Category / Economic Theory

Collateral crises February 18, 2014 at 12:22 pm

From the abstract of Collateral Crises, by Gary Gorton and Guillermo Ordoñez:

Short-term collateralized debt, private money, is efficient if agents are willing to lend without producing costly information about the collateral backing the debt. When the economy relies on such informationally insensitive debt, firms with low quality collateral can borrow, generating a credit boom and an increase in output. Financial fragility is endogenous; it builds up over time as information about counterparties decays. A crisis occurs when a (possibly small) shock causes agents to suddenly have incentives to produce information, leading to a decline in output. A social planner would produce more information than private agents but would not always want to eliminate fragility.

Personally I think this approach is interesting but insufficiently epistemic. It’s easier to explicitly model lender’s beliefs about borrowers, and about collateral. Still, it’s nice to see a formal model of the run on repo insights.

One chart to explain it all January 25, 2014 at 7:18 am

Well, perhaps not quite that much, but still, this, from Business Insider is insightful:

Global Income Growth

The attack on main-stream alchemy November 30, 2013 at 10:25 pm

The staunch defenses of Simon Wren-Lewis and Paul Krugman worry me a little. I respect both of them, and think that Wren-Lewis in particular is both reasonable and careful in his arguments. But really, doesn’t the idea of rational expectations remind you of transmutation – kinda cool if it was true, but more interesting as an idea that cropped on the way to real science than in itself. So no, economists (specifically, anyone who disagrees with Krugman) aren’t the only problem: it is the risible failure of economists models to be able to make meaningfully accurate predictions about the future and the fact that economists are not embarrassed about this that is a problem too. A little more pragmatism and a little less modelling in frameworks that are mathematically tractable but demonstrably ill-connected with reality wouldn’t hurt…

Quotes of the week: ZLB and safe assets November 22, 2013 at 10:39 am

A few memorable lines to muse on:

1. From Paul Krugman, talking about the need for negative real rates:

in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn’t want to deliver – it’s like farm price supports, except for rentiers.

2. From Simon Wren-Lewis, surveying the current ideas in macro about safe assets:

there is still plenty of scope for disagreement on the ability of the private sector to manufacture safe assets… [and] collateral is all important in enabling the creation of risky financial assets.

3. A pre-budget standoff remark from Coppola comment.

international markets need safe assets, and at present the only country that can produce them in the quantity required is the USA.

I’m not sure I agree with this, but it is an interesting point as its veracity depends critically on whether you think pseudo-safe assets (such as AAA securitisation tranches) are ‘good enough’. And that, of course, depends on your purpose: capital preservation at all costs or just collateralisation.

Now I am sure I don’t understand collateral dynamics properly in a world where OIS is (very mildly) positive and short term govy rates are negative, but I do suspect that the incentives here are interesting. One to muse on…

Liquidity economics October 16, 2013 at 7:21 am


I had heard of this but never seen it until recently: this is a part of the Phillips Hydraulic Computer or Monetary National Income Analogue Computer. Personally I agree with Simon Wren-Lewis: more data-based empirical models which give some insight into a key issue or two, like Phillips’, and fewer theoretically sound models ignorant of reality would improve macro hugely.

Tapering, the exit path, and collateral September 21, 2013 at 10:10 am

Peter Stella has an excellent post on VoxEU on the implications of the central bank exit strategy for collateral. What’s nice about this in particular is that Stella understands modern credit creation:

Most credit in the US is created by nonbanks; virtually all bank lending is funded by the creation of liabilities that are not subject to reserve requirements, and central banks do not ration reserves. In fact they take great pains to provide banks with the amount of reserves they desire. Central banks influence credit not by rationing the quantity of reserves but by altering the interest rate that banks must pay to obtain the quantity of reserves they desire.

Stella then points out that the precise exit mechanism chosen from QE has considerable implications for collateral: in particular “reverse-repo has a portfolio effect that [the offer to banks of] term deposits do not”. Indeedy.

Phrase of the day August 28, 2013 at 10:32 am

gathered in all their wonky majesty from Robin Harding writing in the FT about Jackson Hole.

Getting out of three trillion August 27, 2013 at 7:32 pm

What do you do if, in round terms, your balance sheet is three trillion dollars bigger than you want it to be? (Or two. Whatever.) Get into the reverse repo market in a big way, of course. Which is exactly what the FED is doing, as the WSJ spotted:

In the July minutes of the Fed meeting released Wednesday, officials discussed a proposal to introduce a so-called reverse repurchase program

That would be a fixed-rate, full-allotment reverse repo programme, to flesh out the details and correct the WSJ’s lamentable spelling. The idea is to give the FED better control over that key monetary policy transmission mechanism, the repo market, by allowing them to dribble out collateral as needed to meet their target repo rate (or more precisely spread of repo rate over FED funds).

