Long thread at interfluidity

Steve and I go back and forth on this long thread at interfluidity. JKH makes a couple of appearances, injecting sanity into the discussion, so it's worth reading for that alone.

I think Steve understands how loans create deposits, but he does not understand how savings is how you account for real investment. I'm bad at explaining loans->deposits, and I'm even worse at explaining investment->savings.

Here is a very good explanation of how savings and investment are connected (thanks Scott!)

The Fed cannot inflate. Buy Bonds.

Ben Bernanke is famous for saying that the Fed can always inflate if needs be by "dropping money from helicopters".

But the Fed cannot "drop money from helicopters". Only the Treasury can. Helicopter drops of money are fiscal policy, not monetary policy, as they create net new financial assets for the non-Govt sector. The Fed cannot inflate.

If you think about the mechanisms the Fed has, it becomes clear that they do not have to tools to create inflation. They can control interest rates, but rates are a double edged sword as the non-Govt sector has both borrowers and lenders. Low rates help borrowers but hurt savers, and high rates do the opposite. At a sector level, the impact of interest rates is muddled at best, there certainly is no clear mechanism to generate inflation.

The Fed can also alter the level of bank reserves. If banks lent out reserves, this might have some impact on private sector credit expansion, but as banks do not lend out reserves, it does not. There's been a long debate in various blogs about whether, on the margin, a vast sea of reserves might have some impact on bank behavior, but nothing definitive came out of it. As a mechanism, it's weak.

The only thing left is belief, something that Nick Rowe came very close to admitting in a post a few months back. "Monetary policy does not actually work, but if people believe it works, it might". There you have it, Fed as Placebo. I think much of the runup in the S&P has been based on two things: 1) cheap labor (which helps corporate profits) and 2) a belief that the Fed will get the economy restarted. If 2 weakens, then all that's left is unemployment to enrich corporations by helping their bottom line, but there is no demand to help them grow their top line. It's a very ugly scenario, and one that Japan's been enjoying for about 20 years now.

The Obama administration's recent moves to cap deficits means that the hawks have taken control of that, and the Government will stop creating the net financial assets that the private sector so desperately wants. This will put a ceiling on aggregate demand, Another equity downleg and it may be all over.

I blame Robert Rubin. I met him many years ago at U Chicago, and he was intelligent, articulate, and completely different from then Treasury Secretary Snow who begged us to ask him about his Africa trip with Bono because he didn't understand any of the derivative regulation questions we were peppering him with. The Clinton gang, in particular Rubin, believe that the Clinton surpluses were what generated the boom the US enjoyed in the 90s. That is the driver for Obama to get tough on the deficit. In reality, of course, the Clinton surpluses dramatically increased the fragility of the private sector by draining it of savings, leaving it more levered BEFORE the Greenspan orchestrated real estate bubble. The dot com asset bubble, and various other lukcy drivers of aggregate demand papered over this increasing fragility, but sector level balance sheets don't lie. At any rate, Rubin learned the wrong lessons from that episode, and Obama is setting the economy up for a 2010 that will either be bad or worse.

Even at 3% (or whatever) I recommend you buy Treasuries.

Mankiw becomes drunk on power

Mankiw is a cheap date. He doesn't even need real power, just the smell of it is enough. Look at this opening:"One of my many friends working for President Obama sends me this email, along with permission to share it with my blog readers". OMG. One of his many friends, who work for President Obama, who not only leak, but give him permission to share it with his blog readers. Heady stuff, to be sure. And what is the great inside scoop?

The most vivid case in point is the recent policy announcements about implementing the Volcker ideas about separating investment and commercial banking.

This policy process has been in the works for months, and it came to fruition in the normal course of policy operations after extensive meetings and consultations among Treasury, NEC, the PERAB board, and other parties.

So, the Volcker plan is not because the Dems just lost Massachusetts and healthcare, it's been in the works now for months, and the timing was coincidence.

