A Big Banker’s Belated Apology

Jul 30, 2012Jeff Madrick

This op-ed originally appeared at NYTimes.com.

This op-ed originally appeared at NYTimes.com.

Last week, in a CNBC interviewSanford I. Weill, the former chairman of Citigroup, said that America should separate investment banking from commercial banking. This separation, of course, was the prime purpose of the Glass-Steagall Act of 1933, a piece of legislation that Mr. Weill and other bankers had successfully watered down, with Alan Greenspan’s support, before Mr. Weill helped engineer its official demise in 1999. Now, Mr. Weill, the creator of what was once the largest financial conglomerate in the world, suggests that Citigroup and others should be broken up. Banks can no longer “be too big to fail,” he told CNBC.

But what was most eye-catching was Mr. Weill’s claim that the conglomerate model “was right for that time.” Nothing could be further from the truth.

Mr. Weill’s original business concept — the justification of financial conglomeration — was to provide one-stop shopping to any and all customers. This could now include clients for investment banking, stock research, brokerage and insurance. Then, with the 1998 merger of his Travelers Group with Citicorp, it could include savers, business borrowers and credit card users, too. But few, even among his own executives, ever believed the strategy would work.

Rather, conglomeration bred conflicts of interest in Mr. Weill’s firms, and others — the very conflicts that the original Glass-Steagall Act was designed to prevent. This inevitably led to investment in and promotion of risky, poorly run and, in some cases, deceitful companies that brought us the high-technology and telecommunications bubble of the late 1990s.

Indeed, Mr. Weill’s Citigroup was a primary underwriter of and one of the two largest lenders to the oil and futures trading firm Enron, whose accounting charade resulted in what was in 2001 the biggest bankruptcy of its time. Citigroup was a major underwriter for the telecommunications giants Global Crossing and WorldCom, which would later go bankrupt as a result of flagrant accounting deceptions. There were many other, if less visible, debacles.

Read the full article here.

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On Nickels, Bulldozers, JP Morgan's Now $5.8 Billion Dollar Loss, and the Volcker Rule

Jul 19, 2012Mike Konczal

One of the best metaphors for understanding how hedge funds and other elaborate trading strategies work is that they are "picking up nickels in front of a bulldozer." This contrasts nicely with the view within economics that there can never be $100 bills just lying on the street. There is free money, but it is both dangerous and difficult to go after. And while it is profitable to go after the nickels, when the bulldozer crushes you the losses can be spectacular.

One of the best metaphors for understanding how hedge funds and other elaborate trading strategies work is that they are "picking up nickels in front of a bulldozer." This contrasts nicely with the view within economics that there can never be $100 bills just lying on the street. There is free money, but it is both dangerous and difficult to go after. And while it is profitable to go after the nickels, when the bulldozer crushes you the losses can be spectacular. Like getting run over by a steamroller (another vehicle used for this metaphor), the losses are huge, painful, and immediate, yet they manage to continue coming.

The metaphoric bulldozer continues to crush JP Morgan's balance sheet in light of its disastrous credit derivatives trading (remember that?). The losses were originally supposed to be around $2 billion dollars. The losses have now tripled to $5.8 billion dollar, as reported last week in their quarterly losses. According to the New York Times a few weeks ago, some estimate that it will be more like $8 or $9 billion. $9 billion is a lot more than the original $2 billion. And it is a significantly more than the handful of nickles they were looking to pick up if the strategy had worked.

It's worth looking at this in light of the Volcker Rule. There's an argument that this kind of propritary trading is entirely fine and good for the economy, but it does not need to be done by institutions that have taxpayer money on the line or function as a systemically important part of the financial infrastructure of the economy. It will be both well provided and well compensated on its own through hedge funds and smaller players in the financial markets. If anything, taxpayer subsidizes could crowd out smaller players, distorting the way that the financial market works.

But there's also the question of what to do if a large, systemically risky firm fails. Here the Dodd-Frank policy regime involves prompt corrective action to begin prepping a firm that looks like it will fail for failure, much like how the FDIC currently does with commercial banks. This system works better if there is adequate time and if there are no gigantic surprises.

Contrast that with Bear Sterns and its hedge funds. Bear Sterns put up $40 million of its own money into two internal hedge funds between 2004 and 2006, and in June 2007, Bear had to bail out these two funds with a line of credit worth $3.2 billion dollars. $40 million dollars upfront got crushed under the steamroller to the tune of $3 billion. Such a large loss absorbed so quickly put significant pressures on the firm; it later collapsed.

Given this asymmetric payout, prop trading makes a certain type of failure more likely - one that is quick, out of nowhere, and large. This type of collapse strains our system for resolving large, systematically risky financial firms. This system is what we need in order for financial firms to collapse in a fair way, one that allocates losses to those who gained the most while also preventing huge spillovers to third parties. The Volcker Rule is an essential part of this.

