Kotlikoff On The Big Con

In preparing some talks on the financial crisis, 10 years later, I ran across a real prissy article, The Big Con -- Reassessing the "Great" Recession in addition to its "Fix" by Larry Kotlikoff. (Here, if the get-go link doesn't work.) 

Larry is also the writer of Jimmy Stewart is Dead – Ending the World's Ongoing Financial Plague with Limited Purpose Banking, from 2010, which along with Anat Admati in addition to Martin Hellwig's The Bankers' New Clothes is 1 of the key industrial plant outlining the possibility of equity-financed banking in addition to narrow deposit-taking, in addition to how it could terminate financial crises forever at essentially no cost.

Larry points out that the crisis was, centrally a run. He calls it a "multiple equilibrium."  Financial institutions have got promised people they tin have got their coin dorsum inwards full, at whatever time, but they have got invested that coin inwards illiquid in addition to risky assets. When people all do that at the same time, the organisation fails. Such a run is inherently unpredictable. If y'all know it's happening tomorrow, y'all run to teach your coin out in addition to it happens today.

This is a mutual thought echoed past times many others, including Ben Bernanke. What's distinctive near Larry's essay is that he pursues the logical conclusion of this view. If the crisis was, centrally, a run, all the other things that are alluded to equally causes of the crisis are non genuinely central.  Short-term debt, run-prone liabilities are gas inwards the basement. Just what causes the spark, how large the firehouse is, are non central, equally without gas inwards the basement the spark would non campaign a fire.

Larry puts it all together nicely past times starting with the 2011 Financial Crisis Inquiry Commission report:

"There was an explosion inwards risky subprime lending in addition to securitization, an unsustainable rising inwards housing prices, widespread reports of egregious in addition to predatory lending practices, dramatic increases inwards household mortgage debt, in addition to exponential growth inwards financial firms’ trading activities, unregulated derivatives, in addition to short-term “repo” lending markets, with many other cerise flags. Yet in that location was pervasive permissiveness; fiddling meaningful activeness was taken to quell the threats inwards a timely manner. "

Larry in addition to hence takes apart each of these non-culprits, equally below.


In my view, the understanding that the crisis was a run, that without a run in that location would have got been no crisis, somewhat similar the 2000 tech stock bust, in addition to that lots in addition to lots to a greater extent than majuscule is the only existent answer, has emerged slow over the concluding 10 years. Larry's essay is goodness for putting all the others to rest.

The insight is also optimistic. It is possible to create 1 clear uncomplicated thing -- equally good much short-term debt, non plenty capital. If all the long listing of vague maladies named past times the crisis committee demand to live on fixed past times super-powerful in addition to financially clairvoyant regulators, the undertaking is hopeless despite the immense authorities expansion that would entail.

In many of these items, I cry back Larry oversteps a bit. The declaration only needs to live on that "these things mightiness have got been problems, indeed, they mightiness have got caused a recession, but without a run, induced past times short-term debt, in that location would have got been no financial crisis." Larry goes on to cast incertitude whether whatever of them are problems at all, which is fun in addition to provocative but to a greater extent than than necessary. Moreover, Larry genuinely goes on to thought recessions themselves equally multiple equilibria, which is an interesting in addition to provocative idea, but non necessary.

Larry's essay is fifty-fifty to a greater extent than to the dot today. I'm at the Financial Cycles in addition to Regulation conference at the Bundesbank. Every newspaper hence far takes it for granted that in that location is such a thing equally a "financial cycle," a buildup of "excessive" or "imbalanced" debt that precedes an inevitable circular of default in addition to crisis. It is the regulator's undertaking to deal such "debt cycles" actively. Larry's essay disagrees from the give-and-take go. It's prissy to have got 2 diametrically opposed ideas inwards mind.

Larry's List follows. If y'all teach bored, skim to the bottom for his to a greater extent than provocative ideas on runs.

