Financial crisis

10 years after – and nothing has changed.

Published by Anonymous (not verified) on Mon, 22/10/2018 - 8:50am in

The following is an interview with Yena Yoon – a financial journalist with Chosen Ilbo “the largest newspaper in South Korea” conducted on 12 February, 2018, but still relevant.

What is the most remarkable change in financial market after 2008 global crisis do you see? Why do you think so?

The most striking outcome from the global financial crisis of 2007-9 was that there was no structural change to the international financial architecture/system – the system that was at the heart of the global crisis. Instead policy-makers imposed on to the existing financial system – of financial deregulation and capital mobility – two policies: monetary easing and fiscal consolidation. This ‘economic model’ of monetary radicalism and fiscal conservatism has slowed global economic recovery in a way that is historically unprecedented. At the same time it has massively expanded Central Bank balance sheets to provide ‘life support’ to the ‘near-death’ finance sector. Because the finance sector (or the 1%) have been the main beneficiaries of central bank largesse, this has intensified inequality. Last year, at a time when the global economy (‘the semi-comatose patient’) was supposedly in recovery, boosted by growth in the EU, central banks still felt it necessary to inject at least $3 trillion of liquidity into the financial system. The global recovery continues on Central Bank ‘life support’; remains fragile, and is prone to volatility and shocks.

2. Could you pick 3~5 risk elements of our financial market these days? Why do you think so?

 The first risk faced by financial markets is synchronised central bank monetary tightening. Interest rate rises are a threat to a heavily indebted and still weak, global economy – and to the many corporates that have loaded up on debt over this last decade. This risk has risen with the Trump administration’s appointments of inflation ‘hawks’ to key posts at the Federal Reserve, and to the retirement of ECB President, Mario Draghi, in 2019

The second risk is related:  the fall in savings, and the build-up of consumer and corporate debts in both the US and China. Defaults on these debts could lead to financial sector failures, and in a highly integrated, synchronised globalised economy, one bank failure could send shock waves across borders.

The third risk is political: across the world, populations have risen up in anger at governments that allowed self-regulating ‘free’ markets to determine the allocation of resources across societies and across borders. Many are calling for a ‘strong man” (or woman) to protect them from uncontrolled market forces. Hence the election of, for example, Presidents Trump and Duterte (to name but two) who have promised to “build a wall” to protect society from the ‘free market’ – whether that be the trade in goods and services, or in drugs, or in the free movement of people and capital across borders. These nationalist, protectionist reactions will interfere with the workings of markets, and threaten volatility, instability and even war.

3. Do you agree with ‘10 years Crisis cycle’ hypothesis? Why do you think so, and when do you think the next crisis will come?

I do not agree that there is a cycle that is in a sense, inevitable. On the contrary: economic policy is man-made (sic) and can be unmade and transformed. The economic model of monetary easing and fiscal tightening was and is, disastrous. A more enlightened, geniuinely Keynesian model would have re-regulated the finance sector; managed capital mobility, credit creation and the rate of interest for loans across the spectrum of lending (short and long, safe, risky and real.) These monetary policies if combined with fiscal expansion at the time of the 2007-9 crisis, would have raised investment – both public and private. They would have led to the creation of jobs, raised incomes, lowered debts and minimised inequality.

Instead the economic model adopted after the crisis led to higher levels of debt globally; to falls in good, secure employment and income; and has intensified inequality.

History will not treat policy-makers of this era kindly.

End.

The BBC’s Cassandras of the Crash

Published by Anonymous (not verified) on Mon, 22/10/2018 - 8:18am in

 

On Wednesday, 19th September and again on 22nd September, the BBC broadcast an interview in which I participated. It was called Cassandras of the Crash. The programme is available on the BBC’s Radio 4 website, with the following introduction.

“Ten years ago, in autumn 2008, the world watched as the biggest financial meltdown in history unfolded. The crash plunged the world into recession, lost millions of families their homes and its shadow still hangs over our politics today. And when the Queen went to the London School of Economics, she asked the question everyone wanted the answer to: why did no one see it coming? In this programme Aditya Chakrabortty, senior economics commentator at the Guardian newspaper, chairs a discussion between four economists who can claim they did: Raghuram Rajan, former governor of the Reserve Bank of India; Steve Keen, professor of economics at Kingston University in London; Ann Pettifor, director of PRIME, Policy Research in Macroeconomics and council member of the Progressive Economy Forum; and Peter Schiff, American stockbroker and investor. They warned financial crisis was imminent, they wrote books and papers, they even told the powerful to their faces – and they got nowhere. They showed intellectual bravery of a kind that isn’t often celebrated, and it cost some of them dearly. Call them four “Cassandras” – cursed, as Greek myth has it, to utter prophesies that were true but never believed. Had they been heeded we may have averted what the then chief US central banker, Ben Bernanke, calls “the worst financial crisis in global history, including the Great Depression”. How did they see it when no one else did? Why didn’t others listen? And what happens next? Producer: Eve Streeter A Greenpoint Production for Radio 4”

Book Review: Portfolio Society: On the Capitalist Modes of Prediction by Ivan Ascher

Published by Anonymous (not verified) on Tue, 16/10/2018 - 9:46pm in

In Portfolio Society: On the Capitalist Modes of PredictionIvan Ascher explores how the abstraction and securitisation of risk in financial markets have had a profound influence on economic and social relations, with a particular focus on the aftermath of the global financial crisis. The book underscores the extent to which much of the ‘value’ generated by the contemporary economy results from financial engineering or extractive practices, writes Jenny McArthur

Portfolio Society: On the Capitalist Modes of Prediction. Ivan Ascher. MIT Press. 2016.

Find this book: amazon-logo

In Portfolio Society: On the Capitalist Modes of Prediction, Ivan Ascher argues that financial markets have reshaped the contemporary economy, extending Karl Marx’s theory of labour to consider how the abstraction and securitisation of risk in financial markets have profound influence on economic and social relations. The text adds to a growing body of critical literature from various disciplines – including Mariana Mazzucato’s The Value of Everything, Nick Silver’s Finance, Society and Sustainability and Daniel Cohen’s The Infinite Desire for Growth – that scrutinises the 2008 global financial crisis and the contradictions it revealed in the nature of our economies and financial systems.

The book is a concise 192 pages, structured across five chapters that explore the development of financial markets, primarily in the UK and the USA, through the lens of Marx’s Capital. It examines the current financial system (Chapter One) and the development of financial securities that speculate on risk and uncertainty (Chapter Two). Looking inside the black box of prediction in financial markets (Chapter Three), the text shows how the transformation of finance in the US is accompanied by fundamental changes in the conceptualisation and measurement of risk. Through the rolling back of comprehensive social insurance schemes for health insurance and pension funds and the creation of credit scores, financialised risks become embedded within social relations, recasting the individual in society as ‘homo probabilis’: possessing a quantifiable risk profile that can be abstracted, pooled and exchanged in financial markets (Chapter Four). The final chapter returns to the aftermath of the 2008 crisis and reflects on what may lie ahead.

Image Credit: (Pixabay CCO)

While it draws heavily from Marx’s Capital, Portfolio Society is not strictly a Marxist analysis – rather, it extends theories from Capital to argue that risk has now outranked labour power as the central source of value in contemporary capitalism. Examining the current financial system and its crises, it explores the supporting narratives and implicit power relations that shape specific modes of prediction and protection in the economy: characterised by Ascher as a ‘portfolio society’. Taking the 2008 crisis as a point of departure, the text tracks the emergence of the portfolio society through a long-term process of financialisation, starting in the 1970s. A key question is when, and how, speculation became a generalised feature of society. The central critique is that this not only affects financial markets and the tendency towards collapse, but how we can envisage the future:

What Marx did not say, but what can be presumed, is that a world where people decide together on what is to be produced is also a world where people decide together on what possibilities are to be pursued, what dangers are to be avoided, what risks are worth taking (59).

