Why Short Selling Matters

Arnold Kling (hat tip: Matthew Yglesias) argues that short-selling can’t “destroy a good company” because if the company is good, someone will always be willing to pay a good price for it and will be willing to buy it from the short-seller at that good price. But his analysis fails to account for uncertainty and imperfect information. We don’t really know which companies are “good.” Everyone has their own guess about how much a company is worth, but how much is it really worth? We won’t know until we see its results. Actually, we won’t even know then, because it will have more results in the future that we still won’t know about.

In general, since the market value of a company depends on an uncertain guess as to its true value, a good company can be destroyed simply by bad opinions, if people wrongly judge that it is a bad company. And, as I will explain, short-selling can exacerbate this problem in the case of a company that is in fact good but that, in terms of market opinions, is on the margin between being considered good and being considered bad. The “margin” idea applies when there is only one “marginal” short seller, but if there are many, they will effectively widen the margin, so that a clearly “good” company can turn into a clearly “bad” one.

For any given company, the market does not have one opinion, shared by everyone, about the value of its stock. Rather, everyone has a different opinion. People use different methods (including subjective ones, which differ from any one individual to another) to evaluate a stock. Those different methods lead to different conclusions about the stock’s value. One person may think a stock is worth $10; another may think it’s worth $9.99; another may think it’s worth $9.98; and so on down, and maybe, at the other extreme, there is someone who thinks it’s only worth $2.

So suppose the stock is trading at $10, and a large short-seller appears on the scene. The short-seller will satisfy the demand of the person who thinks the stock is worth $10, and then there will be no more demand at $10, and the stock will trade down to $9.99. Then the short-seller (who is, by my construction, “large”) will satisfy the demand of the person who thinks the stock is worth $9.99. Then the stock will trade down to $9.98, and the short-seller will satisfy the demand of the person who thinks it’s worth $9.98, and it will trade down to $9.97. And so on. If there are a lot of large short-sellers, they can bring the price down by quite a lot by, for example, satisfying the demand of everyone who thinks the stock is worth more than $7.

So let’s take that $10/$7 example, and let’s suppose that the definition of “good” requires the stock to be worth $8 or more (in a sense that will become more precise in later paragraphs). By sending the price down from $10 to $7, the short-sellers have effectively shifted the company’s “market reputation” from the “good” category into the “bad” category. No individual has actually changed their opinion, but because of the aggressiveness of the short-sellers (who obviously believe the company is quite a “bad” one), the “market” has changed its “collective opinion.”

Now let’s suppose that the company is (in actual fact rather than opinion) a “good” company but that it needs to raise more equity capital in order to stay good. (When you’re talking about a bank that is solvent but undercapitalized, this might be a reasonable description.) When it offers new shares, the company faces the same demand curve as the short-seller did, and since the price is now down to $7, the company will have to offer the shares at a lower price, say $6, for the offering to be fully subscribed, because it will satisfy the demand of everyone who believes the company is worth $7, $6.99, $6.98, and so on, down to $6.

OK, but suppose that the amount of capital raised at a $6 share price will not be enough to keep the company good. And let’s also suppose that it would have been enough if the offering price had been $9, which it would have been (approximately) if the short-sellers had not become involved. So the company still doesn’t have enough capital, and it needs to raise more. So it offers more shares. But again, the company faces a downward-sloping demand curve for its shares. Suppose it offers additional shares, which satisfy the demand of everyone who thinks they are worth more than $5, so the company offers these new shares at $5. But suppose that still is not enough to keep the company good. It has to offer more shares. But now that it has done two separate offerings, and it attempts a third, it probably won’t have the confidence of the market. Market participants will say, “If we pay $4 now, who is to say that the company won’t come back and offer shares at $3? We’ll wait for that.” And if they wait for $3, why not wait for $2? And if $2, why not $1? Of course at some point everyone is going to realize that the company is going to be unable to raise sufficient capital at any price.

In practice, potential buyers will have realized that much earlier. If they have a reasonable guess as to how much capital the company needs, and a reasonable guess as to what the demand curve for its stock looks like, then they will be able to come up with a reasonable guess as to whether the company can raise the necessary capital. Of course, there will be a variety of guesses, and opinions will differ. But at some point (as the declining stock value makes the problem clearer), only a few people (or none at all) will be of the opinion that the company can raise enough capital. At that point, the company is effectively ruined, the price goes down to near zero, and the short-sellers profit handsomely. If there are enough large short-sellers, not only can they destroy a good company, they can make a lot of money doing it.