Just one question. If Barclays are right about the impact of recent regulatory proposals on the repo market, might the FED be picking up a new tool just when it is about to become less effective?

De-commodification explained simply July 28, 2013 at 3:42 pm

From Peter Frase:

Suppose you and I live in adjacent apartments. Now consider the following ways in which we might satisfy two of our needs: food and a clean habitat.

In scenario A, I cook my own meals and clean my own bathroom, and you do the same for yourself.

In scenario B, you pay me to cook your meals, and I pay you to clean my bathroom.

In scenario C, I pay you to cook for me and clean my bathroom, and you pay me to cook your meals and clean your bathroom… What might make each of these three scenarios desirable?

The advantage of scenario A is that each of us has maximal control over our labor and our lives. I cook and clean when I choose, I eat just what I like, and I will do just enough cleaning to ensure that the bathroom meets my standards of cleanliness.

The advantage of scenario B is that it might be more efficient, if each of us has what economists call “comparative advantage” in one of the tasks. If I’m a better cook, but you’re better at cleaning, then each of us ends up with overall better meals and cleaner bathrooms than we would have had otherwise. The downside, however, is that each of us has now partly alienated our labor to some degree. I have to monitor you to make sure that you’re doing a complete job of cleaning, and you can boss me around if you dislike my food or I don’t have dinner ready on time. What’s more, the only way for this exchange to be fair to both of us is in the unlikely event that you enjoy cleaning the bathroom just as much as I like cooking. In the more likely case that both of us find cleaning much less pleasant than cooking, you get a raw deal.

Scenario C would seem to combine the worst elements of the other two scenarios. There is no efficiency gain, since we are both performing both tasks. And our labor is maximally alienated, since we are doing all our cooking and cleaning at someone else’s command rather than for ourselves.

What is really nice about this explanation, I think, is the clarity with which it brings out the trade-off between economic efficiency and alienation, and the existence of situations which are far from optimal in both dimensions.

QE: real tool, or now just fictional? July 20, 2013 at 7:08 am

Quoth Izzy:

If it’s true that the Fed’s asset purchases are creating liquidity problems in the underlying — so much so that short squeezes are impeding daily market operations, causing settlement fails and negative repo rates — this leaves Bernanke in a tricky communication position… to say “we have to suspend QE because there aren’t enough assets for us to purchase without us becoming the market” is to admit that the Fed’s most important tool — QE — is now broken, which risks freaking out the market completely.

I don’t have a position on whether this is true, but she’s right that if it is, boy will it be a problem if (when) the market finds out.

Four hints and a protestation July 7, 2013 at 3:52 pm

Paul Krugman gives some research advice. Four of his suggestions are helpful:

  1. Pay attention to what intelligent people are saying, even if they do not have your customs or speak your analytical language
  2. In general, if people in a field have bogged down on questions that seem very hard, it is a good idea to ask whether they are really working on the right questions.
  3. Virtue, as an economic theorist, does not consist in squeezing the last drop of blood out of assumptions that have come to seem natural because they have been used in a few hundred earlier papers. If a new set of assumptions seems to yield a valuable set of insights, then never mind if they seem strange.
  4. Always try to express your ideas in the simplest possible model.

This rang particularly true to me after a week in which I heard one of the technically best and intuitively worst talks in years. It would be unfair to reference the authors as they were only following what Krugman calls ‘the safe approach’, making a conceptually minor but mathematically difficult extension to some familiar model. What struck me though, apart from the desire to have the hour I had just wasted back, was how forgiving the audience was of this talk. They didn’t mark the presenter down at all for doing pure maths badly disguised as finance; indeed, they didn’t seem to mind at all that the paper’s assumptions were both palpably false and key to its policy conclusions. It was like going to a string theory talk: the beauty of the maths mattered more than the minimal connection between the object supposedly studied and the work presented. Now I support pure maths research. But I object to researchers disguising their work as applied maths when it isn’t. Krugman’s right – it does sometimes give insight to work on over-simplified models. But equally you can’t just assume that the conclusions of those models apply to the real world, and claiming that they necessarily do is just dishonest.

Performativity in policy June 10, 2013 at 8:32 am

I am buried in final book proofs – when your title is listed on the publisher’s website with a publication date less than six weeks away, you know that it is urgent – but I wanted to at least point to an insightful old post of Chris Dillow’s. He discusses how the ideological environment in which policy is formulated affects its outcome.

the “neoliberal” turn in politics has two adverse effects:

  1. If you believe markets know best and that centralized information-gathering is bound to be a deeply flawed process, then you’ll invest less effort in it, or be sceptical of the product of doing so. Cost-benefit analyses will then be founded upon flimsier evidence, or won’t carry much weight even if it is.
  2. The increased belief in consumer sovereignty and decline in faith that “the man in Whitehall knows best” (to which “Nudge” economics is the counter-reaction) has devalued expertise. If politics is about giving voters what they want, you don’t need experts and evidence, but just pollsters and market researchers.

