More on Bubbles

This will perturb David Andolfatto, who has heard enough about bubbles. But Andolfatto perturbation is enjoyable, for some reason, so here goes. Ben Lester told me about this 1993 paper by Allen, Morris, and Postlewaite on bubbles. Here's the relevant quote:

I think that corresponds quite closely to what I had in mind here (and see this post as well). I'll leave you to judge whether Allen, Morris, and Postlewaite are better or worse economic theorists than Paul Krugman or Noah Smith.

Harvard Conservatives

No, it is not an oxymoron, but a new blog.

Money and Bubbles

Money. Bubble. Liquidity. Fire sale. Those words are used a lot, particularly with reference to the recent financial crisis. Sometimes the words are used as if we all agree on what they mean, but if you engage anyone in a discussion about any of them, you'll find a distinct lack of agreement. I've seen several shouting matches in seminar rooms over what "bubble" means. Thus, it's not surprising that Noah Smith, Paul Krugman, and I don't think about bubbles in the same way.

From my previous post, here's my bubble definition, with examples:

What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

Noah Smith and I once had a conversation along these lines, and I thought we were making progress, but apparently not. Noah says the above paragraph is nonsense, since most payoffs on assets in monetary economies (like the one we live in) are denominated in terms of money. Thus, Noah reasons, if money is a bubble, then all assets are bubbles. How dumb could I be?

The payoffs on my stocks and bonds, and the sale of my house, may be denominated in dollars, but that does not mean that the value of those assets is somehow derived from the value of money. It's useful to ask what would happen if the monetary bubble "bursts." Think about an identical economy where money is not valued (that's always an equilibrium) and ask what happens. Everything changes of course, as now it's more difficult to carry out transactions - but not impossible. People will find other means to get the job done. Private financial intermediaries will issue substitutes for government money; people might engage in barter; people might use commodity monies. There is no reason why stocks and bonds and houses can't exist and be traded, with payoffs denominated in terms of something other than government-issued liabilities. Indeed, because private assets are substituting for government liabilities in exchange, some of those assets will have larger bubble components than in the monetary economy.

To give a practical example, think about monetary arrangements in the United States during the free banking era before the civil war. There was no fiat money or central bank. Transactions were executed primarily using the paper notes issued by private, state-chartered, banks, and using commodity money. Think of the role that gold played in that era. The price of gold had a bubble component as the stuff was used in exchange. It's not used in exchange today, so the bubble has gone away.

Here's Krugman's bubble definition:

I’d start by asking, what do we mean when we talk about bubbles? Basically, I’d argue, we mean that people are basing their decisions on beliefs about the future that are based on recent experience but can’t be fulfilled. E.g., people buy houses because they expect home prices to keep rising at a pace that would eventually leave nobody able to buy a first home...This sounds a lot like what happens in a Ponzi scheme...

It's different, right? My definition was based on rationality, and bubbles can be sustained forever. The crucial elements of a Krugman bubble are irrationality, and lack of sustainability. That's pretty much where the discussion ends. Krugman finds his notion of a bubble useful. I find mine useful. Krugman is in the Shiller bubble camp. I'm in the monetary theorist bubble camp.

Here's something interesting, though. Toward the end of his post, Krugman discusses fiat money, and Samuelson's overlapping generations (OG) model, which is one framework for thinking about money and what it does. No one took this model seriously as a model of money for a long time, perhaps because the tone of Samuelson's article is half-serious. However, Lucas used it in his 1972 paper, and this inspired Neil Wallace and his Minnesota students in the early 1980s to develop it further. The OG model captures Jevons's absence-of-double-coincidence problem in a nice way, it's easy to work with, and it admits complications like credit arrangements in a simple manner. Indeed, this book by Champ/Freeman/Haslag is essentially OG models for undergraduates.

One interesting feature of an equilibrium with valued money in the OG model, is that it looks like a Ponzi scheme - i.e. it has a feature Krugman associates with his bubble. And it's sustained forever. In each period, the young transfer goods to the old in the belief that they will receive goods when old from the next generation. Indeed, that arrangement looks just like social security, which is also a Ponzi scheme, though Krugman doesn't want to admit it. There's nothing wrong with it of course. Under the right conditions, social security can be an efficient and sustainable Ponzi scheme.

