Perceptive comments as usual, JKH. I suspect that the expectations that financial market investors have about returns and risk have been unrealistically optimistic, so that it was difficult to find business projects that measured up. Consumption shifting borrowers, on the other hand, were sufficiently optimistic about their future, or sufficiently desperate, to pay a high enough return to get funded. In my opinion, the central planners - ie the economic authorities - failed in two ways. First, they repeatedly protected financial market investors by cutting interest rates when more extreme risks looked like being realised (eg 1998 LTCM crisis). Second, they could have continued to forcibly divert income into investment by not cutting taxes and spending more on public infrastructure.

If it is of interest, I have explained these two failures in more detail on my blog:
(1) bailouts
(2) government saving

Steve, I think we had two, maybe three things go on here. First, the "originate to sell" model failed because basic underwriting was not done well. The incentives against failure were not left with the originator, i.e., having to hold onto a large equity piece.

If the underwriting had been done well, the next problem would be weak financing structures on the part of the certificate buyers. Many were leveraged higher than prudent, even on "super seniors."

Finally, the servicing models are often flawed. There has to be adequate pay for servicing and special servicing, or else loss mitigation efforts will be poor.

Risks were taken and avoided, but many of the seemingly avoided risks come back when the one guaranteeing the avoid risk cannot perform.

Steve:

I agree with you that central banks bought AAA securities because they were seeking safety, but why is "I don't know right now, I want to postpone the decision" an invalid response to your "what should we do?"

While "a risk free return" may be a sugar coated lie, the demand for a safe store of value is real, rational, and beneficial. Once-upon-a-time, the US government provided this safe store through the good management of the dollar, but that day is gone. While the dollar is still, de facto, the world's reserve currency, it's a crappy one, and I can't blame the world's savers for casting about for something better.

Even if you are that rarest of species, an American saver, you've had a disastrous decade with no end in sight. Your FDIC insured bank deposits and salary has failed to keep pace with housing, health, education, food, and fuel by dramatic amounts. If man lived by flat screen TVs alone all would be well, but that is not the case. There is no obvious mechanism for you to store value today so you can consume it tomorrow.

So in a world where nothing is a safe store of value, everything is. You buy some oil to hedge against fuel increases, and some wheat to hedge against food prices. If you don't own a home, how about a REIT so you're less short, and maybe you can add some gold just in case it all goes to hell. Toss in a basket of foreign currencies since the greenback is looking sickly. I can't think of how to hedge yourself against increases in education and health. But note that all of these capital allocations aren't seeking a positive return, they are just there to avoid negative returns. If the saver could just put their money in a bank account and be done with it, they would, but since Plan A is kaput, it's time for Plan B.

I would also add that all this Plan B asset allocation muddies the signal that you expect from capital markets: "what should we do?". Since the markets cannot respond to "I want to decide later", they're convulsing through a "head for cover"

-zanon

It is the nature of investors to attempt to mitigate risk. The whole of financial analysis is attempting to determine where the risk / reward ratio is favorable. We can't bemoan the investors distaste for risk but we must always point out the folly of anyone ever believing it has been concurred.

JKH: Good stuff. Do you have a blog or column?

(I did not author the 4:18 comment; not quite sure if the handle error was inadvertent or intended; but no and no)

vince: thanks for asking, but no and no

JKH — You really should start a blog. I don't say that to insinuate that your long and thoughtful comments are unwelcome. On the contrary. They are thoughtful and thought well, and you clearly enjoy the conversation. It'd be a public service.

There's a tension, when discussing the financial system, between positive and normative aspects. You are right, as a positive matter, that what I ask of the financial system is more than what the professional class standing beneath the banner "Finance" would consider part of their job description. As a normative matter, I think that's a bad thing. I'm too familiar with what "financial analysts" do, as a profession. Generally speaking, they develop independent opinions tightly constrained by professional norms, in terms of what are reasonable asset classes and assets within classes, that severely limits the possibility that professionally manged capital — that is, most capital — will be deployed outside of what are deemed safe harbors. The "physical and intellectual separation of the real economic system from the financial system, and a separation of real economic investment from financial asset investment" is a bad thing, from my perspective.