Portfolio Society draws from a wide variety of sources to elaborate this argument. The story of former Goldman Sachs trader Fabrice Tourre – one of the few people to be prosecuted following the 2008 financial crisis – draws a common thread throughout the text. Extracts from Tourre’s email exchanges with his girlfriend are telling, showing contradictions revealed through everyday conversation, as even the highly-trained quants responsible for structuring financial products openly admit their ignorance:

Seul surviving potentiel, the fabulous Fab […] standing the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all the implications of those monstruosities [sic]!! (19).

Ascher also traces the historical development of portfolio theory by economists Harry Markowitz, William Sharpe, Fischer Black and Myron Scholes. This historical analysis shows the building blocks of the financial economic theory that underpins financial models, portfolio selection and investment decisions. It shows how the interplay between the generation of new ideas in economics and wider political shifts shaped the financial system we have today. Markowitz’s theory pointed out that investors weren’t solely concerned with the expected return on an investment, but also the uncertainty or variance of this return. Therefore, selection of financial assets for a portfolio jointly considered the value and variance of returns. Markowitz’s student Sharpe extended this, positing the existence of a dominant factor that could explain overall shifts in asset values, providing a benchmark to assess the relative volatility of any single investment. Scholes and Black advanced this further to create a model for the price fluctuations of financial instruments, which enabled the pricing of options (bets on the future prices of assets). A fundamentally speculative logic underpinned these new ideas in economics: it was not just about the actual return on investment but ensuring variance in the volatility of asset prices to balance overall portfolio risk. This enabled individual investors to seemingly eliminate risk – however, Ascher points out that this sort of financial engineering only creates a façade of low-risk investment. In reality, risk is not eliminated –  it is rendered systemic to the financial system.

Ascher makes liberal use of metaphor to evoke his ideas, conjuring images of horror stories, zombies, vampires, Robinson Crusoe, casinos and horse races. This provides powerful insight where Ascher compares financial markets to horse races, to critique the resulting class divisions:

It is not a division that separates “borrowers” from “creditors” [… it] separates those who are free to run a race and those who are free to bet on its outcome […] those whose lives keep placing them at risk and having thus to seek protection (say in the form of a loan or an insurance policy) and those whose position of relative security, by contrast, gives them the opportunity to take risks – say, by lending to others or betting on their probability of default (124)

However, other metaphors conceal important features of the portfolio society that we need to understand better to develop alternatives. Characterising financialisation as a zombie evades the critical question of what impels it forward, and how that may be changing ten years on from the last crisis.

Overall, Portfolio Society makes an important contribution to theorising the contemporary economy, although it would benefit from greater attention to the detail of financialisation processes and how they are mediated through political and economic systems. The book does not capture enough of the variation in financialisation processes and contestation between economic actors to avoid reducing the entire thesis to deterministic relations between risk and financialisation. Focusing on economic systems beyond advanced economies, namely those of the US and UK, could also support a more robust empirical basis for the analysis. It does, however, show the durability of Marx’s distinction between use value and exchange value to problematise the contemporary economy and reveal how much of the apparent ‘value’ generated is indeed fictional, resulting from financial engineering or extractive processes.

Jenny McArthur is a lecturer at UCL Department of Science, Technology, Engineering and Public Policy. Jenny has a background in civil engineering and economics and her research focuses on urban infrastructure governance, policy and finance. Twitter @jen_m_mcarthur. Read more by Jenny McArthur.

Note: This review gives the views of the author, and not the position of the LSE Review of Books blog, or of the London School of Economics. 


‘The world turned upside down’: How the global economy was hit by the crisis

Published by Anonymous (not verified) on Thu, 20/09/2018 - 6:00pm in

David Young

For the global economy, it was the best of times, and then it was the worst of times.  Buoyed by very strong growth in emerging markets, the global economy boomed in the mid-2000s.  On average, annualised world GDP growth exceeded 5% for the four years leading up to 2007 – a pace of growth that hadn’t been sustained since the early 1970s.  But it wasn’t to last.  In this post, I illustrate how the failure of Lehman Brothers in September 2008 coincided with the deepest, most synchronised global downturn since World War II.  And I describe how after having seen the fallout of the Lehman collapse, macroeconomic forecasters were nevertheless surprised by the magnitude of the ensuing global recession.

How severe was the Global Financial Crisis?

The Global Financial Crisis (GFC) caused the worst peacetime contraction in world economic activity since the Great Depression.  Using Maddison Historical Statistics, we can estimate annual world GDP growth rates over the entire 20th century (and even earlier), as shown in Chart 1.

Chart 1: World GDP

Sources: Maddison Historical Statistics, Thomson Reuters DataStream, IMF WEO and author calculations.  Maddison data used to calculate growth rates from 1901 until 1982.

The Great Depression and both World Wars caused steeper falls in global GDP – but the GFC was by far the deepest global downturn that has occurred in the post-war period.  Indeed, so far, 2009 has been the only year since World War II in which world activity contracted relative to the previous year.  Of course, there have been other downturns – the most severe occurred in the mid-1970s, the early 1980s, and the early 1990s.  But annual global growth never fell below 1% in any year of the post-war period – until the GFC.

A similar picture emerges when looking at other indicators of global activity, such as world trade. Chart 2 shows a long time series of annual rates of growth in world trade volumes, taken from Federico and Tena-Junguito (2016).  Again, though less severe than during World War I and the Great Depression (the data don’t cover the World War II period), the fall in global trade volumes during the GFC was by far the deepest contraction that has occurred in the post-war period.  Trade volumes fell by around 12% in 2009 – almost 5 percentage points more than during the next-worst contraction in 1975.

Chart 2: Global trade volumes

Sources: Federico and Tena-Junguito (2016) and author calculations.

Moreover, the GFC wasn’t just the deepest downturn of the post-war period – it was also the most synchronised.  This can be illustrated using four-quarter GDP growth rates from the OECD database.   Starting in 1961, these data cover 25 major economies, rising to 44 economies by the time of the GFC.  As shown in Chart 3, GDP contracted in 40% to 60% of countries during the global downturns in the 1970s, 1980s and 1990s – whereas the share of countries experiencing negative four-quarter GDP growth spiked up sharply to almost 90% in 2009.  And the share of countries experiencing slowing GDP growth reached an unprecedented 100% in 2008.

Chart 3: Share of economies in recession or experiencing a slowdown

Sources: OECD database and author calculations.  Economies are classed as experiencing slowing GDP growth in a given quarter if four-quarter GDP growth was lower than in the previous quarter.

“How did things get so bad, so fast?”

World activity deteriorated extraordinarily quickly.  Global growth was exceptionally strong in the years running up to the GFC, supported by buoyant growth in emerging market economies (EMEs), especially in China.  Annual average global growth reached its pinnacle of around 5½% in 2007 – but as shown in Chart 4, the pinnacle immediately preceded a precipice.

Chart 4: Annualised quarterly GDP growth in advanced economies, emerging market economies, and the world

Sources: OECD database, Thomson Reuters DataStream, IMF WEO and author calculations.

Lehman Brothers filed for bankruptcy on 15 September 2008.  By this point, in the face of tightening financial conditions, advanced economies (AEs) had already entered recession – annualised quarterly AE GDP growth was around -2½% in 2008Q3.  But there was much worse to come: AE GDP growth plummeted to -8½% in 2009Q1 before recovering.  Annualised world GDP growth dropped from above 6% in 2007Q4 to -5¼% in 2009Q1 – an 11 percentage point turnaround in just over a year.  And it was a truly global recession, with aggregate EME GDP also contracting in 2008Q4 and 2009Q1.

It was always going to be challenging to accurately forecast the deepest peacetime contraction in global activity for 80 years, especially given how rapidly the outlook deteriorated.  Indeed, it could easily be argued that the GFC – or at least the magnitude of its repercussions – was inherently unpredictable.  Nevertheless, it is interesting to examine the evolution of macroeconomic forecasts in the run up to and in the months following the failure of Lehman Brothers, when the GFC entered its most acute phase.

