Toward a run-free financial system

A new essay, expanding greatly on a previous WSJ oped and illustrated by a great comic. Here's the introduction, follow the link for the whole thing.

Toward a run-free financial system
John H. Cochrane
April 16 2014

Abstract

The financial crisis was a systemic run. Hence, the central regulatory response should be to eliminate run-prone securities from the financial system. By contrast, current regulation guarantees run-prone bank liabilities and instead tries to regulate bank assets and their values. I survey how a much simpler, rule-based, liability regulation could eliminate runs and crises, while allowing inevitable booms and busts. I show how modern communications, computation, and financial technology overcomes traditional arguments against narrow banking. I survey just how hopeless our current regulatory structure has become.

I suggest that Pigouvian taxes provide a better structure to control debt issue than capital ratios; that banks should be 100% funded by equity, allowing downstream easy-to-fail intermediaries to tranche that equity to debt if needed. Fixed-value debt should be provided by or 100% backed by Treasury or Fed securities.  

 

1. Introduction and overview  

    At its core, our financial crisis was a systemic run. The run started in the shadow banking system of overnight repurchase agreements, asset-backed securities, broker-dealer relationships, and investment banks. Arguably, it was about to spread to the large commercial banks when the Treasury Department and the Federal Reserve Board stepped in with a blanket debt guarantee and TARP (Troubled Asset Relief Program) recapitalization. But the basic economic structure of our financial crisis was the same as that of the panics and runs on demand deposits that we have seen many times before.  

    The run defines the event as a crisis. People lost a lot of money in the 2000 tech stock bust. But there was no run, there was no crisis, and only a mild recession.  Our financial system and economy could easily have handled the decline in home values and mortgage-backed security (MBS) values—which might also have been a lot smaller—had there not been a run.

    The central task for a regulatory response, then, should be to eliminate runs.

    Runs are a pathology of specific contracts, such as deposits and overnight debt, issued by specific kinds of intermediaries. Among other features, run-prone contracts promise fixed values and first-come first-served payment. There was no run in the tech stock bust because tech companies were funded by stock, and stock does not have these run-prone features.

    The central regulatory response to our crisis should therefore be to repair, where possible, run-prone contracts and to curtail severely those contracts that cannot be repaired. "Financial crises are everywhere and always due to problems of short-term debt" is a famous Doug Diamond (2008) aphorism, which we might amend to "and its modern cousins." Well, then, let us purge short-term debt from the system and base regulation on its remaining truly necessary uses.  

    When they failed, Bear Stearns and Lehman Brothers were financing portfolios of mortgage-backed securities with overnight debt at 30:1 leverage. For every thirty dollars of investment, every single day, they had to borrow a new twenty-nine dollars to pay back yesterday's lenders. It is not a surprise that this scheme fell apart. It is a surprise that our policy response consists of enhanced risk supervision, timid increases in bank capital ratios, fancier risk weighting, macroprudential risk regulation, security-price manipulation, a new resolution process in place of bankruptcy, tens of thousands of pages of regulations, and tens of thousands of new regulators.  Wouldn’t it be simpler and more effective to sharply reduce run-prone funding, at least by intermediaries likely to spark runs?

    In this vision, demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable. 

    Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund, stock index fund shares, or even the bank's own shares. A bank can originate and sell mortgages, if it does not want to finance those mortgages with equity or long-term debt. Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt. 

   If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in  an hour, without disrupting any of the operations or claims against the bank, and the government can credibly commit not to bail it out.

    I argue that Pigouvian taxes   provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests.  For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.

1.2 Technology

    The essence of this vision is not novel. Proposals for narrow banking or equity-based banking have been with us about as long as runs and crashes have been with us.  The "Chicago Plan," discarded in the 1930s, is only one of many such milestones  

    Here a second theme emerges: Modern financial, computational, and communication technology allows us to overcome the long-standing objections to narrow banking.  

