Reaching for Yield: A Simple Model

Miles Kimball poses an interesting question: How can we model "reaching for yield?" He poses this question in response to a claim by John Taylor that the Fed's zero interest-rate policy creates incentives for investors
"to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income." Kimball writes that

The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality.

"Modeled Behavior" blog has a complementary post today, also questioning how "reaching for yield" squares with economic theory. So here is my morning modeling exercise. It is a really simple, partial equilibrium model, but a model nonetheless. I'm not saying it's incredibly realistic, but I wanted to come up with the simplest model of "reaching for yield" I could think of. It has neither investor ignorance, nor irrationality, nor fraudulent schemes.

Safe Assets and Financial Crises

Mark Thoma has shared a link to a new working paper by Gary Gorton and Guillermo Ordoñez called "The Supply and Demand for Safe Assets." The paper brings to mind a once-confidential document written by economists in the Clinton Administration called "Life After Debt" which was recently made public by the team at NPR's Planet Money. The report notes:

In the year 2000, the U.S. Treasury began actively buying back the public debt; we should all appreciate the tremendous achievement this represents for the Nation as a whole... We must realize however, that a sharp reduction in Federal debt and the possible accumulation of a Federal asset raises at least three important issues. First, investors looking for an asset free of credit risk can no longer count on an abundant supply of U.S. Treasury securities, and Treasury securities may no longer provide a reliable benchmark for other interest rates. Second, the Federal Reserve may have to change the mechanisms by which it conducts monetary policy. Third, continued surpluses after the public debt has been paid off will require the Federal. government to acquire assets; either directly or though the Social Security Trust Fund. This raises issues about what kinds of assets might be acquired, and the best way to manage this task.”

Gorton and Ordoñez's paper is relevant to the first of these issues. The Clinton Administration report elaborates on this issue, saying:

US Treasuries are considered free of default risk by investors the world over...The remarkable liquidity of Treasuries is also a result of the full faith and credit of the United States Government.  Holding a liquid asset is valuable because it affords an assurance of convertibility, and thus fast and easy access to capital.  Private investors, the Federal Reserve and many foreign central banks have used Treasuries to fulfill their need for a riskless, performing asset with liquidity second only to currency.

Gorton and Ordoñez note that the share of safe assets in the U.S. economy has remained constant since 1952. However, the composition of these safe assets varies. Safe assets consist of both U.S. Treasuries and privately-produced substitutes, so when the supply of Treasuries declines, the share of private subsitutes rises. What can be a private substitute for Treasuries? Typically, asset-backed securities. Collateral is key.

In Gorton and Ordoñez's model, for simplicity there is just one type of collateral: land. Land can be either "high quality" or "low quality." While the average land quality is known, there is no public information about which land is high quality and which is not. Borrowers can use their land as collateral to finance investment projects, and lenders don't know the land quality unless they pay some cost to find out. This is a type of financial friction: it is inefficient for the economy as a whole if lenders pay a cost to learn about collateral quality, because that cost does not result in any production.

In the model, there are normal times and crisis times. In normal times, the average land quality is high enough that lenders are better off NOT paying to check the quality of the land. The inefficiency from the financial friction is avoided. However, there can be shocks to the average quality of land. Land quality may get low enough that  lenders need to check the land quality before they accept it as collateral, resulting in economic ineffiiency and a financial crisis. This is where Treasuries come in. Government bonds can also be used as collateral, and they don't suffer losses in value like land does. In short:

Since bonds can be effectively used as collateral, a larger fraction of bonds buffers the economy from potential shocks to the expected value of land that may reduce its role as collateral, inducing a lower probability that such shock translates into a financial crisis. This is consistent with the empirical findings of Krishnamurthy and Vissing-Jorgensen (2012a); an increase in Treasury debt decreases the probability of a financial crisis. In our setting this is because bonds can be used as superior substitutes for private collateral – they are independent of shocks to land.

Of course, they are not just advocating for the government to run up a huge debt.The model also includes taxes, and they make the important additional note:

But, if taxes to repay bonds are distortionary, it may be optimal for the government to issue debt in times of crisis, but not in normal times. 

"Land," remember, is a modeling simplification, and really encompasses all types of private collateral. Before the recent financial crisis, there was a surge in the creation of "safe" private assets using "pools" of collateral including loans, bonds, and mortgages. Josh Koval and Erik Stafford explain:

The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.