All major macroeconomic forecasters substantially overpredicted  world GDP growth during the GFC.  This can be seen in Chart 5, which plots one year ahead forecast errors for world GDP growth from the IMF and Consensus Economics, and for total OECD GDP growth from the OECD.  In all cases, GDP growth in 2009 was four to five percentage points lower than projected.  And it’s worth emphasising that these forecasters were far from alone in producing – with hindsight – overly optimistic projections during the GFC.

Chart 5: One year ahead GDP growth forecast errors

Sources: OECD database, Consensus Economics, Thomson Reuters DataStream, IMF April WEOs since 1998, and author calculations.  The IMF and Consensus errors are annual world GDP growth outturns minus IMF forecasts from April the previous year, or minus Consensus Economics forecasts from Q2 the previous year.  The OECD errors are total OECD annual GDP growth outturns minus OECD forecasts from June the previous year.

The evolution of IMF forecasts in the months before and after the failure of Lehman Brothers illustrates the dramatic deterioration of the global outlook.  Chart 6 shows successive IMF forecasts of annual average world GDP growth for the year 2009.  It can be seen that in the April 2008 World Economic Outlook (WEO), the IMF was projecting that annual world GDP growth in 2009 would be 3.8% – well above the outturn of around -½%.  Of course, 3.8% growth would have been a material slowdown relative to 2007; the WEO’s opening line was “The global expansion is losing speed in the face of a major financial crisis.”  With hindsight, it’s also interesting to read that “the IMF staff now sees a 25 percent chance that global growth will drop to 3 percent or less in 2008 and 2009 – equivalent to a global recession.”  For world GDP growth in 2008, at least, 3% turned out to be right on the money.  But 2009 would prompt the IMF to reconsider its definition of a global recession.

Chart 6: Successive IMF forecasts for annual GDP growth in 2009

Sources: IMF WEOs from April 2008 until October 2009, Thomson Reuters DataStream and author calculations.

By October 2008, 3% was the IMF’s central projection for world growth in 2009.  Around the publication of the October 2008 WEO, Olivier Blanchard (then the IMF’s chief economist) said “it is not useful to use the word ‘recession’ when the world is growing at 3%.”  In the end, of course, 2009 proved to be a recession in every sense of the word.  The October WEO also included a fan chart around the IMF world GDP growth projections – this showed that the IMF thought world GDP growth in 2009 would be between 1% and 4%, with 90% probability.

The failure of Lehman Brothers prompted a rapid deterioration in the economic outlook, leading the IMF to publish updated forecasts just one month after the October WEO (the October WEO was published after Lehman Brothers filed for bankruptcy, but before the ramifications could be incorporated in the IMF’s projections)World growth in 2009 was revised down again, to 2.2%.  This was the first IMF forecast in which AE GDP was projected to contract in 2009.

The April 2009 WEO was the first IMF forecast in which global GDP was projected to contract in 2009, and the full magnitude of the crisis was recognised.  The first subsection of the WEO is simply entitled, “How Did Things Get So Bad, So Fast?”  At this point, the IMF had revised down its growth forecasts by 5 percentage points after just one year – an unprecedented revision.

Conclusion

To sum up, the Global Financial Crisis was the deepest, most synchronised global downturn since World War II, and it happened incredibly quickly.  After Lehman Brothers failed, macroeconomic forecasters underestimated the economy-wide impacts of an extraordinary financial shock that resulted in the failure of financial institutions, the evaporation of market liquidity, dramatic falls in assets prices, and a collapse in consumer and business confidence.  It served as a sobering reminder that financial crises have sizeable effects on the real economy.

David Young works in the Bank’s Global Analysis Division

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees

‘Running for the exit’: How cross-border bank lending fell

Published by Anonymous (not verified) on Wed, 19/09/2018 - 6:00pm in

Neeltje van Horen

Cross-border bank lending fell dramatically in the aftermath of Lehman Brothers’ failure as funding constraints forced banks to reduce their foreign exposures. While this decline was partly driven by lower demand for international bank credit, it was substantially aggravated by a retrenchment of international banks from cross-border lending. But banks did not cut their cross-border lending in a uniform manner. Instead, they reallocated their foreign portfolios towards countries that were geographically close, in which they had more experience, in which they had close connections with domestic banks or in which they operated a subsidiary. The crisis thus showed that deeper financial integration is associated with more stable cross-border credit when large global banks are hit by a funding shock.

How do banks contract their cross-border lending?

Syndicates – groups of financial institutions that jointly provide large loans – are a key source of cross-border finance for firms in both developed and emerging countries. In 2007, international syndicated loans made up over 40% of all cross-border debt funding of US borrowers and more than two-thirds of cross-border flows to emerging markets. But in the year following the collapse of Lehman Brothers syndicated cross-border lending to private borrowers shrank by 58% according to data from Dealogic Loan Analytics.

As Figure 1 illustrates, the magnitude of this reduction differed substantially across countries. While 46 out of 59 recipient countries experienced a reduction in lending, the decrease varied from a drop of 1 percent to a complete lending stop. Furthermore, 13 recipient countries actually experienced and increase in cross-border flows they received after the collapse of Lehman Brothers. While this partly reflects differences in the adjustment of economic activity and credit demand, I show in a paper co-authored with Ralph De Haas (published in the Review of Financial Studies) that it also reflects variation in how banks reduced their credit-supply across countries.

If banks face a funding or other shock which leads them to cut cross-border lending and focus on domestic credit, they have to decide how to allocate the contraction across different foreign markets. Broadly speaking, international operating banks can follow one of three strategies.

First, they could simply cut cross-border lending uniformly across the board. A second strategy is to cut their credit supply on the basis of broad recipient country characteristics that are common across all lenders, such as political or macroeconomic risk. Whilst this second strategy implies that banks withdraw more from some countries relative to others, both strategies imply that all banks adjust their portfolio by the same magnitude in each recipient country, i.e. there is a generalized run for the exit.

But they could adopt a third strategy, where they cut lending on the basis of characteristics that are specific to bank-country pairs. Banks compare the ‘franchise’ value of future cross-border lending to determine where to retrench more and where to reduce credit less.  Unlike the first two strategies, under this approach two foreign lenders might react differently to a given borrower, and there may not be a generalised run for the exit.

Economic theory suggests several reasons why different banks might react differently to a given lender. One reason is that banks find it easier to overcome information asymmetries when they are geographically closer to borrowers. This channel becomes especially important when default risk increases during a crisis. Another reason is that if a bank has established lending relationships in a country it may also possess local market power, which it can exploit during a crisis. Related, banks with significant experience in a country can lend at lower costs as they know the local business sector well, know more domestic banks they can co-lend with, and are familiar with the legal, institutional, and accounting environment. If banks withdraw less from countries that are relatively ‘close’ to them in a geographic sense or in terms of lending relationships, they will adjust their portfolios differently for each recipient country.

Empirical evidence from syndicated loan data

A useful way to study how lending contracted is by looking at adjustments in syndicated lending. For each syndicated loan all lenders and the borrower are known. So we can observe how much each bank lends to each country in the year after the collapse in Lehman Brothers and compare it to its lending to that country in the year before. As multiple banks lend to the same country we can control for changes in credit demand and how much the country was affected by the financial crisis. We can thus analyse how a particular bank – given a certain funding shock – changes its lending to a particular country compared to another bank.

Using a dataset of syndicated cross-border lending by 117 international banks to 59 recipient countries we find that during the financial crisis international banks did not cut cross-border lending in an indiscriminate manner. In other words, there was no overall run for the exit. Rather, and in line with economic theory, banks followed the third strategy.

