Debt, debt, debt, debt

I’m rather late to by Atif Mian and Amir Sufi, which is recently out in paperback. It argues eloquently and persuasively that the Great Financial Crisis was not only a banking crisis but also a household debt crisis, and that the length and severity of the downturn can largely be explained by the private debt overhang. This is not the received wisdom, of course. All the policy attention has focused on the near-catastrophe of the banking meltdown, and it is terrifying even now to think how serious the economic consequences would have been if the payments systems had stopped working, as they almost did in the UK. The book acknowledges that the authorities were absolutely right to act swiftly to prevent banking meltdown, and argues that more would have been better – more in the sense of the famous ‘helicopter money’ drop advocated by Adair Turner, for one, in his recent

[amazon_image id=”022627165X” link=”true” target=”_blank” size=”medium” ]House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again[/amazon_image]

However, Mian and Sufi also point out that while political campaign contributions can be shown to have led the US Congress to support bank bailouts, there was next to no household debt relief. The core of their argument is that the effects of household leverage spilled over to the whole US economy, and that writing off some of the debt owed by homeowners underwater (not because of idleness or irresponsibility but because of a macro shock) would have benefited everyone. I found their argument convincing, along with the corollary that you can not fix an excess debt problem by getting people to take on more debt. The book makes a strong case for reducing the attractiveness of debt, due in large part to the tax system. They write:

“Debt instruments lead investors to focus on a very small part of the potential set of outcomes …In a world of neglected risks, financial innovation should be viewed with some degree of scepticism. If investors systematically ignore certain outcomes, financial innovation may just be secret code for bankers trying to fool investors into buying securities that look safe but are actually extremely vulnerable.” They are also critical of the extent of the bailouts for the financial sector: “The fundamental business of a bank is lending, just as the fundamental business of a furniture company is to sell furniture. Few economist believe that the government should promote the sale of bad furniture by stepping in to protect the creditors and shareholders of a poorly performing furniture company.” This understates the externalities involved in a bank failure, of course, and – as I noted – Mian and Sufi do not condemn the authorities’ response in 2008/9.

Given where we are, they advocate instead a range of measures to reduce debt dependence in future, including levelling the tax code as between debt and equity, and encouraging the use of more equity-like financial instruments, including in lending for home purchase. They cite approvingly Bob Shiller’s suggestions for instruments to insure against macro risks (in his book ) and s advocacy for far higher levels of equity as opposed to be debt to be required on banks’ balance sheets. These kinds of arguments are slowly making headway in both economics and in policy circles. But slowly. Meanwhile, what is terrifiying is the evidence of a re-inflating of the debt bubble in some economies, including the UK. Can we really be ready to risk going around the same hamster wheel again, just because the financial sector lobbies so effectively?

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American exceptionalism, inequality version

Yesterday on my travels I read a short book, , by Matthew Drennan. Professor Drennan is an urban planning expert, so having read the book’s blurb, I expected it to be a critique of the economics profession, and braced myself.

[amazon_image id=”0300209584″ link=”true” target=”_blank” size=”medium” ]Income Inequality: Why it Matters and Why Most Economists Didn’t Notice[/amazon_image]

It ended up not being what I expected. In fact, the book repeats Raghuram Rajan’s argument in – that low-income Americans went into debt to increase their consumption levels as well as buy homes, keeping up somewhat with the rich thanks to easy credit. One of the central chapters has a long appendix reporting some econometric work claiming to establish causality between higher income inequality and higher debt. However, it is not sufficiently detailed to be able to assess the empirical work, while too technical to be of interest to the general reader. So the central section of the book is a bit odd.

It’s a fair cop to say the generality of the economics profession did not pay enough attention to rising income inequality. The biggest lasting impact of Piketty’s , and the work with Atkinson and Saez on which it was based, will turn out to have been consciousness raising. Nobody is ignoring it now. However, there are now several important books on this subject: as well as and , Mian and Sufi’s , Atkinson’s , Francois Bourguignon’s and Branko Milanovic’s forthcoming . I didn’t find much novelty in Drennan’s , although it is at least a short introduction.

Above all, though, my reaction to the book wasn’t that it was about economics, more that it was about America. We do tend to forget that inequality is greater in the US than most other OECD countries, and has risen more. Perhaps it can act as the canary in the cage for the rest of us, but a good part of the story lies in US politics and institutions. After all, just look at the Republican primary contenders.

OECD income inequality

OECD income inequality

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Bankrupt banks

I’ve been browsing through a new book, , edited by Kenneth Scott, Thomas Jackons and John Taylor. The book is the product of a Hoover Institution project formed in 2009 to address concerns about the moral hazard that would result from bank bailouts. The project quickly concluded that a bank ‘resolution’ procedure was vital, and proposed a Chapter 14 of the US Bankruptcy Code to create a mechanism ready to be applied to restructure or liquidate any large financial institution of systemic importance that gets into trouble.

[amazon_image id=”B015M9SQYK” link=”true” target=”_blank” size=”medium” ]Making Failure Feasible: How Bankruptcy Reform Can End Too Big to Fail[/amazon_image]

The book spells out the rationale for a bank resolution mechanism and explains in more detail how the Chapter 14 would work. It argues that the proposal would make it easier for US banks to comply with the ‘living will’ requirement of the Dodd-Frank Act. As the book notes in a later chapter, however, a domestic resolution procedure, even for the US, is only a partial answer for banks that are of global importance. The Bank of England and IMF have said there are 16 of these institutions. And there is, the cross border chapter here says, no consensus internationally about the right approach to bankruptcy. So if there is another global financial crisis in the short term, we will be in huge trouble again.

