Sunday, February 28, 2010

Fear of Bankruptcy: A Nominal Problem?

If a firm is bankrupt, its ability to produce goods and services is disrupted. However, bankruptcy is caused by losses, and if those losses are due to changes in supply or demand conditions, production should be reduced. In a competitive industry, if bankruptcy disrupts the production of a firm that defaults, then this reduces the losses of competing firms. There is little or no disruption in industry production or employment. If the losses are due to monetary disequilibrium, then not only can the losses be widespread, across many industries, there really should be no decrease in production or employment anywhere. And so, any disruptive impact of bankruptcy on potential output would be undesirable.

There is a second avenue by which bankruptcy, and so, the leverage of firms, might impact the economy. Expected bankruptcy could result in an increase in the demand to hold money. If the quantity of money remains unchanged, or increases by less than the demand, then the result would be a shortage of money and lower nominal expenditure. If prices, including the prices of resources like labor, are less than perfectly flexible, the result will be a decrease in real expenditure, real output, and employment throughout the economy. The associated losses could result in widespread bankruptcies.

It is obvious that those who have lent to a firm would like to avoid losing money from default and bankruptcy. If they expect bankruptcy of some particular firm, they are motivated to sell the bonds of that firm. If they purchase bonds from some other firm, then there is no effect on nominal expenditure. In fact, they could use the proceeds of bond sales to purchase just about anything, and there is no impact on nominal expenditure. They might purchase stock, equity claims, presumably on other firms. They might purchase capital goods, starting a new business. They might go out to eat, using the proceeds of their bond sales for consumption.

The problem only develops if those selling bonds due to fear of default simply hold onto the proceeds and spend them on nothing. Many people, including economists who should know better, assert that as long as the accumulated money is kept in a bank rather than under a mattress, this won't cause a problem. However, the most likely scenario is that whoever ends up buying the bonds already had the money in the bank, and so the transaction simply shifts balances in checkable deposits from the seller to the buyer. Unless the total amount of money created by the banking system expands, then there is a shortage of money that needs to be corrected by a decrease in all prices, so that the real quantity of money rises to meet the demand.

Superficially, if firms are highly-leveraged, then they are more likely to default and become bankrupt. Fear of bankruptcy could lead to an increase in the demand for money. An increase in the demand for money, if the quantity of money is unchanged, leads to a decrease in nominal expenditure. The decrease in nominal expenditure leads to recession. Therefore, increased leverage leads to recession.

However, there are problems with the argument. Suppose firms had no leverage and were financed entirely with equity. If stockholders expect a firm to lose money, they are motivated to sell their stock. They could use the proceeds of those sales to purchase any number of things, including shares in other firms that are not expected to lose money. However, if they choose to hold more money, and the quantity of money doesn't increase, then the result is lower nominal expenditure.

Obviously, the key problem isn't the makeup of the finance of the firms--debt or equity--it is rather than the firms are expected to suffer losses, and when investors try to avoid those losses they might choose to hold more money. Is there any reason why additional leverage might be expected to exacerbate this problem? If debt is a closer substitute for money than equity, then an increase in the expected loss from debt might cause a larger shift into money than an equivalent expected loss on equity. Variation is expected profits for firms with higher leverage might result in a higher variation in the demand for money than the same variation in expected profits for firms with lower leverage. The more similar the debt instruments used to finance firms are to money, the more serious this problem.

However, to conclude that fluctuations in nominal expenditure are caused by over-leverage depends on assumptions about monetary institutions. If the quantity of money changes to accommodate the demand to hold money, then even if an increase in expected losses increases the demand to hold money, nominal expenditure would be maintained.

The monetary disequilibrium approach should never be confused with old-fashioned monetarism. There is no assumption that the demand to hold money (or equivalently, the velocity of money) is unchanging. There is no hidden agenda to argue that there is some aggregate of monetary assets whose quantity can and should be kept on a stable growth path. The monetary disequilibrium approach focuses on two things. First, that changes in nominal expenditure are due to an imbalance between the quantity of money and the demand to hold money. And further, that prices and wages are not perfectly flexible so that the market process by which changes in prices and wages cause the real quantity of money to adjust to the demand to hold money results in undesirable fluctuations in output and employment.

Saturday, February 27, 2010

Leverage and Bankruptcy--A "Real" Problem

If firms have no leverage--they finance all of their activities with equity and use no debt--then they cannot go bankrupt. They can still suffer losses. To minimize those losses, they may contract production and employment. They can even run out of money and be forced to close. But a firm with no leverage cannot possibly default.

The greater a firm's leverage, the smaller the losses it can bear before it becomes insolvent and defaults. If "Corporate America" is highly leveraged, then widespread losses could be associated with more defaults and bankruptcies than if firms funded more of their activities with equity.

If bankrupt firms cease operation, then the productive capacity of a bankrupt firm is at least temporarily not available. The productive capacity of the economy as a whole is slightly less, and so, the total volume of real goods and services that can be produced is smaller--there is a slight decrease in potential output.

If firms are highly leveraged, then widespread losses could generate widespread bankruptcies, and so, reduce the productive capacity of the economy a significant amount. If there are widespread losses, then high levels of leverage by firms could result in a "real" problem--lower potential output.

However, this problem can easily be exaggerated. Suppose there is a shift in demand between different sectors of the economy. Firms in the sector losing demand can suffer losses. If the firms in that sector are highly leveraged, they may be unable to pay debts and go bankrupt. While that bankruptcy will temporarily reduce the productive capacity of the industry and at least slightly reduce the productive capacity of the economy, this hardly matters because the efficient response to the decrease in demand is reduced output. If the change in demand is permanent, productive capacity should decrease and resources be shifted to the expanding sectors of the economy. Any temporary reduction in productive capacity due to bankruptcy is simply a decrease in excess capacity.

Further, suppose some firms in the industry are more leveraged than others. Other things being equal, the most leveraged firm will fail first. Again, assuming its production is disrupted, then the result is increased sales for the surviving firms, reducing their losses and postponing the time before the next most leveraged firm fails. From the point of view of the particular firm that failed, this is a tragedy. But the disruption to production and employment for the economy as whole is minimal.

Of course, default and bankruptcy don't really require that a firm cease operations. All that is necessary is that creditors (or perhaps a bankruptcy judge) be convinced that some level of operation will reduce losses--increasing whatever partial payment the creditors will eventually receive. While default and bankruptcy are not free goods and require resources, and so other goods and services are sacrificed, the additional loss of output resulting from bankruptcies due to "over" leverage is easy to exaggerate.

However, suppose a firm is involved in multiple lines of business. One line of business suffers losses. The other lines of business remain profitable. If the losses from the troubled line of business add up to more than the firm's net worth, it can default and fail. If bankruptcy disrupts production in all lines of business, then the bankruptcy at least temporarily reduces the productive capacity of the economy and it is not simply a reduction in excess capacity.

This sort of collateral damage to other lines of business could be avoided if the firm had more equity and less debt. Of course, the solution is to make sure that profitable lines of business can continue to operate despite default and bankruptcy.

Changes in relative supply and demand conditions in various sectors of the economy generate profits and losses. Default and bankruptcy are a problem for firms suffering losses, and generally, those firms should produce less. If the changes in supply or demand are permanent, then productive capacity should be reduced for the firms suffering losses. That bankruptcy disrupts production is not a problem, it is rather a benefit.

But suppose there are losses throughout the economy, and there is no need to reduce production or employment in any sector of the economy? In other words, suppose the problem is monetary disequilibrium. If the quantity of money is less than the demand to hold money, the market process that returns the economy to equilibrium is a decrease in prices and wages, raising the real quantity of money to again match the amount of purchasing power that people want to hold. The signal that firms receive that these price adjustments are needed is a reduction in aggregate nominal expenditure. If prices and wages were perfectly flexible, then the lower nominal expenditure is consistent with unchanged real expenditure. The real volume of expenditure can remain equal to the productive capacity of the economy. The real quantity of money can rise to match the demand to hold money without any decrease in real output relative to productive capacity or any disruption in the employment of resources, including labor.

However, debts are claims to money, and so a decrease in the price level raises the real value of debt. If firms have no leverage, this would not be a problem for them. If they have sufficient equity, then the stockholders can bear the loss--really a transfer from stockholders to bondholders due to what amounts to a bet on the supply and demand conditions for money. But if the firms have "too much" leverage relative to the size of the needed change in the price level, then firms become insolvent and default. The real gain to the debt holders is less than the decrease in the price level because the stockholders don't have enough equity to lose. If the bankruptcy and default disrupts production, however, then an imbalance between the quantity of money and the demand to hold it would do more that shift wealth from debtors to creditors, it would also disrupt production and employment.

