Knowing and Making

Some interesting research on banks, public guarantees and risk-taking (via the Alea blog ). The researchers use a natural experiment on German banks (some of whom lost the state guarantee on their deposits due to a court ruling in 2001). The research finds that these banks reduced the riskiness of their lending after the change (compared with a control group of other banks who didn't have a guarantee in the first place). This is what you would expect from conventional theory. But I wonder whether their conclusion is correct: "The results suggest that public guarantees may be associated with substantial moral hazard effects." An alternative view: perhaps banks without guarantees take less  risk than is socially optimal, and public guarantees partly correct for this effect. There are several reasons why this might be the case: Information asymmetry - the "market for lemons" argument. Businesses (and consumers) borrowing money have much more information abo...

I have no objection in principle to higher taxes on banks. But the IMF's surprising proposal (outlined by Robert Peston here ) may not quite be taxing the right thing. If the goal of the tax is to pay for the externality imposed on taxpayers by bank behaviour, that's fair enough. In line with the principles of Pigovian taxation , the tax should fall on the activities which impose those costs. That way, it's fair and also creates the right incentives, to shrink those activities if they do not benefit society enough to justify them. The first part of the IMF's tax seems to fit this principle. Peston doesn't explain what this "flat rate" would be levied on - I assume it isn't literally a flat rate, otherwise Goldman Sachs or Citigroup would pay the same amount as the Cheltenham Building Society or the Third State Bank of Des Moines. Presumably therefore it will be in line with the recent Obama proposal: a percentage levy either on total assets or on r...

Anthony Evans at The Filter makes  a suggestion I agree with : ...I recollect a conversation I had with Russ in class once, where I cast doubt on the "follow the money" implications of public choice. He suggested that if you look hard enough it's usually the case that poor policy stems from vested interests. At the time I was unable to articulate my feeling that often it's simply mistaken beliefs. Yes indeed. In fact, many economic phenomena - micro and macro - stem from mistaken or incomplete beliefs. I am developing a model which will shed some light on this, but it may take some time. In the meantime, a simple question. The world is complicated; and there are millions of things I could do that might very well be in my interest. How would I know about all of them?

Does this story sound familiar? Debt rose to unsustainable levels in 2007 Imbalances in the world economy reached unprecedented levels - the Chinese trade surplus approaching $1 trillion, American public deficits around half a trillion dollars... Oil and other commodities soared to historic highs The financial system became overleveraged on the assumption that a permanent era of stable growth had been reached; removing the margin of error for slowdowns The whole system reached a high-water mark and fell back; banks and the rest of the financial industry were unable to cope with the failure of a few highly leveraged firms; and we ended up in an 18-month recession. But is it true? Why do we think that household debt at 150% of GDP, or oil at $150 a barrel, or US public debt of $10 trillion, is unsustainable? I'm quite prepared to believe that enough people were worried about debt to stop accumulating more of it; and that this was a contributing factor to a slowing of monet...

Tyler at MR has been asking recently whether the structure of bankers' pay caused (or contributed to) the financial crisis. Matt Yglesias also has something to say about it (via the above link). I agree with the general skepticism about this - it is a bit too easy as an explanation. Limited liability on the other hand is definitely a contributor - shareholders' interests are actually almost the same as those of employees: take lots of risk as the upside is much higher than the downside. If a bank makes $100 billion, shareholders and employees get to share it out. If it loses $100 billion, shareholders lose their whole stake, employees lose a large part of theirs, but creditors are likely to lose many times more. Or if the creditors in question are insured depositors, the taxpayer loses out instead. Ultimately, banks manage much more of their depositors' and other lenders' money than shareholders' money. So this had some impact on risk-taking. But I am starting to c...

Robert Peston reports that Dunfermline Building Society is going to be taken over by Nationwide, and asks "why Dunfermline took such risks that ultimately cost the society its independence". Here's an article with a bit more detail about the story and what happened. I haven't been able to find out whether management were incentivised with highly leveraged short-term bonuses, but given that this is a Scottish building society, the obvious assumption is that they were not. So why would they take such huge risks? The answer surely is that they did not knowingly do so; but that they felt a pressure to chase profits and closed their eyes to the risk that usually goes with high returns. The pursuit of high profits is ingrained in the behaviour of managers even without financial incentives. This could be seen as a social pressure to keep up with the next guy; a psychological pressure to be the alpha male; or a boundedly rational economic decision based on an inaccurate est...

I promised more on the lemons discussion but Sandro Brusco has gone into more depth in this posting than I could have done in the time I had available yesterday. There's some way to go in analysing this, but Brusco has a couple of important points: The first is that the problem will only be solved by revealing information. He suggests doing this by requiring managers to make a personal investment in the assets, so they have an incentive to get the valuation right. As an alternative, I would consider simply publishing the detail of the assets so that third parties can look at what they consist of and make their own determination of value. Depending on the level of detail, this may raise privacy concerns for the original mortgage borrowers, so it won't be possible to publish absolutely everything. But I'm sure a lot could be released. The second is that the banking system can't function normally until this information is revealed, so it's critical to get it done soo...