UPDATE: Another way to argue that short-selling doesn't matter would be to argue that the person with the $10 opinion has an infinite amount of capital available, and therefore they will demand an unlimited number of shares at $10. Of course, it's rather silly to think that anyone has infinite capital. And for someone with limited capital, the more they pay for the shares, the more risk they are taking. So they will be willing to buy a certain number of shares at $10, but after that, the risk become too high, and the price has to go down to get them to buy more. Essentially, my argument above still applies, except that you can construct the demand curve from just one person's opinion. If there are many potential buyers, each of whom has limited capital and limited risk tolerance, but who have different opinions, the demand curve will still slope downward, and again my argument applies.

WSJ Factual Error

From the top story in today’s Wall Street Journal:

At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured....That’s never happened before.

Actually it has happened before, not in the easily available data, but it has happened – in 1938 (and apparently several other times between 1935 and 1941).

My only source is a talk by Paul Samuelson, for which I cannot even point to a transcript, but I’m confident that primary sources will bear me out. I’m too lazy to go check old copies of The Wall Street Journal on microfilm, but take my word for it.

It’s actually pretty obvious if you look at the monthly data from the Fed. For example, in February 1941, the average yield on 3-month T-bills was 0.03 percent. Considering how the yield fluctuates from day to day and from hour to hour, it’s impossible to believe that it was not negative at certain points during that month. (Technically the Journal was referring to one-month bills, but it’s a safe assumption that, if 3-month bills were selling above maturity value, so were one-month bills for at least part of the time.)


UPDATE: Paul Krugman makes the same claim (hat tip: anonymous commenter)....and I continue to believe it is wrong. I'm not sure his claim is independent: he may have gotten his information from the Journal, or they may have gotten it from the same source, which I hope they will cite so we can follow it up and judge its reliability.

UPDATE2: Reuters and the AP, both citing Los Angeles-based Global Financial Data, report that the last time the 3-month T-bill was at or below zero was January 1940. (Could it merely have been "at" zero? It seems unlikely that the bid would have stopped at exactly zero.) Another AP report says that demand sent "the yield on the 3-month Treasury bill briefly into negative territory for the first time since 1940." Friedman and Jacobson, in A Monetary History of the United States, 1867-1960, say in a footnote that "yields on Treasury bills were occasionally negative in 1940." (Apparently my "obvious" conclusion about 1941 was not correct, buy my main point stands.)

Moral Hazard for Corporations, part 2

I agree with Mark Kleiman's main points here, but this one, as my previous post would suggest, I think is a mistake:

Why shouldn't the government bail out a private company that isn't a regulated bank? Moral hazard. You don't want to protect AIG shareholders from the consequences of the bad bets made by the management, or you offer every big firm the chance to gamble on a "heads I win, tails you cover my losses" basis.

(Just to be clear, he isn't defending his own overall position with that statement; he's just discussing one consideration to be weighed.) As I argued in my previous post, whether or not any "bailout" is attempted, the shareholders are automatically bailed out by the limited liability that is part of the definition of a corporation. In a failure, their stock might become entirely worthless; in a bailout it just becomes almost worthless -- not an important distinction. Prudent stockholders have portfolios of stock, so it's not like a stockholder is someone who will personally be left with nothing in the case of a failure but still have a little bit to keep in the case of a bailout. Typical stockholders will just see changes in the values of their portfolios, and the difference between a 90% drop and a 100% drop in one stock will make only a tiny difference to the value of the portfolio.

Mark Kleiman goes on to discuss the role of moral hazard for creditors, and of course that is the real story. Since stockholders have limited liability, they always have an incentive to take excessive risks, unless the creditors prevent them from doing so (usually by threatening to withdraw credit). The real reason for avoiding bailouts is that the prospect of a bailout takes away the creditors' incentive to provide discipline. OK, I'm not going to repeat more of what I've said like three times already, and I'm not going to quibble with the subsequent wording of the post that I cited. It's worth reading for itself, although the argument is not too different from what I've been saying in recent posts.

Moral Hazard for Corporations

With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

Take, for example, the aphorism (regarding deposit insurance), “Heads stockholders win, tails taxpayers lose.” (This aphorism was recently used by, and may have been coined by, Paul Krugman. To be fair, if you read his whole entry, the language is more precise when he discusses the matter explicitly. But he also uses the misleading expression – which he did not coin – “FDIC put.”) This makes it sound as if deposit insurance were somehow protecting stockholders from the consequences of risky actions taken on their behalf. But what if there were no deposit insurance and the same risky actions were taken? What would happen to stockholders if those risks turned out badly? The stockholders would lose what they put into the corporation but no more – exactly the same as when there is deposit insurance. The moral hazard problem exists in general with stockholders, whether or not the assets are insured, because of the limited liability inherent in the corporate form of ownership. There is no “FDIC put” for stockholders; there is merely the “corporate put” that exists for all corporations.