For a time, the AAA-rated top tranches of these manufactured assets were considered really safe, and it was like the "normal times" in the model when lenders trust that on average, collateral quality is good enough that they don't need to pay the extra cost to check on it. But then it became apparent that the average quality was much lower, and these assets became less effective collateral, and the financial crisis began. There are at least some claims that the Clinton surplus kicked off the rise in mortgage-backed securities issuance. (I included two graphs below, made using data from FRED, in case you want to evaluate the claims for yourself.) If you decide to read "The Supply and Demand for Safe Assets," please do also look at Krishnamurthy and Vissing-Jorgensen's empirical counterpart. Or, for something lighter, listen to Planet Money's episode "What If We Paid Off The Debt? The Secret Government Report."

How I Wish this Book Existed

There already exist many books about the financial crisis and Great Recession, but not the one I am most dying to read. Imagine this: a book about the crisis and recession written each chapter written by a different  top female macro or financial economist. Here is my dream chapter line-up.

Chapter 1: Signs of Impending Crisis, Janet Yellen

Chapter 2: International Integration, Contagion, and Domestic Vulnerability, Graciela Kaminsky

Chapter 3: Bank Competition and Systemic Stability, Asli Demirguc-Kunt

Chapter 4: Minding Our Money: Financial Literacy and the Crisis, Olivia Mitchell

Chapter 5: Unconventional Monetary Policy in Exceptional Times, Lucrezia Reichlin

Chapter 6: Quantitative Easing and Portfolio Choice, Annette Vissing-Jorgensen

Chapter 7: Evaluating TARP, Loretta Mester

Chapter 8: Public and Private Spending, Valerie Ramey

Chapter 9: Inventories and the Delayed Recovery, Martha Olney

Chapter 10: Beyond Unemployment Rates: The Great Recession and Material Hardship, Janet Currie

Afterword: Policy and the Power of Ideas, Christina Romer

What do you think? Would other people be excited to read this too? What chapters and authors am I missing?

Quantity Theory in Chinese History

Yesterday Yaohua Li of the Shanghai University of Economics and Finance presented her research on "The Goal of Private Pensions" at the Berkeley Economic History Lunch. After her presentation, I have a new-found tremendous admiration for anyone brave enough to study Chinese economic history. The data challenges are huge-- and so are the potential rewards for anyone diligent and resourceful enough to confront them.

Li is studying the differences in the private pension systems that arose in the United States and China in the 1920s and 30s and trying to understand why the systems developed the way they did. It is not too hard to find data about pension plans in the U.S. in that era, but for China, due to political constraints, no one has been able to collect such data before. Li is doing it totally from scratch. (As someone who has always been able to download my data straight from the Internet, I am blown away!) Her research is too preliminary for me to share results here, but she did bring up an interesting episode in monetary history that I would like to discuss.

In 1934, the United States passed the Silver Purchase Act and as a result began importing significant volumes of silver from abroad, particularly from China. China was on a silver standard, so as its silver flowed abroad, its money supply shrank. Exactly as Anna Schwarz describes, the shrinking money supply caused interest rates to rise. China was relatively unaffected by the Great Depression in 1929-- that depression rampaged the countries shackled by "golden fetters," which transmitted a monetary contraction in the United States and France around the world. But depression hit China in 1934, concurrent with the decline in its silver money supply. Just as the gold standard countries were forced off of gold in the late stages of the Great Depression, China left its silver standard in 1935.

I wanted to know more about what happened next with China's money. Research is substantially limited because of data restrictions, exacerbated by the Pacific War beginning in 1937. There is a 1954 paper by Colin Campbell and Gordon Tullock which includes as its first footnote, "The personal observations of Mr. Tullock have provided the principal data for this study. He was in Tientsin as a Foreign Service Officer from 1948 to 1950." They describe how the Nationalist, Communist, and Japanese governments in China all issued their own currencies and engaged in "monetary warfare," each prohibiting the use of the others' currency beginning around 1938.

In Free China, with the Japanese invasion in 1937, the government increased bank credit as a means of war finance. Campbell and Tullock were up on their quantity theory. From 1937 to 1938, the government was able to expand the money supply faster than prices rose. But in 1938, "people evidently began to realize that prices would rise continuously. As soon as they tried to hold smaller cash balances because they expected inflation, velocity increased sharply...In 1938-44 and in 1946-47 wholesale prices rose more rapidly than the money supply." This is a textbook-example-worthy case of Milton Friedman's distinction between the short run and long run.

