Topic: Finance, Banking & Monetary Policy

Financial Crisis Lessons From Experimental Economics

Economic scholarship tends to operate in silos. That is, banking scholars don’t talk to macroeconomists, etc. Sadly, this is even more so between finance, monetary and experimental economics.  In his latest book, Rethinking Housing Bubbles, Nobel Prize winner Vernon Smith, the father of experimental economics, offers a number of lessons that could greatly improve the stability of our financial system.

Some of these include:

  • Markets for perishable goods behave generally well and do not tend to display bubbles, whereas asset markets commonly display bubble behavior in experimental settings.
  • Allowing margin buying (leverage) significantly increases bubble size and duration for inexperienced buyers, but not for experienced.
  • Even sophisticated buyers, when inexperienced, display bubble behavior. 
  • Experience helps: repeated play in an experimental game brings price behavior closer to fundamentals.
  • Informed “inside traders” can reduce size of bubbles.
  • Presence of futures markets can stabilize prices in spot markets.
  • Additional liquidity increases size and duration of bubbles.
  • Bubbles can develop even when participants are fully informed as to operation of the market (they know with certainty future incomes streams and how the market functions).

In terms of policy recommendations, the list above suggests a few things to me. First, policymakers should pay close attention to asset markets. Second, higher down-payments, particularly among first-time buyers, are likely to reduce housing bubbles. Policy should be tolerant of informed buyers, such as hedge funds, buying-up foreclosed homes. 

Consumer disclosures, like Truth in Lending, are likely to be useless. Financial literacy should focus less on information and more on experience. Excess central bank liquidity is likely to contribute to asset bubbles.

Perhaps the biggest lesson is that bubbles in experimental asset markets are quite common, especially markets were buyers have little experience and engage in few transactions (sounds like the housing market). 

We will touch upon some of these issues, and others, when Vernon Smith comes to Cato next week to discuss his new book. You can register (or watch streaming) here.

 

Do the Benefits of Mandatory Disclosures Outweigh the Costs?

Current regulations, which require companies that issue stocks and bonds to publicly disclose information to investors, allegedly assist those investors in determining the appropriate price for securities as well as detecting fraud. But mandatory disclosures impose heavy costs on issuers of debt and stock. Do the benefits outweigh the costs?

In the forthcoming issue of Regulation Elisabeth De Fontenay, an associate professor at Duke University Law School, answers that question by examining a natural experiment in corporate debt markets.

Corporate bonds are treated as securities and subject to mandatory information disclosure under SEC regulations. In contrast corporate loans are not subject to SEC disclosure regulations because historically such loans were held to maturity by the issuing bank. But over the last 15 years corporate loans have become functionally equivalent to bonds especially at the “high-risk high-return end of the spectrum.” They are underwritten by many investors and securitized and traded in secondary markets.

If regulation produces net benefits for investors, then they would purchase only corporate bonds rather than syndicated loans. But “the market not subject to mandatory disclosure is not only thriving, it is surging past its regulated counterpart.”  

How is this possible? De Fontenay explains that in secondary loan markets, investors obtain all the information they need through contract. And that information is more relevant to investor needs than the information mandated by regulation.

Getting Government Out of the Mortgage Business, DOJ-Style

Yesterday Bloomberg reported that Federal Housing Administration (FHA) purchase loan guarantees “plunged” compared to a year ago. Part of that plunge, of course, was an expected decline in refinance activity. Currently, FHA endorsement activity is almost 80 percent purchase, whereas a year it ago it was just over half for purchase. Looking at trends in purchase endorsements, the decline looks a lot more moderate.

Even so, there has been a modest decline. Many in the banking industry, as expressed to Bloomberg, believe this is because FHA and the U.S. Deparment of Justice have been too tough on lenders, making them take back soured loans and assessing damages. JP Morgan CEO Jamie Dimon recently asked, because of the legal risk, “should we [JP Morgan] be in the FHA business at all?” 

Personally, this sounds like little more than jawboning. As illustrated by FHA’s recent credit reports, lenders are still dumping an awful lot of junk onto FHA. The average credit score is around a 680 FICO, meaning about half of FHA’s recent business is subprime. Beyond that, even subprime borrowers typically face downpayments of only around 5%, and then there’s the high debt levels witnessed. Lenders should be held responsible for making loans of such poor credit quality.

If DOJ fines on poorly performing FHA loans are chasing banks away from FHA, then I say “great.” That’s one of the reasons I helped get FHA new powers against fraud back in 2008 (see Section 2129 of HERA). As Congress is unlikely to ever scale bank the various mortgage subsidies, perhaps our only hope is that DOJ makes those subsidies so unattractive that lenders won’t use them. But then I could also see DOJ sue lenders, under fair-lending, for not using FHA.

Bankers Advise Fed to Regulate Bitcoin

Four times a year members of the Federal Reserve Board are scheduled to meet with members of the banking industry, as represented by the Fed’s Federal Advisory Council.  This, of course, does not include all the many other occasions that the Fed meets with bankers.  These meetings allow the banking industry to express its views to the Fed on a wide range of issues.  Summarized records of those meetings are released to the public.  In the most recent meeting, bankers raised, among other topics, the issue of Bitcoin. 

While the bankers did not yet view Bitcoin as a viable competitor to their role in the payments system, the bankers did express that Bitcoin “regulation is advisable.”  Those soft-hearted bankers expressed a concern that without adquate consumer protections, users of Bitcoin would be vulnerable to fraud and theft.  Bankers also suggested, presumably out of a concern for national security, that Bitcoin be subject to the same anti-money-laundering procedures, including Know-Your-Consumer, that banks are subjected to.  Bankers explicitly suggested that Bitcoin be subjected to the suspicious activities reports (SARs) that banks must currently file. Personally, this all sounds like an attempt at “raising rivals’ costs” to me.

Interestingly banks also suggested that in “an economy hypothetically dominated by Bitcoin, its finite number (21 million) would prevent the application of traditional monetary policy tools to provide support…” In other words banks are concerned that a Bitcoin world would be one where bank bailouts and assistance were more difficult to achieve.  I guess one man’s bug is another man’s feature.

Bitcoin Charts, Finally

Bitcoin, the new digital currency, remains a mystery to many. There is no better way to lift the fog surrounding bitcoin than to let the data speak. And data speaks loudest through charts. Yes, topological analysis is often the best route to comprehension.

I have constructed – with my assistant, Mazin Al-Rayes – a series of charts that contain illuminating data about bitcoins and brief directions for use following each chart.

How to interpret: Currently there are 13.235 million bitcoins in circulation. The issuance of new bitcoins will halt when the total number of bitcoins “mined” (read: in circulation) reaches 21 million.

Prof. Krugman Snared By 364 Trap

In his New York Times column of September 15, 2014, How to Get It Wrong,Paul Krugman pleas for open-mindedness and reason. From whence did Prof. Krugman convert from his embrace of dogmatism?

Well, it’s clear that he has not converted. Indeed, the evidence resides about three quarters of the way through his column:

“The great majority of policy-oriented economists believe that increasing government spending in a depressed economy creates jobs, and that slashing it destroys jobs — but European leaders and U.S. Republicans decided to believe the handful of economists asserting the opposite. Neither theory nor history justifies panic over current levels of government debt, but politicians decided to panic anyway, citing unvetted (and, it turned out, flawed) research as justification.”

This passage brings back vivid memories of the 364. In 1981, Margaret Thatcher was prime minister and my friend and collaborator, the late Sir Alan Walters, was her economic guru. Britain’s fiscal deficit was relatively large, 5.6% of its gross domestic product, and the economy was in the middle of a nasty slump. To restart the economy, Thatcher instituted a fierce fiscal squeeze, coupled with an expansionary monetary policy. This was immediately condemned by 364 dyed-in-the-wool Keynesian economists - virtually all of the British establishment. In a letter to the Times, they wrote, “Present policies will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.”

Thatcher and Walters were vindicated quickly. No sooner had the 364 affixed their signatures than the economy turned around and boomed for the next five years. That result provoked disbelief among the Keynesians. After all, according to their dogma, the relationship between the direction of a fiscal impulse and economic activity is supposed to be positive, not negative.

The 364’s dogma was proven wrong. Thatcher and Walters were right.

Middle East and North Africa: A Fatal Attraction

Last week, President Obama addressed the nation to proclaim that the U.S. and an unspecified coalition were going to once again ramp up our military operations in Middle East and North Africa (MENA). This time, the target is the Islamic State, the group terrorizing Iraqi and Syrian citizens.

Just what is the economic condition of that troubled MENA region? This is a question that must be addressed by anyone who is looking over the horizon. After all, the state of an economy today will have a great influence on post-war prospects tomorrow.

My Misery Index allows us to obtain a clear picture of the current economic situation. The Index is the simple sum of the inflation rate, unemployment rate and bank lending rate, minus per capita GDP growth. I calculated a misery index for the countries in MENA where sufficient data were available.

As the chart shows, many of the countries in MENA are, well, miserable. Indeed, a score of over twenty indicates that serious structural economic problems exist. To correct these problems, thereby reducing misery, major economic reforms (read: free-market reforms) must be implemented. But, even if the respective governments approve such changes, it is unclear whether they can be implemented. To put a bit of color on that conjecture, consider that only 13 of the 21 countries in MENA reported the four pieces of economic data that are required to calculate my Misery Index. The regional governments’ inability to produce reliable economic data is a canary in a coal mine. When it comes to MENA, most of the countries have been singing for a long time. The region is, by and large, miserable.

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