Greg, who seems to be anybody's after smelling the glass of wine concurs: "Thanks for helping to get the true story out." Others are less credulous. They may believe that the Volcker plan was exactly what it seems like, a panicked response to an unexpected, and terrible, electoral loss after a whole raft of unpopular policies have failed to make a dent in unemployment. And the leak is an attempt to get friendly bloggers to pass along the official party line. Thoughts like this are the basis of conspiracy theories.

Sanity and Insanity at Macro Man

An excellent comment thread at Macro Man. The context: Macro is complaining because the Volcker plan will limit what banks can do, and try to separate out prop trading from taxpayer backstopped institutions.

And while it is probably imprudent to comment too much until the details are known, on the face of it [the Volcker plan's] draconian approach is both woefully misguided and appallingly naive. We can probably all agree that it's in no one's best interests to have a situation where a Lehman Brothers owns $50 billion+ in residential and commercial real estate turds, which brings down the firm and threatens the global financial system.

But there's a big difference between that and having a team of punters (not dissimilar to your author) who coordinate and utilize the market intelligence available to large banks (which is enormous and extremely valuable) to make informed bets in the marketplace.

In the comments, Gary smacks Macro down:

My junior guy, like myself, was unwilling to try to hedge the subordinate tranches from all the deals the securitization group was making. Obviously, securitizing toxic waste was a huge money maker as long as you pretended the risk wasn't there.

Every bank bought the toxic waste, put it in a REMIC/CDO/ABS whatever and sold off the senior tranches. The subordinate tranches stayed on the banks books and were hedged.

When the volume of deals got high enough, the true cost of hedging increased. Experienced traders of course wanted to pass that cost back to the securitization desk -- which would have made many deals less profitable if not unprofitable.

The solution was two fold -- "promote" the senior traders to some other department, get rid of the trained staff, and bring in yes men straight out of college. The newbies wouldn't realize the risk, much less the cost of that risk. They would be happy to book the accounting profits; that they were massively short gamma didn't bother them in the least.


Essentially, these guys were making money by being short straddles in size -- often 20-25 times the banks capital. As soon as there was any volatility, the banks were finished.

Later, the garbage was put into SIVs to conceal the risk (and its size) from the banks' balance sheets. To add fuel to the fire, the short straddles were "financed" with overnight money that would be pulled if (when) the risk became known.

Experienced traders knew this and didn't want their deferred compensation to get hit (deferred comp used to be common in many firms). So management replaced them with crony newbies were happy to go along.

The "banking" crisis occurred in 2003-2004 when these short straddle positions became many times larger than the banks themselves. It wasn't until 2007 when the accounting caught up to the risk

My former junior guy is doing quite well now at a hedge fund. The newbie the bank managers put in is now selling sunglasses in Florida. And the bank is now one of the many zombie banks being propped up at taxpayer expense

BTW Macro Man -- I have no idea how many bank CEOs tried to conceal their problems versus how many simply didn't understand the risk was on their books. I suspect (but could not prove) some of both.

Regardless, if you understand the culture / politics of big banks, then you know the department that is generating massive profits often runs the place. If the CEO "stands up to them", they mutiny and the CEOs job is in jeopardy -- either the group leaves and the firm's profits drop, or the group goes to the board of directors to get the CEO fired.

And there is no way to prove beyond a reasonable doubt that the securitization group really understood the risks -- they just knew one trader was willing and another was not. It sounds bad in 20/20 hindsight, but you can't prove anything beyond a reasonable doubt (i.e. in a court of law).

Even knowing my ex-CEO for years, I couldn't say for sure what he was thinking.

The corporate culture of big banks is why they should not be allowed to prop trade -- the culture prevents good risk management.

Private partnerships err on the side of being a little too cautious -- its their own money they are risking on something they don't understand.

Deferred comp systems only work if management doesn't have lucrative severance packages and if the comp is deferred many years (until the assets mature).

Big banks risk / accounting is decided by committee -- so its quality is completely politics. Ultimately, you have to decide whether to pick a fight and lose YOUR job; or do you keep quiet and let the suckers (aka shareholders) take the hit. Its a classic agency problem

The heart of banking is making loans that get paid back. Every element in their structure and regulatory environment should sharpen this goal, not dull it.

