What Bernanke believes

Let me end my talk [in honor of Milton Friedman’s 90^th birthday] by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna [Schwartz]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Ben Bernanke, University of Chicago, Nov. 8, 1992.

In fact the Federal Reserve has learned nothing, and is doing it again, it being the substitution of controls for monetary policy.

Whatever attention is being paid to Chairman Bernanke’s allusions to an exit strategy from under the massive reserves the Fed has dumped on the banking system – which is not much because observers realize that they merely repeat the musings of a year ago -- are misplaced because the chairman is not really interested in monetary policy. This may seem strange, but it is not the first time the Fed that has been uninterested in what one might have thought was its principal mission.

For example, the Fed allowed the money stock to collapse (falling 38% between 1929 and 1933) while the Hoover administration focused on bank reforms (deposit insurance and changes in banking structure and regulation, including the Glass-Steagall Act that separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation, which was expanded by the New Deal. Among other interventions, RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management. In their monumental Monetary History of the United States, Friedman and Schwartz contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the recovery of the money supply (as Christina Romer also pointed out in a 1992 paper in the Journal of Economic History).

We might have thought, in light of these experiences and the opening quotation, that Chairman Bernanke would eschew direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock. We would be wrong. He and his colleagues have done the opposite. The failed official strategy of the Great Depression has been repeated in the Fed’s lending to specific institutions, its focus on the risk and liquidity of particular markets, the Troubled Asset Relief Program, Asset Backed Commercial Paper, swap agreements, and numerous other market interventions, as well as lobbying for more regulations of financial institutions of which it would be the principal administrator.

What about monetary policy? The easy money (negative real rates) of 2002-2005, followed by the tightening of 2006-2007, is reminiscent of the run-up to the Great Depression. In 1928-29, the Fed focused on credit controls and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and to lower rates in recession – just as in mid-2008, when it suddenly became hawkish about inflation. The intensification of the recession began before the financial turmoil of September 2008. “In this recession, unlike the other recessions that followed the Depression [but like the Depression], commentators [like the Fed] have assigned causality to dysfunction in credit markets,” as Robert Hetzel pointed out in a recent paper in the Richmond Fed’s Economic Quarterly.

Perhaps the key to these similarities is found in Bernanke’s view of the financial markets. His fame as an academic economist rests on his 1983 paper that stressed the banking structure and the nature of capital flows as causes of the Great Depression. He argued that bank failures and falling bank loans – the interruption of credit arrangements – were significant contributors to the severity of the Great Depression that had been overlooked by Friedman and Schwartz. Although the latter’s message that recovery came with the turn-around in money (while bank loans remained weak) has been reinforced, Bernanke has not, despite the protestation quoted above, come around to the Friedman-Schwartz view of the importance of money or, just as significantly, free markets.

As fundamental as money to their monetarist philosophy is the freedom of markets, which necessarily includes their component institutions. The government should (1) let them alone while (2) pursuing a stable monetary policy. The Federal Reserve under Bernanke has done neither.

There is much talk of the Fed’s independence (of what or whom is not made clear). We should be more concerned about our independence of the Fed.

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Blame the Quants

Thanks to their armies of elite scientists, quant funds can model the markets and predict their future behavior, goes the undoubted conventional wisdom.

Pablo Triana, Lecturing Birds on Flying. Can Mathematical Theories

Destroy the Financial Markets? (xxi, Wiley 2009)

It is common, perhaps natural, to attribute increases in the volatility of security prices to improvements in technology. After all, technology reduces the cost of trading, and large price movements are often accompanied by large volumes. It does not seem unreasonable that new technology amplifies the impact of ideas, particularly expectations, on trading volumes and prices.

Certainly, there have been great technological advances. On May 23, 1962, the ticker at the New York Stock Exchange fell 143 minutes behind trades, the longest lag in history to that time except October 24, 1929. It ran late 124 times in 1966, unable to keep pace with daily volumes that sometimes exceeded 10 million shares. The major exchanges closed Wednesdays from June to December 1968 to catch up on paper work. The computer has since made much greater volumes routine: daily trades hit 50 million shares in 1978, 1 billion in 1997, and 14 billion on July 19, 2007; 5 billion is now a slow trading day.

The new technology enables trades of blocks of securities triggered by relative price movements. This program trading accounts for more than a third of the NYSE’s volume, and is especially active during the triple witching hours that occur on the third Fridays of March, June, September, and December, which are the expiration days of stock options, index options, and index futures. Wikipedia tells us that these “simultaneous expirations generally increase the trading volumes of options, futures and the underlying stocks, and occasionally increase the volatility of prices of related securities.”