So, perhaps "excessive" leverage would be at least partly responsible for the adverse impact of monetary disequilibrium. Having firms finance their activities with more equity and less debt would meliorate this particular problem. Reducing the disruption to production from default--keeping firms operating in bankruptcy would be desirable.

However, the first best solution is too avoid an imbalance between the quantity of money and the demand to hold it. One of the many problems with monetary disequilibrium is that it makes all nominal contracts into speculations about changes in the quantity of money relative to the demand to hold it.

What is the best way to avoid monetary disequilibrium? I think the least bad solution is to target a stable growth path for nominal expenditure.

Friday, February 26, 2010

Leverage and Investment Banks

Before 2008, Dick Fuld was the ruler of Lehman Brothers. By Andrew Ross Sorkin's account in Too Big to Fail, Fuld and his team were able to plot empire--various mergers and acquisitions-- expanding their sphere of control across the globe. All the while Fuld was earning a huge salary, moving from being very rich to super rich.

And then, it all fell apart for Dick Fuld. By October 2008, this mover and shaker in the world of business and finance had been pushed aside. Again, according to Sorkin, he was left powerless. Depressed and faced with a life of quiet retirement, forced to live a life of mere super affluence.

What happened to poor Dick Fuld? Lehman Brothers made bad investments. Lehman Brothers lost money.

But why isn't Fuld still at the helm? Why aren't he and his team working to turn Lehman Brothers around?

The problem is that Lehman Brothers was "over" leveraged. They had financed too much of their business activity by debt rather than equity.

"Too much" by what standard? The standard is obvious. The equity finance was not enough so that it was the stockholders that suffered all of the losses. Those holding the debt of Lehman Brothers had to take some loss as well. That meant default, and bankruptcy.

And so, Fuld lost control.

From the point of view of Fuld, the problem with Lehman Brothers was that they made poor investments and had too little equity to cover all of the losses. Given the poor investments, the problem with Lehman Brothers was that it was "over-leveraged."

To me, this sounds like Fuld had a personal problem. To what degree are the personal problems of politically powerful men like Fuld being turned into imagined problems with "over-leverage" for the economy as a whole?

It is something to keep in mind.

Tuesday, February 23, 2010

James Buchanan on Constitutional Monetary Reform

James Buchanan argues that the financial crisis and Great Recession show that there is a need for "The Constitutionalization of Money." I agree with the constitutional approach and believe that a clear mandate for stability is the key element of the monetary constitution. But I reject any constitutional interventions in the banking business--particularly, any mandates for any level of bank reserves, much less 100 percent reserve requirements.

James Buchanan is the leader of the Virginia School of Economics. His training was from "Old Chicago," but after being exposed to Knut Wicksell's approach to public finance, he began to integrate the economics and politics of taxes and spending. Starting at the Thomas Jefferson Center for Political Economy at the University of Virginia in the sixties, he moved to Virginia Tech and began the Center for the Study of Public Choice. And then in the eighties, he moved the Center to George Mason.

I began my undergraduate studies at George Mason, before Buchanan. I moved to Virginia Tech and completed my undergraduate and began my graduate studies. And then, when Buchanan and much of the economics faculty left for George Mason, I became a G.M.U. student. I received my Ph.D. from George Mason in 1987. If I count myself as part of the "Virginia School." My approach to monetary "policy" is constitutional.

Buchanan argues that the monetary authority should be independent of the political branches, but it should be given a constitutional mandate to focus solely on providing money of stable value. The natural interpretation would be a stable price level, presumably measured by a price index.

For many years, I also advocated a stable price level, however, I have been persuaded that a stable growth path of nominal expenditure provides a superior macroeconomic environment for microeconomic coordination. It provides a stable background that is consistent with a stable price level on average. In particular, such a rule would be inconsistent with irresponsible money creation aimed at funding government spending or worse, an effort to inflate away public or private debts.

However, productivity shocks would cause opposite changes in the price level that would persist as long as the shocks. For example, if the supply of oil should fall, so that its price rises and quantity falls, the arithmetical consequence is a higher price level. Having the monetary authority generate a shortage of money so that all the other prices in the economy are deflated enough to return the price level to target is needlessly disruptive. If the supply of oil remains low, then the price of oil and the price level would remain high. If the supply of oil recovers, then the price of oil would fall, and the price level would return back to its initial level.

There is no danger that this will result in persistent inflation. Or rather, persistent inflation would only occur if the supplies of all goods and services persistently fell, and if that is happening, inflation would be the least our problems. And while such a disaster could could be realized by falling nominal incomes and stable prices, it is unclear that higher prices of goods and services are a less appropriate signal of the reduced availability all of goods and services.

Similarly, suppose there is a an exceptionally good wheat harvest. With nominal expenditure targeting, the price of wheat falls, and the price level falls a bit. Rather than having the monetary authority generate monetary disequilibrium so that all the other prices in the economy are bid up a bit so that the price index returns to target, the price level is low for the year with the good harvest. Presumably, when the supply of wheat returns to normal during the next season, the price level rises back to its previous level.

Buchanan suggests that the financial crisis was caused by fractional reserve banking and argues that fractional reserve banking is no longer justified. With a gold standard, gold for monetary purposes must be produced--dug out of the ground. Further, gold must be diverted from industrial purposes, such as jewelry, to be used for monetary purposes. Fractional reserve banking provides the benefit of freeing up resources that would be used to dig up gold to instead produce other goods and services. And more of the gold that has or will produced can be used for industrial purposes.

Since a pure fiat currency can be produced at no cost, there is no reason to economize on its use by fractional reserve banking. Because fractional reserve banking can result in undesirable fluctuations in the quantity of money, Buchanan argues that 100 percent reserve requirements form the best legal environment for the market system.

I disagree with this argument. If the monetary constitution requires a stable price level or stable growth in nominal expenditure, then the monetary authority must stand ready to reduce the monetary base. Money creation is not simply a source of government revenue, but rather a way of borrowing money.

If zero-interest, tangible, hand-to-hand currency is taken to the model of fiat currency, then it is natural to see the government as borrowing at a zero nominal interest rate. As long as the demand for base money is growing, then the government can borrow progressively more at a zero nominal interest rate. But, if the demand for money should fall, keeping the price level stable or nominal income on a stable growth path will require that the government "repay" part of that zero-interest debt. The government doesn't have to reduce its total debt, of course. It can instead issue interest bearing debt in place of the zero-interest currency.

From this perspective, forbidding fractional reserve banking is a way of compelling people to lend more money to the government at a favorable interest rate--zero, in the usual case. Is providing government with a greater opportunity to borrow at a zero interest rate desirable? Or will the result be that the government will borrow too much because it fails to take into account the opportunity cost of this use of people's saving?

Printing currency costs nothing, but the government goods and services purchased with the money have opportunity costs--the private goods and services that could have been produced.

Doesn't the illusion of free money interfere with a sound fiscal constitution where voters compare the benefits of government spending programs to the cost of the private goods sacrificed? Isn't one of the most important element of the fiscal constitution clearly visible tax shares so that voters can make sensible fiscal choices?

If freedom of contract is allowed, then the government faces competition for this source of funds. Banks can issue interest bearing monetary liabilities. Further, paying explicit interest on money reduces the private opportunity cost of holding money. Those holding money can obtain all the liquidity services the private sector is willing to provide, paying only the cost of providing that service--the difference the interest rates banks are willing to pay on money and the interest rates on nonmonetary assets that banks can hold.

With mandated 100 percent reserves, depositors must pay storage costs, and will restrict their holdings of deposit accounts to the point where the implicit liquidity yield at the margin is no less than the difference between the storage cost of currency and the yields on nonmonetary assets. As might be expected, giving government a monopoly on the creation of monetary services results in inefficiency. The real demand for money is too low. Too few monetary services are produced.

Buchanan points to the Great Depression as an example where a shift from deposit money created by banks to base money currency resulted in a decrease in the total quantity of money. The resulting decrease in nominal expenditure resulted in a deep and persistent decrease in real output and employment.

However, if the constitutional requirement is that the purchasing power of money is to be stabilized, (or nominal expenditure is to be kept growing at a stable rate,) the quantity of money must be adjusted to accommodate changes in the demand to hold money.

A ban on fractional reserve banking makes the quantity of money equal to the quantity of base money. Changes in the demand for money and changes in the demand for base money are the same. Maintaining monetary stability requires changes in the quantity of base money to match changes in the demand for money.

