Topic: Finance, Banking & Monetary Policy

Graeber, Once More

After I published my recent post on “The Myth of the Myth of Barter,” I tweeted the link to it to David Graeber himself, as I thought his response might be interesting.

Was it ever!  Before you could say Jack Robinson, Graeber let loose a fusillade of tweets, each more vicious than the last, calling my post “wildly simple-minded & wrong,” “one of the most embarrassing examples of ideological blindness & arrogant stupidity I’ve ever read,” and that sort of thing.  Graeber even asked, in apparent disbelief, “This guy was a professor somewhere?”  Think what you will of his understanding of monetary economics, or of his scholarship in general: when it comes to vitriolic hyperbole, Professor Graeber is no dilettante.  Indeed, there were a lot more barbs besides these, and there have no doubt been others since.  But as Graeber has blocked me on Twitter, presumably to prevent me from replying, I can no longer retrieve most of them.*

But interesting as Graeber’s response was, it fell rather short of the sort of substantive reply I’d hoped to elicit from him.  The closest Graeber came to that was a tweet claiming that my post was just a rehash of arguments Robert Murphy had made some time ago, to which Graeber had already responded, and another saying that he wasn’t about to waste his time repeating what he’d already said.

In fact I’d read Graeber’s reply to Murphy.  What’s more, I quoted from that reply, to which I supplied a link, in my original post, which I would scarcely have been tempted to do had I believed it answered my own complaints about Graeber’s work.

As a matter of fact, it does nothing of the sort.

Were Banks “Too Big to Fail” Before the Fed?

According to Gary Gorton and Ellis W. Tallman, in their  recently released NBER Working Paper, some were.

For several decades prior to the Fed’s establishment, Gorton and Tallman note, “private bank clearinghouses provided lending facilities and assisted member banks when they needed help.”  The pattern of such assistance, they say, reflected a privately-adopted TBTF policy that “was a reasonable response to the vulnerability of short-term debt to runs that could threaten large banks and thereby the entire banking system.”

These clearinghouse bailouts appear, furthermore, to have succeeded in averting more serious crises.  Since, according to Gorton and Tallman’s understanding, “[t]he logic of modern bailouts is the same” as that adopted by 19th-century clearinghouses, they conclude that TBTF remains a reasonable policy today, and not, as many suppose, an invitation to excessive bank risk taking.

But there’s a flaw in Gorton and Tallman’s reasoning, and I’m afraid it’s a lulu.  The flaw consists of their failure to understand what “Too Big to Fail” means.  That meaning has been clear from the time  Congressman Stewart McKinney first popularized the notion during a hearing concerning the Continental Illinois bailout.  “Mr. Chairman,” McKinney said, “Let us not bandy words.  We have a new kind of bank.  It’s called too big to fail.  TBTF, and it’s a wonderful bank.”

Did Dodd-Frank Increase Bank Capital?

Financial reform has taken a prominent role in the current presidential debates, particularly between Clinton and Sanders.  As Clinton is seen as the candidate of the status quo, her defenders have taken to arguing that the Dodd-Frank Act is “working.”

A recent example of such an argument is Paul Krugman’s claim that, thanks to Dodd-Frank, “banks are being forced to hold more capital.”  But is Krugman’s claim true?

Before turning to the numbers, we should consider just how capital has been regulated before and since Dodd-Frank.  Prior to Dodd-Frank, the primary source of regulatory authority for capital was found in Section 38 of the Federal Deposit Insurance Act (FDIA).  The relevant clauses of that section read as follows:

(c)  CAPITAL STANDARDS.–

(1)  RELEVANT CAPITAL MEASURES.–

(A)  IN GENERAL.–Except as provided in subparagraph (B)(ii), the capital standards prescribed by each appropriate Federal banking agency shall include–

(i)  a leverage limit; and

(ii)  a risk-based capital requirement.

(B)  OTHER CAPITAL MEASURES.–An appropriate Federal banking agency may, by regulation–

(i)  establish any additional relevant capital measures to carry out the purpose of this section; or

(ii)  rescind any relevant capital measure required under subparagraph (A) upon determining (with the concurrence of the other Federal banking agencies) that the measure is no longer an appropriate means for carrying out the purpose of this section.

