A Bank is not a Financial Intermediary

As always, good discussion on Monetary Realism. There was an interesting piece in the comments where Ramanan linked to a great paper by Tobin which, I think, revealed a lot about the implicit mental models economists refer to when they do their work.

Some additional context: Cullen has been trying to convince Paul Krugman to embrace MMT or PK or whatever you want to call it, unfortunately with limited success to date. He's certainly picked the right target, if Krugman publicly converts then it's a real game changer, but I don't think it's going to happen (why I think this is another story for another time).

Krugman dismissed Cullen by citing Diamond-Dybvig and Tobin-Brainard, the former I'm very familiar with but the latter is new to me. I won't get into the meat of Krugman's dismissal because it's of the form: either this doesn't fit into the model or it's a trivial case the model already covers, it does not grapple with the question at hand because he does not need to. But the papers themselves are interesting for revealing the underlying assumptions.

I'll focus on Tobin because that was the one that was new to me, and zanon, in comments, highlighted a point that I thought was very interesting. Tobin repeatedly refers to banks as "financial intermediaries." What is a "financial intermediary"? Tobin explains:

“…the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.”

“…intermediation permits borrowers who wish to expand their investments in real assets to be accommodated at lower rates and easier terms than if they had to borrow directly from the lenders.”

So while Tobin understands that banks make loans which then create a deposit, he sees this function as a market making or coordination activity, something which brings efficiency and eases friction between the actual lender and borrower. It's a middleman role which, if we assume is acting appropriately, one can safely abstract out of models to focus on the primary agents in the exchange, the lender and the borrower. Also, a Ramanan correctly notes, when we look at the composition of national accounts, financial firms similarly play an intermediate role where they sit between initial production at the top, and ultimate consumption at (for example) the household level at the bottom.

But it is precisely this characterization of a bank's role that I think is the problem with modern macro. By seeing them as an essentially coordinating function they are not modeled as agents in and of themselves, and therefore the models are wrong because banks are ultimately active lending agents not lending mediators.

Straight from Google:

Intermediary

A person who acts as a link between people in order to try to bring about an agreement or reconciliation; a mediator.

"intermediaries between lenders and borrowers"

Agent

1: one that acts or exerts power

2a : something that produces or is capable of producing an effect : an active or efficient cause

It's awesome that Google itself has "bank" under their definition of Intermediary.

So, to engage with someone who is taking the standard econ line, you need to approach them at the model level. Both papers Krugman cited are really old, so if they aren't canonical, they are certainly the intellectual touch stone that the profession draws on. So go directly to the source and attack the hidden assumption. If you are successful there, then subsequent papers all become vulnerable because you've undermined the foundation.

Because banks don't occupy a "middle or intermediate" position between people who want to borrow and those who want to lend. Note how careful Tobin is in how he describes what the lender and borrower are doing:

"On one side are borrowers, who wish to expland their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.

Emphasis mine. Does "wish to hold part or all of their net worth in assets of stable money value with negligible risk of default" sound like a lender to you or does it sound like a saver?

So banks do play a middle man or intermediary role, but it is between savers and borrowers and it's primarily one of payment settlement. The lender is the bank itself, and there it's acting on behalf of its shareholders, not its depositors, and you need to look at return on capital and capital constraints.

This then is the conceptual fallacy at the heart of academic macro and what it thinks about banks, and it goes at least all the way back to 1963.

Did Paul Krugman lose?

Typically good comments thread over at Monetary Realism. Personally I did not see what was remarkable about the Noah Smith piece, or Noah Smith himself, but they certainly seemed very excited.

That lead me to this comment by Krugman (NYTimes) when discussing the state of macro:

On the academic side: look, to a first approximation nobody ever admits being wrong about anything. But my sense is that a lot of younger economists are aware, even if they don’t dare say so, that freshwater macro has been a great embarrassment these past four years, and that liquidity-trap Keynesianism has done very well. This will affect future research; it will, over time, break the stranglehold of decadent Lucasian doctrine on the journals.

