Matt Nolan

It’s about the “right” counterfactual

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In a recent post, Mark Calabria from the Cato Institute took aim at the idea that the Lehman Brothers crisis was the “trigger” for a big crisis.

Now I do not disagree that there was, and would have been, a recession without Lehman Brothers – and even without the uncertainty caused by the lack of clarity around insurance of the shadow banking system which grew post August 2007.  However, these issues, and in turn the failure of Lehman Brothers did make the crisis significantly more severe than it would have been.

He appears to say that the failure of Lehman Brothers was a good thing (Note:  There is nothing wrong with wiping out the company – but the way it was handled, was a big driver of the global slowdown that was to come), and that the US was on the road to recovery post this.  So here we are focusing just on the US, not the contagion to other countries.  His evidence is the following graph:

Employment and consumption stopped declining not long after Lehman Brothers failed, and although the largest declines occurred WHEN Lehman Brothers failed this doesn’t mean the failure caused them – in fact, employment tends to lag the cycle and the drop may well have been the result of prior economic weakness … and the amazingly high fuel prices through the first half of 2008.

Now I agree that there were factors driving a recession prior to the failure of Lehman Brothers – but the impact of Lehman Brothers as an event is captured by asking what would have happened in the absence of the Global Financial Crisis that stemmed from it, and the full blown “bank run” on wholesale financial markets that had been building pressure from the start of 2008.  Going to FRED, grabbing consumption and population, and running a basic time regression in excel no less (so it’s easy to copy) we can get an idea of what the “trend” rate of consumption per capita was during the 1952-2012 period.  Armed with that, we can ask what the percentage difference is between this trend and actual consumption per capita outcomes.  This is:

Something is broken here – I will try to fix that up tonight.  The strange thing is that I can see the graph when editing the post … but it then wont let me do anything with it

Now we can start arguing that consumption per person was too high and a whole bunch of other things if we want to here.  However, this basic analysis clearly shows that the gap between trend consumption and actual consumption, something that should have a tendancy to head back to zero after a recession, actually deterioarted further … and has continued to deteroriate.  We look at business cycles “around trends” not “around levels” given that our counterfactual involves growth – and this makes this post by the Cato institute a bit misleading.

Saying that the downturn, or even the crisis, started with Lehman Brothers is wrong, I agree with the author here – however Lehman Brothers failure started a new dangerous stage of the crisis which, when combined with the persistent institutional failure in Europe, has made sure that the US economy has remained below potential.  A market monetarist would say that the Fed is truly responsible for this in terms of policy action, but even if we were to accept this it is undeniable that it is the “shocks” that have occurred in financial markets are the very things the Fed needs to respond to by “loosening policy”.

It’s failure is indicative of what was underlying the crisis, and the evidence shown in no way suggests that allowing its failure and initially ignoring the quiet, and then full scale, bank runs in wholesale financial markets was good policy.

Matt Nolan

Dealing with debt, financial regulation, and the lender of last resort

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Previously we’ve talked a lot here about the lender of last resort function of a central bank.  In discussions a trade-off is often discussed, whereby having a lender of last resort can help to prevent financial crises when financial intermediaries are suffering from issues of “illiquidity”, but are not “insolvent” – however, the existence of a LOLR can in turn lead to moral hazard … where financial intermediaries and lenders are willing to take on “too much risk” and charger borrowers “too little”.

Although the discussion of these issues has a long history in economics, Thomas Sargent’s article (REPEC) on the issue – and the solution mentioned – are worth reading.

Now we live in a history dependent world.  Yes, we have had a global banking system willing to take on too much risk – due in a large part to issues of asymmetric information and an implicit solution subsidy of risk.  Yes, in this environment debt accumulated, and the existence of debt and the following credit constraints on people with “useful projects” that they could invest in is having a big negative impact – likely much bigger than any “social boost” that may have existed from the additional marginal projects that took place with easy credit.

We have an environment where people think there is a real risk of the failure of financial intermediaries.  Now if we understood “why” we could ask if there is a solution.  What are some reasons:

  1. There is too much debt.  If we saw this as an issue, we could convert bondholders into equity holders in banks.  After all, isn’t a government bailout really just a transfer from non-depositors to depositors in the bank?
  2. There is no trust.  There was a “capital stock” of trust that was built up between financial institutions, a stock that was destroyed and will have to be rebuilt.  This can be expected to keep hurting the efficiency of financial markets for a long time.
  3. Central banks/governments have lost credibility as lenders of last resort.  I think this is compelling – everyone talks about “too big to fail”, but exactly what that means, exactly what the “insurance” is, and exactly how the “insurance” is paid for are questions that are still up in the air. One can use Life Cover Quotes to find the best life insurance provider.
For me the key issue is the last one – as the negative impact of the first two is “endogenously determined” by the credibility of the financial system stemming from regulation.  The fact we have a government monopoly for fiat money, and direct management, combined with a LOLR function, ensures this.
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Note:  Anyone reading here since the crisis has been in full swing will think I lean strongly on the side of constant bailouts.  However, this is far from the case – I only started writing in favour of them once we already had a crisis where this needed to be the case.  In 2007, once the crisis had begun but a few months before Bear Sterns, I was writing like some sort of “purging our evils” Austrian economist.  After Lehman Brother’s collapse, even a half pint analyst like myself saw the issue of a lack of trust even when it was unclear whether there was a bailout or not 😛 (it was interesting reading these old posts, the lack of clarity around what was going on was even worse than I remember!).   By the time what happened was clear, we had switched our tune in favour of bailouts for that period of time – and even I found the ECB’s call to attack moral hazard in the middle of the crisis strange, even though I saw that as a big issue.

