Is a Love of Finance the Root of All Evil?

There is a syllogism that has gained currency just as financial markets have been devalued. And it goes something like: (i) finance is dangerous (ii) the economy is in danger (iii) finance must therefore be constrained. I regularly attend conferences and hear a panoply of dirigiste sentiment directed against the financial sector, arguing that not only that financial markets and banks been the root cause of the final crisis but that they must now be bound like Prometheus to a stone. Though such a conclusion is tempting, it may not be quite right.

The critiques are well known: financial markets underpriced risk, created excessive liquidity and leverage, unbundled exotic near-worthless debt instruments and at the limit, often via hedge funds, promised semi-permanent excess returns. All activities that rewarded participants on the upside and ended up having government support on the downside. The argument then is that faced with such a skew in returns, too many resources have been devoted to financial activity. It is said that banks and financial institutions have become too large both in absolute size because they cannot then be allowed to fail without creating systemic risk and relative to the size of the economies they service. Maybe.

Let us rehearse the arguments about why finance matters. Finance allows individuals and firms to disconnect in time and space their abilities to earn and their abilities to spend and hence concentrate on one or other at any particular moment. The advantages of specialisation are clear – everyone can benefit from the greater production of goods and services by allowing agents inter-temporal as well as geographical options to share resources. But we do know that the efficient allocation of funds from savers to borrowers is subject to severe informational constraints and also various temptations to renege: the avoidance of these problems requires significant regulation, institutional capability and investment in reputation-building. These kind of first order problems do not in general sort themselves out and it is possible even to write about the vast sweep of economic development itself in terms of the history of solutions, failed or otherwise, to these types of problems.

So we can expect that alongside the development of financial instruments we will have to re-write the book of rules and regulations every generation or so, as we moved from heavyweight capital controls in the immediate post-war era under Bretton Woods to an era of neo-liberalism running from the late 1970s to about now and hopefully beyond. And so let us not take the initial premise too far in that the problems with the global financial system are best solved by reducing the size of that system because it seems likely that at least some of the problems stem from its incompleteness rather than its dominance. Let me illustrate: it is entirely proper that capital flows from “impatient” countries to “patient” countries and at some real interest rate the deficits of the impatient must equal the surpluses of the patient. Over time the patient countries will then build up claims or assets against the debts of the impatient countries. Now let us suppose that the patient countries become wealthier, say as their productivity levels catch-up, and all this extra wealth is saved, global savings will then initially exceed investment and interest rates will have to fall to clear the global market for savings, encouraging the impatient to become more impatient and increase their overall level of indebtedness.

For impatient read the US and for patient read China. Under this equilibrium real rates are low and capital flows uphill from fast growing to mature economy. The problem here is that the extra savings are all being sent to the impatient, as there are limited vehicles for the patient to invest in their own economy. In a closed economy, the extra income would have to be channelled domestically and domestic growth would be stimulated in order to use the savings. And so by the same token, if there is an inadequate development of savings vehicles in the patient economies then these savings will tend to drive up the prices of existing assets, for example, US Treasuries which will be in short supply. This global excess demand for assets hence drives down real interest rates raising other asset prices in turn, for example housing, equity or real commodities.

It is thus the lack of financial development in emerging economies which arguably lies at the heart of the problem of this financial crisis and not, perversely, the excess of financial development. An example from the most recent IMF Article IV report from October 2006 for China suffices to illustrate the point, which reports that the foreign exchange rate market remains tightly managed, there seems to be little development of bond markets even at maturities of less than one-year and little or now availability of bonds in the 1-10 year maturity range and equity markets seem not to allow firms to access the market. Overall the IMF view was that the “limited role of capital markets in China…reflects the dominance of state banks in intermediation, but these markets are plagued with regulatory and governance problems”. Obviously a report form late 2006 may well be rather out of date but it does clearly illustrate the point about a lack of liquid assets in newly emerging economies at the high watermark period of so-called financial excesses.

So rather than shunning financial market development, global policies ought also to think more about deepening capital markets and encouraging the development of assets across the risk spectrum, particularly in parts of the world where surpluses are being generated. By helping the development of such assets, policy makers will help raise global real rates, help prevent the conditions under which asset price bubbles will develop and also help get various parts of the world onto more sustainable growth paths that are not reliant on the capacious appetites of Western-style consumption alone. And if as a consequence, we become a little more patient and they become a little more impatient, then we have all become a lot closer to each other, which is a rather pleasant thought.