With fractional reserve banking, the demand for base money can change even though there is no change in the demand for money. So a ban on fractional reserve banking prevents some changes in the demand for base money, but not all. If the goal is money with a stable purchasing power rather than just a stable quantity of money, then the quantity of base money must change to accommodate changes in the demand to hold base money. Fractional reserve banking simply creates a few additional ways by which the demand for base money can change.

As a practical matter, if counting some financial instrument as money imposes draconian regulations on its creation, such as 100 percent reserves, then those regulations will create a constant incentive to develop liquid financial instruments that don't meet the legal definition of money. For example, if checking accounts count as money and require 100 percent reserves, and savings accounts don't count as money and require no reserves, then there will be a strong motivation to minimize checkable deposits. Banks will create and depositors will hold savings accounts to avoid the reserve requirements. When the banks develop sweep accounts, so that funds in checking accounts are automatically swept into savings accounts each night, what happens? Regulators must be constantly vigilant to impose this regulatory scheme.

While imposing a 100 percent reserve requirement on everything that counts as money will keep worries about the financial health of the issuing institutions from causing a change the quantity of money as officially defined, all this does is shift the instability to the demand for this official measure of money. For example, worry about bank asset portfolios funded by savings accounts that don't count as money will result in a shift out of savings accounts into checking accounts. The result is an increase in the demand for money. The official quantity of money would be unchanged, but the regulatory scheme, combined with worries about the issuing institutions, has created instability in the demand to hold money.

Of course, savings accounts could be counted as money and subject to 100 percent reserve requirements as well. But then there are money market mutual funds. Do they count as money? Do they require 100 percent reserves of base money? Or can they hold interest bearing government debt? What about Certificates of Deposit? What about 30 day commercial paper? What about overnight repurchase agreements?

One important element of the financial crisis was that investment banks were funding portfolios of mortgage backed securities with short term commercial paper and repurchase agreements. Some of the commercial paper was overnight as were the repurchase agreements. None of these investment banks could give their creditors direct access to the payments system. The commercial paper, even overnight commercial paper, wasn't checkable. Some of the commercial paper was sold to money market mutual funds. While those mutual funds were sometimes checkable, the mutual funds didn't have direct access to the payments system. The mutual funds held transactions accounts at commercial banks to clear the checks of their customers.

When the creditors of the investment banks began to worry about their portfolios of mortgage backed securities, they quit rolling over their commercial paper and repurchase agreements. Since the investment banks needed to borrow new money to pay off all of the commercial paper and repurchase agreements coming due every day, they faced what was equivalent to a bank run. Those who had been holding the commercial paper or repurchase agreements didn't demand base money. There was no run to fiat currency. Instead, they purchased Treasury bills and accumulated funds in FDIC insured bank deposits. Through a variety of direct and indirect channels, the result was a large increase in the demand for money, and a very large increase in the demand for base money by banks.

It is not at all clear that requiring 100 percent reserves for all of the transactions accounts of all the depository institutions would have made much difference. Hoping that some scheme regulation will stabilize the financial system so that there will never be a sharp increases in the demand for base money is unrealistic. Making sure that the quantity of base money adjusts to accommodate changes in the demand to hold base money is the more sensible approach.

That the financial crisis led to the Great Recession does provide a reason for fundamental change. The Fed's approach of gradual and judicious changes in the overnight interbank interest rate aimed at reducing the output gap and raising the core CPI 2 percent from its current value has failed. A constitutional commitment to a stable monetary environment is the right approach. Futile efforts to create a stable monetary environment through reserve requirements would be a mistake.

Monday, February 22, 2010

Over-Leveraged Firms--Recession Inevitable?

An individual investor can use "leverage" to increase profit from stock market speculation. While the strategy magnifies possible profits, it also magnifies possible losses. The investor takes his or her own money, or "capital," and then leverages it with "debt"--loans from a broker--and purchases more stock. The size of the investor's "bet" on changes in "the market" can be increased by leverage.

How does this relate to leverage in financing a business? Leverage in business finance is the ratio of debt to equity. If a firm has a net worth of $100 million, and has borrowed $200 million, then its leverage is $200 million/ $100 million = 2.

Surely, if firms are over-leveraged, they are gambling with economic disaster?

How does excessive leverage of firms supposedly relate to recession? The theory is simple. Suppose corporate America is over-leveraged. Firms whose debt is already excessive cannot borrow additional funds to purchase capital goods--machines, buildings and equipment. Worse, existing cash flow must be used to pay down excessive debt rather than purchase capital goods. Firms in capital goods industries suffer reduced sales and respond at least partly by reducing production. Workers are laid off. The result is recession.

However, this theory is based on a fallacy of composition. When an individual firm borrows less or repays debts, it may purchase fewer capital goods. However, the potential lenders have the funds they didn't lend. The creditors receiving repayment have additional funds.

When thinking about the capital expenditures of a single firm, what happens to the funds it doesn't borrow or that it uses to pay down its debts can be ignored. But when considering the entire economy, all funds must be accounted for. What do the potential lenders or former creditors do with the funds? They don't have to spend them on capital goods. Certainly, it is possible for there to be a shift of expenditure away from purchases of capital goods by firms and towards purchases of consumer goods by households.

But leaving aside an imbalance between the quantity of money and the demand to hold money, "over-leverage" by firms does not cause reduced nominal expenditure by all firms and households.

Oddly enough, if the firms are truly "over-leveraged," then those receiving the debt repayments "should" purchase equity claims against firms. The firms should continue to fund purchases of capital goods exactly as before, but financed by equity rather than debt. In fact, the obvious solution to over-leveraged firms is debt-to-equity swaps, with former debt-holders becoming stockholders!

Before trying to explain that odd assertion, there is also a theory by which "over-leveraged" firms are associated with excess capacity and overproduction. The firms borrow money to expand productive capacity. When they attempt to use that capacity and produce goods and services, there is over-production. The over-leverage has caused excess capacity.

That theory is also based upon a fallacy of composition and is inconsistent with the fundamental economic principle of scarcity. While an individual firm can borrow money and purchase resources to expand capacity, the lender no longer has the funds to spend and the resources are no longer available to produce other goods and services. Debt shifts funds between and among firms and households. It doesn't overcome the problem of scarcity and create resources out of nothing.

Why is the theory of over-leverage, overproduction, and recession so seductive? It applies to the individual firm nicely. Suppose a businessman or woman, a sole proprietor, is making profits and sees an opportunity to expand his or her operation. Much of the profit is being plowed back into the firm as new investment, adding to productive capacity, and earning more profit.

Perhaps this businessman could leverage the operation, by borrowing money and expanding even more. Assuming the profit generated by the additional investment covers the interest cost of the funds, the proprietor adds to his or her profit. Unfortunately, if operations are unprofitable, interest on the loan must still be paid. This added expense will magnify losses as well.

The proprietor, then, is in a similar situation to the stock speculator who seeks to "leverage" his or her capital, by borrowing from the broker, purchasing more stock, adding to the size of his or her "bet" on "the market." The proprietor's bet is on the market for his or her product and usually the interest expense of loans weighs heavily against the profits from expansion. Still, the leverage allows profits to be magnified, but only by adding to the risk of magnified losses. If the demand for the product is insufficient, the result could be bankruptcy. The proprietor might lose his or her business.

Further, since the debt is being used to build real productive capacity, there is a natural identification of the increased leverage with increased capacity. If the capacity turns out to be excess in retrospect, with losses and even bankruptcy as a result, then "clearly," the leverage was excessive.

Switching away from the personal finance or business management perspective of the individual investor or businessman "leveraging" his or her own"capital" and instead thinking about the economics of the firm, profit opportunities require finance. Equity investment comes from owners, and debt finance comes from lenders, but both are alternative methods of funding profitable activity. The owners serve as residual claimant, and so reap extra gain and are the first to suffer loss. However, if the losses are so great that the equity investors lose everything, then the debt holders no longer receive all of their promised share of the gain, and also take a loss.

Rather than the owner leveraging his or her capital, investors are funding productive activity, and the division between equity and debt finance is a way of sharing the risk that is inherent in productive activity.

Taking a macroeconomic perspective, there are a variety of firms that must fund their activities through either debt or equity. They must either borrow, or bring in new partners, such as shareholders. From the point of view of the investors, they must either lend to the firms, say, by purchasing the bonds they issue, or else make equity investments, by purchasing shares of ownership. The leverage of firms--the division of finance between equity and debt--isn't about the proper allocation of productive capacity among firms or in aggregate, but rather about the sharing of risk among investors.

