Three stories from the WEO’s data tables
I am a bit of a balance of payments data geek. I like to read the IMF's WEO from the back to the front. The data in the statistical appendix often tells interesting stories.
Here are three that jumped out at me.
A savings glut not an investment drought.
Global savings is estimated to be close to 23.6% of world GDP in 2007, up from around 21% in the 2001-2003 – and above the 22% average between 1993-2000. Investment is up to, but with real rates low globally, the rise in investment likely reflects a rise in savings – i.e. a glut that has driven real rates down.
Certainly there is a “glut” of savings in developing Asia – a group that includes China. Savings is estimated to be 45% of developing Asia’s GDP – up 12% from its 1993-2000 average. Investment is up too – at 38% of GDP in 2007, it is estimated to be about 5% higher than its 1993-2000 average. But even with higher investment, developing Asia is in a position to lend a lot more to the rest of the world – 7% of its GDP in 2007, v. next to nothing from 1993-2000. I tend to side more with Dr. Wolf than Dr. Roubini on this question. I don’t think the US deficit is entirely the product of US policies (the US has brought it fiscal deficit down from its 2004 peak, though it is once again starting to rise). It also has has been induced by the rise in China’s surplus. Indeed, right now the rise in China’s surplus seems to be inducing deficits in Europe as well as the US.
Continues
There is also a savings glut in the Middle East. Savings, at an estimated 44% of GDP in 2007 – is up about 20% from its 1993-2000 average. Investment is up about 4%, not nearly enough to offset the rise in savings. The dynamics here aren’t hard to understand. Oil has soared. Domestic spending and investment are growing rapidly – but not as fast as oil is rising. Here I think the US should be looking a bit more in the mirror. The US cannot do anything – apart from imposing countervailing tariffs – to get China to stop pegging to the dollar, or to adopt policies that would lower its national savings rate. But the US certainly could adopt policies to reduce the United States call on global oil supplies. The US remains a very energy-inefficient economy.
State-led financial globalization
Take a look at Table A13. The IMF estimates the emerging world will add $1085b to its reserves in 2007, and there will be an additional $132b in net official outflows (this mostly comes from a $112 outflow from the Gulf – think sovereign wealth funds). That works out to a $1.2 trillion increase in official assets.
That increase is far larger than the emerging world’s $700b estimated current account surplus. The IMF estimates that net private capital inflows to the emerging world will total about $500b. That total may be a bit high – the August turmoil slowed the pace of capital flows to the emerging world. But there are some signs it has bounced back very strongly. India, for example, is now struggling with huge inflows. Russian reserve growth — judging from this week's data — looks to have resumed.
Imbalances are usually defined in terms of the current account. The US runs a big current account deficit, the emerging world and Japan a big current account surplus.
But they equally could be defined in capital account terms.
Right now, there is an enormous gap between net private capital flows and the US deficit, creating a large “financing gap” that is filled by official inflows.
And, on the other side, the emerging world is now attracting net private inflows on the scale that the US needs even though it is running, in aggregate, a $700b surplus.
IMF data makes it absolutely clear that the uphill flow of capital is not a private flow.
Europe joins Bretton Woods 2
Dooley, Garber and Folkerts-Landau initially argued that Asian reserve growth would finance the US current account deficit.
That story – when augmented with a story about rising oil savings and the investment of the oil surplus in (offshore) dollar assets – describes the world from 2001 to 2005 rather well. The US deficit rose from $385b to $755b (an increase of $370b). That increase offset a $127b increase in developing Asia’s surplus and a $263b increase in the surplus of the oil exporters.
But as the dollar-RMB depreciated against Europe and oil-exporters started buying more European assets, the system evolved. China started to run large bilateral surpluses with Europe. And if 1/3 of the $1.2 trillion increase in official assets is invested in Europe, Europe is now receiving a $400b capital inflow from emerging market central banks and oil funds. That inflow seems to have induced a swing in Europe’s current account balance –
This swing doesn’t show up in the data for the Eurozone as clearly as it shows up in the data for the European Union as a whole. That makes sense. Eurozone banks take the inflow from Asia and the oil states and lend it to Eastern Europe. But the overall result is clear: the IMF now forecasts that the rise in the emerging world’s surplus will be offset by a rise in Europe’s deficit.
Between 2005 and 2008, the IMF expects the US deficit to rise by about $30b (from $755b to $785-790b) and the EU’s deficit to rise by $175-180b (from $30b to $215-220b).
Asia's surplus is expected to rise. The IMF expects developing Asia’s surplus to increase $280b from 2005 to 2008, thank to China. The oil surplus only rises by $30b. By 2008, developing Asia has a signficantly larger surplus than the oil exporting economies.
Obviously, though, that forecast depends on the price of oil, as well as the pace of increase in spending and investment in the oil-exporting economies. I personally suspect the IMF underestimated the rise in spending and investment in the Gulf. But they also may have underestimated the price of oil. $90 a barrel even as the US slows is amazing.
All in all, though, the IMF's balance of payments forecast makes sense. Asian currencies are very, very weak relative to European currencies. And Europe is unquestionably attracting more than enough official inflows to finance a growing external deficit — even if it is attracting far smaller official inflows than the US.
I think I might agree re possible undercounting of domestic spending in the Gulf and some other oil exporters -though not Russia, Kazakhstan or Nigeria which is scaling up spending and has persistently lower oil export volume in comparison with two years ago. the projected surpluses for the UAE in particular struck me as a bit high – for $69 oil perhaps not with what the next few months may bring.
$89 v $69 oil certainly makes a difference.
If global saving and investment are roughly 24 per cent of global GDP, the world must be adding upwards of $ 10 trillion per year to its investment base.
This adds to global wealth, which is then marked to market for measurement purposes.
Who knows what this totals – $ 150 trillion?
So annual global current account deficits are transferring ballpark $ 1 trillion of $ 150 trillion of wealth per year from deficit to surplus countries.
Given the starting advantage of the developed countries, couldn’t this sort of wealth transfer go on for a while longer?
Is everyone satisfied with the method of measuring savings? I ask because China has created 18% more Yuan/year for the last 2 years. Japan, India, Russia, & other countries are creating money/credit rapidly. There is an awful lot of money that is being lent that hasn’t been saved but rather created.
Money creation is definitely not saving by any definition.
It is a balance sheet or stock transaction.
Saving is an income statement or flow transaction.
For example, a current account surplus is effectively an income statement transaction.
It is also representative of a country’s excess saving over investment.
When a central bank intervenes to buy FX from a current account surplus flow, it creates money.
Such money creation merely transforms the form of the saving from FX to domestic money – but it is neither the source nor the substance of saving.
Similar arguments hold in the case of purely domestic intervention. The money created by the central bank in buying bonds for example is just a balance sheet transaction. This in and of itself cannot affect saving – households and businesses can hold saving in many different forms, including bonds, money, or whatever. The fact that the government funds itself effectively through money instead of directly through bonds doesn’t in and of itself change saving of any sector.
Corollary -
China doesn’t have excess saving in the form of a current account surplus because PBOC intervenes to buy US dollars, or because PBOC prints RMB to pay for its intervention. These transactions transform the nature of the savings derived from the surplus, but don’t ‘create’ it.
(Although the size of the surplus no doubt would be different absent intervention – that’s an additional but distinct issue.)
Anonymous: When a central bank intervenes to buy FX from a current account surplus flow, it creates money.
Which will case inflation if nothing else happens. What happens in the Chinese case is that the PBC withdraws RMB from the system in the form of sterilization bonds. This is only possible because China has a large pool of domestic savings. So what happens in the end is a loan consisting of a wealth transfer from Chinese savers to US spenders.
@algernon,
you got it man.
Take a look at that, especially the graph concerning China:
http://www.howestreet.com/articles/index.php?article_id=4918
M1 is China is running at a staggering 20% … if you look at the movements of M1 and the CPI you can see that it took off with a lag of about 3 months. China is printing it´s self to hell! If it was savings China is delivering, then they would need to sterilize the dollar inflows. They stopped that now and are “solving” this issue with the printing press. There is nothing such as a “savings glut”!
Mish says:
” China is overheating now because it refuses to sterilize US dollars flooding into the country via trade deficits. The normal state of affairs (sterilization) would be for China to sell Renminbi (commonly referred to as Yuan) denominated bonds to soak up US dollars. Instead China is printing Renminbi to buy dollars, because like Japan, China does not want its currency to rise.
As an aside, this phenomenon also explains why there is no global savings glut. Massive printing of Renminbi to buy dollars does not constitute “saving” in any way shape or form. Bernanke is either disingenuous or a complete fool when he proposes the idea of a global savings glut.”
That explains the rally in commodities. This can be considered as a worldwide self destruction act. This is the road to hell.
@Twofish,
WRONG! China just stopped that!
AFFG
AFFG:
China has stopped sterilising its intervention? That is interesting and potentially big news. Where did you see that?
I would not get too excited about China’s, or any other country’s, broad money growth. Broad money is just bank intermediated saving/borrowing, and therefore depends on the developments in bank intermediation. For example, as SIVs are forced back onto banks’ balance sheets, you can expect to see broad money grow in the US, but provided that bank capital and reserves accommodate this change, it is not macroeconomically significant.
Brad,
The increase in the global savings rate over the long run average does not sound that large to me. Any idea what the ageing (wealth-weighted) population ought to mean for global savings? If it is intertemporally optimal to increase savings by, say 3%, then we have an investment shortfall.
I would not be surprised if it is indeed the case that America and Europe are not saving enough for their old age, but I must admit, I have not seen any estimates of how much they should save, or tried to evaluate it myself.
Written by Twofish on 2007-10-19 00:05:02
Quite right where sterilization is used effectively – my example was at the margin without sterilization. I guess I used it because sterilization is generally touted as such a great challenge for the CBs of these surplus nations.
But the general point holds with respect to the impact of central bank balance sheet expansion on saving, with or without sterilization.
Central banks do not ‘create’ savings through their own balance sheet expansion – be it high-powered money or sterilization bonds. In either case, it is a mere transformation of savings initially held in the form of FX.
More generally still, the same point holds in terms of broad money expansion by the banking system. That doesn’t change saving either because it’s only a balance sheet transaction. A commercial bank that creates credit also creates money. The net contribution of the bank to saving is 0 and the net contribution of the sum of the borrower and depositor to saving is 0.
” This is only possible because China has a large pool of domestic savings. So what happens in the end is a loan consisting of a wealth transfer from Chinese savers to US spenders.”
Not quite. The causality is that the CA surplus results in excess savings, which is held initially in the form of FX, then RMB money, then sterilization bonds (where used). This in no way constitutes a transfer of wealth from Chinese savers to US spenders. Chinese savers still have the wealth (and the risk of the underlying assets) and US spenders have the liability. In fact, the transfer of wealth in a current account surplus situation is a transfer from the deficit nation to the surplus nation.
@RebelEconomist,
you only save if you have a high enough return. That´s the issue. China/Asia is putting pressures on yields which means that people would have to save an incredible amount to offset the lacking amount of interest and the interest interests effect. I think in Europe we would need to save about 20% on net incomes. That is almost impossible. As the imbalances ease interest rates will go up and the amount of savings accumulation will grow and if the Money supply comes down things will work out.
The way I see it, if we stay on this path, savings are going to be too weak.
I am referring to M1 going to the roof. If you look exactly when M1 started to take off, you will notice that it was at about the time China unpegged it´s currency. My bet is China thought it could avert a deflationary desaster if it increased the amount of cash while throttling credit (M2 + CD throttling with an increase in RRR) and hopped to offset inflationary pressures from the printing press by letting it´s currency go up slowly and have deflating imports.
That is one of the reasons the price of oil is going though the roof. But this scheme only works if it´s counterparts (EU and US) choke the consumer while exports start to grow towards China.
This is going out of hand because speculators are now buying the yuan as fast as they can, because they believe it´s a one way bet. That influx is inflating the hell out of the Yuan. I expect regulation to fight speculators to pickup. We saw something similar in India a couple of days ago.
Got any thoughts on that? Am open for criticisms and inspirations?
Guest: This in no way constitutes a transfer of wealth from Chinese savers to US spenders. Chinese savers still have the wealth (and the risk of the underlying assets) and US spenders have the liability.
Transfer of “purchasing power” may be what I’m trying to get at.
Guest: M1 is China is running at a staggering 20% … if you look at the movements of M1 and the CPI you can see that it took off with a lag of about 3 months.
I think you are looking at statistical noise. M1 growth in China has been high since 1978. China’s been increasing sterilization by increasing reserve requirements in the last several months.
I agree with the anonymous commentator who argues central bank balance sheet expansion does not create savings.
A central bank that prints money (i.e. offsets reserve growth more cash in circulation) will produce inflation, not savings. in china money growth has been fast, but so has growth in money demand — lots of transactions are done in cash.
but most reserve growth has been sterilized. sterilization means selling a bond or a bill and buying cash (for the central bank, it means buying back cash). the bond or bill is sold to some one who already is savings — i.e. to someone who has set aside funds from current income.
the main channels through which the weak RMB have pushed up savings in china are:
a) its impact on corporate porfitability and thus firm savings
b) the government’s desire to offset the expansionary impact of net exports with a contractionary fiscal policy (i.e. less gov savings)
rebel — changes in any variable by 1 or 2% at the global level are pretty big — and in this case, i would argue that the change at the global level comes (unusually) from very large changes in the savings rates of emerging asia and the middle east, both of which constitute a fairly small share of the total. remember, both had to offset a fall in us savings over the same period — and the us is a bigger economy.
what do people think of my argument – based on the weo data — that Europe is replacing the US as the “demand” motor of BW2 with a rising current account deficit?
If the world has to get used to the U.S. not consuming like there’s no tomorrow disaster is on the horizon.
Asia’s wealth and consequent savings rate is on the backs of U.S. and European consumption levels. Savings will decline with a contraction of consumer activity within all of those economies that export to the west. This process is already in motion.
” Europe is replacing the US as the “demand” motor of BW2 with a rising current account deficit ”
Seems a natural demand response based on currency moves.
But the supply response will still be skewed too much to Asia and not enough to the US because of BW2 rigidity.
AFFG,
The level of saving depends on intertemporal preferences as well as return. If you want to live well (maybe even just live) in the future when your capacity to work is impaired, you need to save. It is not inconceivable that you will save more if interest rates are low, depending on income and substitution effects. Since Japan and China are on roughly the same ageing path as Europe and the US, we may well just have to accept lower returns on our savings.
What should happen is that the generally low level of interest rates should increase physical investment (eg in public infrastructure) so that the world as a whole can save more. But I fear that this is not happening enough, mainly because our system of insufficiently informed democracy is not good at dealing with approaching adversity. People tend to vote for the smiley guy who tells them that the future is bright.
At this time of year, a good example of saving for adversity is provided by the squirrel. When it buries nuts, it does not intend to leave them long enough to grow into nut trees!
By the way, the validity of my point about disintermediation of savings depends on whether Chinese M1 includes interest bearing deposits.
Dr. Setser, lots of good stuff here. Definitely, the Eurozone is taking the dual brunt of a strong Euro / artificially weak RMB. Some other points:
(1) You are correct in saying the price of oil is understated by the IMF. This from footnote 1 on p. 49:
Average prices between 2006:Q1 and 2007:Q2 were used for estimates, where crude oil prices averaged about $65. Subsidies and transport costs are not considered in the cost estimates.