The first thing to notice is the lack of a ceiling.  Although Section 38(c)(3)(B)  requires that a bank’s capital be “not less than 2 percent of total assets,” there’s no maximum.  Also notice how 38(c)(1)(B)(i) above allows regulators to set additional capital requirements.  In plain English, bank regulators, prior to Dodd-Frank, could have pretty much required whatever capital levels they wanted.

It was under this FDIA authority that U.S. bank regulators began the “Basel III” process, the first consultative paper for which was published in December 2009, a good seven months before Dodd-Frank was signed into law.  Basel III itself was introduced in December 2010, and most of the work of implementing Basel III had been completed before Dodd-Frank’s passage.  Despite what Paul Krugman says, the increases in bank capital that have occurred since the crisis, in so far as they were a result of changes in the law, were largely a consequence of these developments, rather than of Dodd-Frank.  Were Dodd-Frank to be repealed in its entirety, our current bank capital standards would largely be unchanged.

Contrary to Trump-Sanders Theory Imports Rise in Booms and Fall in Recessions

Real GDP Growth and ImportsNearly all surviving Democrat and Republican presidential candidates (except John Kasich) have essentially endorsed the shared campaign theme of Donald Trump and Bernie Sanders that the U.S. economy is weak because we import too many goods from foreign countries.  If only we could raise the cost of imports with tariffs, according to the Trump-Sanders theory, then the U.S. economy would supposedly have more jobs and higher real wages.   

Paying more for anything (such as Fords or iPhones) is no way to get rich.  Yet that concept somehow eludes many non-economists.  Theory aside, the idea that fewer imports are good for the economy is the exact opposite of what we have experienced.  The fact is that U.S. imports always fall when the economy slips into recession and imports rise briskly whenever the economy does.

Government-Directed Lending Comes to America

In perhaps the greatest example of wishful thinking we’ve seen in recent times, the Consumer Financial Protection Board Administrator Richard Cordray testified before Congress last month that banks and credit unions should step up their loans to low-income workers with poor credit by creating new products that compete with payday loans. It is a notion that’s completely at odds with the actions of the CFPB as well as the capabilities of banks and credit unions.

Since its inception the CFPB has all but declared war on payday and title loan companies, the two entities that do the most lending to people with poor or nonexistent credit. The CFPB resents them because the loans are costly and in their view potentially exploitative: a typical loan would be for three or four weeks and amount to $400, with $500 to be repaid at the end of the term. A 25% interest rates for a loan of less than a month amounts to an astronomical annual percentage rate and the CFPB and Department of Justice have deemed it to be needlessly excessive. They have made a concerted effort to make it difficult or impossible for these businesses to survive via something called “Operation Choke Point. ” For instance, it is now much more difficult for these businesses to get bank accounts.

The retrenchment of the industry has created a lacuna: despite fervent wishes to the contrary by the CFPB, many low-income workers find themselves in need of credit, and it’s unclear what will fill this niche.

What is abundantly clear is that banks and credit unions will not be the ones to do this. The large banks in particular feel–rightly or wrongly–to be the government’s victims in the aftermath of the Great Recession, as Congress and the various regulatory agencies sought to assign blame for the financial crisis. The Justice Department fined several banks billions of dollars in the last decade, and not a single one of those banks came out of those negotiations feeling warm and happy thoughts about the federal government.  The notion that they would pick up a new and likely unprofitable business line because Richard Cordray asked them to is absurd when they risk being charged with exploiting these people by loaning them money, as they were with their mortgage loans.

Besides, banks have never been particularly adept at retail innovation: opening more branches has been the extent of their efforts. Retail banking is a conservative business that is ill-suited and disinclined to take risks or try new things.

In my experience banks find it difficult to change their hidebound ways. Twenty years ago I completed my Ph.D. in economics. The day I arrived at my parents’ house with my degree in hand my father made me put on a suit and accompany him to some meetings with various banks and finance companies. He was a bankruptcy attorney and one of his concerns was helping his clients establish some modicum of credit after filing. A good proportion of his clients were forced into bankruptcy by a single unforeseen incident–a health emergency, a divorce, or the short-term loss of a job.

Once these people escaped their debt and were past their crisis, he reasoned, there was no reason why a profit-maximizing business shouldn’t extend them credit, especially if it was secured by some sort of asset. So I spent the day meeting with various banks to discuss the plight of a couple of his recent clients who needed capital to buy a truck for their profitable small business.