As for the expansion of capacity, the key question is whether or not it is value enhancing. Are the extra goods and services that can be produced worth more than the opportunity cost-- the goods and services that cannot be produced because the resources were used to expand capacity.

For a single firm, an expansion of its productive capacity is, for the most part, a shift of resources away from other firms. "Excess" capacity is a situation where the resources could have been used by other firms to produce other, more valuable goods or services.

However, from a macroeconomic perspective, aggregate net investment is an expansion in the productive capacity of all firms, and it comes at the expense of the current production of consumer goods. The relevant issue is whether the consumer goods that can be produced in the future are worth more than the consumer goods that must be sacrificed now--taking into account marginal time preference--when do people prefer to consume goods and services.

A single firm could have no leverage, and still have overcapacity. It could be financed entirely by equity, but be utilizing resources that dould be more profitably utilized to by other firms to produce other goods and services. The owners would lose money and would be motivated to curtail operations and eventually will run out of money and be forced to curtail operations. If the firm truly has no debt, it cannot go bankrupt, but it can still fail.

Similarly, it would be possible for no firm to have any leverage, and still, in aggregate, for the firms to devote too many resources to produce capital goods, and not enough to produce consumer goods in the present. It is even possible for net investment to turn negative, so that existing capital goods are not replaced, and resources are used to produce consumer goods and services at levels that cannot be sustained in the long run.

Given how much productive capacity is appropriate both in aggregate and for various indistries and firms, there is the separate question of how it should be financed. Returning to the individual firm, it isn't simply a possible expansion that must be considered. How much of the firm's total activity should be funded by equity and how much by debt? Perhaps the existing owner should sell out and put his "capital" in a bond mutual fund. Perhaps the existing level of equity investment is too high, and the new owners will fund more of the firm's existing operations with debt.

If the firm is over-leveraged, then it needs to finance more or of its activity by equity and less by debt. New partners--say, shareholders--need to be brought in, and the proceeds used to pay off debt.

If the firm needs to expand because there are profitable opportunities, and it is already over-leveraged, then it should expand by bringing in new owners--sell new shares. It should still expand, but by using equity finance.

From a macroeconomic perspective, to say that all firms are over-leveraged is not to say that have expanded too much or have excess capacity. It is rather to say that they should be funding their activities with equity rather than debt. They should be selling stock and paying off debts.

Equally important, if firms are "over-leveraged" that means that investors should be buying stock rather than bonds. As firms pay down their debts, those investors receiving the repayments should be buying stock to fund the profitable activities of the firms.

And so, the solution to over-leveraged firms is debt-to-equity conversions. Some debt-holders should become stockholders.

But suppose the bond-holders don't want to hold more equity? If investors want to hold bonds rather than stock, then the firms aren't over-leveraged. What can over-leverage mean other than the existing debt to equity ratio fails to reflect the preferences of investors?

But what if investors don't want to hold stock or bonds? It is, of course, possible that people would prefer to spend their incomes on consumer goods and services rather than save and accumulate assets. If that is true, then firms should not be expanding capacity because the resources are needed to produce consumer goods and services now.

But suppose people want to save, but not by purchasing risky assets like stocks or bonds issued by leveraged firms. Suppose they want to save by accumulating riskless assets? And suppose the market clearing interest rate on such assets would be zero, or even negative? Can't households still save by just accumulating money? Yes, that is possible. And an imbalance between the quantity of money and the amount of money people choose to hold is the problem. Worry about over-leveraged firms is a diversion.

Sunday, February 21, 2010

What is Leverage?

In personal finance, the concept of leverage involves an investor using his or her own money to purchase an asset, such as a stock, and then borrowing money from a broker to purchase more of that stock. The investor "leverages" his or her own funds to increase return. With a 50 percent margin requirement, the investor puts up 50 percent of the money to purchase the stock. The investor has leveraged his own money by a factor of 2.

This allows an increase in return. Ignoring interest on the loan, if the stock increases in value by 10 percent, the investor receives a 20 percent return on his investment.

Suppose an investor has $10,000 available for investment. The investor borrows an equal amount, $10,000. The $20,000 is invested in the stock. The stock rises in value by 10 percent, so it is now worth $22,000. The stock is sold and the investor earned a $2,000 capital gain. After paying back the $10,000 loan, the investor now has the $12,000. A $2,000 gain on a $10,000 investment is a 20% return.

But leverage is "risky." Suppose the stock falls in value by 10 percent. The investor again puts up $10,000 and borrows another $10,000 and buys $20,000 worth of stock. The stock falls in value by 10 percent. It is now worth $18,000. The investor sells the stock and then pays back the $10,000 loan. The investor has $8,000, which is $2,000 less than the original investment. The loss is 20 percent.

Suppose the stock fell in value by 50%. Again, the investor had $10,000 to invest and borrowed another $10,000 to purchase $20,000 worth of stock. The stock falls in value by 50 percent and it is now worth $10,000. This is sold, and all $10,000 is used to repay the loan. The investor has nothing left. The stock fell in value by 50 percent, and the investor has lost 100 percent of his investment. All the hard earned savings are gone.

It could be worse. Suppose the stock falls in value by 60 percent. The investor put his $10,000 up and borrowed $10,000. The stock fell in value to $8,000. The investor sells the stock and has $8,000. But he or she owes the brokerage firm $10,000. The investor has turned the $10,000 that he had saved into a $2,000 debt.

While "leveraging" an investment provides better a better "upside," the downside risk makes it look like a foolish strategy. At least, I would never leverage my limited savings.

But supposedly the "banks" on Wall Street were leveraged 35 to 1. The examples above were based upon a 2 to 1 leverage ratio. Think about the upside? At 35 to 1, a 10% increase in stock prices results in a 350% gain. On other other hand, a 3% decrease in stock prices would result in a 105 percent loss, and so a $5 billion dollar investment would turn into a $250 million debt. No wonder we had a financial crisis!

However, the personal finance version of "leverage" has little connection to the corporate finance version of "leverage" and less connection to the banking version of "leverage."

And there is next to now connection with a household that lived it up on borrowed funds, and spent more on consumer goods and service than its income, and now has to pay down those debts by consuming less than income.

Saturday, February 20, 2010

Over-leveraged Households: Recession Inevitable?

"Excessive" leverage has been blamed for the Great Recession. The story is that there was too much borrowing and lending. Total debt became too large. Somehow, this excessive debt has led to recession.

The view is fundamentally mistaken, and reduces to an "overproduction" theory of recession. Overproduction theories are inconsistent with the fundamental economic principle of scarcity.

How can such an error be made? The key problem is the fallacy of composition. What may be true for the individual household and firm is generalized to the economy as a whole. Such composition is a fallacy because what is true for an individual household or firm may not be true for the economy as a whole.

Suppose an individual household borrows money to finance consumption greater than income. For the individual household, this generates a larger stream of consumption expenditure.

Consider now the individual firm that the household patronizes. This additional debt-funded stream of expenditure is an additional stream of sales. This increased demand for the firm's product motivates it to raise both the prices it charges and the volume it sells. The firm's profitability is enhanced.

The individual firm is motivated to expand production to maintain this greater volume of sales. Additional resources, must be utilized, including labor. The firm might even need to offer slightly increased wages to attract more workers.

And so, the individual household's debt-financed consumption generates greater nominal and real expenditure, and an increased nominal and real volume of sales for the individual firm that the household patronizes. The individual firm selling to that household expands production and employment. It enjoys enhanced prices and profitability. Households supplying labor obtain greater employment opportunities and wages from that individual firm.

Surely, a "boom" in the economy is simply that same scenario writ large? Households on the whole borrow more money to fund more consumption. Firms on the whole receive greater volume of sales. Firms on the whole raise prices and production and enjoy enhanced profitability. Workers on the whole enjoy higher wages and employment. (No, this is a fallacy of composition on two fronts.)

Continuing the story of the individual household and firm, the great prosperity of the individual household and especially, the firm that the household patronizes, cannot be maintained because it is being built on unsustainable debt. At some point, the household must slow its borrowing. Perhaps it will begin to worry about being unable to repay all of this debt and will stop borrowing. Or, perhaps it is the lenders that worry about the household's profligacy and cut off additional loans. Regardless, the debt-funded flow of consumption expenditure stops, and only consumption funded by income remains.

Worse, the household may choose to start repaying its debt. Not only isn't it spending on consumer goods beyond its income, it will begin spending less than income, using part of income to repay debt. Again, this could be because the household chooses to reduce its indebtedness, or else, lenders might force this to happen by limiting the extension of new loans as old loans come due. (Later I will discuss some fallacies of composition in banking, where this decision of whether or not to extend new loans to cover old ones or else "bite the bullet" and "liquidate" is the key to macroeconomic disturbances.)