    Most deeply, "liquidity" no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities. With today's technology, you could buy a cup of coffee by swiping a card or tapping a cell phone, selling two dollars and fifty cents of an S&P 500 fund, and crediting the coffee seller's two dollars and fifty cents mortgage-backed security fund. If money (reserves) are involved at all—if the transaction is not simply netted among intermediaries—reserves are held for milliseconds. In the 1930s, this was not possible. We could not instantly look up the value of the S&P 500 (communication). There was no such thing as an index fund, so stock sales faced informational illiquidity and large bid-ask spreads (financial innovation).  And transactions costs would have ruled out the whole project (computation, financial innovation). Closer to current institutions, electronic transactions can easily be made with treasury-backed or floating-value money-market fund shares, in which the vast majority of transactions are simply netted by the intermediary. When you buy something, your account loses an electronic dollar and the seller’s account gains one, and no security actually changes hands. 

    On the supply end, $18 trillion of government debt is enough to back any conceivable remaining need for fixed-value default-free assets. Three trillion dollars of interest-paying reserves can easily be $6 trillion of reserves. We can live Milton Friedman's (1969) optimal quantity of money, in which the economy is awash in liquidity. This optimal quantity will have financial stability benefit far beyond its traditional elimination of shoe-leather costs. Again, technology has fundamentally changed the game: instant communication means that interest-paying money is now a reality, so we can have the optimal quantity without deflation. Our government should take over its natural monopoly position in supplying interest-paying money, just as it took over a monopoly position in supplying nineteenth-century bank notes, and for the same reason: to eliminate crises, which have the same fundamental source.

    The quantification of credit risk, the invention of securitized debt, long-only floating-value mutual funds, and the size and liquidity of today's markets mean that financial flows needed to finance home and business investment can come from everyday saver/investors who bear risk rather than hold traditional deposits.

    So, the most fundamental objection is met: that society "needs" a large stock of money-like assets, more than can be supplied by other means, so banks must try to "transform" maturity, liquidity, and risk, both to supply adequate assets for transaction-type needs and to provide adequate credit for real investment. I treat a wide range of additional common objections below.  

1.3 Current policy

    Our current regulatory response to financial crises is based on a different basic vision that evolved piecemeal over more than a century. In order to stop runs, our government guarantees debts, implicitly or explicitly, and often ex-post with credit guarantees, bailouts, last-resort lending, and other crisis-fighting efforts. But guaranteeing debts gives the borrowers (banks and similar institutions) an incentive to take on too much asset risk and an incentive to fund those risks by too much debt. It gives depositors an incentive to ignore bank risks when lending. So our government tries to regulate the riskiness of bank assets and imposes capital requirements to limit banks' debt funding. Then banks game their way around regulations, take on more risk, and skirt capital requirements; shadow banks grow up around regulations; and another crisis happens. The government guarantees more debts, expands its regulatory reach, and intensifies asset regulation.

    Less heralded, but no less important, this regulatory approach demands strong limits on competition and innovation, even before banks try to capture it. If regulators let new institutions circumvent regulated ones, the problems erupt again. Too big to fail means too big to lose money, and too big to lose money means too big to compete.

    Thus, Dodd-Frank regulation and its international cousins are not a radical new approach. They are just a natural expansion of a longstanding philosophy. Each new step follows naturally to clean up the unintended consequences of the last one. The expansion is nonetheless breathtaking.  Beyond massively ramping up the intensity, scope, and detail of financial institutions and markets regulation, central banks are now trying to control the underlying market prices of assets, to keep banks from losing money in the first place.

    The little old lady swallowed a fly, then a spider to catch the fly, a bird to catch the spider, and so on. Horse is on the menu. Will we eat?

1.4 Comparison

    The insight that the crisis was a systemic run, that we can fix runs by fixing and removing run-prone financial contracts, and that new financial and communication technology addresses the classic objections, liberates us from this Rube Goldbergian (or Orwellian?) regulatory project.