1) Liar Loans, No Doc Loans, NINJA Loans in addition to Other Subprime Mortgages

There exactly weren't that many subprime defaults, especially before the crisis hit. (And, I would add, defaults non insured past times fannie, freddie, etc.) 

2) The “Unsustainable” Rise inwards Housing Prices

House prices have got risen in addition to fallen before. And, I mightiness add, many are sustained. If you're waiting for houses inwards Palo Alto or Manhattan to autumn to, say Joliet IL levels, y'all may have got a long hold off ahead of you. 

Larry makes an interesting comparing of existent theatre prices with existent GDP, 

.. existent theatre prices tin rising for years, indeed, decades. They did hence essentially every twelvemonth for the 32 years betwixt Q1 1975 in addition to Q1 2007. The rising was both smoothen in addition to gradual with existent theatre prices only 64 percent higher inwards Q1 2007 than they were inwards Q1 1975 – this despite existent gross domestic product rising past times 170 percent over the same interval.  

...between Q1 2003 in addition to Q1 2007 ... existent theatre prices rose past times 22 percent. But over this menses existent gross domestic product rose past times fourteen percent. Hence, existent theatre prices rose only 2 percent faster per twelvemonth than did the economic scheme during the menses of “unsustainable” theatre toll increases.

The comparing betwixt existent theatre toll in addition to existent gross domestic product is unusual. Larry writes

One tin write downward models with a fixed provide of housing inwards which theatre prices volition rising pari passu with output, at to the lowest degree inwards the long run. One tin also write downward models inwards which in that location is a variable provide of housing in addition to the toll of housing stays fixed, piece the quantity of housing rises with output.

In whatever case, it's non a financial crisis without short-term debt. 

Certainly, a temporary drib inwards theatre prices could have got produced a contraction inwards construction.... Moreover, a pass upwards inwards a given sector doesn’t augur an economy- broad recession. 

And, an of import point

a drib inwards the toll of homes does non adversely impact most homeowners. Yes, the value of their property falls. ...

But y'all even hence teach to alive inwards the house. If y'all could pay the mortgage before, y'all even hence can. 

 if we’re talking near a nationwide pass upwards inwards theatre prices, equally nosotros are with the GR, fifty-fifty those who moved experienced no economical damage because their powerfulness to purchase at a lower toll offset their demand to sell at a lower price.

The theatre toll drib was slap-up intelligence for immature people who alive inwards apartments, equally the stock toll drib was slap-up intelligence for their retirement investment opportunities. Yes, in that location are theories inwards which the losers impact the economic scheme asymmetrically, such equally Mian in addition to Sufi's, but we're straying away from the dot here. Influenza A virus subtype H5N1 theatre toll "bubble" in addition to "burst" is non per se a argue for a financial crisis.  

As inwards many of these "causes" it's of import to distinguish events before Oct 2008 from those afterwards. Yes, in that location was a huge recession, in addition to that caused theatre toll declines, undertaking losses, mortgage defaults, in addition to hence forth. But causes of the crisis have got to come upwards first. 

3) Ratings Shopping

"overrating affected less than 1 one-half of 1 percent of the US bond market. Furthermore, this modest figure for certain overstates the importance of ratings shopping equally many of the downgrades were caused past times the GR itself,"

4) Increased Bank Leverage

"Sky-high banking concern leverage is some other piece of work of the criterion GR explanation....Bank leverage genuinely brutal over the menses 1988 through 2008.16 Equity rose from vi percent of banking concern assets inwards Q1 1988 to 10 percent inwards Q1 2008."

Be careful here. Larry's dot is that in that location was no voluntary increase in leverage, in addition to especially equally measured in addition to monitored past times regulators, in addition to no such increment was a key campaign of the crisis.  That doesn't hateful the overall amount of leverage is fine. Larry's main point, equally mine, is that the banking organisation has means equally good much leverage overall. 