So, the "over-leveraged" household may reduce its flow of consumption expenditure to its income, or go even further, and reduce it to even less than its income and pay off debts.

Now, consider the impact on the individual firm that the individual household was patronizing. The volume of its sales falls. At best, it returns to the level of sales before the boom. The firm may reduce its price a bit in response to the lower demand, but it also reduces its real volume of sales. Since it must pay for the resources used for production, its profitability suffers, perhaps it even suffers losses. It cuts back on production. It uses less resources, including labor. While it might cut employee wages a bit, with less production, it needs less labor and workers lose jobs.

While this could be simply a return to the pre-boom levels of prices, sales, profits, production, wages, and employment, if the household is reducing debt and spending less than income, then the reduction will go further. There is "bust," that clearly follows from the boom. While there were high levels of prices, profits, production, employment, and wages during the boom, funded by easy credit and debt, when those debts need to be repaid, the reduced expenditures by the individual household result in extra low sales, prices, profits, production, wages, and employment at the individual firm it patronizes.

Naturally, then, it must be that the "booms" observed in the economy must end and will generally be followed by "busts." Households on the whole are "over-leveraged," and must reduce their consumption spending at the very least to pre-boom levels. At worst, they cut consumption expenditures even more to reduce debt. Firms suffer reduced sales and respond with lower prices. Profitability and production falls. Perhaps wages fall as well, but so does employment. Surely, this is what causes recessions? (No, there are two fallacies of composition involved.)

Finally, what is to be done? Fortunately, once the individual household has paid down its debts to a more sustainable level, consumption expenditure can resume. While it is possible that the individual household will foolishly begin building unsustainable levels of debt, a more responsible expansion is possible--consumption expenditure can instead be funded by current income. The individual firm selling to the individual household, then, will see a recovery of sales, hopefully, on what is now a sound basis. Prices and production recovers, as do employment and wages.

And so, for the economy as a whole, once the households have paid down their debts, consumption spending will recover, and the firms can begin a sound expansion. Prices, profits, production, wages, and employment all recover, and hopefully the economy can prosper on a sound basis. Of course, there is always the danger of excessive lending and borrowing, leading again to an unsustainable boom.

If only, somehow, someone can prevent another orgy of debt financed false prosperity, then a sound and prosperous economy remains possible. Surely, this is the answer to macroeconomic stability? (No, there are two fallacies of composition involved.)

What bothers me most about this "credit cycle" story of economic cycles is that it is inconsistent with perhaps the most important principle of economics--scarcity. The fallacy of composition is exactly the one that so worried Bastiat--"what is seen, and what is not seen." It is similar to the fallacy of the broken window. Someone breaks a shopkeeper's window. Surely, that helps the economy. There is a greater demand for the glazier's product, which then leads to general prosperity. What the shopkeeper with the broken window would have done with his or her funds are ignored. What could have been done with the labor and other resources used to replace the window are ignored.

The market economic system is a spontaneous order. No one directs the economy as a whole, and so, no one really has to understand the macroeconomy. The perspective of the individual firms--producing particular products for profit--has little to do with the what this means for the composition of demand or the allocation of resources across fields of endeavor. It is the unintended consequences of their actions that tend to match the allocation of resources to the demands of household for a variety of goods.

From the perspective of the individual firm, changes in the demand for its product should result in changes in the production of that product and changes the utilization of resources, including labor. However, the role of these signals and incentives in a market economy system are about shifting the allocation of resources in order to match a shift in the composition of demand between different good and services.

An individual firm with greater demand will be able to raise prices and earn more profit. Such a firm can expand the production of its particular product and pull resources, including labor, from firms producing other goods and services. It may need to bid up the prices of at least some of those resources, including labor.

And a firm with lower demand may need to lower prices and suffer reduced profitability or even losses. It is receiving a signal that the resources it is using are more needed elsewhere. It must reduce production and allow those resources, including labor, to be used to produce other goods.

The notion that lower demand for all products signals that all firms should produce less and use less labor is incoherent. It follows from a failure to understand how the individual firm fits into a market economic system.

How does this relate to scarcity? The credit cycle theory, where the changes in demand faced by an individual firm are projected into changes in demand for the entire economy, suggests that the fundamental economic problem is having sufficient demand. While true for the individual firm, for the economy as a whole, the fundamental economic problem is that there are inadequate resources, including labor, to produce all the goods and services in quantities sufficient for everyone to achieve their goals. The market system provides incentives for individual firms to respond to changes in the demand for their particular products so that the market system adjusts the composition of output to reflect the particular goods and services people most want to buy.

So, one fallacy of composition in the "credit cycle" story is that the while a firm receiving additional sales can expand production, the resources, including labor, are being pulled away from the production of other goods and services. The production of those goods fall. Employment of labor in the rest of the economy falls. The increase in production and employment for the individual firm cannot be generalized for the economy as a whole.

Similarly, if an individual firm faces less demand for its product, this is generally a signal that it should produce less and that resources, including labor, need to be used to produce other goods and services. However, the credit cycle theory, that the recession is a time when production needs to be reduced across the board because households don't want to buy because they are using their incomes to pay down debt is incoherent. All firms can reduce production, but they cannot all do so in order to free up resources to producing other things. If somehow profits and losses are signalling everybody produce less because the resources have more important uses, then the market signals are in error and inconsistent with the reality of scarcity. There are plenty of goals and purposes that could be achieved with the products of those resources.

The theory of recovery, where the households pay down their debts out of current income, and then, once that is done, can begin to consume an amount equal to their income, hopefully now on a sustainable level, is also based upon a fallacy of composition. The income of an individual household can be treated as being independent of its expenditures. However, if all households decrease expenditures, so that all firms suffer reduced sales and respond by reduced production, then the income earned by the households will decrease as well. The notion that the total of everyone's income needs to fall so that everyone will be able to pay down their debts is incoherent. Again, if the market economic system is creating signals and incentives for this to occur, then those signals and incentives are in error.

This last fallacy of composition--that the individual debtor can reduce expenditure out of income and pay down debts, but that all debtors cannot reduce expenditure and pay down debts, is just an aspect of the second fallacy of composition involved in the "credit cycle" story.

The individual household can borrow and expand its consumption expenditures beyond its income. An individual household might become "over-leveraged" and need to slow the pace of borrowing. Perhaps it will even need to reduce consumption below income and repay debts.

Surely, then, it is possible for all households to expand consumption above income? Surely, if we look at the ratio of household debt to income, this will show that "the" household is "over-leveraged" so that aggregate consumption must slow. Perhaps consumption must even fall below income so that "the" household, can pay down its debts.

No, this is a fallacy of composition. It is a fallacy because for every borrower there is a lender. Credit transfers funds from lenders to borrowers. Credit shifts the allocation of resources away from producing what the lenders would have purchased to what the borrowers want to purchase.

Take the simplest scenario. The consumption of some households is less than income--they save. The consumption of other household is greater than income--they dissave. The households that save lend to the households that borrow to fund dissaving. Even if the amount borrowed and lent each year is small, it is possible for these amounts to accumulate and grow quite large. It is even possible for total household debt to grow to a multiple of the total income of all the households. If it were the same households that were saving and lending to the same households that are borrowing and consuming, then the wealth of the savers would be an even larger multiple of their income than the aggregate debt/income ratio. And, of course, the households that have been borrowing to fund their orgy of consumption would be more "over-leveraged" than all the households together.

Various individual households have been borrowing, and the individual businesses patronized by those households "boom." However, the funds that those households were spending came from the households that were saving and lending. The various firms that they would have patronized sell less. Of course, it could be the very same firms that the borrowers patronize, and there is no impact on the prices, profitability, volume of sales, production, employment, or wages of any individual firm. But, of course, there might be a shift in the composition of demand between firms and industries. There may be a shift in the allocation of resources, including labor, throughout the economy. However, the supposed "boom" for the firms is simply a fallacy of composition. Where the lenders would have spent the funds--what is unseen--is ignored.

Consider the supposed "bust" from the credit cycle. It is certainly correct that a single household can be "over-leveraged" and can choose or be compelled to slow borrowing, or even repay debt. However, for every borrower there is a lender. For every debtor there is a creditor. If a household chooses to slow its pace of borrowing and expand consumption more slowly or even reduce consumption, the question remains, what happens to the funds of whoever would have made the loans? In the more extreme situation, where the borrower repays the loans, what happens to funds that are repaid?