"[T]he counterfactual would seem to involve at lot more central planning in the economy. Otherwise, how can we say that business was responding to anything other than the invisible hand that was dealt to it?"

I don't think that's reasonable. That an outcome occurred in an environment largely free of central planning does not imply that the same outcome would always have occured in similar circumstances absent central planning. The fact that demand for safety translated to a housing boom had everything to do with an institutional environment, with both public and private aspects, that is by no means predetermined. The existence of Fannie and Freddie, and the infrastructure and expertise devoted to generating and securitizing conforming mortgages, served as the seed and template for much of the innovation in the sub-prime, alt-A, and jumbo sector. Housing seemed a good candidate for "instasafety" because it was the only asset conventionally securitized, and had a pseudohistory of "never" having declined on a national basis. It would be quite possible to define tranched paper secured by pooled sector-specific inventories, plant, intellectual property, or subsidiary securities that would have allowed moderate-risk fixed-income investors to make qualitative choices about where their capital would generate the highest margin of safety. Of course none of those would have had the quantitative characteristics to simulate out as AAA paper in rating agency models. But those models were foundationally wrong, and surely not a necessary outcome absent central planning. The scenario we observed was a collaboration between the invisible hand and a set of institutions, habits, conventional assumptions and shortcuts. It was not what "the" invisible hand foreordained.

That said, the relationship between central planning and free markets in a "good" economy is a challenging one, and I don't want to accept an implicit assumption that more central planning is always worse. I'm very biased towards market solutions to informationally challenging problems. But there is a "superstructure" (I know! That's a Marx-word!) that generated constraints and biases under which the "invisible hand" operates, and there's little evidence to suggest that relying on a meta-invisible hand to get those biases right is better than even very flawed state actors. Of course, I'd be very glad to improve upon flawed state actors, but one must make a case for how, not just hurl epithets about socialism and central planning, to do that.

When savers finance the current consumption of negative-savers, absent agency costs, they do so only contingent upon assurance that the negative savers will generate suplus future production a portion of which they can skim. That is to say that you are right that current savers are happy to transfer dis-savers future production to current consumption, for a price. And that's fine, so long as they can discriminate wannabe current consumers with surplus future production from wannabe current consumers without. Rational savers absolutely do not finance the latter party's consumption, but a lot of savings did in fact go to dissavers without expected surplus production. That was not a matter of volunatry allocation by invisible hands, but uninformed investors and malfunctioning agencies. Depositors would not have made the same loans their banks did. I'm glad to question those outcomes, and againwon't concede that what flawed institutions have wrought was the only possible outcome absent central planning.

I agree that there was lots of intrafinancial risk, in terms of leverage and the structure of a variety of assets and derivatives. I framed this piece as "too little risk?" to be provocative. I'd suggest that there was too little risk taken along certain dimensions, and too much risk taken along others. However, even synthetic assets impact the real allocation of capital. If I buy a synthetic bond built out of Treasuries and GM CDS contracts, the teentsy little firm I'm funding is selling protection on GM bonds, driving down the cost of that protection, which affects the credit spreads demanded on "real" bonds, which affects GM's cost of capital. I won't make the strong claim that purchasing such a bond is equivalent to actually lending GM money. But broadly and in general, derivative transactions are "passed through" to the real economy by arbitrage and equilibrium, they are not a cul-de-sac unto themselves.

I'm mostly with the Austrians, by the way, on commercial banks and deposits. There's this myth that there'd be no investment without highly leverage commercial banks and "maturity transformation" (which is the ultimate juvenile demand for safety that should not in general be accommodated). If all the funds deposited in checking accounts, savings accounts, and CDS were kept as cash in mattresses, that wouldn't affect the quantity of real capital available for investment. It would undermine the system that we currently have for allocating capital, and the system that we currently use to mediate current exchange. I won't quarrel that it would be disruptive. But the usual justification for leveraged, fractional reserve banking is that they are necessary to persuade the masses to invest society's resources, which otherwise would sit unused. That's BS. As long as wealth is stored as money or future claims, savings does not deplete the capital available for investing. the current banking system has more to do with who decides how capital is allocated than with making capital available.