When we talk about corporations whose assets are insured, either explicitly or implicitly, the special moral hazard problem is not with stockholders but with creditors. In the case of commercial banks, the creditors are known as depositors. The problem with deposit insurance is that it takes away the incentive that depositors would have to select and police their banks in such a way as to prevent excessive risk-taking. Overall, in the case of commercial banks, removing this incentive is a good thing, because depositors – with limited information and resources – aren’t able to do a very good job of policing and selecting banks. Their attempts to identify “bad banks” often result in “false positives” that precipitate bank runs. It makes much more sense to have regulators – who have more resources and better information – do the policing.

So I’ll repeat the point I’ve made several times before. When we talk about the implicit insurance that is (apparently not, as of yesterday) offered to investment banks and the like, the issue is not whether the stockholders are being protected – they’re always protected by the rules of corporate ownership – but whether the creditors are being protected. Are creditors being encouraged to make rash decisions about where to lend their money? Is the process of avoiding those rash decisions (as in the case of commercial banks) an inefficient one that could be done better by someone else (regulators, presumably)?

I have argued that, in the case of major investment banks, the moral hazard for creditors should not be a major concern. The comments have convinced me that I may have overstated my case, but I stand behind the policy recommendation. (Well, a “recommendation” after the fact is known as a “criticism,” but I would have recommended the same thing before the fact. The main reason I didn’t talk about it before the fact is that I expected officials to do what I would have recommended anyhow.) Large investment banks can, and perhaps should, be allowed to fail sometimes, but not when the country is already in the midst of an ongoing financial crisis and interest rates are low enough to limit the potential for using monetary policy to blunt the economic effects. Creditors should perhaps take the risk of losing their investment during generally good times, when the effect on the economy would not be potentially disastrous. I’ll reserve judgment as to whether creditors should be (implicitly or explicitly) insured (and I will certainly agree that such insurance should come with additional regulation), but I will not retract my opinion that the financial system as a whole should be insured. Sometimes implementing insurance for the system as a whole requires that individual institutions be bailed out.

Third Rant of the Day

When it rains, it pours. This one is really sort of a repeat of my first rant, but with more explanation and less sarcasm. Well, more explanation, anyhow.

Here’s Treasury Secretary Paulson at a press briefing this afternoon:

I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers.

When I first read this, I interpreted it to mean, “I never once considered the possibility that it was appropriate...,” and I was ready to write a somewhat more obnoxious rant about how Paulson was either a liar or irresponsible, and I hoped he was a liar. But a more careful parsing reveals that he is neither lying nor being irresponsible; he is just engaging in doubletalk. I don’t fault him for that, since it’s pretty much part of the treasury secretary’s job description. He never considered it to be the case that it was appropriate to put taxpayer money on the line.

Secretary Paulson is drawing his macho line in the sand and saying, “See, Mr. and Mrs. Average American, who faithfully pay your taxes, I’m protecting your money from the whining Wall Street plutocrats. So never think that just because I came from Wall Street, I will put Wall Street’s interests above those of Main Street. And never say that Republicans always help the rich.”

Which is fine if you believe that financial events have no impact on the nonfinancial economy. But most economists (and, I would guess, Secretary Paulson himself) don’t believe that. Let me assert – and see whether I get broad disagreement – that the failure of the 4th largest investment bank in the country can be expected to increase significantly the risks faced by participants in the nonfinancial economy. In particular, when the financial system is strained and interest rates on Treasury securities are already quite low, there is an increased risk that a weak economy will turn into a serious recession which the Fed will have little power to combat. If you depend on your job to earn a living, that’s a pretty serious risk.

So instead of putting “taxpayer money” on the line, Secretary Paulson is putting taxpayers on the line.

But then there is also the question of whether even “taxpayer money” is really less on the line than it would be if the Treasury had provided loan guarantees. I’ve addressed this question before in connection with the Fed’s Term Securities Lending Facility. Each individual taxpayer who benefits from public services depends on the taxes collected from all the other taxpayers to help pay for those services. If the other taxpayers start losing their jobs, tax receipts will go down, and this taxpayer will eventually have to pay more taxes, or give up more public services, to make up for that loss. If you risk the potential economic effects of a major investment bank failure, you are risking that taxpayers will have to pay higher taxes. That’s just the same as if you had provided loan guarantees, which risk that the loans will go sour and require an increase in taxes to make up the difference. In which case is the risk bigger? Not obvious to me, but if I had to guess, I would say that the investment bank failure risks taxpayer money more than would the loan guarantees. So I would say that Secretary Paulson’s stance on “taxpayer money” is either politically disingenuous or economically naïve.