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Four Issues with Miles Kimball's “Federal Lines of Credit” Policy Proposal

Jul 18, 2012Mike Konczal

Economics professor Miles Kimball has a new blog, Confessions of a Supply-Side Liberal. In one of his first posts, he outlines a plan for stimulus that he calls “Federal Lines of Credit” (FLOC).

Economics professor Miles Kimball has a new blog, Confessions of a Supply-Side Liberal. In one of his first posts, he outlines a plan for stimulus that he calls “Federal Lines of Credit” (FLOC). It's presented in a longer policy paper, “Getting the Biggest Bang for the Buck in Fiscal Policy." This has gotten interest across the political spectrum. Bill Greider has written about it in The Nation, as has Reihan Salam in the National Review.

What's the idea? Under normal fiscal stimulus policy in a recession, we often send people checks so that they'll spend money and boost aggregate demand. Let's say we are going to, as a result of this current recession, send everyone $200. Kimball writes, "What if instead of giving each taxpayer a $200 tax rebate, each taxpayer is mailed a government-issued credit card with a $2,000 line of credit?" What's the advantage here, especially over, say, giving people $2,000? "[B]ecause taxpayers have to pay back whatever they borrow in their monthly withholding taxes, the cost to the government in the end—and therefore the ultimate addition to the national debt—should be smaller. Since the main thing holding back the size of fiscal stimulus in our current situation has been concerns about adding to the national debt, getting more stimulus per dollar added to the national debt is getting more bang for the buck."

Let's kick the tires of this policy. There's a lot to like about the proposal, particularly how it could be used after a recession is over to provide high-quality government services to the under-banked or those who find financial services yet another way in which it is expensive to be poor (modified, it turns right into Steve Waldman's Treasury Express idea). It's not clear whether this is meant to supplement or replace normal demand-based fiscal policy - at one point he proposes it could balance out a "relatively-quickly-phased-in austerity program."

As a supplement it has promise, but I think there are some major problems with this proposal, which can be grouped under four categories.

I: Isn't deleveraging the issue? Is this a solution looking for a problem? From the policy description, you'd think that a big is credit access holding the economy in check.

But taking a look at the latest Federal Reserve credit market growth by sector, you can see that credit demand has collapsed in this recession. Consumer credit drops throughout the beginning of the recession, particularly in 2009. This is true even for consumer credit by itself, which rebounds in 2011. It's not clear that these lines of credit would be used to expand demand at the macro-level; likely, given what we see, it would be used to replace other, higher-interest forms of debt (see III), a giant transfer of credit risk from credit card companies to taxpayers. But certainly some people will benefit, so let's examine why this policy is supposed to work.

II: This policy is like giving a Rorschach test to a vigilante. No, not that vigilante. I mean the bond vigilantes. Because to assume this plan would work, you need to make some curious assumptions about how bond vigilantes think, as it increases the debt by a significant amount.

Let's say our country has a balanced budget with a debt-to-GDP ratio of 50 percent and we hit a recession while at the zero-bound. As a result of less tax revenue coming in and more automatic stabilizers going out, debt-to-GDP will be 60 percent at the end of the year. We want to stimulate the economy further using fiscal stimulus.

Let's say our default is that we take three percent of GDP, divide it among the population, and mail it out. At the end of the year, the debt-to-GDP ratio will be 63 percent (I am ignoring that fiscal stimulus at the zero-bound can be largely self-financing for this example).

In Kimball's FLOC, we instead take 9 percent of GDP, divide it evenly among the population, and mail out lines of credit that add up to that 9 percent of GDP. Let's also say that perfect forecasting tells us that within the year, 6 percent of it will be utilized as a loan not yet paid back, and 3 percent is still available as credit.

What's the government's debt-to-GDP ratio at the end of the year in Kimball's example? I'm not sure how he'd account for it. I imagine it should be 69 percent (60 + 9). Perhaps it is 66 percent (60 + 6)? Either way, it is more than the 63 percent of just giving people money. His plan requires a larger debt-to-GDP ratio. If his accounting ends up with just 60 percent, I'm not sure I understand how he is doing it.

Now Kimball will say that bond vigilantes will be happy with this. Why? Because there's a built-in plan for repaying it. "[T]he fact that much of the money would ultimately be repaid would dramatically reduce the ultimate addition to the national debt...(though at a relatively attractive ratio of additional aggregate demand to addition to national debt)."

If we are guessing as to what the bond vigilantes want, it is clear they want more U.S. government debt. Ten-year Treasuries are selling at 1.5 percent, while real interest rates are negative! But for the purposes of the FOLC, we need a few assumptions about what the bond vigilantes think, which aren't clear.