In 1988, the Chinese authorities were worried about double-digit inflation and remembered how perfectly Friedman's theories described their own history before 1949. They sought Friedman's advice and apparently followed it, bringing inflation down to acceptable levels.

Real Estate Monetary Standard: the New Wildcat Banking?

Michael Sankowski at Monetary Realism suggests that we may be on a "real estate monetary standard." He writes:

Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.
Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.

He makes the comparison to a gold standard, but I suggest another analogy: the Free Banking Era. The Free Banking Era refers to the period from 1837 to 1863. Prior to free banking, opening a bank was a difficult process that involved obtaining a charter from a state legislature, and the Second Bank of the United States required state banks to keep an adequate supply of specie on hand, thereby limiting the amount of notes that they could issue. When the Second Bank closed, states needed to make bank entry easier to fill the void in banking services. New York and Michigan were early adopters of free banking laws, which allowed anyone to operate a bank as long as notes were redeemable on demand and backed by state bonds held at the state auditor's office. Eventually, 18 states adopted free banking laws. I would like to compare the state bond-backed monetary system to what Sankowski calls our real estate monetary standard.

With the passage of the free banking laws, many new banks opened and a plethora of different kinds of banknotes circulated as currency. An expansion of the banking sector in that era has its analogue in the expansion of mortgage lending, including subprime lending, from around 2003-2007, when there was also large growth in non-bank independent mortgage originators. (See Joshua Wojnilower's post on how tax policies created a real estate monetary standard.)

The Free Banking Era is notorious for a large number of bank failures, which often resulted in losses to noteholders. The conventional explanation for the problems of free banking is also a common explanation for the bank failures of recent years: fraud and greed. The evil bankers of those days were called “wildcat bankers." In a well known 1974 paper, Hugh Rockoff explains the link between wildcat banking and free banking laws. Some states allowed banks to issue notes equal to the face value, instead of the market value, of the bonds backing. So wildcat bankers could buy state bonds that had depreciated, deposit them with the state auditor, and issue currency amounting to the face value, rather than the depreciated value, of the bonds. They could then circulate these notes to the public, in exchange for specie and investments worth more than what they paid for the state bonds, forfeit the bonds and run off with the bank’s assets. Sound familiar? Consider Felix Salmon's description of the "enormous mortgage bond scandal."

This is where things get positively evil. The investment banks didn't mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren't going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker. In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors. 

However, as the Economist notes, there has been "a lot of debate over whether blame [for the recent financial crisis] should be assigned to deliberate fraud by financial-industry actors, or whether the whole phenomenon was simply an unfortunate catastrophe based on systemic miscalculations. General opinion settled on the unfortunate-catastrophe thesis." Likewise regarding the free banking era, later authors such as Gerald Dwyer and Arthur Rolnick and Warren Weber argue that most bank closings and noteholder losses were not caused by fraudulent wildcat banks, but rather by capital losses due to drops in state bond prices. There were systemic miscalculations concerning state bonds like there were with mortgage-backed securities. And in fact, they were eerily similar.

State governments at the time were in the business of building roads and canals, running up big debts to do so. It seemed like a great investment, given New York's success with the Erie Canal. States expected to be able to service debt with the revenue proceeds of an expanding tax base; the land boom of the 1830s seemed to promise growing property tax revenues. Plus, the roads and canals that they were borrowing to build were expected to bring in even more revenue. So state bonds were presumably extremely safe assets. It was very similar to the subprime loans made during the housing bubble: even though borrowers didn't have the income they would need to pay their mortgages, they were allowed to borrow because home values were expected to keep rising. But just as AAA-rated subprime-mortgage-backed securities were downgraded to junk status when borrowers started defaulting, the state bonds also sunk in value when many states went into default.

Then as now, leverage mattered. Nine of the ten states with the highest per capita debts defaulted; none of the states with below median per capita debts defaulted. The defaults of course caused financial turmoil and also adversely impacted the real economy. And although the pros and cons of free banking were not well understood until well over a century later, policymakers were fairly quick to impose new regulations. The Free Banking Era came to an end with the passage of the National Bank Acts of 1863 and 1864, which set up a national system of banking with federally issued charters and a uniform national currency backed by Treasury securities. The Comptroller of the Currency was established as a supervisor in 1863; the Federal Housing Finance Agency was established in 2008 to supervise secondary mortgage market components. The parallels are so interesting--this is why I love economic history!