Let’s consider the possibility that it is politically disingenuous and that his motivation is actually something different than protecting taxpayer money. I’m not suggesting anything sinister; I’m just suggesting that there is a (slightly) more reasonable, but harder to explain, argument for avoiding a bailout. As Secretary Paulson says elsewhere in the briefing:

Moral hazard is something I don't take lightly.

Rather than trying to define moral hazard, I’ll go with the definition used by the AP in the report about the briefing: “the belief that when the government steps in to rescue a private financial firm it encourages other firms to engage in risky behavior.”

But does it? When the government steps in to rescue a firm by facilitating its sale at a small fraction of the price that it fetched a year or two ago, does that really encourage other firms to engage in risky behavior? It’s kind of like when your health insurer requires only a $950 co-payment for a $1000 procedure. Does that give you an incentive to make excessive use of the health care system? If I were a financial firm contemplating engaging in risky behavior, I wouldn’t find the prospect of a fire-sale rescue to be very encouraging.

It’s really not the firm that would be bailed out, but the firm’s creditors. Were the creditors engaging in risky behavior that needs to be discouraged? There isn’t much I can say about that that I didn’t already say this morning. In general, I think that doing business with major investment banks is something that we should encourage. A financial system doesn’t work very well when everyone is afraid to do business with everyone else. Should counterparties really be expected to do extensive due diligence on the 4th largest investment bank in the country before they engage in credit swaps with it? It seems to me that would not be a very efficient use of resources. And in any case, it’s not clear that even extensive due diligence would have uncovered the depth of Lehman’s problems.

End of rant. Executive summary: They should have bailed out Lehman.

Moral Hazard and Protecting the Taxpayer

What? You've been doing business with the 4th largest investment bank in the country? How imprudent of you! We can't allow such rashness to be rewarded. No, we must let the market punish you for your imprudence. Otherwise, it will encourage people to do such risky things in the future -- expecting the risks to fall on the taxpayer.

Yes, it is the taxpayer that we are trying to protect. The taxpayer cannot accept the consequences of your imprudent actions. Never mind that, given the possible economic impact, most people who pay taxes will face even greater risks than the they would if the government had facilitated a sale by guaranteeing some of Lehman's assets. The Treasury's obligation is not to the people who pay taxes. It is to the taxpayer!

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.

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?

Paradoxical Responses to Fedspeak

Throughout November, the US Treasury bond market seems to have been responding to Fedspeak by going in the opposite direction from what Fed statements would suggest about interest rates. Early in the month, when Fed officials were sounding (to my ears, anyhow) hawkish, interest rates fell. Over the past few days, with Fed officials sounding more dovish, interest rates have risen.

With respect to long-term bonds, this behavior is consistent with a view in which statements by Fed officials give clues about the Fed’s degree of commitment to keeping inflation low. Hawkish statements mean less inflation, which means lower long-term interest rates. Dovish statements mean more inflation, which means higher long-term interest rates.

It’s a bit harder to rationalize the response of short-term bonds (by which I mean 2-year Treasury notes, Treasury bills, and seasoned securities nearing maturity). The Fed’s commitment to keeping inflation low shouldn’t be much of an issue here, because there isn’t enough time for the inflation to develop before the bond matures.

Another explanation is flight to quality: when the Fed is more hawkish, bondholders worry more about the creditworthiness of other borrowers and shift their assets into Treasury securities, causing the interest rates on those securities to fall. But even the Eurodollar market, which is considered more risky than the Treasury market, has been responding in the same direction.

A variation on the flight to quality explanation is that the flight is from stocks: hawkish statements by the Fed cause investors to sell stocks and replace them with bonds, thus causing bond yields to fall. But presumably the reason investors sell stocks is that they think higher interest rates are bad for the stock market. Why would this cause them to bid down interest rates to an even lower level? Once interest rates fall, wouldn’t they immediately go back into stocks?

My best guess about what’s going on is that the bond market thinks it understands Fed policy better than the Fed does. The bond market is convinced that interest rates will eventually have to come down to prevent, or to recover from, a recession. The sooner the Fed starts cutting – the sooner it sets into motion the recovery process – the less cutting it will eventually have to do. In particular, if the Fed cuts sufficiently at the next two meetings, it may be able to avoid a recession. If not, a recession is nearly certain, and more dramatic (and longer lasting) cuts will be necessary to recover from the recession. This is how I imagine that the bond market reasons, but I’m not convinced that the bond market is right.