We find that bank-borrower closeness was strongly related to the resilience of cross-border credit. Banks continued to lend more to countries that were geographically close, where they were integrated in a network of domestic co-lenders, and where they had built up more lending experience. Banks that operated a local subsidiary were more stable providers of cross-border credit too, in particular in countries with weaker institutions.

What did the crisis reveal about the resilience of cross border lending?

The global financial crisis provided a stark natural experiment in how international credit contractions play out. It demonstrated that cross-border lending can be very unstable in times of stress which can have important negative consequences for firm performance and the real economy. However, alongside the aggregate contraction, the crisis also demonstrated that not all cross-border lending is equally unstable. This yields several important insights:

First, when international banks that provide cross-border bank lending are more entrenched in the recipient country they are less likely to cut lending. This entrenchment naturally results from cultivating long-term lending relationships with domestic banks and firms.

Second, a local presence in terms of a subsidiary or branch also tends to increase lending stability, especially in countries with weaker institutional environments. Not only do foreign-bank subsidiaries provide a relatively stable credit source themselves in these countries, their presence also tends to stabilize cross-border lending flows provided by the parent banks.

Third, a country’s vulnerability to capital outflows depends on the geographical proximity and experience of its creditors. For countries and firms that depend on international banks that are remote and have less local experience, the risk of a significant homebound retrenchment when foreign creditors are faced by a funding shock will be higher.

The crisis thus showed that shocks to the core of the global financial system can easily transmit to other parts of the world via a sharp reduction in cross-border lending. But when two countries are more deeply integrated financially, cross border lending flows between them are likely to be more resilient.

Neeltje van Horen works in the Bank’s Research Hub Division

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

Teaching macroeconomics as though Lehmans didn’t happen

Published by Anonymous (not verified) on Mon, 17/09/2018 - 11:42pm in

September 15th marked the tenth anniversary of the fall of Lehman Brothers, destabilizing Western economies at levels not seen since the 1930s. It also marked the second week of fall classes, with many economics graduate students cranking through equations that define the discipline’s conventional macroeconomic models. With such names as New Classical, Real Business Cycle and New Keynesian, these models can all be traced to the rational expectations revolution of the 1970s, which sought to explain stagflation when the conventional Keynesian framework could not. The rational expectations approach attempted to provide more precise behavioral microfoundations than the Keynesian model by positing that economic actors can form expectations of future economic values, say inflation, such that on average, their predictions of future values tend to be correct. This assumes the actors share the same understanding of the structure of the economy and past economic data. This research program would come to dominate macroeconomic scholarship and strongly influence policy makers, culminating in the creation of the dynamic stochastic general equilibrium (DSGE) model, a popular forecasting and policy analysis tool used in central banks and finance departments.

This approach to macroeconomic modeling came under scrutiny following the 2008 crisis, with Nobel laureate Paul Krugman asserting that most of the macroeconomics over the past 30 years was “spectacularly useless at best, and positively harmful at worst”. While this did spark some soul-searching within the discipline, the debate has been inconclusive. Several policy-making bodies are taking seriously the limitations of 1970s macroeconomics. In its recent Medium-term Research Plan, the Bank of Canada recognises that the crisis has challenged its reliance on New Keynesian DSGE models, encouraging the exploration of alternative modeling paradigms, such as agent-based and stock-flow consistent models.

On Canadian campuses, however, where the next generation of macroeconomists are being trained, there is no clear signal that similar changes are being made in the curriculum of grad-level macroeconomics. A recent panel discussion among academic economists featured the admission that the 2008 crisis was the most embarrassing empirical failure of the profession since the Great Inflation of the 1970. Yet, in the same breath, that professor said he wouldn’t change a thing in his teaching. Indeed, a glance at the macroeconomics syllabuses of several top Canadian grad schools find little evidence of a shift away from teaching the rational expectations-grounded macro models that have come under criticism.

Professors tend to teach what they are taught. With the sunk cost of prepping for PhD macroeconomic comprehensive exams, they have little incentive to develop a new course involving subject matter in which they are not trained. Further reinforcing the status quo is the tendency to teach what you research. Working in a climate of publish or perish, macroeconomic profs have good reason to not deviate from the dominant research agenda, which remains wedded to 1970s macro. In the absence of strong leadership for change or a mandate from either the dean or the premier to sit down with one another and re-design the curriculum, teaching macro in the post-crisis era will continue to be business as usual.

Yet this is not in the public interest. Given the acute financial stress experienced ten years ago, we have a stake in knowing that the policy makers of tomorrow are well prepared to confront episodes of economic downturn and instability. Learning to use a larger modeling toolbox is part of such preparation.

So, what are Canada’s economics students to do in the meantime as they are grind through the math describing a DSGE model? As befitting any college course where critical thinking is one of the learning outcomes, here are some questions students may ask about the models they are taught:

1. Who is in the model? The basic models tend to have a single agent representing all consumers who are assumed to be sufficiently alike as autonomous rational optimizers sharing common knowledge. Can the model accommodate multiple actors who may differ by age, preference, belief, resources and class?

2. Is there room for “black swans”? The 2008 crisis was precipitated by the collapse of the U.S. subprime mortgage market, an event deemed of low risk but of high impact. How does the model address this and other examples of fundamental uncertainty?

3. What kind of markets are modelled? Models with perfect competition behave very differently from more realistic models with imperfect competition, information asymmetries, price rigidities and institutional constraints.

4. Is there a financial sector? Perhaps the strongest criticism of the 1970s macro models was the reduction of complex financial plumbing to a single interest rate variable. Can these models feature lenders and borrowers? Are there banks? How does money fit in?

5. Does the model have to move to equilibrium? Following an economic shock, standard models tend to instantaneously jump to a new equilibrium path. However, observations of macroeconomic variables as they unfold over time suggest that such adjustment may be a much slower, sequential process. Understanding this path of adjustment may be of greater importance than the equilibrium destination.

6. How are these models empirically tested? A model’s usefulness should be judged by how it explains actual economic history.

With these and other critical questions about the core macro teaching models, tomorrow’s dismal scientists should be better prepared to confront challenging economics times.

Teaching macroeconomics as though Lehmans didn’t happen

Published by Anonymous (not verified) on Mon, 17/09/2018 - 11:42pm in

September 15th marked the tenth anniversary of the fall of Lehman Brothers, destabilizing Western economies at levels not seen since the 1930s. It also marked the second week of fall classes, with many economics graduate students cranking through equations that define the discipline’s conventional macroeconomic models. With such names as New Classical, Real Business Cycle and New Keynesian, these models can all be traced to the rational expectations revolution of the 1970s, which sought to explain stagflation when the conventional Keynesian framework could not. The rational expectations approach attempted to provide more precise behavioral microfoundations than the Keynesian model by positing that economic actors can form expectations of future economic values, say inflation, such that on average, their predictions of future values tend to be correct. This assumes the actors share the same understanding of the structure of the economy and past economic data. This research program would come to dominate macroeconomic scholarship and strongly influence policy makers, culminating in the creation of the dynamic stochastic general equilibrium (DSGE) model, a popular forecasting and policy analysis tool used in central banks and finance departments.

This approach to macroeconomic modeling came under scrutiny following the 2008 crisis, with Nobel laureate Paul Krugman asserting that most of the macroeconomics over the past 30 years was “spectacularly useless at best, and positively harmful at worst”. While this did spark some soul-searching within the discipline, the debate has been inconclusive. Several policy-making bodies are taking seriously the limitations of 1970s macroeconomics. In its recent Medium-term Research Plan, the Bank of Canada recognises that the crisis has challenged its reliance on New Keynesian DSGE models, encouraging the exploration of alternative modeling paradigms, such as agent-based and stock-flow consistent models.