I'm not sure if we're disagreeing at all about the "global savings glut". Contingent upon certain policy choices, China and the Gulf states have no choice but to invest in USD assets, and they prefer safety to risk with the vast majority. That was my point, it seems to be yours too. They drove up the price of safety, which created a great demand for cheaper (that is higher yielding) safe assets from the private sector, which also largely wanted safety.

Again, I do agree that the financial system took all sorts of "intrafinancial" risk, and that had much to do with the crisis. That's why I used the formulation "equally accurate to suggest that the financial system took on too little risk."

David M — I don't disagree at all. Investors "outside" wanted cheap safety, intermediaries "inside" didn't have naturally cheap safety, so they manufactured it, with weak underwriting and by leveraging pseudo-risk-free assets into pseudo-risk-free assets. (You can leverage a zero-beta asset all you want! It's still zero-beta! And perpetual motion machines really work!)

As I wrote JKH, it wasn't my intention to claim that "too little risk" was the problem to the exclusion of "too much risk". The claim is that there was too little risk, by some parties and along some dimensions, and too much risk along other dimensions. (Although the parties taking "too much risk" largely succeeded in isolating themselves individually from the downside of those risks. Those bonuses are not being clawed back. Within the financials, individuals got safety while business entities, taxpayers, and fragmented equityholders got risks they were unaware of taking.)

bsetser — I certainly agree that investors wanted safety and carry, but I think we have to distinguish that from the conventional continuous trade-off in risk and return. "Safe" assets were a distinct category of assets (which oddly included even heavily leveraged variants thereof), and were not deemed substitable for "risky" assets, even at equivalent yield. In theory, investors should understand that nondiversifiable risk is priced, and there's no free lunch. In practice, investors took certain assets to be risk-free (and therefore not worth diversifying, tho' sometimes they were diversified internally), and looked for the cheapest/highest carry assets within that "safe" category. That makes no sense under any asset pricing model, but I think it's descriptively accurate.

MasterPlan (now there's an ominous name!) — It is of course natural, and not worth bemoaning, that investors want as much safety as possible given for any given level of expected or possible returns. What is worth bemoaning, though, is when investors demand safety at ever increasing levels of return. Perfect safety can't be had, and conventional safety — no default or nonpayment risk within a stated currency &mdash' can only be offered at one price, and in quantities determined by the sovereign that prints the currency. When investors demand "equivalent" safety at something other than the sovereign yield, or a greater quantity of "risk-free" assets than the sovereign is willing to offer, that is quite unreasonable, and merits a bit of bemoaning and belly-achin', no?

IA — I'm not at all surprised (and certainly glad) to hear that...

Alessandro — I think the calculation you're making is one that's been made. There can be all kinds of ancillary benefits from getting taken by a Ponzi scheme, and depending on where one gets in on such a scheme, one doesn't have to lose. To bring it back to the topic of this post, some of the investors seeking "safety" were really not enthusiastic about their investment, not only indifferent to what they were funding, they were not so much interested in achieving any return at all, but merely limiting and rendering predictable their loss. Given the ancillary benefits that generated these negative-return investments, these investors' participation may well have been rational. But from the perspective of the economy that received the capital, the indifference with which it was allocated might have made a negative contribution to the overall efficiency of the capital allocation decision.

Steve, London Banker over at RGE has a post on how we reached here, what to expect for the future and what it needs to be done. His history matches most of your points and his gloomy future scenario looks all to probable to me.

http://www.rgemonitor.com/financemarkets-monitor/253292

I do not think that China bid up the relative price of safety. If China had been the driver of the process, their influence would have been transmitted through wider spreads during the boom, not narrower spreads. I explain the argument in more detail in a post on my blog.

An explanation that fits the facts better is that the origin of the process was the boom in spread product driven by financial innovation and complacent investors, which fed a consumption boom that sucked in Chinese imports, which, given their peg to the dollar, led the Chinese to buy dollars and then reserve assets.