My presence didn’t change a thing: Not a single bank would consider making a $10,000 secured loan for a $20,000 truck. They understood our point and often even agreed that these loans could very well make good business sense for them, but lending to a bankrupt is not what banks do, profits be damned.

We ultimately did find financing for his clients, from the household finance and installment loan companies in our city. These firms that were able to think creatively and understand the situation these people were in. The people there knew the community and the people who lived there and had the wherewithal to think on their feet and make decisions that can’t be easily covered by a blanket rule.

Eight percent of the population does not have a bank account and fully twenty percent of the population is considered to be “underbanked” in that they sometimes obtain financing outside of the normal bank/credit union route. Over a third of all households do not own their own home, which in today’s world can limit access to credit too.  These people need to be able to access credit outside of the banking system. Making life more difficult for entities whose business model is to lend to this cohort helps no one.

A few years ago one of my graduate school roommates, who had risen to become a vice president at a major regional bank, embarked on an ambitious plan to help his employer enter the market to provide loans to the underbanked. The effort failed miserably: their bank proved itself unable to make quick decisions on lending, and as a result few people in that market found it of any use. The default rates on their loans were acceptably low but they didn’t come close to covering their investment in this market and they abandoned their efforts within a year.

There is no doubt that there are still some bad actors that take advantage of low-income borrowers, but we are approaching a situation whereby the government considers any entity lending money to the underbanked to be exploiting them. The pendulum has swung too far: we need a government regulator to allow companies to make loans to the underbanked and make a profit in doing so, because squeezing them out, which the CFPB seems intent on doing, won’t benefit anyone.

The Myth of the Myth of Barter

So far as some people are concerned, when it comes to bashing economists, any old stick will do.

That, at least, seems to be true of those anthropologists and fellow-travelers who imagine that, in demonstrating that certain forms of credit must be older than either monetary exchange or barter, they’ve got some of the leading lights of our profession by the short hairs.

The stick in this case consists of anthropological evidence that’s supposed to contradict the theory that monetary exchange is an outgrowth of barter, with credit coming afterwards.  That view is a staple of economics textbooks.  Were it nothing more than that, the attacks would hardly matter, since finding nonsense in textbooks is easier than falling off a log.  But these critics have mostly directed their ire at a more heavyweight target: Adam Smith.

Marketplace Lending: Regulation Ahead?

The Consumer Financial Protection Bureau (CFPB) recently announced that it would start accepting consumer complaints about marketplace lending.  Marketplace lending, previously known as “peer to peer” or “P2P” lending, emerged in the aftermath of the financial crisis.  A combination of tightening credit markets and low interest rates created a perfect marriage between consumers looking for loans and investors looking for profit.  In its first incarnation, peer to peer lending served as an online matchmaking service, allowing prospective borrowers to post requests for loans to be reviewed by individuals willing to make those loans.  “Peer to peer” referred to the fact that the lenders were ordinary people, just like the borrowers.  The loans are non-recourse, meaning that if the borrower fails to repay, the lender is simply out of luck.  Although these would appear to be risky loans, in fact, the default rate has been surprisingly low: 4.9 percent at market-leader Prosper as of the end of 2014, and 5.3 percent at the other leader, Lending Club, during the period between Q1 2007 and Q1 2015.

The loans have performed so well that the market quickly attracted institutional investors and more sophisticated business models.  As the two leading providers of marketplace loans today, Prosper and Lending Club use the same (somewhat complex) model.  The companies issue notes to investors that are obligations of the issuing company. Simultaneously, WebBank, a Utah-based FDIC-insured bank, originates a loan which is sold to the company. The company pays for the loan with the proceeds from the sale of notes to investors. The loan is disbursed to the borrower. The borrower repays the funds in accordance with the terms of the loan. And the payments from the borrower are used to pay the purchasers of the company’s notes. The payment of the notes is explicitly dependent on the borrower’s repayment of the loan.

Since marketplace lending has gained momentum, there have been concerns about its regulation – expressed both by those who worry that it’s completely unregulated (not true, but there have been no new regulations specifically targeting the industry), and by those–like me–who worry that its innovation will be smothered while the industry is still in its infancy.