Topic: Finance, Banking & Monetary Policy

Private Money, Theoretically

Henry James, T.S. Elliot famously remarked, “Had a mind so fine that no idea could violate it.”  Similarly, more than a few economics papers involve formal models so fine that no facts can violate them.

Two recent examples purport to demonstrate the instability and inefficiency of “private money.”  One, on “Private Money and Banking Regulation,” appeared in the September 2015 Journal of Money, Credit and Banking (JMCB).  Its authors are Cyril Monnet, a Professor at the University of Bern, and Daniel Sanches, an economist at the Philadelphia Fed.  The other, by Sanches alone, is called “On the Inherent Instability of Private Money,” and is about to be published in the Review of Economic Dynamics (RED, for short).

That the models in these papers are indeed “fine,” meaning first-rate, from a strictly analytical point of view, can’t be gainsaid.  They meet all of the exacting requirements of  those economists who insist that a model’s institutional features should be “essential” in the sense Frank Hahn had in mind when he argued that monetary GE models should provide an essential role for money.  The features must, in other words, overcome frictions inherent in the model environment that would otherwise condemn optimizing agents to lower levels of utility.  In particular, the models in question supply “essential” roles for indirect exchange, banks, and banknotes.  Yet they are tractable enough to allow their authors to draw inferences from them concerning both the stability and the efficiency of private currency.  So far as the realm of formal economic modeling is concerned, these are highly impressive achievements.

Good Question: What to Do Before Major Change

“Dean Dad” Matt Reed has responded to my rebuttal to him Tuesday, and I appreciate his engaging me in discussion. His main point now: The student loan default problem is not mainly about big total debts, but smaller debts that are hard to pay off because the students dropped out before getting a degree.

I agree. Indeed, that was pretty much the point of my Wall Street Journal article that kicked off the exchange. As I wrote:

Many dropouts have loans, which are much harder to repay when one fails to finish, or gets a worthless degree. Borrowers on the academic margins, who often attend community colleges and for-profit schools, likely struggle the most to repay even though their debts tend to be relatively small. The Federal Reserve Bank of New York found that 34% of borrowers with debts between $1,000 and $5,000 defaulted, versus only 18% with debts in excess of $100,000, a level of debt associated with advanced degrees.

Where the confusion might lie is that I thought in his response to me Reed was suggesting that a major problem for anyone coming out of community college was that the minimum wage was too low and, connected to that, so were the wages of entry-level jobs. This was based on the following:

Why are former students having a hard time paying debt back? Mostly because entry-level jobs don’t pay very well. But McCluskey never addresses either the supply of entry-level jobs, or the minimum wage. 

Knowing that Reed did not mean to include graduates among “former students” makes his comments about low wages less alarming. Still, his solution – raise low wages instead of requiring evidence of college readiness – seems a broad, slow, and dubious way to deal with the debt problem. “Broad” because it calls for, essentially, overhauling a huge part of the economy as opposed to specifically reforming students loans; “slow” because doing that would take a pretty long time; and “dubious” because there is a lot of evidence that raising the minimum wage has substantial negative effects.

In addition to raising the minimum wage, Reed calls for “free (or much less expensive) community college.”

Free community college would probably solve the problem of community college noncompleters leaving with debt, depending on how one accounted for living expenses, but it comes with its own set of troubles. The first is that we would likely still have lots of people not finishing, only the costs would be borne more by taxpayers and less by students. The second is that, unless “free” were somehow focused on the poor, you would have taxpayers subsidizing well-to-do people. Recent data show about 39 percent of dependent undergraduate students at community colleges, and about 54 percent of independent students, are from the upper half of the income distribution.  About 16 and 28 percent are from the highest income quartile. Then there is the question of how to pay for this, especially if making it free leads to even more people enrolling. And will community colleges be able to handle all of the new students, or will they have to ration spots? What will encourage students to complete their studies as quickly as possible?

The Administration’s Puerto Rico Jujitsu Threatens the States’ Ability to Borrow

The New York Times reported last week on some of the details of the Obama Administration’s recovery plan for Puerto Rico, and it does not bode well for investors — or for states and municipalities that borrow money.

The island’s government is $72 billion in debt, with billions more in unfunded pension obligations.  It has been in recession for a decade during which time it has never run a balanced budget, and today it is nearly bankrupt.  The government has appealed to the federal government to help, and the Treasury has drawn up a plan.  A major feature of that plan is that it will ignore the law by putting government employee pensions in front of general obligation bondholders in the hierarchy of credits, despite the provision of Puerto Rico’s Constitution that mandates GO bondholders will be paid before all other government obligations.  The rationale for doing so is, essentially, that public sector pension holders are in greater need of the money than the investors (many of whom are retirees and pensioners themselves), so this ex post change is simply a matter of fairness.