Steve, excellent ass kicker(as usual)

Too much...risk or too much moral hazard?
Too much...risk or too much "gaming Globalization"?
Too much...risk or too much Ponzification?
Too much...risk or too much P.T. Barnumization?sucker born
Too much...risk or too much special interest?
Too much...risk or too much Quid Pro Quo? state finance/CB
Too much...risk or too much CB back-stopping bad finance?
Too much...risk or too much i-rate manipulation?
Too much...risk or too much dollar hegemony?
Too much...risk or too much printing press?

Too much...risk or too much DISHONESTY?

Crowded trade, the quest for "safety" became.

Crowded trades are expensive to buy into, and easy to lose capital in.

When everyone goes looking for (especially when arbitraged by fee-taking young boiler-room dudes in cheap suits driving Ferraris) "safety", time to run the other way.

Key to the real estate bust was the transformation of Capital instantly into Consumption, with consumer homes mis-labeled as capital investments.

That John Stuart Mill quote about "misallocation of capital"; the capital is already lost. It was lost the day it was loaned to CONSUMERS to buy a CONSUMPTION item that forseeably could not hold relative value throughout a 30-year span of aging occupants, declining production and a vanishing Empire.

Now they're just trying to allocate the "haircuts" and who ponies up the lost capital into soothing various "black-hole" institutions with the political clout to get labeled TBTF.

There's been only one investment to hold since 2001.

And there have been very few businesses into which intelligently invest capital since then.

We are in the process of rebooting our monetary system, called "Dollar" or other, with any Fed/IMF balance sheet gold actually still in hand, as when the world left the Pound behind in 1930s for the dollar. But the monetary transition striptease will require employing every other fan or veil before getting down to that final revealing.

Question personally is, do YOU hold the capital that will be in demand when the moment of such transition is upon us? Then you get to be part of the system reboot, rather than an old floppy drive getting thrown away...

All — Apologies are cheap, since I don't change my ways, but sorry as usual for disappearing.

Ben (way above) — I think you're absolutely right.

JKH — I don't disagree with you at all that whatever "real economy" issuers were out there with "sellable" projects did get funded during the credit boom. Loose money was loose everywhere. As you say, the problem had to do with the mix of projects out there that were sellable, that is, that an entrepreneur proposed in some manner that a "prudent person" manager could reasonably put other peoples' money into. You're quite right to point out the aggregate diversification issue: any reviewer of US aggregate investment during the boom would be nervous from a portfolio-risk management perspective. Almost everything was correlated to real-estate one way or another. If we're going to draw boundaries for blame, one might then argue that we should blame an absence of good entrepreneurs for offering the financial system too few ideas to invest in. But I think that's letting the finance side off the hook much too easily.

As we saw in the 1990s (to our peril, but to our relatively mild peril), when there is money that wants to invest in a sector, entrepreneurs pop out of the woodwork to take it. What the financials ought to have been doing these past few years, what is frankly their job in the universe, is to "think big" about long-term aggregate investment needs and start up venture cap funds, incubators, recruiters, all the machinery that diminishes the chasm of entrepreneurship, in sectors they knew had long-term potential. They know how to do this, but it is an intrafinancial problem that delegated money is uncomfortable doing what hasn't already been legitimated by the fact that others are doing it. That money seeks the safe harbor of the herd — and crowds that harbor until there is a catastrpohic collapse — is an outgrowth of the degree to which we have professionalized the investment process, and mix of incentives and hazards we have created for managers.

On the Austrian-ish stuff, I'm not a big believer in "flag days" (a term I owe to Mencius Moldbug). I do think fixing the financial system — that is building a system whose asset prices more faithfully respect the real economic value of what backs them and which better directs real economic decision-making — does require foundational changes in the structure of banking and money. But I don't think we get there in one fell swoop, I think we evolve to it. I think we have to introduce a variety of alternative practices, new media of exchange, "point-of-sale" technology that permits sellers and buyers to price and pay in different "currencies" conveniently, infrastructure for managing assets that represent claims on future goods and services rather than claims on future currency as stores of value and hedges on future consumption, etc. We don't have to eliminate existing banks or the Fed or whatever, but we do have to curtail their ability to define the terms of commerce in ways that prevent alternatives from outcompeting them.