First (i) it assumes that the bond market will only care about the government's long-run debt ratio instead of the short-term. I think that's correct. But much of the bond vigilante argument is predicated on the opposite, that no matter what the long-term is, the capital markets will freak on short-term deficits.

It also assumes (ii) that the repayments of these FOLC will be made easier through debt collection than just collecting the equivalent amount of money through taxation. I see no reason why that's the case, and many reasons to believe the opposite.

III: This policy will involve trying to get blood from a turnip. I very much distrust it when economists waive away bankruptcy protection. Especially for experimental, controversial debts that have never been tried in known human history.

As the paper admits, this is a machine for generating adverse selection, as the people most likely to use it are people whose credit access is cut due to the recession. High-risk users will likely transfer their balances from higher rate credit cards to their FOLC (either explicitly or implicitly over time if barred) - transferring a nice chunk of credit risk from the financial industry to taxpayers.

It's also not clear what happens a few years later when consumers start to pay off the FOLC. Could that trigger another recession, especially if the creditor (the United States) doesn't increase spending to compensate?

The issue isn't whether or not the government will be able to collect these debts at some point. It has a long time-horizon, the ability to jail debtors and use bail to pay debts, the ability to seize income, old-age pensions and a wide variety of income, and the more general ability to deploy its monopoly on violence. The question is whether this will be smoother, easier, and more predictable than just collecting the money in taxes. We have a really smooth system for collecting taxes, one at least as good as whatever debt collection agencies are out there. If that is the case, there's no reason to believe that this will satisfy the bond vigilantes or bring down our debt-to-GDP ratio in a more satisfactory way.

IV: Since we've very quickly gotten to the idea that we'll need to jettison legal protections under bankruptcy for this plan to work, it is important to emphasize that this policy is the opposite of social insurance.

I don't see a macroeconomic difference between the government borrowing 3 percent of GDP and giving it away and collecting it through taxes later versus the government borrowing 3 percent of GDP, loaning it to individuals, and collecting it later through debt collectors except in the efficiency and the distribution.

The distributional consequences of this proposal aren't addressed, but they are quite radical. Normally taxes in this country are progressive. Some people call for a flat tax. This proposal would be the equivalent of the most regressive taxation, a head tax. And it also undermines the whole idea of social insurance.

Let's assume the poorest would be the people most likely to use this to boost or maintain their spending. I think that's largely fair - certainly the top 10 percent are less likely to use this (they'll prefer to use high-end credit cards that give them money back). This means that as the bottom 50 percent of Americans borrow and pay it off themselves, they would bear all the burden for macroeconomic stability through fiscal policy. Given that the top 1 percent captured 93 percent of the income growth in the first year of this recovery, that's a pretty major transfer of wealth. One nice thing about tax policy, especially progressive tax policy, is that those who benefit the most from the economy provide more of the resources. This would be the opposite of that, especially in the context of a ""relatively-quickly-phased-in austerity program."

Efficiency is also relevant - as the economy grows, the debt-to-GDP ratio declines, making the debt easier to bear. The most likely borrowers under FOLC, the bottom 50 percent, have seen stagnant or declining wages overall, especially in recessions. A growing economy would keep their wages from falling in the medium term, but this is still a problematic issue - their income is not more likely to grow to balance out the payment burdens than if we did this at a national level, like normal tax policy.

The policy also ignores social insurance's role in macroeconomic stability, and that's insurance against low incomes. Making sure incomes don't fall below a certain threshold when times are tough makes good macroeconomic sense and also happens to be quite humane. This is not that. As friend-of-the-blog JW Mason said, when discussing this proposal, the FOLC is like "if your fire insurance simply consisted of a right to borrow money to rebuild your house if it burned down."

What else am I missing about this proposal?

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Washington Monthly on the Future of Savings

Jul 18, 2012Mike Konczal

The latest issue of Washington Monthly has several fascinating pieces on the future of savings. John Gravois has a piece on where the Consumer Financial Protection Bureau currently stands. Barry C.

The latest issue of Washington Monthly has several fascinating pieces on the future of savings. John Gravois has a piece on where the Consumer Financial Protection Bureau currently stands. Barry C. Lynn and Lina Khan have a piece on the collapse on American business start-ups. My colleague Mark Schmitt has a piece on the idea of government savings accounts, a piece which is also fascinating as a history of a policy idea. Reid Cramer of the New America Foundation has a great list summarizing some of the policies at the forefront of the movement to build savings and assets, which include universal childhood savings accounts, autoIRAs, addressing the unbanked and, a favorite around here, the Save to Win program that puts a lottery in a savings account.