The bondholders, naturally, do not like this. After lending money to the Puerto Rican government under the explicit assurance that they would have the highest priority in all payment scenarios, having this promise revoked seems a tad unfair, as well as blatantly illegal.

It isn’t just the Puerto Rican bondholders that should be angry.  The problems with screwing over bondholders in order to protect government pensioners goes farther than its illegality:  Doing so sets a precedent for dealing with other bankrupt states in the future.  While the Administration avers that this in no way sets a precedent, since the fifty states have recourse to use Chapter 9 of the federal bankruptcy code to reorganize, the reality is otherwise.

The Times correctly notes that Chapter 9 makes no provision for the states extricating themselves from their own general obligation debt.  No out was given for a very good reason:  Foreclosing the possibility of a default up front (at least as much as possible) makes it easier and cheaper for states to borrow money.

The Obama Administration’s proposal threatens to upset this equilibrium.  By upending the law and decades of precedent, the Treasury’s plan threatens to make it more difficult for the states and municipalities to borrow money as well, since their lenders see that they too, might get their promise of being first to be repaid pulled out from under them.

This administration has a long history of picking winners and losers in bankruptcy.  In the Chrysler and GM bankruptcies, the secured bondholders took a major hit being reduced to unsecured status while workers and pensioners were elevated to protected status, and the Detroit bankruptcy did the same thing.

While it may seem “fair” to help little old ladies rather than mean old hedge funds, the investors who lost money in these maneuvers weren’t Wall Street plutocrats — they were regular people who invested their money into assets they thought were safe, because the law explicitly said they were. Many of them are retirees and pensioners themselves, and thousands of them will see a reduction in the value of their retirement funds.  CNN recently reported that 45% of Puerto Rico’s debt is held by “middle class Puerto Ricans” and “average Joe Americans.”  Abrogating bankruptcy law isn’t akin to Robin Hood — it’s transferring money from one group of retirees to another.

A Puerto Rico bailout that punishes secured bondholders would represent a short-term political win for the Treasury but at a long-run cost to the rest of the country in the form of higher borrowing rates.  It would be a terrible precedent.  It is hard to conceive of a reason for a Republican Congress to acquiesce to such a thing, or to allow a control board to do such a thing down the road.

[Cross-posted from]

The War against Cash, Part III

Although it doesn’t get nearly as much attention as it warrants, one of the greatest threats to liberty and prosperity is the potential curtailment and elimination of cash.

As I’ve previously noted, there are two reasons why statists don’t like cash and instead would prefer all of us to use digital money (under their rules, of course, not something outside their control like bitcoin).

First, tax collectors can’t easily monitor all cash transactions, so they want a system that would allow them to track and tax every possible penny of our income and purchases.

Second, Keynesian central planners would like to force us to spend more money by imposing negative interest rates (i.e., taxes) on our savings, but that can’t be done if people can hold cash.

To provide some background, a report in the Wall Street Journal looks at both government incentives to get rid of high-value bills and to abolish currency altogether.

Some economists and bankers are demanding a ban on large denomination bills as one way to fight the organized criminals and terrorists who mainly use these notes. But the desire to ditch big bills is also being fueled from unexpected quarter: central bank’s use of negative interest rates. …if a central bank drives interest rates into negative territory, it’ll struggle to manage with physical cash. When a bank balance starts being eaten away by a sub-zero interest rate, cash starts to look inviting. That’s a particular problem for an economy that issues high-denomination banknotes like the eurozone, because it’s easier for a citizen to withdraw and hoard any money they have got in the bank.

Now let’s take a closer look at what folks on the left are saying to the public. In general, they don’t talk about taxing our savings with government-imposed negative interest rates. Instead, they make it seem like their goal is to fight crime.

Money-Market Mutual Funds: Restrictions, Run-Proofing, and Regulatory Pretense

You may recall from my last post that in September 2008 the failure of Lehman Brothers caused sizable losses to a large money-market mutual fund, The Reserve Primary Fund, which held hundreds of millions in Lehman IOUs. These losses reduced the fund’s asset portfolio value below its total share value at the pegged redemption rate of $1 per share. For two business days the fund’s management neither reduced the share claims nor injected capital to restore the assets. Alert institutional shareholders saw that there wasn’t enough asset value to pay everyone $1 per share, but the first to redeem could get that much, and so quite rationally ran to redeem. On the second day Reserve Primary “broke the buck,” re-pricing its NAV to 97 cents. It was eventually liquidated. Other “prime” mutual funds experienced heavy redemptions during those two and the following two days, although none broke the buck. (Many received capital injections from their sponsoring firms.) On the fifth day the Treasury stepped in to guarantee the $1 share price of all money market mutual funds.