Benign — Implicit in the caveat implied by your use of the term "fiat", it seems like you think that bubble investing is not an irreducible fact of human psychology, but might be amenable to a better monetary / financial system.

I don't disagree at all that the one we have seems to consistently generate bubbles. Most defenders of that status quo would say that it's utopian to hope to eliminate (or even much mitigate) financial bubbliciousness. After all, tulip bulbs happened under a gold standard. I'm more optimistic than that (though I don't think that "sound money" would be enough).

Do you think there's any way out of the fact that talented con-men are capable of making worthless paper that is difficult to distinguish from claims against genuinely valuable future projects? Is it possible to devise financial markets that are efficiently foresighted, or must we resort to greater central planning (which has its own weaknesses)? Are we simply incapable of evaluating and funding roundabout projects without tolerating a great deal of expropriation (either by corrupt public officials or by artful thieves)?

Henry — I think the "one investment to hold" became a crowded trade too recently, and it hasn't been so easy to hold (though I do hold it, if I've guessed right). I love "the monetary transition striptease will require employing every other fan or veil before getting down to that final revealing." I think that's almost just right — we are dealing with our problems with a combination of hopeful denial and cynical cost-shifting that amounts to a bewildering dance likely to leave all but the most clever or cautious wounded. I don't think there will ever be a final revealing... if the one asset to hold were ever to be so plainly vindicated as such, it would become liable to confiscation, one way or another, and the dance would continue.

After all, the point of the dance is to perform a reboot without anyone noticing, and to ensure that the costs and gains seem fair, like acts of nature, even though they are not acts of nature and can never be fair.

Steve -

A hard money system is indeed subject to bubbles. But I would submit that a "democratically controlled" fiat system has generated more bubbles than any hard money system.

It's like the problem we have in Congress: tax cuts sell, spending cuts don't; inflation that makes people feel rich sells, monetary or credit discipline that risks being blamed for a recession and possibly causing the loss of the Fed's illusory "independence" doesn't.

Whether in Congress or the Executive or the Fed, we're being "governed" by short-run political capital maximizers (and the judiciary is hardly non-political, but they don't have their fingers on the purse strings).

A fiat money system just makes it too easy to screw up. Anyone have a reference on the prevalence of bubbles in fiat vs. hard money regimes?

Steve,

I suppose that it would be possible to construct sufficiently weird consumer preferences and supply response to get spread narrowing on additional central bank buying of premium product, but I find your example particularly implausible. Your non-central bank consumers seem to ignore their $1 price premium for chocolate when they take their first scoop, such that they end up paying a $3 premium!

What would you regard as representative of spread product? If data for it is readily available, I would be glad to repeat my analysis using that instead of swaps.

Rebel — My conjecture is that "safe" asset buyers traditionally had expectations regarding absolute return, that a combination of low interest rates on the short end and CB buying on the long violated. That is, low-risk investors were presented with the choice circa 2004 of either recalibrating return expectations upon which a great deal of future planning was based, or to become "risk" investors. That combination created demand for something that was not "risk", but that also was not Treasuries. A class of assets for which there was little demand (low coupon, but not Full-Faith-And-Credit or AAA corporate) suddenly had a new clientele, and its price moved sharply, more sharply even than the Treasury prices whose up-bidding was the catalyst for the change.

My ice cream example is very contrived, but I don't think it's as bad as you think. What you're objecting to is price discrimination (in sequence rather than over consumers here), that is, I'm presuming the supplier gets the full consumer surplus on both scoops. Two scoops of ice-cream are worth $6 to our consumers, and chocolate is worth a buck more on any scoop, and that's exactly what our supplier gets. Given the a fixed supply of both commodities and a strategic monopolist who knows consumers' preferences, this should be achievable.

Your objection that I've really posited a $3 premium for chocolate implies consumers could have opted for a greater quantity of the inferior vanilla, which (by assumption) they can't. If we let the quantity of vanilla be unlimited and set to a uniform price in a competitive market, then sure, the price of vanilla would be its marginal cost, and the price of chocolate could be no more than $1 + the price of vanilla. But with fixed supplies and a monopolist, consumers would buy both scoops if offered at $4.99 for chocolate and $1.99 for vanilla, because the cost of only buying the cheap vanilla is a forgone $5 in potential joy for a savings of only $4.99. (The total achievable joy is two scoops, one of 'em chocolate, worth $7, and eating vanilla only gives 'en $2 worth.)