Pablo Triana has responded to the recent financial crisis with a book which argues that the implementation of recent financial theories made possible by the new technology “drastically moves” (xxv) and is destroying the financial markets. Both pillars of the argument are imaginary. I begin with theory, which is an attempt to understand events, for example, price movements. Triana’s observations that the Black-Scholes-Merton (BSM) option-pricing model (the book’s chief culprit), is unrealistic and a poor predictor are redundant. Theories must be simplified to be understood; the “real” world cannot be modeled. Their inability to predict in fact supports efficient-market pricing theories, which assert that prices incorporate information so that future price movements are random. Furthermore, most traders don’t apply the theory. Nevertheless, Triana claims that the crash of October 19, 1987, and later crashes, were caused by “computationally charged stock-trading strategies directly inspired by the mathematical spirit of the Black-Scholes formula” (p. xlviii).

It is in principle possible that such “inspired strategies” have been guilty of any number of evils, including increases in volatility. However, the latter has not occurred. The belief in a positive correlation between volatility and technology finds no support in the data. Financial theories are innocent even of a second-hand cause of volatility.

It is also reasonable to believe that technology reduces volatility. Kenneth Garbade and William Silber (1978) reported that the overland telegraph greatly reduced spreads between security prices in New York, Philadelphia, and New Orleans in the 1840s; a result repeated by the Atlantic cable for prices in New York and London in the 1860s. This implies reductions in volatility to the extent that the effects of location-specific shocks are spread over the greater areas made possible by improved communications and lower transaction costs. Thick markets are associated with low volatility.

However, in December 1857, the Merchants’ Magazine and Commercial Review identified the recent invention of the telegraph, “by means of which bad news, such as the failure or embarrassment of a bank … was immediately communicated to all the cities and large towns of the United States,” as the immediate cause of the panic” (Jalil 2009).

The proof is in the pudding. Our view of the correlation between technology and volatility ought to depend on the data, which predominately points to zero. A strong and well-known example is the history of the volatility of stock prices depicted in the figure (with standard-deviations derived from data through Robert Shiller’s homepage). Many believe that stock and other asset prices are “too volatile” for consistency with the rest of financial theory (Shiller 2000), but there has been little headway in explaining changes in volatility. The figure shows the absence of a trend in the volatility of American stock prices since 1875. The outlier of the 1930s has encouraged investigations of the effects of variations in the volatility of monetary policy (Bordo 2001), company news (Goonatilake 2007; Schwert 1989), and derivatives trading, including triple witches (Edwards 1988), with insubstantial results. The almost continuous advance in technology (exacerbated or not by new financial theories) has had no effect.

Optimistic expectations, excessive leverage, and volatile episodes are as old as the financial markets. The Extraordinary Popular Delusions and the Madness of Crowds (Mackay 1841) during the tulipomania of the 1630s, the collapses of the Mississippi scheme and the South Sea bubble in France and Britain in 1720, and many later booms and busts occurred without computers or sophisticated financial theories. We are told that history will teach people to never again say “this time is different.”

The four most dangerous words in finance are “this time is different.” Thanks to this masterpiece by Carmen Reinhart and Kenneth Rogoff, no one can doubt this again.

Martin Wolf, Financial Times, review (Sept 28, 2009) of This Time is Different:

Eight Centuries of Financial Folly (Princeton U. Press 2009)

Don’t bet on it.

References

Bordo, Michael, Michael Dueker, and David Wheelock. 2001. “Aggregate price shocks and financial instability: A historical analysis,” WP 2000-005B. Federal Reserve Bank of St. Louis.

Edwards, Franklin. 1988. “Does futures trading increase stock return volatility?” Financial Analysts J., Feb.

Garbade, Kenneth, and William Silber. 1978. “Technology, communication, and the performance of financial markets: 1840-1975,” J. Finance, June.

Goonatilake, Rohitha.and Susantha Herath. 2007. “The volatility of the stock market and news,” International Research J. of Finance and Economics, 11.

Jalil, Andrew. 2009. “A new history of banking panics in the U.S., 1825-1929,” Univ. of California, Berkeley.

Mackey, Charles. 1841. Extraordinary Popular Delusions and the Madness of Crowds. London: Richard Bentley.

Schwert, William. 1989. “Why does stock market volatility change over time?” J. Finance, Dec.

Shiller, Robert. 2000. Irrational Exuberance. Princeton Univ. Press.

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The House’s proposed bank regulation fails to address adverse incentives,

and even reinforces some.