Falling Angels

Tanta at Calculated Risk has an interesting (but very long) post about the nature of “subprime” lending. A central idea is that, before the recent lending boom, subprime borrowers were essentially just prime borrowers whose credit had gone sour – typically people with mortgages who needed to borrow more money to keep making the payments on their existing mortgages. The availability of “traditional” subprime loans often allowed them to avoid default on their original mortgages, which kept those mortgages in the “prime” category. The increased availability of subprime credit in recent years has thus helped keep down default rates on prime loans. But now that subprime credit has dried up, the prime loans are going to start looking worse than ever: potential defaulters that would, in the past, have been caught by the subprime safety net, will now become actual defaulters.

It occurs to me that there is an imperfect but perhaps useful analogy to be drawn with the junk bond market in 1980s. Prior to the 1980s, “junk bonds” were almost all “fallen angels” – bonds that had been considered investment grade at the time they were issued but which had been downgraded. During the 1980s, through the efforts of Michael Milken and others, it became acceptable to issue bonds with low ratings, and the junk bond market as we now know it was born. As I recall, the junk bond market fell into disarray in 1990, but it eventually recovered, Michael Milken got out of jail, and “high-yield bonds” are now a permanent niche within the investment world.

Tanta is not so optimistic about the future of subprime lending for original purchases (analogous to the type of junk bond issuance that became popular in the 1980s). She seems to regard that type of subprime lending as an inherently bad idea. On the other hand, she sees the “fallen angel” type of subprime lending as being critically important, and she argues that (particularly given the type of positive feedback that occurs in the housing market) most prime borrowers are in danger of falling from grace: “We are all subprime now.”

The Seven Effect

A lot of people have compared the recent financial crisis to the crisis of 1907. It’s interesting that the time difference is exactly 100 years, but it’s easy to call that a coincidence. The modern economy hasn’t been around long enough, hasn’t provided enough data to say whether the 7th year of a century has been a more likely occasion for a financial crisis, and there’s no particular reason (that I know of) to think that it would be. But it’s vaguely interesting that both years end in 7: there are enough years ending in 7 that one could look for a correlation in the actual data if one thought there were any point in doing so.

The story gets more interesting in the light of a piece by financial historian Harold James (hat tip: Greg Mankiw). Without any apparent inclination to look specifically for sevens, he comes up with three years that he thinks are better parallels for 2007: they are 1837, 1847, and 1857. Since only 1 in 10 years end in 7, the chance of pulling 3 such years by random chance is 1 in 1000. That’s looking like statistical significance, considering that we already had an empirical basis for the hypothesis that there is something special about 7. Thinking back over the last two decades, I also recall that that the great Asian financial crisis began in 1997, and the US stock market crash happened in 1987.

Perhaps this is still all coincidence, but it seems that, if someone could think of a reason why financial crises are more likely in years ending with 7, it would make sense to listen to that reason. (Maybe the “lucky number” 7 makes people more inclined to take imprudent risks? Maybe there is a pattern of confidence-building during each decade, and it reaches an unstable point after 7 years?) Anyhow, this “seven effect” should fit nicely into my delusional system, along with the nine-zero effect wherein decades boom at the end and crash at the beginning.

All for the Want of a Nail

I’m going to pick on Jeff Miron again, and in this case my only source is a couple of paragraphs in Monday’s Harvard Crimson (hat tip: Mark Thoma), so I won’t pretend that I’m really being fair to him, but I think these paragraphs are representative of a point of view that is in need of attack:

Miron...expressed less sympathy than others for the subprime lenders and borrowers, who he suggested are playing the roles of both perpetrator and victim in the current crisis.

"The subprime event is not that big a deal. It’s a small part of the economy. There will be some foreclosures, banks will lose money. That’s life. That’s capitalism. They took risks, and they lost. Policy should not bail out people for greed and stupidity, or their risk taking."

As it happens, I do think that we should have some compassion for subprime borrowers and lenders, not necessarily out of general compassion but for the reasons I discussed here. But I see that compassion as a minor issue. The fact that interest rate cuts (for example) would help these people, is one additional pebble in the balance that weighs toward my advocacy of interest rate cuts, but by itself this factor is not enough to make 25 basis points worth of difference in my opinion on the federal funds rate target. Is it possible that this factor – and the associated “moral hazard” issue – weighs 25 basis points worth (or more) against interest rate cuts for some people? It seems like it does, and that seems foolish to me, but let’s get to the main issue:

The subprime event is not that big a deal. It’s a small part of the economy.

