Yes, this has nothing to do with economics. It's just cool.
Saturday, May 25, 2013
Anaphylaxis
My daughter Sally is at the Grand Central Academy of Art in New York. This is one of her still lives (yes, it's a painting). See if you can figure out what it means. Then click on the figure for an explanation. Don't miss "ceci n’est pas une molécule d’histamine."
Yes, this has nothing to do with economics. It's just cool.
Yes, this has nothing to do with economics. It's just cool.
Thursday, May 23, 2013
The Fed and Shadow Banking
The WSJ has a fascinating Op-Ed by Andy Kessler, "The Fed Squeezes the Shadow-Banking System" Andy thinks that Quantiative Easing has the opposite, contractionary effect.
QE is just a huge open market operation. The Fed buys Treasury securities and issues bank reserves instead. Why does this do anything? Why isn't this like trading some red M&Ms for some green M&Ms and expecting it to affect your weight? (M&M of course stands for "Modigliani Miller" if you didn't get the joke.)
The usual thinking is that bank reserves are "special." They are connected to GDP in a way that Treasuries are not. In the conventional monetary view, MV = PY. Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.
In Andy's view (my interpretation), that is turned around now. Now, Treasuries supply more "liquidity" needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.
Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don't do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don't make a difference to anything. More treasuries, according to Andy, we can do something with.
More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can't push on a string, as the saying goes. Much "constraint" economics forgets that once the constraint is off, the relationship doesn't hold any more.
Andy describes the repo market and the sense in which Treasuries are "special" in providing low-haircut collateral. Lots of academic research is now viewing Treasuries as special or liquidity-providing in the shadow banking system.
So, this is at least a gorgeous possibility: In a frictionless world, open-market operations, buying one kind of government debt (Treasuries) and issuing another (reserves) have zero effect on anything, by the M&M theorem. Monetary economics thinks the M&M theorem is violated, because one kind of government debt (M) is connected to nominal GDP and the other is not.
But financial systems change. When the textbooks were written, banks mattered a lot, so bank reserves, leveraged to loans and checking accounts, were the "special" asset. In today's market, and given today's glut of reserves, Treasuries, leveraged to mortgage backed securities and money market funds through the repo market and "shadow banking system," might be the "special" asset connected to nominal GDP. In that case, the effects of open market operations might have the opposite sign. As Andy says,
You repo a security so that you can borrow against it. For example, you might buy a mortgage-backed security, then leave (repo, really) that security as collateral for a loan, which you used to buy the security in the first place. But what sense does it make to repo-finance a Treasury? You can't borrow at lower interest rate to make money on a Treasury! You could, possibly, if it's a long term Treasury and you're borrowing short, betting that interest rates don't rise. But I would think an interest rate swap or future would be a cheaper way to make that bet, and anyway betting on the slope of Treasury yield curve doesn't add up to the necessary GDP-linked lending that Andy has in mind.
In short, if you have money to buy a Treasury, why do you need to borrow? For any of this to get off the ground, you have to have some other, not totally rational, reason for buying the Treasury, and then you want to borrow against the Treasury so you can buy the risky asset that you really wanted all along. Who is that? Why is this such a necessary part of our financial system? Can't we fix things so they just buy the MBS with their initial cash?
Andy points out that repos are re-hypothecated. You use your Treasury as collateral against a loan, then the guy you gave it to uses it again as collateral to get the money to give to you. So one Treasury is used as collateral against two or three loans. Hmm. As the money multiplier creates run-prone structures, so using the same thing as collateral two or three times is a lot of what makes banks "too big to fail." If we all go down, who has the collateral?
A system awash in all kinds of liquidity, following the Freidman optimal quantity of money, seems a lot safer to me. I'd rather we expand the "bank reserve" concept -- fixed-value, floating-rate, electronically-transferable Treasury debt, and lots of it, washing the shadow banking system in liquidity and putting the run-prone structures out of business. Of course, open market operations would then have no effect in my world either, as I have removed the liquidity constraint in the shadow banking system just as Mr. Bernanke has removed it in the conventional banking system. But violations of M&M always mean the system can be made better.
If you want to comment and explain shadow banking, please use little words that the rest of us can understand.
QE is just a huge open market operation. The Fed buys Treasury securities and issues bank reserves instead. Why does this do anything? Why isn't this like trading some red M&Ms for some green M&Ms and expecting it to affect your weight? (M&M of course stands for "Modigliani Miller" if you didn't get the joke.)
The usual thinking is that bank reserves are "special." They are connected to GDP in a way that Treasuries are not. In the conventional monetary view, MV = PY. Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.
In Andy's view (my interpretation), that is turned around now. Now, Treasuries supply more "liquidity" needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.
Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don't do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don't make a difference to anything. More treasuries, according to Andy, we can do something with.
More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can't push on a string, as the saying goes. Much "constraint" economics forgets that once the constraint is off, the relationship doesn't hold any more.
Andy describes the repo market and the sense in which Treasuries are "special" in providing low-haircut collateral. Lots of academic research is now viewing Treasuries as special or liquidity-providing in the shadow banking system.
So, this is at least a gorgeous possibility: In a frictionless world, open-market operations, buying one kind of government debt (Treasuries) and issuing another (reserves) have zero effect on anything, by the M&M theorem. Monetary economics thinks the M&M theorem is violated, because one kind of government debt (M) is connected to nominal GDP and the other is not.
But financial systems change. When the textbooks were written, banks mattered a lot, so bank reserves, leveraged to loans and checking accounts, were the "special" asset. In today's market, and given today's glut of reserves, Treasuries, leveraged to mortgage backed securities and money market funds through the repo market and "shadow banking system," might be the "special" asset connected to nominal GDP. In that case, the effects of open market operations might have the opposite sign. As Andy says,
... the Federal Reserve's policy—to stimulate lending and the economy by buying Treasurys..—is creating a shortage of safe collateral, the very thing needed to create credit in the shadow banking system for the private economy. The quantitative easing policy appears self-defeating, perversely keeping economic growth slower and jobs scarcer.I'm not totally convinced, though this story and the alleged enormous demand for Treasuries is being bandied around as established fact. I'm also not convinced that this is all a good idea. Maybe the Fed should starve the shadow banking system.
You repo a security so that you can borrow against it. For example, you might buy a mortgage-backed security, then leave (repo, really) that security as collateral for a loan, which you used to buy the security in the first place. But what sense does it make to repo-finance a Treasury? You can't borrow at lower interest rate to make money on a Treasury! You could, possibly, if it's a long term Treasury and you're borrowing short, betting that interest rates don't rise. But I would think an interest rate swap or future would be a cheaper way to make that bet, and anyway betting on the slope of Treasury yield curve doesn't add up to the necessary GDP-linked lending that Andy has in mind.
In short, if you have money to buy a Treasury, why do you need to borrow? For any of this to get off the ground, you have to have some other, not totally rational, reason for buying the Treasury, and then you want to borrow against the Treasury so you can buy the risky asset that you really wanted all along. Who is that? Why is this such a necessary part of our financial system? Can't we fix things so they just buy the MBS with their initial cash?