The Value and Values of Finance

When I was an undergraduate at Georgia Tech from 2006 to 2010, I was one of a group of ten Stamps Scholars. The scholarship program was founded by E. Roe Stamps, founding partner of the private equity firm Summit Partners. Since then, the program has expanded to 32 schools and hundreds of scholars. (This is not an economics scholarship-- students have a wide variety of majors.) Now that the program is so large, they hold a Stamps Scholars National Convention every other year. This year's conference will be hosted by the University of Michigan in early April, and the theme is "Solving Big Problems."

Today I received an email sent to all of the Stamps alumni asking for suggested topics for convention sessions. What "Big Problems" should several hundred bright undergraduates think about and work on during the next few years? We were asked to provide a topic, a link to a relevant article, and brief written comments for the students. 

Shortly before receiving this email, I was reading and thinking about Noah Smith's post, "How much value does the finance industry create?" and related posts about the social cost of finance on the Uneasy Money blog. I still don't know exactly where I stand on this topic, but I think it's big and interesting enough to ask this large group of undergrads to think about. They have all benefited from the fortune that Mr. Stamps made in finance, and many are probably considering careers in finance. Here is what I wrote to them. Hopefully it will prompt a good discussion in April and stick in the back of a few young people's minds. If you have other "Big Problems" that you think undergraduates should be thinking about, please leave comments!

Topic: The Value and Values of Finance.

Article: http://www.newyorker.com/reporting/2010/11/29/101129fa_fact_cassidy?currentPage=all

My comments (directed to Stamps Scholars):

As Stamps Scholars, we have all benefited tremendously from finance. Mr. and Mrs. Stamps epitomize the good that can come from finance. They have invested not only in businesses, but also in our education and the future of the community. In the aftermath of the financial crisis, there is increasing sentiment that not all finance is so good.

In the article by John Cassidy, he writes: 

"Since 1980, according to the Bureau of Labor Statistics, the number of people employed in finance, broadly defined, has shot up from roughly five million to more than seven and a half million. During the same period, the profitability of the financial sector has increased greatly relative to other industries. Think of all the profits produced by businesses operating in the U.S. as a cake. Twenty-five years ago, the slice taken by financial firms was about a seventh of the whole. Last year, it was more than a quarter. (In 2006, at the peak of the boom, it was about a third.) In other words, during a period in which American companies have created iPhones, Home Depot, and Lipitor, the best place to work has been in an industry that doesn’t design, build, or sell a single tangible thing...Not surprisingly, Wall Street has become the preferred destination for the bright young people who used to want to start up their own companies, work for NASA, or join the Peace Corps. At Harvard this spring, about a third of the seniors with secure jobs were heading to work in finance. Ben Friedman, a professor of economics at Harvard, recently wrote an article lamenting 'the direction of such a large fraction of our most-skilled, best-educated, and most highly motivated young citizens to the financial sector.'"

You, Stamps Scholars, are without a doubt some of our "most-skilled, best-educated, and most highly motivated young citizens." Whether or not you are considering a career in finance, you will be interacting with the financial sector in one way or another. So how do you decide when finance adds value to society, and when it does not? How do you decide when finance operated with values you can agree with, and when it does not? These are complicated, weighty questions that challenge economists and policymakers alike, and I encourage you to challenge yourselves with them as well.

Japan and the Formation of Inflation Expectations

With the Bank of Japan's adoption of a 2% inflation target making headline news, it seems like a good time to discuss some recent research on the psychology of inflation expecations by Berkeley Professor Ulrike Malmendier, who was recently awarded the 2013 Fischer Black Prize from the American Finance Association. This biennial prize honors the top finance scholar under the age of 40 years old. Malmendier works in the intersection between finance and behavioral economics and is known for her incredible creativity.