5) Too Little [Regulatory] Capital  

"According to Cox [ Christopher Cox, Chairman of the US Securities in addition to Exchange Commission (SEC)..], Bear Stearns was good capitalized when it failed, with a majuscule ratio over thirteen percent in addition to a debt-equity ratio of vi to 1. Indeed, it appears that Bear Stearns could have got easily passed the electrical flow Dodd-Frank stress bear witness straight off prior to its demise. Consider this declaration from Chairman Cox. 

"The fate of Bear Stearns was the outcome of a lack of confidence, non a lack of capital. When the tumult began concluding week, in addition to at all times until its understanding to live on acquired past times JP Morgan Chase during the weekend, the work solid had a majuscule cushion good higher upwards what is required to regard supervisory standards calculated using the Basel II standard. "

Lehman was also good capitalized prior to its demise. It had tier-1 majuscule of eleven percent when its creditors pulled the plug. An eleven percent majuscule ratio is closed to the electrical flow banking system’s tier-1 majuscule ratio of 12.3 percent, calculated based on the Federal Reserve’s recent stress tests. This indicates that today’s banking organisation is no safer than was Lehman Brothers when it was driven out of business."

Again, inwards this draft, Larry doesn't emphasize plenty that the dot is a decline in capital, a weakening of regulations, or a pass upwards inwards regulatory capital. His in addition to my overall dot is that majuscule needs to live on much, much larger overall, in addition to that volition halt runs. But the lawsuit of the crisis was a combustion of the regular old gas inwards the basement, non an add-on of lots of novel gas. 

6) Egregious in addition to Predatory Lending

i.e. 

"adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages, piggy-back, in addition to so-called pay-option ARM loans."

of these, 

"...in 2007, before the GR, the foreclosure charge per unit of measurement was five percent. Its lowest value, betwixt 2002 in addition to 2007, was 3 percent, which was observed inwards Q3 2005.If 1 assumes that all of the 2 percentage-point increment inwards subprimes involved predatory lending, we’re even hence talking near predatory lending causing, at most, 0.3 percent to a greater extent than mortgages to definitely default, namely, come inwards foreclosure. This is only equally good modest a figure to affair to the overall economy. Indeed, given the size of the 2007 mortgage market, it represents exactly $32 billion. In 2007, US gross domestic product was $14.4 trillion. The economy’s 2007 total internet wealth was $68 trillion."

The Dodd-Frank human activeness piled every suggested create to every perceived financial work inwards 1 place. Even if 1 regards predatory lending equally a problem, fifty-fifty if 1 does non regard contest equally the best disinfectant in addition to guarantor of goodness treatment, fifty-fifty if 1 thinks it needs fixing, Larry's dot is that such a create has aught to do with stopping crises. 

7) Dramatic Increases inwards Household Mortgage Debt

Surely, the add-on of over $750 billion inwards mortgage debt inwards the course of didactics of vi brusque years must stand upwards for a priori evidence that a massive recession was inwards the works. Not so. ... The increment inwards borrowing to purchase homes was non associated with a massive spending spree on the piece of work of the American public. Indeed, the percentage of gross domestic product consumed past times the populace remained fixed at roughly 67 percent betwixt early on 2002 in addition to belatedly 2007.

What near household debt payment service equally a percentage of disposable personal income? There was an increment prior to the GR, but aught extraordinary. Between Q4 2001 in addition to Q4 2007, the ratio troughed at 12.1 percent inwards Q2 2004 in addition to peaked inwards Q4 2007 at 13.2 percent. Influenza A virus subtype H5N1 13.2 percent ratio is modest in addition to the increment from trough to meridian is only ix percent

As with houses, your debt is my asset. Larry is verging hither into causes of the recession rather than the crisis. There is a representative for asymmetries, but the first-order error is to cry back that exactly because I am inwards debt nosotros all are inwards debt.

8) Exponential Growth inwards Trading Activity past times Financial Firms

Here, again, nosotros have got a supposed argue for the Great Recession that has no counterpart inwards economical theory. If Joe in addition to Sally sell the same percentage of stock dorsum in addition to forth to each other an infinite number of times in, say, a second, aught existent volition spill out to Joe in addition to Sally or the economy.