Scott Brown vs Timothy Geithner

Paul Volker has been passing his cup along for a long time now, and has been used for nothing more than window dressing in the Obama Administration. Volker isn't a PhD, and is thus free from a lot of nonsense that's being taught in Economics departments, but he isn't an accountant by training nor has he ever had an operational role in a bank. So he isn't good, he just isn't appallingly bad.

Volker's skills, though, are not what catapulted him from the periphery of the Obama administration to its political center. It was Scott Brown's win in Massachusetts, and the end of Obama's health care hopes.

Timothy Geither and Larry Summers, by transferring money from taxpayers to the banks, and telling Obama that "once that banks are healthy the economy will follow" have killed healthcare. Banks are pro-cyclical, and Geither and Summers' advice was wrong. Employment is at 10%, and banks are making record profits. Obama has lost Massachusetts, he's lost healthcare, and the midterm results are just going to make things worse. I wonder if he's mad at Geithner, Bernanke, and Summers.

The Volker proposal is a step in the right direction. It isn't nearly far enough, but he labors under the same "gold standard" fallacy that infests the profession, but is thankfully free of "banks should be unregulated" nonsense pushed by Greenspan. I don't think that this proposal will go very far either, though.

Taxing Wall Street Down to Size

I do not agree with the prescription in this NYTimes Op Ed, but I agree with much in the description.

WHILE supply-side catechism insists that lower taxes are a growth tonic, the theory also argues that if you want less of something, tax it more. The economy desperately needs less of our bloated, unproductive and increasingly parasitic banking system. In this respect, the White House appears to have gone over to the supply side with its proposed tax on big banks, as it scores populist points against the banksters, too.

At a structural level, the economy needs a financial sector that adds value, and that is certainly a smaller one. But it also needs more net private savings, which a bank tax (or any tax) will not do.

Make no mistake. The banking system has become an agent of destruction for the gross domestic product and of impoverishment for the middle class. To be sure, it was lured into these unsavory missions by a truly insane monetary policy under which, most recently, the Federal Reserve purchased $1.5 trillion of longer-dated Treasury bonds and housing agency securities in less than a year. It was an unprecedented exercise in market-rigging with printing-press money, and it gave a sharp boost to the price of bonds and other securities held by banks, permitting them to book huge revenues from trading and bookkeeping gains.

A bigger problem than low interest rates was poor capital controls. Capital controls are what limit lending, not reserves, and capital controls have absolutely stunk for a while now at every level. The situation is worse now as private capital is no longer in a first loss position.

In supplying the banks with free deposit money (effectively, zero-interest loans), the savers of America are taking a $250 billion annual haircut in lost interest income. And the banks, after reaping this ill-deserved windfall, are pleased to pronounce themselves solvent, ignoring the bad loans still on their books.

This is an excellent point that is totally lost on the monetary fanatics who walk the halls of the Academy -- low interest rates rob the private sector of interest income, and thus have a deflationary impact as well as their supposed inflationary impact. The harder one looks for an inflationary mechanism though, the harder it is to find. Low interest rates may, net, hurt the economy.

To argue, as some conservatives surely will, that a policy-directed shrinking of big banking is an inappropriate interference in the marketplace is to miss a crucial point: the big Wall Street banks are wards of the state, not private enterprises.

This is another, excellent point, but if anything too narrow. Banks in general are public private enterprises, with their access to reserve accounts giving them money printing ability that other parts of the private sector do not have. The Federal Reserve is technically a private organization too, but that's obviously nonsense -- it is part of the Government. Banks and GSEs have more in common than they realize.

To be sure, the most direct way to cure the banking system’s ills would be to return to a rational monetary policy based on sensible interest rates, an end to frantic monetization of federal debt and a stable exchange value for the dollar.

Monetary policy has almost no impact on the economy. The most direct way to cure the financial system's ills would be to fund the demand for private sector savings via a payroll tax holiday. Banks should be restructured to an extent that makes Glass Steagal look like Barak Obama's financial "reform" act.