(2)Actually, the US isn’t a very energy inefficient economy even by OECD standards. True, it’s less than half as energy efficient per $ of GDP as standout Japan, but it beats the likes of Canada and the Netherlands and is not far off the pace of Germany, France, italy, etc. Developed economies are well behind the US on this measure. Look at the EIA figures.
(3) The first stop of petrodollar recycling proceeds is usually Europe (i.e., London) and not the US. Some of it is due to Europe being closer geography- and time-wise. Also, dating back to the oil embargo days, there is a perception that the EU is less iikely to freeze GCC assets than the US should push comes to shove.
“Actually, the US isn’t a very energy inefficient economy even by OECD standards.”
LOL! … that´s a good one. Small issue here … the US basically produces nothing. Take the imports of good´s manufactured in the named countries and other very inefficient economies such as China and recalculate the maths … the US is one of the most energetically inefficient economies on the planet. By far and large. Sorry, don´t want to hurt any feelings, but we should stay sober so we can start to make changes. I believe though that this is going to start to change.
“Dr. Setser, lots of good stuff here. Definitely, the Eurozone is taking the dual brunt of a strong Euro / artificially weak RMB.”
The stuff here is very good. Funny .. the Euro is heading north since about 7 years and has balanced books … actually the Eurozone just posted a surplus of 4,3 billion Euros. I believe that some parts of Europe are going to go into recession (Spain) which have been a massive drag on the Euro for some time now, which means that imports are going to go down. I am not persuaded that the Eurozone will drive massive deficit against the rest of the world. The dollar is fundamentally oversold. If the Euro master continue to hike that should put pressure on the money supply and make it harder for debt to run out of control. Furthermore Europe has large plans to reduce fossil fuel consumption. France as an example wants to see new houses be energetically self sustainable at the latest 2020 and so on.
I believe China and a lot of countries are going to start to reevaluate their currencies at a higher rate. They have massive inflation problems creeping up and they know that. All this rate hiking and RRR increase is not going to help at all! There was an article on Bloomberg which was addressing that topic not long ago. It´s coming … and people are going to loose a lot of money.
Can somebody tell me where we can find the PBoC Note issuances and other “mopping” devices?
A central bank that prints money (i.e. offsets reserve growth with more cash in circulation) will produce inflation, not savings. In china money growth has been fast, but so has growth in money demand — lots of transactions are done in cash.
These words inflation and savings are not really English words, in the sense that classical, Austrian or “literary” economists use words. They are more like variable names. They are labels for of a kind of variable that appears in a style of macro model that owes its present popularity to Fisher and Keynes.
Models of this type cannot demonstrate causality. Using them as if they could is a wonderful way to confuse oneself. When Steve Levitt, for example, http://freakonomics.blogs.nytimes.com/2007/10/04/a-criminal-history-of-the-us-dollar-a-qa-on-a-nation-of-counterfeiters/#more-1934“>deploys the amazing formulation that “the demand for money outstripped the supply,” we can see that his undoubted skill in the construction and analysis of models has completely eradicated any ability he may once have had to reason logically in English about economic cause and effect.
Fans of Murray Rothbard may recall his wonderful analogy to Fisher’s equation of exchange (aka, quantity theory of money): the amount of rain that falls out of the sky is the amount of water that hits the ground. The statement is unconditionally true. But it doesn’t help you predict the weather.
So, in English: the PBoC is producing RMB to buy dollars. Since this by definition increases the supply of RMB, ceteris paribus (ie, compared to an imaginary world in which the PBoC did not produce RMB to buy dollars), it lowers the marginal rates at which holders of RMB are willing to exchange RMB for other goods. These goods may be pork, oil, or shares on the Shanghai exchange. (The distinction between “asset” and “consumer” prices has no foundation in reality. It exists only to make the models tractable. All prices are set by marginal supply and demand.)
But wait, we say. What the PBoC gives with one hand it removes with the other. It sells “sterilization bonds.”
A sterilization bond is actually a sort of living fossil. It is a mutant, degenerate, but distinctly recognizable case of true deposit banking. In true deposit banking, the bank serves as a warehouse – it holds your goods, typically shiny pieces of metal, in exchange for a deposit ticket. The Amsterdamsche Wisselbank was a true deposit bank, and its “bank money” can be seen as a sterilization bond.
Of course, the Amsterdamsche Wisselbank charged fees, whereas the PBoC pays interest. 3% interest, or whatever, but interest is interest. Normally it’s pretty difficult to pay interest on a true deposit, but since the PBoC can print RMB, it ain’t no thing.
And of course, the deposit term at the Wisselbank was zero, whereas the PBoC’s sterilization bonds have a maturity date. This seems like a difference, but in fact it is not. Buyers of sterilization bonds have no motivation to match their maturities, because the PBoC will surely not allow a liquidity crunch to develop in its own notes! The maturity of these bonds could be 1 year, 10 years, 100 years, or 1000 years. When political reality is taken into account, the decision structure for the buyer of such a bond is clear: buy the highest yielding note, and sell it whenever you want to sell it.
The important point is that true deposit banking does not increase or decrease the demand for RMB. When the PBoC “sops up” RMB with sterilization bonds, it is in no way counteracting its dilution of the RMB supply. It is only refusing to exacerbate that dilution further by piling Pelion on Ossa, and letting that money flow into conventional maturity-mismatched fractional-reserve “deposits,” which by creating multiple current claims to the same piece of paper would make its problem of “inflation” even worse.
What does increase the demand for RMB is that the PBoC pays a low, but nontrivial, interest rate on these cash holdings. But 3% is pretty lame when the quantity of RMB, whether “sterilized” or not, is growing at 20% a year.
We can see this easily by imagining that the PBoC converted all RMB into interest-paying sterilization bonds with infinite maturity, consol style. Every piece of paper money would be stamped with an issue date, and its face value would be computed by compounding interest from that date. Perhaps we could use pieces of plastic instead of paper, and they could have a smart chip that displayed their current face value.
This would increase the demand to hold RMB even further, because RMB holders would not need to go to the bank to trade their cards in for sterilization bonds. But the increase would probably be small, because even in China, it’s not that hard to go to the bank.
Better to trade your RMB for whatever everyone else is trading it for – Shanghai shares, anyone? Pork prices may be the political problem, but the financial problem is that diluting your money supply creates asset-price bubbles. The persistent institutional denial of this fact is fast approaching “Baghdad Bob” levels, and even the most diligent of careerists must be starting to think twice about which way the wind is blowing.
Prof Setser: what do people think of my argument – based on the weo data — that Europe is replacing the US as the “demand” motor of BW2 with a rising current account deficit
I’ll buy it.
Now, run with it – where does it lead?
1. Lower interest rates in Europe.
1.1 European investment boom. Housing bubbles and speculative investing?
1.2 Continued investment in Eastern Europe will absorb lots of cheap financing, accelerating its integration with the West, especially after those countries join the Euro.
2. Increased European imports, with follow on painful effects on European manufacturing.
2.1 Higher low-wage/unskilled unemployment – and more disaffected ethnic youth? Uh oh…
3. Current Euro appreciation will eventually slow (and reverse?) as trade pressures push the RMB up.
4. European outward FDI will increase as it gets cheaper.
4.1 The combined effect of 3 & 4 will be to greatly strengthen Europe’s investment income balance.
This is a great opportunity for Europe. Asia is offering LOTS of cheap financing for the next several years, so now’s a good time to make the big long-term investments, especially in integrating and educating the large minority communities that will soon start to feel even more pressure from Chinese competition. In the long run, prudent economic decisions – like not starting any new wars – will ensure that Europe takes full advantage of this opportunity. In time, Asia’s savers will decide they have saved enough and want to start investing at home again. Europe will be far richer as a result – unlike a certain neighbor across the pond.
” Models of this type cannot demonstrate causality. ”
That is the key thought for all of conventional economic theory.
More (much) later.
Rest easy.
Re Chinese fixing:
“so what happens in the end is a loan consisting of a wealth transfer from Chinese savers to US spenders.”
It seems to me that the actual effect is a wealth transfer from Chinese savers—and capital and technology transfer from the USA—to the Chinese Communist Party. Which I presume is the actual intent. The world’s biggest rentier ever: Capitalism-Leninism.
The Chinese (government) still have the wealth—a call on future production and resources—not US spenders. A rich person who spends his wealth is usually referred to as “broke”.
Maybe mercantilism will end up winning after all?
@EthanJ,
Amen … you hit the nail on the head. The problem with the US is not it´s dependency on foreign capital, but it´s low quality of investments. Europe is going under a massive transition, which means save save save … save energy … and manufacturing plays a key role in this game.
Brad you are inconsistent. The oil “savings glut” can be “deglutted” by slowing consumption but cannot/could not do so for the Chinese (/Asian/Japanese?, total/marginal? CA/currency intervention based?) “savings glut”.
Things do have reasons you know.
Re: my inconsistency –
Cutting energy consumption has a clear impact on price (I think) in a supply constrained market, and thus would i think lower the oil states savings rate considerably (by reducing the oil price considerably). And this could be done w/o necessarily slowing the broad economy. Severe curbs on demand in the US would have an impact on asia, no doubt, but I would posit the impacts are smaller b/c
a) asian goods are only maybe 5-10% of total consumption, so more of the impact is felt domestically
b) a broad demand slowdown = slower us growth = a weaker dollar = a weaker rmb = more chinese exports to the world and a rising chinese surplus to the world ex usa
b) isn’t entirely hypothetical. it more or less is what has happened. us demand growth has — per the imf — fallen significantly, tho more from the investment side than the consumption side. that produced $ weakness and rmb weakness and a chinese export boom to europe …
hence i think targetted energy conservation measures would deliver more bang for the buck.
AFFG –most of the i-banks produce data on chinese sterilization bill issuance. I like UBS and Standard Chartered, but all now track this data.
Ethan — no need to call me prof. setser, especially as it isn’t entirely accurate –
american multinationals in ireland have begun to lay off workers because they cannot export as much, because of the strong euro \ weak dollar, – to america (!)
i am getting dizzy.
meanwhile i know an irish family ( breadwinner is a teacher ) whose cleaning lady is planning her christmas shopping in new york. she can tell you what euros to dollar rate her various friends got as well.
people who do not understand the causes of currency fluctuation or the origins of glut – nevertheless remain as actors in the unfolding events.
I’ve read this week that gasoline was at 9,99 pouds/litre in UK.
That means 7,75 the gallon in $.
Chritsmas shopping apart, if the dollar goes on plunging british drinkers going to Latvia or Mallorca, will head to USA (the language advantage).
It must be something between the overtaxed britons and untaxed northamericans to meet the ends, don’t you think so?
The Super SIV is an obvious attempt to avoid price discovery and marking to market for the trillions of dollars in derivative securities on the books of major US money center banks. The Bernanke Federal Reserve is socializing the highly inflationary cost of the banking bailout by flooding the market with excess US dollar liquidity. The mantra of the Wall Street Banking cartel remains the same as before: privatize the profits to Wall Street insiders, socialize the costs to the American general public. History has a way of repeating itself, soon a loaf of bread will be the equilvalent monetary value to US dollars carried in a wheelbarrel.
Contrary to popular opinion, the super SIV idea actually has potential. The first idea is to strip out good stuff that probably constitutes at least 90 per cent of SIV assets. This portion will be rolled into the super SIV – such a restructuring forces a new discipline of transparency on this 90 per cent, and will allow the rollover of an economically viable CP program for this portion. The real credit problem is the other 10 per cent. This is what will have to be written down to market and put on the balance sheets of the banks. But it’s manageable. What is not manageable is trying to deal with the problem without somehow moving a big logjam that includes good and bad assets. The super SIV is a process to separate these two components and deal with each appropriately.
The real credit problem is the other 10 per cent.
I disagree. IMHO the real credit problem is that the good/bad split may be a long, long way from 90/10 (assuming “good” means “worth purchasing at close to par”).
ozajh on 2007-10-21 03:52:40
You may be right. We’ll see. That’s the issue.
The answer by definition will come out in the wash with the super SIV approach. What will be will be. If you’re right, the banks will be forced to take write-downs on more than 10 per cent. (The actual write-downs obviously won’t be 100 per cent of the 10 per cent (or more)).
I don’t think that changes the merits of considering the super SIV approach. The idea is that something is salvageable – some of the assets. This is an approach that will transform opacity to transparency and use CP funding where the credit quality is re-established properly. The rest of it will subject to credit losses for the banks.
Finally, sub-prime credit losses are a bad thing. But global distribution of those losses is a good thing. As a credit risk category, sub-prime may be more globally distributed than normal. This makes the overall loss more manageable economically.
DC: The Super SIV is an obvious attempt to avoid price discovery and marking to market for the trillions of dollars in derivative securities on the books of major US money center banks.
It’s actually the opposite. To mark-to-market you have to have a market. As long as you can get an number (any number), you know what your P&L is. Without a market, you don’t have any numbers to put into balance sheets.
Also, derivative securities are two-way bets. As Goldman-Sachs has demonstrated, if you get a number someone is going to win. If it turns out that hypothetically SIV are worth near zero, then someone is going to make a huge amount of money, as long as there is a liquid market.
DC: The mantra of the Wall Street Banking cartel remains the same as before: privatize the profits to Wall Street insiders, socialize the costs to the American general public.
Which explains why all of the Wall Street investment banks and hedge funds are recording record profits…. Except they aren’t.
DC: History has a way of repeating itself, soon a loaf of bread will be the equilvalent monetary value to US dollars carried in a wheelbarrel.
One thing that I enjoy about Wall Street is the intellectual discipline it provides. If you are 100% sure that there will be hyperinflation in the next year and you are right, then it is trivially easy to become extremely wealthy person. Take every bit of credit your have, borrow as much money as you can, and buy gold stocks.
The trouble with this strategy is that it will bankrupt you if you are wrong, and there isn’t hyperinflation. One thing that you learn once you are in this sort of environment is not to be sure of anything, and to be very quick to admit that you are wrong and limit the damage when the market turns against you.
In academia and in blogs, you can say and believe anything that you want, and there are no consequences. On Wall Street, there are plenty of chances to put your money where your mouth is, and based on whether you are right or not, become either insanely wealthy or a pauper.
Quite fun……
Pangloss…….sorry, Twofish,
I seem to recall you arguing in previous posts that marking to model is OK. Anyway, derivatives are not a two-way bet if the counterparties mark them at different prices. Are there any cross-checking mechanisms?
Disappointing earnings are not necessarily a sign that investment banks are not being bailed out (eg by interest rate cuts) if they would be bust otherwise.
In my experience of involvement in financial markets, most who try to make their money purely by making bets do not last very long. True, a few make winning bets for a while by using their superior knowledge in niche areas, but more survive by gaming institutional inefficiencies, by constructing and selling pigs in pokes, or by cheerleading and helping other people to take bets. I doubt whether globally much would be lost if they were all swept away by a tide of scepticism. Unfortunately for you in the US and me in the UK, our countries would lose an important source of revenue.