9) Unregulated Derivatives in addition to the Repo Market

The reigning narrative – that derivatives were misunderstood in addition to over rated past times compliant rating companies – has been questioned inwards a recent study past times economists Juan Ospinal in addition to Harald Uhlig. They examined 8,615 residential mortgage-backed securities (RMBS) over the menses 2007-2013, almost all of which were rated AAA. Through 2013, the cumulative loss on these “toxic” securities was only 2.3 percent. Some iii quarters of the AAA-rated RMBS had essentially null losses through 2013. On a principal-weighted basis, the average loss charge per unit of measurement was only 0.42 percent. 

Yes, losses were far higher for non-AAA rated segments of the RMBS market. But that’s what 1 would expression from a “great” recession. However, these securities represented a modest fraction of the RMBS market.

I cry back the logic hither is that if securities were overpriced, in addition to hence they should have got fallen. That they did non is interesting. Of course, if they had fallen that is non necessarily evidence of overpricing, equally in that location was a huge recession after the run! 

What near REPOs? Did they campaign the GR? Well, they certainly increased inwards the sew together to the GR. But short-term financial-company borrowing has been growing far faster than the economic scheme for decades. The fact that some economical variable rose speedily prior to the GR is non evidence that it caused the GR. Smart telephone sales tripled betwixt 2005 in addition to 2008, but no 1 would link that to the GR. Of course, Repos would live on implicated inwards causing the GR had they been piece of work of excessive leveraging past times financial intermediaries. But, equally discussed above, overall financial- fellowship leverage fell, non rose prior to the GR.

Here 1 time to a greater extent than I cry back a large qualification is inwards order. The run on repo was a key piece of work of the crisis, in addition to I cry back Larry in addition to I concord that means equally good much such run-prone financing was the key campaign of the crisis. Again, I cry back the dot Larry is making is that the financial organisation equally constructed is ever vulnerable, that the crisis was non brought on past times some abrupt in addition to preventable increment inwards debt. 

10) Investors Mispriced/Ignored Risk

11) Unaligned CEO Incentives

Yet some other explanation for the GR is that CEOs of financial institutions had equally good fiddling “skin inwards the game.” Jimmy Cayne, quondam caput of Bears Stern, would for certain disagree. Cayne lost closed to $1 billion equally his banking concern collapsed. Ken Lewis, CEO of the Bank of America, had $190 1000000 to lose past times making incorrect decisions in addition to succeeded inwards losing $142 million. Lehman Brothers’ Dick Fuld received most of his 2007 compensation inwards the shape of Lehman Brothers’ stock.

12) Democratization of Finance

Under this theory, authorities sponsored enterprises (Fanny in addition to Freddie) in addition to authorities regulators were equally good permissive with banks inwards their request to assist the wretched teach into affordable housing. ...if this were the main or fifty-fifty a major campaign of the GR, subprime mortgages would demand to have got played a much larger piece of work than they did.

13) The Federal Reserve Kept Interest Rates Too Low

Thirty-year mortgage involvement rates were certainly lower betwixt 2000 in addition to 2007 than inwards the prior quarter century. But they weren’t that depression especially adjusted for inflation. In the 1990s, the existent 30-year mortgage charge per unit of measurement averaged 7.91 percent. It averaged 6.27 betwixt Jan 2000 in addition to Dec 2007. This pass upwards is hardly something to write habitation about, allow lone pretend is the underlying GR culprit.

Runs

..the foundational bank-run models --- Bryant (1980), Diamond-Dybvig (1983), Pech in addition to Shell (2003) in addition to related models – acknowledge multiple equilibrium inwards which financial-market collapse arises absent whatever fundamental financial- or real-sector problem...  from the perspective of these models, the query is non whether the banking organisation volition fail, but when. Hence, it’s passing foreign that the FCIC study makes no cry whatsoever of either paper, allow lone the theory underlying banking concern runs. 