Andy points out that repos are re-hypothecated. You use your Treasury as collateral against a loan, then the guy you gave it to uses it again as collateral to get the money to give to you. So one Treasury is used as collateral against two or three loans. Hmm. As the money multiplier creates run-prone structures, so using the same thing as collateral two or three times is a lot of what makes banks "too big to fail." If we all go down, who has the collateral?
A system awash in all kinds of liquidity, following the Freidman optimal quantity of money, seems a lot safer to me. I'd rather we expand the "bank reserve" concept -- fixed-value, floating-rate, electronically-transferable Treasury debt, and lots of it, washing the shadow banking system in liquidity and putting the run-prone structures out of business. Of course, open market operations would then have no effect in my world either, as I have removed the liquidity constraint in the shadow banking system just as Mr. Bernanke has removed it in the conventional banking system. But violations of M&M always mean the system can be made better.
If you want to comment and explain shadow banking, please use little words that the rest of us can understand.
Wednesday, May 22, 2013
Epstein on the IRS and more
Richard Epstein has a lovely essay, "The Real Lesson of the IRS Scandal" As lots of commentators left and right are realizing, this kind of outcome is baked in to our regulatory system. A small excerpt:
I think the point is larger still. The ACA (Obamacare) under Health and Human Services and financial regulation under the Dodd-Frank act are even more stark instances of the phenomenon. The regulations are immense, vague, contradictory, and demand discretionary approval by regulators. For a company to speak out against those acts is very dangerous.
India's sclerosis was once described as the "permit raj." That describes our future well.
But at least Americans are still outraged at this sort of thing. At least, unlike most other over-regulated countries, regulatory discretion is still traded for political support, not suitcases full of cash. However, what Epstein makes clear is, a witch-hunt at the IRS won't solve the problem.
The larger answer here seems pretty clear to me too. Why do we have tax-exempt status for any political groups? Actually, why do we have tax-exempt status for any groups at all? It's easy to be a non-profit -- just don't make any money. When you look at what a lot of "non-profits" do, how efficiently their money is used, the idea that we should be subsidizing most of them seems pretty silly. If we chucked out the whole tax-exempt business entirely, and allowed people to give money to any group they feel like giving it to without tax preference one way or another, the whole temptation for the IRS to hand out this subsidy in nefarious ways would vanish.
The dismal performance of the IRS is but a symptom of a much larger disease which has taken root in the charters of many of the major administrative agencies in the United States today: the permit power. Private individuals are not allowed to engage in certain activities or to claim certain benefits without the approval of some major government agency. The standards for approval are nebulous at best, which makes it hard for any outside reviewer to overturn the agency’s decision on a particular application.Richard goes on to skewer the FCC, the EPA, and the FDA. The fight over approval of liquid natural gas exports, which Richard doesn't mention is a perfect example.
That power also gives the agency discretion to drag out its review, since few individuals or groups are foolhardy enough to jump the gun and set up shop without obtaining the necessary approvals first. It takes literally a few minutes for a skilled government administrator to demand information that costs millions of dollars to collect and that can tie up a project for years. That delay becomes even longer for projects that need approval from multiple agencies at the federal or state level, or both.
The beauty of all of this (for the government) is that there is no effective legal remedy. Any lawsuit that protests the improper government delay only delays the matter more. Worse still, it also invites that agency (and other agencies with which it has good relations) to slow down the clock on any other applications that the same party brings to the table. Faced with this unappetizing scenario, most sophisticated applicants prefer quiet diplomacy to frontal assault, especially if their solid connections or campaign contributions might expedite the application process. Every eager applicant may also be stymied by astute competitors intent on slowing the approval process down, in order to protect their own financial profits. So more quiet diplomacy leads to further social waste.
I think the point is larger still. The ACA (Obamacare) under Health and Human Services and financial regulation under the Dodd-Frank act are even more stark instances of the phenomenon. The regulations are immense, vague, contradictory, and demand discretionary approval by regulators. For a company to speak out against those acts is very dangerous.
India's sclerosis was once described as the "permit raj." That describes our future well.
But at least Americans are still outraged at this sort of thing. At least, unlike most other over-regulated countries, regulatory discretion is still traded for political support, not suitcases full of cash. However, what Epstein makes clear is, a witch-hunt at the IRS won't solve the problem.
The larger answer here seems pretty clear to me too. Why do we have tax-exempt status for any political groups? Actually, why do we have tax-exempt status for any groups at all? It's easy to be a non-profit -- just don't make any money. When you look at what a lot of "non-profits" do, how efficiently their money is used, the idea that we should be subsidizing most of them seems pretty silly. If we chucked out the whole tax-exempt business entirely, and allowed people to give money to any group they feel like giving it to without tax preference one way or another, the whole temptation for the IRS to hand out this subsidy in nefarious ways would vanish.
Local Austerity
The Wall Street Journal had a really heart-warming article, Europe's Recession Sparks Grass-Roots Political Push about groups taking over local governments in southern Europe, and cleaning out years of mismanagement. An excerpt
At her inauguration Ms. Biurrun [the new mayor of Torroledones, Spain] choked up before a jubilant crowd.Great, no?
Then she began slashing away. She lowered the mayor's salary by 21%, to €49,500 a year, trimmed council members' salaries and eliminated four paid advisory positions.
She got rid of the police escort and the leased car, and gave the chauffeur a different job. She returned a carpet, emblazoned with the town seal, that had cost nearly €300 a month to clean. She ordered council members to pay for their own meals at work events instead of billing the town.
"I was so indignant seeing what these people had been doing with everyone's money as if it were their own," Ms. Biurrun said.
Those cuts, combined with savings achieved by renegotiating contracts for garbage pickup and other services, helped give a million-euro boost to the city treasury in her first year in office.
But wait, isn't this all "austerity?" Isn't cutting spending exactly the kind of thing that Keynesian macroeconomists, as well as the reigning IMF-style policy consensus decries, saying we need stimulus now, austerity later?
Keynesian, and especially new-Keynesian economics wants more government spending, even if completely wasted. Those trimmed salaries, fired "advisers," cleaning bills, restaurant spending, overpaid contracts are, in the standard mindset, all crucial for "demand" and goosing GDP. If stimulus advocates were at all honest, they would be writing blog posts decrying Ms. Birrun and her kind.
Of course they don't. Abstract "spending" sounds good, and touting abstract "topsy-turvy" model predictions sounds fine. But when it is concrete, it's so patently absurd that you don't hear it.
The Greek city of Thessaloniki cut costs after Yannis Boutaris, a businessman-turned-politician, took office in late 2010 and ended City Hall's relationship with a few selected providers. Competitive bidding has saved the city 80% of its previous spending on accounting, 25% on waste disposal trucks and 20% on printer paper. The savings have allowed Mr. Boutaris to spend more on social services, even while cutting taxes and paying down City Hall's debt to suppliers.How sad. So much "demand"-destroying "austerity."
(Of course, the main point of the articles is about a political realignment, in which local governments are becoming responsive to local voters, transparent, and efficient, rather than being cronyist machines of national political parties. I can't imagine anyone not feeling warm about that!)
Update: Courtesy Marginal Revolution, I found this nice story about the new Spanish $680 million submarine that will sink if put in water. MR snarkily asks "did this help Spain or hurt Spain." $680 million of government spending raises Spanish GDP by nearly $1 billion, so this is great, right?