In these senses, “neoliberalism” has had some performative effects upon policy.

This is clearly right. There’s no such thing as an ‘objective’ cost benefit analysis, however hard you (or aren’t) trying to produce one. Politics can’t help but colour any policy making process — which is one of the reasons that it is so important.

Update. It occurs to me that there is a variant of the Sapir-Whorf hypothesis here: instead of `the structure of your languages affects your cognition’ we have `your politics affects which policies you can implement’.

Quote of the day June 3, 2013 at 8:36 am

From the Chairman of the Board of Governors of the Federal Reserve System:

Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much.

Should the state care about savers? May 23, 2013 at 9:05 am

I have been perhaps too focussed in this past on the potential influence on monetary policy of savers: issuing linkers rather than fixed rate bonds, for instance, to facilitate better ALM for pension funds. Suitable government debt can, after all, substitute for some of the equity component of a traditional pension fund.

Reading the ever-excellent Simon Wren-Lewis, it occurred to me that NGDP targeting has a place in this discussion. First he points out:

A good deal of the borrowing that goes on in the economy is to smooth consumption over the life cycle. We borrow when young and incomes are low, and pay back that borrowing in middle age when incomes are high. To do this, we almost certainly have to borrow using a contract that specifies a fixed nominal repayment. The problem with this is that our future nominal incomes are uncertain – partly for individual reasons, but also because we have little idea how the economy as a whole is going to perform in the future. If the real economy grows strongly, and our real incomes grow with it, repaying the debt will be much easier than if the economy grows slowly.

As most individuals are risk averse, this is a problem. In an ‘ideal’ world this could be overcome by issuing what economists call state contingent contracts, which would be a bit like a personal version of equities issued by firms. If economic growth is weak, I have a contract that allows me to reduce the payments on my debt. However most people cannot take out debt contracts of that kind, or insure against the aggregate risk involved in nominal debt contracts.

Linkers help both borrowers and savers here of course. However, they are not quite what we want – that would be a risk-free security that pays out based on the path of nominal GDP* – but they are close.

Wren-Lewis then goes on the discuss a paper by Sheedy which suggests – in a stylised model – that NGDP-targeting produces lower over-the-cycle costs for savers than inflation targeting. (Or rather that the optimal mix between the two is heavily biased to NGDP targeting.) He suggests that

It may make sense for inflation to be high when real growth is low, and vice versa, because this reduces the risks faced by borrowers.

The obvious corollary of this argument is that governments should issue those NGDP-linked bonds to provide a curve against which private borrowers can issue. Such instruments would be even more attractive to many classes of savers than linkers, and would produce a better match to borrowers needs too. Moreover, combined with monetary policy which targeted NGDP, such instruments should be rather low volatility, stable stores of wealth.

*By analogy with linkers, I have in mind a security that pays a constant spread on and returns an NGDP-linked notional.

Equilibrium in Economics April 4, 2013 at 8:19 pm

Noahpinion has an interesting post on the variety of equilibria in economics:

Walrasian equilibrium, also called “competitive equilibrium” or sometimes “general equilibrium”, is basically when prices adjust so that all markets clear…

A Nash equilibrium is when people’s strategies are best responses to each other – in other words, when no one would choose to change their plans if everyone else’s plans stayed fixed…

A Rational Expectations Equilibrium (REE) is a kind of Walrasian equilibrium with uncertainty about the future. In addition to the condition that prices adjust to clear markets, a REE includes the condition that people’s subjective beliefs about the probability of future events are equal to the actual probabilities of those future events.

What if prices can’t adjust to clear markets? … In that case, markets might not clear, so you wouldn’t have a Walrasian equilibrium. BUT, you’d still have people’s plans being consistent with each other. In this case, you’d have the kind of equilibrium in a sticky-price New Keynesian macro model, in which labor markets don’t always clear.

In most dynamic models (for example, DSGE models), the economy tends toward some “steady state”, in which either nothing in the economy is changing, or in which things are only changing at constant long-term trend rates.

What’s interesting, I think, is how rare these are in practice. You do get Walrasian equilibria in financial markets with price transparency, informed agents, and highly fungible goods. The others, though, are theoretically nice but in practice rare, not least because the forcing – external event – happens more frequently than the relaxation time (the time to get close to equilibria). And because agents aren’t rational, and don’t plan…

Reacting to Cyprus March 25, 2013 at 4:55 pm

There has been a lot of negative comment about the Cyprus deal. That is understandable: you can reasonably argue that it will produce crippling austerity; that it is ridden with moral hazard; that it will create a bank run across most of Southern Europe. But what you can’t argue is that it was unexpected. After all, as Sony Kapoor points out, the standard template for bank resolution calls for bond holder and, if needed, uninsured depositor bail in together with liquidity assistance from the money printer. We got what was planned. If the plan isn’t a good one, there are bigger issues than Cyprus that we need to address.