For those interested in more, New America had a series of panels on the events which you can find here. The previous paradigm of an "Ownership Society" has collapsed. It seems unlikely that, with 401(k) programs looking insufficient to cover retirements, that we are going to privatize Social Security in the near future. And using housing equity in a bubble as a quick source of savings has turned out to be both a giant problem and no longer available. Given that the current recession is a crisis of over-leveraged households, having more stable and sufficient ways of saving and buiding wealth isn't just a matter that impacts individuals, but one that impacts the country as a whole. This needs to be at the front of the policy agenda and this issue will catch you up to the debate.

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A Shameful Few Weeks Begs the Question: Where’s Government?

Jul 17, 2012Jeff Madrick

With the recent crises in the financial world, it's clearer than ever that we need government to step up and address our problems.

With the recent crises in the financial world, it's clearer than ever that we need government to step up and address our problems.

There are certain periods in our history during which one can only sit back and wonder what the limits of astonishment really are. A couple of years since Dodd-Frank first passed, we have come through a period of such disrepute for business that one wonders why the working class has not risen as one — except, of course, because it is exhausted with efforts at reform that seem so futile. We have uncovered many disreputable and perhaps fraudulent business activities, but they essentially represent a failure of government. 

Facebook's initial public offering collapsed in price, leaving small investors holding the bag. Brokers took care of their big customers far better than their small ones. Where was the SEC?

New insider trading convictions, most recently of the widely respected Goldman Sachs director Rajan Gupta, show how rampant trading on insider information really is. The $6 billion losses at JPMorgan Chase by a department that was supposed to neutralize risk showed that trading risk is too profitable to be foregone voluntarily.

And now we find out that LIBOR is incontrovertibly rigged. Some may not realize that Barclays, which agreed to pay a $450 million fine, signed a Statement of Facts that admitted its traders rigged this key rate to make profits on positions, and collaborated with bankers/traders at other banks. Now we find out that Treasury Secretary Tim Geithner, while president of the New York Fed, was worried and even wrote British regulators about this. That’s nice. But why didn't government — and Tim Geithner himself — actually do something about it? Are government regulators that feckless?

Of course, there was a certain political advantage in a LIBOR that could be fudged. LIBOR is the rate at which banks lend to each other. It should be nearly riskless, and is therefore used as such in many transactions. LIBOR was the basis, in fact, for up to 100 percent of subprime mortgages. It is often a key input into complex pricing models for securities like derivatives and collateralized debt obligations.     

It could be that the Bank of England looked the other way when some bankers, including Barclays's, lied and said they were paying a lower interest rate than they were in order to make it seem their credit was good. Especially in the fall of 2008, after Lehman’s collapse, governments wanted to calm the waters. Did the Fed also tolerate fudging the numbers?

Why wouldn’t they? The Treasury puts a better face on matters all the time, as does the White House, no matter who is president. PR is an integral part of government. Has the practice in this age of greed slid off onto regulatory agencies? Surely Ben Bernanke was overly optimistic about controlling any impending subprime wreckage in 2007 because he knew it was better to err on the side of Pollyanish hopes that risk precipitating a crisis. What better way to underplay a crisis than to let the banks do it for you?

But for all these remarkable events — and government failures — most disturbing is the ongoing demands for austerity that even President Obama himself makes. The president wants to extend tax cuts for all except those who make $250,000 or more. But he cannot make the case without saying we have to get our fiscal house in order. The nation is likely to need stimulus. But Obama bought into the budget balancing process so early on by appointing Bowles and Simpson to come up with a solution that there is no effective opposition to impending obtuse budget policies in late 2012 and 2013. The classic case is made by the CEO of Honeywell on the front page of the Financial Times. Seeking to blame Republicans and Democrats alike, the esteemed chairman and member of the Bowles-Simpson Commission claims that business has no confidence until this is resolved.

The truth is more simple. Uncertainly surrounds the possibility that the Republicans will hold up the government again, claiming they demand budget cutting. And Mitt Romney promises to do far more damage. There is no contest between the two, and let’s keep in mind that Obamacare, and even Dodd-Frank, contain very good measures that Romney would try to overturn.  

As we end a bad few weeks and start a period of remedying the damage, let’s keep in mind that America’s fiscal problems in the near run are highly exaggerated. But even down the road, the problem is not what we spend, but the tax cuts we have been giving ourselves for 30 years. I will begin to believe the sincerity of arch deficit hawks when they argue for tax hikes, not only cuts in Medicare and Social Security. And so should the chairman of Honeywell and others of influence like him.

The myths of austerity economics are paralyzing the government and keeping the nation from getting its house in order. How may times can one say it? Not often enough, apparently.