In the simple scenario, where some households have lent to other households and the debts of some households are matched by the wealth of other households, then one possible answer is quite simple. When wealthy households who were lending now confront "over-leveraged" borrowers, so they can not, or will not, lend more, then they simply stop saving and spend their incomes on consumer goods and services.

Similarly, if the "over-leveraged" households choose to reduce their debts, or must reduce their debts, the households that are their creditors can simply spend more than their incomes on consumer goods and services. The wealthy households can now dissave, not by going into debt, but by spending accumulated wealth on consumer goods and services. This process could conceivably continue until debt falls to zero, the the aggregate level of household debt to household income is zero. While the individual firm selling to a household paying down its debt will sell less, the firms selling to the households receiving and spending those debt repayments will sell more.

The simple scenario of consumption loans between households is a good place to start, but there are, of course, other scenarios. From a nationalist perspective, it is possible for households in one nation to borrow from foreign lenders. However, this result in no "boom" for domestic firms. The result of borrowing from the foreigners is imports. Further, while foreign producers may "boom" from all of their exports, what would have the lenders have done with the funds if they hadn't lent them out. Similarly, rather than a "recession" when households can no longer obtain foreign loans to fund their consumption, domestic firms find new prosperity in selling export goods to the foreigners now importing goods as they obtain repayment of the loans they had made.

More importantly, household saving can be used to fund business investment. Resources, including labor, can be shifted from the production of consumer goods to the production of capital goods--machines, buildings, and equipment. If households increase their borrowing to fund additional consumption, then that leaves less household lending to fund business investment. The individual firm might sell more consumer goods to the individual household, but those firms selling capital goods sell less.

In reverse, it is possible that over-leveraged households will reduce consumption spending to repay debt. And those households receiving debt repayments won't expand their consumption. Instead, the resources freed up from the production of consumer goods can be used to fund capital investment by firms.

Individual households may be "over-leveraged." It is possible that a household may regret its past levels of consumption and be unhappy with the currently reduced levels of consumption made necessary by the need to repay loans. It is possible for all households in a single nation to be in this situation. It is even possible for all households in the world to be in this situation, having produced and enjoyed too many consumer goods and failed to produce enough capital goods.

What is incoherent is the simple minded aggregation of the single household and the single firm. The notion that increased lending allows for increased spending in the aggregate, which is necessary for the resources to be fully employed producing goods and services. In other words, the notion that the economic problem is coming up with something to do with labor and other resources, rather than scarcity. That the fundamental economic problem is coming up with a way to generate sufficient spending.

And most importantly, what is incoherent is the notion that excessive debt must result in decreased expenditure in aggregate. And even more incoherent is the notion that the appropriate response to that situation is to lower production and employment until the excess debt is paid down.

From the point of view of the individual household and the individual firm, these relationships between debt, spending, demand, production and employment are perfectly sensible. When all individuals are aggregated, they make no sense.

P.S. Can't banks make loans with new money created out of thin air? When loans are repaid, can't those receiving the funds just hold on to it? If prices, including wages, are less than perfectly flexible, can't changes in nominal expenditure result in changes in real output and employment? Yes! To all of it. And that is the source of the problem, an imbalance between the quantity of money and the demand to hold it. Complaints about "over-leveraged" households are just a diversion.

P.P.S. But can't households choose to work less, produce less, and enjoy more leisure? Yes! And if changing levels of debt and consumption impact how much leisure households prefer to enjoy and that results in changes in production, then any associated relationship between the levels of household debt and the productive capacity of the economy is not a problem.

Friday, February 19, 2010

Discount Rate at 3/4 Percent!

The news is that the Fed has increased the "discount rate" from its current level of 1/2 percent to 3/4 percent. Scott Sumner claimed that the Fed has shown its true stripes, offsetting the Obama administration's fiscal stimulus with a dose of monetary contraction. He blamed some losses in S&P futures on the move.

Thursday afternoon, my colleague said, did you hear that the Fed raised rates? I said, "what?" The Fed has been promising to keep rates low for an extended period of time. It is their odd (but directly out the the play book of orthodox macro theory) approach to dealing with the zero bound. She said, "they raised it 1/4 percent up to 3/4 percent." I said, "it was 1/4 percent before, isn't that a 1/2 percent increase." She said, "no.." I said, "oh, that must have been the primary credit rate. It's not important."

My local paper included the news in a small blurb in the back of the second section. That is where the business and economics news appears. Of course, the Wall Street Journal headline was "Rate Rise Stirs Questions." I just turned on the TV to check, and the stock market averages were up for the day.

It has been about seven years ago now that the Fed quit talking about the "discount rate," and instead began to call it the primary credit rate. The rate was to be pegged at one percent above the target for the federal funds rate. That would, of course, discourage banks from directly borrowing from the Fed. Instead, they would be more likely to borrow overnight from other banks at the lower, federal funds rate. Bank borrowing from the Fed was usually a few hundred million dollars.

In 2007, the Fed began to encourage banks to directly borrow. Perhaps the most remarkable action was to "jawbone" the four largest U.S. banks into borrowing $500 million each from the Fed on 22 August, 2007. The Fed had reduced the "penalty" on the primary credit rate from 1 percent to .5 percent a few days before. And then, in March of 2008, it reduced the penalty to .25 percent.

With the fed funds rate currently being targeted at a range from 0 to .25 percent, that .25 percent penalty made the primary credit rate .5 percent. And, now, the penalty is back to where it was in March of 2008, .5 percent. And so, the primary credit rate is now .75 percent.

As long the dollar is defined in terms of a unit of base money monopolized by the Fed, I believe the Fed should serve as "lender of last resort" to the banking system. What that means, however, is that the Fed should adjust the quantity of the monetary base to match increases in the demand by banks to hold reserves and other firms and households to hold currency.

There is no need for the Fed to ever make loans to particular banks, but rather it should simply purchase securities on the market. As long as there are government bonds with positive yields, it should purchase those. If those are gone, perhaps high quality private securities should be purchased next. If the Fed is running out of things to buy, then direct loans to banks may be necessary.

The danger of direct loans to banks is the Fed may seek to bail out politically influential, but insolvent banks. Raising the interest rate the Fed charges on direct loans to banks is a move away from the Fed's recent practice of making loans to banks.

Before the crisis, direct bank borrowing from the Fed was usually well below $1 billion. This was out of the nearly $800 billion of base money. The Fed created base money by purchasing government bonds. (It also made repurchase agreements, secured overnight loans to security dealers.)

During the crisis, the Fed increased direct lending to banks. Primary credit lending peaked at about $400 billion. However, it has dropped off rapidly, until slightly less than $100 billion of primary credit loans remain.

There were other sorts of lending to depository institutions that added another $300 billion at the peak, so that total lending by the Fed to the depository institutions peaked at $700 billion. However, total lending has now dropped to slightly more than $100 billion.

Suppose the increase in the primary credit rate should reduce this lending even more? Suppose it returns to the levels of before the crisis, of less than $1 billion?

The total monetary base is now approximately $2 trillion. The current level of Fed lending to banks is approximately 5 percent of the base. More importantly, the Fed can easily expand its purchases of Treasury bonds or mortgage-backed securities to offset the impact of any decease in lending to banks on the monetary base.

I believe that the Fed should stop targeting interest rates. The Fed should commit to increasing Final Sales of Domestic Product to $16.2 trillion by the first quarter of 2011. The Fed should announce that as the economy begins to recover, it fully expects all interest rates, including interbank lending rates, to rise substantially from their currently depressed levels. And while closing the discount window would be the first best solution, pegging the primary credit rate at one percent above a market-driven federal funds rate would be a step in the right direction.

Bank Lending, CD's and Monetary Disequilibrium

Suppose the demand for loans expands, and banks accommodate this by funding new loans with newly-issued Certificates of Deposit. Those obtaining the bank loans have more money to spend. But those buying the banks' C.D.s have less money to spend. Ignoring secondary effects, there is no impact on aggregate nominal expenditure.

There is a shift of funds from those buying the C.D.s to those obtaining bank loans. Presumably, it will be matched by a shift in the allocation of resources. Hopefully, this shift will be value enhancing. If it is value enhancing, the productive capacity of the economy is slightly higher than it otherwise would be, but it has nothing to do with a change in nominal expenditure.

It is possible that this transaction would be value enhancing, but it cannot be made because the bank cannot make new loans due to inadequate capital--inadequate net worth. Perhaps the bank took losses because of poor past investment decisions and government prohibits banks from making new loans until they somehow rebuild their net worth. It is even possible that potential CD buyers would refuse to buy C.D.s from poorly capitalized banks.