Government regulations tend to ignore the private incentives that elicit quality products. This is perhaps best seen in the product-specific subsidies of official health care that discourage consumers from acquiring information about costs and qualities, and suppliers from developing reputations. But it is also seen in banking regulation, such as deposit insurance. What do we care about our bank’s safety if our deposits are insured against loss and even inconvenience? The FDIC insures that the availability of our deposits is not interrupted as the new bank takes them over (usually with a subsidy) from our old failed bank. What do we care about the costs of our medical services if someone else is paying?

The reduced concern for risk due to deposit insurance has been limited by ceilings on the amounts insured ($5,000 in 1934, $10,000 in 1950, $100,000 in 1980, and $250,000 in 2008, at first “temporarily” until the end of 2009, then extended to January 1, 2014; although coverage is increased by multiple accounts), which means that large depositors (such as firms with payrolls and other large bills) might have had incentives to monitor their banks. But even this positive residue is eliminated by the regulators’ philosophy – underwritten by Congress – of too big to fail.

House Democrats have promised to end this problem in a “sweeping financial regulation bill designed to prevent another financial crisis.” “The bailouts of AIG and Bear Sterns would not be possible – made illegal – under this bill,” Barney Frank , chairman of the House Financial Services Committee, said last week. “If a company fails, it’ll be put to death.”

Experience tells us of the vacuousness of this resolution. Frank was a leader in the bailouts arranged by panic-stricken Congresses and administrations in 2008 and 2009. His successful lobbying for TARP funds for a local bank that had received a cease and desist order from the FDIC for unsound lending practices and excessive executive pay and perks is well known.

The Federal Deposit Insurance Corporation Improvement Act of 1991 that followed the bank failures of the 1980s was intended to reduce the TBTF doctrine. “A two-thirds majority of both the Board of Governors and the directors of the FDIC, as well as the approval of the Secretary of the Treasury, are required” to agree that a bank’s failure would “have serious adverse effects on economic conditions or financial stability” (Mishkin, p. 279). The Fed was directed to stop lending to insolvent institutions.

The futility of these resolutions, no matter how often thay are repeated, will continue until the incentives of government officials, elected and appointed, have changed.

Other components of the current bill according to news reports are “more oversight and higher capital requirements,” and a new Consumer Financial Protection Agency to oversee consumer financial products lie credit cards and mortgages.”

We have seen the ineffectiveness – and worse -- of capital requirements. They are easily evaded and used as cover against serious regulatory oversight, and contributed to the recent financial crisis. They induced banks to reduce risk (so the regulators believed) through credit default swaps issued by AIG, which allowed them to make riskier loans. Banks should have known that these bets on the state of the economy violated a basic requirement of insurance, which is independence of risks, but they succumbed to the regulatory incentive to buy them (Carrey March 2, 2009).

The new “protection” agency will be seen, like other agencies in the past (such as the Interstate Commerce Commission and the Securities and Exchange Commission) to reduce competition and consumer choice. Those who will enjoy the most protection will be large firms at the expense of consumers. Nothing fundamental has changed

As a rule, regulation is acquired by the industry [despite its pretended protests for the public’s benefit] and is designed and operated for its benefit.

George Stigler

A few hundred billion dollars extra won’t hurt, either.

References

John Carney. 2009. “How bank regulation helped destroy AIG,” The Business Insider, March 2.

Fredric Mishkin. 2006. The Economics of Money, Banking, and Financial Markets, 7^th ed. Pearson Addison Wesley.

George Stigler. 1971. “The theory of economic regulation,” Bell Journal of Economics and Management Science, Spring.

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There are two college economics courses

College catalogs list many economics courses, but there are really only two: a theory course and an applied (?) course. (I’ll explain the question mark later.) The former, by which the student is introduced to economics, explains the free choices by intelligent and informed individuals (consumers or entrepreneurs) of their preferred consumption and production paths subject to the limitations set by market prices, incomes, and production possibilities. The model abstracts from uncertainty (except within well-defined limits) and the costs of information and transactions. Its simplicity is revealed by the fixed availability of well-defined goods and technology (there is no innovation) and the uniqueness of prices. There is one price per good/market, that is, no spread between what the buyer pays and the seller receives.

It is taught that these conditions produce efficient outcomes such that trade-offs between the utilities and costs of goods are equal. Selfish interests are led as if by an invisible hand to promote the general welfare. This theoretical construct defines economics, and students of its finer details, such as the existence and stability of equilibria, are the most prestigious of their profession and are rewarded by Nobel prizes.