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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Jeff Madrick: Banks and Regulators Should Be Held Accountable for LIBOR

Jul 12, 2012

Roosevelt Institute Senior Fellow and Rediscovering Government director Jeff Madrick appeared on Viewpoint with Eliot Spitzer this week along with Financial Times correspondent Tracy Alloway to discuss who should bear the blame for the growing LIBOR scandal.

Roosevelt Institute Senior Fellow and Rediscovering Government director Jeff Madrick appeared on Viewpoint with Eliot Spitzer this week along with Financial Times correspondent Tracy Alloway to discuss who should bear the blame for the growing LIBOR scandal. Responding to evidence that Fed officials knew the banks were up to no good, Jeff says in the clip below that "this culture of manipulation and acceptance of manipulation I think went very deep throughout Wall Street." 

Jeff says that given these revelations, "any idea any longer that one can trust bankers or investment bankers or mortgage brokers to do the right thing and set the right rate rather than make a very easy buck should be out the window." In the online exclusive below, he adds that "the idea they let this happen should anger people on top of all the other financial crisis we've had... They should be demanding some form of justice." But he notes that banks shouldn't be the only ones sharing the blame -- there's plenty to go around for regulators "if it turns out they really fully understood it was going on, and I think they understood enough that was going on that they should be held responsible."

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New Deal Numerology: Nobody Expects the British Inquisition

Jul 12, 2012Tim Price

This week's numbers: $453 million; $800 trillion; $31 million; 20; 150

$453 million... is a chastened number. That’s how much Barclays agreed to pay U.S. and British regulators for manipulating LIBOR. If the mortgage settlement was any indication, they’ll make up that money in no time by manipulating LIBOR.

This week's numbers: $453 million; $800 trillion; $31 million; 20; 150

$453 million... is a chastened number. That’s how much Barclays agreed to pay U.S. and British regulators for manipulating LIBOR. If the mortgage settlement was any indication, they’ll make up that money in no time by manipulating LIBOR.

$800 trillion... is a mammoth number. That’s the total value of the loans and securities linked to LIBOR – over 10 times the combined GDP of every nation on Earth. With all that imaginary money, they couldn't resist creating imaginary interest rates.

$31 million... is a sacrificial number. That’s how much in bonuses ex-Barclays CEO Bob Diamond gave up when he resigned. He still settled for $2 million and the knowledge that most people would confuse him with the head of JPMorgan anyway.

20... is a scandalized number. That’s how many big banks have been named in cases related to LIBOR so far. Maybe they figured there was no real harm if they all broke the law together, like drivers deciding they'd like to try out the wrong side of the road.

150... is a complex number. That’s how many LIBORs are published daily, including 10 different currencies and 15 different time-scales. Manipulating it must have seemed like the perfect crime: one only a very bored nerd could fully comprehend. 

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Can Tighter Financial Regulation and a Smaller Financial Sector Increase Economic Growth?

Jul 9, 2012Ugo Panizza

Economists are increasingly using statistics to debunk the age-old belief that economic growth goes hand in hand with a large financial sector. 

Economists are increasingly using statistics to debunk the age-old belief that economic growth goes hand in hand with a large financial sector. 

For a long time it was simply taken for granted that a large financial sector was beneficial to economic growth. This assumption supported the long period of financial deregulation and weak enforcement that began in the 1970s. Increasingly, economists are using statistical techniques to challenge this view. In the piece below, Ugo Panizza, the international economist who works for UNCTAD, summarizes the analysis he has done to show that a large financial sector is associated with slower economic growth. Links to the detailed papers he and colleagues have done are included at the end of this post. -Jeff Madrick, Director, Rediscovering Government Initiative


The financial system acts like the central nervous system of modern market economies. Without a functioning banking and payment system, it would be impossible to manage the complex web of economic relationships that are necessary for a modern decentralized economy. Finance facilitates the exchange of goods and services, allows diversifying and managing risk, and improves capital allocation through the production of information about investment opportunities.

However, there is also a dark side of finance. Hyman Minsky and Charles Kindleberger emphasized the relationship between finance and macroeconomic volatility and wrote extensively about financial instability and financial manias. James Tobin suggested that large financial sector can lead to a misallocation of resources and that "we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity."

A large financial sector could also capture the political process and push for policies that may bring benefits to the sector but not to society at large. This process of political capture is partly driven by campaign contributions but also by the sector's ability to promote a worldview in which what is good for finance is also good for the country. In an influential article on the lobbying power of the U.S. financial industry, former IMF chief economist Simon Johnson suggested that:

The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

The objective of financial regulation is to strike the optimal balance between the risks and opportunities of financial deepening. After the collapse of Lehman Brothers, many observers and policymakers concluded that the process of financial deregulation that started in the 1980s went too far. It is in fact striking that, after 50 years of relative stability, deregulation was accompanied by a wave of banking, stock market, and financial crises. Calls for tighter financial regulation were eventually followed by the Dodd-Frank Wall Street Reform and Consumer Protection Act and by tighter capital standards in the Basel III international regulatory framework for banks.

