Monday, 1 June 2009

Long or short Buiter - the origins of the Crunch

This is a rather long post on some aspects of the origins of the Crunch. It is definitely work in progress, so please bear with me, or skip on to something shorter and less drafty.

Let's begin with Long or Short Capital, one of my favourite places to go for financial sarcasm. Commenting on the recent falls in the US treasury market, they say:
Apparently, there is a finite limit to increasing the supply of something such that it will begin to become less dear. Some refer to this reversionary force as part of the unproven theory “supply and demand” wherein the basic concept is that if there is demand X for some thing and there is supply Y then there will be price Z. If Y is decreased, then a new equilibrium price will be attained that will be higher than Z. If Y is increased, then a new equilibrium price will be attained that is lower than Z...

Some people, and most politicians, insist that such forces and theories are not only unproven but are unlikely to exist. If they were to allow that “supply and demand”
may exist, they would stress that it’s important that we do what we can to obviate our need for such burdensome natural laws. Is that not the mission statement of Government?
Now of course this is true in the large rather than the small. If you have a trillion of debt out there and you want to blow out another ten billion, it probably won't move the yield. But if you want to double your debt, then expect to pay more. The stickiness of price under changing supply make it easier to deny that eventually too much supply meeting too little demand will move prices.

Now to Willem Buiter, one of the most serious economists of his generation. In a recent blog post (reprinting parts of a longer paper) he discusses the causes of the crunch. I will quote selectively as the post is quite long. Buiter identifies five causes to the Crunch, of which the following are important for my purposes:
1. The ex-ante global saving glut that resulted from the emergence of the BRICs and the redistribution of global wealth and income towards the Gulf states caused by the rise in oil and gas prices. This depressed long-term global real interest rates to unprecedentedly low levels.

2. The extraordinary preference among the nouveaux-riches countries (BRICs and GCC countries) for building up huge foreign exchange reserves (overwhelmingly in US dollars) and for allocating their financial portfolios overwhelmingly towards the safest financial securities, especially US Treasury bonds. This increase in the demand for high-grade, safe financial assets was not met by a matching increase in the supply of safe financial assets. This further depressed long-term risk-free interest rates. Western banks and investors of all kinds who had target or hurdle rates of return that were no longer achievable by investing in conventional safe instruments, began to scout around for alternative, higher-yielding financial investment opportunities - the search for yield or for ‘pure alpha’, which, as everyone knows, is doomed to failure in the aggregate.

3. Following the entry of China, India, Vietnam and other labour-rich but capital-scarce countries into the global economy, the return to physical capital formation everywhere was lifted significantly. The share of profits rose almost everywhere.

4. Following the collapse of the tech bubble in late 2000 - early 2001, monetary policy in the US and, to a lesser extent also in the Euro Area, was too expansionary for too long starting around 2003, flooding the world with excess liquidity... this excess liquidity went primarily into credit growth and asset price booms and bubbles
Let's pick this apart a little. First we have a wall of money from newly cash rich countries. Combine this with the retirement savings of the baby boomers, and you have an awful lot of cash looking for a home. The mistaken policy of keeping short rates too low was amplified by this, as the new money bought bonds, leaving the back end of the yield curve low too. (Contrast this with the current environment where the short rate is zero but the back end is much higher.)

There were not enough safe homes for the cash, and the banks soaked up the excess demand by creating new AAA instruments - CDOs and ABS and such like. Investors who wanted a bit of yield but still the security of a AAA rating bought these in droves. This further loosened the credit channel as lending decisions became disintermediated from risk taking.

What is interesting about this account - which I buy as at least one of the major mechanisms which caused the crisis - is that it focusses on the excess supply of investable funds, something that even today central banks do not monitor. Even if they did, the only monetary tools available are the price and availability of short term money. What Buiter's account implies is that central banks also need to control the ease of distribution of longer term funds into credit, something that would require a much more dynamic view of bank regulation. If everyone wants to buy five year AAA-rated bonds, then the existing ones are going to get more expensive, AAA borrowers will be able to raise funds more cheaply, and banks will find a way to create more AAA bonds. A large drop in the cost of credit is bad for financial stability. Moreover you cannot necessarily fix the problem by raising the short rate: what the central bank needs to do is intervene in the credit market. Hmmm...

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5 Comments:

Blogger Charles Butler said...

David,

Can we consider this to be part two of your control theory piece? If so, a late comment.

I believe there is a limit to the utility of considering the financial realm an automaton, appealing as it might be. Specifically... If we were to have controlled the incentives offered to the (inherently extrasytemic) actors within the system, would we have arrived at the same place?

I believe not because the reward scheme allowed players to identify opportunity cost with real loss, shifting the burden of probabilities on to the automaton itself.

If there's any merit at all to this argument, it means we control the much smaller than we thought barrel, not the plank.

9:58 am  
Blogger Dave said...

I've never really understood the "savings glut" hypothesis.

As your third point notes, the entry of around 3 billion people into the global economy created a huge surplus of labour - ie scarcity of capital. So, this should have created sufficient investment demand to soak up the "savings glut".

But, instead of building capital in the BRICs, these savings were diverted into building unaffordable and unproductive McMansions in the US which, even at low interest rates, were uneconomic. This surely is the market failure. Do you agree?

Why did this happen? Was it the fault of banks, investors, regulators or governments (US or BRIC)?

Is Buiter suggesting that central banks might intervene to prevent such malinvestment? That is, that central banks should "pick winners"?

12:19 am  
Blogger David Murphy said...

Charles

I believe there is a limit to the utility of considering the financial realm an automaton, appealing as it might be.
Specifically... If we were to have controlled the incentives offered to the (inherently extrasytemic) actors within the system, would we have arrived at the same place?


Almost certainly not.

I would consider the characterisation of the financial system as an automaton as rather narrow. 'Complex adaptive system' is perhaps more appropriate. One of the nice things about control theory is that it tells you not just how to control the system in certain situations, but it also places limits on how much you can control. Impossibility results are useful precisely because they show us the limits of what is possible. Of course the model risk in this kind of analysis is huge, but still I think that the style of thinking is useful.

David.

8:07 am  
Blogger David Murphy said...

Dave

I've never really understood the "savings glut" hypothesis...
instead of building capital in the BRICs, these savings were diverted into building unaffordable and unproductive McMansions in the US which, even at low interest rates, were uneconomic. This surely is the market failure. Do you agree?
I do.

Why did this happen? Well, the conventional explanation is to blame Alan Greenspan for keeping rates in the US too low for too long. But actually I think that although Alan is an important actor in this tragedy, there were other factors too. First investors had bad information about the relative riskiness of capital commitment to the BRICs vs. McMansions thanks to the ratings agencies. Second banks had capital rules which encouraged lending in one chanel vs. the other. Third cultural biases and infrastructural lags encouraged the Chinese, to pick one example, to buy Fannie bonds rather than Brazilian ones.

Is Buiter suggesting that central banks might intervene to prevent such malinvestment? That is, that central banks should "pick winners"? He is suggesting, I think, first that central banks should shut down the alternative banking system which allowed credit to be allocated to McMansions without leverage constraints. That would then allow them to control the general price of credit more effectively, so that when there is a wall of money heading towards the market, they can increase capital requirements. This isn't picking winners, but it is an attempt to mitigate the intensity of swings in the general price of credit.

8:23 am  
Blogger Dave said...

OK, so the usual combination of asymmetric information, exuberance and stupidity. Yes, I agree.

12:31 am  

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