Finance, Banking & Monetary Policy

January 11, 2021 11:33AM

The New Deal and Recovery, Part 9: The AAA

Having devoted the last two posts in my New Deal series to the NRA, I may have given readers the impression that I had nothing to say about the consequences of the Agricultural Adjustment Act (AAA) passed more than a month before the National Recovery Act. As this series is about the New Deal's contribution to economic recovery, you perhaps assumed that I skipped the AAA because it was a farm relief and reform measure only, and not an important part of FDR's recovery strategy.

If so, you were mistaken, for I realize that FDR saw the AAA and NRA as twin pillars of his recovery plan. The NRA was supposed to boost manufacturers' revenues by ending cutthroat competition, while enhancing their workers' purchasing power by raising their wage rates. The AAA was, in the meantime, supposed to raise farm product prices, and thereby boost farmers' purchasing power, by getting farmers to cut their output. Indeed, if FDR can be said to have considered either program more crucial to recovery than the other, it was to the AAA that he assigned top priority. I took up the NRA first, not because I considered the AAA less important, but because the NRA's tendency to reduce the real gains from gold-based demand growth made it seem natural to turn to it immediately after discussing New Deal gold policies.

Despite its name, the NRA ended up hampering "national recovery" instead of promoting it. In contrast, many experts believe that the less ambitiously-named AAA did promote recovery. In today's installment to my New Deal series, I discuss the AAA's origins, how it was supposed to help end the depression, the extent to which it succeeded, and its long-run repercussions. To anticipate: although the AAA may have aided recovery, its contribution was probably very modest, while its long-run consequences have been so negative that one may well conclude that it ultimately did more harm than good.

Read the rest of this post »
January 4, 2021 2:38PM

The Economics of Divestment

The comptroller of New York State, Thomas P. DiNapoli, recently announced that the New York State pension fund will divest itself of many fossil fuel stocks within five years. He said, “investing for the low‐​carbon future is essential to protect the fund’s long‐​term value.” He had resisted such a strategy for many years because of his fiduciary duty to fund the retirement benefits of state and local public sector workers.

Investment restrictions are increasingly common. 26 percent of all U.S. professionally managed assets—worth $12 trillion—are governed by investing limitations; $3 trillion have fossil fuel restrictions.

And some claim that the tradeoffs Di Napoli worried about have disappeared: you can sell fossil fuel assets and improve returns. The Rockefeller Brothers Fund claims to have reduced its exposure to fossil fuel companies and increased its returns relative to a benchmark investment portfolio.

How should we evaluate such claims? What can disinvestment achieve?

If investment markets are efficient, then all known factors affecting the future returns of assets are already incorporated into the values of stocks and bonds. Thus, if investors believe that future climate change policy will reduce the demand for and the future returns from fossil fuel investments, that knowledge already has been incorporated into the relevant stock and bond prices. New York State’s (or any other investor’s) decision to reduce fossil fuel investments over the next few years cannot prevent investment losses of this type because they have already occurred and will recur in the future if additional negative information arises.

What if fossil fuel demand continues for decades and fossil fuel investments generate profits for decades? How does a policy of shunning fossil fuel assets affect the returns of those assets and the other assets that remain in the portfolios of those who divest?

Before divestment occurs, assume that all investors hold the portfolios of stocks and bonds that they prefer. Many are index investors who own the entire market. Others weight assets differently because they have beliefs about future earnings of sectors or companies that are not incorporated in current asset market prices.

Now assume that some holders of fossil fuel assets want to sell them to signal their moral disapproval and/​or force the companies to change behavior. The first question is who will buy the shunned assets and at what price? The only buyers are individual investors or managed mutual funds. And both already were satisfied with their portfolio composition. To induce either to (in effect) “overweight” fossil fuels in their portfolios, the price of fossil fuel assets must fall, which compensates for the future “thinner” resale market for such stocks because of “shunning.”