Blinder and Mankiw Webcast

Alan Blinder and I will be speaking at the 8th Annual Gulf Coast Economics Association Teaching Conference on November 8th and 9th, 2012.  Even if you can't make it to the conference in Orlando, Florida, you can watch us via a free webcast.  For more information, click here.

The State of the World

There is some stuff in this Krugman blog post that is worth discussing. It's hard to get past his usual self-aggrandizement (I am a remarkably prescient forecaster; I am an island of clarity in an ocean of confusion; blah blah blah), but I'll try. We need to be tolerant, even when it's hard.

Here's what Krugman thinks is the key effect of the financial crisis:

Here’s how I interpret what we see in the historical data: financial crises leave an overhang of private-sector problems, principally excessive debt on the part of some subset of economic agents — households, in the case of the United States. Because these agents are either forced or strongly induced to slash spending, the “natural” rate of interest, the interest rate consistent with full employment, falls sharply — and in the case of a severe crisis, falls well below zero.

He's got the sign wrong. Suppose that for various reasons debt constraints bind more severely. That's in Eggertsson-Krugman for example. They just impose debt limits exogenously, but you could do something more sophisticated and tie the debt limits to the value of collateral, or what a would-be borrower stands to lose from default. In any case, what you get is more severe credit frictions, which make safe assets - government debt and safe private liabilities - more valuable. Why? These assets are now more useful at the margin in financial trade and as collateral. The safe market rate of interest is now too low, relative to where it should, or could, be. The "natural rate of interest" has not fallen. For more detail, see this post, point #1.

Krugman thinks economists and policymakers (past and present) are subject to "conceptual confusion." According to him, there are three facets to this:

1. Krugman is worried that people think he is being inconsistent (see my previous post for example). How can the Reinhart-Rogoff regularity (extended recovery after a financial crisis) be a regularity, and also represent an opportunity for Keynesian policy? Here's the heart of Krugman's argument:

...there are simple policy actions that could quickly end this depression now, there were simple policy actions that could have quickly ended depressions past. The problem is that now and then policy makers tend not to take these actions — which is why some of us write books.

A simple and quick solution is at hand. Easy. To buy this argument, you have to think that Krugman is really really smart, and the remainder of the human race is really really stupid. There are plenty of economists - with and without Nobel prizes - who don't think the solutions are easy.

2. Demand/supply and bubbles:

Over and over again one hears that we can’t expect to return to 2007 levels of employment, because there was a bubble back then. But what is a bubble? It’s a situation in which some people are spending too much — and we can’t expect those people to return to past spending habits.

What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

But the bubble component of housing prices after, say, 2000, does not appear to have been entirely a good thing, as it was built on false pretenses. Various kinds of deception resulted in housing prices - and prices of mortgage-related assets - that, by anyone's measure, exceeded what was socially optimal. As a result, I think we can make the case that pre-2008 real GDP in the US was higher than it would have been otherwise. Further, the housing-market and mortgage-market boom could have masked underlying changes taking place in US labor markets - for example David Autor's "hollowing out" phenomenon. One could argue that there was a cumulative effect in terms of the labor market adjustments needed, and that these adjustments took place during the recent recession, and are still taking place. See for example this paper by Jaimovich and Siu. That's why all the long-term unemployed. So that's not some confusion. People are talking about alternative ideas that have some legs, and may have quantitative significance. Why dismiss them?

3. Sectoral shifts:

One last point: we still keep hearing the “structural” argument, that we have to expect prolonged high unemployment because it takes time to turn construction workers into manufacturing workers or whatever. One answer is that this portrait of the economy is factually wrong: job losses have not been concentrated in a few sectors or professions, they have been broadly spread across the economy. But there’s also a conceptual answer: if shifting workers across sectors requires mass unemployment, how come the bubble years — when we were moving out of manufacturing into housing — weren’t high-unemployment years? Why does moving into the bubble sectors mean more jobs, but moving out into other sectors mean fewer jobs? I’ve never heard a coherent answer.