Quantitatively speaking, it’s certainly true that the volume of subprime loans is small compared to the size of the economy. But does that observation justify the conclusion that “the subprime event is not that big a deal”? To me, it seems that the question should be rhetorical, because the obvious answer is “no,” but apparently others don’t find that answer to be obvious. And (assuming that the Crimson quoted him correctly and that he intended those two propositions to be logically connected) I’d have to say that, from my point of view, Jeff Miron doesn’t seem to understand what’s going on.

I’ll allow that Mr. Miron was quoted out of context (by both the Crimson and me); that the reporter probably surprised him when he was thinking about something else, and he didn’t get a chance to think through his answer; that he probably didn’t feel he needed to be too careful about his words when he was talking to the college paper. But when we take into account indirect effects, the subprime event is a very big deal. Subprime may be “a small part of the economy,” but LIBOR – which rose about 35 basis points because of the subprime fallout (in spite of a large drop in T-bill yields at similar maturities) – is not small: as far as short-term lending is concerned, LIBOR is most of the economy.

If it were just a matter of a few institutions that made subprime loans and had to recognize some losses because defaults were higher than they had planned, that would have been a virtual non-event in the grand scheme of things. But the subprime risk is not concentrated in a few institutions – or, to be more precise, maybe it is; we just don’t know where the hell it is, and that’s the problem. Can one say that walking across a minefield is “not that big a deal” because the actual mines underlie only a small fraction of the total area? When you suddenly find that institutions in France and Germany are close to toppling because of a small problem in the US, you’ve got a big problem, because people start to lose confidence in the whole global financial system.

And that’s just the beginning. Another effect of the subprime crisis has been diminished confidence in the bond rating agencies. When investors don’t know which bonds are safe and which aren’t, it becomes hard to borrow money by selling bonds. This has not been a big problem for traditional investment-grade corporate bonds outside the financial sector, but it has been a big problem for lower-rated bonds, and it has been a huge problem for just about any kind of asset-backed security that doesn’t seem to have a government guarantee. One of the results is that it has now become difficult and expensive – even for prime borrowers – to get a mortgage for any property that doesn’t conform to the requirements of government agencies or government-sponsored enterprises. (A particular case in point is the oversized “jumbo” loans that are now required to purchase even many mid-level houses in the post-boom coastal areas.)

And then there is the liquidity crisis. With all the uncertainty about the quality of loans and institutions, the institutions themselves face increased withdrawals of capital and increased uncertainty about withdrawals. At the same time, with all the uncertainty about the quality of bonds and other assets, these assets become more difficult to sell. Leverage is forcibly unwound. Failures cascade. Many of the failures occur outside the banking system and therefore outside the direct influence of central banks. Assets deflate. Otherwise solvent institutions become insolvent. Disintermediation further weakens the financial system.

Job losses in construction, finance, and home furnishings also have multiplier effects. In the financial chaos, with even prime borrowers facing difficulties in purchasing new houses, house prices could fall below fundamental value, and households will be bound by more stringent liquidity constraints and forced to curtail consumption. Financial problems abroad can be expected to dampen improvements in the US trade balance. Damn, I’m really talking myself into forecasting a recession now. Anyhow, to reiterate my original point, even though the subprime problem is a small part of the economy, it is a big deal.

Inflation Worries?

Tim Duy is worried about inflation:

Note also that gold broke out above $700, copper bounced today, oil is poised to make a run for $80, the Baltic Dry Index is off the charts, productivity growth is falling, and the Dollar is set to make another drop. Moreover, I suspect China will be revisiting their currency/foreign exchange reserve policies after the 2008 Olympics, adding to additional downward pressure on the Dollar.

In short, I think the Fed is rightfully cautious about the inflation outlook, but policymakers are likely to cut rates anyway. Historians should take note; I have a sick feeling that this is the moment the tide turned on the 25+ year battle against inflation.

Considering Professor Duy’s apparently high inflation expectations and my low expectations (see point 3 from yesterday), this might be a good occasion for a wager. Unfortunately, pseudonymous persona that I am, I don’t think I’m permitted to make wagers. But if Professor Duy is a betting man, he can get plenty of action from my friend Mr. Market. I see the 10-year T-note quoted at a yield of 4.31%, while the 10-year TIPS is quoted at 2.12% -- a spread of 2.19%, even slightly narrower than the 2.20% where it closed at the end of August. I’ve been keeping track of the month-end closes of this spread, and August 2007 was the narrowest close since October 2003. So if anyone wants to bet on higher inflation, Mr. Market is offering rather attractive terms.