Here is the abstract of Malmendier's paper with Steven Nagel titled "Learning from Inflation Experiences":

How do individuals form expectations about future inflation? We propose that past inflation experiences are an important determinant absent from existing models. Individuals overweigh inflation rates experienced during their life-times so far, relative to other historical data on inflation. Differently from adaptive-learning models, experience-based learning implies that young individuals place more weight on recently experienced inflation than older individuals since recent experiences make up a larger part of their life-times so far. Averaged across cohorts, expectations resemble those obtained from constant-gain learning algorithms common in macroeconomics, but the speed of learning differs between cohorts.
Using 54 years of microdata on inflation expectations from the Reuters/Michigan Survey of Consumers, we show that differences in life-time experiences strongly predict differences in subjective inflation expectations. As implied by the model, young individuals place more weight on recently experienced inflation than older individuals. We find substantial disagreement between young and old individuals about future inflation rates in periods of high surprise inflation, such as the 1970s. The experience effect also helps to predict the time-series of forecast errors in the Reuters/Michigan survey and the Survey of Professional Forecasters, as well as the excess returns on nominal long-term bonds.

Malmendier and Nagel's paper over a time period covering several monetary policy regimes, which differ markedly from that of Japan. But a related paper by David Blanchflower and Conall Mac Coille focuses on the UK, which practices inflation targeting.  "The Formation of Inflation Expectations: an Empirical Analysis for the UK" (2009) includes a summary of why inflation expectations matter for monetary policy, and how this is relevant to inflation targeting: 

In the neo-Keynesian model (see, for example, Clarida et al. 2000), sticky prices result in forward looking behaviour; inflation today is a function of expected future inflation as well as the pressure of demand, captured in an output gap term. Thus, expectations are deemed to be an important link in the monetary transmission mechanism. Monetary policy can be more successful when long-term inflation expectations are well anchored. Hence, many studies have focused on the question of how to assess the response of inflation expectations to macroeconomic shocks, and whether this is likely to be lower in inflation targeting regimes. 

Blanchflower and Mac Coille also summarize three paths through which inflation expectations matter:

Wages are set on an infrequent basis, thus wage setters have to form a view on future inflation.  If inflation is expected to be persistently higher in the future, employees may seek higher nominal wages in order to maintain their purchasing power.  This in turn could lead to upward pressure on companies’ output prices, and hence higher consumer prices.  Additionally, if companies expect general inflation to be higher in the future, they may be more inclined to raise prices, believing that they can do so without suffering a drop in demand for their output.  A third path by which inflation expectations could potentially impact inflation is through their influence on consumption and investment decisions.  For a given path of nominal market interest rates, if households and companies expect higher inflation, this implies lower expected real interest rates, making spending more attractive relative to saving. 

In Japan, the third path may be most important. The higher inflation target is intended to lower real interest rates and boost consumption and investment. But there is a fourth reason, not listed by Blanchflower and Mac Coille, of particular relevance to Japan. Foreigners' expectations of future inflation affect the value of the currency. the Japanese Ministry of Finance recently revealed a 222.4 billion yen ($2.5 billion) current account deficit-- a measure of how much imports exceed exports. When people expect Japanese inflation to be higher in the future, the yen gets less valuable now, because it won't be able to buy as much stuff later; the yen weakens. But in this case, weakness is not necessarily bad. A weaker yen means that Japanese people will find it more expensive to import stuff, so they will import less. Likewise, people outside of Japan will find it cheaper to buy Japanese stuff, so Japan will export more. This helps shrink the current account deficit. And depending on the sizes of the income and substitution effects, Japanese consumers may buy more Japanese products.

Under inflation targeting in the UK, even though inflation expectations are reasonably well anchored, and median expectations are around the inflation target, there is substantial heterogeneity across agents in their inflation expectations. Malmendier and Nagel's paper provides a behavioral theory to explain part of this heterogeneity based on agents' heterogeneous past experiences of inflation. Heterogeneous inflation expectations have the potential to affect the workings of all the paths through which inflation expectations matter. We need to understand not only how Japan's inflation target will influence median inflation expectations, but also how it will affect expectations of price setters, wage setters, borrowers, savers, exporters, trade partners, etc. More than likely, these groups differ significantly in their demographics, have had different experiences, and thus form different expectations of inflation. (For reference, the graph below displays Japanese inflation, interest rates, real GDP per capita growth rate, and M2 growth rate. Japan has not seen 2% inflation since 1997.) Extensions of Malmendier's research to other countries and monetary regimes will be very useful in understanding the effects of monetary policy.