The result is that whatever price would be consistent with the cash flows generated by fossil fuel stocks if they were “normal” firms must now be discounted to induce anyone to own them because the stigma associated with the industry implies that the future ability to resell the stock is lower. One receives the same expected future cash flows for a lower price to compensate investors for the “thinner” resale market.

What happens to the prices of those investments bought by those who shun (and thus sold) fossil fuel stocks? Using the same logic as before, the individual investors who purchase the fossil fuel stocks at a discount simultaneously sell other stocks at a premium to those who shun fossil fuel stocks.

By lowering the price on existing investments, disinvestment does reduce investment in future fossil fuel projects. Investors’ willingness to pay for estimated future cash flows from new fossil fuel projects decreases to be consistent with the lower price for current cash flows from existing investments. Thus, the set of projects for which investment covers costs and produce sufficient cash flows to induce investment is now smaller. Stated differently, lower prices for fossil fuel assets mean a higher cost of raising funds for new investments because, at a lower price, fossil fuel firms have to issue more shares to raise a given amount of funds, which is costly to existing owners because it dilutes their existing ownership.

Is there evidence consistent with this discussion of theory? A recent paper examines the returns of all public U.S. companies from 2005 through 2017. After controlling for variables that predict investment returns, firms with higher CO2 emissions generate higher returns. A one‐​standard‐​deviation increase in the level and change of total emissions leads to 1.8% and 3.1%, respectively, increases in annualized returns.

To summarize, disinvestment decreases the price of disfavored stocks and increases the price of all other stocks. As long as all other factors remain constant, fossil fuel stock returns increase and all other stock returns decrease. But the silver lining for those who advocate disinvestment is a higher cost of capital for and thus fewer future fossil fuel projects. Thus, disinvestment does promote the objectives of its advocates; but claims that doing so is costless do not stand up to theory or evidence.

December 28, 2020 9:34AM

Has Bitcoin Succeeded?

The answer depends on what you mean. Succeeded at what?

With the US dollar price of Bitcoin reaching an all-time high above $23,000 this month, and its market cap reaching an all-time high above $400 billion, there has been much celebration among Bitcoin holders about their success at investing. The run-up has accompanied the announcements by large institutional investors Grayscale, MicroStrategy, and MassMutual that they are acquiring hundreds of millions of dollars in Bitcoin for their investment portfolios. There isn't much doubt that the Bitcoin project has succeeded remarkably at creating a new type of asset.

Read the rest of this post »
December 18, 2020 1:59PM

Modeling the Legend, or, the Trouble with Diamond and Dybvig: Part II

[This is the last half of a two-part critique of Douglas Diamond and Philip Dybvig's highly influential paper purporting to show that fractional reserve banking systems are inherently unstable. Part I can be found here.]

Sauce for the Goose…

Half a century after the fact, the "aggregate uncertainty" version of the Diamond-Dybvig model appeared at long last to offer solid proof of the inherent instability of ordinary banks, together with an equally solid foundation for government deposit insurance. But no sooner had the inspectors started poking their flashlights around that supposedly solid structure than its serious weaknesses became evident.

The first casualty of that inspection was Diamond and Dybvig's case for deposit insurance. That case depends on their model's "sequential service" constraint, which calls upon their bank to meet its depositors' demands on a first-come-first-served basis. The constraint matters because, if it could instead delay paying its customers until it has received all of their requests, a Diamond-Dybvig ("D-D") type bank could make its period-1 payments contingent on total period 1 withdrawals, thereby ruling-out runs despite aggregate uncertainly, by achieving the same structure of expected returns it might achieve using the threat of suspension in the aggregate certainly-sequential service case.

The problem with Diamond and Dybvig's case for deposit insurance is that it implicitly and illogically exempts government authorities from the sequential service constraint imposed on the D-D bank. In order for the deposit insurance solution to work, the government must itself accumulate all period-1 payment requests, and then present those making such requests with their (optimal) tax bills before they actually withdraw funds, lest unwanted withdrawals should cut into period-2 returns by interrupting the production process. There must, in other words, be no "first-come-first-taxed" constraint on the government corresponding to the bank's "first-come-first-served" constraint. Although Diamond and Dybvig recognize that their case for deposit insurance rests upon this "asymmetry" in their treatment of the sequential service constraint, they never bother to justify it. They therefore opened themselves to the charge, leveled at them by Neil Wallace, of not taking their model's sequential service constraint "seriously."

