Bear Sterns

I started this post last Monday and then got distracted. Looking at it now, I think the fragment is worth preserving.

I’ve spent the past week being pissed off at all the people who were pissed off about the so-called “bailout” of Bear Stearns. In the light of this morning’s [Monday the 24th] news, I’m starting to half agree with them.

Earlier, I was going to write a post about what a lucky accident it was that the current Fed Chairman is also one of the world’s foremost experts on the problems of the early 1930’s. Now I’m beginning to wonder if it would have been better to have someone with a less well-matched academic background and more poker skills.

In retrospect, it appears that the $2/share price in the original version of the Bear deal was not a real price, just a piece of propaganda, intended to give the impression that it wasn't a bailout. But it's now clear that, whether or not one calls it a bailout, Bernanke offered a lot more in loan guarantees than was really required to get J.P. Morgan to do the deal. (The $1 billion deductible on the new version of the deal is not very convincing as a concession by Morgan, and in any case, it only makes it more obvious that the Fed's original offer was much higher than it needed to be, if Morgan is willing to take a hit both on the special financing and on the purchase price.)

I don't think that's exactly a moral hazard problem, but it's the same general idea. The next time the Fed wants somebody's help to keep the financial system afloat, that somebody will know to charge dearly for that help.


UPDATE: And another thing. What the hell were Ben's priorities? If he wanted to reassure the financial markets, he shouldn't have pushed for a price that made Bear Stearns appear to be in much worse shape than it actually was. (Did that just not occur to him? Did it not occur to Tim Geithner? Did it not occur to anybody at the Fed?) If he wanted to make the Fed look tough, he shouldn't have offered way better financing terms than were really needed to get the deal done. (As noted above, both the price and the financing terms got worse for Morgan subsequently, and they were still willing to play.) Did it not occur to him that being tough with winners was important for the Fed's reputation too, as well as being tough with losers? This was a major screw-up.

Where is “Sex” in the NAICS?

This business with Eliot Spitzer is bringing up issues in labor economics for me. In particular, how should we refer to Ms. Dupré’s occupation? Some people insist that she was a “sex worker.”

I have a number of problems with this terminology. For one thing, is there any other occupation where the title includes “worker” and the hourly billing rate can be in the quadruple digits? I mean, there are a few cinematic production workers who make that kind of pay – but they’re known invariably by other titles (actors, directors, etc.) – and a few sports workers – but they’re known as athletes – and quite a few finance workers – known as investment bankers, fund managers, and such – and quite a few…I guess I’d have to call them generic workers, since they can be in any industry…but they’re known as corporate executives – and a few legal service workers known as attorneys, and a few professional service workers known as consultants, and maybe a few health care workers known as doctors and surgeons, and so on.

Which brings me to my second, related point, which is that we don’t normally identify an occupation by the industry to which it belongs. The exceptions are sort of residual categories: we do call some people “health care workers” if we can’t think of anything better to call them, but most people in health care occupations (nurses, for example) would probably find it insulting to have their occupation identified as “health care worker.”

According to Wikipedia, a sex worker is someone (anyone, apparently) who works in the “sex industry.” I have a feeling that many people who work in the “sex industry” would be insulted to be called “sex workers” (rather like nurses, if you call them “health care workers”). I mean, really, doesn’t everyone know that the phrase “sex worker” is a euphemism for “prostitute”? (I know, technically, that’s not the case, but in real life, other “sex workers” seem to use the phrase for themselves only when they’re trying to make a show of their solidarity with prostitutes.)

But here’s the real problem: What the hell is the “sex industry”? And more to the point, what kind of industry is it?

• An information industry? (The adult video industry, as best I can tell, is part of NAICS 512110, “Video production,” an information industry.)
  
  
• A personal service industry? (Officially, Miss Dupré was probably working in NAICS 812990, the “Social escort services” industry, a personal service industry. As to what she was actually doing, it seems to me that prostitution is clearly a service, and it’s about as personal as services get.)
  
