Between Debt and the Devil

In progress

1 Utopia of finance for all

“Finance got bigger, more complex, and better paid.” Financial intensity (share of financial services in national output) increased until WWI, flattened until 1970, and then surged again until today. Private sector debt (household and company debts) increased but for every financial liability, there must be some matching asset, so assets also grew. After 1970 it was not just households and corporations that borrowed money from banks. Numerous financial institutions including money market funds institutional investors and hedge funds entered the field. They introduced complexity to this highly leveraged system as they began trading derivatives, securities debt, and credit default swaps. In so doing, their salaries also swelled relative to salaries of people with comparable skills in other industries.

Three axioms of pre-crisis financial innovation are presented. First, increased freedom (deregulation, liberalization) in the marketplace increased liquidity and better price discovery and thus completed markets making them more efficient and stable (Efficient Markets Hypothesis). Second, the supply of credit drove economic growth and homeownership (supply-side argument). Third, macro models did not account for credit supply by banks and shadow banks and thus ignored leverage, leaving it for micro theorists. Alas, precrisis empirical evidence seemed to justify the financial deepening and intensity idea that finance is good for growth. But finance was unlike other markets and it was not separate from macro questions.

2 Inefficient financial markets

Financial institutions (banks and markets for equity and debt) play a crucial role in liquidity and maturity transformation. The case for more finance up to some level is therefore strong. But just because it was beneficial for the early growth of capitalism does not mean that it should never be tamed later on. Competitive equilibrium theory (initially grasped by free-market economists since Adam Smith’s Wealth of Nations and later proven mathematically by Kenneth arrow and Girard Debro in 1954) provided a “rigorous theoretical underpinning for the assumption that financial innovation and increased financial intensity must be beneficial.” Although competitive conditions did not always exist as documented in research, it was argued that freer markets only enabled the required conditions for market completion, better price discovery, and hedging against risk. The efficient market hypothesis undergirded by the rational expectations hypothesis posited that the average investor cannot consistently beat the market. The EMH assumes that people are in general rational, that even if some of them are irrational this irrationality is random, and that even if enough irrational actors move prices away from equilibrium, the actions of rational arbitrageurs will ensure that the reversion to equilibrium is swift. People, however, have proven to act irrationally, making the system not only less efficient but less stable.

“Price setting was driven by beliefs and actions inexplicable in terms of the” two hypotheses. Five factors explain why markets are susceptible to inefficiency and collective irrationality (why prices and yields diverge from rational equilibrium levels). First, people can act irrationally and, second, they can drive each other to do so. Third, arbitrageurs who try to profit from price swings cannot do so when the entire market is overpriced and, fourth, in any case, by doing so they exacerbate price swings. Fifth, the two hypotheses do not capture inherent irreducible immodelable uncertainty. Markets can price assets well relative to each other but not always overall.

What about social value and stability? “Free financial markets can create private incentives for levels of intra-financial activity that go far beyond those required to deliver true social value” in the form of liquidity and marginal benefits in price discovery. In fact, they hurt the economy by knocking GDP growth off its path during shocks. Instability has not been conclusively linked to either trading volumes or market liquidity but neither can be said to reduce volatility. Financial innovation (new contract types such as a CDS for instance) on the other hand is more strongly linked to volatility.[2]

The conclusion is that we “should reject axiomatic arguments in favor of more market liberalization and market completion” and instead we should “consider public policy interventions to address issues of value for money.” We should also identify the riskiest financial activities that lead to the greatest macroeconomic instability.

Studies:

• Andrei Schleifer in Inefficient Markets: An Introduction to Behavioral Finance (200) argues that “arbitrage does not help to pin down price levels of stocks and bonds as a whole”

• Roman Frydman and Michael Goldberg in "Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State" (2011) point out that occasional significant divergences of market prices from equilibrium values are inevitable.