Saturday, May 18, 2013
The Role of Monetary Policy, Revisited
I am giving a talk Thursday May 30, titled "The Role of Monetary Policy, Revisited." The event is at Booth's Gleacher Center in downtown Chicago, reception 4:30 and talk 5:15. It's part of a series of talks sponsored by the Becker-Friedman Institute.
The talk is based on an essay I'm working on, and will be presenting at a few central banks this summer. Once per generation we re-think what central banks do, can't do, should do, and shouldn't do. Milton Friedman's famous 1968 address marked the last big transition. I think, we are in a similar moment. I will look at the big picture in the same spirit. I'm aiming at a serious talk, grounded in academic research, but accessible.
Blog followers, students, colleagues, friends, and even glider pilots are most welcome. Please rsvp so they know how many people to plan for.
The event announcement invitation and rsvp links are here on the BFI webpage
There is also an event announcement and rsvp link on the Booth Alumni events webpage here.
The talk is based on an essay I'm working on, and will be presenting at a few central banks this summer. Once per generation we re-think what central banks do, can't do, should do, and shouldn't do. Milton Friedman's famous 1968 address marked the last big transition. I think, we are in a similar moment. I will look at the big picture in the same spirit. I'm aiming at a serious talk, grounded in academic research, but accessible.
Blog followers, students, colleagues, friends, and even glider pilots are most welcome. Please rsvp so they know how many people to plan for.
The event announcement invitation and rsvp links are here on the BFI webpage
There is also an event announcement and rsvp link on the Booth Alumni events webpage here.
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Friday, May 17, 2013
More Interest-Rate Graphs
For a talk I gave a week or so ago, I made some more interest-rate graphs. This extends the last post on the subject. It also might be useful if you're teaching forward rates and expectations hypothesis.
The question: Are interest rates going up or down, especially long term rates? Investors obviously care, they want to know whether they should put money in long term bonds vs. short term bonds. As one who worries about debt and inflation, I'm also sensitive to the criticism that market rates are very low, forecasting apparently low rates for a long time. Yes, markets never see bad times coming, and markets 3 years ago got it way wrong thinking rates would be much higher than they are today (see last post) but still, markets don't seem to worry.
But rather than talk, let's look at the numbers. I start with the forward curve. The forward rate is the "market expectation" of interest rates, in that it is the rate you can contract today to borrow in the future. If you know better than the forward rate, you can make a lot of money.
Here, I unite the recent history of interest rates together with forecasts made from today's forward curve. The one year rate (red) is just today's forward curve. I find the longer rates as the average of the forward curves on those dates. Today's forward curve is the market forceast of the future forward curve too, so to find the forecast 5 year bond yield in 2020, I take the average of today's forward rates for 2020, 2021,..2024.
I found it rather surprising just how much, and how fast, markets still think interest rates will rise. (Or, perhaps, how large the risk premium is. If you know enough to ask about Q measure or P measure, you know enough to answer your own question.)
How can the forecast rise faster than the actual long term yields? Well, remember that long yields are the average of expected future short rates, and if short rates are below today's 10 year rate for 5 years, then they must be above today's 10 year rate for another 5 years. So, it's a misconception to read from today's 2% 10 year rate that markets expect interest rates to be 2% in the future. Markets expect a rise to 4% within 10 years.
The forward curve has the nice property that if interest rates follow this forecast, then returns on bonds of all maturities are always exactly the same. The higher yields of long-term bonds exactly compensate for the price declines when interest rates rise. I graphed returns on bonds of different maturities here to make that point.
So, Mr. Bond speculator, if you believe the forecast in the first graph, it makes absolutely no difference whether you buy long or short. Otherwise, decide whether you think rates will rise faster or slower than the forward curve.
Now, let's think about other scenarios. One possibility is Japan. Interest rates get stuck at zero for a decade. This would come with sclerotic growth, low inflation, and a massive increase in debt, as it has in Japan. Eventually that debt is unsustainable, but as Japan shows, it can go on quite a long time. What might that look like?
Here is a "Japan scenario." I set the one year rate to zero forever. I only changed the level of the market forecast, however, not the slope. Thus, to form the expected forward curve in 2020, I shifted today's forward curve downwards so that the 2020 rate is zero, but other rates rise above that just as they do now.
This scenario is another boon to long term bond holders. They already got two big presents. Notice the two upward camel-humps in long term rates -- those were foreasts of rate risks that didn't work out, and people who bought long term bonds made money.
In a Japan scenario that happens again. Holders of long-term government bonds rejoice at their 2% yields. They get quite nice returns, shown left, as rates fail to rise as expected and the price of their bonds rises. Until the debt bomb explodes.
OK, what if things go the other way? What would an unexpectedly large rise in interest rates look like?
For example Feburary 1994 looked a lot like today, and then rates all of a sudden jumped up when the Fed started tightening.
To generate a 1994 style scenario from today's yields, I did the opposite of the Japan scenario. I took today's forward curve and added 1%, 2%, 3% and 4% to the one-year rate forecast. As with the Japan scenario, I shifted the whole forward curve up on those dates. We'll play with forward steepness in a moment.
Here are cumulative returns from the 1994 scenario. Long term bonds take a beating, of course. Returns all gradually rise, as interest rates rise. (These are returns to strategies that keep a constant maturity, i.e. buy a 10 year bond, sell it next year as a 9 year bond, buy a new 10 year bond, etc)
These have been fun, but I've only changed the level of the forward curve forecast, not the slope. Implicitly, I've gone along with the idea that the Fed controls everything about interest rates. If you worry, as I do, you worry that long rates can go up all on their own. Japan's 10 year rate has been doing this lately. When markets lose faith, long rates rise. Central bankers see "confidence" or "speculators" or "bubbles" or "conundrums." What does that look like?
To generate a "steepening" scenario, I imagined that markets one year from now decide that interest rates in 2017 will spike up 5 percentage points. This may be a "fear" not an "expectation," i.e. a rise in risk premium.
Then, the 5 and 10 year rates rise immediately, even though the Fed (red line) didn't do anything to the one-year rate. The bond market vigilantes stage a strike on long term debt.
Here are the consequences for cumulative returns of my steepening scenario. The long term bonds are hit much more than the shorter term bonds. This really is a bloodbath for 10 year and higher investors, leaving those under 5 years much less hurt.
So what will happen? I don't know, I don't make forecasts. But I do think it's useful to generate some vaguely coherent scenarios. The forward curve is not a rock solid this is what will happen forecast. The forward curve adds up all of these possiblities, with probabilities assigned to each, plus risk premium. There is a lot of uncertainty, and good portfolio formation starts with risk management not chasing alpha.
The question: Are interest rates going up or down, especially long term rates? Investors obviously care, they want to know whether they should put money in long term bonds vs. short term bonds. As one who worries about debt and inflation, I'm also sensitive to the criticism that market rates are very low, forecasting apparently low rates for a long time. Yes, markets never see bad times coming, and markets 3 years ago got it way wrong thinking rates would be much higher than they are today (see last post) but still, markets don't seem to worry.
But rather than talk, let's look at the numbers. I start with the forward curve. The forward rate is the "market expectation" of interest rates, in that it is the rate you can contract today to borrow in the future. If you know better than the forward rate, you can make a lot of money.