I do agree that the super SIV can play a useful role in reducing the amount of reintermediation that banks will need to do, but care will have to be taken that the transfer prices used for the relatively good assets sold to the super-SIV are not used for the toxic waste that remains. That will have to either be taken onto the banks’ balance sheets, or sold at market prices when an SIV without bank support goes into administration.
anonymous:
The whole problem is that the only way to separate “good stuff” from “bad stuff” is a liquid free market in… stuff.
So the MLEC will only accept AA rated paper. So what? What is a rating agency? A thinly-disguised branch of the government. What is rating? Administrative pricing in the credit market. As any real economist will tell you, there is only one thing to do with administrative pricing: take it out and shoot it.
Instead we hear all the usual cries for more regulation of the NRSROs. In other words, the solution to administrative pricing is… better administrative pricing. This is a pat on the head, not a bullet in it.
Sadly, a liquid free market in loans and a bank run are the same thing.
Most of the demand for 30-year money is not real 30-year demand. It is short-term demand laundered through maturity-mismatch structures, such as SIVs. If there is any prospect that these vehicles are not solvent, short-term moneyholders have many other places to put their money.
The only way for the SIVs – including the new super-SIV – to convince investors that they are solvent is to present balance sheets which are balanced not by the old administrative prices, which are now discredited, but by market prices.
Unfortunately, these market prices need to be set by a market in which the only buyers are people who actually demand long-term money. Because the short-term demanders have no economic reason to buy SIV notes, “super” or otherwise, which are balanced by administratively priced securities. See above. The trap is indeed a trap.
In such a market, even perfectly performing mortgage securities will be priced at astronomical implied interest rates. In today’s financial system, it is almost impossible to know what the actual demand for 30-year money may be. Systematic maturity mismatching has completely obliterated this Hayekian price signal. But with currencies that are diluting at 10-20% a year, the actual yield curve can’t be too pretty.
There are only two escapes from this trap. The first is to taste the pain.
The second is for the State to admit that since it caused the problem, it has to fix it. For the Fed to print dollars and buy mortgage securities or entire SIVs is not monetization. It is formalization of a covert and informal monetization that already happened. As Garet Garrett put it, “the revolution was.”
If such a formalization is accompanied by a public and unambiguous admission that maturity mismatching is an inherently corrupt practice, and by changes in accounting standards that prevent it in future – or, even better, a constitutional amendment which prohibits the US government from guaranteeing any private loan – I for one would be satisfied that it would not constitute the first step in the usual hyperinflationary spiral. Also, since monetization merely confirms the price of what the holders of money-market funds thought was short-term money, it does not affect their supply or demand schedules – as the destruction of these ambiguously quasiguaranteed loans surely would.
(On the other hand, if it is accompanied by the usual rhetoric that free markets have failed and the only solution is more parental intervention from our mother and father, the State, monetary destruction might even be preferable.)
Actually, the ideal “separation of finance and state” amendment would (a) prohibit the US from guaranteeing or insuring any loan, or fixing any price or exchange rate; (b) repeal the language about “gold or silver” in the Constitution; (c) make the paper dollar the official US currency; and (d) fix the number of dollars in the world and put that number in the Constitution itself.
Ideally someone will let me know before this passes, so I can dispose of my mold
moldbug,
The credit debacle was as much a failure of blind faith in rating agencies as the agencies themselves. This faith was itself opaque and irresponsible. In any event, the rating agencies have been downgraded, and those responsible for investment decisions will require more cover than this in the future. It is difficult at this stage to imagine a super SIV process where qualifying ratings aren’t subject to some kind of additional scrutiny – such as – competent proprietary financial analysis?
Banking is indeed subject to maturity mismatching – sometimes more benignly called liquidity transformation. But the world is subject to maturity mismatching. The need for money to buy real goods and services is itself a maturity mismatch. It’s a risk, but it’s not the only risk. Credit risk, interest rate risk, and others are often required to activate maturity risk into its most malignant form.
I’m not sure that bank depositors and shareholders would suffer less if bad bank assets (in addition to their money liabilities) were short-term in maturity – the rollover problem gets propagated to the next level. I think the issue of whether banks should be allowed to have assets that go bad in the first place is separate from the issue of whether maturity mismatches are evil or not. The key is whether banks have enough capital to support risk taking in the form of maturity mismatching and other risks. I’m not clear on the evils of maturity mismatching provided that the nature of it is reasonably transparent, and there is adequate risk capital to support it. As for transparency – that is also a matter for an investor’s responsibility. Caveat emptor. The bank can be taken to task for poor transparency, as it should be, but investors can’t really complain about being surprised by the content of a black hole where the darkness was quite visible at the outset.
anon,
I’m not sure what you mean when you say: “the need for real money to buy real goods and services is itself a maturity mismatch.”
To me, a maturity mismatch happens when someone demands real money (either to buy real goods and services, or to fulfill a commitment to someone else who wants to buy real goods and services) at time T, but instead buys a promise of money which matures at xT, where x is typically greater than 1.
Often much greater than 1. Since the slope of the natural yield curve, due to the higher return on “more roundabout” forms of production (as Austrians put it), is positive, the motivation for maturity mismatching is obvious.
And obviously, if only one individual mismatches maturities, he can resell his xT note at T and cash out with no harm. However, if a herd mismatches maturities, they will all be running for the same exit at once, depressing the price of xT notes at time T, and the yield curve will flip out like a snake on acid. (Note that this is an intertemporal version of the “burying the corpse” problem in commodity market manipulation.)
Therefore, in a free market, rational investors will avoid becoming members in any such herd, and they will match their maturities. The historical prevalence of maturity mismatching is a direct consequence of official interference with the banking system – for example, suspending redemption on behalf of insolvent banks, common even in the 19th-century US period of so-called “free banking.”
When there is any kind of official insurance, the risk is socialized and the rational actor will mismatch maturities. Also, when there is official insurance, the distinction between insolvency and illiquidity can only be made – as I outlined above – through administrative pricing.
There is an easy way for a rational actor to avoid maturity mismatching, even in cases where a bank’s portfolio is opaque. Never roll over. Never place yourself in a herd with other investors who do roll over. If you have money and you don’t know when you’ll need to use it, you have a demand for zero-term cash and you should not expect to earn interest on it, because no real production can occur under a zero term.
The fact that, under the Wisselbank 100%-reserve system, Dutch burghers could finance multiyear trading voyages in wooden sailing ships to Indonesia, strikes me as adequate evidence that the connection between maturity mismatching and risky long-term investment is not essential. Plenty of people really do demand long-term money and are willing to take high risks for high rewards.
As for “competent proprietary financial analysis,” two things.
One, this is of course a case of “better administrative pricing.”
Two, while competence is wonderful, it is no remedy for Knightian uncertainty. And it is even less a remedy for recursive uncertainty. For example, the health of many mortgage securities depends on the health of the real estate market. Which depends on the market for mortgage securities. Which depends on the success of the super-SIV. Which depends on the health of many mortgage securities…
If there is any way to predict the outcome of this feedback loop, it is surely more a matter of entrepreneurial intuition than accounting competence. The problem with the rating agencies is not, so far as I understand, that they were corrupt or incompetent. The problem is that they predicted future results by analyzing past performance. This is unwise in any context, but in a financial system ineradicably infected by the twin instabilities of monetary dilution and maturity mismatching, it is mooning the Saxons. And it’s not clear to me what sort of analysis could be deployed to replace it. Perhaps Twofish knows. (Perhaps he is doing it right now.)
Therefore, I would expect rational investors to avoid the super-SIV, just as they avoid the existing SIVs. Of course, a certain amount of informal arm-twisting may change their mind. But I find it far, far healthier for the Fed to buy the SIV itself, than for the Treasury to twist bankers’ arms to invest in it. Informality in government is corruption, period.
As for: investors can’t really complain about being surprised by the content of a black hole – well, of course you are right. Personally, I am amazed that anyone would exchange perfectly good mold for any of these instruments.
On the other hand, the behavior of investors with respect to the SIVs – which, let’s not forget, are banked by bank liquidity facilities, which are backed by the Fed, which holds legal tender power, which was first granted by a packed Supreme Court in one of the US’s most corrupt administrations – is really much the same as that of bank savers in the early 19th century, when there was no explicit legal guarantee of bank solvency. There was nonetheless an implicit guarantee, not unlike today’s Bernanke Put, and so people used the banks or were penalized by loss of interest. This created a moral onus to save the banks when they did run into trouble. While I am obviously no fan of this system, I do think the implicit guarantee creates moral responsibility. And thus my support for formal monetization.
Moldie,
Part of the “revolution that was”
RegW 23A exemption amount limits on “Securities financing transactions” to Affiliated Broker Deaers and unaffiliated market participants:
Citibank ………25bn
JP Morgan……25bn
BofA…………..25bn
Deutsche…….13bn
Barclays………20bn
RBS………….. 10bn
Most expansive RegW and 23a exemptions stated purposes fr RBS and Barclays:
… “to extend credit to market participants in need of short-term liquidity to finance their holdings of certain
residential and commercial mortgage loans and mortgage-backed securities, commercial paper and other structured products… the transactions between Affiliated Broker Dealer… and unaffiliated market participants will take the form of either reverse repurchase agreements or securites borrowing transactions”.
Other conditions:
-over-collateralised
-daily M-to-M
-daily margin maintenance
-SFT with affiliated must be accompanied by SFT with unaffiliated market participant on same terms
-collection even in case of bankcruptcy
-available for SFTs initiated while special discount window lending facility (SDWLF) is available
-For SFTs whose term exceeds SDWLF life, transactions can be held to maturity
Moldbug is right.
P. Krugman about the SIV in few words:
“I haven’t written about the rescue scheme being concocted to deal with the subprime fallout, because I don’t understand it — it does not, as far as I can tell, do anything except move money in a circle. And I’ve assumed I must be missing something.
But maybe not: it turns out that others share my puzzlement. And Yves Smith at naked capitalism has a line to remember:
‘Or as one reader put it, rearranging the deck chairs on the Titanic.’
But even that view may be optimistic.”
I liked the “move money in a circle” description.
moldbug,
I don’t see risk being socialized for SIV commercial paper in the same way as is the case for bank deposits. As you say, the SIVs are backed by bank liquidity facilities, which are backed by the Fed, which holds legal tender power … But the Fed’s discount window lending to banks is more tightly collateralized than the SIV liabilities that the banks backstop. The Fed’s discount margin requirements are generally realistic, verifiable, and transparent. This reflects the fact that the window is primarily a liquidity facility, not a solvency facility.
Whatever the SIV structure might be, the participating banks will take credit losses of some magnitude. To that extent the losses will not be socialized. I see the super SIV structure as requiring that administrative pricing converge to market pricing on those assets that qualify, which would be more tradable than the rest by definition. On the rest, banks will have to take them on to their balance sheets or sell them, either way with losses. Presumably the marking process will have to be supervised by various audit functions as well as Fed examiners.
My reference to a mismatch between money and goods and services is a stretch. The effective maturity structure of cash outflows to purchase goods and services is usually more contingent than certain. If one could forecast those cash outflows with more certainty, one could match their term structure more precisely to assets with the same cash flows, thereby locking in term money that paid some better interest rate. Holding precautionary cash balances is acknowledgment of this uncertainty – it is a mismatch between the ‘elementary’ terms structure of money (0 days or 1 day, depending on how you look at it) and its expenditure. Of course, if this can be viewed as a mismatch, it is certainly a prudent one, although it is pervasive. This is just an observation.
On the general topic of maturity mismatching, I suspect you’re making a profound point that I’m just not clear on yet.
I should have said risk analysis rather than financial analysis. True the rating agencies may have used historical data like everybody else (e.g. ‘value at risk’ models). But they should have been using scenario analysis as well. The general problem is the over-reliance on normal probability distributions for risk analysis. LTCM make the same type of error. In the final analysis, the effective use of scenario analysis very much depends on ‘entrepreneurial intuition’ as you say, rather than some insightful appreciation of ‘fat tails’.
Anon,
Thanks for the interesting discussion!
I now understand your point about precautionary cash balances. You are right that I would not view this as a maturity mismatch. Here is why.
Sometimes it’s easy to forget that money is subject to the same rules of supply and demand as any other good. One way to unforget this is to look at the same problem with respect to another important good: guns.
Suppose you need a gun by Tuesday. You ripped off Savage Hank. Sold him a bad K which was supposed to be China. It was actually plaster of Paris. You’re not sure Hank knows you switched the load. But he sure might, and he’s in town this week. You therefore are in need of a precautionary gun, just as one might need a precautionary cash balance.
So you call your buddy MC Ben. “Ben,” you say, “can you get me a piece by Tuesday?”
“Sure can, Angelo,” he says. “But it’ll cost ya.” Well, the long and short of it is that MC Ben takes your money and jacks you. He never shows. But neither does Savage Hank. Maybe his carotids are just clogged, with all that plaster of Paris. In any case, it’s Wednesday and you’re fine.
Now: did you need that precautionary gun? You didn’t. If you had had it, would you have used it? Not even. But did you demand it? You did. That the motivation for your demand was contingent, probabilistic, and in fact motivated by a major paranoid freakout that turned out to be quite unsubstantiated, does not affect the fact that you demanded a gun on Tuesday. Thus doing your small part to raise the price of Tuesday gun futures.
So when we look at the demand for money at some time T, which may be now or in the future, we can ignore the motivation for that demand. We are interested only in the effect of said demand on the market.
A good thought-experiment for thinking about maturity is to imagine that an asteroid is scheduled to hit the earth in, say, 2017. (I think this example is due to Rothbard, but I’m not sure.) The asteroid’s impact is certain, it is too big to be deflected, and it will destroy all life on earth.
Thus we can safely say that all demand for money at 2017 or later is zilch. Rather, humanity will go out in a bacchanalian orgy of decadent consumption, ramming caviar into our throats with great golden beer-bongs. The question is: how would the discovery of this asteroid affect the price of thirty-year mortgages?
In a maturity-mismatched world, it’s not obvious that it would affect them much at all. Because most of the demand for mortgage securities right now passes through mismatch vehicles. It actually comes from people who demand only short-term money – whether commercial paper, bank deposits, etc. If the demand doesn’t fall, why should the price fall? The homeowners have no reason to stop making payments – they still need somewhere to live until 2017. So the loans are still performing. But something, still, seems wrong.
Another good thought experiment is to imagine that the supply of paper dollars – what is it, now, 750B? – becomes fixed. The Fed cannot use its press to defend any sort of liquidity facility. Perhaps my constitutional amendment is passed, but without any preparatory monetization. The question is: how would this affect the ratio between the price of a dollar at T=now and T=10 years? Ie, how would it affect long-term interest rates?
The answer is that we’d see mindblowing asset-price deflation and incredible rates, because people right now hold many assets – checking deposits, money-market funds, etc – which in practice they think of as “virtual dollars.” Ie, they think of the Fed as using its power of the press to peg the current price of these assets 1:1 to actual paper dollars. If the peg is not rock-solid, you see a 1932 event. People rush to exchange their virtual dollars for real dollars, banks liquidate future money in favor of present money, implied rates skyrocket.
Now, it’s possible that not all of these virtual dollars represent actual demand for a precautionary cash balance. But with a maturity-mismatched financial system, it’s impossible to know, because nothing compels savers to make a choice between zero-rate cash on hand or nonzero-rate cash in future. The spread between CDs and continuously-mature instruments is relatively small.