  
• A food service industry? (I know that doesn’t make much sense, but where do strip clubs fit in the NAICS? As best I can tell, they are part of NAICS 722410, “Night clubs, alcoholic beverage,” a food service industry.)
  
  
• An entertainment industry? (It’s really tough to find a NAICS code that would actually apply here, but aren’t strippers entertainers? Of course strippers also give lap dances, which are really more of a personal service than a form of entertainment. In fact, in that respect I have to question whether strippers are really more like prostitutes than entertainers.)
  
  
• An amusement and recreation industry? (That’s pretty much just a wild guess. But where the hell do brothels fall in the NAICS? There are legal brothels in Nevada, so I assume they must have a NAICS code.)

As far as I can tell, the whole concept of a “sex industry” makes a mockery of the way we normally classify industries. I don’t have a problem with changing the occupational title of prostitutes to something that has less of a stigmatizing history. But “sex worker” just doesn’t do it for me. I’m going to try “personal sexual service provider” (PSSP for short) and see if it catches on. Otherwise I’ll just call them hookers – a term which doesn’t seem to offend people even though its etymology is rather scurrilous.

What's going on?

In Paul Krugman’s latest column (hat tip: Mark Thoma), he compares the current financial crisis to the bank runs of 1930 and 1931:

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

That sounds like a pretty good description of what’s going on, but there’s something missing. Thinking about this as a regular person rather than an economist, I have to ask, “Who are these ‘people’ that are pulling their money out of the shadow banking system and putting it into treasury bills?” Because it sure isn’t me. I have my cash in a prime money market fund; I deliberately passed up the “treasury-only” option, and I see no reason to change my mind now. My fund hasn’t broken the buck. In fact, I haven’t heard of any money market fund that has broken the buck recently. (Possibly something escaped my attention, with all the news that’s come out lately, but even if there have been one or two cases, there haven’t been many, and they haven’t been big ones.)

I don’t know exactly what my fund manager is doing; I imagine they’ve probably increased the proportion of treasuries in their portfolio, and I guess, technically, it was “people” that made that decision, but it wasn’t any people that I know personally. If anything, I’d like my fund to skate closer to the edge. It would not drive me into bankruptcy if the share price went from $1.00 to $0.99. In fact, I probably wouldn’t even notice, except for the fact that I’d read about it in the newspaper, and the fund would probably send me all kinds of stuff in the mail about how something went terribly wrong and the employee has been fired and this will never ever happen again in a million years and they’re completely changing all their control procedures and they’re changing their name just to show that they aren’t really the ones who lost that one cent.

So I guess the point is, it’s not really “people,” in the sense of retail investors, who have lost confidence; it’s institutions. Maybe that’s why so many “people” have a hard time seeing what the big deal is and why the Fed needs to help “bail out” Bear Stearns. As for me, when I see the TED spread approaching 200 basis points and the treasury bill rate approaching zero, I know that something is very wrong and that the Fed has good reason to be taking drastic measures, but I’m still a little confused as to why all this is happening. I understand that the consequences of the failure of a major investment bank under these conditions would be disastrous, but I still have trouble seeing why J.P. Morgan needed $30 billion in non-recourse financing to convince it to buy Bear Stearns for a tiny fraction of what the market seemed to think it was worth.

Capital Flight is Good

Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.

In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:

1. Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
   
   
2. Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
   
   
3. Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
   
   
4. (in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.

For the US today, the real problem would be if foreigners insisted on continuing to purchase US assets. That would support the dollar, making it that much harder to sell US goods and services and contributing to the weakening of the economy, thereby exacerbating the positive feedback between a weak economy and a weak financial system.

As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.

If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)

If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).

There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.

Moral Hazard

[Hypothetical future investor]: I own a major stake in an investment bank, and I’m getting concerned about their risk management. Should I bring this up at the shareholders’ meeting?