Not surprisingly, the financial industry was not happy about this rather mild tightening in financial regulation. The Institute of International Finance argued that that tighter capital regulation will have a negative effect on bank profits and lead to a contraction of lending with negative consequences on future GDP growth. Along similar lines, the former chairman of the Federal Reserve, Alan Greenspan, wrote an op-ed in the Financial Times titled “Regulators must risk more, and intervene less,” stating that tighter regulation will lead to the accumulation of "idle resources that are not otherwise engaged in the production of goods and services" and are instead devoted "to fending off once-in-50 or 100-year crises," resulting in an "excess of buffers at the expense of our standards of living"

Greenspan's op-ed was followed by a debate on whether capital buffers are indeed idle resources or, as postulated by the Modigliani-Miller theorem, they have no effect on firms' valuation. To the best of my knowledge, there was no discussion on Greenspan's implicit assumption that larger financial sectors are always good for economic growth and that a reduction in total lending may have a negative effect on future standards of living.

In a new Working Paper titled “Too Much Finance?” and published by the International Monetary Fund, Jean Louis Arcand, Enrico Berkes, and I use various econometric techniques to test whether it is true that limiting the size of the financial sector has a negative effect on economic growth. We reproduce one standard result: at intermediate levels of financial depth, there is a positive relationship between the size of the financial system and economic growth. However, we also show that, at high levels of financial depth, a larger financial sector is associated with less growth. Our findings show that there can be "too much" finance. While Greenspan argued that less credit may hurt our future standard of living, our results indicate that, in countries with very large financial sectors, regulatory policies that reduce the size of the financial sector may have a positive effect on economic growth.

Countries with large financial sectors (the data are for the year 2006):

Source: Arcand, Berkes, and Panizza.

Ugo Panizza is a chief economist with UNCTAD, the United Nations agency dealing with trade, investment, and development, and is a visiting professor at the Geneva Institute.



Arcand, J.L., Berkes, E., and Panizza U. (2012) “Too Much Finance” IMF Working Paper WP/12/161 http://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf

Greenspan, A. (2011) "Regulators must risk more, and intervene less," Financial Times, July 26, 2011.

Johnson, S. (2009), "The quiet coup," The Atlantic (May 2009).

Kindleberger, C. P. (1978), Manias, Panics, and Crashes: A History of Financial Crises, Basic Books, New York.

Minsky, H. P., (1974), "The modeling of financial instability: An introduction," in Modelling and Simulation, Vol. 5, Proceedings of the Fifth Annual Pittsburgh Conference, Instruments Society of America, pp. 267—72.

Tobin, J. (1984), "On the efficiency of the financial system," Lloyds Bank Review 153, 1—15. 

This piece draws from a longer article titled “Finance and Economic Development” and published in International Development Policy (http://poldev.revues.org/?lang=en).

Wall Street image via Shutterstock.com.

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How LIBOR Impacts Financial Models and Why the Scandal Matters

Jul 9, 2012Mike Konczal

If we can't rely on the accuracy of basic measurements used to set loan prices, we can't respond effectively to brewing financial crises.

If we can't rely on the accuracy of basic measurements used to set loan prices, we can't respond effectively to brewing financial crises.

Matt Taibbi asks why nobody is freaking out about the LIBOR scandal, Robert Reich calls it the scandal of all scandals, and Dylan Matthews has a great explainer of the whole thing here. Abigail Field has more at Reality Check.

This can be confusing stuff, so I want to go through a very simple example of how this impacts the markets. Here's a basic equation for the price of a loan:

The rate of a loan consists of adding the "risk-free" rate to a risk-premium. If either the risk-free rate or risk-premium goes up, then the price of a loan goes up. If you are a particularly risky borrower, you will pay more for a loan. This is because your risk-premium, compared to other borrowers, is higher, and that is added into your loan rate. If the risk-free rate is 3 percent and your risk of not paying back a mortgage requires a 2 percent premium, then your mortgage rate is 5 percent. If your risk of not paying back unsecured debt on a credit card requires an 8 percent premium, then your interest rate on your credit card is 11 percent.

More complicated models include more types of risk-premia and other things, but this basic approach is how financial markets work. They all need a measure of what money costs independent of the risks associated with any specific loan. As a result, all the most complicated models have this "risk-free" rate at their core.

Now think of some of the scandals and controversies over recent loan pricing. Here's a great Washington Post piece by Ylan Mui on African American homeowners scarred by the subprime implosion. There are cases where people with the same risk profiles were given different interest rates. Here's a report from EPI by Algernon Austin arguing that African Americans and Latinos with the same credit risks as whites were charged a higher total interest rate for mortgages even though the risk-free rate and their risk-premium rate should have been the same. The data implies that an additional, illegitimate "+ race" was added to the equation above.