In the real case, Treasuries and "safe" private paper, the supply of Treasuries is (in the short term) fixed with respect to market demand, while supply of the substitute is potentially unlimited, but clearly subject to a lag. (Remember, Wall Street worked desperately to increase the supply of this stuff -- it was obviously profitable to make, and supply did not quickly expand until putting together deals was no longer profitable.)

Let's try again. There are three kinds of consumers. Everyone likes chocolate at least as much as vanilla, but [Type 1] values chocolate at $6 and vanilla at 0, [Type 2] values chocolate at $5 and vanilla at $4, and [Type 3] values both types at $2. Health-conscious consumers value a second scoop at zero.

Initially there are 5 scoops of each available, 6 consumers of [Type 2] and 10 of [Type 3]. Suppliers know these preferences, and are (short-run) monopolists. Their revenue-maximizing menu is $4.99 chocolate and $2 vanilla ($25 + $10 = $35).

Next round, everything is the same, except two [Type 1]s enter the market, so there are 2 T1, 6 T2, and 10 T3. Now the revenue-maximizing menu is $4.99 chocolate and $4 vanilla, [$25 + $12 = $37]. The price of chocolate has not changed at all, but the price of vanilla has doubled, even though all the "new demand" was for chocolate only.

I don't think there's anything that weird or strained about these stories. We need to posit market power and clienteles with distinct preferences, both of which seemed to exist in credit markets. (CBs and private safety-seekers behaved differently, Wall Street "engineers" strategically bundled and priced deals in a manner that gave them economic profit.)

I can't tell you what a better measure would be because I don't think the test works, at least not without making some explicit assumptions about the elasticities and cross-elasticities between Treasuries and other safe assets, which implicitly means assumptions about the clienteles buying and selling these assets.

I feel (I often feel) like I'm being an asshole, because you're trying to test something, and I'm ignoring the result and saying it can't so easily be tested. I think it plausible that CB treasury buying might have raised the price of Treasuries more than that of other safe assets or less than that of other safe assets. I think if you were to look, you'd find that in relative terms, yields compressed more for "safe" assets as a category than for "risk assets" (e.g. low investment grade/high-junk bonds) over the period of CB enthusiasm, so the spread between should have widened. But even if so, a quick glance doesn't unambiguously bear that out, it looks like business cycle considerations overwhelm whatever impact a monotonic increase in CB buying might have had on the data. (I should be using the 30yr Treasury series, but for some reason I can't make it work passed a few years ago.)

I do take the "conundrum" as evidence if CB buying, exactly the conjecture you are trying to refute. Maybe the thing to look at is term-premium on non-AAA corporates vs term premium on Treasuries, on the theory that long corporates would have widened more with increasing short interest rates than long Treasuries, as CBs play (though not exclusively) in longer Treasuries but not longer corporates, and non-AAA corporates and treasuries are less direct substitutes than Treasuries and other "safe" assets. But honestly, it's much easier to poke holes in other peoples' tests than to come up with a good one. I apologize for taking the easier and more annoying side of the debate!

Rebel — I don't forbid trade between consumers, I only conjecture limited supply and specific preferences among different clienteles.

I agree very much with the Einstein quote, it's one of my faves actually, but we're focusing on different halves. You say, given the price behavior you've observed, parsimony suggests we reject the CB-demand hypothesis. I say, given other aspects of the price behavior we've observed, your argument violates the "no simpler" clause. I cannot find explanations I find remotely compelling for the disappearance of bond vigilanteism during this decade other than CB demand, and I view implausible the conjecture that the extraordinary capital-flows they've provoked have been entirely inframarginal and irrelevant to the unusual price behavior we've observed.

I think we'll have to agree to disagree here. I'll concede a tip o' the hat, because you tried at least to take data to a model (and I certainly have not), but I won't alas concede that your model lives up to the "no simpler" rule.