Many regulators and economic analysts have inferred from these events that money-market mutual funds (MMMFs) are inherently run-prone.  The fact that this was the first run in MMMF history, however, should give us pause.  There is a more plausible reading of the evidence.   Although the Reserve Primary Fund did invite a run by letting its total shareholder claims exceed its total assets in value for a bit more than a day, MMMFs can be structured and managed so that this never happens.

In a nutshell, the stage is set for a run on a bank or mutual fund when claims can be redeemed on demand, and claimants have reason to believe that their total claims exceed total assets (plus any off-balance-sheet funds) available for paying them.  Bank deposits are debt claims to fixed dollar sums, so a sudden drop in the market value of assets can trigger a run if the bank is so thinly capitalized that market net worth becomes negative.  Mutual fund shares are not fixed-dollar debts, but equity claims to percentages of the asset portfolio, such that total claims are supposed to add up to 100% of the asset portfolio and no more.  (Neglect of the distinction between debt and equity funding, by the way, is embodied in the obfuscatory language according to which MMMFs and hedge funds are part of a “shadow banking” system.)  When assets drop in value, share accounts are to be marked down correspondingly, so that they never over-claim the assets.

Cowen on Central Banks and Liquidity Traps

These are challenging times for monetary economists like myself, what with central banks making one dramatic departure after another from conventional ways of conducting monetary policy.

Yet so far as I’m concerned, coming to grips with negative interest rates, overnight reverse repos, and  other newfangled monetary control devices is a cinch compared to meeting a challenge that nowadays confronts, not just monetary economists, but economists of all sorts.  I mean the challenge of  getting one’s ideas noticed by that great arbiter of all things economic, Tyler Cowen.

Last week, however, Tyler may have given me just the break I need, in the shape of a brief Marginal Revolution post entitled,  “Simple Points about Central Banking and Monetary Policy.”

Tyler’s “simple points” are these:

Central banks around the world could raise rates of price inflation, and boost aggregate demand, if they were allowed to buy corporate bonds and other higher-yielding assets.  Admittedly this could require changes in law and custom in many countries[.]

There is no economic theory which says central banks could not do this, as supposed liquidity traps would not apply.  These are not nearly equivalent assets with nearly equivalent yields.

Tyler isn’t one to traffic in banalities, so it’s no surprise that his claims are controversial.  Why so? Because the prevailing monetary policy orthodoxy, here in the U.S. at least, insists that, rare emergencies aside, the Fed should stick to a “Treasury’s only” policy, meaning that it should limit its open-market purchases to various Treasury securities.  For the Fed to do otherwise, the argument goes, would be for it to involve itself in “fiscal” policy,  because its security purchases would then influence, not just the overall availability of credit, but its allocation across different firms and industries.  So far as the proponents of “Treasuries only” are concerned, Tyler’s remedy for deflation would create a set of privileged or “pet” corporate securities, analogous to, and no less obnoxious than, the “pet banks” of the Jacksonian era.

All of which is good news for me, because I’m prepared, not only to side with Tyler in this debate, but to offer further arguments in support of his position.  For I took essentially the same position in a paper I prepared for Cato’s 2011 Monetary Conference.  In that paper, I first counter various arguments against having the Fed purchase private securities, and then proceed to recommend a set of Fed operating-system reforms involving broad-based security purchases.  I figure that, with a little luck, Tyler may find those arguments and suggestions worthy of other economists’ attention.

Here is a quick summary of my paper’s arguments and suggestions.

Tax Reform Revenues Wrongly Contrasted with Soaring CBO estimates

CBO Baseline Projected Revenue

When the Brookings Institution and Urban Institute claim any tax reform will “lose trillions” they are comparing their static estimates of revenues from those plans (which assume tax rates could double or be cut in half with no effect on growth or tax avoidance) to totally unrealistic “baseline” projections from the Congresional Budget Office.  Those CBO projections assume that rapid 2.4% annual increases in real hourly compensation over the next decade will push more people into higher tax brackets every year.  As a result, the average tax burden supposedly rises forever – from 17.7% of GDP in 2015 to 19.9% in 2045 and 23.8% by 2090.  And, typical of static estimates, this ever-increasing tax burden is imagined to have no bad effects on the economy.

Such a high level of federal taxation never happened in the past (20% was a record set in the tech stock boom of 2000) and it will never happen in the future.  In short, this is an entirely bogus basis by which to judge tax reform plans.

A far more sensible question would be this:

Will the Cruz or Rubio tax reforms raise just as much money as the Obama “tax increase” has – namely, 17.5% of GDP from 2013 to 2015. If so, then real tax revenues will grow faster after reform because real GDP growth will surely be at least 1.2% faster – or a middling 3.5% a year, which is all the cautious Tax Foundation estimates suggest.