    We do not have to fix every actual and perceived fault of the financial system in order to protect against future crises.  We do not have to diagnose and correct the sources of the crisis, Fannie Mae and Freddie Mac, the community reinvestment act, so-called predatory lending, no-documentation loans, perceived global imbalances or  savings gluts, Wall Street "greed," executive compensation, perceived bubbles (whether thought to be caused by irrational speculation or too-low interest rates), and so on. We do not have to fix credit card fees, disparate-impact analysis, student loans, or hedge fund fees. We don't need to micromanage over-the-counter versus exchange-traded derivatives, swap margins, position limits, the bloated Basel bank regulation mess, the definition of risk-weighted assets, the internal process and regulatory designation of S&P and Moody ratings, the treatment of off-balance-sheet credit guarantees, and on and on and on. The thousand pages of the Volker rule alone can start a nice bonfire. If a crisis is a run, and we can remove or fix run-prone securities, none of these steps is either necessary (whew) or sufficient (ouch) to stop a future crisis. A narrower regulatory approach that can stop runs, and hence crises, without requiring these Herculean (or Sisyphean?) tasks, no matter how desirable each one might be, is much more likely to succeed.

    If financial institutions’ liabilities no longer can cause runs and crises, we don't have to try to micromanage institutions' asset choices or the market prices of those assets. Nor do we have to  stop entry by new and innovative institutions.   Rather than dream up a financial system so tightly controlled that no important institution ever loses money in the first place, we can simply ensure that inevitable booms and busts, losses and failures, transfer seamlessly to final investors without producing runs.

    Zero cost is not the standard. The financial crisis was, by most accounts, a hugely expensive event. Dodd-Frank regulation and its international cousins are not cheap, either. The challenge is only to show that my vision, which narrowly focuses on eliminating the poison in the well—run-prone assets—stops crises more effectively and costs less than these alternatives.

Keep reading here...

Weekend Labor Markets

This weekend produced several interesting readings on the state of labor markets.

1. Glenn Hubbard,

In the Wall Street Journal on "The Unemployment Puzzle: Where Have All the Workers Gone?" Like economists of all stripes, the fact that the unemployment rate -- the fraction of people looking for jobs -- is down masks the deeper problem, that so many people are not working and not looking.

Glenn sets out well the basic question:

In one view, this decline is just a temporary, cyclical result of the Great Recession. If so, we should expect workers to come back as the economy continues to expand...But structural changes are plainly at work too, ...

This part of the drop is a function of various factors, including simple discouragement, poor work incentives created by public policies, inadequate schooling and training, and a greater propensity to seek disability insurance.

Glenn advocates a mix of serious fundamental get-out-of-the-way reforms, with some puzzlingly dirigiste tinkering.

A sustained infrastructure program, rather than a temporary one for "shovel-ready" projects, would have provided more reassurance of longer-term demand. 

Infrastructure is fine for building infrastructure. But the idea that unemployed middle-age mortgage brokers are going to get jobs running a backhoe on a road crew, or the idea that building roads creates "demand," are both a bit far fetched.

...far-reaching tax reform 

is a good idea, but not because it

could have provided both a near-term fillip from front-loaded business tax cuts and a credible prospect for future growth.

Again, Keynesian thinking at least in the former. Economists should focus on margins, which is what drives the growth.

What we need most urgently is to rethink the federal government's wider role in the labor market. 

Now we're getting somewhere, and it is a great point that

The fierce debate now going on in Washington about extending unemployment insurance and raising the minimum wage largely ignores these issues. Such policies may affect the incomes of some Americans, but they won't do much to expand opportunity and bring more people back into the labor force.

But then Glenn goes back to  tweaking the earned income tax credit, and trying to fix social security disability by providing

the employers of disabled employees with tax advantages for retraining them to remain on the job.

Really, long term growth and employment doesn't come from more clever little tax credits. That contradicts "far reaching tax reform."