Regardless, the inability of the banks to make these value enhancing transactions would prevent an enhancement of the productive capacity of the economy, but would have nothing to do with aggregate nominal expenditure. The potential borrower would not have the funds to spend. The potential CD buyer instead has the funds to spend.

Does that mean that banking is irrelevant to nominal expenditure? No, banks are very much involved because banks don't just fund their loans with Certificates of Deposits. They also fund their loans with transactions accounts. Further, banks don't use all of their available funds to make loans or buy securities, but rather hold vault cash or balances at the Federal Reserve banks. It is the relationship between the amount of "reserves" banks choose to hold and the amount of monetary liabilities that banks create, that has a major impact on nominal expenditure.

Unfortunately, the simple truths of money and banking are masked when central banks manipulate these relationships to control short term interest rates. They don't disappear, but rather whatever loans the banking system wants to fund given the target interest rates will be funded, in the last resort, by transactions accounts created by the system. Unlike the C.D.s, where the depositor chooses to hold them, the transactions accounts are simply accepted in payment. While someone is, of course, holding them, they may intend to spend them. It is the ability of central banks to manipulate this process, so that loans are funded by deposits that people may not want to hold, that allows them to manipulate interest rates.

If capital requirements impact banks is such a way that it would lower the equilibrium value of the particular interest rate that a central bank is targeting, the way the central bank is going to keep interest rates from falling is by manipulating the relationship between bank reserves and transactions deposits so that there is a reduction in the amount of transactions deposits used to fund loans. That is what will tend to depress nominal expenditures. If the central bank fails to respond to the prospective decreases in nominal expenditures by a sufficiently large decrease in its target for interest rates, then nominal expenditures will fall.

But the reason for the drop in nominal expenditure isn't the decrease in bank lending. It is rather that the central bank is creating an excess demand--a shortage--of transactions accounts to keep interest rates from falling faster than it prefers. And it is that imbalance between the supply and demand for transactions accounts--money--that depresses nominal expenditure.

Thursday, February 18, 2010

The Money Multiplier

David Beckworth, on Macro and other Market Musings, discussed the Fed's "exit" strategy for reducing the large quantity of excess reserves. He was reporting on Bernanke's statement that the Fed would use increases in the interest rate on excess reserve balances to prevent any excess supply of base money. He then criticized the Fed's policy of holding large quantities of mortgage-backed securities as "fiscal policy."

Beckworth received a flurry of comments claiming that these excess reserves irrelevant, because bank lending depends on loan risk and bank capital. There were claims that worry about excess reserves reflects wrongheaded "money multiplier" reasoning.

Nick Rowe commented in that thread (as did I) and prepared a post on Worthwhile Canadian Initiative about fallacies of composition and decomposition, relating bank reserves and the quantity of money. Rowe's focus was on the difference between the individual bank and the banking system. His focus was on how a single bank faces an effective 100 percent reserve requirement on lending.

My basic model of the individual bank is financial intermediation under monopolistic competition. Banks borrow money from depositors and lend it to borrowers. Bank set interest rates on both deposits and loans so that they grow together.

If deposits grow more slowly than than loans, a bank raises both the interest rates it pays and charges. This attracts more depositors, so that deposits grow more rapidly. It makes loan less attractive, so loans grow more slowly.

If, on the other hand, deposits grow more rapidly than loans, then the bank lowers the interest rates it both pays and charges. Deposits are less attractive, so deposit growth slows. Bargain interest rates attract borrowers, so loan demand grows more rapidly.

A bank that wishes to expand more rapidly raises the interest rates paid on deposits and lowers the interest rates charged on loans. Both deposits and loans expand more rapidly. If the marginal revenue from the increased size of the balance sheet is greater than the marginal cost of expanding the operations of the bank, then profits grow more rapidly.

Of course, lower growth might expand profits, (or, sadly, reduce losses.) A bank raises the interest rates charged on loans and lowers the interest rate paid on deposits. The margin between the two expands, but the balance sheet grows more slowly, or in the extreme, shrinks. If the savings in operational cost are greater than the decrease in marginal revenue, then profit expands or losses shrink.

Even if the interest rates a bank sets balance the growth of deposits and loans on average, they will not balance continuously. Banks trade money market instruments, like T-bills and interbank lending, to balance temporary imbalances between loans and deposits. For example, a bank receiving many loan repayments and seeing few new loan customers might buy T-bills. If a bank's depositors make payments and few receive payments, the bank might borrow overnight from another bank.

This basic analysis of the banking business ignores bank capital as well as reserves. I think both are very important, but I think this sort of model is the right starting point.

Bank capital, or net worth, plays a key role in reassuring depositors and other bank creditors. Of course, capital requirements play a key role in current banking regulation. I think it is essential to understand that the fundamental nature of banking, as financial intermediation, makes asimplistic application of the concept of "leverage" inappropriate. Of course banks are highly leveraged.

Bank reserves-vault cash and reserve balances- reduce the need to trade money market instruments and so reduce transactions costs. Again, reserve requirements play a role in current banking regulations.

Why would anyone instead start with a model of an individual bank that passively receives deposits and then makes commercial loans equal to a fixed proportion of the deposit, say, 90%?
Suppose that bank "deposits" are banknotes. Paying interest on banknotes is difficult, and is ignored. The banks borrow at zero interest.

Now, suppose, that there are usury laws--binding interest rate ceilings on loans, so that borrowers face a shortage of bank loans.

If a bank receives a zero-interest deposit, then it has more funds to ration out. Presumably, a prudent banker rations by credit risk, and so, expands lending to slightly worse credit risks.

The notion that banks would simultaneously adjust the interest rates paid and charged to maximize profit would be foreign in such a scenario.

As a monetary theorist, the key element of banking is the issue of deposits used as money--as medium of exchange. At one time, banks issued banknotes--private currency. More recently, they issue transactions accounts--deposits that can be transferred electronically or by means of check. From the individual bank's point of view, these are simply one source of funds. Various classes of savings accounts, certificates of deposits, are alternative funding sources. And, of course, banks can issue bonds, commercial paper, or fund their activities by equity--capital.

Bank lending is of little intrinsic interest to a monetary theorist. Of course, banks must match their liabilities, including monetary liabilities, as well as their net worth, with some kind of assets. Banks can make loans, but they can hold various sorts of government bonds, as well as private securities--bonds, commercial paper, or mortgage backed securities.

However, there is one kind of asset that banks hold that is of special interest to the monetary theorist--what we call "reserves." These can be either vault cash, hand-to-hand currency issued by the government, or else balances at the central bank. Currency, of course, serves as medium of exchange. And balances at the central bank also serve as a type of medium of exchange, but only for banks making payments from one to another.

Return the the scenario of the bank funded entirely by the issue of zero-issue banknotes rationing commercial loans. All the bank's liabilities serve as the medium of exchange. The only bank assets are commercial loans or else reserves--vault cash or balances with the central bank. Instead of all of the complications of a variety of deposits, loans, other assets, liabilities, and bank capital, the two items of interest to the monetary theorist--monetary liabilities of the banks and the central bank, are at center stage, with only commercial lending as a complication. And bank lending is not of special interest--it is just an afterthought.

Further, what is interesting to the monetary theorist is the relationship between the monetary liabilities created by the banks--transactions accounts these days--and the monetary liabilities created by the central bank--hand-to-hand currency and reserve balances kept at the central bank. It is not the individual bank that is of interest, but rather how the interactions of the banks impact the total quantity of the medium of exchange.

In particular, the point of the money multiplier process is not that an individual bank with excess reserves will create more commercial loans. Rather the point is understanding how an excess supply of reserves in the banking system results in an expansion in the amount of transactions accounts that businesses and households hold in banks until the excess supply of reserves ends--either through withdrawals of currency from banks or an increase in the demand by banks to hold reserves.

From the point of view of the individual bank, the most obvious thing to do with excess reserves is to purchase liquid assets--such as purchasing T-bills or making overnight loans to other banks. Alternatively, the funds could be used to pay off debts coming due--for example, repaying overnight loans received from other banks. However, these actions simply shift reserves to other banks.

Because reserves serve as medium of exchange from the point of view of banks, there is no reason to believe that banks only accept reserves in payment if they want to hold more of them. For example, suppose a bank has "excess reserves," an excess supply of reserves, and purchases a T-bill on the secondary market. The bank wires funds to the seller's bank. The bank that had the excess reserves now has T-bills. The seller of the T-bills now has a balance in his or her transactions account at his or her bank. And the seller's bank now has an additional balance in its reserve account at the central bank. The seller's bank didn't choose to accumulate more reserves. Other things being equal, it has excess reserves.