And the giggles and whispers thing — in which anything resembling non-microfounded Keynesian analysis was the subject of automatic ridicule — is already, I think, over.

Look at Delong/Summers on fiscal policy: the analytical core is, yes, the IS-LM model.
In a better world, Brad and I and our fellow-travelers would have achieved an immediate transformation of both policy and doctrine. We don’t live in that world. But I think we are winning the argument, in ways that will make a difference.

First of all, Krugman just comes out and says a number of points I've been making about the social and political economy inside of the economics profession, and how those individuals then become "thought leaders" and drive public opinion through the NYTimes Op Ed column.

He says "nobody ever admits being wrong about anything" which is quite true. And even if younger economists believe this stuff is nonsense, they daren't say so out loud because it's career suicide to do so. More important, note what Krugman is saying -- he's saying that economics as a discipline is about fashion, not facts, and that it prioritizes the research process over research itself. He isn't saying this too loudly because it calls his own identity into disrepute, but there isn't another way to interpret what he's saying. His criticism of Lucas isn't that it's wrong, it's that it's decadent. Kind of like wide shoulders in the 80s. And when it cycles out of favor we'll giggle and call it gauche. Also like wide shoulders in the 80s.

Also, look at the tricks Krugman plays -- he brings up the IS-LM model as the supporter of his brand of Keynesianism. But IS-LM is also the micro-foundations of DGSE. And DGSE is at the heart of all macro. And IS-LM/DGSE do not get the accounting right. Which is why they are not only wrong, but actively block the path to right-ness.

You can see similar groupthink between Krugman and DeLong who are ideologically sympatico, with Krugman being much higher up the ladder (which sets the dynamic between them). Noah is broadly in line as well, and it is the Krugman engagement that I think has been the catalyst. Anyway, DeLong writes:

..My view is that macroeconomists know a great deal about how to avert and cure the macroeconomic consequences of financial crises, and have known how to do it since John Stuart Mill drafted his "Essays on Some Unsettled Questions in Political Economy" back in 1829. A general glut--a desire on the part of agents in the economy as a whole to spend less than their total incomes--is the consequence of a general belief on the part of agents that they are holding too few or the wrong kind of financial assets. It can and should be cured by having some lender-of-last-resort-like agency--the tallest midget in the room--create the financial assets needed for people to be happy with the amount and type of their holdings, and so push economy-wide spending up to income.

And yet, in spite of everything, this was not done. There were lots of technocratic details and questions about how to do it. But back in late 2008 I had no doubt that all of us economists agreed that that was what needed to be done, and it would be done.

I still don't understand why it was not done. I thought that those of us who understood John Stuart Mill (1829) exercised intellectual hegemony over economic policy discourse. And it turns out we did not…

DeLong is wrong. In the case of a general glut you don't need a lender-of-last-resort, you need a printer-of-last-resort, or at least you need to tell the unprinter-of-last-resort to take a chill pill for a while. JKH will hate me, but the core issue here is that DeLong is out-of-paradigm, and his New Keynesian approach is interpreted as a just-so story for Democrats. This is because, so long as it remains out of paradigm, it is a just-so story for Democrats. Also, I will note that Mosler is technically wrong when he talks about taxes being taken to the shredder -- they are not -- conceptually this can help someone get their head around how balance sheet expansion and contraction across sector can work. So even though he was wrong, this moved the ball forward for me.

Noah responds and lays his cards on the table:

Well, although I agree with Mill/you, and although I think we are *right* to think these things, I also think that's very different from *knowing* these things. The way I use the term, if we *knew* these things, then we could get the whole public to laugh at the Chicago School as much as we laugh at the Chicago School. Just like even people who will never understand the research of Copernicus or Kepler or Galileo or Newton now laugh at geocentrism.

The point is that, as things stand, we cannot easily *prove* that we know how to clean up after financial crises. And it's just because we don't have sufficient data or data-gathering methods, not because our ideas are BS.

Right -- so there's the enemy, the Chicago School. Never mind that it's in all the textbooks published for the past 50 years, Krugman believes it, Smith believes it, and DeLong believes it. And the folks who are right -- the MMT/PK guys -- they are the actual folks being laughed at.