Realistically, one has to recognize that the TIPS-to-nominals spread is narrow in part because of a liquidity premium in the TIPS yield, given today’s thirsty market conditions. So I’m not entitled to say with confidence that the bond market anticipates a CPI inflation rate of 2.19% over the next 10 years or that its anticipated inflation rate is lower than it has been since 2003. Nonetheless, since the yield on nominal T-notes should include a premium for purchasing power risk, and since, by now, TIPS are not all that much less liquid than nominal T-notes, I think it’s fair to say that the bond market doesn’t share Professor Duy’s sick feeling.

Monetary Policy Targets

Pondering my last post, I got to thinking: Why stop with LIBOR? Why not target commercial paper yields? Or even maturing junk bond yields? In practice, there are a couple of reasons I wouldn’t suggest such things. First, I don’t trust the rating agencies enough to make them partners in monetary policy. (The definition of what is being targeted would have to be standardized on the basis of ratings, which means that any upgrade or downgrade would change the de facto target.) Second, market-specific problems could distort the economic meaning of the policy. (The latter is already an issue, though, because problems specific to the banking system can distort the economic impact of a federal funds rate target.) But I still think that, in theory, targeting risky interest rates is a good idea.

Here’s my argument: The Fed sets its policy based on an economic forecast, which contains some implicit or explicit assumption about the price of risk. If the price of risk changes, there ought to be some automatic mechanism for altering policy so as to offset the change in the forecast. Targeting risky interest rates would be such a mechanism. (This is essentially the argument I made last month about why a cut in September would make sense.) In fact, the Fed already does this to some extent by targeting the federal funds rate: if the price of risk rises, so does the spread of the funds rate over the risk-free T-bill rate, and the Fed acts to push down the risk-free rate so as to keep the funds rate constant.

But if automatic policy adjustment is a good idea, why stop with risky interest rates? Why not, instead of targeting a single interest rate or reserve aggregate, target some linear (or nonlinear) combination of economic and financial data. (I’ve always thought, for example, that while targeting a single monetary aggregate makes little sense, the aggregates do contain information about how Fed policy is affecting the economy. I’d like to see them be part of such a composite target.) Seems to me that, with today’s technology, it is quite feasible to put monetary policy on autopilot between meetings instead of fixing some particular interest rate (which is kind of like just a primitive version of autopilot). And the formula could be announced and followed by the markets, as any competent quant could program her spreadsheet to mimic the Fed’s spreadsheet. And the decision at a meeting would be, not whether to change an interest rate target, but whether to adjust the autopilot parameters. OK, I’m dreaming, but…

The Fed Funds Puzzle

Greg Mankiw has a post today about “the LIBOR puzzle” – the observation that LIBOR has recently moved up even while other interest rates (such as the 3-month T-bill rate and the expected federal funds rate) have moved down. (In fact, a lot of interest rates that businesses and consumers actually pay have moved up, but these typically are too idiosyncratic to produce the nice statistical series that economists like.)

As I said in Greg’s comments section, I don’t find this to be much of a puzzle: there is the T-bill rate, which is risk-free, and then there is the LIBOR spread – the price of LIBOR counterparty risk – which typically moves in the opposite direction except in response to unexpected news about inflation or Fed policy. The spread (typically <1%, though it is higher at the moment) is normally smaller than the T-bill rate (typically >3%), so the movements in the T-bill rate are usually larger in absolute terms; thus the sum of the two – namely LIBOR – usually moves in the same direction as the T-bill rate. The only difference now is that the spread has moved more than the T-bill rate in absolute terms; thus the sum – LIBOR – has moved contrary to the T-bill rate. It just happens that we’ve experienced a shock which has had more effect on credit spreads than on the level of risk-free interest rates. That’s actually what you might expect from a large shock to the financial sector: since it has only a small expected effect the real economy, it produces a relatively small change in the risk-free interest rate; since it has a large effect on financial conditions, it produces a large change in the risk spread.

You can read more of my ideas about this in the comments section of Greg’s post, but I want to bring up something that has puzzled me for a while. It’s an institutional puzzle. Since the Humphrey-Hawkins Act, the Fed’s primary responsibility has been the management of the US macroeconomy. That being the case, why does the Fed choose to target an interest rate which

1. has little direct relevance to the US macroeconomy and
2. is not under the Fed’s direct control?