On Canadian campuses, however, where the next generation of macroeconomists are being trained, there is no clear signal that similar changes are being made in the curriculum of grad-level macroeconomics. A recent panel discussion among academic economists featured the admission that the 2008 crisis was the most embarrassing empirical failure of the profession since the Great Inflation of the 1970. Yet, in the same breath, that professor said he wouldn’t change a thing in his teaching. Indeed, a glance at the macroeconomics syllabuses of several top Canadian grad schools find little evidence of a shift away from teaching the rational expectations-grounded macro models that have come under criticism.

Professors tend to teach what they are taught. With the sunk cost of prepping for PhD macroeconomic comprehensive exams, they have little incentive to develop a new course involving subject matter in which they are not trained. Further reinforcing the status quo is the tendency to teach what you research. Working in a climate of publish or perish, macroeconomic profs have good reason to not deviate from the dominant research agenda, which remains wedded to 1970s macro. In the absence of strong leadership for change or a mandate from either the dean or the premier to sit down with one another and re-design the curriculum, teaching macro in the post-crisis era will continue to be business as usual.

Yet this is not in the public interest. Given the acute financial stress experienced ten years ago, we have a stake in knowing that the policy makers of tomorrow are well prepared to confront episodes of economic downturn and instability. Learning to use a larger modeling toolbox is part of such preparation.

So, what are Canada’s economics students to do in the meantime as they are grind through the math describing a DSGE model? As befitting any college course where critical thinking is one of the learning outcomes, here are some questions students may ask about the models they are taught:

1. Who is in the model? The basic models tend to have a single agent representing all consumers who are assumed to be sufficiently alike as autonomous rational optimizers sharing common knowledge. Can the model accommodate multiple actors who may differ by age, preference, belief, resources and class?

2. Is there room for “black swans”? The 2008 crisis was precipitated by the collapse of the U.S. subprime mortgage market, an event deemed of low risk but of high impact. How does the model address this and other examples of fundamental uncertainty?

3. What kind of markets are modelled? Models with perfect competition behave very differently from more realistic models with imperfect competition, information asymmetries, price rigidities and institutional constraints.

4. Is there a financial sector? Perhaps the strongest criticism of the 1970s macro models was the reduction of complex financial plumbing to a single interest rate variable. Can these models feature lenders and borrowers? Are there banks? How does money fit in?

5. Does the model have to move to equilibrium? Following an economic shock, standard models tend to instantaneously jump to a new equilibrium path. However, observations of macroeconomic variables as they unfold over time suggest that such adjustment may be a much slower, sequential process. Understanding this path of adjustment may be of greater importance than the equilibrium destination.

6. How are these models empirically tested? A model’s usefulness should be judged by how it explains actual economic history.

With these and other critical questions about the core macro teaching models, tomorrow’s dismal scientists should be better prepared to confront challenging economics times.

Do you remember yesterday?

Published by Anonymous (not verified) on Sat, 15/09/2018 - 7:11pm in

It’s ten years since the fall of Lehman Brothers. Ten years…. but it seems much longer. I look back on the mid-2000s as if they were a past century. Those days are gone forever, and the future is increasingly dark and uncertain. How a single event can change the course of history...

“Do you remember yesterday, that was a hundred years ago?” cries Lucretia in Benjamin Britten's The Rape of Lucretia, shortly before committing suicide. Lucretia's death was the event that brought about the fall of the Tarquin dynasty and the establishment of the Republic of Rome. A fundamental re-ordering of Roman society was triggered by a single act of betrayal. Tarquinius raped the wife of one of his senior generals. She committed suicide. Appalled, the Roman army overthrew him. No doubt Tarquinius had raped many other women. But Lucretia was a noblewoman and the wife of a loyal supporter. It was too much.

History is scattered with similar triggers for earth-shattering political changes. The pin that, when pulled, blew up four of the great 19thcentury empires was the assassination of Archduke Franz Ferdinand and his wife. Now, we know that appalling period of destruction as the First World War.

The Wall Street Crash of 1929 similarly ushered in the worst depression in recorded history, followed by radical social reform in the United States and disastrous political upheaval across much of Europe. Who would have foreseen that? It was just another stock market crash.

The fallout from such "trigger" events can extend far further than we imagine. I remember watching the news of the fall of Lehman, seeing the people leaving Lehman’s London headquarters carrying cardboard boxes containing the contents of their desks. At the time, it did not seem particularly significant. A year before, Northern Rock had failed, and since then there had been other failures, such as Bear Sterns and Merrill Lynch. It was just another bank failure.

But over the next few weeks, as the dominoes fell, it became apparent that this was not “just another bank failure”. We did not know it, but Lehman was the linchpin that held together the global financial system. When it failed, the whole thing collapsed.

Or rather, when it was allowed to fail. All the banks that failed over the previous year were rescued, one way or another – Northern Rock through nationalisation, Fannie Mae and Freddie Mac through government conservatorship, Bear Sterns and Merrill Lynch by being bought by other banks. It was not Lehman itself that held together the global financial system, but an implied guarantee that said “Global banks cannot be allowed to fail”. Over that fateful weekend when the Barclays deal fell through and the U.S. government refused to bail out Lehman, that implied guarantee became worthless. The financial system froze as everyone looked suspiciously at everyone else, wondering who would be the next to collapse.

Unprecedented intervention by central banks and governments around the world eventually got the financial system functioning again. But the damage was done. The world slid into the deepest recession since the 1930s. It has never really recovered.

Since the fall of Lehman, there have been innumerable attempts to end the “too big to fail” status of global banks. But the reality is that no-one now would allow a Lehman Brothers to fail in that manner. “Too big to fail” is even more deeply entrenched than it was ten years ago.

The price that the big banks pay for the world accepting that they really are “too big to fail” is heavy and intrusive regulation. This has opened the field to a host of smaller, nimbler financial companies, many of them offering digital financial solutions. These little businesses buzz around building new constituencies while the big banks, encumbered by regulation and weighed down by their own history, can only watch. The fall of Lehman Brothers has enabled new providers, and new technologies, to flourish.

Perhaps the big banks, like the big dinosaurs, are doomed, and the future lies with these new digital companies. After all, small dinosaurs weren’t killed off by the asteroid. They evolved into birds.

Though I’m not sure I would write off big banks that quickly. There are plenty of big companies that have successfully reinvented themselves when their original offering became obsolete. IBM, for example, or AT&T. Big banks are already investing in digital technologies and buying or partnering with smaller fintech companies. Perhaps some big banks will become the digital finance powerhouses of the future.

For central banks, the decade since the fall of Lehman Brothers has been a golden age. Never have they been so powerful.“Bring back the good times!” cried desperate financial markets, governments and people. And central bankers, basking in their new-found fame, promised them that they would. A short period of low interest rates and a dose of QE, and the economy will be back to normal, they said – “normal” meaning the globalised, consumption-driven, debt-laden world of the mid-2000s.

Cynics said “Central banks can’t do it all”. But no-one was listening. Secure in the belief that central banks had their backs, governments imposed tax rises and welfare cuts on their populations to reduce the public deficits caused by the bank bailouts and, above all, by the deep recession. Ordinary people paid for bankers’ folly. As the recovery fizzled out, wages stagnated and living standards fell. Popular anger grew.

Bizarrely, popular anger was not aimed at the bankers. Whipped up by right-wing media, the anger of people who had jobs was aimed at those who had not; the anger of those who were fit and well was aimed at those who were sick and disabled; the anger of those who were securely rooted was aimed at those who, through no fault of their own, had no permanent home. Governments responded with harsh repression of the jobless, the sick, the disabled, single mothers, the homeless, immigrants and refugees.

Now, we reap the fruits of that anger; the deaths of Aylan Kurdi and thousands of other refugees in the Mediterranean, the Windrush scandal, the growing evidence that sick and disabled people, especially those with mental health problems, were unfairly denied the means to live. Yet the tabloid press still whips up anger against “scroungers and shirkers”, immigrants and refugees.

