Monday, September 28, 2009

Hamilton on Sumner 1

Last but not least, economist James Hamilton commented on Sumner. His responses are the most challenging to both Sumner and my perspectives.

When I read Sumner's original article and his claim that the subprime mortgage crisis was "a fluke," I thought, what is up with that, Scott? Hamilton apparently interpreted it to mean that Sumner was claiming that the subprime mortgage crisis was unimportant. Hamilton, then, provided some great anecdotal information about how bad one of the pools of mortgages behind some of the mortgage backed securities really were. Perhaps he thought Sumner's claim of "fluke" meant that Sumner was one of those who thinks that subprime mortgage crisis was just an irrational panic and that the solution would be for investors to go back to buying the commercial paper issued by the investment banks so they can continue funding mortgage backed securities, raising housing demand and prices, and the entire shadow banking house of cards could be reconstructed.


Neither Sumner nor I dispute that financial institutions will lose money if they make loans secured by overvalued assets to people who cannot afford to make the payments. I think Hamilton is exactly right that these loans could only be paid if there had been continued rapid appreciation in home prices. I would summarize the problem as lending into a speculative bubble.

Hamilton writes less about the macroeconomic implications of the losses. He mentions that financial institutions had "leveraged" exposure to these losses. Again, that financial intermediaries are highly leveraged is normal, so that the risk of bankruptcy is relatively high. Personally, I think the concept of leverage is confusing, especially for financial intermediaries, and prefer the standard money and banking concept of capital ratios. To me, 5 to 1 leverage sounds alarming, but I think a 20% capital ratio would be great. Keep in mind that a 10% capital ratio, or 10 to 1 leverage is counted as well capitalized. The very alarming 20 to 1 or even 35 to 1 leverage ratios, represent 5% and 3% capital ratios. None of these capital ratios will be sufficient to protect those lending to a financial institution that concentrates its lending into a speculative bubble.

Finally, the key. Hamilton asserts:

fear of their failure crippled lending, sending economic activity into a
nosedive in the fall of 2008.
And that is where Sumner and other monetary disequilibrium theorists disagree. Certainly, we don't want to deny that crippled lending would negatively impact the productive capacity of the economy. While lending into a speculative bubble was hardly helping the effective allocation of resources, credit markets that move funds from less valued to more valued uses are better than universal self-financing.

The economy did go into a tailspin during the fall of 2008. By tailspin, I mean falling nominal expenditure. If prices and wages were perfectly flexible, real expenditure could have been maintained, but they aren't, so the falling nominal expenditure resulted in demand constrained sales in almost every sector of the economy. Real output dropped rapidly, employment began to drop more rapidly, and the unemployment rate began to skyrocket.

Monetary disequilibrium theorists, like Sumner, insist that this can only occur if there is either a decrease the the quantity of money or else an increase in the demand for money. Fear of failure of financial institutions with low capital ratios holding claims to pools of mortgages made to people who cannot afford the payments and secured by overvalued real estate could plausibly lead to a decrease in the quantity of money or an increase in the demand for money. But to get lower nominal expenditure, the crisis must have such an impact.

And, of course, Sumner's key argument is that the Federal Reserve can control the quantity of money, if it chooses, and that it could have increased the quantity of money enough to meet any increase in the demand for money, leaving nominal expenditure unchanged.

How is it possible for nominal expenditure to be maintained despite crippled lending? First, nearly all expenditure is funded from current income. People earn income and purchase consumer goods. Similarly, firms earn revenue and purchase capital goods with funds accounted for as depreciation or retained earnings. Credit transactions (and new issues of equity) involve shifting funds between and among households and firms. If credit markets are crippled, then those who would have borrowed spend less, but those who would have lent have those funds to spend. The source of the problem, then, is that those who have those funds available to spend, don't, and instead increase their money holdings. Or, the banking system would have lent the money into existence, and doesn't, so the money doesn't exist.

If the nominal quantity of money rose enough to match any increase in the demand for money at the target value of nominal expenditure, and credit markets were crippled, then any resulting change in the composition of expenditure would be reflected in rising demand, prices, profits, production and employment in some sectors, and falling demand, falling profits or rising losses, falling production and employment in other sectors. Because of bottlenecks in expanding sectors, production rises more slowly there than it falls elsewhere. Because of sticky prices in shrinking sectors, those prices don't fall as much as prices rise in growing sectors. The result would be reduced production (from its long run growth path) and higher prices, stagflation. Assuming there really was a speculative bubble in housing, it is not at all clear that productivity would be hampered by the crippled credit markets compared to what went on before, but compared to healthy credit markets, some productive investments would be forgone, and resources would be used for less productive investments or else consumption. Obviously, crippled credit markets are a bad thing.

What Sumner and other monetary disequilibrium theorists find troubling is that there is some kind of easy shift among many economists from, lending is crippled, to aggregate expenditure falls, and so there is a demand constrained contraction in output. No, not necessarily. With the proper monetary institutions, demand constrained contractions in output could be prevented, though that doesn't prevent sectoral shifts or reduced productivity from depressing productive capacity.

1 comment:

  1. Time permitting, I'd love to get a succint description of the key tenets of the monetary disequilibrium theory. It is new to me, though I'm increasingly coming across references to it on various blogs. I'm particularly confused by arguments that an increase in money demand can explain the crisis - I want this to increase the opportunity cost of money, which seems inconsistent with the zero-bound we now find ourselves at. Maybe this is the "disequilibrium" part of the theory. Anyway, explanation or references welcome.