Noting 80 - 100% marginal tax rates,

A broader tax reform that gives a more uniform subsidy for health insurance and health spending 

is a great idea. But then

complement traditional unemployment insurance with block grants to states to support training and workforce development through community colleges and vocational education...Advancing and updating skills are also important: Funds currently in other federal training programs could be repurposed to provide this pro-work support.

There's that regulatory passive and layers more tweaking.

Overall, I rate it a nice essay on the problem, but I'd rather see more detailed analysis of just what causes the problem and get-out-of-the-way solutions before we start passing around more tax credits here and there.

2. Tyler Cowen and driverless cars. 

Tyler Cowen chipped in with a Marginal Revolution blog post, and a New York Times Column. The Times column starts on the same track,

employment opportunities remain stubbornly low in the United States, 

But Tyler is after something other than social program disincentives. Rather

giving new prominence to the old notion that automation throws people out of work.

For example

Driverless vehicles and drone aircraft are no longer science fiction, and over time, they may eliminate millions of transportation jobs

Why is this more of a problem than, say, the steam engine?  Why has

history ... seen many waves of innovation and automation, and yet as recently as 2000, the rate of unemployment was a mere 4 percent.[?]

His worry,

Labor markets just aren’t as flexible these days for workers,...Many of the new jobs today are in health care and education, where specialized training and study are required.

...young men...with especially restless temperaments.. aren’t always well-suited to the new class of service jobs, like greeting customers or taking care of the aged, which require much discipline or sometimes even a subordination of will. 

Many expanding economic sectors are not very labor-intensive, be they tech fields like online retailing or even new mining and extraction industries. That means it’s harder for the rate of job creation to keep up with the rate of job destruction, because a given amount of economic growth isn’t bringing as many jobs

Here, I think Tyler is making a classic mistake. Over the long run -- the kind of long run where technical change like driverless cars and a shift to high education service jobs matters -- changing demand for worker characteristics changes wages, it does not cause unemployment or joblessness.  "Jobs" are not created in fixed quantity independent of wages, skills are not acquired in fixed quantity independent of wages, and wages are not sticky forever.  This is econ 101 supply and demand.

Driverless cars and trucks will, after the 20 years they take to become introduced, lower wages of people who formerly drove cabs and trucks -- a serious worry -- but that does not mean millions of people sitting idle on the street corner.  Low wages alone do not cause people to stop working unless they have an alternative. Tyler knows that, I know that he knows that, and he's writing for a popular audience. But I don't think using popular fallacies to communicate is a good idea.

Like Glenn, when he gets back to the immediate problem, he spies what I think is a central part of the story. The recession led to long term joblessness because inefficiencies, private and government induced, that are papered over in a boom, make it harder for the economy to recover.  One of many little inflexibilities.

The law is yet another source of labor market inflexibility: The number of jobs covered by occupational licensing continues to rise and is almost one-third of the work force. We don’t need such laws for, say, barbers or interior designers, 

i.e. making it harder for an unemployed taxi driver to take up such professions. "Sticky" wages, "inflexible" labor markets are not mysterious, they are born of a thousand grains of sand in the gears.

3. Temporary workers

Damian Paletta at the  Wall Street Journal Monday notices the surge in temporary employees.

Why is there even a distinction between "temporary" and "permanent" employees? Aren't we all "temporary employees?"

Well, no. We have a system, largely because of labor laws, where there is a large fixed cost to hire "permanent" employees. Obamacare has added substantially to that. So you only hire a "permanent" employee if it overcomes the fixed costs to doing so.

The worry is that we are more and more bifurcating into a market with a small number of "permanent," high benefit, high hours worked, career jobs, and a larger group of "temporary" employees, limited in hours and incidentally limited in career and human capital development.