The point is that in the Wisselbank world, where no one can print dollars, or compel anyone to accept anything that is not a present dollar at par for a present dollar, we see a yield curve, and that yield curve is natural – that is, it is entirely a result of market preferences, with no policy lever. For the natural yield curve to fluctuate sharply, sharp changes in the real world – such as the discovery of a doomsday asteroid – have to happen.
In the present financial world, this Hayekian price signal is entirely inaudible. The maturity mismatching industry is jamming its band, so to speak. There is no way to know at what marginal rate today’s dollar holders would be willing to exchange their dollars for 10-year dollars.
One way to restore a natural yield curve would be to turn off artificial liquidity entirely, breaking the plates as described above. But who needs the uber-recession that would surely result? The point of a formal monetization is that the State, by providing liquidity insurance, has informally made slices of 30-year mortgage legal tender – in exactly the same sense that it has made pieces of paper legal tender. And if destroying its own citizens’ money was not politically viable or desirable for the US in 1932, it surely isn’t now.
Let me relate this back to SIVs and to your view of risk.
I think what’s missing from this view of risk is a sense that today’s normal yield curve, as measured by risk-free T-bill rates, differs from the natural yield curve. If these curves were the same, you could define the present value of any fixed-income security in the usual way, by first discounting its default risk, then constructing a synthetic risk-free security that mirrored its return, then pricing that security as a composite of T-bills. The only entrepreneurial part of this problem is guessing the default risk, and this is relatively easy – at least, it’s easy relative to the problem I’m about to describe.
Because the normal and natural yield curves are not the same. They are not the same because systematic maturity mismatching transmutes a huge quantity of short-term demand for money into long-term demand for money. By definition, the normal curve reflects this demand and the natural doesn’t.
And there is no such thing as value – only price. So if the systematic maturity mismatching breaks down with respect to any class of securities – if short-term savers refuse to enter the mismatch vehicles that would purchase these securities – their price will reflect not the normal yield curve, but something more like the natural yield curve.
This is why the Powers That Be are trying so hard to prevent a liquid free market in these kinds of assets from developing. They understand that this market will produce prices which reflect the natural yield curve, leading to mass insolvency and still more panic selling – the classic bank-run phenomenon.
As with bank customers, anything that gives the buyers of SIV paper any reason to suspect that their money is in danger will cause them to defect. Either the “bank” must have risk-free deposit insurance; or its assets must cover its liabilities, discounted at the natural yield-curve rate (unlikely); or its assets must cover its liabilities, discounted at the normal rate, and the price of these assets must be unaffected by maturity-mismatch breakdowns in the market at large.
Rational people are bailing out of SIVs right now because they cannot verify any of these propositions. (Irrational people are bailing out because the acronym reminds them of the simian immunodeficiency virus, ie, monkey AIDS.)
For example, the liquidity insurance that banks give to their attached SIVs is not unambiguous, because it covers illiquidity but not insolvency. As we’ve seen, in the case of a maturity-mismatch failure, the two cannot be distinguished – market prices of any security supported by mismatch demand tend to collapse, even in the absence of default risk. We all love guns and money, but this one calls for lawyers – and who needs that?
If you are right that the super-SIV will command market confidence because the assets it buys will perform at the specified rate, it will work without any socialization of risk. Given that there’s no way it can buy all the good MBS in the world, however, it’s a little hard to see how it will be able to convince buyers of its notes of its solvency. Whatever MBS it doesn’t buy will still be priced by the evil natural yield curve, and it will have a hard time defending its disparate accounting versus these market-priced instruments.
If it is protected by the effective equivalent of deposit insurance, however – as I think it will need to be – and if the assets it buys are performing, if the administrative pricing is correctly done, what we see is a return to the pre-crash status quo with no socialization of default risk. Of course, all maturity mismatching is in a sense an inflationary tax, because it dilutes present money with future money. But we have lived with this for quite some time.
Of course, if the MLEC is protected and its assets are mispriced, it will mean socialization of default risk. Unfortunate. But again, not the end of the world.
For me, again, the takeaway is that maturity mismatching is always dependent on administrative pricing, because administrative pricing is the only way to distinguish between illiquidity and insolvency.
In a matched-maturity financial system, an imaginary creature which does not at present exist, the answer of “when in doubt, liquidate” is always correct. In ours, it isn’t. And this game of regulatory whack-a-mole and Chinese fire drills, not to mention our decidedly untamed business cycle, strikes me as unending.
RebelEconomist: Anyway, derivatives are not a two-way bet if the counterparties mark them at different prices. Are there any cross-checking mechanisms?
Yes, if you have two vendors marking the same derivative at different prices, then a third party is going to make a lot of money buying from one vendor and selling the derivative to the other (or doing the mathematical equivalent).
RebelEconomist: In my experience of involvement in financial markets, most who try to make their money purely by making bets do not last very long.
Which is why the big banks rarely do that.
moldbug: (Assume the supply of paper money goes fixed). The question is: how would this affect the ratio between the price of a dollar at T=now and T=10 years? Ie, how would it affect long-term interest rates?
You’d have a short period in which people run around looking for a substitute for paper money, but they’d find it. The problem here I think is that you are confusing the ruler with the thing being measured. People measure “value” in terms of exchanges with dollars but in the absence of dollars, they’d find something else.
moldbug: The answer is that we’d see mindblowing asset-price deflation and incredible rates.
Actually I think you’d see the opposite. Massive inflation as people dump dollars and interest rates drop. Once there is uncertainty in the future usefulness of the dollar as a medium for exchange, the dollar becomes worthless and people will dump it and exchange it for something else that they can use as a medium of exchange.
By contrast in the asteroid example, 30-year mortgages would be become worthless.
moldbug: If the peg is not rock-solid, you see a 1932 event. People rush to exchange their virtual dollars for real dollars, banks liquidate future money in favor of present money, implied rates skyrocket.
People rush to exchange their virtual dollars for something else (gold or Euros for example), this will make dollars (both “real” and “virtual”) worthless. All dollars are virtual.
moldbug: Therefore, in a free market, rational investors will avoid becoming members in any such herd, and they will match their maturities.
No they won’t since the rational actors will only see the information available in front of them, and are limited as to how other people will behave.
moldbug: There is an easy way for a rational actor to avoid maturity mismatching, even in cases where a bank’s portfolio is opaque. Never roll over. Never place yourself in a herd with other investors who do roll over.
And in the real world, there are people who are willing to pay you money in exchange for using your cash, and the rational actor will accept that payment if the counterparty has good credit. The term of the cash you have is indeterminate, but it isn’t zero.
Twofish,
You are being deliberately obtuse!
As you know, firms do not commit to trade at accounting prices (or even at some realistic spread off them), so trade does not act as a quality control.
It was your point that the process of putting one’s money where one’s mouth enforced intellectual discipline on Wall Street. The fact that, as you say, so few do so is probably the main reason why market pundits spout and recycle such a lot of vivid, unrigorous rubbish.
One such canard, in my opinion, is that unrealistic credit ratings have been a major contributor to the SIV problem (and – Moldbug – they certainly do not represent a price). I agree that back and forth discussion between the structurers and the rating agencies is unhealthy, but I think that the real problem is that investors have willfully misused the ratings. They are measures of default risk only, not of general risk, but agent investors are happy to ignore the difference if it allows them to beat their benchmark for long enough to get rich, and principal investors are too lazy to work out the difference. The consequence may be that policy makers reform the rating system rather than addressing the real problem, which is moral hazard. Monetising the problem will only make it worse (albeit delayed) whatever institutional promises are made about money in future.
moldbug,
At the risk of overextending the discussion, several (near) final observations:
It seems to me that a system without maturity mismatches is one without credit and without money supply growth from credit. Perhaps that’s the point behind something like a strict gold standard and/or the purest definition of a ‘deposit’.
At the macroeconomic level, in a fiat money system, banks create money by creating credit. Central banks create ‘high-powered’ money by purchasing government debt, foreign exchange, or other assets. Commercial banks create regular money by making loans.
I think such a fiat system actually requires maturity mismatches. Credit is basically a non-0 maturity contract to repay a 0 maturity deposit. Credit of 0 maturity would be quite useless to the borrower, because the money created would not be free to circulate due to the ever threatening presence of the liability to repay it, which contradicts the purpose of money. Such credit would be a constantly callable loan, based not on the credit quality of the borrower, but on the liquidity preference of the depositor. I don’t see this being a viable connection between money and credit. Conversely, money of stated non-0 maturity is quite useless, because it can’t circulate by contract, and therefore doesn’t satisfy the core purpose or definition or usefulness of money. With non-0 maturity ‘money’, there is no ‘there there’.
It then seems to me all other forms of maturity mismatch (e.g. SIV assets funded by commercial paper) are extensions of the elementary case of bank credit in a fiat system.
There is a difference of course between maturity of money (liquidity maturity) and maturity of interest rate (‘duration’). Commercial paper can fund a variable rate note of longer maturity whose interest rate resets along with the commercial paper interest rate, in accordance with some short-term market index. The earliest application of interest rate derivatives (swaps) was to sever the presence of interest rate duration risk from liquidity mismatch risk.
A perverse example of mismatched maturity/matched duration is that of adjustable rate mortgages after the fixed ‘teaser’ rate expires, and the current rate begins to reset at short-term market indexed levels. Once the ‘teaser’ fixed rates on these mortgages reset, the interest sensitivity of bank assets and liabilities is reasonably matched. The problem of course is that profoundly low ‘teaser rates’ sucked gullible borrowers into expectations of similarly low rate experience down the road. Credit risk then sunk in its teeth, as a contingent function of increasing short-term interest rates. These ‘teaser rates’ are in my view the most egregious structural mismatch in the entire mortgage industry, and those who designed and marketed them deserve the greatest blame for the current debacle.
Ironically, the era of ‘disinflation’ that began with Volker gradually expanded the zone of danger for the ‘duration’ mismatch – from one of short funding and long assets (e.g. S&Ls), to one that also included long funding and short assets (e.g. pension funds). The yield curve ‘conundrum’ had a good deal to do with pension funds desperately seeking duration to match long term liabilities that grew increasingly mismatched as interest rates declined and present values increased. This yield curve pressure was augmented by the effect of massive current account surpluses desperately seeking assets with anything longer than 0 maturity.
RebelEconomist: As you know, firms do not commit to trade at accounting prices (or even at some realistic spread off them), so trade does not act as a quality control.
Yes they do (or rather the accounting prices are set to the trade prices). This is what mark-to-market means.
RebelEconomist: It was your point that the process of putting one’s money where one’s mouth enforced intellectual discipline on Wall Street. The fact that, as you say, so few do so is probably the main reason why market pundits spout and recycle such a lot of vivid, unrigorous rubbish.
Market pundits are generally clueless. Anyone who actually has a clue on Wall Street is doing something other than being a pundit.
Twofish,
You are doing it again! (Being deliberately obtuse I mean)
Of course if the asset trades, then the trade price should replace the estimated one, but the problem is, as you well know, that the assets that are the focus of the SIV question hardly trade.
There are a lot of pundits who do make a living on Wall Street, and they are the ones who are the most visible to the outside.
Twofish,
Wow! We certainly are operating under very different theories of money.
In your world, the dollar seem to be a “measure of value.” In mine it is a good like any other, and its exchange rate vis a vis other goods is set by the same process of supply and demand as any other.
You’re arguing that if a source of dollar supply is turned off, the price of the dollar – versus other goods – will go down. Again, all I can say is wow.
Why, if the Fed “breaks the plates,” should I lose confidence in my future ability to exchange dollars for useful goods and services? Breaking the plates does not make $30 trillion in dollar debt go away. A lot of people owe dollars. In a world where they can’t get current dollars from the Fed, or from anyone who gets them from the Fed, the chance that they will be breaking their backs to provide goods and services in order to have some miserable chance of paying off their hellacious debt can only increase.
moldbug: Why, if the Fed “breaks the plates,” should I lose confidence in my future ability to exchange dollars for useful goods and services?
Because the Fed has just said that it won’t accept any new liabilities above the amount in circulation.
moldbug: A lot of people owe dollars.
A lot of people owe debt denominated in dollars. There’s a difference. If someone owes me $100, and they give me two large bars of gold in payment or five thousand euros, I’m not going to say no. If I stop trusting dollars, I’d actually rather they give me gold or euros.
anon,
If anyone has overextended the discussion, it is certainly me!
A world without maturity mismatches is certainly a world without money supply growth. But it is certainly not a world without credit. It is a world in which credit relationships match the time preferences of borrowers and lenders.
So, for example, let’s say you have a 30-year fixed-rate mortgage. This is certainly credit. As a product, a 30-year fixed-rate mortgage is a stream of preset payments spread out over 30 years. In a maturity-matched credit market, who would exchange present dollars for this product? Anyone who wanted to trade a large sum of present dollars for a cumulatively larger stream of future dollars. Buying an annuity is a perfect example.
If this isn’t credit, I don’t know what is. Note that it still depends on the entrepreneurial talents of the banker to assess the quality of the loan. This is still a market for promises. Kindergarten it ain’t.
You are certainly right that maturity mismatching is a generalization of the normal process of fractional-reserve banking in a fiat-paper financial system. However, I don’t think you’re right that fiat paper implies maturity mismatching.
The two certainly developed together historically. The link to gold was severed in response to the excess of current claims created by mismatching. When you have N gold dollars and xN zero-maturity claims to dollars, where x exceeds 1, irredeemable paper is probably in your future.
It’s fascinating to note how violently this was resisted. Burke’s Reflections is a good indication of how our ancestors 200 years ago saw paper money:
“When all the frauds, impostures, violences, rapines, burnings, murders, confiscations, compulsory paper currencies, and every description of tyranny and cruelty employed to bring about and to uphold this Revolution have their natural effect, that is, to shock the moral sentiments of all virtuous and sober minds…”
Yet even in Burke’s day the Bank of England circulated more pounds than it held gold to cover them. And during the Napoleonic wars it suspended redemption. The problem is truly an ancient one.
Setting aside the historical and political realities, there’s no economic reason at all that a fixed money supply could not be achieved with paper or electronic money. This would actually be a much harder currency than gold, because new gold is constantly discovered. (Gold is “natural money” because its intrinsic desireability, for jewelry and the like, bootstraps the “Austrian circle.” But such direct demand is a minor element of the demand for gold, even at present when it is officially demonetized. Most of the demand is still monetary – ie, gold is demanded primarily for its exchangeability, not its utility, and this is true even for most of the jewelry gold sold in Southeast Asia. In other words, gold is more like paper money than most goldbugs think.)
To fix the dollar supply, figure out how many present dollars there are in the world, renumber them consecutively, and take some legal measure that ensures that this number will remain constant.
No elastic or metallic currency could compete with such a beast. Because the supply of other monetary instruments would be continuously rising as they do now, whereas the supply of dollars would be constant, futures of all other currencies would go into permanent contango versus the dollar. Effectively, holders of elastic currencies would be paying an inflation tax which they could easily avoid by holding dollars instead. The resultant feedback loop would mean certain death for all other currencies – even gold. Which might well return to $20 an ounce.