Wouldn’t it make more sense to target, say, LIBOR, off of which many interest rates in the US are priced, and which in any case reflects the general cost of the type of risky credit available to private sector agents in the US? Or, alternatively, wouldn’t it make more sense to target, say, the 3-month Treasury bill rate, which the Fed could (if it chose to do so) control with great precision by making a market in T-bills at a temporarily fixed bid and offer.

I presume the Fed has its reasons for targeting the federal funds rate, but if I, in my ignorance, were asked (and I’m just as glad I won’t be) to design a monetary policy, I think I would start by coming up with a LIBOR target and then estimating the expected spread between LIBOR and T-bills, and then I would fix the T-bill rate such that the expected LIBOR would equal the target. Then I would monitor the spread and adjust the T-bill target as the spread changed over time.

In extreme circumstances (like right now, perhaps), it might be necessary to free up the T-bill rate to deal with issues in the banking system. Perhaps under today’s circumstances I would maintain the bid for T-bills but temporarily stop offering them, thus placing a ceiling on the T-bill rate. That’s actually roughly what the Fed has done with the federal funds rate, except that it can’t enforce the ceiling precisely, and it is making a vague pretense to putting a floor on the funds rate, even though the data seem to show zero as the only floor.

Markets Normalizing?

Not especially. Come back when the TED Spread is once again measured in basis points rather than percentage points, and then we can talk about whether markets are normalizing.

Punch at Caesar's Funeral

Contrarian that I am, Daniel Gross’ latest Moneybox commentary in Slate (hat tip: Mark Thoma) has all but convinced me that a drastic easing of Fed policy will be necessary to avoid a major recession. The main thrust of his commentary seems to be that, because a lot of rich people and conservatives want the Fed to cut interest rates, therefore anyone who is not rich or conservative should regard such a cut as a bad idea. (He doesn’t make that logic explicit, but since the commentary contains little explicit logic, I feel entitled to read between the lines.) To me, as a non-conservative* who is not (yet) rich (certainly not in the same league as Mr. Gross’ “motley collection of gazillionaires”), the observation that such people are “begging the Fed to cut interest rates” tends to reflect well on them rather than reflecting badly on the possibility of interest rate cuts.

At the end of the commentary, Mr. Gross does attempt to make an actual argument against interest rate cuts, but I fear he has confused metaphor with reality:

College students don't alleviate the after-effects of an evening spent at the punch bowl by returning to lap up the dregs. Just so, finance types should know that cheap money, credit on demand, and endless leverage aren't the cure for a hangover caused by too much cheap money, leverage, and credit on demand.

Or perhaps he has merely forgotten some relevant history. Unlike me, Mr. Gross does have a degree in history, so perhaps he will be able to find historical examples to buttress his case. (There were none in this particular commentary.) But to my own sparsely tutored ear, his analogy bears an unpleasant resemblance to the type of argument that was often heard in policy circles during the period 1929-1932.

As a matter of macroeconomics, I would say that “cheap money, leverage, and credit on demand” are precisely the cure “for a hangover caused by too much cheap money, leverage, and credit on demand” – at least to the extent that said hangover carries a risk of recession or deflation. If only the Fed had provided cheap money and credit on demand in late 1929 and 1930 (or, for that matter, 1931 and 1932), history might have turned out quite differently (and, I dare say, better). Perhaps Mr. Gross can cite some recent history – the 1998 experience – as an example of what’s wrong with easing monetary policy in response to a mass deleveraging. I have to ask, though: If the choice is between risking another 1999 and risking another 1931, which one should we be more concerned about? I pause for reply....


Not that we really have to worry about a repeat of the 1930s. Ben Bernanke is an economic historian – and an expert on the Great Depression, at that. As soon as he gets a strong whiff of recession, he will do anything but repeat the mistakes of the early 1930s. But it’s also clear that Chairman Bernanke is bending over backward to avoid repeating 1998. The last three weeks have been a case study in how to loosen monetary policy without loosening monetary policy. And it’s worth noting that the US economy was a lot stronger going into 1998 than it was going into 2007.

The classic “punch bowl” metaphor adopted by Mr. Gross has (at least) one major limitation: unlike alcohol, money is pretty much essential to the functioning of a modern economy. Certainly the Fed should take away the ice cream before our waistlines start to inflate. But when our bulimic economy realizes it has eaten too much, there are healthier approaches than encouraging vomiting and fasting.


* I hesitate to use the word “conservative” in any substantive context, however. The fact that “conservatives” are calling for easy money is yet one more small contribution to the mounting evidence that such words have little left in the way of meaning.