Answer: If you're not listening, you can't hear. There is plenty of unusual behavior in the recent labor market data: (i) the jobless recoveries that Krugman highlights here; (ii) the large drop in employment relative to output in the recent recession; (iii) the abnormally large fraction of long-term unemployed. One element of unusual behavior is the failure of residential construction to lead the recovery. David Autor and others (as mentioned above) have highlighted the recent shift out of middle-skill occupations. There is plenty here for any labor economist or macroeconomist to sink their teeth into. How do you tie together the financial crisis, the shifts in employment across sectors, and the changes in the skill mix? It's well-known that sectoral changes have macroeconomic consequences - economists have been discussing this at least since the early 1980s.

So, there is a lot going on. If we want to think of our current predicament as an aggregate demand management problem, we're missing all or most of what is important. It's certainly not simple, but it's a lot more interesting than an IS-LM model.

Financial Crises

I just received Gary Gorton's new book, Misunderstanding Financial Crises in the mail. This is as good an account of the financial crisis as any I have seen, and adds to Gary's previous book, Slapped by the Invisible Hand. Gary has an unusually broad grasp of banking history, modern banking theory, financial theory, and the practical aspects of modern finance and institutions. Indeed, some of his consulting work placed him at the center of the financial crisis. In the late 1980s, Gary taught me that securitization was important, long before most economists had any idea what that was about. I don't agree with everything he writes, but you can learn a lot from his new book.

Lucas once said that business cycles are all alike. Gorton wants to focus on what makes financial crises all alike. His key point seems to be that, in any financial crisis, we can find a run. In the United States, bank runs were a key feature of panic episodes during the National Banking era (1863-1913) and the Great Depression. Bank runs were certainly not a feature of the recent financial crisis, but Gorton thinks that "repo runs" were essentially the same phenomenon.

Gorton's idea is that any financial entity that intermediates across maturities can be subject to a run. The Diamond-Dybvig view is that bank runs are inherent to the liquidity transformation carried out by banks. A well-diversified bank transforms illiquid assets into liquid liabilities, subject to withdrawal. Everything is fine unless depositors anticipate that others will run on the bank, in which case we find ourselves in a bad equilibrium - a bank run. In the run equilibrium, it is optimal for each depositor to run to the bank to withdraw his or her deposit, since their best hope in this equilibrium is to get to the bank before the assets are exhausted.

A shadow bank is not quite like a Diamond-Dybvig bank. A typical shadow bank holds long-maturity liquid assets and finances its portfolio by rolling over short-term repos (repurchase agreements), using the underlying assets as collateral. One might think that, because the shadow bank's assets are liquid, a run could never occur. If financial market participants are reluctant to roll over the shadow bank's repos, it can sell assets to pay off its debts. The problem arises if there is a systemic revaluation of shadow bank assets. Then, an individual shadow bank could default because new repo holders are demanding large haircuts in their repo contracts. Worse, since all shadow banks are selling assets simultaneously, the prices of assets are further depressed (a fire sale), which amplifies the repo run.

A debt contract is an efficient arrangement that works extremely well in good times. The payments required under a debt contract are non-contingent, and there is no fuss about what it means to fulfill the terms of the contract. Problems occur in default states, however, particularly when there are multiple creditors. For a bank, the coordination problem that arises in the event of default is particularly severe, given the large number of small depositors. However, coordination can be very costly even if a financial institution's creditors consist of a few other financial institutions. In a Diamond-Dybvig model, coordination is formalized as "sequential service," which inhibits communication among the bank's depositors in a rather brutal fashion. Of course, a shadow bank run really has nothing to do with creditors "lining up" at the shadow bank, so we can't take sequential service literally if we want to think of repo runs as akin to Diamond-Dybvig runs.