There's also debates about what is appropriate to add to the risk-premium equation. The FTC alleged that credit card companies were using charges for marriage counseling or massage parlors to increase the risk-premium, and thus the total rate. Some would argue that, from the credit risk modeling point-of-view, these are appropriate measures to hedge against divorce; others would say that it looks like a cheap excuse to jack up the total rate using the risk-premium part of the equation as an excuse.

But those issues focus on how to price risk and what the total rate should look like. Running underneath all of these loans is what the "risk-free" rate should be. And by manipulating that rate, which forms the core of any financial model of how to price a loan, you manipulate every loan. Digging through some old financial engineering textbooks, it's amusing how many mathematical cartwheels are done to try and get an edge on the movement of LIBOR. Sadly. one can't model the dynamic of making an internal phone call and asking to please manipulate the numbers.

Now let's build out from a very simple model of a financial instrument to one of the more complicated ones -- the Black-Scholes PDE for pricing options and derivatives:

There's a lot of stuff going on in this equation which you can learn about here. But there's one variable you should catch. That "r" in the equation is the risk-free rate, which is usually LIBOR. One of the things Black-Scholes does is create a framework for understanding options and derivatives as owning pieces of the underlying object along with some cash, and getting the price of a derivative by understanding what it would mean to manipulate those two items. The cash in this framework, a crucial part, has its value determined by LIBOR. Which, as many are pointing out, implicates the gigantic derivatives market in this scandal.

Implicating the derivatives market makes it clear why this matters to the market. But what about the role this scandal played in the financial crisis? This brings me to part of Karl Smith's argument for why this scandal doesn't matter much. On Up with Chris Hayes he argued that both parts of the allegations shouldn't get us too upset, and in particular that the second allegation, that Barclays systemically manipulated its LIBOR rates downward (perhaps with the approval of regulators) to make it seem like it was healthier than it was, is a good thing. Why? Because it made the financial system seem healthier than it was, which was important to prevent a collapse.

In two follow-up posts (I, II) Smith clarifies his response. Smith argues that since the central banks were facing a financial crisis of epic proportions, one that would hurt many people, banks manipulating LIBOR helped keep that crisis at bay, which is a great thing. I think Smith has a theory I'm not following in which the only problem the banks had in 2008 was insufficient monetary policy, and not the fact that these banks were sitting on hundreds of billions of dollars in toxic loans that were causing a repo market bank run combined with an opaque over-the-counter derivatives system designed to induce counterparty risk in a crisis.

But the reason it matters is because that tactic can't work forever. You can manipulate prices and juke government stress tests and otherwise lie to make people believe your bank's balance-sheet is healthier than it is, but eventually that system is going to collapse. And, crucially, if the primary objective is "delay," then when the crisis actually hits, it hits in an overwhelming way with no plausible way to fairly allocate losses or take other actions.

As a side-note, if Smith agrees with manipulating LIBOR to look healthier, then he must really support the actions the Federal Reserve Bank of New York was taking in March 2008 to juke Lehman Brother's stress tests: "The FRBNY developed two new stress scenarios: 'Bear Stearns' and 'Bear Stearns Light.' Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed." Thank god that prevented an out-of-nowhere collapse that totally surprised the entire market!

The "TED Spread" is the difference between LIBOR and U.S. Government debt, and many used it in 2008 to track the financial crisis in real time (here's Krugman with "My Friend TED" from the time). Pushing LIBOR down makes the TED Spread look better. This looking healthier than it should meant that there was less pressure by regulators and legislators to find ways to allow these firms to fail, and that the most obvious way of dealing with the crisis was with a mass bailout. If you really want to deal with the crisis, you should affect either end of it that the price is reflecting, by either making the banks healthier or making sure we can deal with the failure.

The possibility that the regulators were in on it further clarifies the "protect the health of the largest banks at all costs" approach, one that squeezes every last bit of blood out of our turnip housing market and creates mass unemployment through a balance-sheet recession. And even if they weren't, that means that future measures to adeqately monitor the health of the banks through disclosures and market information might also be manipulated without (or even with) serious jail time or penalties.

This, by Smith, is wrong: "To my knowledge no one takes out an adjustable rate mortgage saying, 'what I really want is for my mortgage rate to reflect the level of panic in the global financial system should there by a once in 75 year crisis.' No, what everyone thinks is that they are getting the rate set by Federal Reserve and the Bank of England."

