make them able to retain investors. This return may go down as risk goes down, but it certainly does not go down proportionate to risk decreases because of the opportunity cost of capital for investors. 

Given this, in the long term, significantly deleveraging banks would almost certainly reduce credit availability and increase interest rates for those who can get credit. It would necessitate a substantial increase in the money supply to maintain systemic liquidity. Note that we have already observed deleveraging, reduced credit availability and a flood of new money. Interest rates to individuals or organizations who aren't great credits will almost certainly have to rise from here - banks are almost universally earning an ROE below any decent measure of their cost of equity capital, and while it takes time for them to rework their balance sheet, a delevered bank needs a lot of equity and this will eventually revert upwards, which means lousy depositor rates continue but creditor rates creep upward. 

The dynamic leads us to the unfortunate conclusion that it is close to impossible to have credit easily available to groups with credit risk (small businesses and low income individuals) while also having a highly stable financial system. Countries that have avoided this problem are few, far between and largely riding a commodities boom out of China that won't last forever. I'm trying to think of adjustments to the tax system or effective government programs that could mitigate this credit availability issue but all of the solutions I can think of are highly inefficient. 

This also makes me think about the efficacy of monetary policy under different leverage levels. Safer credits are safe because they have predictable businesses. Adjusting interest rates may not affect their borrowing and investing decisions as much as it would for lesser credits and we may thus need more aggressive monetary policy responses for the same effect under a safer banking system. 

Wednesday, April 24, 2013

GDP-Indexed Bonds

Tyler Cowen outlined a number of hypotheses on why countries don't issue GDP-indexed bonds. It can be found here:  Marginal Revolution Why no gdp-indexed bonds? 

He had 5 hypotheses - Falsification, Adverse Selection, Existing CDS markets, Illiquidity of splitting a small country's bond market, and governments not running big budget surpluses in good times.

I have a sixth that I suspect may dominate all of the above: who are the investors? Banks, who I suspect are by far the largest purchasers of government bonds, tend to already have plenty of floating rate liquidity available to them on both the asset and liability sides (note that GDP-indexed and floating interest rate bonds should come close to comovement, unless you're basing it on real GDP, in which case all you're doing is stripping the inflation protection from floating rate bonds, which would be a substantively inferior product to what banks can get already and would thus require a discount). Individual investors who buy bonds tend to do so because they want the reliability of a fixed cash flow even (especially!) when GDP drops. And making products to sell to financial services firms (mutual funds and hedge funds) is not exactly a recipe for great pricing.

I am sure countries COULD sell GDP-indexed bonds, but how much worse would the terms be relative to a fixed rate?

Monday, February 4, 2013

The US Government Suing the Ratings Agencies?!


The choice to sue the ratings agencies demonstrates three very sad things about the Obama Administration, as I'm fairly certain the Justice Department would not go ahead with the lawsuit without the Administration's okay.

1) There aren't very many members of the financial system who can be sued at this point that would not just a) undo a lot of the positives Geithner and Bernanke did and b) make the Administration look bad for backing someone who they felt were unethical. So they found a scapegoat they had never been associated with (and the fact that S&P downgraded Treasury debt makes a lawsuit even more appealing to the government). The Administration needs the approval and seem to have nothing in the pipeline that will garner it. They also want to continue blaming Bush and the financial system for the slow recovery to avoid negative blowback on the stimulus, etc, in a time of deficit battles. So they lash out. Particularly galling right after HSBC gets away with money laundering for Mexican drug cartels.  A piss-poor demonstration of leadership. 

2) The administration really has no idea how commerce, business, finance or anything else work, or are at least willing to act in a manner that makes it seem that way. A rating is an opinion, not a certification... every financial rating everywhere includes risks that it could be catastrophically wrong. There seems to be this technocracy pervasive in government that if you want things to work a certain way, they magically do, so if the ratings agencies wanted to get the ratings right, they would have. Unfortunately, in the real world, there are risks and sometimes failures, but you sometimes need to let those go to promote a system where people are willing to put their necks on the line. For the ratings agencies to be useful, you need them to feel they can tell the truth about what they think, to the positive or the negative. Otherwise, you lose an environment of accountability and everywhere turns into the government - exhibiting a sort of CYA reactivity instead of people being willing to put their reputations on the line. It's no different to why we have reasonably lenient personal bankruptcy laws relative to other countries.

3) Ultimately, this hurts issuers of debt and small buyers and helps large buyers that can do their own analysis (who, ironically, are the people the issuances in question were sold to). If ratings agencies are legally accountable for their ratings, why on earth would they take on complex issuances? And even if they do because they want the fees, won't they artificially rate all of them lower than expected? That'll either a) devalue low ratings in the eyes of investors and make them ignore the ratings agencies, ironically leading to more risk-taking or b) scare off small investors and leave the securities for big investors who can see through the bulls*t. As a financial professional, I suppose this makes my job easier, but not for a reason that makes me particularly happy.

For that matter, how does this not hurt the Federal Government? It's not like the debt issued by the Treasury is free of future concerns, and if this move makes the ratings agencies much faster to pull the trigger on downgrading US debt, that would be called "backfiring".

I really, really try to give Obama the benefit of the doubt on things, but on the fiscal and economic front, he has made it harder and harder to do so over time.

Sunday, January 27, 2013

The best paper I've seen on the Financial Crisis


Highly recommended for anyone with an interest in understanding the crisis. In summary, the fact that everyone expected that housing prices could only rise over time (in aggregate, the authors leave out but their mental model implies, not necessarily region by region) describes almost all of the reasons for the behavior and results we observed, more than corruption, dishonesty, underregulation or bad policy.

Sunday, January 20, 2013

Why there is inflation in Greece - one explanation

Tyler Cowen pondered:
"The rates of price inflation in Greece have been running in the range of 0.8% to 2%.


It's funny how many people pretend to understand what is going on here.  If Greece were seeing a stronger bout of price deflation, the situation would be much clearer.  How can you try to explain these disparate facts?"

I think I have one possible explanation. If the turmoil is significantly impacting Greek productivity - either from a "trust" perspective, as Tyler suggests, or because all of the austerity measures and riots are reducing the ability of existing workers to be productive*, and thus costs go up, then either domestic prices go up or Greeks need to substitute towards potentially more expensive imports. This should be particularly important if Greece were far from operating at capacity anyway or if the lion's share of Greek production costs are variable. 

I have no evidence, just trying to think structurally.

*note that this, in and of itself, is not a reason to oppose austerity. It's just one of the "benefits" that should be incorporated into the cost-benefit evaluation of the cut.