Read the rest of this post »
December 17, 2020 2:07PM

Modeling the Legend, or, the Trouble with Diamond and Dybvig: Part I

Has any theoretical work on banking been more influential than Douglas Diamond and Phillip Dybvig's 1983 JPE article, "Bank Runs, Deposit Insurance, and Liquidity"? If so, I can't think of it. With well over 12,000 Google citations and counting, it's certainly among the most cited academic papers in economics, let alone in the sub-discipline of monetary economics.

Nor has that paper's influence been merely academic. Far from it: it is routinely cited by policymakers as supplying a rationale for government intervention in banking, and for explicit national deposit insurance schemes in particular. That the number of countries that adopted such schemes more than quadrupled during the two decades immediately following the article's appearance—from just 20 to 87—almost certainly owes something to Diamond and Dybvig's influential publication, which is bound to have informed the thinking of experts at the IMF and other international agencies who recommended deposit insurance as the best cure for banking crises.[1] Alas for Diamond and Dybvig and the citizens of the countries that followed those experts' advice, its practical results can't be said to have been universally benign.

That the Diamond-Dybvig model should have become so popular in policy circles isn't hard to fathom. So far as many policymakers (and more than a few economists) are concerned, it shows, "rigorously," that ordinary (that is, fractional-reserve) banking systems are inherently unstable, and that deposit insurance or an alert and efficient lender of last resort or some other form of intervention, like narrow banking, is needed to stabilize them. Ask an expert who advocates any of these solutions for proof that it's necessary, and chances are he or she will eventually get around to saying, in essence, "See Diamond and Dybvig (1983)." Q.E.D.

There's just one problem. It's that Diamond and Dybig (1983) demonstrate no such thing.

Read the rest of this post »
December 10, 2020 10:06AM

Ending the Fed’s Emergency Lending Facilities: Mnuchin v. Waters

On November 19, Treasury Secretary Steven Mnuchin announced that he would sunset five of the Federal Reserve's emergency lending programs at year-end: the Primary Market Corporate Credit Facility, Secondary Market CCF, Municipal Liquidity Facility, Main Street Lending Program, and Term Asset-Backed Securities Loan Facility (TALF). His decision, expressed in a letter to Fed Chairman Jerome Powell, is based on the claim that the Coronavirus Aid, Relief, and Economic Security (CARES) Act requires that the programs be ended on December 31, 2020.

However, he also thinks that the five emergency lending programs, established under Section 13(3) of the Federal Reserve Act, are no longer needed. In particular, he contends that the mere announcement of substantial support for distressed corporate and municipal debt markets helped stabilize financial markets and reduce spreads.

The Fed has only funded about $25 billion of loans and assets for the five programs out of $454 billion Congress provided to establish the facilities under the CARES Act. Mnuchin would like the Fed to return the unused funds so that the incoming Congress could reallocate them, presumably for another stimulus package. In a proviso, Mnuchin argues that, if necessary, the Fed could request one or more of the rescinded facilities to be refunded using the Treasury's exchange stabilization fund, "to the extent permitted by law," or funds appropriated by the incoming Congress.

Read the rest of this post »
December 3, 2020 2:34PM

The Wide World of ESG

Remember the Wide World of Sports?

Spanning the globe to bring you the constant variety of sport… the thrill of victory… and the agony of defeat… the human drama of athletic competition.

I loved it. You never knew exactly which sport you'd be watching when you tuned in, but you knew you'd be in for drama. Lately, I've begun to think about the term "ESG" in the same way. You never know exactly which concept you're discussing, but you know there will be drama.

Read the rest of this post »