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Orthodox and Heterodox Monetary Policies

The financial crisis has shaken some core beliefs of central bankers as they find themselves running increasingly heterodox policies. Having spent much of the last two decades developing simple rules about the operational conduct of monetary policy, they now find that this new rule book has to be torn up. Although initially controversial, the adoption of the interest rate as the main operational instrument in pursuit of a clearly defined policy objective had become a near universal article of faith.

But with interest rates heading towards zero and having little impact on lending behaviour, because a freeze in financial intermediation, central bankers have had to think of new policy measures. Attention is moving from the price of money to ensuring that a sufficient quantity of money is held by the private sector in order to effect transactions. In this blog I outline the crossing of the central bank Rubicon.

The nice, linear story central banks liked to tell about monetary policy was illustrated in my blog: Deflation: A Real Problem and a Possible Cure and also in a recent working paper. The policy rate sets the base level for the funding costs of the banking sector and acts as the floor to financing in a given currency. Central banks ensure that the policy rate remains at or near the floor by draining the overall banking system of reserves and selling these back at the policy rate via open market operations, which have no monetary consequences. The hidden assumption in this framework is that the constellation of all other market interest rates, from interbank to long term corporate bond rates and beyond, will respond proportionately to any impetus from the central bank’s policy rate. The set of market interest rates are thus thought to be akin to a sequence of mark-ups over costs, related to the costs of monitoring credit and market risk. And so much of the transmission of monetary policy operates through its impact on other market interest rates.

When setting the policy rate, the central bank commits to supplying central bank money perfectly elastically at that interest rate to commercial banks. At lower interest rates, the demand for narrow money should increase, as the opportunity cost of its holding has fallen, and this extra demand is satisfied by central bank provision of base money. The expansion in narrow (central bank) money is multiplied through the economy by the money multiplier, which is the extent to which commercial banks increase their balance sheets by more than the amount of narrow money alone by extending bank credit to the private sector. And it is arguably this money multiplier that has collapsed in the current banking crisis.

In the stylised balance sheet of a fractional reserve commercial banking sector, commercial banks hold central bank money as liquid assets and loans as illiquid assets. Loans to the private sector will ultimately correspond to deposits by the private sector in the banks, which are liabilities. The ratio of broad to narrow (base) money is the money multiplier and so we can observe that when the market for central bank money clears at a higher quantity and if the money multiplier remains constant, then broad money will expand by the change in the central bank money times the money multiplier. To the extent that broad money is required to fund private sector transactions, a change in broad money will correspond to a given level of nominal transactions. If the banking system is unable to convert base money into a sufficient quantity of broad money activity may suffer in the short run and over the longer run a deflationary impetus will be established.

Clearly when and if interest rates arrive at zero, central banks can no longer control the policy interest rate via open market operations and so monetary policy is driven by the need to set the quantity of base money in circulation directly. Furthermore if financial intermediation is severely impaired, policy may also have to provide a direct impetus for the creation of broad money liabilities and this is our working definition of quantitative easing.

The central bank balance sheet typically comprises assets of foreign exchange reserves, loans to the government, bonds, claims on banks and on the private sector. Liabilities comprise currency, commercial banks’ reserves deposited with the central bank, central bank securities, government deposits and any capital reserves. Central bank balance sheets are typically dominated by the main liabilities of base money (notes, and in some cases coin, on issue) and foreign assets and claims on financial institutions.

When the central bank effects a purchase of government bonds, the following changes to the balance sheet occur. Central bank assets will rise and liabilities will expand by the exact amount of currency issued to pay for the bonds. The currency is remitted to the commercial bank, government or insurance company from whom the central bank has bought the asset and this will be measured as a commercial bank deposit. And so the purchase of government bonds will show up as both an expansion of the central bank balance sheet, an increase in base money and an increase in broad money.

At some point in the future, the central bank can close out its position in government bonds by selling back to the private sector the bonds it holds on the asset side of the balance sheet, soak up the currency created and deflate its balance sheet. This begs the question of what is the initial purpose of buying government bonds? The hope is that by creating more short-term deposits in the commercial bank sector, this will generate commercial bank lending, given a reasonably stable money multiplier. The problem is that when commercial banks are uncertain about both the availability of future liquidity, losses from past lending and the riskiness of new lending in a recession, the new monetary liabilities may not translate very easily into new lending.