This was seen as a major issue coming into the crisis, it was viewed as a key issue during the crisis (I would argue that the efficiency of NGDP targeting would still depend on a banking system without bank runs), and now during these later stages of the crisis it is an issue receiving a lot of research and taken into account for regulation.  Mainstream economics has the tools to understand what has happened, and hopefully policies can be developed that ensure that the next economic crisis is something completely different.

Matt Nolan

Seperating shocks on financial intermediation

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Goldman Sachs has raised an interesting issue regarding the future of financial intermediation following the crisis:

New bank regulations and capital requirements are “structural” changes to the industry that are more to blame for declining profits than the U.S. economic slump, Goldman Sachs Group Inc. (GS) analysts said.

Remember, we have had the failure of Lehman Brothers (the Global Financial Crisis), the sovereign debt issues in Europe (the European debt crisis), and in the NZ context the failure of the non-bank financial sector post-05.  These crises can be expected to have a relatively persistent impact on economic activity – but not permanent.  Once all is said and done, and financial stability is returned, economic activity should in turn recover.

However, if the “wedge” (inefficiency) in financial markets persists indefinitely this suggest that something else is the cause.  Let’s also remember that at the same time that all this was going on financial regulation by central banks around the world has also changed!  While these changes will increase the stability of the financial system – they come with a permanent cost in terms of economic efficiency … there could potentially be a persistent wedge between the return to lenders and the cost to borrowers due to these policies.

Given both happened at the same time we can’t “identify” what did what – which makes the outlook even more unclear than it usually is.  However, it is important to keep all these disparate causes in mind when trying to understand what is going on.

Matt Nolan

Big news from Europe

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It should not be understated how important this would be for the world, and more importantly for New Zealand 😉

The suggestion that there is now a clear consensus for a plan that will essentially make the ECB a lender of last resort for the European financial system will help to knock the “financial crisis” element of what is going at the moment on its head.

If the ECB commits to limiting bond yields on government debt in the Eurozone, and backs that commitment with a statment saying it will do “unlimited purchases of bonds” we will finally have a conclusion to the bitter uncertainty that the European debt crisis has created for the world more generally.  As a result, Europe will continue to struggle, but the rest of the world can move forward.

Another thing that will become clear is the nature of the crisis – are peripheral governments facing a crisis of liquidity, or are they insolvent?  If it is liquidity, the ECB’s commitment will be enough to solve the problem – they won’t even need to actually buy many bonds!  If these countries are insolvent then the ECB is taking on a bunch of bad debt – a cost that will have to be faced by someone eventually.

If the ECB does come out full hog, we are going to see a significant improvement in the outlook for the global and New Zealand economies – albeit from the current incredibly negative outlook that most people currently have.

Matt Nolan

Where are we with the Eurozone at the moment

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It’s been a while since I’ve written down my impression of what is going on and what is happening with New Zealand – because things are just not changing.  The events in Europe continue to have a significant impact on what is going on in New Zealand, both by lowering businesses willingness to invest in staff and other forms of capital and by lowering the returns to exporters (more than its reduced the price of our imports).

However, we are currently in the middle of a fascinating example of political economy – something I am poorly versed in, and so will instead just link to.

The Eurozone needs a lender of last restort, a credible lender of last resort.  The weird actions going on in Europe are indicative of some institutions recognising this, while other groups who have to take on any perceived risk (eg Germany) are less than willing to do so.

Of course, the belief that the Eurozone needs a lender of last resort depends on the “multiple equilibrium” view of credit markets in Europe – are these banks truly insolvent, or do they just look insolvent because of liquidity/expectations.  If you are in the first camp there is a burden that must be shared in some way, if you are in the second camp there is much less of a real burden – and a strong requirement of a lender of last resort.  The different things being said by different people inside and outside of Europe are not just a result of a normative belief in what is a “fair distribution of the burden”, but also a different implicit model which implies different costs and benefits from different policy actions.

No wonder agreement has been so difficult.

jamesz

Greece: party like it’s 1999

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The Economist estimates how far back the GFC has set various economies:

They’ve used GDP, consumption, wages, stockmarket indices, house prices, wealth and unemployment to calculate that single index. I really like the concept as a way of showing the effect of the crisis to people who aren’t familiar with macroeconomic statistics, but I wonder how they managed to combine that lot without double counting. The Economist Intelligence Unit has certainly not been immune to criticism of its indicators in the past, with Chris Auld calling their Liveability Index “…an arbitrarily weighted sum of arbitrary measures which can neither be meaningfully summed nor measured.” So, I like the concept, but I’d take the actual numbers with a grain of salt until we can see the methodology.