Weekend links

Billy Blog has the post-Keynesians take on the Austrians here. The whole thing is a little inside baseball, so only read it if you care. The irony is, of course, that when Keynes displaced the Austrians, their description of economic reality was actually closer to the truth, as Austrianism understands gold standard economies pretty well, and the General Theory is a muddle. When Keynes was overtaken by the Monetarists, you essentially had the Austrians re-establish themselves, but under an even more confused and muddled barrage of mathematics, in a fiat monetary system that complies pretty well with the General Theory!

Finally, a word on Obama's bank tax.

Like Megan, I do not support it, although my reasoning is different. The private sector is not done deleveraging, and any action that drains private sector savings, be it quantitative easing or a bank tax, is bad as it will undermine aggregate demand when that is still very weak. If you hear the phrase "it will be good for taxpayers" then it will almost certainly be bad for taxpayers as the US needs higher deficits still right now, not lower ones.

Also, banks are still undercapitalized, especially if they recognize the market value of their assets. The Fed has waived capital requirements so this does not impact them operationally, but those requirements, I assume, will come back some day and an adequately capitalized banking sector is something that the economy needs. Banks are de-capitalizing themselves through absurdly large salaries and bonuses, which is bad, but taxing them has the same effect. The UK approach -- taxing the bonuses themselves -- is better in this regard.

As a tax payer, I don't want to get my bailout money back. I want to see that we got something for the money, namely a sanely managed financial system. I'm not seeing that yet.

Updates to weekend reading

Warren Mosler has more on the decline in private sector credit.

Also, Scott Fullwiler has an excellent post on why Ben Bernanke's "helicopter drop" is fiscal not monetary.

A comment on this last point. The last refuge of scoundrel economists, who argue that monetary policy is all you need, is the assertion that a helicopter drop is somehow "monetary" too when it is clearly fiscal. if you redefine monetary to mean fiscal, then yes, monetary is all you need, but let's be honest about what's actually happening. It's fiscal. Here's a clip from some email correspondence I had illustrating this exact subterfuge:

Academic economist: At least to me, it's clear that your example [helicopter drop] is two operations.
1) Adding 1M to bank reserves gratis is fiscal policy. Effectively it was a $1M transfer. (We've added to government liabilities without adding anything to its assets, so that's fiscal policy via my definition.)
2) Because an addition to bank reserves has increased the money supply, it's also monetary policy.

winterspeak: By this definition, all fiscal policy is monetary policy. Whenever the Treasury spends, it changes the money supply, Whenever the Treasury taxes, it changes the money supply.

Can you please define monetary policy in a way that is not fiscal policy.

There you go. If you believe that bank reserves do a damn thing, which in a normal environment they do barely as they influence the FFR, and in this environment they really don't because the Fed is paying interest on reserves, then anything that impacts reserves is monetary policy. And since deficit spending can impact reserves, all fiscal becomes monetary.

Weekend links

Kevin Murphy was the smartest person I met at Chicago. Becker ran a close second. It's sad to see them write editorials like this one in the WSJ:

In terms of discouraging a rapid recovery, other government proposals created greater uncertainty and risk for businesses and investors. These include plans to increase greatly marginal tax rates for higher incomes. In addition, discussions at the Copenhagen conference and by the president to impose high taxes on carbon dioxide emissions must surely discourage investments in refineries, power plants, factories and other businesses that are big emitters of greenhouse gases.

The stuff on reserves and the banking system is standard academic macroeconomics, and therefore completely wrong. I cannot think when "the market hates uncertainty" sounded more tone deaf.

A number of articles pointed to the ongoing de-leveraging within the private sector. This is the key story of the economy, with the only question being whether the Govt funds this de-leveraging by actively running deficits, or instead uses unemployment as a policy tool and does nothing, letting automatic stabilizers fund private demand for savings.