How much active investing do we need?

Interesting article here on passive vs. active investing:

But the data misses one important aspect, something that is bigger than any statistical fact or researched conclusion:

We are human beings.

The Taliban's efforts to talk people into doing the perfectly rational thing is admirable, except where it becomes disdainful of the fact that for roughly 3 million investors, this is a hobby.

I think there is truth to that observation. The data on this is pretty clear, but the data on Vegas slot machines is equally clear and people still play them. Clearly, making money is not the driving force.

But then this:

You may want to consider that there is a major paradox at work here - the more successful passive investing is in converting the masses, the less successful it will be going forward. The last thing a passive indexer should want is for everyone to stop guessing and trading in the markets. Massive amounts of speculation is what fuels the winship of the passive approach over other strategies. If there were only a handful of institutions left picking stocks and the whole world was sitting in a Vanguard fund, the returns of the pros would probably become incredible thanks to all the unexploited inefficiencies. And so, counterintuitively, the Taliban should be celebrating the Seekers of Alpha, not looking to discourage them or insulting them at every turn.

It is certainly true that if 100% of all investors were passive, then there would be no signal in the marketplace and it would not work. But how much active investing really needs to happen for passive to be the right strategy for everyone else? What % of our current active trading volume would we really need to get the informational benefit for a passive portfolio?

Someone's probably getting ripped off now.

Article in the NYTimes about Henrietta Lack's family, with some help, shaming the NIH into giving them a couple of sinecures:

The Lacks family and the N.I.H. settled on an agreement: the data from both studies should be stored in the institutes’ database of genotypes and phenotypes. Researchers who want to use the data can apply for access and will have to submit annual reports about their research. A so-called HeLa Genome Data Access working group at the N.I.H. will review the applications. Two members of the Lacks family will be members. The agreement does not provide the Lacks family with proceeds from any commercial products that may be developed from research on the HeLa genome.  

None of this is about the Lacks though. Look at what's missing in the article. Here's the opening paragraph:

Henrietta Lacks was only 31 when she died of cervical cancer in 1951 in a Baltimore hospital. Not long before her death, doctors removed some of her tumor cells. They later discovered that the cells could thrive in a lab, a feat no human cells had achieved before.

Pay attention to the phrasing. It says "...doctors removed some of her tumor cells. They later discovered that the cells could thrive in a lab, a feat no human cells had achieved before." The implication is clearly that there is something special about Lacks' cells since they were able to thrive where no cells had thrived before. The article needs this to setup the legitimacy of the Lacks family grievance, which then lead to... but I'm skipping ahead.

Cancer is a million diseases all with the same result: the effected cell becomes immortal. Lacks' cervical cancer cells were not special in any way save that the normal apoptosis process had ceased to function, and therefore the cells would grow uncontrollably and (tragically) kill her. What was special about Lacks' cells was not the cells themselves, but that they were the first human cell line to find itself in a cell culture that worked instead of the Baltimore hospital's incinerator. This is not the story of Henrietta's special cells, this is the story of George Otto Gey's brilliant medical discovery.

Gey chose not to try and personally benefit from his breakthrough -- he gave the cell line, plus the formula for the culture -- to humanity and it's been the model for human mammalian cells ever since. But writing about the brilliance and magnanimity of scientists like Gey has fallen out of favor at the Times as it pursues other political ends.

The Lacks family sounds like a lower-middle class African American Baltimore family, and it's hard to imagine what they're going to be doing sitting around a conference table with a bunch of Government PhD and MDs going into the nitty gritty of genomics, recombinant biochemistry, and what privacy and ethical concerns should be debated before sharing "The haplotype-resolved genome and epigenome of the aneuploid HeLa cancer cell line." They're going to be told what to think. The article paints them as heroes, while some of the commentators say they are villains, but personally I think they're getting caught up in someone else's career ambitions. I also could not find who else would be on the new Access Group along with Lacks' relatives.