• James Tobin in his 1984 work, On the Efficiency of the Financial System, argues that information arbitrage efficiency and fundamental valuation efficiency are two different concepts meaning prices can move reasonably relative to each other but not necessarily overall. Hence bubbles happen.

• Summers and Summers (1989,1990) papers argue for a securities transactions tax to discourage herd-driven short-term traders and thus reduce volatility. A few other studies show varied results. See footnote 25 chapter 2.

Continue revising here

3 Debt, Banks, and the Money they Create

In the decades leading up to the great recession, “real economy leverage grew because private credit grew faster than nominal GDP.” Debt contracts as opposed to equity contracts protect investors from risks they cannot control. Thus, although both contract types facilitate liquidity transformation, debt contracts bring into the market more risk-averse investors thereby mobilizing more capital. Banks catalyze this process by serving not only to link investors and entrepreneurs but also by lending out savings in a fractional reserve system. So debt enables economic growth and capital formation, but they also come with risks.

First, debt contracts can fool investors into ignoring risks. As opposed to equity (stock) prices that witness large daily variation, debt returns are labeled fixed income because they are assumed to be safer. They are less volatile and the downside of default is considered improbable. But they lead to myopia as Schleifer and colleagues argue in a 2012 paper. Second, debt financing is subject to sudden stops and drops in investor confidence that hinder debt rollover, unlike equity financing the payoff date or maturity of which is to some level discretionary and without which business can continue for some time. Third, when operations (businesses or mortgages) go underwater or default due to unsustainable debt contracts, the bankruptcy procedure is costly and disruptive. Fourth, default and bankruptcy lead to fire sales and a downward spiral of lower confidence, asset prices, and credit supply. Fifth, Fisher’s debt-deflation theory: falling asset prices due to fire sales depress the asset prices of otherwise operational businesses or the values of houses in a neighborhood with many foreclosures. Thus businesses cut investment and households cut spending as their asset base becomes less valuable and they become less solvent. This is also called the debt overhang effect.

Banks create credit, money, and thus purchasing power through a maturity transformation: the loans that banks extend to borrowers (the banks’ assets) are repayable at a later date, but the deposits that savers extend to banks (the banks’ liabilities) are immediately available. Thus bank credit creation generates purchasing power and is enhanced by fractional reserve requirements (which can but have not been controlled) and highly liquid interbank lending markets (controlling which using the interest rate has been the name of the pre-crisis game).

Studies

• Townsend (1979) “Optimal contracts and competitive markets with costly state verification” discusses why Equity contracts are costly for the investor.

• Gerschenkron (1962) “economic backwardness in historical perspective: a book of essays” argues that investment banks in late 19th century Germany played a role as important as industrial technologies in driving economic growth.

• Gennaioli, Schliefer, Vishny (2012)“Neglected risks, financial innovation, and financial fragility” argue that investors in good times assume that full payout is not only likely but certain, and they exclude from their consideration the possibility of loss: local thinking, myopia.

• Fisher (1933) “the debt-deflation theory of the great depressions“ argues for falling asset prices in debt default lead to downward spiral.

4 Too much of the wrong sort of debt

Real estate is inherently valuable. Individuals will want to borrow to eventually own it and lenders will take it as collateral. But left to themselves, lenders will produce too much of the wrong sort of debt of which mortgages are but one type. Credit-finance consumption is unsustainable especially when future income prospects are worsening due to inequality or falling real wages. In contrast, credit-financed investment can produce cycles of over investment and leave behind wasted real resources and a debt overhang problem as was witnessed around 2008. Finally, credit-financed purchases of existing assets reflects the inevitably rising importance of real estate as a share of wealth in increasingly rich societies. “A world in which the volume of information and communication capacity embedded in capital goods relentlessly increases is a world in which real estate and infrastructure constructions are bound to account for an increasing share of the value of all investment.” Consumption dynamics will tip the scale further: expenditures compared to income will rise for increasingly scarce real estate (locationally specific housing) while they will fall or remain constant for increasingly cheap technological goods. [1] Thus the infinite capacity of banks to create credit along with infinite nominal demand (price elasticity) for housing conflicts with the inelastic constraint on housing supply. There are not enough houses to meet people’s insatiable and increasing desire to own property in certain locations.