Notwithstanding these simplifications, advocates of free markets point to their practical successes. The societies in which the behavior described above is given freest rein are the world’s richest, healthiest, and most egalitarian.

Having learned economic theory, students look forward to its application to real world problems. They look in vain, for the lessons of the first course are rejected or ignored. They find that transactions costs are large, information is lacking or perverse, uncertainty is insuperable, individual actions have external effects whose costs and benefits are not fully captured by prices, and most of all, preventing solutions to these problems, individuals are dull and passive. Students learn that these disabilities result in market failures which requiring the government’s correction.

We saw in earlier blogs how these views have resulted in financial regulations, and will come back to financial markets next time. In preparation, it will be useful to learn more about the strategies of those opposed to free markets. A good place to begin is medicine, where arguments for market failures are carried furthest. Regulated utility monopolies are justified by economies of scale (because unregulated cost minimization is presumed to be inconsistent with profits) and the regulation of financial firms is justified by externalities (a firm’s failure has wider effects) and imperfect information (leading to bank runs), but it seems that no part of economic theory is satisfied in medical markets.

The seminal article on the economics of medical care was Kenneth Arrow’s “Uncertainty and the welfare economics of medical care” (1963). He contended that the market for medical services differed from ideal markets in (1) the irregularity and unpredictability of demand, (2) supply restricted by the high cost of training and doctor licensing, (3) patient (demanders) relations with their doctors (suppliers), who have superior information and emphasize patients’ welfare relative to profits, (4) uncertainty as to the quality of the product, and (5) price discrimination (bills depend on ability to pay). Leading textbooks cite these differences as sufficient reasons for the allocation of medical services according to official cost-benefit analysis (Phelps 2003).

We have not yet determined the best system of medical care, nor will we. We can say, however, that it does not follow that because the assumptions of the ideal model are incompletely satisfied, government intervention is an improvement. Arrow also made this leap of logic in other places (1971). General equilibrium theorists have developed sufficient conditions (summarized above) for the existence of an unregulated ideal system, and then concluded that because these conditions are incomplete, regulation is necessary. But sufficiency does not imply necessity. The markets seen by Arrow might work as well, or better, if left alone than when regulated. He is a devotee of the nirvana approach that chooses between “an ideal norm and an existing ‘imperfect’ institutional arrangement,” which must therefore be rearranged (Demsetz 1969).

It is often not clear that the resulting rearrangement is an improvement, and in the case of medical care it sometimes looks quite the opposite. Many actual and proposed interventions worsen the problems seen by Arrow. Consider his primary theme of uncertainty, where Arrow neglects the most important theoretical and practical approach to its resolution, which is reputation based on experience. We know nothing about anything until we’ve tried it. Arrow’s argument is like those simple textbook introductions that consist of one-period cases with no learning, or indeed any chance of learning. George Akerlof received a Nobel Prize for his “market for lemons” paper that proved the impossibility of a used-car market. This market does exist, of course, because people invest in information. The practical point of that article, and others on insurance and other contracts affected by uncertainty, is that information has value. Arrow’s implied suggestion that people will not invest in information about the performances of doctors and hospitals, as they do in other markets, is not to be believed. Nor are the other problems raised by Arrow beyond remedies by consumers and suppliers.

In addition to discouraging investment in the reduction of uncertainty, another unfortunate effect of some health-care proposals is the rejection of information through bureaucratic cost-benefit analyses. Only patients can know the value of their medical services (as with other services, however uncertain the outcomes), which is not realized unless their choices are based on the costs they bear. The high cost (to society) of medical care is due to a related problem: subsidies that cause excess demands which are paid for by third parties (taxpayers).

Markets are never ideal, but we should ask why the advocates of change prefer further departures from free-markets to the opposite. The case that medical care is less amenable than other markets to deregulations bringing it closer to the conditions of economic theory has not been made.

Economic analysis is rejected in the market for medical care, as in other markets, in favor of politically powerful interests who hope to benefit from regulations and subsidies. They should be grateful to Arrow and other economists of the second sort.

References

Akerlof, George. 1970. “The market for lemons: quality uncertainty and the market mechanism," Quarterly J. Economics.

Arrow, Kenneth. 1963. “Uncertainty and the welfare economics of medical care,” American Economic Rev.

_____ and Frank Hahn. 1971. General Competitive Analysis. Holden-Day.

Demsetz, Harold. 1969. “Information and efficiency: another viewpoint,” J. Law and Economics.

Phelps, Charles. 2003. Health Economics, 3^rd ed. Addison-Wesley.

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