WaPo & Bezos

I've seen lots of articles on Jeff Bezos buying WaPo, but not one has linked this with the rise of the tech industry lobby in DC. Papers, particularly a brand as venerable as WaPo, are first and foremost channels to influence the public. Not only do they frame the debate itself, but they set the agenda.

The tech lobby's central roll in the recent immigration bill comes to mind. From (ironically) the New Yorker:

In the past fifteen years or so, Andreessen explained, Silicon Valley’s hands-off attitude has changed, as the industry has grown larger and its activities keep colliding with regulations. Technology leaders began to realize that Washington could sometimes be useful to them. “A small number of very high-end Valley people have got involved in politics, but in a way that a lot of us think is relentlessly self-interested,” Andreessen said. The issues that first animated these technology executives were stock options, subsidies, and tax breaks. “They started giving the Valley a bad name in Washington—that the Valley was just another special-interest group.”...

Zuckerberg and Green began talking to Silicon Valley leaders about starting a political-advocacy group: Andreessen; Horowitz; Reid Hoffman; Marissa Mayer, of Yahoo; Eric Schmidt, of Google; and at least three dozen others. The interest was strong, as if they had all been waiting for something like this. Though Andreessen and Horowitz didn’t join the project, Andreessen thought it represented “the maturation of the industry” and a greater level of engagement in politics—“deeper, longer-term, with, frankly, more money.”

Hoffman, who believes that immigration reform would right a wrong and also create new jobs at every level, from software engineers to dry cleaners, told Zuckerberg, “The normal Silicon Valley thing is to focus on high-end visas and say, ‘The rest of it’s not my problem.’ ”

“Yes,” Zuckerberg said. “But there’s this huge moral component. We might as well go after all of it.”

“O.K., good,” Hoffman said. “I’m in.”

Bezos is in too now. He just bought DC's newspaper.

Update:  Gabe Stein of Fast Company breezes past what seems to be the most obvious reason for the purchase before diving straight into his wish-fulfillment fantasies for what he's do with WaPo.

Jeff Bezos didn’t buy the Washington Post yesterday to “re-invest in the infrastructure of our public intelligence,” as James Fallows wrote in the Atlantic, and he didn’t buy it for a propaganda machine.

Really? Hasn't the major tech story of the past 5 years been Silicon Valley's huge move into propaganda? Isn't Fwd.us, both the Red and Blue flavor, basically about manufacturing consent? Aren't the massive rise in tech lobbying in DC a reflection of the extent to which politics and tech are deliberately integrating? Hasn't the Snowden leaks shown us the degree to which these two entities enable and support each other? Isn't Amazon neck deep in a number of legal issues, including clauses on interstate commerce and nexus, sales tax, alcohol sales, patents, etc.? Mightn't Jeff Bezos be looking for an elder statesmen role of some sort as he approaches 50? If you've spent the last 20 years being told you were a visionary genius, wouldn't you be?

Updated update: I finally find something that states the obvious. From Bezos' biographer:

LB: But strategically speaking, why else do you think Bezos wanted the Post?

BS: This is maybe going out on a little bit of a limb: but look, he’s buying a lot of political influence. And we can’t discard the fact that Amazon hasn’t been an enormous player, at least up until the dispute over sales taxes, and in buying The Washington Post, he has a seat at the table. And I think particularly legislators and anti-trust regulators are gonna be weighing the dominance of Amazon a lot in the years ahead.

I'll have more on this exchange in the future post, but when Brad Stone (BS) says "maybe [I'm] going out on a little bit of a limb" he was not saying "what I'm going to say next is highly speculative". He was worried about his professional reputation, and was concerned that what he was going to say next might put that at risk.

Bezos' named his company Amazon. Biggest river in the world. He is investing in his own space travel company on his personal ranch in Texas. Does anyone really think he bought WaPo because he's interested in a little vanity press?

Human Beings and Little Data

The promise of big data seems to be that it does away with needing to understand causation and intentionality. We don't need to know why, only what.