Here, I unite the recent history of interest rates together with forecasts made from today's forward curve. The one year rate (red) is just today's forward curve. I find the longer rates as the average of the forward curves on those dates. Today's forward curve is the market forceast of the future forward curve too, so to find the forecast 5 year bond yield in 2020, I take the average of today's forward rates for 2020, 2021,..2024.
I found it rather surprising just how much, and how fast, markets still think interest rates will rise. (Or, perhaps, how large the risk premium is. If you know enough to ask about Q measure or P measure, you know enough to answer your own question.)
How can the forecast rise faster than the actual long term yields? Well, remember that long yields are the average of expected future short rates, and if short rates are below today's 10 year rate for 5 years, then they must be above today's 10 year rate for another 5 years. So, it's a misconception to read from today's 2% 10 year rate that markets expect interest rates to be 2% in the future. Markets expect a rise to 4% within 10 years.
The forward curve has the nice property that if interest rates follow this forecast, then returns on bonds of all maturities are always exactly the same. The higher yields of long-term bonds exactly compensate for the price declines when interest rates rise. I graphed returns on bonds of different maturities here to make that point.So, Mr. Bond speculator, if you believe the forecast in the first graph, it makes absolutely no difference whether you buy long or short. Otherwise, decide whether you think rates will rise faster or slower than the forward curve.
Now, let's think about other scenarios. One possibility is Japan. Interest rates get stuck at zero for a decade. This would come with sclerotic growth, low inflation, and a massive increase in debt, as it has in Japan. Eventually that debt is unsustainable, but as Japan shows, it can go on quite a long time. What might that look like?
This scenario is another boon to long term bond holders. They already got two big presents. Notice the two upward camel-humps in long term rates -- those were foreasts of rate risks that didn't work out, and people who bought long term bonds made money.
OK, what if things go the other way? What would an unexpectedly large rise in interest rates look like?
For example Feburary 1994 looked a lot like today, and then rates all of a sudden jumped up when the Fed started tightening.
To generate a 1994 style scenario from today's yields, I did the opposite of the Japan scenario. I took today's forward curve and added 1%, 2%, 3% and 4% to the one-year rate forecast. As with the Japan scenario, I shifted the whole forward curve up on those dates. We'll play with forward steepness in a moment.
These have been fun, but I've only changed the level of the forward curve forecast, not the slope. Implicitly, I've gone along with the idea that the Fed controls everything about interest rates. If you worry, as I do, you worry that long rates can go up all on their own. Japan's 10 year rate has been doing this lately. When markets lose faith, long rates rise. Central bankers see "confidence" or "speculators" or "bubbles" or "conundrums." What does that look like?
To generate a "steepening" scenario, I imagined that markets one year from now decide that interest rates in 2017 will spike up 5 percentage points. This may be a "fear" not an "expectation," i.e. a rise in risk premium.
Then, the 5 and 10 year rates rise immediately, even though the Fed (red line) didn't do anything to the one-year rate. The bond market vigilantes stage a strike on long term debt.
Here are the consequences for cumulative returns of my steepening scenario. The long term bonds are hit much more than the shorter term bonds. This really is a bloodbath for 10 year and higher investors, leaving those under 5 years much less hurt.
So what will happen? I don't know, I don't make forecasts. But I do think it's useful to generate some vaguely coherent scenarios. The forward curve is not a rock solid this is what will happen forecast. The forward curve adds up all of these possiblities, with probabilities assigned to each, plus risk premium. There is a lot of uncertainty, and good portfolio formation starts with risk management not chasing alpha.
Doctor-owned hospitals
In writing about the ACA and our health-care problems, I started to think more and more about supply restrictions. In every other industry, costs come down when new suppliers come in and compete. Yet our health-care system is full of restrictions and protections to keep new suppliers out, and competition down. Then we wonder why hospitals won't tell you how much care will cost, and send you bills with $100 band aids on them.
In that context, I was interested to learn this week about the ACA's limits on expansion of doctor-owned hospitals. The Wall Street Journal article is here, and I found interesting coverage in American Medical News. The text and analysis of the amazing section 6001 of the ACA is here
In astouding (to me) news, the ACA prohibits doctor-owned hospitals from expanding, and prevents new doctor-owned hospitals at all, if they are going to serve Medicare or Medicaid patients. From WSJ
As a reader of this blog might expect, for-profit institutions, run by crucial employees, are run efficiently, make money and serve their customers
In related news, what's with the crazy hospital bills which nobody pays? A New York Times article has two tidbits.
In that context, I was interested to learn this week about the ACA's limits on expansion of doctor-owned hospitals. The Wall Street Journal article is here, and I found interesting coverage in American Medical News. The text and analysis of the amazing section 6001 of the ACA is here
In astouding (to me) news, the ACA prohibits doctor-owned hospitals from expanding, and prevents new doctor-owned hospitals at all, if they are going to serve Medicare or Medicaid patients. From WSJ
The Affordable Care Act aimed to end a boom in doctor-owned hospitals, a highly profitable niche known for its luxury facilities. Instead, many of the hospitals are wiggling around the federal health-care law's growth caps and even thriving.Only in medicine is "highly profitable niche known for its luxury facilities" a bad thing. Didn't the left like employee-owned companies, worker cooperatives and all that? And when is getting around silly restrictions "wiggling?" Et tu, WSJ?
The law, passed in 2010, blocked building any new physician-owned hospitals and prevented existing ones from adding beds or operating rooms in order to qualify for Medicare paymentsNow, let's see if it takes you more than 10 seconds to figure out the unintended consequences of this brilliant idea. Don't peek...
...to grow without running afoul of the rules, some of the country's roughly 275 doctor-owned hospitals are expanding their operating hours, increasing procedures in ways not restricted by the law and rejecting patients on Medicare...Then, some try to give up and do what the government wants....
"they are scheduling operations later and on weekends, instead of 7 a.m. to 5 p.m." North Cypress Medical Center outside Houston is building up practice areas, such as same-day surgeries, that don't require admitting patients overnight... Forest Park Medical Center in Dallas has stopped accepting Medicare patients, allowing it to escape the law's restrictions entirely.
The Surgical Institute of Reading in Pennsylvania tried to sell itself to a local community hospital. "We couldn't expand, but we thought a partnership would allow us to continue our practice," said its board chairman, Charles Lutz.Let's see, reorganizing so you are allowed to expand decreases competition? You just can't make this stuff up.
But the Federal Trade Commission blocked the merger, saying the sale would decrease competition and could lead to higher costs for patients and the government.
As a reader of this blog might expect, for-profit institutions, run by crucial employees, are run efficiently, make money and serve their customers
...many physician-owned hospitals have enjoyed 20% to 35% profit margins in recent years. U.S. community hospitals' profits hovered around 7% in 2010... new Medicare measurements showing that doctor-owned hospitals represent about half of the top 100 facilities whose performance will merit bonus Medicare reimbursements because of their cost efficiency and patient satisfaction.They even provide a
"5-star atmosphere" and a gourmet restaurant with a wine list and cigarsFrom American Medical news,
When the federal government sorted through the first round of clinical information it was using to reward hospitals for providing higher-quality care in December 2012, the No. 1 hospital on the list was physician-owned Treasure Valley Hospital in Boise, Idaho. Nine of the top 10 performing hospitals were physician-owned, as were 48 of the top 100.So why in the world does the government want to restrict them? WSJ:
But any effort to undo the expansion limits faces an uphill battle with Democrats, because the restrictions were a deal-breaker for hospitals when the White House sought their support for the law in 2009, industry lobbyists say.and AMN:
The American Hospital Assn. and the Federation of American Hospitals continue to back that section of the ACA. Several key lawmakers, including Senate Finance Committee Chair Max Baucus (D, Mont.) and panel member Chuck Grassley (R, Iowa), are in strong support of community hospitals in the debate.Aha. In return for political support for the ACA the major hospitals put in this blatant supply restriction against efficient competitors. And we wonder why health care is so expensive.
In related news, what's with the crazy hospital bills which nobody pays? A New York Times article has two tidbits.
Until a recent ruling by the Internal Revenue Service, ... a hospital could use the higher prices when calculating the amount of charity care it was providing, said Gerard Anderson, director of the Center for Hospital Finance and Management at Johns Hopkins. “There is a method to the madness, though it is still madness,” Mr. Anderson said.Aha. Quote $100 for a band-aid, and when the patient doesn't pay it, write it off as a tax loss. The next one is really clever.
To make money from Bayonne Medical, the new buyers made some big changes in the hospital’s business strategy.Really, does nobody every think for a minute, "Hmm, if we pass this law, what awful unintended consequences will it have?"
First, they converted Bayonne Medical from a nonprofit to a for-profit hospital...Next, they moved to sever existing contracts with large private insurers, essentially making Bayonne Medical an out-of-network hospital for most insurance plans.
Under New Jersey law, patients treated in a hospital emergency room outside their provider’s network have to pay out of pocket only what they would have paid if the hospital was in the network. But an out-of-network hospital can bill the patient’s insurer at essentially whatever rate it cares to set....
In recent years, Bayonne Medical put up digital billboards highlighting the short waits in its emergency rooms in an effort to attract more patients....
While the law was aimed at giving patients more hospitals to choose from, it “has had the unintended consequence of rewarding folks for these inflated charges,” said Wardell Sanders, president of the New Jersey Association of Health Plans...
Community leaders in Bayonne...said the buyers were always candid about the methods they intended to use to make the hospital a profitable enterprise.
FL Court Rules Statute of Limitations Apply in Arbitration
We finally have a ruling on the questionable argument that is often advanced that the statute of limitations does not apply in arbitration. The argument is premised on a contorted interpretation of a Florida statute and requires one to believe that an arbitration proceeding is not a "civil action or proceeding." Unfortunately, a lower court agreed with this argument, and ruled that the statute of limitations did not apply when a dispute was brought in arbitration, rather than court. The Florida Supreme Court reversed.
Every so often a claimant attempts to convince an arbitration panel that the statute of limitations does not apply to their claims. For better or worse, every type of legal claim has a statute of limitations. The Florida statute adopting limitation periods uses the phrase "civil action or proceeding." In an attempt to avoid the limitations period, some attorneys have argued that an arbitration is not a "civil action or proceeding." The argument continues to the illogical conclusion, that there is no statute of limitations for a claim that is brought in arbitration, and the only restriction is whether or not an arbitration forum will process an old claim.
Fortunately, the language used in the Florida statute is not used by a significant number of states, and in those states the door is not open to such wordsmithing. That door is also now shut in Florida, and we can expect it to be shut in other states where similar language is used.
The Florida Supreme Court put an end to this, and ruled that Florida's statute of limitations apply not only to court proceedings, but to securities arbitration cases between investors and their brokers. The ruling resolves this dispute and forces investors to file their claims in a timely fashion like everyone else.
While some in the press are calling this a significant blow to investors, this is nothing more than a court enforcing the law. Very few states use the phrasing that is used in the Florida statute, and this is not a significant change in arbitration practice.
The simple fact is, you need to pay attention to the statute of limitations, whether you are in court, or in arbitration.
The attorneys at Sallah Astarita & Cox have represented parties in hundreds of arbitrations in over 20 states. For more information regarding our securities arbitration representation, contact us by email or visit our website at www.sallahlaw.com. For more information on this case, visit
Florida court rules state time limits apply to securities arbitration
Every so often a claimant attempts to convince an arbitration panel that the statute of limitations does not apply to their claims. For better or worse, every type of legal claim has a statute of limitations. The Florida statute adopting limitation periods uses the phrase "civil action or proceeding." In an attempt to avoid the limitations period, some attorneys have argued that an arbitration is not a "civil action or proceeding." The argument continues to the illogical conclusion, that there is no statute of limitations for a claim that is brought in arbitration, and the only restriction is whether or not an arbitration forum will process an old claim.
Fortunately, the language used in the Florida statute is not used by a significant number of states, and in those states the door is not open to such wordsmithing. That door is also now shut in Florida, and we can expect it to be shut in other states where similar language is used.
The Florida Supreme Court put an end to this, and ruled that Florida's statute of limitations apply not only to court proceedings, but to securities arbitration cases between investors and their brokers. The ruling resolves this dispute and forces investors to file their claims in a timely fashion like everyone else.
While some in the press are calling this a significant blow to investors, this is nothing more than a court enforcing the law. Very few states use the phrasing that is used in the Florida statute, and this is not a significant change in arbitration practice.
The simple fact is, you need to pay attention to the statute of limitations, whether you are in court, or in arbitration.
The attorneys at Sallah Astarita & Cox have represented parties in hundreds of arbitrations in over 20 states. For more information regarding our securities arbitration representation, contact us by email or visit our website at www.sallahlaw.com. For more information on this case, visit
Florida court rules state time limits apply to securities arbitration
Tuesday, May 14, 2013
SEC, FINRA Issue Investor Alert On Pension or Settlement Income Streams
The SEC and FINRA issued an investor alert entitled Pension or Settlement Income Streams – What You Need to Know Before Buying or Selling Them. The investor alert informs investors about the risks involved when selling their rights to an income stream or investing in someone else’s income stream.
The alert urges investors considering an investment in pension or settlement income streams to proceed with caution. Anyone receiving a monthly pension or regular distributions from a settlement following a personal injury lawsuit may be targeted by salespeople offering an immediate lump sum in exchange for the rights to some or all of the payments the person would otherwise receive in future.
ypically, recipients of a pension or structured settlement will sign over the rights to some or all of their monthly payments to a factoring company in return for a lump-sum amount, which will almost always be significantly lower than the present value of that future income stream.
“Investors should always learn as much as possible before making an investment decision, and this is certainly true with respect to investing in pension or structured settlement income stream products,” said Lori J. Schock, Director of the SEC’s Office of Investor Education and Advocacy. “This alert will help investors understand the costs as well as the potentially significant risks of these transactions.”
Thursday, May 9, 2013
Solar Panel Tariffs
It's time to start a new series on "energy idiocy." You just can't make this stuff up... From today's WSJ:
The US doesn't get to indulge in any Europe bashing here,
Of course it was a bit of a miracle that prices came down in the first place. Usually, subsidizing and protecting an industry in the idea that just making it bigger makes it cheaper leads to large inefficient industries. The correlation between big and cheap comes from competition. Hence revealing that it was the Chinese who figured out how to exploit European subsidies and actually make panels cheaper.
If you have any remaining thought that concern for the environment motivates any of this mania, reading between the lines of the rest of the story will put that to rest:
If we want to subsidize solar panel production (debateable, but "if") for environmental reasons, and if China decides to tax their citizens to provide the subsidies rather than us tax our citizens, the appropriate response is flowers, chocolates, and a nice thank-you card.
Update: Donald Boudreaux at Cafe Hayek did a much better job.
*Update: A reader catches me with possibly out-of-date facts. I'll leave his comment here and postpone getting in to a sidetrack about corn ethanol. I'll look in to it, as it seems a good topic for another "energy idiocy" post at some point.
BRUSSELS—Chinese solar-panel manufacturers will face import tariffs of up to 67.9% at European Union borders under a plan from the 27-nation bloc's executive body...Europe, like the US, subsidizes the installation of solar panels. So, we subsidize things to make the prices to consumers go down and encourage the industry. Then when the industry is encouraged and prices do go down, we pass tariffs to make prices go up. This is almost as fun as oil, which we subsidize to make prices go down, then pass regulations to try to stop people from using it.
The US doesn't get to indulge in any Europe bashing here,
The U.S. has already placed tariffs on solar-panel imports from China.We also subsidize ethanol, but only from midwestern corn. We have tariffs against ethanol from Brazilian sugar cane, which is a whole lot better environmentally (is a lot less closer to using 1 btu of petroleum to produce 1 btu of ethanol, wash away topsoil and fertilizers down the Mississippi, drive up corn prices)* but seems not to show up at the Iowa caucuses.
Of course it was a bit of a miracle that prices came down in the first place. Usually, subsidizing and protecting an industry in the idea that just making it bigger makes it cheaper leads to large inefficient industries. The correlation between big and cheap comes from competition. Hence revealing that it was the Chinese who figured out how to exploit European subsidies and actually make panels cheaper.
If you have any remaining thought that concern for the environment motivates any of this mania, reading between the lines of the rest of the story will put that to rest:
Suntech Power Holdings ..and its subsidiaries will face tariffs of 48.6%, according to the document. Tariffs on LDK Solar ... will be 55.9%, and tariffs on Trina Solar Ltd.... will be 51.5%. JingAo Solar Co. will face tariffs of 58.7%..The tariffs vary specifically company by company, and reward those that played along politically.
Most other Chinese companies in the sector that cooperated with the investigation will pay the average tariff of 47.6%. Those that didn't will pay a tariff of 67.9%, according to the document.
...European manufacturers have filed a separate complaint against the Chinese firms alleging they receive Chinese-government supportThey are shocked, shocked to find that subsidies and bailouts are occurring in the Chinese solar panel industry.
European import duties would deal a blow to these (Chinese) manufacturers, which have been piling up losses and struggling to refinance huge debts.
In March, Suntech sought bankruptcy protection in China, after defaulting on a $541 million bond repayment it owed mainly to Western investors.Western investors, who appaarently are not as well connected as the western investors in European solar panel plants.
LDK and Trina are both facing large debt repayments. LDK's hometown of Xinyu, China, bailed out the company in 2012, agreeing to repay $80 million of its debts.Here in the land of free markets, we never bail out large politically connected solar panel plants....
If we want to subsidize solar panel production (debateable, but "if") for environmental reasons, and if China decides to tax their citizens to provide the subsidies rather than us tax our citizens, the appropriate response is flowers, chocolates, and a nice thank-you card.
Update: Donald Boudreaux at Cafe Hayek did a much better job.
*Update: A reader catches me with possibly out-of-date facts. I'll leave his comment here and postpone getting in to a sidetrack about corn ethanol. I'll look in to it, as it seems a good topic for another "energy idiocy" post at some point.
The tariffs on Brazilian ethanol were removed back in 2011. In fact, because of the misinformation around environmental impacts of corn ethanol, California imports Brazilian cane ethanol in remarkable quantities (and at remarkable expense, compared to Midwestern corn ethanol). We also repealed the VEETC at the same time we eliminated the tariff, which is what I assume you’re referencing in your comment about subsidization of corn ethanol. There are still incentives for some ethanol feedstocks, but corn is explicity excluded.
The information about the energy consumed to produce ethanol is also considerably out of date.... And the stuff around environmental impacts is very much in dispute—but life-cycle “science” is so lacking in data one is usually left trying to prove a negative when defending the issue
I won’t dispute Gulf of Mexico hypoxia, but there’s remarkable progress being made with agricultural production today. We still need to get homeowners to stop fertilizing their lawns at a rate 4-8X what farmers use in cornfields if we’re going to stop it, but at least the corn farmers are cleaning up their act.
Wednesday, May 8, 2013
Finance: Function Matters, not Size
"Finance: Function Matters, not Size" This is the new title of the published version of "The Size of Finance," which I posted on this blog here as a working paper. If you enjoyed the original, here is the better final version. If you didn't, here it is all fresh and new.
Published version (my webpage)
Published version (Journal of Economic Perspectives)
Growth of the Financial Sector" symposium (Journal of Economic Perspectives)
Published version (my webpage)
Published version (Journal of Economic Perspectives)
Growth of the Financial Sector" symposium (Journal of Economic Perspectives)
Cyprus and Resolution Authority
Holman Jenkins has a revealing Cyprus update in today's Wall Street Jounal. For those of you who haven't been following the news, Cyprus' banks failed, borrowing huge amounts of money and investing it in Greek debt (yes). Cyprus was bailed out by the EU after a chaotic week, including an agreement that large depositors would lose some money, called a "bail-in."
Since us economists have been saying that unsecured creditors and uninsured depositors should lose money when banks fail, it was sort of a watershed moment. I expressed some reservations at the political, discretionary, and chaotic nature of the bail-in. It turns out I underestimated that nature.
From Holman:
A few weeks ago, the Central Bank of Cyprus published a curious set of "clarifications for the better understanding of the resolution measures." The principle of a bail-in—that uninsured creditors should suffer losses before taxpayers are on the hook—turns out to contain a few lacunae. "Financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, and educational institutions" will be excused from contributing to the depositor haircuts, though insurers later were removed from the exempt list.This all matters for our financial "reform." Recall, lots of financial institutions were bailed out in 2008-2009, meaning really that their creditors were bailed out. (Normally, when an institution fails, who gets what is determined by bankruptcy law; the creditors become the new owners, the institution is suddenly recapitalized, and either continues or is carved up depending on what makes more sense to the new owners.)
There will be no haircut on the €9 billion ($11.8 billion) the European Central Bank injected, for political reasons, in 2012 to keep Cyprus's Laiki Bank temporarily afloat—€9 billion that has now somehow become a liability of Bank of Cyprus depositors, whose losses are bigger as a result.
...
We should mention another possible offense, in a sense, against creditor priority in reports that certain connected customers withdrew funds just before the haircuts. A daughter and son-in-law of Cyprus's president seem to make a good case that their transfer of €10.5 million to a London bank was a coincidence, but then they proffered a "voluntary haircut" anyway via a donation to a church fund for the poor. Hmm
...
we have to chuckle when legislators on Capitol Hill talk about ending "too big to fail"—as if there is any chance of stopping politicians from bailing out whatever institutions politicians decide their own interests require bailing out, or any chance of imposing legal order on what are invariably chaotic, highly politicized decisions in the heat of crisis.
...
Cyprus turns out to be a good template after all. Modern financial systems may be incompatible with the rule of law that mankind has labored so mightily to build over the centuries.
On the theory that "bankruptcy doesn't work for big banks" the Dodd-Frank law posits a "Resolution Authority," composed of Administration officials, that will sit in the place of bankruptcy court and decide who loses money, with pretty much discretion to do what they want. To get paid off, make sure you persuade the "authority" that you losing money would be a "systemic" danger. It might help to have your campaign contributions up to date. I wrote about that danger in a Regulation article here.
The GM bankruptcy here is a small template. As Holman points out, when politicians and political appointees have great power to decide who gets money and who doesn't, watch out. Oh, no, I forgot; our political appointees are so much more uncorruptible than the Eurocrats that sort of thing can't happen here. (That was a joke)
His last two paragraphs are better than anything I can write. Go read them again. My one disagreement: Modern financial systems are fine. Modern political systems have abandoned rule of law in favor of a monarchic rule by discretion of appointed bureaucrats. That is incompatible with any financial system.
Saturday, May 4, 2013
Floating-rate Treasury debt
Last week the Treasury announced that is it going ahead with floating-rate debt, and gave some details how it will work. The Wall Street Journal coverage is here and the Treasury announcement is here. I wrote about the issue at some length last fall, here (And freely admit some of today's essay repeats points made there.)
Right now, the Treasury rolls over a lot of debt. For example, about one and a half trillion dollars is in the form of Treasury bills, which mature in less than a year. So, every year, the Treasury sells one and a half trillion dollars of new bills, which it uses to pay off one and a half trillion dollars of old bills.
With floating-rate debt, all the buying and selling is avoided. Instead, the Treasury periodically sets a new rate, so that the floating rate security has value one dollar (just as the maturing bill would have). It's the same thing, except the bill sits in the investor's pocket.
When interest rates go up, fixed-coupon long term debt falls in price. Floating-rate debt does not -- the interest payment goes up, so that the value of the debt is stable. Thus, even though its maturity may be long -- the Treasury mentioned two years -- the value of the debt is as safe as that of very short-term debt.
Homeowners are familiar with the system. An adjustable rate mortgage works the same way. You could take out a one-year balloon mortgage and refinance every year. But the adjustable rate is a lot simpler .
Now, I'm usually a Modigliani-Miller fan, and from the point of view of frictionless finance, it doesn't make any difference whether the Treasury has floating rate debt or rolls over debt. So why do I like this so much?
As a minor benefit, floating rate debt is just a little bit safer. It is possible that markets refuse to roll over debt, leaving the Treasury technically insolvent, unable to pay the principal on its existing debt. This is basically what happened in Greece. With floating rate debt, the Treasury would still face a crisis, unable to borrow new money, and forced next month to pay huge interest on the floating rate debt. But at least the crisis would be averted a bit and not result in immediate default. This is a very unlikely circumstance, you say, and I agree, but we all thought the last financial crisis was unlikely too until it happened.
A deeper benefit, I think, is that floating-rate Treasury debt opens the way to a run-free financial system. I want huge capital requirements on banks for all assets except floating-rate or short term Treasury debt. And I don't like runs in money market funds.
The usual answer is, "that's nice, but people need lots of safe securities. We need banks and money market funds holding risky securities to intermediate to provide the vast amount of safe securities people want. You have to put up with runs, TBTF guarantees, massive regulation and so on."
Well, suppose the Treasury were to fund itself entirely by floating rate debt. We could have $11 trillion of floating-rate debt, generating $11 trillion of perfectly safe money-market fund assets. We can be awash in fixed-value assets, and could happily ban the rest, largely eliminating run-prone assets from the financial system.
(What about the interest rate risk, you ask? Didn't I just advocate the opposite, that Treasury needs to issue longer-term debt? Yes, but the Treasury can swap out the interest rate risk with fixed-for-floating swaps. Who will buy those swaps? The same people who are buying long-term Treasuries now. Of course, I also suspect that in addition to the Fed's $3 trillion of interest-paying reserves, which are also floating-rate US government debt, the demand will not be more than a few trillion.)
My complaint though (you knew I'd complain, no?) is that Treasury did not go far enough. The proposal says that the Treasury will pay a rate determined by an index,
I would much rather that the Treasury pegged the value to exactly $100 at all times, buying and selling at that price between auctions, and using direct auctions to reset the rate every month or so.
Why? The alleged "safe asset" demand is for assets with absolutely fixed value. This is why money market funds and their customers are howling about proposals to let values float. With these floating-rate bonds as assets, we will still need money market funds or narrow banks to intermediate, and provide assets with truly fixed values, wiping out a few tens of precious basis points for the end customer in the process (and tempting that customer to "reach for yield" and get us back in to trouble again).
If the Treasury issued fixed-value floating-rate debt, in small denominations, electronically transferable, we might not need such funds at all. Or, they would have to compete on providing better IT services for retail customers (likely!) rather than managing the small price fluctuations of floating-rate Treasury assets. The Treasury says it wants to broaden the investor base. Well, the "Treasury money market fund" open to retail investors like you and me is the broadest base it can imagine!
The Treasury may be deliberately avoiding this outcome, to keep money market funds in business (i.e. to provide them with a little artificial profit), as the Fed kept the Federal funds rate 10 bp or so above zero to keep such funds in business. But if funds need an artificially hobbled government security to stay in business, we should let them vanish.
I think the Treasury should also make them perpetual. The proposal says the floaters will have a two-year maturity, forcing owners to cash in principal and buy new again, and Treasury to refinance. Why? Why not make this just like a money market account -- floating rate perpetuities? Big enough surpluses so that the Treasury has to buy back perpetuities are a long way away!
In sum, A- Treasury! But, instead of indexing, fix the price at $100 at all times, using an auction to reset rates; make them available in small denominations to regular investors with easy electronic transfers; and lengthen the maturity. A lot.
Then we can start clamping down on all the stuff that blew up in 2008.
Right now, the Treasury rolls over a lot of debt. For example, about one and a half trillion dollars is in the form of Treasury bills, which mature in less than a year. So, every year, the Treasury sells one and a half trillion dollars of new bills, which it uses to pay off one and a half trillion dollars of old bills.
With floating-rate debt, all the buying and selling is avoided. Instead, the Treasury periodically sets a new rate, so that the floating rate security has value one dollar (just as the maturing bill would have). It's the same thing, except the bill sits in the investor's pocket.
When interest rates go up, fixed-coupon long term debt falls in price. Floating-rate debt does not -- the interest payment goes up, so that the value of the debt is stable. Thus, even though its maturity may be long -- the Treasury mentioned two years -- the value of the debt is as safe as that of very short-term debt.
Homeowners are familiar with the system. An adjustable rate mortgage works the same way. You could take out a one-year balloon mortgage and refinance every year. But the adjustable rate is a lot simpler .
Now, I'm usually a Modigliani-Miller fan, and from the point of view of frictionless finance, it doesn't make any difference whether the Treasury has floating rate debt or rolls over debt. So why do I like this so much?
As a minor benefit, floating rate debt is just a little bit safer. It is possible that markets refuse to roll over debt, leaving the Treasury technically insolvent, unable to pay the principal on its existing debt. This is basically what happened in Greece. With floating rate debt, the Treasury would still face a crisis, unable to borrow new money, and forced next month to pay huge interest on the floating rate debt. But at least the crisis would be averted a bit and not result in immediate default. This is a very unlikely circumstance, you say, and I agree, but we all thought the last financial crisis was unlikely too until it happened.
A deeper benefit, I think, is that floating-rate Treasury debt opens the way to a run-free financial system. I want huge capital requirements on banks for all assets except floating-rate or short term Treasury debt. And I don't like runs in money market funds.
The usual answer is, "that's nice, but people need lots of safe securities. We need banks and money market funds holding risky securities to intermediate to provide the vast amount of safe securities people want. You have to put up with runs, TBTF guarantees, massive regulation and so on."
Well, suppose the Treasury were to fund itself entirely by floating rate debt. We could have $11 trillion of floating-rate debt, generating $11 trillion of perfectly safe money-market fund assets. We can be awash in fixed-value assets, and could happily ban the rest, largely eliminating run-prone assets from the financial system.
(What about the interest rate risk, you ask? Didn't I just advocate the opposite, that Treasury needs to issue longer-term debt? Yes, but the Treasury can swap out the interest rate risk with fixed-for-floating swaps. Who will buy those swaps? The same people who are buying long-term Treasuries now. Of course, I also suspect that in addition to the Fed's $3 trillion of interest-paying reserves, which are also floating-rate US government debt, the demand will not be more than a few trillion.)
My complaint though (you knew I'd complain, no?) is that Treasury did not go far enough. The proposal says that the Treasury will pay a rate determined by an index,
We have decided to use the weekly High Rate of 13-week Treasury bill auctions, which was described in the ANPR, as the index for Treasury FRNs.This means that the price of the floating-rate notes will deviate somewhat from par ($100.)
I would much rather that the Treasury pegged the value to exactly $100 at all times, buying and selling at that price between auctions, and using direct auctions to reset the rate every month or so.
Why? The alleged "safe asset" demand is for assets with absolutely fixed value. This is why money market funds and their customers are howling about proposals to let values float. With these floating-rate bonds as assets, we will still need money market funds or narrow banks to intermediate, and provide assets with truly fixed values, wiping out a few tens of precious basis points for the end customer in the process (and tempting that customer to "reach for yield" and get us back in to trouble again).
If the Treasury issued fixed-value floating-rate debt, in small denominations, electronically transferable, we might not need such funds at all. Or, they would have to compete on providing better IT services for retail customers (likely!) rather than managing the small price fluctuations of floating-rate Treasury assets. The Treasury says it wants to broaden the investor base. Well, the "Treasury money market fund" open to retail investors like you and me is the broadest base it can imagine!
The Treasury may be deliberately avoiding this outcome, to keep money market funds in business (i.e. to provide them with a little artificial profit), as the Fed kept the Federal funds rate 10 bp or so above zero to keep such funds in business. But if funds need an artificially hobbled government security to stay in business, we should let them vanish.
I think the Treasury should also make them perpetual. The proposal says the floaters will have a two-year maturity, forcing owners to cash in principal and buy new again, and Treasury to refinance. Why? Why not make this just like a money market account -- floating rate perpetuities? Big enough surpluses so that the Treasury has to buy back perpetuities are a long way away!
In sum, A- Treasury! But, instead of indexing, fix the price at $100 at all times, using an auction to reset rates; make them available in small denominations to regular investors with easy electronic transfers; and lengthen the maturity. A lot.
Then we can start clamping down on all the stuff that blew up in 2008.
Wednesday, May 1, 2013
Small monetary policy question
A small monetary policy question has been bugging me this morning.
The Fed is buying long term bonds and agency debt, with stated desire to drive down long term Treasury and mortgage-backed security rates.
Why does the Fed not simply say "We are going to peg the 10 year Treasury rate at 1.5%. We buy and sell at that price." If the Fed wants the 10 year rate to be, say, 1.5%, then this seems a lot simpler than setting a quantity ($80 billion a month), and then enduring endless arguments with academics like me whether it's having any effect at all, or commissioning complex staff studies to determine whether the impact is 10 or 15 basis points and how long it lasts.
The answers I can come up with are not pretty. Perhaps the Fed understands that any "segmentation" is smaller than it thinks, and doesn't last that long. So, the required bond purchases would rapidly explode in size. If that's the answer, then the Fed isn't doing it so that it can continue to seem powerful when in fact it really is not.
Perhaps it's political. If the Fed can say "we're buying $80 billion a month. This is helping, but we don't know exactly how much," then it avoids responsibility for what the rate actually is. If it says 1.5%, then every car dealer and mortgage broker in the country wants to know, why not 1.4%? This is even more cleverly Macchiavellian. But such deeply political decisions are a long way from the benevolent independent central bank we write about in papers.
Any ideas anyone?
While we're here, two great quotes from Fed economists (obviously un-named) I've talked to recently.
Me: Aren't you worried about big banks borrowing short and lending long? What happens when, inevitably, interest rates rise?
Economist A: "Don't worry, we'll let them know ahead of time."
This was some time ago. I think last week's announcements that the "stress tests" were (at last) going to include plain - vanilla interest rate risk might count as such warning.
Economist B: "Inflation is just not a concern. The Fed now is balancing growth against financial stability."
A new dual mandate, and a fascinating can of worms. I'd love to see that Phillips curve.
The Fed is buying long term bonds and agency debt, with stated desire to drive down long term Treasury and mortgage-backed security rates.
Why does the Fed not simply say "We are going to peg the 10 year Treasury rate at 1.5%. We buy and sell at that price." If the Fed wants the 10 year rate to be, say, 1.5%, then this seems a lot simpler than setting a quantity ($80 billion a month), and then enduring endless arguments with academics like me whether it's having any effect at all, or commissioning complex staff studies to determine whether the impact is 10 or 15 basis points and how long it lasts.
The answers I can come up with are not pretty. Perhaps the Fed understands that any "segmentation" is smaller than it thinks, and doesn't last that long. So, the required bond purchases would rapidly explode in size. If that's the answer, then the Fed isn't doing it so that it can continue to seem powerful when in fact it really is not.
Perhaps it's political. If the Fed can say "we're buying $80 billion a month. This is helping, but we don't know exactly how much," then it avoids responsibility for what the rate actually is. If it says 1.5%, then every car dealer and mortgage broker in the country wants to know, why not 1.4%? This is even more cleverly Macchiavellian. But such deeply political decisions are a long way from the benevolent independent central bank we write about in papers.
Any ideas anyone?
While we're here, two great quotes from Fed economists (obviously un-named) I've talked to recently.
Me: Aren't you worried about big banks borrowing short and lending long? What happens when, inevitably, interest rates rise?
Economist A: "Don't worry, we'll let them know ahead of time."
This was some time ago. I think last week's announcements that the "stress tests" were (at last) going to include plain - vanilla interest rate risk might count as such warning.
Economist B: "Inflation is just not a concern. The Fed now is balancing growth against financial stability."
A new dual mandate, and a fascinating can of worms. I'd love to see that Phillips curve.
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