If you believe the Austrians, which I do, this world would also be entirely lacking in business or credit cycles. It would have no “Minsky moments.” I suspect that it would not even exhibit financial-market trends – ie, no “beta.”
But it would also have no liquidity facilities. Which does not mean that maturity mismatching would be illegal, as the Austrians want. But does mean that it would be very imprudent, and I suspect people would learn to avoid it.
The only problem is that there is no easy way to get from here to there. Such a transition would basically involve a complete reconstruction of the financial system. Not easy – especially if your goal is to avoid rewarding or penalizing anyone. On the other hand, managing the present system isn’t easy, either!
Twofish,
Again, that the Fed cannot or will not issue more dollars constitutes a ceteris paribus reduction in the supply of dollars, not in the demand. In order for the price of the dollar to sink, presumably you have to increase the supply or reduce the demand.
Loans of course can always be renegotiated. But a loan is a contract, and renegotiation requires the consent of both parties. The borrower does not want to pay anything worth more than a dollar, and the lender does not want to receive anything worth less. So whether the loan is repaid in gold, euros, or chickens, the payment will equal whatever a dollar buys you in chickens.
RE,
I certainly do think a credit rating is a price. It represents a default risk – or at least a range of default risks – and converting this to a price, by comparing it to the price of risk-free future money (Treasury notes) is standard.
Perhaps the problem is just that I meant “price” in a sort of grand, elliptical Austrian sense of the word
Moldbug,
My objection to considering a credit rating as a price is that the price of risk in terms of other items including money depends on preferences.
Again, you assert that the value of gold is increased by its monetary use, and, for my own research purposes, I ask what the evidence for this is.
The problem I see with your idea about fixed money supply is that the legislation could easily be reversed. You only have to look at recent events – eg with Northern Rock in the UK – to see that it is difficult for central bankers to stick to their principles. If people did not want this money, couldn’t they get rid of it by paying it to the government that declared it as legal tender in settlement of taxes?
I think it is slightly overbroad to say that a credit rating is used to price “risk in terms of other items.” It is the price of some promise of future dollars in terms of present dollars. We can even get rid of the time element by comparing it to Treasury notes.
If what you mean by “preferences” is that some buyers want risk and some don’t, this is certainly true. But price does tend to converge on risk-adjusted expected value, because we do have a financial industry that is very good at aggregating and diversifying to spread risks.
As for gold, Daniel Gross at Slate wrote a decent overview of the market, albeit based on reporting from the egregious Virtual Metals. (Note another sighting of “demand outweighs supply” – in this case, I guess, quite literally.) Also bear in mind that the real question is not who buys and sells the stuff, but who holds it, and at white price they are willing to sell. Again, I prefer to avoid the word “value.”
Yes, the legislation could easily be reversed. At the very least you’d want to throw it in the Constitution or something like that. Note that the supply of the original US paper money, the greenback, was statutorily limited. It worked – for a while.
moldbug,
I’m fairly close to agreeing with you now. My point related to the effect of 0 maturity bank deposits on the match/mismatch inherent in a bank’s balance sheet. With fractional reserve banking, there is certainly a gap between the size of a bank’s 0 maturity money liabilities, and the corresponding level of its required 0 maturity reserve assets. With some central banks tending to reduce reserve requirements over time, this gap has grown larger. Something has to fill that gap. But in rethinking the possibilities, this wouldn’t necessarily force a mismatched asset, because a bank could choose to hold voluntary 0 maturity liquid assets of some type, rather than create > 0 maturity credit. Having said that, the gap can be fairly large. Banks may not hold 0 maturity assets in such size, given the cost of doing so. But I guess that goes to your point.
Your comments have been very worthwhile. I understand more now than at the start. Thanks for a good discussion.
Moldbug,
Why would anybody lend out money if the supply of money was fixed. Why not just hoard money.
moldbug: Again, that the Fed cannot or will not issue more dollars constitutes a ceteris paribus reduction in the supply of dollars, not in the demand.
Once it becomes clear that the Fed is not going to exchange the assets it holds for legal tender paper, demand will plummet. Also, the supply of money is not controlled by the government and has nothing to do with the amount of paper money in the system. Money is created when the same dollar is recirculated more quickly or more slowly, and the government can only influence the process, not control it.
moldbug: To fix the dollar supply, figure out how many present dollars there are in the world, renumber them consecutively, and take some legal measure that ensures that this number will remain constant.
Money just doesn’t work that way. You can no more enact a law that fixes the amount of money in circulation than you can outlaw inflation by legislation.
RebelEconomist: You are doing it again! (Being deliberately obtuse I mean)
I’m trying to make the point that the idea that you can take a derivative security and just fix a random price to it is not how things work. Most banking transactions involve people owing money to each other, and if there is anyway you can argue that the bank owes you more money or that you owe the bank less money, you’ll have your lawyers screaming at the bank. If you have a contract with the bank, a valuation that is good for the bank is bad for you and vice versa, and so that neither you or the bank can pick a random number for the value of the contract.
moldbug: So, for example, let’s say you have a 30-year fixed-rate mortgage. This is certainly credit. As a product, a 30-year fixed-rate mortgage is a stream of preset payments spread out over 30 years. In a maturity-matched credit market, who would exchange present dollars for this product? Anyone who wanted to trade a large sum of present dollars for a cumulatively larger stream of future dollars. Buying an annuity is a perfect example.
So I have a portfolio of 30-year fixed-rate mortgages that I can buy and sell on the market. Right?
OK. then I find some investors to pool money to buy 30 year mortgages. If someone puts in money into the pool, I buy more mortgages. If someone wants out of the pool, I sell those mortgages and let the investor cash out.
Since the price of 30 year mortgages fluctuates, I set aside a reserve that makes sure that I can still redeem the investor shares if the value of 30 year mortgages goes down.
At this point, we have the current banking system……
anon (1),
I too have learned. I find it very interesting how specialized to the details of the present-day financial system most finance professionals’ knowledge is. Talking to a modern banker about Austrian economics and hard-money finance is much like talking to a modern lawyer about Roman law or the Napoleonic code. A British or American lawyer simply has no practical need to understand these alternate realities – especially the former, since it is extinct. But the lawyer can at least take classes in comparative law. Whereas there is basically no such thing as comparative finance.
One way to think about the problem you describe is to imagine that accounting treated money as a dimensional quantity. Rather than balancing assets and liabilities as dimensionless scalars, by valuing them at their present market price and constructing a scalar sum on each side, you could associate every payment the balance sheet expects to receive with a date and an expected quantity (and perhaps, to get really fancy, a probability distribution), and every payment it is contractually obligated to make with a date and a quantity.
The purpose of accounting, after all, is to formally determine the probability that the entity will default on its obligations. Various covenants can be associated with various probabilities of default. Adding a time dimension to cash flows can only improve the precision of this instrument.
In this sort of dimensional accounting, needless to say, one would not assume that one’s creditors would automatically roll over their loans, or even depend on some historically observed probability of rollover. The result is that any balance sheet with mismatched maturities is “dimensionally insolvent.”
In today’s world, in which central banks provide ultimate backstop liquidity, lenders have no motivation to demand dimensional solvency from financial intermediaries. Indeed they have a motivation to demand no such thing, because dimensionally insolvent structures produce higher returns – as long as they are protected against a breakdown of maturity mismatching. The trouble, again, is that any such insurance must depend on regulatory / administrative pricing, and when administrative pricing fails it cannot use a simple free market to compute the entrepreneurial consensus of default risk.
With a fixed money supply, however, I believe that a rational investor would indeed demand dimensional, ie maturity-matched, accounting. Otherwise the risk of loss in a bank run is considerable. It certainly outweighs the prospective gains from receiving long returns on a short term.
One way to think of the investor’s decision model is to see it as a sort of “financial hygiene,” or financial Kantian imperative. A Kantian investor makes financial decisions by assuming that her decisions are paralleled by a herd which is also making the same decisions. Therefore, she will try to avoid mismatching maturities, because if a herd of investors lends at xT where x>1, while really intending their money to be mature at T, they will lose – at least if Savage Hank shows up, and they actually do need the money at T.
The analogy to hygiene reflects the fact that if you are the only one who coughs into the soup, you need not quail at having a bowl. But are you the only one who coughs into the soup? Needless to say, this sort of discipline is more or less nonexistent in the real world today. But a fixed money supply, or at least a metallic currency, would go a long way toward enforcing it.
anon(2),
If your cash balance is something you think you may need tomorrow, as we needed the gun in case Savage Hank showed up, no – you will not loan.
On the other hand, if you have money you know is just going to sit in the vault for the next year, any year-term investment (ie, a “time deposit” or CD) that offers positive expected value will appeal to you. This allows entrepreneurs to finance a profitable capital investment with a term of one year. If there is no such investment at such a term, your money should just sit in the vault.
In the real world, there are plenty of long-term savers and plenty of long-term investments. Thus it is unnecessary to envision the complete disappearance of the financial industry when faced with the removal of the substantial disincentive that a dilutive maturity-mismatched financial system inflicts on those who prefer the Bank of Mattress.
However, you would see a considerable shift away from the construction of exotic instruments and the prediction of cyclically unstable feedback loops, and toward the more traditional task of estimating the expected future return on various items of capital. I suppose whether this is a boon or a curse depends on what one’s current specialty is.
2fish: Also, the supply of money is not controlled by the government and has nothing to do with the amount of paper money in the system.
By paper money, I mean M0, ie high-powered money, ie bills plus Fed deposits. This quantity is certainly both measurable and controllable. I apologize for not being clear about this.
2fish: Once it becomes clear that the Fed is not going to exchange the assets it holds for legal tender paper, demand will plummet.
Are you saying that the Fed will not redeem M0 paper for the assets that back it, eg T-bills, mold, “Sub-Prime Credit Card Loans,” or whatever they’re buying these days?
First: this is entirely different from enjoining the Fed from producing more M0 paper to buy more assets. And second: I was not aware that Fed paper was in any sense redeemable for Fed assets, and I certainly have never heard of any such redemption. Perhaps this is simply my own ignorance.
But at least no holders of FRNs I have ever met held them based their demand for these goods on their valuation of the Fed’s portfolio or their faith in redemption. Exchange value is quite sufficient. If the Fed burned all its assets tomorrow (setting aside, again, that this has nothing to do with “breaking the plates”) and acknowledged the dollar as a pure fiat currency, I don’t see why the demand for dollars would go up or down. Pure fiat currencies work for the same reason gold works – monetary demand has nothing to do with “intrinsic value.” Currencies are demanded for game-theoretic herd-behavior reasons.
2fish: OK. then I find some investors to pool money to buy 30 year mortgages. If someone puts in money into the pool, I buy more mortgages. If someone wants out of the pool, I sell those mortgages and let the investor cash out.
See the discussion of “dimensional accounting” above.
Another way to see the problem is that what’s missing from this design is that you are looking at it from the perspective of the bank, not the perspective of the investor. It takes two to tango.
When you sell or resell a mortgage, what you’re doing is finding a short-term buyer for long-term money. By buying a mortgage, the buyer is essentially a lender. So your design could be rephrased as:
If someone wants out of the pool, I find someone else who wants in to the pool.
That you are selling a mortgage on the open market, not finding a new customer to assume the position of the old customer, only means that you are finding a new direct lender instead of a new indirect lender. The distinction is negligible.
A rational investor who follows the Kantian imperative will avoid not only your bank, but any instruments your bank is buying. Because if your bank is buying them, other banks are probably buying them as well. Which means the price of these long-term investments includes some positive contribution from investors who in reality demand short-term or zero-term money. Unless Savage Hank never shows up and their patterns of rollover in fact replicate the behavior of long-term investors, which is a factor you have no control over whatsoever (if anyone exhibits Knightian uncertainty, it’s gotta be Savage Hank) lossage due to a bank run is quite likely.
Of course, this is again in the absence of official protection. Protection for maturity mismatching can take the case of liquidity backstops, deposit insurance, bankruptcy suspension, bailouts, etc, etc, all of which need to be backed by fiat or legal tender power to be really 100% reliable.
(For an interesting variant of protection by suspension, see the dissident “option clause” Austrians, the free-banking men Selgin and White. Needless to say, I don’t buy the Selgin-White line. What they miss is that, absent legal-tender laws, the value of a note on a suspended bank would surely not be par, since the noteholder cannot distinguish between insolvency and illiquidity. But it’s worth checking out their work and comparing it to the conventional Austrian approach of Mises, Rothbard and De Soto. I think the conventional Austrians put too much weight on the argument that maturity mismatching should be illegal, and not enough on the argument that investors have a game-theoretic motivation to avoid it. But the latter is certainly implicit in their approach.)
moldbug: On the other hand, if you have money you know is just going to sit in the vault for the next year,
What if (like most people) you don’t know exactly when you will need the money? What if you think you need the money now but you are wrong or what if you think that you don’t need the money now, but you are wrong?
I actually am a fan of Austrian economics, in particular von Mises and Hayek’s theories on the impossibility of socialist calculation. However, I think their theories of credit are just plain wrong.
The examples that you gave of what happens if the central bank limits the formation of paper money or what happens if an asteroid is about to hit are situations which are empirically testable. You can find out what happens in real life situations in which similar things happen, and off the top of my head, I think that this happen in a way that is opposite to the way that the Austrians predict. For example, the amount of Deutsche Marks is capped. No more Deutsche Marks are being printed, yet this hasn’t resulted in a increase in the value of Deutsche Marks.
moldbug:. Which means the price of these long-term investments includes some positive contribution from investors who in reality demand short-term or zero-term money
Why? I’m *selling* 30-years notes, not buying them. Presumably anyone that wants to buy a 30-year old has no need for present cash otherwise they wouldn’t be buying a 30 year note.
moldbug: Unless Savage Hank never shows up and their patterns of rollover in fact replicate the behavior of long-term investors, which is a factor you have no control over whatsoever.
Correct.
moldbug: Of course, this is again in the absence of official protection. Protection for maturity mismatching can take the case of liquidity backstops, deposit insurance, bankruptcy suspension, bailouts, etc, etc, all of which need to be backed by fiat or legal tender power to be really 100% reliable
There’s nothing that is 100% reliable in the world.
The big problem I have with Austrian theories of credit is that it fails to deal in an optimal with way with the fact that we have no idea what the future value of money really is. For example, suppose 10 years from now someone discovers cold fusion. You would have a massive increase in the total amount of wealth available in world. Suppose 10 years from now, the earth gets hit by an asteroiod, you have a massive decrease in the total amount of wealth avaliable in the world. Those massive increases or decreases in wealth have to be matched by massive increases and decreases in the money supply.
The Austrian approach to credit seems to be to limit the amount of money to deal with the possibly of a crash. The trouble is that limiting the supply of money doesn’t deal rationally with the possibility that the total amount of wealth will drastically and unexpectedly increase due to technological changes.
The issue of maturity mismatches is an important one in banking, but there are mechanisms that have been developed by trial and error to deal with them, and I’m not sure what those mechanisms should be abandoned for some other mechanism based on theory. It’s at this point that two of the strands of Austrian thought collide with each other. Personally, I’m a fan of von Mises and Hayek’s theories on the impossibility of socialist calculation.