And so central banks have already gone further. The purchase of commercial bank assets and mortgage backed securities at discount provide both succour to commercial banks’ balance sheets by providing liquidity against possibly undervalued long term assets, as well as expanding broad money, and the possibility that central banks may profit from the resale of these assets. The open questions here are then at what price are these assets bought – not so high as to endanger the sustainability of the central bank balance sheet but not so low as to question the sustainability of the commercial banks and to discourage their future lending.

With such a large expansion of the central bank balance sheet, central banks increase the relative supply of short term debt (including central bank debt) to long term debt, which should lead to a change in the relative price of short to long term debt, with the latter becoming relatively expensive. And if long term interest rates do indeed fall during a quantitative easing then the private sector will have an incentive to invest as the user costs of capital falls, household balance sheets should be ameliorated with lower interest and debt burdens and asset prices should be stabilised, underpinned by lower long term rates. The question then is when all this activity starts to take off when will inflationary pressures start to re-emerge?

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The Portfolio Approach to...Monetary Policy

Let me start with a poser. You have the chance to allocate your income across two assets A and B, which currently trade at the same price. The eventual payoff from holding these assets depends on one of two states. You do not know which will occur but are given the probabilities of each state at 0.5. Which asset do you hold?

Your choice on relative assets holdings will, of course, depend on the payoff in the various states. In the example below, the expected payoff from Asset A is 5 (10*0.5+0*0.5), as is the payoff from Asset B (2*0.5+8*0.5). So should you be indifferent between holding asset A or B? Not necessarily. Let imagine you decide to hold A, then you will receive either 10 or 0, when the state is revealed. Similarly if you decide only to hold B, then you receive 2 or 8, when the state is revealed. But if you hold 50% in A and 50% in B, then you will receive 6 or 4 when the state is revealed, which may be preferable to the outcome from holding only A or B. Note that your expected return across the states is the same and is independent of your allocation in this case but the variability of your payoff across the states can be reduced by choosing a combination of assets in inverse proportion to their variability. So if we choose 3/8 in Asset A and 5/8 in Asset B, we will have an income of 5 whatever the state turns out to be and this may be preferable to the alternatives.

The observation that an investor is likely to have mean and variance in his or her utility function won Harry Markowitz a Nobel prize in 1990. And there are a number of areas to which we may be able to apply these insights. Let us, for example, use this framework to think about the recent monetary policy problems facing the UK. It is becoming fashionable to argue that the Bank of England’s Monetary Policy Committee (MPC) should have responded in a forward-looking manner to offset the strong possibility of recession and so cut policy rates much earlier and decisively this year. Using our previous analysis would such a policy have been especially wise?

Imagine that Asset A is inflation and Asset B is output and payoffs are negative rather than positive. So the policy maker’s problem is to minimise losses by choosing an appropriate path for Bank Rate. So under X1 there is an inflation problem and something of a downturn and under X2 there is no inflation problem but a severe downturn. Should the MPC have kept interest rates mostly on hold, because of offsetting risks, until it was clear which state would obtain or taken a gamble and judged that X1 was simply not going to happen? In other words should the MPC have behaved like a speculator with his or her own strong prior beliefs and plumped for one outcome or the other? Or more like a portfolio manager and adopted a policy that delivers some stability in either possible state?

Some MPC members and one in particular seem to have adopted the speculator’s stance to go overweight on one asset rather than manage the possible portfolio of risks. Some might consider this to be a dangerous way to set policy because even though you may get lucky, and the inflation threat may dissipate, you may also get very unlucky and exacerbate the inflation threat. The MPC as a whole plumped for the portfolio approach. In the August 2008 Inflation Report (http://www.bankofengland.co.uk/publications/inflationreport/irspnote130808.pdf), the collective judgement of the MPC was that there were upside risks to inflation and downside risks to output and so like our portfolio manager they played it safe and did not move interest rates radically until it had become clear on which side the risks emerged.