In completely ignoring the theory of banking concern runs... the FCIC pretended that what happened wasn’t intrinsic to how the financial marketplace is structured. Instead, the commission, for whatever reasons, appears to have got rounded upwards the common suspects in addition to held a sham trial.

(My emphasis.) Larry goes on for several pages documenting spreading panic. An before quote is goodness here

SEC Chairman, Mary Schapiro’s, 2010 testimony to the House Financial Services Committee...includes this statement.

 The immediate campaign of Lehman's bankruptcy filing on September 15, 2008 stemmed from a loss of confidence inwards the firm's continued viability resulting from concerns regarding its important holdings of illiquid assets in addition to questions regarding the valuation of those assets. The loss of confidence resulted inwards counterparties in addition to clearing entities demanding increasing amounts of collateral in addition to margin, such that eventually Lehman was unable to obtain routine financing from sure of its lenders in addition to counterparties

Unsafe at Any Speed, in addition to the limits on bailouts

The banks failed because they could. And they could neglect because they were leveraged. They falsely promised to brand repayments regardless of the circumstances. 

The overall storey of leverage is means equally good high. This reinforces my before interpretation of Larry's comment near leverage non beingness the work -- in that location was means equally good much leverage, but its increment did non straight campaign a crisis. 

The side past times side piece of work is genuinely interesting. 

The Federal Reserve is also leveraged. In the aftermath of Lehman’s collapse, the Fed effectively insured non exactly checking in addition to saving accounts, but also coin marketplace funds. These obligations were officially and, respectively, FDIC in addition to Treasury obligations. They ran to some $6 trillion. But neither establishment had $6 trillion inwards ready cash to brand goodness on its insurance. Hence, the Fed would have got been on the hook. Indeed, had things gotten worse, in that location would for certain have got been a run on the life insurance industry’s cash-surrender value policies, which, at the time, also totaled roughly $6 trillion.

Now imagine, equally discussed inwards Kotlikoff (2010), that the government’s explicit in addition to implicit pledges of insurance had been called past times the public. I.e., suppose the populace had, despite the promises of authorities insurance, headed straight to the banks, coin marketplace funds, in addition to insurance companies to empty out their accounts in addition to cash out their cash-surrender value policies. In this case, the Fed would have got had to impress $12 trillion virtually overnight. The M1 coin provide at the fourth dimension was exactly $1.5 trillion. Hence, this would have got produced fully-justified fears of hyperinflation leading everyone to run for their coin before prices soared

The US has yet to sense a run on its key bank. But this is mutual inwards countries similar Argentina, ...

Larry is, of course, an goodness on all the explicit in addition to implicit credit guarantees our authorities offers. I was unaware that $6 trillion of "cash give upwards value policies" existed, in addition to given the bailouts of other insurance policies nosotros would certainly have got seen them bailed out too. Fannie in addition to Freddie guarantee most mortgages. 

Though it does stand upwards for promises of payment, I don't cry back this genuinely is "leverage" of the Federal Reserve. The authorities has, inwards essence, written a lot of seat options, which is a dissimilar thing. 

What happens inwards an fifty-fifty to a greater extent than massive run, with to a greater extent than massive bailouts is an interesting question. It's non equally uncomplicated equally "print [ing] $12 trillion overnight." The Fed issues reserves, convertible to cash, but ever inwards homecoming for something else. So, this would have got seat a large strain on the Fed's legal limitations of what collateral it tin have got in addition to from who. 

The Fed to a greater extent than frequently than non deals with commercial banks. Imagine a massive run on commercial banks, maybe stemming from a rumored cyberattack that emptied 1 of them out. The Fed would have got to lend against the entire portfolio of banking concern assets, non exactly liquid securities. Goodbye Badgehot.

As Larry points out, genuinely the FDIC in addition to Treasury are the ones guaranteeing non-bank debts.  The Treasury would have got to borrow $12 billion overnight, sell it to the Fed, in addition to and hence utilisation it to bail out hither in addition to there. The ban on direct Fed-Treasury purchases would brand this real hard, in addition to would in all likelihood have got to live on scrapped. 