What happens in practice is that we live in an imperfect world. Everyone knows that companies and even financial institutions fail, and calculations of the future are wrong. What people do is to develop systems that don’t fall apart when people’s calculations are wrong. Suppose people think that the future growth of the economy is 5%, but it turns out to be 2% or 10%. Someone has to absorb the loss, and modern banking involves trying to figure out who absorbs the losses if you are wrong about the future, because you are wrong about the future.
moldbug: you could associate every payment the balance sheet expects to receive with a date and an expected quantity (and perhaps, to get really fancy, a probability distribution), and every payment it is contractually obligated to make with a date and a quantity.
People try to do this. The trouble is that you run into counterparty risk. What happens if someone is contractually obligated to make a payment with a date an quantity, and they don’t. In that case, you have to have provision for figuring out who eats the loss.
moldbug: In today’s world, in which central banks provide ultimate backstop liquidity, lenders have no motivation to demand dimensional solvency from financial intermediaries.
They do because the Fed will shut the bank down if it is taking too many risks. What happens in practice is that because the Fed knows that it is ultimately responsible for a loss, that the Fed watches the big banks like hawks to make sure that the banks don’t have large risk exposures. The big banks then watch the little banks and hedge funds like hawks to make sure that the little banks and hedge funds don’t have large risk exposures.
moldbug: With a fixed money supply, however, I believe that a rational investor would indeed demand dimensional, ie maturity-matched, accounting. Otherwise the risk of loss in a bank run is considerable. It certainly outweighs the prospective gains from receiving long returns on a short term.
Trouble is that people aren’t rational. People do have a habit of investing in stupid things that are clearly going to result in a loss for most people, because most people think that they are special and the rules that apply to most people don’t apply to them. One reason that I dislike social systems based on thought is that they try to create a “new man’ that behaves differently from how people actually do behave. If you try to fix the money supply, people acting out of greed will figure out clever ways of expanding it, and if you try to crack down using legal methods then you end up in that cycle that creates socialist hells because you are trying to fit people to theories rather than fitting theories to people.
Moldbug,
This is anon(2):
If the money supply is kept fixed and we assume a positive interest rate we must also assume negative returns for some entities to keep the money supply constant.
Assuming people don’t want to have negative returns they will stop lending and would hoard cash knowing that their money will become more valuable because of productivity increases.
I am a fan of Austrian economics but have never understood how they work their way out of this dilemma.
moldbug,
This is still too interesting to put down.
Your comparative finance comment is right on. I’d expand it to comparative economics/finance/accounting paradigms – as well as inter-temporal comparisons within each discipline.
Accounting doesn’t constrain economics and finance. But the extension of accounting to these dimensions is desirable, as you suggest. Accounting is only a prison for the uncreative. It is instrumental for the creative. This is evident in cultural tension among various disciplines, all of which rely to some degree on some appropriate extension of accounting discipline. (I am not an accountant.)
As twofish notes, bank liquidity accounting systems are in fact surprisingly sophisticated, and they do incorporate the timing of cash flows, their contingencies, their risks, and their scenarios in bank liquidity management systems.
I agree that “dimensional insolvency” would be the logical implication of maturity mismatches when one assumes no “rollover”. That’s an important assumption/constraint. And fixing the money supply reduces the probability of mismatch rollover, and increases the probability of such insolvency. Fixing the money supply is permanently tight monetary policy when compared to today’s system. Permanent tightness requires permanent discipline.
A suite of related (concluding?) question(s):
The matched maturity paradigm strikes me as a risk free system in the dimension of liquidity -
If this is desirable, why should the system also not be risk free in all other dimensions – credit risk, interest rate risk, foreign exchange risk, etc?
And if the system is entirely risk free, what is its purpose?
More specifically, what is the purpose of bank capital in such a risk free system?
And if the system is not risk free, why should there be 0 liquidity risk while other risks are allowed?
And if the normal purpose of bank capital is to support risk taking, why shouldn’t a portion of this capital support liquidity risk?
These are all excellent questions. But there are a lot of them! Let me see if I can fold a few questions into one answer.
First, as we’ve agreed, we are comparing apples and oranges here. Apples: bank accounting in the real financial system that exists in the real world today, with an elastic fiat currency and a central bank which acts a lender of last resort. Oranges: bank accounting in an imaginary financial system that does not exist today, with an inelastic metallic or fixed-supply virtual currency and no central bank.
It’s useful to compare apples and oranges if your goal is to understand the difference between an apple and an orange. It’s not useful if your goal is to claim that: since oranges are better than apples, we should throw away all our apples; since we already have apples, there is no point in thinking about oranges; since both apples and oranges are round fruit, you can convert the former to the latter by spray-painting them orange; etc.
Apple accounting and orange accounting are just different things. There is no reason to expect there to be any useful intermediate form between them, just as there is none between a plane and a helicopter.
I’ve spent a certain amount of time thinking about oranges. I know very little about apples. I find the exercise of trying to explain oranges to apple experts very productive. I appreciate their patience with the inevitable misunderstandings.
This strikes me as the essential question: if the normal purpose of bank capital is to support risk taking, why shouldn’t a portion of this capital support liquidity risk?
The short answer is that liquidity risk is not measurable entrepreneurial risk, but immeasurable Knightian uncertainty.
This is an assertion that may seem intuitively obvious to some. Others may demand an actual explanation. Let me see if I can provide one.
First: why do we have accounting, rather than nothing? One reason is that accounting is useful for internal management purposes. At a certain point, post-its on your monitor bezel just don’t scale. But if we disregard this, we see that apple accounting and orange accounting have very different purposes.
Apple accounting, as practiced by financial institutions that have direct or indirect liquidity protection (direct = Fed, indirect = Fed-backed bank) exists to satisfy the ultimate source of protection, the State, that it is sponsoring sound investments and not monetizing dodgy loans to someone’s cousin’s emu farm. In other words, it could also be described as regulatory accounting.
Lenders to a financial institution that is regulated and protected do not need to worry about that institution’s balance sheet. Or, to be more precise, the extent to which they need to worry is the complement of the reliability of protection.
For example, the run on Northern Rock happened because British deposit insurance was weak in several ways. For example, it had a low account size cap, which many of its customers exceeded. When this was fixed, the run stopped and the lines disappeared overnight.
The run on SIVs is happening because SIVs, instead of deposit insurance, have liquidity backstop facilities. (At least most do. To anyone who buys paper from an unprotected SIV, all I can say is “pity the fool.”) Contra 2fish, it is not realistic to imagine deposit insurance failing, any more than it is realistic to imagine the US defaulting on T-bills, because the US has an ironclad motive and an ironclad opportunity to print before it defaults. I am not familiar with the contractual details, but it strikes me as considerably easier to imagine a situation in which even a protected SIV defaults and its creditors are not made whole. At least, if this event was unimaginable, I think people would be buying SIV paper.
Orange accounting, which is accounting practiced by unprotected, decentralized financial intermediaries, in a world where the only role of the State is to enforce contracts as written, has a different purpose. An “orange bank” practices accounting solely to satisfy the desires of its creditors – whose every whim we can expect it to cater to. If they want peeled grapes, it will peel grapes.
A creditor is someone who expects future payment events from the bank. In all cases, the creditor needs to know the expected values (using the word “value” in the probability sense, not as in, say, “labor theory of value”) of these payments. A full probability distribution would be even better. If the payments are fixed, creditors will probably also demand covenants tied to the probability of default. Again, the grapes will get peeled.
What does it mean to “know the expected values” (or probability distributions)? Risk exists. The future is inherently unknowable. However, in all cases, the creditor will demand and receive the bank’s estimate of the probability distributions of all its receivables (including, of course, counterparty risk), and its schedule of payments to all creditors. These can be used to compute the probability that the bank will default on or before any time T. If some of this information is proprietary, as is likely, it can be disclosed to a third-party accountant which computes the function and reveals its output, not its input.
Here we get to the distinction between counterparty risk and liquidity risk.
Counterparty risk is entrepreneurially measurable. To measure the risk that any instrument will default, just sell it on a free market. Or to be more precise, price it against a risk-free instrument of the same maturity, separating time preference from default risk.
The market may of course err. But anyone who finds patterns of error will win and anyone who misses them will lose. It thus selects for “price makers” who are as good as humanly possible at pricing, and whose efforts “price takers” can draft off.
But there is no place for liquidity risk in orange accounting. To see why not, let’s try to put it in and see why it doesn’t fly. Call the experiment “lemon accounting.”
In lemon accounting, the bank informs its creditors that although its cashflow structure will not allow it to satisfy all its creditors at time T, based on historical patterns of behavior it expects a certain percentage of creditors to roll over their loans, or to find new creditors who will assume the old loans, or if this doesn’t work to find buyers who will pay cash for its assets. All three of these cases are, as I have noted, basically the same thing.
As the Russians put it, doveryai no proveryai – trust, but verify. The reason liquidity risk is Knightian and counterparty risk is entrepreneurial is that you can verify the latter, whereas you have to trust the former. There is no way to construct a market that assesses liquidity risk.
Worse, liquidity risk is Knightian for an even more obvious reason. It incorporates a feedback loop. The bank’s estimate of its liquidity risk determines its solvency, and its solvency determines its liquidity risk – since creditors of an insolvent institution will refuse to roll over by definition.
The usual neoclassical theory of bank runs, due to Diamond and Dybvig I think, treats this as a multiple equilibrium. But since creditors have no reason to subject themselves to Knightian uncertainty, without protection I think “multiple” is overdoing it. There is only one equilibrium and it’s not the one you want it to be.
Thus, rational lenders to unprotected financial intermediaries will prefer orange accounting to lemon accounting. Lemon accounting, which accepts maturity mismatching, promises higher returns but tends to collapse with Knightian uncertainty. Orange accounting is not safe, but it fails only when the market’s entrepreneurial estimate of default risk errs.
If the above analysis is correct, in a free-market economy with an inelastic money supply, no central bank, and no administrative interference with private contracts, we would expect orange accounting to exist and we would expect lemon accounting to not exist. The two are easy to distinguish, and since a rational lender will prefer the former, it will be hard to make a business out of the latter. Whether lemon accounting should actually be illegal, as orthodox Austrians prefer, is a political question, not an economic one.
2fish,
The above should answer – or at least respond to – most of your questions. But here are some others.
For example, the amount of Deutsche Marks is capped. No more Deutsche Marks are being printed, yet this hasn’t resulted in a increase in the value of Deutsche Marks.
The DM was not abandoned – it was converted into the euro. The German state defined a price ratio between DM and euro, just as it did between DM and Ostmark. It used its sovereign power to enforce all contracts in DM at the euro rate. It converted all tax obligations in DM into obligations in euro. This was a case of renaming and redenominating a currency, not particularly different from the conversion of 1M old Turkish lira to 1 new Turkish lira.
A better example is the Somali shilling, which held its value long after the state that printed it disappeared, although I believe entrepreneurial Somalis have found a way to print new ones and the currency has since deteriorated. I believe Czarist currency hung on in the same way for a while.
The state certainly has the power to create demand for a currency – for example, by demanding it in payment of taxes. It also has the power to destroy demand – for example, by nullifying private contractual obligations to deliver it, as FDR did with the gold clauses. (Some of us economic royalists have never forgiven That Man for this one.) However, it does not have the power to violate the principle of supply and demand, any more than it can set the value of pi.
Why? I’m *selling* 30-years notes, not buying them. Presumably anyone that wants to buy a 30-year old has no need for present cash otherwise they wouldn’t be buying a 30 year note.
Not in a maturity-mismatched financial system with state protection. In a classic, Wonderful-Life style mortgage bank, checkbook depositors who demand mature, T=0 cash fund long-term mortgages. (Mr. Potter was right!)
anon(2),
If the money supply is kept fixed and we assume a positive interest rate we must also assume negative returns for some entities to keep the money supply constant.
I disagree. Certainly some people will fail and generate entrepreneurial losses. But the main source of positive returns on capital, in a closed-loop financial system, is simply people who spend their savings.
After all, the only reason to save is so that you can spend later. If there is no pattern of saving and then spending, you won’t see profitable investment. But in this case there is no need for a monetary system at all.
One way to think about an economy with a fixed money supply is to imagine that economic calculation was performed not in terms of nominal dollars, not in terms of “real” dollars adjusted by a causally irrelevant price index, but in terms of fractions of the dollar supply. That way, printing new dollars is just a way to transfer dollars from existing moneyholders to the printer’s beneficiary, and the money supply is always fixed at 1.
Intuitively, it’s easy to see that productive economic activity should not depend on these kinds of involuntary transfers.
Of course, in an economy with liquidity protection, precisely estimating the supply of dollars at any given maturity, whether 0 or some longer term, is impossible, because not all protection is perfect, and imperfect protection admits Knightian uncertainty. Checking deposits are perfectly protected, SIV paper is not.
However, we can imagine an economy without liquidity protection and without a fixed money supply. A metallic currency, which expands due to mining, is a good example. Mining is to metallic money as counterfeiting is to paper money. The only reason that metallic currencies work, or at least worked, so well, is that mining is such an enormous pain in the ass – for sovereign and nonsovereign entities alike.
2fish,
The big problem I have with Austrian theories of credit is that it fails to deal in an optimal with way with the fact that we have no idea what the future value of money really is. For example, suppose 10 years from now someone discovers cold fusion. You would have a massive increase in the total amount of wealth available in world. Suppose 10 years from now, the earth gets hit by an asteroiod, you have a massive decrease in the total amount of wealth avaliable in the world. Those massive increases or decreases in wealth have to be matched by massive increases and decreases in the money supply.
Why?
The implicit assumption is that money is a measure of wealth, or a measure of value, or whatever. Indeed it is sometimes useful to think of it this way. But it can also be very confusing.
The Austrian view is that money – whether paper, metallic, or digital – is just a commodity. There is no objective way to measure wealth, value, happiness, etc. There is no such thing as value, there is only price, and prices are constantly changing. Etc, etc, etc.
For example, there is no objective way to compare the “value” of a 1907 dollar, or even a 2006 dollar, to that of a 2007 dollar. We cannot establish a market exchange rate between these two goods, because we do not have time machines and we can’t exchange them. If we found out that there was intelligent life on Jupiter and they called their currency the dollar, same thing – until we can trade with Jupiter, there is no exchange rate between Earth and Jupiter dollars.
In 2007 you can buy an iPhone. In 2006 you couldn’t. In some vague sense this is an increase in wealth. But there is no reason for it to cause any kind of financial instability, and there is certainly no reason that a bunch of new dollars need to be printed to sop up the new iPhone supply.
BTW, I get the impression that this position of liking Austrian economics in theory and in general, but not being able to relate the strict orthodox Austrian worldview to the real world today, is very, very common in the financial world.
There are a number of substantial hurdles to reading the Austrians. First and foremost is the fact that the basic 20th-century Austrian text, Mises’ Theory of Money and Credit, was published in the Austro-Hungarian Empire in 1912. It was basically written to suggest monetary reforms for a time and a world that no longer exist.
There are a lot of great Austrians publishing today, but they tend to work within the conceptual and terminological framework that Mises set out in 1912. This leaves the modern reader with two orthogonal problems to disentangle: the difference between apple economics and orange economics, and the difference between Hapsburg finance and modern finance. The difficulty of this task is not lessened by pretending that it doesn’t exist.