And now we also know that the cynics were right. Central banks can’t “do it all”. True, they did prevent a recession from becoming a 1930s-style debt deflationary Depression. But things are far from “normal”. Interest rates are still on the floor, some central banks are still doing QE, and growth remains elusive. In much of Europe, unemployment is still high. In the UK and the US, there are plenty of jobs, but productivity is poor and wage growth flat. Government spending cuts and tax rises have bitten deep into the incomes of the poor, while QE has vastly increased the wealth of the rich. No-one is happy.

Central banks are now being blamed for economic doldrums and ever-lengthening misery. Fairly, since they promised the moon – but also unfairly, because they were seriously impeded in their quest for it. Central banks now face challenges to their independence, and even to their existence. In the coming political realignment, central banks as we know them may disappear, casualties of their own hubris.

The first few years after the failure of Lehman were not just a golden age for central banks. They were also a golden age for bloggers like me. Back in 2010, when I started writing, financial reform was the dinner-party subject of choice, and every man and his dog had an opinion on what to do with RBS. The establishment was completely blindsided by the financial crisis and had little idea what had caused it, let alone what to do about it. Suddenly, the blogosphere and social media became terribly important. Ideas ranging from the reasonable to the lunatic had a ready-made audience. A singing teacher from darkest Kent could make her views on banking known to journalists, economists and policymakers, and be taken seriously.

But in about 2015, the establishment started to fight back. Suddenly barriers started to go up everywhere. Online media publications put up paywalls. Social media started to become hierarchical: Twitter’s “blue tick” segregated amateur writers from professional journalists. People started to ask for the “affiliation” of a writer or speaker and the “organisation they represented”, instead of judging the quality of their ideas. Now, in 2018, it would be much more difficult for an amateur entering the field to make her views known.

At about the same time, far-right movements were appearing all over the developed world. I don’t think this is unconnected. Social media was instrumental in helping these movements to grow, just as it gave a platform to ordinary people with opinions. It is hardly surprising that the establishment clamped down on social media. Ordinary people with opinions were collateral damage.

We call these movements “far-right”, but this is a poor term for movements that aim to overthrow the post-war global consensus and establish a world of antagonistic nation states. Really, this is the rejection of globalism and the resurgence of nationalism. The neoliberal consensus that has dominated political thought for the last thirty or so years is hardly left-wing, and although many of these movements self-identify as “right-wing”, some equally self-identify as socialist. When nationalists of the right and left unite to overturn the existing political system, the “left-right” paradigm becomes meaningless.

Of course, the political establishment, like the academic establishment and the media establishment, is fighting back. We seem now to be locked into a battle between those who wish to restore the globalised, financialised, atomised world of the pre-Lehman days, and those who wish to shatter it to pieces and replace it with something more to their liking.

Nowhere is that tension more acute than in Europe. There, the central bank never tried to do it all. Instead, the establishment sacrificed the people of southern Europe on the altar of the single currency. In Greece, deep spending cuts and tax rises, with no attempt by the central bank to soften the blow, caused a Depression of the same depth as that in the U.S. in the 1930s, and now rather longer. Popular anger grew, not just in Greece, but in countries like the U.K., where the treatment meted out to Greece by the Troika of the IMF, European Commission and ECB fed a growing desire to break the link with the European Union.

The EU’s inept handling of inflows of refugees from the war-torn areas of the Middle East added fuel to the nationalist, anti-establishment flames. In 2016, the people of the U.K. voted to leave the EU. Six months later, the people of the U.S. elected a President committed to closing the borders to refugees and eliminating the existing American political establishment – “draining the swamp”, he calls it. But his aim goes beyond that. NATO, the organisation created to preserve peace in Europe after World War II, is under threat. So too is the EU, which President Trump clearly would like to break up. And even the United Nations is facing existential pressure. The post-war institutions are threatened as never before.

Ten years ago, who would have foreseen that a bank failure would be the trigger for a fundamental reshaping of the global order?

An edited version of this piece appears on The Mint magazine. 

Related reading:

Lehman's Aftershocks

Image is a detail from "The Story of Lucretia" by Sandro Botticelli, courtesy of The Yorck Project (2002) 10.000 Meisterwerke der Malerei (DVD-ROM), distributed by DIRECTMEDIA Publishing GmbH. ISBN: 3936122202., Public Domain, at Wikipedia

Minskyan Reflections on the Ides of September

Published by Anonymous (not verified) on Sat, 15/09/2018 - 1:40am in

The 10th anniversary of the September collapse of the US financial system has led to a number of commentaries on the causes of the Lehman bankruptcy and cures for its aftermath. Most tend to focus on identifying the proximate causes of the crisis in an attempt to assess the adequacy of the regulations put in place after the crisis to prevent a repetition. It is interesting that while Hy Minsky’s work became a touchstone of attempts to analyze the crisis as it was occurring, his work is notably absent in the current discussions.

While it is impossible to discern how Minsky might have answered these questions, his work does provide an indication of his likely response. Those familiar with Minsky’s work would recall his emphasis on the endogenous generation of fragility in the financial system, a process building up over time as borrowers and lenders use positive outcomes to increase their confidence in expectations of future success. The result is a slow erosion of the buffers available to cushion disappointment in those overconfident expectations. And disappointed these expectations must be, for, as Minsky argued, the confirmation of expectations of future results depends on decisions that will only be taken in the future. Since these decisions cannot be known with certainty, today’s expectations are extremely unlikely to be fully validated by future events. In a capitalist economy financial commitments are financed by incurring debt, so the disappointment of expectations will produce a failure to validate debt, leading to the inexorable transformation of financial positions from what Minsky called “hedge” to “speculative” to “Ponzi” financing structures. These structures refer to the ability of current cash flows to meet these commitments.

Thus, for Minsky, the crisis that broke out ten years ago would have been considered as the culmination of a process that started much earlier, sometime in the 1980s. An important aspect was the attack on the role of government and support for more restrictive fiscal policies that followed Reagan’s pronouncement “government is not the solution to our problem; government is the problem,” producing more procyclical budget policy that removed the “Big Government” floor under incomes during a recession. For Minsky, the sign of the budget was not important, but its role as an automatic stabilizer was crucial to financial stability. At the same time, the rise of monetarist monetary policies meant the “Big Bank” was no longer assured of placing a floor under asset prices by acting as a lender of last resort. By the early 1990s, Minsky had thus reversed his belief that a repetition of the Great Depression was unlikely because of the role of the “Big Government” and the “Big Bank.” Both had been diminished to the extent that they were no longer able to counter the inevitable translation of fragility into instability. By the 1990s, he clearly believed it could happen again.

A part of the reduced role of government was the push for deregulation of the financial system. Minsky’s view of the operation of the financial system was couched in the recognition that banks were profit-maximizing enterprises just like any other capitalist firm. And their pursuit of profit was an important source of the endogenous decline in the cushions of safety that led to financial instability. But Minsky understood, as did Schumpeter, that banks created their profits in a different way from other business firms. There was no limit on the ability of banks to finance investment positions, because banks could “create money out of nothing.” Since there is no financing constraint for banks as a whole, pursuit of profit is little constrained by rising costs (largely determined by the need to prevent deposit drain due to competition from other banks). Profit maximization for the system as a whole thus leads to maximizing loan volume. It was the role of bank regulations to put a cap on volume: prudential regulations were meant to make the system safe, but they also placed a constraint on bank profitability. Banks were thus ever led to expand into new activities and to innovate new mechanisms of liquidity creation to circumvent bank regulation.

One of the main elements of the success of the New Deal banking legislation was the monopoly given to commercial banks on deposit creation liquidity to fund investments. This regulation is often presented as providing banks with zero cost funding (they already had the ability to create money out of nothing), but what was important was that it provided protection against competition and a kind of guarantee on commercial bank profits, which dampened the importance of innovation. But Regulation Q proved to be its own undoing, as policy rates increased with the implementation of tighter monetary policies and large corporations increasingly moved their cash management and financing business away from regulated commercial banks and eventually into the arms of investment banks providing innovations that competed with bank deposits but escaped regulation.