Coordination costs that arise in a default involving multiple creditors are reflected in legal costs, and the time that assets are tied up in litigation. In the case of banking, deposit insurance minimizes those costs in a nice way. The FDIC stands in for all creditors, thus eliminating the replication of default costs among creditors and doing away with disputes among creditors. Further, resolution occurs quickly. Of course, we all know about the fallout from insuring the liabilities of financial intermediaries. Absent constraints on risk-taking, insurance creates a moral hazard problem, whereby intermediaries take on more risk than is socially optimal.

So if, as Gorton suggests, a financial crisis is defined by widespread runs on financial intermediaries, how is that helpful?

1. Does this mean that central banks should respond to every financial crisis in the same way? Probably not. Banking panics in the National Banking era and the Great Depression were essentially currency shortages. The recent financial crisis involved a shortage of safe assets, more broadly. A currency shortage can be solved with a central bank open market purchase of government debt. A shortage of safe assets may be a problem for fiscal policy - as asset swaps by the central bank will not change the net supply of safe assets. Further, central bank lending policies may depend on the particulars of the crisis.

2. If we think of a financial crisis as a run problem, and draw an analogy to banking and deposit insurance, this must mean we should insure everything that looks vaguely like banking. Moral hazard everywhere. Great.

3. One of the lessons of the financial crisis is that financial factors are important. Surprisingly, many people once thought otherwise, and some continue to think so. But the importance of financial factors is not confined to the events we want to call "financial crises." It seems wrongheaded to take episodes in history and put them in "crisis" and "non-crisis" bins.

You can see how fussing over what is a financial crisis and what is not can be unproductive. Case in point:

1. Reinhart and Rogoff define a financial crisis in a particular way, and argue that there is a regularity in the data. Recoveries after financial crises are protracted. People use that "fact" in different ways. Jim Bullard wants to argue that the Reinhart-Rogoff regularity tells us that the Fed should not held responsible for the slow recovery. Paul Krugman wants to use the Reinhart-Rogoff regularity to absolve the Obama administration. Of course, he is walking a fine line here as, in contrast to Bullard (apparently) he seems to think that appropriate monetary and fiscal policy would have left Reinhart and Rogoff with no regularity to talk about.

2. Mike Bordo and Joe Haubrich define a financial crisis differently (from Reinhart and Rogoff) and argue that, in the United States, it's hard to argue that the Reinhart/Rogoff regularity is in the data. Sometimes we see it. Sometimes we don't. John Taylor picks up on this. Like Krugman, he has an ax to grind - different ax though. According to Taylor, things are worse than they should be because of you-know-who.

Taylor does point out something useful, though, and quotes Bordo:

The mistaken view comes largely from the 2009 book “This Time Is Different,” by economists Carmen Reinhart and Kenneth Rogoff, and other studies based on the experience of several countries in recent decades. The problem with these studies is that they lump together countries with diverse institutions, financial structures and economic policies.

That's important. The U.S. financial system is unique in many ways. It still has many small banks; U.S. financial regulation is unusually complicated, with a confusing patchwork of overlapping regulatory authority; the U.S. supplies the world's reserve currency; the Fed intervenes in different ways because of peculiarities in our financial markets. The comparison with Canada is useful. Canada and the U.S. are similar in many ways, but it is difficult or impossible to find anything that Reinhart-Rogoff or Bordo-Haubrich would call a financial crisis, in all of Canadian history. How come? They have debt contracts, banking, and financial intermediation across maturities in Canada. Why no panics?

Why indeed. Definitions and data give us something, but they can't substitute for theories that can help us organize our thinking about the data. The immediate question is whether or not the monetary and fiscal authorities in the United States are doing the appropriate things. There are good reasons to think that recessions are not alike, and that the most recent recession has features that are different from previous ones in the United States - and different in important ways from episodes where we think that there was some element of "financial crisis." Even if we could figure out the Great Depression, and understood completely the policies that would have been appropriate at the time, that would be no guarantee of success under current conditions.

John Taylor versus Paul Krugman

1. Taylor: Simple Proof (of weak recovery)
2. Krugman criticism: Financial Crisis Denialism
3. Taylor response: Weak Recovery Denial