In my experience this is true in a limited number of cases where the phenomenon under discussion is narrow, and there are no vested interests looking to push an agenda. So contra Peter Norvig, "All models are wrong, and increasingly you can succeed without them" but not in most of the domains where we're trying to make decisions with limited data, which include some important ones.

I'm not trying to setup or knock down a straw man here. I'm sure that Norvig, when pushed, will agree that theory, intentionality, causality, remains important and that the strong claim was more for rhetorical effect than an axiom. But I do want to point out a dangerous arrogance behind these statements, and this is beyond the conceit that you can build a perfect dashboard, being fed information, with you omniscient in the center controlling everything.

The arrogance I'm talking about is to believe that the world has nothing more to tell you. This generates a particularly awful sort of blindness because now, not only can the person not see, they also cannot get any better. Serious business.

Anyone who has seriously done this sort of work for any length of time will probably have realized that true learning comes not from accumulating facts, but from developing new ways to see. It's a cognitive flip that brings structure to facts so lets you learn them very quickly, but the initial comprehension may take an age to get to, but once it comes it's fast. With Big Data, you can only see what you have instrumented, and what you instrument is a function of your comprehension of the situation at that time. So not only are you limited in what you can see, you are similarly limited in how you can see.

Two related articles that made me think of this.

The first is from Jason Friend about all the "inefficiency" they've purposefully instrumented into their new product.

But automation can also lead to myopia. And premature-automation can lead to blindness. When you take human interaction out of a system, you’re removing key opportunities to see what really happens along the way. You miss stories, experiences, and struggles – and that’s often where the real insights are hiding...

So with Know Your Company we wanted to reset our assumptions and eliminate a lot of the automation we usually lean on. Rather than separate ourselves from the customer, we wanted to bump into the customer as often as we possibly could.

He lists a number of crazy inefficient processes, like insisting on live demos, manual, one-at-a-time record entry, etc. These aren't things to hang onto forever, but they will give them opportunities to see things in new ways.

The second is from Venkat Rao about how, when you're going through a change, it's the miscellaneous folder that explodes and how exception handling becomes the core organizational driver.

When the flow changes, the way we usually handle it is by consigning more of it to the miscellaneous folder. This follows obviously from the fact that the new elements are by definition the ones that are not comprehended by the existing organization scheme.

Depending on urgency and importance, we interrupt normal functioning to cannibalize resources to handle it there, using ad hoc schemes, on a case-by-case basis. This is an opportunistic process and we call people who are good at stealing resources this way resourceful.

You know you have a problem when the miscellaneous folder swells from handling 20% of the flow to 80%. At this point, your organization scheme is adding no value at all, since 20% of the scheme is handling 20% of the flow and 80% is handling 80%. There is no leverage. You might as well dismantle the scheme and let the anarchy of the miscellaneous folder reign everywhere.

Lived this one many times. Again, the miscellaneous folder is the right place to look for where the actual flow of actual work is going, as it's where the stuff which cannot be handled elsewhere in the organization for structural reasons ends up living.

Intentionality and Accounting

Some weeks ago I had a good back-and-forth with the indomitable JKH in the forums about how useful Mosler's "paradigm shift" approach was vs JKHs "strictly the accounting" strategy. Mosler plays fast and loose with the language a little at time to better get his point across, and my position was (and remains) that if your goal is to knock people out of one way of thinking and into another, then sometimes you need to hit them over the head. But I don't think anyone has quite cracked that nut (no pun intended).

And yes, the term "paradigm shift" is grotesquely over and mis-used, but I think in term of MMT/PK vs standard academic economics, it is the correct term as we really are talking about taking an entire worldview, not just an isolated theory, and all of the implications that come with it; and jettisoning it for something else. This is a multiple-organ transplant procedure here, not a buttock lift, so roll up your sleeves.

I think this recent piece by Kotlikoff that Warren has up on his site is a good example. It's mostly appeals to authority, but here's the nut graph:

The INFORM ACT, which I drafted in large part with the assistance of Alan Auerbach, requires the Congressional Budget Office (CBO), the Government Accountability Office (GAO), and the Office of Management and Budget (OMB) to do fiscal gap and generational accounting on an annual basis and, upon request by Congress, to use these accounting methods to evaluate major pieces of proposed legislation.