As the share of financial assets on commercial banks’ balance sheets declined, so did their profitability, pushing them to seek innovations on the liability side of their balance sheets to offset the decline in their asset earnings. With the reappearance of the chorus announcing the disappearance of commercial banking (it had initially appeared in the late 1920s as corporations shifted from bank funding to cheaper equity issuance in a booming market), joined by free market economists arguing against the deposit monopoly, Congress was led to initiate an era of deregulation based on the pretext of saving the commercial banks from disintermediation.

The perceived need to support banks’ profits led to the paradox of regulators willing to deregulate and sacrifice stability in order to restore bank profitability. It is not necessary to rehearse the experience of the S&L crisis, or the 1980s commercial real estate crisis, to see this process at work. To understand the culmination of the process of deregulation in the 1999 financial reforms and the genesis of September 2008, it is sufficient to recognize that bank regulations are written to support bank profits. The subprime mortgage crisis was thus a relatively small bump on the inevitable path to crisis.

There is a second element in this endogenous process of fragility, better represented by two prior anniversaries: the Long Term Capital Management (LTCM) crisis of 20 years ago, which was itself an echo of the junk bond crisis 10 years before that. Michael Milken’s Drexel Burnham junk bond financing unit created an unlimited source of liquidity for what was euphemistically called “value extraction” by corporate raiders – to finance the arbitrage buying and selling of whole companies. In Minsky’s initial writing, the emergence of instability came from the financing decisions of business firms engaging with bankers to finance productive investments. The key to stability was the generation of income from the investments sufficient to meet the financial commitments. But Milken substituted whole companies for individual investment projects, and the validation of the financing was generated by manipulating the company’s financial operations to increase leverage and then reissue equity to sell the company at a profit. Capital gains replaced income as the source of validation, while the companies ended up holding the increased debt—an endogenous process of increasing financial fragility in the business sector at the expense of shareholders.

LTCM represented the crisis of modern finance in embryo; the Lehman of its time. A financial institution born of the combination of high mathematical finance and high-speed computing capacity, it specialized in relative value trades, not of companies but of financial asset positions – arbitraging small mispricing of financial instruments due to market imperfections of various sorts. These small basis point differences could only be exploited by high-volume borrowing to combine offsetting short and long positions that would contractually converge to produce sure (ignoring counterparty risk) profit. LTCM thus provides a variant of the shift of financial institutions from providing funding for investment in productive activities, with the validation of the loans depending on income flows, to providing funding for investments validated solely by the evolution of prices determined by the investment decisions of other investment institutions—what is now called “proprietary trading” and depends on increasing volume to increase profits. This is the origin of Minsky’s “money manager capitalism,” in which the validation of debt by means of income generation from the market success of an investment is replaced by the validation of debt by the capital gains generated from predictions of future asset prices. Indeed, the downfall of LTCM, aside from the collapse of the liquidity it required to hold its relative value positions, was caused by venturing into more purely speculative equity and other positions in which there was no contractual future market price.

The impact of these two factors became visible in the earnings statements of banks starting in the 1980s: the decline of net interest income and the increase in proprietary trading income and the fees and commission income from advisory and wealth management. We could say that net interest income is a fossil of the Glass-Steagall regulatory system, while proprietary trading income reflects the new regulatory system that came to dominance in the 2000s. The system was transformed from one in which productivity gains produced the income to validate debt to one in which innovation increased liquidity sufficiently to drive up asset prices to generate capital gains income. But while productivity gains may continue permanently, increasing liquidity to produce capital gains eventually falters on the inevitable disappointment of expectations. And the system inevitably became more fragile and more crisis prone.

In one of his early papers, Minsky produced a very simple formula for bank equity returns as the result of the returns on its asset positions and balance sheet leverage. The current system can be read as a substitution of productivity gains as the driver of asset returns with arbitrage or capital gains as the driver of asset returns under money manager capitalism. Innovation in liquidity creation driven by regulation thus provides the higher leverage that supercharges asset returns. The evolution of the system has thus influenced both elements determining bank returns: towards increased fragility and dependence on movements in asset prices (rather than movements in income flows) to validate debt. The impacts of the major post-crisis regulatory changes—increasing capital and liquidity ratios—have a contrasting impact on fragility. Higher capital ratios match the higher risk and volatility of asset returns based on market price appreciation, but they also increase costs and create an incentive to increase leverage and undertake regulatory innovation.

At the recent Minsky Conference, Frank Veneroso noted two anomalies of the impact of money manager finance in the current system. The first is the substantial rise in the ratio of nonfinancial corporate debt to GDP in the presence of large corporate cash accumulations and the highest corporate profit rates since the 1920s. The second is the large number of public corporations (one-third to one-half) with zero net income in the presence of historically high equity market multiples and negative interest coverage ratios in the presence of historically low interest rates. Veneroso makes the case that the corporate debt figures are understated, while the corporate profit figures are overstated. At the same conference, Robert McCauley presented similar figures for European and emerging market companies. One obvious explanation of this paradox is that the debt cannot be validated by income but will require increasing asset prices, which can only occur with higher liquidity creation and financing—what Minsky would have called a Ponzi scheme. It also seems clear that a return to more normal interest rate policies would worsen debt coverage ratios and call into question the ability of equity markets to continue their historic bull market. While structured subprime securities have disappeared from the financial landscape, the modus operandi of the financial institutions, now populated by even larger “too big to fail” banks, seems to have changed little from that which led to the crisis in 2008.

For Minsky, financial fragility is a never-ending story; we cannot eliminate it, we can only attempt to understand it, and resist calls to save the system by relaxing regulation. This is why the Big Government and the Big Bank were the most important bulwarks against the inherent instability of the financial system and the certainty that there will always be another crisis, since they provide automatic system-wide buffers. Since crisis is inherent in the system, seeking the cause of the last crisis and assessing the regulation introduced to prevent it occurring again is largely irrelevant; the important point is to understand Minsky’s basic contribution that crisis is inherent to capitalist finance.

Minskyan Reflections on the Ides of September

Published by Anonymous (not verified) on Sat, 15/09/2018 - 1:40am in

The 10th anniversary of the September collapse of the US financial system has led to a number of commentaries on the causes of the Lehman bankruptcy and cures for its aftermath. Most tend to focus on identifying the proximate causes of the crisis in an attempt to assess the adequacy of the regulations put in place after the crisis to prevent a repetition. It is interesting that while Hy Minsky’s work became a touchstone of attempts to analyze the crisis as it was occurring, his work is notably absent in the current discussions.

While it is impossible to discern how Minsky might have answered these questions, his work does provide an indication of his likely response. Those familiar with Minsky’s work would recall his emphasis on the endogenous generation of fragility in the financial system, a process building up over time as borrowers and lenders use positive outcomes to increase their confidence in expectations of future success. The result is a slow erosion of the buffers available to cushion disappointment in those overconfident expectations. And disappointed these expectations must be, for, as Minsky argued, the confirmation of expectations of future results depends on decisions that will only be taken in the future. Since these decisions cannot be known with certainty, today’s expectations are extremely unlikely to be fully validated by future events. In a capitalist economy financial commitments are financed by incurring debt, so the disappointment of expectations will produce a failure to validate debt, leading to the inexorable transformation of financial positions from what Minsky called “hedge” to “speculative” to “Ponzi” financing structures. These structures refer to the ability of current cash flows to meet these commitments.

Thus, for Minsky, the crisis that broke out ten years ago would have been considered as the culmination of a process that started much earlier, sometime in the 1980s. An important aspect was the attack on the role of government and support for more restrictive fiscal policies that followed Reagan’s pronouncement “government is not the solution to our problem; government is the problem,” producing more procyclical budget policy that removed the “Big Government” floor under incomes during a recession. For Minsky, the sign of the budget was not important, but its role as an automatic stabilizer was crucial to financial stability. At the same time, the rise of monetarist monetary policies meant the “Big Bank” was no longer assured of placing a floor under asset prices by acting as a lender of last resort. By the early 1990s, Minsky had thus reversed his belief that a repetition of the Great Depression was unlikely because of the role of the “Big Government” and the “Big Bank.” Both had been diminished to the extent that they were no longer able to counter the inevitable translation of fragility into instability. By the 1990s, he clearly believed it could happen again.