Whether this will lead to banks to make more loans is not central to the process. The seller has a larger balance in his transaction account. If banks' demand for reserves are positively related to the balances their customers have in transactions accounts, then this raises the demand for reserves. If the demand for currency by firms or households is positively related to their balances in their transactions deposits, then currency will be withdrawn from the banks, and so help clear up the excess supply of reserves.

Of course, if banks are purchasing T-bills or other money market instruments, the yields on those instruments would tend to fall. This would motivate banks to lower the interest rates changed on loans and expand lending. It also would motivate them to lower the interest rates paid on deposits.

Loans are created by crediting funds to transactions deposits, and as those funds are spent by the borrowers, the transactions deposits is extinguished. But when those selling to the borrowers deposit the funds, they have a transactions deposit. As far as the impact on transactions deposits and the excess supply of reserves in the banking system, the process is similar to a bank purchasing a T-bill.

To the degree lower interest rates on deposits results in an increase in the demand for currency by households and firms, this would be an avenue by which an excess supply of reserves clears up as vault cash leaves the banking system.

Returning to the simple scenario of a bank rationing commercial loans funded by zero-interest banknotes, the excess reserves can have no other immediate effect than an increase in commercial lending. However, the increase in commercial lending is not the point of the analysis. It is that those selling to the borrowers end up with additional money balances, which they deposit. The surplus of reserves is not extinguished through the loan. It simply moves to another bank. However, if the demand for bank reserves is positively related to the outstanding issues of the banks' monetary liabilities, then the process will lead to an increase in the banks' monetary liabilities and close off the excess supply of reserves.

If central banks manipulate the quantity of base money in order to target short term interest rates, and an excess supply of reserves results in downward pressure on the yields on money market instruments, the result will be a prompt response by the central bank to reduce the quantity of reserves. Among monetary economists, one of the the rationales of interest rate targeting is that it prevents the process described by "the money multiplier" from occurring. That doesn't make the money multiplier analysis pointless. It rather explains what would happen if the central bank targeting interest rates didn't take action that forestalls the market process that corrects for an excess supply (or demand for) of reserves in the banking system.

I oppose interest rate targeting. I believe it is better for all interest rates, including short term, low risk interest rates, to freely float depending upon market conditions. On the other hand, I think that the nominal quantity of bank reserves should change to accommodate the demand to hold them--consistent with nominal expenditure growing on a 3 percent growth path. If such a system were implemented, the market process by which an excess supply or demand for a fixed nominal quantity of reserves would be cleared, would not happen. That doesn't mean that it isn't an important for monetary theorists to understand the process.

Woodford, Interest Rate Targets, and Inflation

I have been reading Michael Woodford's Interest and Prices. He describes his approach as "neo-Wicksellian," and spends a good bit of time discussing "cashless payments systems." Woodford also insists that monetary policy should be based on implementation of rules.

I have always been a fan of Wicksell, and "cashless payments systems," have been one of my passions. Most importantly, my basic understanding of "monetary policy" involves the appropriate rules for the monetary constitution.

However, the focus of Woodford's book is explaining and justifying a central bank policy for manipulating the overnight interbank lending rate.
"I have argued that the central problem of the theory of monetary policy is to provide principles that can be used in selecting a desirable rule for setting a central bank's interest-rate operating target."
I believe that the Federal Reserve should stop targeting the federal fund rate. I won't dispute Woodford's claim,
"it does not seem at all natural or useful to try to explain the predicted paths of inflation and output as consequences of the implied path of the money supply. Instead, it proves possible to discuss the determinants of inflation and output in a fairly straightforward way in terms of the coefficients of an interest rate rule."
or even,

"optimal policy can be conveniently represented in terms of specification of exactly that sort."

My complaint is that Woodford's framing of the issue is having an impact on the proposed goals of monetary policy.

It is bad enough that we have put up with a two percent trend rate of inflation for the last two decades. But now, Oliver Blanchard, whose blurb on the back of Woodford's book compares it to Patinkin's Money, Interest and Prices, is calling for a four percent trend inflation rate.

Why? In the end, it comes down to the following statement from Woodford,
"My focus on the choice of an interest-rate rule should not surprise readers familiar with the current practice of central banks. Monetary policy decision making almost everywhere means a decision about the operating target for an overnight interest rate, and the increased transparency about policy in recent years has almost always meant greater explicitness about the central bank's interest-rate target and the way interest-rate decisions are made."
Perhaps we should instead take Milton Friedman's approach. I don't mean a target for the growth rate of some measure of the quantity of money. But instead, to consider that maybe central bankers have gotten it wrong. If the central bankers penchant for setting overnight interbank interest rates means that the rest of us must put up with 4 percent inflation, then perhaps the central bankers should change their ways.

Wednesday, February 17, 2010

Pete Boettke visits Charleston

Pete Boettke visited Charleston yesterday. (I just don't understand why people can't organize these things around the church calendar. Doesn't everyone spend Shrove Tuesday in the parish hall cooking pancakes? Or is it drinking on Bourbon Street or dancing in Rio?)

I had never heard Pete lecture before, and he was very good. The presentation to the undergraduates at the College of Charleston was sponsored by the BB&T Initiative for Public Choice and Market Processes. (Many thanks to BB&T and Pete Calcagno of the College of Charleston's Economics Department.)

Boettke's lecture was about the difference between the mainline and the mainstream of economics. The mainline goes from Adam Smith, through Say, and on to Hayek. (He also mentioned Buchanan sometimes. Go Virginia School!) The mainline is about understanding the market process--methodological individualism and self-organization in markets. The mainstream varies with the times. Sometimes the mainline is the mainstream, but other times, the mainstream goes off in different directions. His example for the current mainstream was Stiglitz, and that it is a bit off the mainline.

The most challenging part of the lecture for me was when he discussed a four by four chart, where the economist is student or else savior and the government is referee or player. The opportunity of the economist to be a savior when the government is a player is one of Boettke's explanations for why the mainstream frequently deviates from the mainline.

Like Boettke, I think that the government should be the referee and the the economist should be a student. Why his lecture was personally challenging is that I am left puzzling over where I stand, calling for the Fed to target Final Sales of Domestic Product at $16.2 trillion in the first quarter of 2011?

My favorite part of his lecture was his discussion of "y" vs. "ics" Boettke pointed out that in the old days, the "mainstream" was described as "political economy." Of course, today, we do "economics" Who do we want to be with? Do we want to be with the "y's," like philosophy and history? Or do we want to be with the "manly" fields, like mathematics or physics?

After a return to the parish hall kitchen, it was off to Bastiat. The Bastiat Society meets once a month for a reception and a speaker--usually from off. (That means, "not from Charleston" in the local lingo.) Boettke's presentation was about the financial crisis, The House that Uncle Sam Built, a paper he had written with Steve Horwitz. Boettke's story was that periods of a negative real federal funds rates in the naughties led to malinvestment in housing. He had a long list of government interventions that directed excess credit into housing.

Recovery involves letting the market heal. He was very critical of bailouts and the fiscal stimulus. He was very concerned about the prospect of deficits, debt, and debasement. In other words, deficits to fund fiscal stimulus will increase the national debt, and sooner or later, government will create money to pay off these debts, resulting in massive inflation.

Unfortunately, we didn't get to his last slide, where he was going to bring up the differences among free market economists regarding the proper Fed response in 2008. (I did very much appreciate his too kind words about my expertise in this area. When I turned around and saw that my associate Dean was at the lecture too, I was even more pleased.)

I still think that the most serious macreconomic problem today is that nominal expenditure is 10 percent below trend, and I still favor having the Fed target Final Sales of Domestic product at $16.2 trillion for the first quarter of 2011. I even am sticking to my odd notion that maybe the real level of very short and low risk interest rates, including perhaps the interbank overnight lending rate, should sometimes be negative.

On the hand, I am more and more convinced that the Fed's policy of interest rate targeting, and especially, interest rate smoothing, is a serious mistake. Promising that the Federal Funds rate will stay near zero for a good long time is a bad idea. While I am not really confident in the Congressional Budget Office's ability to measure the productive capacity of the economy, much less forecast it for the next decade, that their current estimate shows that about 1/3 of the decrease in real output from trend is due to lower potential output and that slow growth will continue, leaving real output 15 percent below its long term trend at the end of the next decade, has made me put more weight on the role of the "hangover" from the malinvestment and more concern about the impact of "regime uncertainty" on long run real investment and productivity growth.

After Bastiat, it was back to the parish hall. Kathy and I got the last pancakes. And then there was clean up. After that great Charleston "carnival," I am ready for Lent.