Following up Geithner versus Darling by Robert Peston: There are three reasons why the assets held by banks (loans to weak borrowers, packaged in whatever way) might not be worth very much: The borrowers really can't (or won't) pay them back There is not enough liquidity so the banks can't sell them There is a "lemon" discount based on asymmetric information [ Updated ] Buyers or sellers of the assets are somehow irrational. I don't analyse this option in the article below but will try to work out for a future article whether it is a major factor. I am trying not to suggest a bounded rationality explanation for everything in the world! There is a huge argument going on about which of these is the real answer - because it has a bearing on which kind of bank rescue plan we should implement. If the answer is number 1, then the banks have screwed up and we may not want to throw more good money after bad by buying the loans. If the answer is number 2, we should be...

Martin Wolf's article on Lord Turner's review is a good one (by which I mean, of course, that he agrees with me). He identifies irrationality as "the main analytical conclusion" of the report, but he doesn't take the next step of suggesting that it can be directly regulated. There are a range of interpretations of Turner's report. Some think his diagnosis was that banks are too thinly capitalised. Some that he condemns financial innovation. I think Martin Wolf has found the most important part: his conclusions about irrationality, both collective and individual. But while Turner has diagnosed the right disease, he doesn't propose a workable cure. To combat irrationality, he suggests a set of tools that work through rational means. Counter-cyclical capital requirements, leverage ratios, remuneration and centralised CDS clearance are perfectly sensible measures, but - like interest rates, the main tool of existing counter-cyclical policy - they work by mark...

Lord Turner's report " A regulatory response to the banking crisis " was released yesterday. One of the key findings is that markets, and market participants, can be irrational. This can lead to problematic outcomes such as bubbles in asset prices and massive mispricing of derivatives such as CDOs and CDSs. However, Turner's recommendations barely address this problem. There are several valid recommendations about procyclical reserves and a hint at a power to intervene in momentum trading (such as short-selling which feeds on itself). But this only dances around the edges of the problem. He also recommends technical training or qualifications for bank executives. But that's not where the irrationality is. Indeed, many bankers have been all too rational throughout this crisis - extracting rents for themselves at the expense of shareholders and creditors. Turner does recognise this principal-agent problem and some of his recommendations deal with it. However it is n...

Via Stephanie Flanders, the IMF starts to give us a way to estimate the return on investment of recent financial bailouts from various countries. Apart from anything else, this may help to silence some of the complaints from people offended at us "giving" money to banks to "bail them out". There are two different ways to calculate ROI: first, what is the cost and benefit to the state as an entity, and second, what is the cost and benefit to the economy as a whole. Note that the 'cost' here does not refer to the entire cost of the crisis in lost economic output or reduced asset prices - because most of that is a sunk cost and our decisions can have no impact on it. It refers to costs specifically incurred by explicit decisions taken to rescue financial institutions. In the case of the UK, the cost to the state (according to the IMF) of the bailouts is about 9% of GDP or £130 billion. The return will include: Whatever is gained from selling off government sta...

From an unusual source (John Reid, chairman of Celtic Football Club - oh, and the UK's former Home Secretary) comes a proposal for international exchanges for interbank lending. Tim Worstall understandably dislikes the idea that the interest rate is the same regardless of who the borrower is. But that is partly addressed by the insurance premium that would be paid by all borrowers. My question is different: is interbank lending still the problem? I have the feeling that the interbank market no longer suffers from the problems it had last year - LIBOR/TED spreads are down and governments have effectively guaranteed the majority of interbank loans. Instead it seems that the problem in the financial economy is either demand for or supply of credit to the non-financial sector. This is resulting in a shrinkage of money in circulation and - since it's not compensated by an increased velocity of money - reduced prices or GDP. Still, it's not a ridiculous idea. Perhaps instead of...

On Radio 4 this morning is an amazing programme exploring some really deep and technical issues about quantum theory and the nature of reality in physics. Amazingly in that they are brave enough to broadcast it at a time more associated with The Archers . Amazing in that the level of discussion is one that would challenge most physics and philosophy graduates, and they let it loose on a mainstream audience. I'm impressed. But then I read Robert Peston's latest post about China , and it became even more resonant. That old question is asked: who or what is to blame? In particular, was the financial crisis caused by excessive borrowing by Westerners or excessive lending by China? The thing is, of course, that neither of those things could happen without the other. That makes it impossible to really debate whether saving caused lending or vice versa, let alone which one caused the financial crisis. And that's where I am reminded of the methods of quantum physics and how we sol...