Still, it is good to see that people have been working on detailed bankruptcy proposals – although the detail will be of interest mainly to banking specialists, which I’m not. Let’s hope the regulators get on to the global complexities soon.

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The devil take the debt

Adair Turner’s – out this month – joins a select group of books that provide as clear an explanation of the financial crisis as one could hope for. It complements John Kay’s , with its emphasis on globalisation, financialisation and the switch from relationship to transactional finance. emphasises above all the inherent instability of banks’ ability to create credit, when not restrained by policy, especially given the scarce supply of that all-important asset, real estate. The growth of the shadow banking sector amplified this pre-existing source of volatility.

[amazon_image id=”0691169640″ link=”true” target=”_blank” size=”medium” ]Between Debt and the Devil: Money, Credit, and Fixing Global Finance[/amazon_image]

The book starts by pointing out that it was always foolish to think financial markets would satisfy the criteria for efficient (and stable) outcomes. The pre-crisis orthodoxy of liberalisation ignored the pervasive information asymmetries and non-rational choices in finance. features prominently here. As Turner points out, it isn’t as if there was any shortage of evidence from history that financial crises occur reasonably frequently. He adds the distinctive feature of the recent crisis, the increased inequality of incomes driving demand for easy credit, which banks were only too happy to meet. (Echoes of of Raghuram Rajan’s .)

The third part of the book covers the global dimensions of the crisis, in particular the China-US flows, and the role of the Euro. The financial flows not intended for direct investment were both immense and destabilizing, he writes. Among the high income countries, gross cross-border flows increased from less than 10 times GDP in the 1970s to 37 times GDP in the 2000s, with even larger proportionate increases for middle income countries. There is no evidence at all, he argues, that financial flows on this scale play any socially useful role at all.

And in this context of unsustainable credit growth at home and destabilizing flows across borders, only a minority of banks proved able to manage their balance sheet risks. To make matters worse, those that were good at risk management looked after themselves by offloading their bad risks onto other financial institutions, less well able to manage them. So the outcome for the system as a whole was even worse.

Given the difficulty of tackling the three drivers of the crisis – a limited supply of land and real estate, income inequality and global imbalances – what does Turner, a former head of the FSA, recommend? His answers are interventionist, suggesting a total rejection of the idea that finance can be left to ‘the market’. “To achieve a less credit-intensive and more stable economy, we must … deliberately manage and constrain lending against real estate assets,” he writes. He also advocates central bank monitoring of credit growth, constraining it when necessary; taxation of land values; taxation of debt to bring its treatment in line with taxation of equity; and raising bank equity ratios and minimum liquidity requirements (a step advocated by every, but every, economist who has given a moment’s thought to the crisis – shocking that the banks have lobbied their way out of this minimal step towards systemic stability).

Indeed, the book’s final chapter has some sympathy for even stronger measures: outlawing private money and credit creation; taxing credit creation funded by debt; and encouraging equity and hybrid instruments in place of debt.

However, the book concludes with a caution: “We face a choice of imperfections, and some of the imperfections are unfixable.” Financial markets are imperfect; so are policy-makers. Simple rules will never deliver stability, Turner argues. Far tougher constraints on the financial sector are needed. But policymakers will always have to make judgments as conditions change, and will get it wrong sometimes. Still, he suggests, not as wrong as in the mid-2000s.

Turner is at the tougher end of the spectrum in terms of his recommendations for constraints on the financial sector. But his calls for reforms join an honourable roll call of economists – as well as and , , , for example. As points out, millions of people are still suffering from the effects of the financial crisis. Yet the policy response has been minimal, and there is nothing to stop the whole thing from happening all over again. At least if it does, nobody will be able to blame the economists this time for not having sounded the warning.

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Not the sharks’ fault

Joris Luyendijk is speaking at the Festival of Economics in Bristol in November so naturally I had to read his book and have torn through it. It’s a fantastic book, and is up there with Whoops! by John Lanchester as a guide to the financial crisis. There is lots of close observation, not unsympathetic. For example, spotting that it’s the Continental European bankers who wear blue suits and brown shoes – so true. What’s that about? His many interviews also provide revealing vignettes, like the group of middle-ranking bankers singing ‘Another One Bites the Dust’ in authumn 2008 when news of another bank failure broke.

[amazon_image id=”1783350644″ link=”true” target=”_blank” size=”medium” ]Swimming With Sharks: My Journey into the World of the Bankers[/amazon_image]

It’s also a terrifying book. In the opening pages Luyendijk reminds us how close the economy and consequently society came to collapse in October 2008. In the UK we were a few hours away from cash machines, supermarket and petrol station tills not working, logistic chains breaking down. The Bank of England Court minutes recently published confirmed demand for cash had shot up and new banknotes had to be printed. I certainly got out a lot of cash. By the end of , you realise that the whole thing can happen again, and probably will. Nothing has changed.

This is not because bankers are immoral and greedy, although many, he says, are amoral. It is a whole system problem: the gripping image is a plane, on which we’re all sitting having a meal and a drink, slowly realising that the cockpit is empty. Interestingly, he pinpoints a specific London problem of people staying with high-paying City jobs because they have a huge mortgage and high school fees.

Like Luyendijk, I’ve often wondered why there has been so little political imperative to change the system – it is a matter of politics. And some of the key measures are not at all difficult to get your head round: smaller banks, and much, much more equity capital and less leverage. Simples. It’s a good time for new books about finance, with John Kay’s and Adair Turner’s . Let’s hope that a new crop of books making exactly the same recommendations will help change the political climate. That means lots of people need to read them – and of course come the the Festival of Economics.

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