No, if that was the case there would be no use for LIBOR, and people would just use those rates. As Nemo summarizes in a great post on LIBOR from his bond series from years ago, the people pricing any loans at LIBOR want the pricing of a systemic credit crisis in their model. As Nemo says, "It is impossible to overstate how fundamental LIBOR is to the bond market." These prices are supposed to mean something, and the ability to add that information is a crucial reason it has shown up in so many pricing models. It would be a better world if those numbers weren't being manipulated to the advantage of inside traders.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Today's Banks Don't Do What Banks Are Supposed to Do

Jun 27, 2012Bruce Judson

Banks in a capitalist society are meant to create wealth and decrease risk. JPMorgan and its kind do the opposite.

In his testimony before a congressional panel on the recent Swiss trading debacle, Jamie Dimon, CEO of JPMorgan Chase, said, “We’re doing what a bank is supposed to do.”

Was Dimon correct? In a capitalist economy, was Chase doing “what a bank is supposed to do"?

Banks in a capitalist society are meant to create wealth and decrease risk. JPMorgan and its kind do the opposite.

In his testimony before a congressional panel on the recent Swiss trading debacle, Jamie Dimon, CEO of JPMorgan Chase, said, “We’re doing what a bank is supposed to do.”

Was Dimon correct? In a capitalist economy, was Chase doing “what a bank is supposed to do"?

The answer is assuredly no. A bank is not supposed to do what JPMorgan Chase and its fellow too-big-to-fail compatriots do every day. They are practicing something other than actual capitalism. As this column has consistently stated, capitalism is not a vague idea. It is an economic system with well-defined principles designed to create wealth for society. These principles have powered the creation of wealth in America since the nation’s founding and empowered our country with an extraordinary resilience.

But importantly, wealth does not mean profits. Wealth is anything that can be experienced or physically used. Profits are an accounting proxy for the wealth that an entity generates. Like most proxies, the idea of profits as a measure of the wealth created for society may often be a good indicator, but as I have written previously, this proxy has failed spectacularly in the financial sector. The profits generated by today’s financial institutions bear little resemblance to the (lack of) wealth they have created for our society.

Capitalism also means there is no such thing as a “free market.” All markets require rules in order to operate fairly. The word “regulation” is really just another term for the rules that govern how participants in a market must behave. Indeed, one modern example of a free market economy may have been the period of economic chaos in Russia that followed the collapse of the Soviet Union, when the absence of rules led in part to devastating results.

Now let’s turn to the purpose of banks in a capitalist economy. Finance is an intermediary good: You cannot eat it, experience it, or physically use it. The purpose of finance is to support other activities in the economy. Banks are meant to allocate capital (funds) to the best possible use. In a capitalist economy, this means allocating money to the people or entities that will create the greatest wealth for the overall society. At the same time, risk management is supposedly a primary skill for bankers. When capital is allocated well and available to wealth creating entities, societies flourish. When capital is poorly allocated, economies can collapse.

Speaking broadly, banks allocate capital in two ways: through loans and by facilitating investments. Indeed, as we read breathless news reports on the first-day performance of IPOs, it’s easy to forget that the central purpose of an initial public offering (IPO) is to channel investment money into an enterprise that will hopefully create wealth for our entire society.

In light of today’s overly complex, overly concentrated, and overly influential financial sector, the above description may seem far too simplistic. But it's not. In Judaism, there is a well-known story of the famous Rabbi Hillel describing the essence of Judaism in a simple statement, and then saying “the rest is commentary.” The same holds true in today’s financial sector. All of finance is meant to allocate capital to the best use, the rest is commentary.

Since capitalism is a system designed to create wealth for society, gambling is antithetical not for moral reasons but because no wealth is created. Gambling is a zero-sum game. In a heads I win, tails you lose transaction, it's impossible to create wealth.

Now, let’s return to Jamie Dimon’s statement before Congress and reframe it. Was Chase “doing what banks are supposed to do”? 

First, as numerous commentators have pointed out, Chase was trading to increase its profits. This type of trading is simply gambling by another name. The outcome has no impact on the larger wealth of our society. It had nothing to do with the purpose of banks in the economy. At the same time, many of the so-called brilliant financial innovations of the recent era are, in themselves, nothing more than hidden forms of gambling.

Second, Chase was increasing rather than decreasing the risk associated with its banking functions. It has become blindingly obvious that in trading and creating complex financial instruments (also called weapons of mass destruction) our Masters of the Universe never fully understand the risks they are creating for their own institutions or our larger society.

Mr. Dimon's idea of what banks are supposed to do does not exist within the principles that makes a capitalist economy function. 

I do, however, have one question for him. I strongly suspect he would argue that the purpose of management decisions is to increase shareholder value. In 2011, the value of JPMorgan Chase’s stock price decreased by 20 percent, yet he was paid $23 million. Is this also what a bank is supposed to do?

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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