Last year Myron Scholes predicted the credit crisis would be over on 7th March 2009. That's coming up this Saturday, so how's the prediction looking? Well, AIG has lost $60bn and received a further capital injection; the US government has just converted a bunch of debt into 30-odd percent of Citigroup; Martin Wolf has written another article with some nasty-sounding predictions. We're running short of time to fix the system if Myron is to be proved right. To be clear, this is not about the recession. I don't think we expect economic growth to start in the next four days. It's about fixing the problems in the financial system so that money can start flowing and the recovery can properly begin. The debate in the US over nationalisation is growing louder. Unusually, the argument is getting simpler rather than more complicated: the losses are there, shareholders have been (as close as makes no difference) wiped out, so do the remaining losses go to creditors or taxpay...

The FT's Market Insight column from a couple of days ago contained a reference which at first I skimmed over with barely a glance: "[bankers] feared that public sales would produce painfully low prices. That is a valid fear. After all, there are very few investors in the system right now with any appetite or capacity to take risk." A rather orthodox assertion and hardly worthy of note, thought I. And yet - a little thought shows that the riskiness of an investment is not only a characteristic of the underlying asset itself. Recall that, just a year or two ago, lots of not-very-risky assets with unexciting yields were being converted into riskier, high-return instruments by the simple trick of leverage. Borrow £200,000 at 4%, bung in £10,000 of equity, buy £210,000 of property or shares yielding 5%, and your £10,000 of cash magically earns a return of 25%, in return for a vast increase in risk. But the same trick is even easier to do in reverse. Let's say you are offe...

The Wall Street Journal today says that the UK government "...has already spent £600 billion on its financial bailout" This is simply misleading. The government has made a lot of liquidity available in exchange for other assets  through several Bank of England schemes. It has barely spent anything at all; even if you include the bank recapitalisations, which are also in exchange for equity, the figure is around 5% of the number quoted. While this kind of stuff is to be expected from the Daily Mail and other tabloids, I am pretty surprised at it in the Wall Street Journal . I'm glad that the FT  still maintains a standard of reporting that allows us to rely on its interpretations as well as its raw facts.

Continuing the discussion of a few days ago , Nick Rowe joins in correcting Niall Ferguson 's "average debt" logic. Maybe we should give the guy a break - he is only a historian, not an economist. No doubt whenever a historian writes a book about the history of [X], they get brickbats from all the practitioners of [X]. But then that's the price of intellectual engagement. The comments on Nick's post set me thinking about better ways to measure the total impact of debt in the economy. One commenter (Patrick) reminded me of the issue of debt maturity mismatch, which seems to have been a major contributor to of the current financial crisis (aside from the effect on the real economy). Here's the response I posted there: It sounds attractive that there would be some meaningful measure that at least partly captures the way in which debt influences the economy. We could certainly build models where a large amount of gross debt has almost no effect at all (e.g. A owes...

In pure asset-allocation terms, nationalisation of bust banks seems to be the most reasonable option. Shareholders have taken big risks (or allowed their appointed representatives to do so), the risks did not pay off, and government now has to step in and help. Therefore, government should now own the banks. I have broadly supported this argument, but it does hide a big problem: the knowledge problem . (There's a whole blog about this subject) In order to best allocate economic resources, those who control them need to have knowledge about where they can get the best return. This knowledge is distributed all over a population of billions of people. Therefore how can we ensure the information can most quickly and reliably find its way to the person who controls the resource? First we need to note that 'knowledge' is a tricky concept. At the risk of stepping through a vast minefield of epistemological thought, I'll assert that nobody knows anything about the world with a...

According to Robert Peston , Barclays' share price appears not to reflect the underlying state of the bank. It raised £10bn in new (private, not public) capital last year and made £6bn in pre-tax profits (between £4bn and £5bn post-tax). Thus, in theory, its balance sheet should contain around £15bn of new capital since this time last year. Not to mention whatever was on there before. And yet, its shares are valued at under £9bn. Presumably this is because of uncertainty about the value of some of its assets, and the fear that they will be written down - eliminating the capital base of the bank. So why doesn't Barclays take - on its own initiative - the advice many economists have given to the US government, and create its own "bad bank"? It could simply split itself into two or more pieces, with the better half of the assets in Bank A and the riskier half in Bank B; and provide the minimal required capitalisation to bank B. B would carry off a big chunk of capital bu...

Another article (this time by Niall Ferguson, of whom more later) on the too-much-debt theory. The subtitle is: "Governments cling to the delusion that a crisis of excess debt can be solved by creating more debt". Well, this isn't a crisis of excess debt. To the extent that credit problems are responsible for the recession, it is a reduction  in the availability of credit that has triggered it. Ferguson may think that companies and individuals owe too much. But who do they owe it to? Er, other companies and individuals! He doesn't present much evidence for the "too much" theory, except an assertion: The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities...