Freshwater and Saltwater: macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molongolo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher long term interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays. I have detailed that mistake here. Bill Gross made a similar mistake declaring the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was in good company.

Now the subject of freshwater, salterwater and other macroeconomic elixirs is the thing in the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton

Scandinavian bank collapse - not all the same

Do not bother reading this post unless you are directly interested in a history of Norwegian versus Swedish bank collapses...

It seems that some central bankers read this blog. I got an email from a senior Scandinavian central banker following the exchanges on this blog (see this exchange for an example).

Anyway he points me to a note by P Honohanen of the World Bank (written several years ago) and which I reproduce here. I think this should close some of the debate. Either way it is useful if you wish to know what actually went on...

For several years it has been fashionable to look to Sweden as offering a policy model for recovering from a banking crisis. And your editors have to admit that, along with most other commentators, they had been inclined to assume that the Swedish case was mirrored by the roughly contemporaneous crises in the rest of Scandinavia. But the Norwegian crisis actually predated that in Sweden and, as we have discovered by reading the comprehensive volume on the Norwegian case which has just been published by Norges Bank (“The Norwegian Banking Crisis”), containment and resolution policy was quite different. Certainly the two countries both made a good recovery: on some reckonings the Norwegian government, like that of Sweden, may have ended up with a small cash profit after selling back into the market bank shares that it had acquired in the crash. Though sometimes thought of as a classic macro boom-and-bust, the Norwegian crisis may be better classified as the result of inexperienced bankers trading in a newly liberalized market with recently lowered capital requirements and a sharply reduced frequency of on-site supervisory inspection. The crisis was a big one: the three largest banks (DNB, Fokus and Christiania) all failed along with many smaller banks including sizable regional banks. The privately owned and managed deposit protection schemes were overwhelmed and had to be nationalized – illustrating a weakness inherent in what is otherwise a good idea: distancing deposit protection from the government. Government took ownership of the major banks – and retains, for strategic or political reasons, a major stake in DNB. But, and this is the first important contrast with the policy stance adopted in Sweden, in no case were shareholders bailed out. (Yes, the authorities were sued by disappointed shareholders, but unsuccessfully.) Two other key points to notice: government did not issue a blanket deposit guarantee and they did not set up Asset Management Companies. These striking contrasts certainly argue for avoiding knee-jerk application of the Swedish policy approach in these three dimensions.

The perfect appointment

I have – framed above my desk – a $100,000,000 note – serial number AA23100220 and signed by Dr G Gono – the Governor of the Reserve Bank of Zimbabwe.

This – it seems – offers the solution to all our deflationary woes.

It seems that no matter how many dollars the Fed prints it can’t induce inflationary fears.  I suggested that the Fed rent a couple of hundred helicopters and (literally) push $2 billion out the window.  That I thought was irresponsible enough to raise inflationary expectations.

Alas real objections can be made – not the least that people might climb on rooftops looking for the booty – and slip and die.  I can’t morally justify the deaths.

But the Zimbabwe note has given me another solution – one that doesn’t require any helicopters or even the printing of any money.  It is more than sufficiently irresponsible – yet nobody will die.

Ben Bernanke should resign forthwith and Dr G Gono should be appointed as Chairman of the Fed Reserve.  

Nothing need change.  Monetary policy can remain in the effective hands of the other governors – but the appointment of Dr Gono will rapidly raise inflationary expectations – and the new inflationary expectations should induce the spending of the massive hoard of saved dollars – providing all the economic stimulus needed.

Dr Gono may be the wrong man for Zimbabwe – and the right hand man of a dictator.  But he is what America needs right now.  

Do you think we can get him confirmed?

John Hempton

What is a non-performing loan?

Once upon a time I saw loan restructurings as code for faking the accounts.  That was with good justification.

Conseco – before it blew up – had a habit of restructuring any loan that was delinquent.  After restructure it was no longer delinquent – and lo – the credit metrics seemed OK.

After Conseco finally went bankrupt the truth came out.  Loan performance went from sort-of-OK-if-you-ignored-the-fact-that-cash-actually-coming-back-in-payments-was-low to utterly desperate.  The AAA strips of Conseco securitisations failed widely.

These days restructuring loans is the stated objective of many powers that be – most notably Sheila Bair.  I never quite got that.  If you show too many non performing assets (NPAs) Sheila Bair will just confiscate your bank.  So the incentive is to restructure and restructure early.  If the borrower can perform to restructured spec then presumably they are no longer an NPA.  What Sheila Bair appeared to be advocating was government sanctioned account faking.

Then of course some banks tell it straight – and count the restructured loans amongst their NPAs.  Here is an extract from the recent Fifth Third conference call.  Fifth Third is a problematic bank and in WaMu fashion I own the subordinated debt – not the common – and in WaMu fashion I probably have reason to be nervous.  Anyway to quote:

Turning to the consumer portfolio, we also continued to be very aggressive in restructuring consumer loans, modifying over $200 million in the quarter. We believe restructuring loans where appropriate will result in significantly greater likelihood of payment and more value ultimately received by Fifth Third. These activities are beneficial not only to our shareholders, but are also consistent with the needs of our customers.  [Sheila Bair’s line precisely – are they pandering?]

As of year end, we had $574 million in troubled debt restructurings and NPAs, classified that way because they hadn't met the six-month consecutive performance threshold.  [Hey wow – they count restructured loans as non-performing – so they are not producing the Conseco fake numbers…  My cynicism is misplaced in this instance.]

Fifth Third has been among the most active of banks in the US in restructuring loans for consumer borrowers, a process we began over a year ago. We've been among the most active among our peers in these restructurings only one of the 15 largest US banks reports a higher dollar amount of restructured loans among its nonaccrual loans, according to regulatory filings.

Now this is very odd.  $574 million of restructured loans in the NPAs is about the highest in America!  But we know lots of banks are restructuring many loans – many billions worth.  Sheila Bair is telling them to do it.  But if you take Fifth Third at its word (and I think you should here) all the other banks are classifying most those restructured loans as performing.

In other words they are – Conseco like – faking their accounting.  And Sheila Bair is not only complicit – she is actively encouraging.

Welcome to modern banking.  

Cute

By far the best reaction to the helicopter post from one of my favourite bloggers.

See Cassandra.


John

Reaction to the Helicopter post

The helicopter post has had the most reaction of any post on this blog. I guess that is the territory when you suggest that the solution to the financial crisis is to literally throw money from helicopters. Nonetheless I wish I could get that sort of reaction to a more serious post.

The reaction to the helicopter post fell into three categories:

• those that didn’t get it
  
• those that got it but may have had ethical problems, and
  
• those that understood it all too well.
  

I got one comment – via email – which explained very simply why the helicopter proposal wouldn’t work. I think that commentator’s argument is accurate – so – at the end I will lay it out and (tentatively) withdraw the helicopter proposal.

Those that didn’t get it

There seemed to be several comments (email and on blog) which suggested that it would be better if we just gave everyone a tax holiday (payroll, income, death duties depending on where in the political spectrum the commentator was).

This does not cut it. The purpose of the proposal (throwing money out of helicopters) was not to distribute money (for which plenty of effective mechanisms exist). The purpose was much more radical – to remove trust in money itself.

The proposal I made was remarkably cheap (a $2 billion solution to a multi-trillion dollar problem) and if it works it works for purely psychological reasons – which is that it is so reckless and irresponsible that nobody could ignore the inflationary impacts of Federal Reserve policy. Reckless and irresponsible (and small) was the charm of this proposal.

Indeed I suggested in the comments that it would work even better if Bernanke continuously surrounded himself with buxom prostitutes paid out of freshly minted moolah, but that image was just too horrific – even for this purpose (although it may be effective).

Some that simply got it

There were a couple of posts that simply got it. The cutest came from someone calling themselves the German Trader who put it very simply (if in very poor English):

You only give something away when you think it is worthless and what you get is of greater worth. While seeing the riots after Bens helicopters came past I surely want buy a new car.

Kieren (who I do not know) pointed out that the trick was really to produce inflationary expectations (and hence to get people to spend) without producing inflation. That is why this might work. The amount of money involved is small ($2 billion versus over $2 trillion in money supply) so its effect should also be small – but the expectations effect could be enormous. That was – in theoretical terms – what I was trying to achieve.

Some who got it and raised ethical objections

There were a few ethical objections raised – firstly by people who thought I was right that this policy would cause riots and deaths and then promoted more responsible ways of doing the same trick. The people killed in riots are collateral damage of a deliberately irresponsible policy. I don’t know how to weigh one life versus another – but this financial crisis will kill hundreds of people before it is over – either suicides or more bluntly hunger in some countries badly hit. The ethical objection is real – and I have no solution. The policy proposed is deliberately irresponsible – and irresponsibility causes death in some instances.

The main ethical objection I expected was about property rights and theft. I wrote the post in Australian hours and it was seen by Australian/Asians then English/Europeans and finally by North Americans.

I had to wait until American waking hours for someone to point out the obvious - which is that the policy being advocated was the deliberate theft of property (deliberate inflation being theft). Europeans somehow seem less concerned than Americans about property rights.

I am usually very harsh on government policies which involve the removal of property rights simply because those policies are usually counter-productive. There are plenty of posts on this blog along those lines. However those posts are argued on a facts-and-circumstances basis – the abrogation of property rights is argued as a problem in this instance and property rights are not automatically given full moral status. That is my position generally – honouring property rights is a good thing to do because it generally leads to better outcomes. I understand that some people (almost all Americans and including many readers of this blog) have raised property rights to full ethical status (along with for instance the rights to liberty etc). Not my ethics – but I understand – and the outcomes are usually OK so I am generally happy to leave that form of right wing fundamentalism alone.

I prefer argue for property rights from an outcomes perspective (as incidentally did many Modern Scots - esp Hume - but later Smith with regard to some economic matters*). Your blogger does not really wish to comment on the property rights as a moral precept here – other than to note for some people this really is fundamental. Just leave it at that.

The commentators that got it all too well

The comment on the post which got the most comment from other commentators was someone that got it all too well. The comment was that – as a result of this policy – some right wing “nut” would load a truck with fertilizer and diesel and blow up the Federal Reserve.

Some people objected to calling that person a nut – but I have no other word for suicide bomber of any persuasion. More to the point – this person – and eventually many others – would realise what this policy was about – which is removing all trust from dollars – and hence theft of one ideal that they hold quite dear.

The question which was raised in emails was about how you would reintroduce trust after you have destroyed it. I think that is actually a key problem. Trust is essential for an economic system in general – but trust in money at the moment is quite destructive as people would prefer hold enormous quantities of money rather than build real assets and employ real people. However you can’t build real assets and employ real people without trust either. The helicopter proposal is targeted at getting rid of trust in one place and one time only (the trust in money in the rare instance of a liquidity trap). Whether you can conduct a strike that surgical with a helicopter full of rolls of money is open for question. Military strikes are nowhere near as precise as the pictures on CNN.

Finally – the real objection

This came in an email from one of the most astute commentators on my blog:

It won't work because immediately after the drop, Congress would arrest Bernanke along with the entire Fed board (probably replace it with a money czar)…. Politicians would be forced to promise responsibility and accountability in the face of the threat of civil unrest - don't forget, a lot of people own guns legally in this country. There will be new laws designed to keep the value of the dollar. In the end, the dollar would get stronger, not weaker…

In other words the whole idea won’t work because it is actually not possible to be that irresponsible – that the underlying US system is sufficiently strong – that if Bernanke were that irresponsible he would simply be replaced.

If Bernanke can’t plausibly be quite that irresponsible we might as well park the helicopters.

And if you can’t use monetary policy to solve this recession then alas we are left with what appears to be two inferior choices (a) a fiscal expansion of gargantuan proportions or (b) letting the system burn and winding up in a great depression type scenario. Both are unpalatable – but I would vote for the fiscal expansion.

It would be much better to just load up that helicopter. Alas...

John

*There is a serious edit to the this post because I have not read theory of moral sentiments for twenty years and then did not finish it. I have pulled out my copy and I was wrong. I wasn't about Hume (who I have always thought right). Smith it seems thought that moral laws within the economic sphere were made by man - but outside Man was not capable of such moralizing. The rights to property seem - from my quick skim fall into manmade lot - but... suggestion withdrawn...

J

Why the Federal Reserve should LITERALLY throw money out of helicopters

Cassandra (who normally does Tokyo) has a diary note in which (s)he explains – in layman’s terms – why the Fed printing all that money (expanding its balance sheet) is not inflationary.  The key section quotes Perry Merhling (whom shamefully I had previously not heard of).  Here it is.

 

It seems to me that what we are seeing is simply the balance sheet consequences of the Fed's decision to take the wholesale money market onto its own balance sheet. Banks (and other entities) that used to lend to one another, are now lending and borrowing through the intermediation of the Fed. This is so not just domestically but also internationally (the huge swap line), since foreign banks used to fund dollar asset holdings in the dollar money market.

In this view, inflation seems much less likely. Why not? If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary. 

Posted by: Perry Mehrling at December 22, 2008 05:12 AM

This is of course correct – as far as it goes.  To the extent that Fed balance sheet expansion simply offsets private balance sheet contraction there is no net increase in money and near substitutes – and so the Fed balance sheet expansion cannot be inflationary.  We are – to that end – stuck in our deflationary spiral.

The situation has a name in the economic jargon - a liquidity trap.  An American – not a Japanese version of a liquidity trap – but a liquidity trap nonetheless.  No matter how much “money” the Fed supplies the public will want to hold it.  Monetary policy is thus useless.  

This is usually made out (by Krugman et al) as an excuse for massive fiscal policy.  And I am not averse to that.  

However there is another approach which I detailed in my lessons from shorting JGBs post.  The argument: if you can’t fix the problem with increasing money supply then maybe you can fix the problem with decreasing money demand.  

You need to convince people not to hold money.  You need to convince them that cash is trash.

And to do that you need to convince the public that there will be inflation (the above gross leverage argument notwithstanding).  

To do that the Federal Reserve has to be credibly irresponsible.  It is not enough to print a couple of trillion dollars (which they have) because everyone thinks (with some justification) that they will suck back the money supply when the crisis is over.

No – you have to be more visibly reckless than that.  You have to really convince people that there will be inflation.  

So the suggestion in my title is literal.  The Federal Reserve should hire a couple of hundred helicopters and load each one 10 million dollars in neatly bound parcels of $1000 each.  Total cost $2 billion plus trivial helicopter hire.

It should fly them over 200 randomly picked American cities and throw the money out the window.  It should press release this – but press coverage will be excessive.  Indeed I suspect that the press coverage would give the Fed’s inflation policy greater awareness than the Coca Cola Company.  (The Coca Cola Company’s annual advertising budget is $2.8 billion – so this is already cheap compared to some private sector alternatives.)  

The press release should be simple.  We are doing this to induce inflation.  If there is no inflation as a result we will simply do it again. 

Of course people will fall of roofs after searching for money that might have landed on their house.  They might die.  Of course people might get trampled in the crush.  They might die too.  

All of this increases the visible recklessness of the policy.

But the charm of this.  It may actually induce mass spending of American dollars for (self-fulfilling fear of inflation)– a massive stimulus.  And it will do it all for $2 billon.  Obama has a stimulus package of $1.2 trillion – or about 600 times as large.  This is relatively cheap.

The real case for throwing money out of helicopters is that it looks like it will work better than anything else that anyone has come up with yet.

And it will be cheap.  Much cheaper than alternatives that are actually being implemented.

The secondary benefit is that most of the losses from inflation will be in the hands of the Chinese who have built huge reserves of soon-to-be-deflated US dollars.  

Hey what better – lets kick start the economy and get the Chinese to pay.

I am serious.  At least serious until I can get a credible explanation as to why this won't work at least as well as any of the alternatives being mooted.

John Hempton

Felix Salmon asks the question: is nationlisation contagious?

The answer to that is YES if it is done without giving existing capital holders the belief that they are being treated fairly.  (See Felix's post here.)  

A bank that loses access to capital eventually fails.  Certainly in a current account deficit country if it loses access to intermediate funding it fails - and intermediate funders are not that keen if the bank has no access to capital.

If private shareholders feel that government will ride roughshod over their rights then there will be no private shareholders.  They will have "fear of government".

So there must be a process which respects the capital that private shareholders offer - and which is seen to honour that capital.  

If done that way - and the Scandinavian countries groped towards such a solution, then nationalisation is NOT contagious.  

As noted in my last post Svenska Handelsbanken did not surrender ANY equity to the government even though it took government liquidity support.  It was seen to have capital and the shareholder capital was respected.

There was - and the histories referred to in my last post - a contagion until the due process was implemented an no contagion afterwards.

I have no objection at all to nationalisation - but it must be accompanied by a process that both respects and is seen to respect existing capital holders.

Can we please get this straight?  Contagious nationalisation - and that is where Willem Buiter et al are heading - is a disaster.  It is also an simply not necessary.

John Hempton

PS.  Notwithstanding the above - a pretty-close-to-complete nationalisation will probably happen in the UK.  Due process will lead us there.

Scandinavian bank nationalisation and due process

The proposal in my nationalisation after due process post the proposal I gave was not new.  I probably should have pointed out it had a precedent - Norway.  Norway was the country with the most pervasive nationalisation in the crisis.

You can find the reasonable history of Scandinavian bank nationalisation here.  Read Chapter 3 if you are interested in this stuff.  The biggest nationaliser was Norway - not Sweden - though Sweden did buy out the minority shareholders for token sums.

The process used in Norway was to assess the shareholder capital of the bank.  Shareholders were given FIRST RIGHT to recapitalise it.  If private money could be raised they kept the bank.  If they were short capital the government loans (which had previously guaranteed liquidity) were converted to equity and the old equity was written down.  Here is the key paragraph explaining the Norway result for the biggest banks:

Amendments were also made to the banking law, enabling the government under certain conditions to write down a bank’s shares to zero. This ensured that share capital really was written down to the extent that capital was lost.

It was soon realised that Christiania Bank and Fokus Bank had lost their entire share capital.  The share capital in Den norske Bank was written down by 90% according to losses.  The banks needed more capital, but private investors were unwilling to invest. All three banks thus received a substantial capital infusion from the GBIF [which was an independent but government owned bank manager] at the end of 1991. Conditions were established regarding balance sheet restructuring/downsizing, cost cuts and other measures to improve results. Share capital was written down to cover estimated losses. In both Christiania Bank and Fokus Bank the share capital was written down to zero by government decision (after shareholders had refused to do so). The existing shareholders thus did not receive anything for their shares, and the GBIF became the sole owner of the two banks. The boards and the top management were replaced. The banks received further capital support from the GBIF in 1992.

What we had here was a recapitalistion by government with rules which were widely understood and where the existing shareholders were given first rights of refusal over the recapitalistion.

In other words it was nationalisation without theft and it was not theft because there was a process which treated shareholders fairly.  Because Den Norske Bank had 10% of the required capital when assessed the private shareholders kept 10% of the equity.  Christiana and Fokus had less than zero capital and the shareholders were wiped out without compensation but after due process.

In Sweden similar processes were involved - but like Den Noske Bank the companies mostly had some capital left and so existing shareholders received some value.  One major bank (the very well run Svenska Handlesbanken) never surrendered any ownership to the government.  It had liquidity problems (it actually needed government money from memory) but it had no capital problem when it was assessed. 

Finland also had a crisis - but as far as I can tell (and know no banking expert that speaks the language) it was handled much worse.

The lessons of Scandinavian crisis are many.  One of them however was that if you want to reconstruct a banking sector post crisis (and I presume most people do) then you probably want to treat the existing shareholders fairly.  Fairly can mean confiscation as per Fokus or Christiana bank - but it is fairly after due process.

I only mention this - and also remention Chapter 3 of this document - because Kevin Drum and Interfluidity are maintaining their argument about what happened and how it should be handled.

Nationalisation probably will happen for some banks.  It has already happened for Royal Bank of Scotland for the most part.  It happened without much process - and the lack of process has put the fear of government into everyone who might fund banks.  Lack of process will wind up meaning that everything gets nationalised because if there is no fair process there will be no private money as an alternative to nationalisation.  In that case nationalisation becomes a self-fulfilling prophecy...  

Will the policy makers PLEASE read Chapter 3.

Pretty please.

John Hempton

The last bank with an antidilution clause...

Was Washington Mutual. It caused them no end of trouble.

Barclays has one.

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article5563223.ece

Implication - either Abu Dubai waives the clause or it is confiscation for Barclays.

If I were Abu Dubai I would be waiving the clause NOW.

But then I was not long Barclays - unlike SMFG who put almost 700 billion yen in only a little while ago. (Hey what is 700 billion yen between friends?)



John Hempton