[Hypothetical friend]: I don’t see why. What’s the worst that can happen? The bank will go sour, the Fed will arrange a bailout, and you’ll only lose 95 percent of the money you invested, 96 tops. What’s the big deal?

[Hypothetical future investor]: You’re right. Isn’t the [Hypothetical future Fed chairman] put great?

TSLF: Is the government taking a risk?

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

Now I like Eliot Spitzer

Eliot Spitzer has always struck me as a pompous, self-righteous, arrogant, heavy-handed, politically motivated ass. I find the publicly disgraced hypocrite to be a much more sympathetic character. Pretty much the bad things about Spitzer were things I already knew. I didn’t know the specifics of his being a john and a philanderer, but neither did I imagine that he could possibly achieve for himself the high moral standard that he seemed to require of everyone else. The main difference now is that he’s been caught. And being caught tends to neutralize the things I didn’t like about him: his political career is over; his hand is weak; and he is no longer in a position to be pompous, self-righteous, and arrogant. He’s still an ass, I guess, but nobody’s perfect.


UPDATE: Now that I read about what Spitzer has done to reduce human trafficking, I like him even more. Not quite as cool as keeping abortion legal, perhaps, but surely it's worth at least a hand job.

This inflaiton report scares me.

Quoting myself from the comments section of my last post:

...Japan had plenty of missed opportunities in the early to mid 90s to prevent the depression from getting out of hand. It was only when the inflation rate went to zero...that it really became intractable.

Speak of the devil, and he shall arrive appear. I'm pretty sure we'll get positive core inflation in March (and there's no question that we'll get positive headline inflation), but seeing zero even in one month (as in today's February CPI report), while commodity prices are rising at unprecedented rates, is pretty disturbing. Both the 12-month CPI inflation rate and the 3-month annualized rate are 2.3%, which is right in the middle of the normal range. This is disturbing because it seems to indicate that business don't even have enough pricing power to pass on part of the huge cost increases they are facing in energy and materials. What happens when commodity prices stop rising? I don't think I want to find out.

Rising Inflation Expectations: Bad News or Good News?

Suppose that Greg Mankiw and others are correct in suggesting that inflation expectations have risen dramatically. Is this bad news or good news?

By way of full disclosure, I should note that it’s clearly good news for me, since I’m short nominal Treasury notes. If you follow the logic, that means it’s in my interest to convince other investors that conditions are more inflationary than I really think they are, so while the main point of my last post still stands, you should probably take the caveats (“There's little question that the expected inflation rate has risen...”) with a grain of salt. (Rising inflation expectations are clearly good news for me, but if this is what the good news looks like, I’d hate to see what happens to nominal yields when inflation expectations are falling!)

As to the “general interest,” however, the most obvious interpretation is that rising inflation expectations are bad news, because they mean that markets have lost confidence in the Fed’s willingness to keep inflation within its perceived target range. Or, as Greg puts it (quoting the Cleveland Fed’s Web server and adding a double entendre), “the system ‘has experienced an unexpected error.’” If the market loses confidence in the Fed’s inflation target, then, theoretically, the change in the expectations term in the Phillips curve causes it to shift upward, and we can anticipate both higher unemployment rates (in the short run) and higher inflation rates (in both the short run and the long run, unless confidence is eventually restored) than we would otherwise experience at any given level of aggregate demand.

Under that interpretation, the higher unemployment rates in the short run are clearly bad news. As for the higher inflation rates, I’m not so sure. A slightly different, but related, interpretation is that the market correctly perceives that the Fed has finally come to its senses and raised its inflation target from an unreasonably low level. Indeed, the current crisis, in which reasonable people are worried both about inflation becoming unhinged and about a potential deflationary collapse, is a good demonstration of why the target should be higher. It is kind of hard to believe that the Fed has come to its senses, though, since the rest of the world’s major central banks have been even further from their senses than the Fed.