While no measure of fiscal sustainability and generational equity is perfect, fiscal gap and generational accounting offer significant advantages relative to conventional measures of official debt. First, they are comprehensive and forward-looking. Second, they are based on the government’s intertemporal budget constraint, which is a mainstay of our dynamic models of fiscal policy. Third, do not leave anything off the books.

Emphasis is mine. Note that Kotlikoff probably thought the third point, "[they] do not leave anything off the books" was the important one because the CBO currently scores things on a ten year time scale. This methodology means that lots of plans, such as Obamacare, are engineered to have triggers, cliffs, and vests right at the ten year mark in order to get the CBO score the politician wants. Kotlikoff, like any responsible economist/civil servant/authority wants those shenanigans to stop, thus the (reasonable, in context) move to fiscal gap and generational accounting which extends the window to infinity. And beyond.

I'm emphasizing the second point though because that's the problem. Who cares how you do the accounting if it's conceptualized around an intertemporal budget constraint which is the mainstay of [the world's experts on this] dynamic models of fiscal policy--and this conceptualization is false?

MMT/PKers often complain to economists that "you're doing the accounting wrong" and they respond "maybe, so what?" because accounting is merely how you account for something after the fact, and so not fundamental to the conceptualization. Except in the case of finance, it is. But if you focus on the accounting without the broader context of the conceptualization it drives (or contradicts) then it just seems like bean counting. And those guys don't get invited to any of the good parties.

If you focus on the conceptualization, then the accounting has a point beyond bringing closure to anal retentives. But you'll need to make some simplifying/illumination assumptions along the way and those will be wrong.

I haven't seen any approach we successful yet with anyone that matters, and it's been 5 years since the crises hit. It will likely take a generation, with all new warm bodies occupying those tenured chairs, before the text books get rewritten.

Foie Gras Bubble

Nice post by Sankowski talking about the impact of negative rates and shrinking yield:

It’s worth stating clearly: negative interest rates involve paying the borrower to borrow money. In a negative interest rate environment, the lender is paying money to the borrower so they will borrow money...

It’s entirely reasonable for anyone – even a jackass like Larry Summers – to question what types of investments are so terrible someone needs to shove cash money into your hands so you will do the investment. It’s also reasonable to think forcing companies to take loans could lead to another bubble.

There is a case to be made that we should be giving private businesses and people money to promote investment. I’ve made this argument before. And, paying people to take out loans is a way to give people money, so let’s force them to take out loans, right? (Italics mine--ws)

However, if we have a choice between giving people money in the form of loans, or simply giving people cash money, I strongly prefer cash money. We do have this choice, so we should probably prefer just giving people money over incenting them to take out loans.

Not to criticize Sankowski, who I don't think believes this, but since when and how is "paying people to take out loans" a way of "giving people money"? When you take out a loan, even if it is at a very low interest rate, even if people can claim it's a negative real rate, you are not getting more money. You're getting more levered, which is the opposite of getting more money. When the problem is an overlevered economy, the solution cannot be even more leverage, but that's the only lever (apologies) the Fed really has and the confusion between this sort of horizontal money and the vertical money provided by government fiscal policy continues to lie at the heart of our ongoing financial crises and the difficulty of traditional economics to apprehend what is going on.

Another interesting consequence of QE:

First, James Monitor:

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.

Then, Sankowski:

Still, he gets close to a problem of high asset prices. His concern in the paper is about investing – it’s hard to make money in a market where the expected future returns are very low. The problem with low expected future returns is this means there is a higher possibility of losses in the asset class, and those losses are potentially larger.

Think about the household sector--if a family thinks that their 401(k) retirement plans are going to appreciate at 4% a year instead of 8% a year, does that motivate them to save more or less? Remember, the logic behind QE is that it should motivate spending, investment, and borrowing but at a household level, clearly if you expect your 401(k) to underperform, you will try and save more even though that is contrary to the policy goal.