4. Claudia Goldin and women.

High fixed costs, and the need to work employees long hours to recoup them, is particularly a problem for women. Claudia Goldin's Presidential address is out at the American Economic Review and it's a must-read.  It deserves its own blog post (and will get one). One big point from the abstract

The gender gap in pay  would be considerably reduced and might vanish altogether if firms did not have an incentive to disproportionately reward individuals who labored long hours and worked particular hours. Such change has taken off in various sectors, such as technology, science, and health, but is less apparent in the corporate, financial, and legal worlds.

As our president will apparently be championing "wage equity" this week, the speech is particularly topical.

5.  Casey Mulligan

His latest, The ACA: Some Unpleasant Welfare Arithmetic adds up some more disincentives

Under the Affordable Care Act, between six and eleven million workers would increase their disposable income by cutting their weekly work hours. About half of them would primarily do so by making themselves eligible for the ACA's federal assistance with health insurance premiums and out-of-pocket health costs, despite the fact that subsidized workers are not able to pay health premiums with pre-tax dollars. The remainder would do so primarily by relieving their employers from penalties, or the threat of penalties, pursuant to the ACA's employer mandate. Women, especially those who are not married, are more likely than men to have their short-term financial reward to full-time work eliminated by the ACA. Additional workers, beyond the six to eleven million, could increase their disposable income by using reduced hours to climb one of the "cliffs" that are part of the ACA's mapping from household income to federal assistance.

Note that some of these also push people to the part-time world.

6. Long term unemployed and Phillips curve

Tyler brings up the very interesting Kruger, Cramer and Cho paper, Are the Long-Term Unemployed on the Margins of the Labor Market? which I've been meaning to blog about.

Their basic view is that long-term unemplyed are not on the margins, which means that monetary policy -- "demand" -- really can't help them much (my conclusion, they're a bit softer).  One piece of evidence, Phillips curves (Figure 1) fit better with short-term unemployment.

Their conclusion gives interesting meat to "margins"

Although the long-term unemployed have about a one in ten chance of moving into employment in any given month, when they do return to work their new jobs are often transitory.  After 15 months, the long-term unemployed are more than twice as likely to have withdrawn  from the labor force than to have settled into steady, full-time employment. And when they exit  the labor force, the long-term unemployed tend to say that they no longer want a job, suggesting  that many labor force exits could be enduring. The subset of the long-term unemployed who do  regain employment tend to return to jobs in the same occupations and industries from which they  were displaced, suggesting that significant challenges exist for helping the long-term unemployed to transition to growing sectors of the economy. A stronger macroeconomy helps the long-term unemployed in part because it raises demand in their previous sectors. But even in  good times, the long-term unemployed are often on the margins of the labor market, with  diminished employment prospects and relatively high labor force withdrawal rates

If you otherwise read the New York Times you think all macro is preordained by political persuasion. This interesting paper is a great counterexample.

7. Discrimination against the long-term unemployed

Cowen again, in the blog post, brings up the issue. Are employers "discriminating" against long-term unemployed? We know they are less likely to hire them. I asked an employer once, who said he didn't want to hire "people on the way down," an interesting comment.  Kruger, Cramer and Cho think of the long-term unemployed as "unlucky". Tyler:

I think attributing all of this labor market misfortune to luck is unlikely...

There were two classes of workers fired in the great liquidity shortage of 2008-2010.  The first were those revealed to be not very productive or bad for firm morale.  They skew male rather than female, and young rather than old.  The second affected class were workers who simply happened to be doing the wrong thing for shrinking firms: “sorry Joe, we’re not going to be starting a new advertising campaign this year.  We’re letting you go.”

The two groups have ended up lumped together and indeed a superficial glance at their resumes may suggest — for reemployment purposes — that they are observationally equivalent.  This discriminatory outcome is unfair, and it is also inefficient, because some perfectly good workers cannot find suitable jobs.  Still, this form of discrimination gets imposed on the second class of workers only because there really are a large number of workers who fall into the first category.

In short, is it discriminatory and "unfair" to use conditional probability and Bayes' theorem, in a world where information is expensive? A deep question.

Krugman on reading

Paul Krugman has a fascinating blog post up. To be fair, I will quote it in its entirety, with my emphasis added in bold. 

