Sunday, April 25, 2010

Bad Fixes

I have something to say about two recent pieces in the New York Times. The first is here in Sunday's Week in Review section (you can tell I still read the physical object), and the second was Krugman's April 23 column. Krugman gets some things right. First, the moral hazard problem associated with too-big-to-fail led large financial institutions to create aggregate risk that would have otherwise been diversified away. Second, the creation of sophisticated financial instruments cuts both ways - it makes financial markets more efficient by concentrating aggregate risk in institutions that are best able to bear it, but it (along with, or in tandem with sophisticated accounting practices) also permits financial institutions to hide what they are doing. (I'm using "sophisticated" here in the same sense in which I would say that a thief is sophisticated.) Other than this, both pieces are essentially a summary of some bad ideas that are in circulation. I'll go through the bad ideas in sequence and try to debunk them.

1. The Chinese and the Fed kept our interest rates too low, and thus helped cause the financial crisis. First, the Chinese are giving us a great deal; they sell us their goods cheap, and lend us the funds to finance these purchases at low interest rates. Who could ask for more? Stop bashing China, it's unseemly. Second, we are still groping our way toward understanding what an optimal inflation rate might be, and to figuring out how and why a central bank can make real rates of return move around. Frankly, no one has the faintest idea whether real interest rates in the United States were too high, too low, or just right in the late-Greenspan era before the financial crisis. The financial crisis was caused by incentive problems in mortgage markets and at higher levels in the financial system. Of course, these incentive problems were exacerbated by low real interest rates. The point is that we are not going to solve the incentive problems of the financial industry by, for example, ending the use of the U.S. dollar as the primary international reserve currency, as Stiglitz seems to be suggesting. What a stupid idea!

2. Narrow banking will help. Kotlikoff's suggestion that we have deposit-taking banks hold only safe assets is familiar to anyone who has read Friedman's Program for Monetary Stability. This is much like Friedman's 100% reserve requirement proposal, though the motivation is different. It's wrongheaded for the same reasons, as it throws the baby out with the bathwater. Converting risky and illiquid assets into relatively safe liquid assets that can be traded in transactions is what banks are about. The benefits from this intermediation activity are large, and likely these benefits are larger than conventionally measured. Further, the financial industry is becoming a place where it is hard to tell what is a bank and what is not - we need a systemic approach to regulating the whole industry, not some attempt to fix deposit-taking institutions.

3. The problem is that financial institutions are too big. I have addressed this before here and here. Krugman in his Friday column falls into this trap.

4. Subordinated debt might work. This proposal has been around for a long time. See for example, this piece by Charlie Calomiris. The idea is to constrain banks to structuring themselves to include a subordinated class of debt on their balance sheets. The holders of this debt would bear the risk of a bank failure along with the shareholders. The key to the proposal is that the risk would then be priced in credit markets, and the subordinated-debt holders would take an interest in and constrain a bank's risk-taking. It is unclear to me why we were unable to price mortgage-backed securities but would somehow figure out how to price subordinated debt. What we actually need are correctly motivated regulators who we can appoint to optimally constrain large financial institutions.

5. It helps to blame someone. We shouldn't let our moral indignation get in the way of good policy. The behavior of the Bank of America, AIG, Lehman Brothers, Bernie Madoff, or whoever, may work us into a lather, just as I could get worked up if some poor person walked off with my flat-screen TV. However, my anger at the flat-screen thief does not help me think about how to efficiently deal with crime. As Krugman recognizes, moral indignation can be used in a good way to get a political job done. He,unfortunately, lets it get the better of him, and proceeds to blame everyone in sight (in his Friday piece and elsewhere) - large banks, small banks, Republicans, Democrats, laissez-faire economists, macroeconomists in general, whatever. It might be better if we all take the collective blame for this mess - after all we elected the politicians. These politicians (members of both parties) made the regulations and appointed the regulators who failed to exercise sufficient oversight.

6. Financial innovation is bad. Here is what Krugman says:
What’s the matter with finance? Start with the fact that the modern financial industry generates huge profits and paychecks, yet delivers few tangible benefits.
The history of thought here, according to Krugman appears to be: Once all economists told us that all financial innovation was good. It completes markets, allows us to share risk, promotes growth, etc. What a wonderful thing. The financial crisis happens. Now it is clear all financial innovation is bad. What actually happened was the following. Basic Arrow-Debreu theory from the 1950s tells us about the gains from trade in financial markets, and the benefits of diversification and risk-sharing. From 1970s information theory, and the 1980s theory of financial intermediation and banking, we understand a lot about moral hazard, adverse selection, incentive problems in financial markets and the banking sector, and the need for regulation. Most financial economists understand the tradeoff between risk-sharing and incentives. The financial crisis gave us a large quantity of new information about risks and incentives in the financial system which we can use to do a better job of the regulation. Again, don't throw out the baby with the bathwater. For example, appropriate regulation of derivatives markets requires more transparency and possibly some constraints on what can be traded, but probably should not prohibit whole classes of securities.


  1. A bit of a tangential question regarding China: I've often heard that the country is keeping its currency artificially low in order to boost exports. At the same time, I've also heard from some economists that currency exchange rates don't really matter in the long term. Which is true?

  2. The second. Look at Chapter 14 of my textbook, "Macroeconomics," 4th edition, which is a more-or-less standard analysis of long-run exchange rate policy. Whether a country fixes its exchange rate relative to some other currency, or allows it to be market-determined, China cannot gain anything at another country's expense through manipulating the relative price of its currency to U.S. currency. The notion of keeping the value of your currency "artificially low" has no economic content.