Studies

• Hayek 2008 1931 “prices and production and other works.” Minsky 2008 1986 “stabilizing an unstable economy.” Credit creation can produce cycles of overinvestment that leave behind wasted real resources and a debt overhang problem.

• Jorda, schularick, and Taylor (2014) “The great mortgaging” in 2007 banks in most countries have turn primarily into real estate lenders.

• Piketty (2014) “capital in the 21st century” points to the remarkable increase in the ratio of wealth to income in advanced economies over the past 40 years.

• Knoll, schularick, and Steiger (2014) “No price like home” argues that 80% of house price increases can be attributed to rising land prices and 20% to the constructed value of housing.

• Calomiris and Haber (2014) “Fragile by design: the political origins of banking crises and scarce credit” argues that before the mid 20th century, banks and several advanced economies were restricted or at least discouraged from entering real estate lending markets and that, once the constraints were removed, these institutions increasingly became real estate lenders.

• Mian and Sufi (2014) “House of debt” argues that house price blooms in busts can take place in already existing real estate such as in geographically constrained Manhattan or San Francisco.

• Borio and Drehman (2009) “ Financial instability in macroeconomics: bridging the golf.“ borio (2012) “ The financial cycle and macroeconomics: what have we learned?”

• Muelbauer at al. (2012) “ Credit, housing collateral and consumption in the UK, US, and Japan.“ Credit and asset price cycles are not just part of the story of financial instability in modern economies, they are its essence

5 Caught in the debt overhang trap

Monetary and fiscal measures enacted by the fed and treasury after 08 were necessary but insufficient in the face of a massive debt overhang that followed the real estate credit boom. A similar episode unfolded in Japan just a decade or two earlier in what Richard Koo calls a “balance sheet recession” following excessive private credit but western economists did not heed. Highly leveraged US households that ended up insolvent and sold their assets (the house at fire sale prices) are the 08 equivalent to the Japanese companies of 1990. Mian and Sufi find that house price fluctuations occurred in counties where housing supply is inelastic due to physical constraints or zoning. They also find that the more indebted households were, the more they cut spending which in turn caused a drop in local employment and business investment.

So households and companies deleveraged, but debt did not disappear. It only shifted to the public sector or to other countries. Policy levers seem ineffective in an over leveraged economy. Monetary policy might reduce the dangers of deflation and enhance real growth by stimulating investment in businesses and purchases of stocks and bonds or other consumption among wealthier households, but it is bound to increase wealth inequality. Low interest rates further distort recoveries by incentivizing financial innovation to take advantage of yet more leverage.

Studies

• Eggertson and Krugman (2012) “ death, deleveraging, and liquidity tribe: a Fisher-Minsky-Koo approach“ I forgot it’s a formal analysis of the negative impact on demand arising from the asymmetry of response between net debtors and net creditors.

• Mian and Sufi (2014) “House of Debt”

• Butiglione et al (2014) “deleveraging, what deleveraging?” shows that household debt is down as a percentage of GDP since 2009, corporate debt is flat, but public debt has dramatically increased.

• Kapetanios et al. (2012) “Assessing the economy-wide effects of quantitative easing“ argues that UK nominal GDP was about 1.5% higher as a result of its quantitative easing program.

6 Liberalization, Inequality, and unnecessary credit

______

[1] question: is real estate really all that scarce? Isn’t the earth big enough to ensure prices drop even if they get insanely high? Surely, at least generationally, people will abandon overpriced locations and create a new London or New York. Perhaps that’s too long-term.

[2] See work by Alp Simsek and sources therein.