I’ve written before about the myth of the stupid progressive economist.Many conservative economists have a fixed idea in their heads — it’s more than just a presumption, because it seems completely impervious to evidence — that progressive economists are dumb guys who don’t understand basic economics. And because of this fixed idea, conservatives appear literally unable to read what my side writes; they criticize the dumb things they’re sure we must have said, without checking to see if that’s what we actually said.

In the linked post I wrote about health reform issues, but you also see this in macro: five years and more into this discussion, freshwater economists still can’t wrap their brains around the notion that modern Keynesians (both New and eclectic) have actually done a lot of hard thinking over the past few decades. I’ve called this a failure of reading comprehension, but it’s actually an unwillingness to read at all, to so much as glance at what the actual argument might be.

And I mean that quite literally. Brad DeLong quotes from a John Cochrane paper (no link) which declares that those stupid Keynesians don’t understand why monetary policy is ineffective. It’s not because of the zero lower bound, it’s because bonds and monetary base are perfect substitutes:

In this analysis, monetary policy is impotent, but not for the usual reason that interest rates are nearly zero. The Fed can arbitrarily exchange Treasury debt for money, and increase the money supply as much as we like. But nobody cares if it does so, since the “flight to liquidity” is equally towards all forms of Government debt. If we want more fruit and less cheese, putting more apples and less oranges in the fruit basket won’t help. 

So, I think I can say without boasting that the modern revival of liquidity-trap economics began with my 1998 Brookings Paper (pdf). Here’s the first sentence of that paper:

THE LIQUIDITY TRAP – that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes – played a central role in the early years of macroeconomics as a discipline.

That was 16 years ago. Just saying.

It's pretty amazing to write a whole column about people who, and I quote "criticize the dumb things they’re sure we must have said, without checking to see if that’s what we actually said." and then so patently and blatantly not, well, check to see if that's what I actually said.

"no link?" Dear Professor, let me acquaint you with this thing called Google, with which you can check quotes if you are so inclined when Brad doesn't give you the link. (Update: Hilarious "let me google that for you" link from a correspondent.)

If you did, you would find no statement of mine, ever, that says anything like "those stupid Keynesians don’t understand why monetary policy is ineffective." This is slander, pure and simple. I have never used the word "stupid" to describe any economist.  Serious, scholarly, new-Keynesians like Mike Woodford are incredibly smart.

And to write this in the middle of a column complaining that I don't check to see what others have actually said??? Are there no mirrors at the New York Times?

As for my supposed lack of reading skills, I invite the learned professor, if he wishes to join the club of people who check facts, to browse my research webpage and or the page of my monetary economics class. He will find a lifetime of work reading and thinking hard about New, and Old Keynesian models, going back decades. I even got an A in my Keynesian classes at Berkeley in the 1980s.

Since he advocates reading, let me suggest my Determinacy and Identification with Taylor Rules, including the references, or the more recent New Keynesian Liquidity Trap. You can say it's all wrong, but you cannot say I have not read and thought hard about new-Keynesian economics, including all of Woodford's book. But to do that, you have to read past one 2009 blog post, which seems to be the beginning and end of Brad DeLong's reading, and Krugman's passing along of opinions without doing any reading.

Perhaps this is all petulance because I didn't cite Krugman for the idea that at zero rates bonds and money are perfect substitutes. (In, let us remember, a blog post designed to explain to a popular audience how neoclassical models work, with very few citations, not an academic article.) Anyway, Keynes and Friedman (optimum quantity of money) had those ideas long ago. Indeed it did "play a central role in the early years," which is why a citation is not required for every paper that talks about it afterward. And perhaps I should add a little Emily Post etiquette lesson: There is a fine art of fishing for citations. Slander and insults are usually not very effective.

It was April 1. It's so outrageous I did stop to check that it wasn't a parody! Apparently not.

PS: Comments off, for obvious reasons.