Even if you think the Fed’s perceived* inflation target (between 1.75% and 2% on the personal consumption deflator, which is maybe about 2.25% to 2.5% on the CPI) is reasonable, you might think there are certain situations where the target should be raised. One of those situations might be a “safety trap” – where investors shun all but ultra-safe assets, even when the expected returns become much lower than those on risky assets. Arguably (though the argument becomes much weaker when you look at the stock market instead of the credit markets) the US is experiencing a safety trap now, and one solution is to take away the safety of the supposed safe asset by promising to inflate away the returns to be earned by government bondholders. Another situation where raising the target might be a good idea is when the uncertainty around the expected inflation rate increases, so that pursuing the original target would produce a significant risk of deflation. There might be a fairly strong case (as I suggest in the previous paragraph) that the US is in that situation right now. Obviously if you think that current circumstances call for an increase in the inflation target, then it is good news to learn that (in the judgment of the market) the target has actually increased.

But all these interpretations assume that the general shape of the distribution of inflation possibilities remains roughly the same. Moreover, casual talk of “expected inflation” suggests that we think the mean and the median of the distribution are roughly the same, since “expected inflation” could refer to either one. But perhaps what has happened is that the mean of the distribution has risen but the median has not. I would interpret the Fed’s target more as a median than as a mean. I would certainly hope that it isn’t the mean, and that the Fed would be more willing to tolerate inflation rates 3% above its target (high by recent standards but far from disastrous) than rates 3% below its target (deflation, which could be disastrous). Under this interpretation, the market still has confidence in the Fed’s target as a median, but the market is reassured that extremely low inflation rates will not be tolerated, so that the distribution has become more skewed to the right, and the mean has risen. In that case, the increase in mean (but not median) inflation expectations is good news.

[UPDATE: Paul Krugman, using what seems to be another species of the "in this situation, the inflation target should be raised" argument, makes the case that high inflation expectations are good news.]


*The Fed has actually announced a 3-year-ahead forecast, which can perhaps be reasonably interpreted as a target.

Inflation Expectations

This chart is showing up in too many places. The latest, to which I link, is Greg Mankiw's blog.

The implication is that the expected CPI inflation rate over the next ten years has risen from its typical value of around 2.5% to around 3.4% recently. There's little question that the expected inflation rate has risen over the past couple of months, with commodity prices rallying like never before (literally), and that is certainly an issue that the Fed has to be concerned about, but do we really believe that the expected inflation rate has risen quite so dramatically?

I don't. If you look at the raw breakeven inflation rate from the 10-year tips-to-nominals spread, it has only risen by about 20 basis points in the past couple of months, and it still hasn't taken out the highs that it made in 2005 and 2006. We can reasonably surmise that this understates the increase in expected inflation, since we also know that liquidity has gone to a premium over the past 6 months and that TIPS are less liquid than nominal Treasury notes. We can't quite be sure, though, because inflation uncertainty has also increased, so the increased risk premium for inflation uncertainty (which applies to nominal Treasuries) may be offsetting the increased liquidity premium (which applies to TIPS).

The 3.4 percent figure comes from a very specific way of estimating the liquidity premium. IIRC the Cleveland Fed does a regression on the spread between on-the-run (recently auctioned and therefore highly liquid) and off-the-run (slightly less liquid) Treasury notes. Recently that spread has increased dramatically, so the methodology is adding a large liquidity premium onto the expected inflation rate. But how large, exactly, should it be? Given that liquidity conditions are outside the range of the data prior to August 2007, and given that I think there are omitted variables (specifically, a time trend over the period during which TIPS were becoming more available and gaining more market acceptance, as well as a reverse time trend at the very beginning, when TIPS were new and exciting and therefore didn't need to offer high yields) in the specification, and given that I'm not sure that the on-the-run-to-off-the-run spread is the best measure of the liquidity premium anyhow, and given that there are issues about the inflation risk premium, I'm not at all comfortable accepting the Cleveland Fed's estimate.