The financial markets were perhaps more circumspect (!) than some MPC members. The chart below shows the five year inflation forwards calculated from the difference between the yield on nominal and index-linked (real) government bonds, which are linked to the retail price index (RPI). It is not a simple matter to interpret the inflation forwards as necessarily measuring inflation expectations as they may encompass either or both of inflation and liquidity premia. But if we hold those concerns to one side temporarily (and perhaps heroically), we can see a drift up in the expected inflation rate five years ahead from mid-2002, possibly reflecting concerns about the house price boom and second round effects from oil and commodity price rises. And throughout this year these inflation expectations also continued to drift upwards and it seems that only after end-August did these start to fall, and then somewhat precipitously. (Some of this fall seems relate to a flight to liquid assets as the financial crisis once again took a turn for the worse.) And that was the time interest rates should have started to fall as we found out that we were likely to have arrived in State X2. Since that August Report, Bank Rate has come down in three large steps from 5% to 2%, so what’s the problem?

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Here’s That Rainy Day

Like the visitation of a medieval plague, Recession seems to have returned to our shores. These events are rare. So what exactly is a recession? I quite like Christopher Dow’s (Major Recessions, Britain the World, 1920-1995, OUP, 1998) definition of a fall in the level of GDP in one year compared to the previous year. According to Dow we only had five major recessions in the post-WW1 20th century (three after WWII) and it looks as though we are about have our first of the 21st century. In a book which will now be re-read, Dow finds that in these recessions, which typically have duration of around 1-3years, the level of output typically falls by up to 10% below the level it would have arrived at if trend growth was maintained. (He attributes around half this fall to a reduction in productivity.) During these episodes unemployment typically rises by up to 3-4% points.

A key additional finding is that recessions seem to have been unpredictable in real time, reflect changes in demand as much as any supply reductions and occur nearly simultaneously in major economies. Clearly the simultaneous occurrence of negative growth across economies might well be a candidate explanation for the severity, as trade multipliers will be running at full pelt. I do not know whether this recession will be a major one or not but the extent of the fall today in Sterling (closed on 22nd October 88.3 compared to previous day at 90.4 with Sterling falling over 6c against the US$ alone) and in the equity index (FTSE-100 and FTSE All-Share both fell by over 4%) suggests that the financial markets expect both a strong negative domestic interest rate response, which drags down sterling, and a large fall in corporate profitability, which drags down the equity index (recall that equity prices should be present value of expected corporate profits, which are in return a function of output).

In a speech on Tuesday, the Governor of the Bank of England gave two reasons for the recession. The credit market shock, which has deprived household and firms of liquidity against their collateral in some degree and so reduced demand, and a global price shock to fuel and commodities that has reduced household disposable income, rather like a large unanticipated tax rise levied by a foreign government. I suspect the financial shock has another consequence. The impecunity of the UK household balance sheet has been exposed - as perceptions of net wealth have been eroded with sustained falls in asset prices. And this means that the UK private sector balance sheet, currently well in deficit to the tune of around 5% of GDP, is certainly even more in need of a sustained bout of savings, which will surely reduce demand further.

Each of these arguments concern demand and so can, to some extent, be offset by appropriate interest rate policy. The Table above dates the trough and peak in the business cycles around the time of Dow’s major recessions. I also note level of policy rates at around the same time with their nearest peaks and troughs.

The peaks in interest rates occurred sometime after the business cycle peak but there is no clear pattern in the interest rate troughs (as in the most recent recession, policy rates were constrained by ERM membership). When inflation was more of a problem, in the earlier recessions, interest rates did not move especially far in proportional terms – falling by around 25-30% of their peak value in both cases. But when inflation was reasonably under control, as in the most recent recession, interest rates fell by a much larger fraction, by around 65%. If we mechanically apply these boundaries to the current scenario, we arrive at a corridor for base rate at 4.00% to 2.00% as the floor this time round. Clearly the current consensus is for inflation to reduce radically as commodity prices fall in response to lower world demand and the increasingly large negative UK output gap drives down pricing power of firms.

And so we might conclude for the moment that the markets have priced more of the latter scenario in than the former and hence the large exchange rate and equity price responses we have observed. But as ever we shall have to wait and see what that rainy day actually brings.

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What a great time to be an economist…rather than banker...

The financial crisis has dominated the headlines for over a year now and provided a chronic migraine to bankers, policymakers and academic economists as we try to locate the causes, cures and consequences of this crisis. Whilst I am not going to provide a definitive answer in this column (yet), what I think I can do is set the scene in the first instance about some causes of this crisis. I will deal with some other aspects in future weeks.