But the huge increment inwards coin would clearly live on a temporary increment inwards coin demand, in addition to non evidently inflationary. Moreover, the Treasury, Fed, FDIC, etc. would convey on assets. If these operations could live on reversed after the panic passes -- if in that location is non a tremendous amount of actual lost value, equally in that location was non concluding time, the coin could live on soaked upwards again. Even if not, the performance would non live on inflationary if people thought the authorities could retire the debt in addition to soak upwards the interest-paying reserves past times futurity surpluses. We teach inflation -- in addition to Argentine Republic gets inflation -- if in addition to only if this nightmare involves a large financial transfer, that the US authorities cannot or volition non pay off, that is financed past times a permanent increment inwards non-interest-paying money.  

US Federal debt is near $10 trillion larger than inwards 2008, in addition to we're running $1 trillion deficits, with no terminate inwards sight. The reliability of the financial resources to brand goodness on all these seat options is, I think, a serious problem, in addition to the inwardness of the potential inflation Larry describes. 

The Role of Opacity

Bear Stearns was with the get-go to live on picked off past times those who stood to gain past times a financial collapse because it was viewed equally peculiarly opaque

The fact that Bear’s stock was valued at $60 per percentage 1 calendar week before JP Morgan bought it for $2 per percentage (less a $29 billion sale of Bear’s troubled assets to the Fed valued at far less than $29 billion) tells us that no 1 knew anything near Bear’s assets, either before it died or when it died. Its valuation was, it seems, purely a affair of conjecture. Before it didn’t, the marketplace apparently though Bear’s assets were worth something because everyone else thought its assets were worth something. This equally good is the materials of multiple equilibria

Gary Gorton likens financial crises to a salad bar, where someone says "there's a intelligence study of e-coli inwards the (inaudible)". So what do y'all do? Absent data on which constituent has the e-coli, in addition to the fourth dimension or inclination to investigate, y'all teach social club a hamburger. 

Now inquire yourself, where is in that location a mount of debt that can't live on repaid, much of it real brusque term, phoney-baloney accounting, in addition to opaque off-balance-sheet exposures (put options)? Sovereigns. 

Bottom line 

Bad/greedy/lazy/irresponsible actors, we’re told, engaged inwards all means of financial malfeasance, adventure taking, negligence, theft in addition to greed. And what we’re told is true. There were plenty of bad actors... But the story of these bad actors is non the existent story of the Great Recession. The existent story is that both the economic scheme in addition to the banking organisation are inherently unstable. ... If plenty people cry back plenty people cry back a banking concern is going down, that banking concern volition teach downward regardless of its truthful condition. If plenty people cry back the economic scheme is going down, the economic scheme volition teach down, also regardless of its truthful condition.

The get-go conclusion seems to me spot on. The minute 1 is to a greater extent than provocative. Here Larry signs upwards with multiple-equilibrium theories of recessions, equally good equally uncomplicated multiple equilibria associated with run-prone assets similar overnight debt. It's verbally plausible. If y'all cry back in that location volition live on a recession tomorrow, y'all burn workers in addition to do non invest, in addition to in that location is a recession today. But y'all tin regard a crucial derivative needs to live on greater than 1.0 for that to work. Lots of formal models have got multiple equilibria, but I've spent 10 years putting nominal multiple equilibria dorsum inwards the new-Keynesian model, in addition to existent multiple equilibria are harder to teach going. 

One approach to addressing the work of financial multiple equilibrium is to supervene upon Dodd- Frank with to a greater extent than fundamental financial reform, such equally Kotlikoff (2010)’s Limited Purpose Banking (LPB). LPB would transform all financial corporations into 100 percent equity-financed mutual fund belongings companies bailiwick to total in addition to real-time disclosure supervised past times the government.

Choose your equity-financed banking flavor, in addition to nosotros tin terminate financial crises forever. Just why nosotros don't do it seems an of import -- in addition to sadly forgotten -- question.

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