A part of the reduced role of government was the push for deregulation of the financial system. Minsky’s view of the operation of the financial system was couched in the recognition that banks were profit-maximizing enterprises just like any other capitalist firm. And their pursuit of profit was an important source of the endogenous decline in the cushions of safety that led to financial instability. But Minsky understood, as did Schumpeter, that banks created their profits in a different way from other business firms. There was no limit on the ability of banks to finance investment positions, because banks could “create money out of nothing.” Since there is no financing constraint for banks as a whole, pursuit of profit is little constrained by rising costs (largely determined by the need to prevent deposit drain due to competition from other banks). Profit maximization for the system as a whole thus leads to maximizing loan volume. It was the role of bank regulations to put a cap on volume: prudential regulations were meant to make the system safe, but they also placed a constraint on bank profitability. Banks were thus ever led to expand into new activities and to innovate new mechanisms of liquidity creation to circumvent bank regulation.

One of the main elements of the success of the New Deal banking legislation was the monopoly given to commercial banks on deposit creation liquidity to fund investments. This regulation is often presented as providing banks with zero cost funding (they already had the ability to create money out of nothing), but what was important was that it provided protection against competition and a kind of guarantee on commercial bank profits, which dampened the importance of innovation. But Regulation Q proved to be its own undoing, as policy rates increased with the implementation of tighter monetary policies and large corporations increasingly moved their cash management and financing business away from regulated commercial banks and eventually into the arms of investment banks providing innovations that competed with bank deposits but escaped regulation.

As the share of financial assets on commercial banks’ balance sheets declined, so did their profitability, pushing them to seek innovations on the liability side of their balance sheets to offset the decline in their asset earnings. With the reappearance of the chorus announcing the disappearance of commercial banking (it had initially appeared in the late 1920s as corporations shifted from bank funding to cheaper equity issuance in a booming market), joined by free market economists arguing against the deposit monopoly, Congress was led to initiate an era of deregulation based on the pretext of saving the commercial banks from disintermediation.

The perceived need to support banks’ profits led to the paradox of regulators willing to deregulate and sacrifice stability in order to restore bank profitability. It is not necessary to rehearse the experience of the S&L crisis, or the 1980s commercial real estate crisis, to see this process at work. To understand the culmination of the process of deregulation in the 1999 financial reforms and the genesis of September 2008, it is sufficient to recognize that bank regulations are written to support bank profits. The subprime mortgage crisis was thus a relatively small bump on the inevitable path to crisis.

There is a second element in this endogenous process of fragility, better represented by two prior anniversaries: the Long Term Capital Management (LTCM) crisis of 20 years ago, which was itself an echo of the junk bond crisis 10 years before that. Michael Milken’s Drexel Burnham junk bond financing unit created an unlimited source of liquidity for what was euphemistically called “value extraction” by corporate raiders – to finance the arbitrage buying and selling of whole companies. In Minsky’s initial writing, the emergence of instability came from the financing decisions of business firms engaging with bankers to finance productive investments. The key to stability was the generation of income from the investments sufficient to meet the financial commitments. But Milken substituted whole companies for individual investment projects, and the validation of the financing was generated by manipulating the company’s financial operations to increase leverage and then reissue equity to sell the company at a profit. Capital gains replaced income as the source of validation, while the companies ended up holding the increased debt—an endogenous process of increasing financial fragility in the business sector at the expense of shareholders.

LTCM represented the crisis of modern finance in embryo; the Lehman of its time. A financial institution born of the combination of high mathematical finance and high-speed computing capacity, it specialized in relative value trades, not of companies but of financial asset positions – arbitraging small mispricing of financial instruments due to market imperfections of various sorts. These small basis point differences could only be exploited by high-volume borrowing to combine offsetting short and long positions that would contractually converge to produce sure (ignoring counterparty risk) profit. LTCM thus provides a variant of the shift of financial institutions from providing funding for investment in productive activities, with the validation of the loans depending on income flows, to providing funding for investments validated solely by the evolution of prices determined by the investment decisions of other investment institutions—what is now called “proprietary trading” and depends on increasing volume to increase profits. This is the origin of Minsky’s “money manager capitalism,” in which the validation of debt by means of income generation from the market success of an investment is replaced by the validation of debt by the capital gains generated from predictions of future asset prices. Indeed, the downfall of LTCM, aside from the collapse of the liquidity it required to hold its relative value positions, was caused by venturing into more purely speculative equity and other positions in which there was no contractual future market price.

The impact of these two factors became visible in the earnings statements of banks starting in the 1980s: the decline of net interest income and the increase in proprietary trading income and the fees and commission income from advisory and wealth management. We could say that net interest income is a fossil of the Glass-Steagall regulatory system, while proprietary trading income reflects the new regulatory system that came to dominance in the 2000s. The system was transformed from one in which productivity gains produced the income to validate debt to one in which innovation increased liquidity sufficiently to drive up asset prices to generate capital gains income. But while productivity gains may continue permanently, increasing liquidity to produce capital gains eventually falters on the inevitable disappointment of expectations. And the system inevitably became more fragile and more crisis prone.

In one of his early papers, Minsky produced a very simple formula for bank equity returns as the result of the returns on its asset positions and balance sheet leverage. The current system can be read as a substitution of productivity gains as the driver of asset returns with arbitrage or capital gains as the driver of asset returns under money manager capitalism. Innovation in liquidity creation driven by regulation thus provides the higher leverage that supercharges asset returns. The evolution of the system has thus influenced both elements determining bank returns: towards increased fragility and dependence on movements in asset prices (rather than movements in income flows) to validate debt. The impacts of the major post-crisis regulatory changes—increasing capital and liquidity ratios—have a contrasting impact on fragility. Higher capital ratios match the higher risk and volatility of asset returns based on market price appreciation, but they also increase costs and create an incentive to increase leverage and undertake regulatory innovation.

At the recent Minsky Conference, Frank Veneroso noted two anomalies of the impact of money manager finance in the current system. The first is the substantial rise in the ratio of nonfinancial corporate debt to GDP in the presence of large corporate cash accumulations and the highest corporate profit rates since the 1920s. The second is the large number of public corporations (one-third to one-half) with zero net income in the presence of historically high equity market multiples and negative interest coverage ratios in the presence of historically low interest rates. Veneroso makes the case that the corporate debt figures are understated, while the corporate profit figures are overstated. At the same conference, Robert McCauley presented similar figures for European and emerging market companies. One obvious explanation of this paradox is that the debt cannot be validated by income but will require increasing asset prices, which can only occur with higher liquidity creation and financing—what Minsky would have called a Ponzi scheme. It also seems clear that a return to more normal interest rate policies would worsen debt coverage ratios and call into question the ability of equity markets to continue their historic bull market. While structured subprime securities have disappeared from the financial landscape, the modus operandi of the financial institutions, now populated by even larger “too big to fail” banks, seems to have changed little from that which led to the crisis in 2008.

For Minsky, financial fragility is a never-ending story; we cannot eliminate it, we can only attempt to understand it, and resist calls to save the system by relaxing regulation. This is why the Big Government and the Big Bank were the most important bulwarks against the inherent instability of the financial system and the certainty that there will always be another crisis, since they provide automatic system-wide buffers. Since crisis is inherent in the system, seeking the cause of the last crisis and assessing the regulation introduced to prevent it occurring again is largely irrelevant; the important point is to understand Minsky’s basic contribution that crisis is inherent to capitalist finance.

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