I still think the best way to learn Austrian economics is to start with Theory of Money and Credit, then skip to Rothbard’s 1962 Man, Economy and State, then Jesus Huerta de Soto’s modern Money, Bank Credit, and Economic Cycles. But note that none of these books is written for the modern financial reader – they really need to be interpreted as their own tradition. The easiest way to understand that tradition is to learn it on its own terms, then try to map it to 2007 reality.
2fish,
They do because the Fed will shut the bank down if it is taking too many risks. What happens in practice is that because the Fed knows that it is ultimately responsible for a loss, that the Fed watches the big banks like hawks to make sure that the banks don’t have large risk exposures. The big banks then watch the little banks and hedge funds like hawks to make sure that the little banks and hedge funds don’t have large risk exposures.
Note the number of essentially judgmental, even aesthetic, adjectives in the description of this regulatory system. Indeed, any regulatory system involved in any sort of protection or guarantee of the value of any security is a price-fixing system by definition. Mises’ calculation theorem is exactly what it succumbs to.
Again, the Austrian business cycle theorem, if you put it in modern terms, says that in a world with a fixed money supply and no official protection of loans, you will not see systematic price fluctuations, whether in consumer or “asset” prices.
Note that the neoclassicals, who essentially achieved power by stabbing the Austrians in the intradepartmental back (many prominent neoclassicals, such as Hicks, Haberler, Robbins, etc, had started out as Austrians, or at least “literary” subjectivist marginalists, then surfed the wave and became neoclassicals, in a sort of New Deal version of Czeslaw Milosz’s Alpha. Many of these people were in fact Mises’ own students – it’s a zoo out there, boys and girls) – note that the neoclassicals have been promising to stabilize business cycles for at least the last 75 years if not the last century. And still we seem to see them.
And meanwhile: the pest approaches.
moldbug: This strikes me as the essential question: if the normal purpose of bank capital is to support risk taking, why shouldn’t a portion of this capital support liquidity risk?
It does. In fact one can argue that the sole purpose of the banks capital is to support liquidity risk. One has to distinguish between the “bank’s capital” and the liabilities that the bank holds to its depositors. If the bank reneges on the promises it makes to its depositors, this is very, very bad. If the bank loses its own capital, then no one except for the shareholders mind. If there is a run on the bank, and the bank can’t liquidate its loan portfolio, the first people to lose the money are the shareholders.
moldbug: Lenders to a financial institution that is regulated and protected do not need to worry about that institution’s balance sheet.
Actually they do. In most cases, government protection doesn’t extend to most loans people make to banks. Government insurance is merely a band-aid that adds some stability in the system.
moldbug: However, in all cases, the creditor will demand and receive the bank’s estimate of the probability distributions of all its receivables (including, of course, counterparty risk), and its schedule of payments to all creditors.
Which is what people in finance do. The trouble with these estimates is that they often turn out to be wrong.
moldbug: But anyone who finds patterns of error will win and anyone who misses them will lose. It thus selects for “price makers” who are as good as humanly possible at pricing, and whose efforts “price takers” can draft off.
But in the end there is unknowable and irreducible risk in the world. People in banks spend a huge amount of time building and perfecting default models, but in the end there is a lot which is unknowable.
moldbug: Orange accounting is not safe, but it fails only when the market’s entrepreneurial estimate of default risk errs.
Which happens all of the time. There is an active market for credit default swaps where you can buy and sell credit. These give you good market estimates for default, which are often wrong.
moldbug: However, you would see a considerable shift away from the construction of exotic instruments and the prediction of cyclically unstable feedback loops.
On the contrary. There reason that you have exotic instruments is that people are willing to accept certain risks and not willing to accept others. Also, no one seriously thinks that they can predict feedback loops.
Most of banking today involves dealing with the maturity matching problem that you are talking about. Suppose you are a regional bank with liabilities consisting of checking account deposits and assets consisting of 30 year mortgages. This is bad because if your depositors all withdraw money at the same time, you are sunk. What you can do is to buy option contracts in which people agree to buy your mortgages at an agreed price. That way if people suddenly withdraw money, you exercise those options, and get the cash you need to pay your depositors.
moldbug: In a classic, Wonderful-Life style mortgage bank, checkbook depositors who demand mature, T=0 cash fund long-term mortgages.
Those banks don’t exist anymore…….
as Frank Shostak shows here, the idea of a ‘global savings glut’ being responsible for the US current account deficit is most definitely wrong. as it were, it is best understood as misdirection by the current Fed chief (who came up with the idea). the problem lies in the ongoing confusion between money and savings. the real pool of funding can’t be measured, but how it comes into being can be explained. the printing presses of the world’s central banks only damage this pool, by furthering consumption without preceding production. i encourage everyone to read Shostak’s elegant explanation of the issue.
http://www.mises.org/story/1882
moldbug: In 2007 you can buy an iPhone. In 2006 you couldn’t. In some vague sense this is an increase in wealth.
It’s not a vague sense. There is this object that people are willing to pay cash money that they weren’t willing to pay money for before.
moldbug: But there is no reason for it to cause any kind of financial instability, and there is certainly no reason that a bunch of new dollars need to be printed to sop up the new iPhone supply.
Yes there is. If there is no way to compare 2006 prices with 2007 or 2008 prices then savings is impossible since you don’t know whether the one dollar you save in the bank today will be worth anything in 2007 or 2008.
So there needs to be a mechanism so that a dollar in 2007 will buy what people in 2006 thought that a dollar will buy at that time. This means adjusting the supply of dollars so that the value of each dollar in the future matches the expectation of that value in the past. This is hard to do because the amount of future wealth is inherently an unknowable quantity.
The problem is that I think you are mistaking rulers with the thing being measured. A dollar is merely a ruler for measuring economic value. If you want stable prices then the number of dollars available needs to match the amount of wealth available in the economy.
moldbug: Indeed, any regulatory system involved in any sort of protection or guarantee of the value of any security is a price-fixing system by definition.
That’s not what the Fed does. It doesn’t offer protection or guarantee of the price of any security. What it does do is to make sure that banks are managing risk and reporting results honestly.
moldbug: Again, the Austrian business cycle theorem, if you put it in modern terms, says that in a world with a fixed money supply and no official protection of loans, you will not see systematic price fluctuations, whether in consumer or “asset” prices.
And that is just wrong. If you increase the amount of wealth in the economy and the money supply remains fixed, then prices have to go down. Imagine an economy with 100 erasers and $100 dollars. Each eraser is worth one dollar. If you have 200 erasers and $100 dollars, then each eraser is worth 0.50.
moldbug: note that the neoclassicals have been promising to stabilize business cycles for at least the last 75 years if not the last century.
And you can’t, because the amount of wealth available changes from second to second whereas government policies take months to have an effect. You can’t eliminate the business cycle because the calculations involved are too complex. You can put some dampers to keep things from getting too far out of control.
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moldbug,
Your analysis of the bank capital/liquidity question makes sense. In fact, banks actually treat liquidity risk in a way that is consistent with your answer. They don’t allocate capital in the same specific way to liquidity risk as they do for other risks through ‘value at risk’ based capital calculations – at least, not for the type of liquidity risk we are discussing, which is maturity mismatch risk. They do incorporate ‘time to close’ calculations in assessing the risk capital for tradable instruments, but this is a different idea than bank funding liquidity risk.
I’ve struggled in the past with the distinction between risk and Knightian uncertainty. The Wiki entry on this was surprising, accurate or inaccurate as it may be. I had always thought the distinction typically mandated that risk be asymmetrically adverse and asymmetrically measurable, whereas uncertainty included a full range of outcomes, favorable or adverse, while being asymmetrically unmeasurable. I think this is consistent with the way Knight approached it. These are non-intersecting pieces whose sum is an incomplete picture of a larger universe. Such a framework ignores favorable outcomes that are measurable. This is an awkward and unappealing Boolean partition.
The Wiki entry refers to a more coherent framework (Hubbard 2007), where uncertainty is defined to include outcomes that are favorable or adverse, measurable or unmeasurable. Risk is defined as the adverse, measurable subset of these outcomes. This is much cleaner.
Either way, I can see how you relate liquidity risk to Knightian uncertainty, as unmeasurable uncertainty. Perhaps we should call it liquidity uncertainty.
I agree it seems irrational for creditors to subject themselves to Knightian uncertainty in a system (orange) without regulatory protection. Of course, creditors operating in an unprotected orange system have no rational choice about whether they operate in an apple or orange system. These are mutually exclusive combinations of protection and liquidity structures. The system is a given.
I would define the ‘apple put’ as a complex that includes deposit insurance, SIV liquidity backstops, and central bank interest rate put options (aka Greenspan/Bernanke puts), among other things. This is a complex of moral hazards.
The orange world owns no such puts. I can see why it admits no deliberate maturity mismatches. But as you say, a given unregulated orange system can still fail when “the market’s entrepreneurial estimate of default risk errs”.
One variation – the possibility of such failure suggests to me that counterparty risk is a source of contingent liquidity uncertainty. If the expected cash flow is not forthcoming due to an error in market estimate, there will be a mismatch between the cash flow expected by the creditor and the realized cash flow. This becomes a liquidity event to the degree that an intended match becomes an unintended mismatch. It is Knightian in the sense that the final accuracy of the market’s current counterparty risk assessment is uncertain and unmeasurable, due to unknown or unconceived future event possibilities.
Moreover, the failure of a single counterparty in a portfolio of bank assets may not result in the immediate insolvency of the bank. Yet it would result in a pure liquidity event in an otherwise matched maturity bank. Such an event might have knock-on implications for bank solvency risk in the same way as a liquidity event resulting from a deliberate maturity mismatch.
So orange operators have no real choice about the existence of liquidity uncertainty – in the form of contingent liquidity uncertainty – once they accept counterparty risk. In this sense, all orange systems fade to partial lemon due to contingent liquidity uncertainty.
Granted, an orange system with only contingent liquidity uncertainty (no deliberate maturity mismatches) has less risk than the corresponding apple system with the same contingent liquidity plus deliberate maturity mismatches. In this sense, I concur with your closing summary:
“Thus, rational lenders to unprotected financial intermediaries will prefer orange accounting to lemon accounting. Lemon accounting, which accepts maturity mismatching, promises higher returns but tends to collapse with Knightian uncertainty. Orange accounting is not safe, but it fails only when the market’s entrepreneurial estimate of default risk errs.”
We could say that liquidity risk exists at the instant where liquidity uncertainty becomes a liquidity event. It is then adverse and measurable. Such an event can result from a deliberate apple maturity mismatch or a mismatch resulting from counterparty failure under either apple or orange systems. Either way, there’s a liquidity event in the form of a mismatch.
Unique apple liquidity uncertainty exposes the bank unnecessarily to a potential acceleration of liquidity events, triggered by the fear of counterparty failure combined with the opportunity to actualize that fear at the juncture of a deliberate mismatch. The intervention of authorities is generally designed to ‘buy time’ for the possibility that the expectation of default risk at that point is wrong.
Additional liquidity uncertainty is present contingently in both apple and orange systems due to the possibility of actual counterparty failure triggering an actual liquidity event. There are no authorities to intervene and no systematic put option available in the orange case. But there does seem to be a liquidity event that may or may not unnecessarily exacerbate broader bank solvency issues.
Anon,
Thanks again for this interesting discussion. When we’re done, please feel free to ping me via email. Or at least select an RGE nym – the process is not difficult. Anonymity is wonderful, but hard to thank properly.
I find your hypothesis of involuntary maturity mismatches as the consequence of market errors in assessing default (counterparty) risk fascinating. If you are right about this, you are right that liquidity insurance can still be – at least in theory – a stabilizing force in a closed-loop financial system. (I also really like your succinct and general definition of the “apple put.”)
(”Closed-loop” has a better sound to my ear than “fixed-money-supply,” which is simply too long, “hard-money,” which is imprecise and sounds evil, or “sound-money,” which is historically correct but imprecise, and makes its opposite sound evil. No one ever got anywhere by telling anyone they are evil.)
However, I don’t think this variant is right. Let me explain why.
Markets err. We know this. We expect errors in markets. When we look at the price of June 2008 wheat in October 2007, then wait until June 2008 arrives, then look at the spot market for wheat, it would be very surprising if these two prices are exactly the same.
However, forgetting Knightian liquidity events for a moment, we do not expect significant patterns of systematic price miscalculation in free markets. This is not because of any magical force associated with the M-word. It is because a large number of market participants undergo a Darwinian selection process which tends to reward and promote those who correctly identify patterns, and punish and dismiss those who incorrectly misidentify them. Since correctly identifying a pattern invokes arbitrage and destroys the pattern, patterns tend not to survive. Even if many market participants are misguided amateurs whose errors are predictable for some crude behavioral reason, the system will simply evolve a corresponding set of experts who feed off them.
So if and only if all price signals are generated by an entrepreneurial unhampered market for future contingencies, we should not expect the market to make systematic price errors.
Moreover, there is no reason why a really sophisticated 21st-century market should not be able to generate a price signal with error bars. Ie, with a full probability distribution, also constructed by entrepreneurial selection. Of course, some of this is done already with volatility trading, but the present financial market was never designed to generate good volatility signals and I suspect it could be considerably improved in this department.
If this is true, in a closed-loop financial system it should be possible to eliminate cascading failures of counterparty risk, aka snowballing defaults, by good old-fashioned diversification. The central limit theorem is your friend.
The problem with diversification in a world that includes Knightian liquidity events is that these Knightian events are not just the cause of incalculable price fluctuations in individual securities. Rather, they cause patterns of fluctuation that one usually hears described as “correlation” when securities are on the way up, and “contagion” when they are on the way down. Same effect, different sign.
I think it would be a mistake to assume that all correlated unpredictable fluctuations are the result of liquidity instabilities driven by maturity mismatching. After all, there are also monetary instabilities which are the consequence of similar game-theoretic macro herd behavior problems. For example, in a world without central banks, forex rates would exhibit momentum feedback effects that would lead to the victory of a single currency and the demonetization of all others, much the way gold defeated silver in the 19th century. But this too can be categorized as a symptom of open-loop finance.
So I remain doggedly committed to my orthodox ideological dogma, and I claim that in a closed-loop financial system, the efficient market hypothesis is actually correct. At least I see no reason why it wouldn’t be correct, which is more than I can say for this thing we have now. That said, of course many people have tried to redesign the world and they have all failed, often disastrously – as 2fish points out. Caveat lector.
See also Nicholas Taleb’s rant along vaguely similar lines. Taleb may not be barking up exactly the right tree, but he is surely in the right forest.
2fish,
You are expressing the classic points of Fisher-Friedman price-stability theory. This view is certainly conventional – or at least more conventional than my neo-Austrian approach. So you are right in assuming that it is my burden to argue that it is wrong. However, I think the burden is lighter than you may suspect.
If there is no way to compare 2006 prices with 2007 or 2008 prices then savings is impossible since you don’t know whether the one dollar you save in the bank today will be worth anything in 2007 or 2008.
Okay. Let’s say my name is Ricky and I have a problem. I have goods in 2006, and I want to exchange them for goods in 2008. How do I solve this problem?