Early commentary on the current financial crisis treated it as a necessary re-pricing of market risk and it is still difficult to disagree with that basic point. Promulgated by the emergent-saver nations, such China, world interest rates fell in the past decade or so. And taking a lead from Japan and then the US, the early years of the 21^st century had been characterised by low policy rates, which were accompanied by a widely-offered argument about the possible end of the business cycle and a series of innovative ways for the financial sector to expand the liquidity of financial intermediaries. All of which perhaps contributed to a sense of hubris or infallibility within the financial sector and in the wider economy and certainly a sense that risk had somehow dissipated. Accordingly, the price of risk fell as likelihood of bad outcomes was collectively judged to have fallen markedly.

Under these circumstances, asset prices could not help but be bid up and the risk premia required by investors to hold various classes of risk evaporated. High asset prices provided the means for further liquidity creation for the private sector, as owners of capital and homes found themselves with bankable quantities of equity. They also provided an impetus to financial engineering, with liquidity combining with a search for yield to produce new methods of handling the consequences of financial intermediation. Banks found that they could borrow their liabilities increasingly from other banks rather than from arguably more reliable retail customers and create loans (assets) that would amount to many times their underlying level of capital.

The relaxation of credit constraints provided a boost to economic activity, which might typically have been managed with a temporary increase in policy rates to ensure that demand did not run away from the gradual increase in supply. But at the same time there was a deflationary impetus from newly industrialising economies that placed downward pressure on traded goods inflation. So that inflation targeting, in some cases quasi-inflation targeting, central banks did not feel that it was necessary to raise policy rates to a sufficient degree. And so the long expansion, or what we might eventually look back upon as a boom, continued unabated.

It was argued that the overall risk from extending loans could be mitigated by more sophisticated forms of risk management (which we will explore in future weeks). But as loans are extended to more and more agents, the quality of the marginal agent – in terms of ability to repay - will at some point deteriorate. Escalating debt levels and greater coverage of loans amongst a given population leads to two possible sources of instability, that the private sector expectations about the path of interest rates and the growth of future income have been too optimistic and that the asset price-based collateral used to back a given loan may deteriorate. The former will make debt service more difficult and any downward shock to asset prices will increase the implied level of gearing for any loan and so threaten net worth. And so it would seem that higher levels of more widespread debt may actually tend to increase overall market risk.

To some extent this is indeed what happened. Even though risk was spread amongst many financial institutions many of the original loans became riskier. So we ended up with a position of low market rates, high asset prices and escalating rather than declining economic risk. The trinity is impossible and something would have to change and in this case it was the first two relative prices. Banks and private individuals both had to re-assess the viability of their balance sheets and seem to have come to a similar conclusion that capital and savings have to increase. Households may be able save, if their income flows are maintained but that is a big if, but banks cannot re-capitalise when liquidity is low and so governments came to the rescue with a fiscal bail-out.

To some extent the crisis has finally come to a head in the past week. The recent bail out of two large Government sponsored enterprises, Fannie Mae and Freddie Mac, the bankruptcy of the once-venerable institution Lehman Brothers and the take-over of HBOS by Lloyds TSB. It seems likely now that the as well as continuing to offer short term liquidity to help banks finance their ongoing operations, there will be some attempt by the US authorities to buy up the bad assets from banks who own them at a deep discount and hope fully try to develop some form of secondary market for these assets.

If we are now to move from a regime of easy money (low interest rates, low inflation, high asset prices and high gearing) to one of tighter money (higher interest rates, higher inflation, lower asset prices and lower gearing) what are the implications? By which I mean what will the landscape of the financial and banking system look like, how will it be regulated and how will the transition from one regime to the other be managed.

In a market economy, with collateral required for lending, raising the required rate of return on marginal projects will reduce the level of capital employed in the long run and hence the rate of economic growth. So we will have to transition to a lower than expected level of growth. The transition will probably lead to a public and private debt overhang, along with further possible bail-outs for the financial sector. And the danger is that this will change the terms of trade for monetary policy, particularly as deflation will have to be avoided, with a strong inflationary incentive re-emerging. Tighter regulation of the banking and financial sector will be difficult to avoid and so we may end up with an economy that ultimately is less reliant on the financial sector for its growth, I am not quite sure that lower growth, higher inflation, higher taxes and a less dynamic financial sector will be preferred by all. But if the alternative is occasional busts on this scale, there may in fact be little alternative, even if we did mostly enjoy the ride.

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