Consumer Credit outstanding fell a greater than expected $17.5b m/o/m in Nov vs an estimated drop of $5b and follows a revised $4.2b decline in Oct. It is the 13th month of the last 14 that has seen a reduction and is the biggest monthly drop ever. The decline was led by a sharp 18.5% annualized drop in revolving credit which consists mostly of credit cards. Nonrevolving credit outstanding fell 2.9% annualized and is made up mostly of auto loans. Total consumer credit outstanding now stands at $2.464T, the lowest since July ‘07 and has fallen $117b from the record high in July ‘08. To put the last decade of credit growth into perspective, nominal personal consumption rose 55% (same increase as overall GDP) while consumer credit rose 61% over the same period. Thus, highlighting how dependent on credit the US became rather than on savings in generating growth.

People want to save more. Will the Govt help or hinder?

Why you should walk away from your mortgage

Megan McArdle argues that underwater homeowners should continue to pay their mortgages, and not "ruthlessly default" by walking away if they can continue making their mortgage payments. She argues that the social norm to honor debt are important to a well functioning society, and if this norm was eroded we would all pay through higher interest rates etc.

I disagree. In the context of the credit bubble, banks made loans to customers who could not service that debt out of income. It was a two way bet on rising asset prices. Since that bet did not work out, the borrower should walk away, and the bank should write the asset down. If the loan had been made on the basis of income, then I would agree with Megan.

Waldmann, and I think Salmon, view the tightening of credit as a feature rather than a bug, of course--they'd like to return to the days of paternalistic credit markets

Waldmann and Salmon want to return to the days where banks made loans that would be paid back. This is not paternalism, this is Sanity.

Amazingly, Megan has managed to write a post on the credit bubble without realizing there was a credit bubble at all.

Richard Koo, who is so close, is still wrong

In an earlier post I highlighted why predicting what will happen in the future is so difficult. Geither, Obama, and Summers have no idea how the monetary system works and therefore are unpredictable in whether they will act to improve the situation or make it worse. Richard Koo, who understands the situation in Japan (which is very very similar) quite well still makes suboptimal recommendations because he too does not understand how the financial system works. Here's him in an article in Barron's:

I'm explaining to the Americans that the disease you've got, is the disease we got 15 years earlier. Most Americans are flabbergasted by the fact that the Federal Reserve has lowered interest rates to zero, flooded the market with liquidity -- and the economy is still going absolutely nowhere. Unemployment is still increasing, people are still retrenching, deleveraging. When the central bank brings rates down to zero, a lot of things are supposed to happen, but there's nothing happening. But that's what we experienced in Japan. The Bank of Japan brought the rates down to zero, did massive quantitative easing, with no result whatsoever. This happens because of a balance-sheet recession.

This is exactly correct. The private sector in the US has taken on more debt than it can/wants to support out of income. Therefore, it is de-leveraging, paying down debt and saving, which is driving aggregate demand lower. Only fiscal action through higher deficits can support aggregate demand while this happens. So, Koo gets that right, but then there is this:

In an ordinary, garden-variety recession, as we learned in school, the private sector uses money more efficiently, and a budget deficit is considered bad. But when the private sector is completely absent and paying down debt at zero interest rates, and the government doesn't borrow this money, what happens? Even a child would understand the whole thing could collapse. The only way the government can turn this economy around is to do the opposite of the private sector -- borrow the money the private sector saved and spend it, which means fiscal stimulus. That's what saved Japan from entering a Great Depression.

He's correct in saying that massive fiscal stimulus saved Japan. They really were on the brink of their Great Depression in the 80s, and have avoided it without going to War. This is good, but none of it was necessary, so really represents a massive failure.

Koo thinks that the Govt is spending the money the private sector has saved. In fact, Govt spending is what is giving the private sector its savings! Government is not borrowing anything. Japan should really just massively slash taxes and fund its private sector. Let the balance sheets heal already!

Koo does not talk about all the terrible malinvestment that the Governments fiscal spending did. The US should simply implement a payroll tax holiday until inflation starts to tick up.

Right now, the US's savings desire is not as high as the Japanese's, but a double dip might get it closer. That just means the US will need even higher deficits. It took Japan 20 years to start getting comfortable with sufficiently large deficits. Now might be a good time to go long the Nikkei, actually.