One way is to simply hold onto my 2006 goods, keep them in my backyard for a couple of years, and exchange them for other stuff in 2008. Perhaps for some people this is possible. But I, Ricky, am a fisherman. And I am quite confident that no one in 2008 will want to exchange an iPhone for any quantity of rotting, two-year-old salmon.
Therefore, I have a simple solution. I exchange my salmon for a storable good G which I expect to be exchangeable for the goods I want in 2008.
The problem of saving is the problem of selecting between any two such goods. For example, the trivial good G0 is simply the original, ie, a pile of dead salmon. Any good Ga is a better good for intermediate exchange than any good Gb if, counting storage costs, the price ratio Ga/Gb:(2008) exceeds the price ratio Ga/Gb:(2006). For example, if Gb is a pile of salmon, we notice that almost any Ga is superior, because in 2008 said pile of salmon will be no asset but a liability.
(The question of how goods with low intrinsic usability, such as precious metals, pieces of stamped paper, Yap stones, etc, etc, become the indirect exchange good of choice is mildly nontrivial and depends on herd-behavior game theory. See under Misesian regression, although I find the approach of Menger and Mises too focused on circulation and not enough on savings, and it also relies on a rather cumbersome approach which anticipates game theory, one of the few useful products of 20th-century mathematical economics.)
In 2006 we cannot know the value of Ga/Gb:2008. But we can certainly use entrepreneurial methods to predict it, because it is a precise, well-defined number that will certainly be known in 2008.
The important point is to note that the decision process between any two goods Ga and Gb is completely orthogonal to the set of desirable consumer goods that is offered in 2008. If I, Ricky, want to know whether to exchange my 2006 salmon for 2006 dollars or for 2006 euros, the only question I have to answer is how the dollar-euro rate will change over the next two years. The iPhone has simply dropped out of the equation.
Let’s say I, Ricky, am not only a good fisherman but an even better forex man, and so I exchange my salmon not for 2006 dollars but for 2006 euros. Can I do better?
Yes, I can. Because rather than storing 2006 euros, I can store a 2006 promise of 2008 euros. Assuming I live in a capitalist free-market economy in which productive enterprise exists, the expected value – in terms of 2008 euros – of a 2008 euro note should exceed the expected value – in terms of 2008 euros – of the 2006 euros that I otherwise would have kept under the mattress.
(The word “saving” has become quite an ambiguous way to describe this pattern of behavior. Whatever I do, I, Ricky, am storing some good. A pattern of storing currency can be called “hoarding,” and a pattern of storing promises of currency can be called “investing.”
There are sound subjective motivations for both of these behaviors. Neither is in any sense antisocial. If you feel that hoarding is somehow evil, note that while this puts you in the same camp as most famous 20th-century economists, it also puts you in the same camp as Ezra Pound.
But in any case, note that nothing in this decision process required me, Ricky, to make any kind of comparison between 2006 goods and 2008 goods, 2006 prices and 2008 prices, or to consider any other exchange ratio which is not precisely defined and entrepreneurially predictable.
You persist in using terms associated with objective price theory, such as worth and value. At one software company I used to work for, people had developed the odd habit of saying, when they were in a meeting and they thought someone else was too inside the box, “you’re just clinging to your linear, Western way of thinking.” Needless to say, this phrase was always uttered ironically. And it never had anything to do with anyone’s ethnicity or national origin, unless “Berkeley” counts as either.
But that said: “you’re just clinging to your linear, Western way of thinking.” If you cease to regard this thing we call the “dollar” as an objective philosophical or even mathematical construct, and see it instead as a mere physical object, whose purpose within this wheel of suffering we call the world is merely to exist, which has no meaning other than itself, I am confident that you will find it easier to derive your macro conclusions from patterns of human action.
2fish, you also write:
moldbug: Again, the Austrian business cycle theorem, if you put it in modern terms, says that in a world with a fixed money supply and no official protection of loans, you will not see systematic price fluctuations, whether in consumer or “asset” prices.
And that is just wrong. If you increase the amount of wealth in the economy and the money supply remains fixed, then prices have to go down. Imagine an economy with 100 erasers and $100 dollars. Each eraser is worth one dollar. If you have 200 erasers and $100 dollars, then each eraser is worth 0.50.
I think above I have explained more precisely what I meant by “systematic price fluctuations.” This is certainly a phrase that can be interpreted ambiguously, and I should have defined it better when I first used it. In case it’s still not clear, however, let me try and express it again.
Prices change. They change because of the fundamental instabilities I have been describing, but they also change because reality changes. If we eliminate the former we will still see the latter.
A classic example of price change over time is Moore’s law: the drop in the price of a transistor. A Friedmanite would call this “deflation.”
Note that, despite the appalling deflation the semiconductor industry has experienced over the last 40 years, it somehow manages to remain in business. It even makes substantial long-term capital investments. To anyone whose sense of finance is based on Fisher-Friedman price stability, this must be something of a puzzle. Transistors are the deflationary version of Deinococcus radiodurans. How in the world can this be? It’s like shooting a bullet at a piece of tinfoil, and having it bounce back at you.
Of course, a transistor is not really a fungible commodity. A CPU is a loose pile of perfectly interchangeable, industry-standard transistors. But one could imagine a real world in which it was. And this real world would still obey the laws of economics.
The answer is that the price of transistors is not fixed, but it is predictable. In fact, we have a rule for this prediction – Moore’s law. If transistors were a fungible commodity, we could buy and sell transistor futures, and we could assess the market’s prediction of whether Moore’s law will or will not continue.
Because the price of transistors is predictable, it is possible for entrepreneurs to calculate the return on investment of a new semiconductor fab. If this return is positive, new fabs will be built. If it is not, they won’t.
Note that this calculation is computed not in “wealth” or in “value,” but merely in money, a good like any other. The question is whether I, Ricky, can expect to convert N 2006 dollars to (N + x) 2008 dollars by investing in a semi fab. If not, we will see no new semi fabs.
What I mean by “fluctuations” is immeasurably uncertain events that upset this system of price prediction and cause patterns of gross systematic error, which are predictable only in hindsight. Ie: the business cycle.
Note that the semiconductor industry is notoriously sensitive to the business cycle. This is because success in the semiconductor industry really does depend on long-range price predictions. Even if semiconductor executives were also experts in finance and banking, they could not predict the business cycle, because experts in finance and banking cannot predict the business cycle. But they are not experts in finance and banking, nor should they be, and when the cycle turns they often find themselves wishing they had done A when in fact they did B. Hence the deadweight efficiency loss of unstable finance.
Another simple example is trends in the stock market. Obviously, equities exhibit correlated trends. Anyone who is capable of ignoring this must be a much better mathematician than me.
In a stable financial system, overall trends in equity prices, or interest rates, or any other such broad aggregate, will (I predict) be rare. And when we do see them, they will be due to broad and unanticipated changes in the personal preferences of large numbers of humans. Because history only happens once, we cannot expect the market to be perfect – the prices it generates are only the best guesses about the future that we can produce right now. A doomsday asteroid may indeed appear. But this doesn’t mean we have to live with a never-ending stream of financial panics caused by the breakdown of administrative pricing systems.
@anonymous
In jurisdictions where interest on borrowings are tax deductible and there is no ceiling on the amount of interest deducted,one can effectively ask a bank to grant a loan whose proceeds would go to one’s savings account;the tax avoided more than compensates the interest rate gap between the loan and the savings accounts!The bank’s balance sheet would show an increase in savings as liabilities but this does not constitute
“saving” per se .Savings statistics are
thus distorted and lead to erroneous
interpretation of macro economic data.
“the US basically produces nothing”
“This is a great opportunity for Europe …. Europe will be far richer as a result – unlike a certain neighbor across the pond.
“History has a way of repeating itself, soon a loaf of bread will be the equilvalent monetary value to US dollars carried in a wheelbarrel.”
I come back to this otherwise excellent blog about once every few weeks to read Brad’s insight, and marvel at the ignorant jingoism of its similarly otherwise informed (with some exception) commenters.
moldbug: But I, Ricky, am a fisherman. And I am quite confident that no one in 2008 will want to exchange an iPhone for any quantity of rotting, two-year-old salmon.
This isn’t true. Lots of people want two year old rotting salmon. Farmers. Marine biologists. If you have ten tons of rotting salmon, you might be able to sell it to a farmer for fertilizer in exchange for an iPhone. Or not.
In order to figure out whether or not to sell the fish and exchange it for a more durable object or let it rot, you need to do an economic calculation, and this economic calculation is impossible without a unit of measure. That unit of measure could be Euros, dollars, ounces of gold, or anything else. To keep this unit of measure useful so that you can do calculations across time, it is useful to keep the value constant and predictable.
Once you have a ruler (lets call them dollars), it becomes possible to do calculations regarding value. I can calculate how many ounces of gold to trade for salmon or to make calculations regarding time value.
moldbug: It is because a large number of market participants undergo a Darwinian selection process which tends to reward and promote those who correctly identify patterns, and punish and dismiss those who incorrectly misidentify them.
The people that tend to survive the markets are people who don’t try very hard to make firm predictions and who respect the fundamental uncertainty and unpredictability of reality.
moldbug,
Thanks for the kind response. I’ll keep the anon tag temporarily for continuity …
If we compare non-market forces in an administered (apple) system with the free market system (orange), it makes intuitive sense that the former will be subject to more Knightian uncertainty, and the latter will be more efficient. The presence of the Fed and the PboC for example are surely factors of Knightian uncertainty.
A free market system should exhibit more continuity and lower volatility over time, as there would be no ongoing gaming of the ‘apple puts’ and so forth. This seems consistent with a more efficient market.
Conversely, when monetary authorities aim to reduce economic and inflation volatilities, monetary volatility inevitably follows. This includes cycles of overshooting. So they impede efficiency with a sort of feedback loop in their own actions. The more general administered “apple put” is a complex of pricing asymmetry (an option) that interrupts otherwise free market probability beliefs.
Another larger category of asymmetry – “information asymmetry” – has been in vogue recently. This is an old idea that is fundamental to the operation of a bank. Originally, a bank’s advantage in information asymmetry constituted value inherent in the intermediation services it provided. Now it’s become a beast of opacity, hidden from creditors and investors. This evolution was channeled largely by securitization. Securitization strips banks of their former integrating role in capitalizing information asymmetry. It replaces this with a partial role (origination/servicing) in a chain of relatively independent operators who capitalize different subsets of the same total bundle of information asymmetry. The result is a more complex chain of information asymmetries that was previously the case with a bank.
While the first kind of asymmetry – the “apple” put – would not be present in a purely free market, I’m not sure about the second. Perhaps the natural evolution of free markets toward more granularity and differentiation produces waves of information asymmetry that inevitably interfere with otherwise smoothly interacting risk probabilities. Both types are inherently hidden from the broad market, thereby inducing Knightian uncertainty.
Taleb’s theme is true. Too many risk management systems are dense black holes of stunted statistical analysis – necessary to a degree, but in no way sufficient, and to the degree that their insufficiency is unappreciated and their necessity overemphasized, extremely dangerous.
I particularly like one Mendelbrot quote on this subject:
“Value at risk is a theory of ocean waves whose swells are forbidden to exceed six feet.”
That says it all.
2fish:
In order to figure out whether or not to sell the fish and exchange it for a more durable object or let it rot, you need to do an economic calculation, and this economic calculation is impossible without a unit of measure. That unit of measure could be Euros, dollars, ounces of gold, or anything else. To keep this unit of measure useful so that you can do calculations across time, it is useful to keep the value constant and predictable.
Again this word “value.” How can you hold something constant when you can’t even construct an objective definition of it?
Every definition of “real” (as in “inflation-adjusted”) that can be constructed – that is, every comparison of prices across time, or any other absolute barrier to exchange – depends on someone’s subjective, aesthetic assessment. These indexes are pure fudge. And who wants fudge in their equation? When you mix numbers and fudge, the result is fudge.
Look again at the calculation of saving I describe above. The goods are actual goods, the prices are actual prices, the numerators and denominators have the same units, etc, etc. And there is no fudge.
anon,
I am vehemently in agreement with the opinion that attempts to “stabilize” markets represent time-delayed feedback. While this is not the only conceivable cause of cyclical behavior, surely it is the most obvious!
In a free financial market, third-party accounting is the treatment for information asymmetry. The trust relationships work like this: the bank trusts the accountant not to reveal its proprietary information, and the bank’s creditor trusts the accountant to evaluate its balance sheet as effectively as if the creditor itself could see everything under the kimono. In principle, the accountant’s estimate of the bank’s financial position should produce all the information the creditor needs to evaluate its prospects of default, while retaining all the information the bank needs to keep a secret. While in practice this may not work perfectly, in practice nothing works perfectly.
As far as cascading waves of default, one way to think of it is to use the analogy of a snowball. For a snowball to get bigger as it rolls downhill, you need two things: snow, and a hill.
Ordinary risk is the snow. The inherent instability of maturity mismatching is the hill. If you have a financial system that does not create demand for long-term money by alchemically synthesizing it from demand for short-term money, an inherently unstable reaction as we’ve seen, you have snow but no hill. In other words, there is no automatic direction in which the system tends to panic. Keep a couple percent as a reserve buffer, and you have a tremendously resilient design.
Today’s financial system has no parallel in history in its ability to diversify risk. In this department, at least, it is like a tough kid who grew up in the ghetto. Perhaps there shouldn’t be a ghetto, but it’s not so bad to be tough.
The key to avoiding Knightian uncertainty is to keep patterns of cause and effect repeatable and analyzable. To overuse a metaphor, no market can predict the path of the hurricane from the butterfly’s wing. If you can get the feedback loops out of the system, you will still see real effects from real events – the doomsday asteroid, and so forth. But even asteroids are insurable risks, and there are no feedback loops involved. An asteroid can change the return on an investment, but changing the return on an investment can’t create an asteroid.
moldbug,
Your analysis is very good; you’re clearer on information asymmetry than I was.
I need more time to consider your ideas on fixed money supply and matched maturities, among others.
Thanks for an excellent discussion – hopefully we can recommence at a later date.
Guest on 2007-10-24 15:54:42
The GDP measure of savings is picked up from income statements, not balance sheets. The transaction in your example wouldn’t appear in savings statistics, and wouldn’t be interpreted as savings. And it shouldn’t be.
Anon,
Thanks for the kind words and for a fun discussion.
You might enjoy Condy Raguet’s 1839 treatise on currency and banking. Raguet scours some strange corners of the world for evidence that hard-money economies are not subject to the business cycle. From p.37:
“Such being the theory of this branch of my subject, I have the satisfaction to state in regard to the practice under it, upon the testimony of a respectable American merchant, who resided and carried on extensive operations for near twenty years at Gibraltar, where there has never been any but a metallic currency, that he never knew during that whole period, such a thing as a general pressure for money. He has known individuals to fail from incautious speculations, or indiscreet advances, or expensive living; but he never saw a time that money was not readily available, at the ordinary rate of interest, by any merchant in good credit. He assured me, that no such thing as a general rise or fall in the prices of commodities or property was known there; and that so satisfied were the inhabitants of the advantages they enjoyed from a metallic currency, although attended by the inconveniences of keeping in iron chests, and of counting large sums in Spanish dollars and doubloons, that several attempts to establish a bank there were put down by almost common consent.”
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