Macroeconomics with Canadian potatoes February 23, 2013 at 6:12 am

There is a nice parable of the money supply here, from Worthwhile Canadian Initiative. Have a nice weekend.

Misconceptions about bank equity February 2, 2013 at 6:51 am

Izabella Kaminska, good though she usually is, is mistaken. She says on FT Alphaville:

Bank resolution is fundamentally about transferring bank responsibility (and risk) away from the public sector and back to the private sector. It’s about making the banks responsible for themselves again by weaning them off state-aid.

Even though government loans have on the surface been repaid, the central bank put and the understanding that these institutions are now too big to fail, implicitly continues to provide an equity backstop. The equity risk has thus not yet really been transferred to the private sector at all.

(Emphasis from the original.) In resolution, bank equity is usually written off. That hurts private sector investors. Resolution regimes even allow debt to be written down. Again, this is a risk private sector investors in banks bear. So Izzy’s claim in the final sentence does not hold water.

Next, QE and the lack of a bid for bank equity:

while QE has been successful at encouraging the market to take risk in some quarters of the market, it’s failed dismally at persuading investors that the bank model is ever going to be a good bet — even in a less risky environment.

Yes, because bank investors are terrified that supervisors might listen to someone like Admati (an academic who inspired Izzy’s article) and demand that banks issue a lot more equity. If they do, current investors are diluted. The risk of that, combined with bank opacity, means that there are few buyers for bank equity. Most large banks are perfectly profitable, so Izzy’s claim that

banks are borrowing short and lending or investing long … in a way that continuously destroys capital.

Is simply wrong – they are having ROE issues, but that’s different. From errors of fact, it is hardly a surprise that errors of diagnosis result. For instance further down the post we find

the only solution lies either in fully equitising banking or turning to a borrowing long, lending short alternative

Banking isn’t broken, and there is still plenty of money (and bearable amounts of risk) to be made in taking deposits and making loans. Banks borrow short and invest long because that is what clients want them to do. And yes, because the curve usually points up and so you can make money doing it. Upward pointing curves will come back in due course. What’s broken is investor’s trust in bank regulation and bank disclosures – and the solution to that isn’t using a theorem that doesn’t hold in practice (Miller Modigliani) to justify a radical, unproven change in regulation like requiring that banks be 100% equity funded at a time when the monetary transmission mechanism is broken. I would even suggest that there is far more systemic risk in taking Admati’s ideas seriously than there is in current arrangements.

Collateral = risk capacity January 29, 2013 at 10:26 am

US GC repo is going lower, because, well, the Treasury has most of the assets, thanks to QE. Given that these assets are needed for collateralised funding and collateralised risk taking, that is having an impact. Izzy at Alphaville relays the following, very much along the line we have taken on this:

overly strict collateral policy, implemented post crisis, is now constraining the market’s ability to take on risk, because the ability to fund or run “risk-on” trades is determined by how many safe assets an institution has available for margin posting.

Risk positioning is increasingly being held back by a static pool of risk-free collateral.

Furthermore, if and when the risk positions sour, that divide only gets wider as further safe collateral calls are made, sucking more safe assets out of the system.

You can’t both demand that funding and risk taking are often collateralised then buy up most of the collateral without it having an impact.

Too much to say today January 3, 2013 at 2:56 pm

Like the pent-up demand released in yesterday’s equity rally, there has clearly been a lot of good writing going on over the holidays that is coming out. There is too much to comment on in detail today, so here are some highlights:

  • Lisa Pollack in FT Alphaville on reconciling between US GAAP and IFRS presentations of derivatives. The bottom line is that accounting standards are a mess, but at least footnotes will now provide some reconciliation between the differing approaches. If you level the differences, the top of the list of banks by size of derivatives balance sheet is JPM, BAC, BNP, Barclays, DB, RBS, SG, UBS, CS, GS, MS. Is anyone else as surprised by how high the French are in this list as I am?
  • Lisa again on the slightly troubling lack of clarity on who collateral posted by ERISA pension funds at FCMs should be returned to in the event of bankruptcy. Ooops.
  • A good, long read from Frank Partnoy and Jesse Eisinger in Atlantic magazine on bank disclosures. Favourite quote: “There is no major financial institution today whose financial statements provide a meaningful clue about its risks”.
  • Coppola comment on a BIS paper on safe assets (which I have yet to read, but will get to). I agree (and have been pushing) the idea that we consider the perspective whereby “the purpose of government debt is not to fund government spending. It is to provide safe assets.” (HT to Izzy for picking this one up.)
  • Ross Gittins in the Sydney Morning Herald on the gangs which run America.