Tuesday, June 20, 2017

Financial economics is hard.

I saw this on twitter today.

The natural equilibration of a free economy is so difficult for people to understand that even most traders and practitioners seem to fail to wrap their heads around it.

In this comic, we have the banks and the GSEs.  The effect of "bailouts" or safety nets for these firms is generally understood, as far as it goes.  The effect is explicit in most complaints about those safety nets, but then gets forgotten when applied to social criticism.

I'm not particularly a fan of the private/public GSE model or of the capital requirements and public deposit insurance that form the foundation of public support of banks.  This post is not a defense of those regimes.  But, if we are going to critique them, let's critique them for the right reasons.

What is the primary effect of the public safety net under banks?  The primary effect is to protect lenders to banks.  Who are lenders to banks?  Depositors are.  Public support means that depositors are less sensitive to bank financial instability, because they are protected.  Equity holders aren't protected.  They are generally wiped out when public support is used to save these institutions.  And, what is the effect on those depositors?  The effect is that, because their deposits have a public safety net, they have lower systematic risk, and thus, they earn lower yields.

Look in any description of the low risk investments available to savers, and it will describe bank deposits as one form of very low risk saving, then it will describe any number of similar savings options that have higher yields because they don't have insurance.

It's almost like these markets are highly efficient and things like rational expectations overwhelmingly guide markets in ways that we universally take for granted.  (But, if you want to be a sophisticated fish, you publish articles casting doubt on the na├»ve theories about "water".)

Similarly, the complaints about the GSEs always center around the "implicit guarantee" that GSE debt always carried.  And, how did we know that there was an implicit guarantee to complain about?  Because yields on GSE debt were low!  Again, the mathematical relationship between risk and return is explicit in the complaint!  The complaint itself is based on a rational expectations, efficiency assumption!

Then, we move to social commentary and we act like none of that happened.  Bailouts help the capitalists and cost the taxpayer, don't ya know.

But, every action has an opposite and equal reaction!  If you made the complaint, you had to know this!  Those safety nets meant that bondholders and depositors earned lower yields.  In other words, those safety nets meant that capital incomes were lower - capitalists earned less.  Do I need to go all caps on this?  Because I will, if I have to!

We can argue about exactly what forms of stabilization are appropriate.  And, believe you me, you don't need to twist my arm to convince me that the stabilizing policies of summer 2008 were not exactly optimal.  But, this idea that financial safety nets mean capital gets its cake and eats it too is just wrong.  The only way to have it both ways is to regulate away potential competition.  Markets with reasonably free entry can't help but pay it back.

And, in the meantime, there seems to be near unanimity about maintaining instability and keeping out competition in the housing market.  "Oh, no!  It's time to tighten again!  There are homeowners who still think real estate is a safe investment.  When will they learn?"  And, gee, guess what investment has yields well above the alternatives and far above the pre-crisis norms?  Rent income is through the roof.  No comics about that though, because for those yields to go down, prices and supply would have to go up, and a sophisticated fish knows there can never be not enough, only too much.


  1. I'm fine with protecting deposits up to some limit. And I agree equity tends to go to zero. But that leaves a lot of the capital structure between those two extremes. I highly object to bailing out lenders who knowingly received interest well above the risk-free rate. The knew they were being rewarded for taking certain risks.

    1. It would definitely be better to clarify these things, because much of the excess income comes from the uncertainty. And, the uncertainty comes, in part, from a lack of appreciation for this. For instance, if the GSE guarantee had been explicit from the outset, the bondholders would have earned even lower yields.

  2. Deposit insurance and the government guarantee of GSE debt are underpriced: occasionally the general taxpayer has to contribute to paying for them, so the depositor and the holder of GSE debt, while they are paying something for the guarantee (through relatively meagre return), are not paying the full price.

    1. That's true. But, I don't think our cartoonist had depositors in mind when he drew his fat banker falling from the sky. And, clarity on this issue would have led to an explicit GSE guarantee, instead of an implicit one. The excess income came from the uncertainty because there isn't enough appreciation for the fact that the guarantee lowers yields.

  3. You gotta love James Grant. He is erudite and thoughtful, probably a great dinner guest and conversationalist. I would like to have a James Grant in my circle of friends.

    Grant has been wrong for many decades in a row on inflation, interest rates, monetary policy, everything. He has been predicting runaway inflation since the 1980s.

    In fact, the way Japan is going, Grant may never, ever be validated. Perhaps Grant will arrange for some forecasts to be published annually and posthumously, so that he might be validated someday.

    As it stands now, the Bank of Japan will buy back Japan's national debt, and that will be that. They printed money and ran big national government deficits, and so what?

    A valid critique is that the Bank of Japan, and the Fed should have just gone to helicopter drops, rather than the QE and federal deficits flim-flammery.

    On bailouts: I have less reservations than many on government bailouts of financial institutions, if the equity holders are wiped out. The idea that depositors must suffer…well, not everyone can read a balance sheet and predict the future (the way James Grant has).

    In fact, the federal financial-industry bailouts amounted to less than $1 trillion, and my understanding is that taxpayers got it all back.

    Frankly, when financial institutions are failing is probably a good time to print up $1 trillion and spend it somehow. We are talking about once-a-lifetime events, sui generis. And there are real people out there who need to earn living.

    The People's Bank of China periodically prints money and buys bad loans, unburdening its banking system, much to the dismay of the "China will bust" crowd. You can almost hear them whimper, "But that is not fair!"

    The PBOC method seems to work. Maybe the bad bank managers end up as coal miners, I do not know. You do not want to be a coal miner in Red China.

    And I will conclude, as I nearly always do, by reminding everyone that the financial-industry embrace of and exposure to the artificially inflated values of zoned real estate is a key problem in developed economies.

    So let's talk about labor shortages. the Fed's Labor Markets Condition Index keeps declining, but you should read the anecdotes.

    Car lots in Alabama cannot hire car salespeople, even when they offer $10,000 a month. I read it on the Internet.

    The Fed says labor shortages are spreading.