Wednesday, June 27, 2012

In Which I Dare to Correct Felix Salmon

Felix Salmon is my favorite business blogger -- super smart, cosmopolitan and impressively unimpressed by the Masters of the Universe he spends his days observing. In general, I'd expect him to be much more on top of current financial data than I am. But in today's post on the commercial paper market, he makes an uncharacteristic mistake -- or rather, uncharacteristic for him but highly characteristic of the larger conversation around finance.

According to Felix:
The commercial paper market has to a first approximation become an entirely financial market, a place for banks and shadow banks to do their short-term borrowing while the interbank market remains closed.
According to David S. Scharfstein of Harvard Business School, who also testified last week, of the 50 largest issuers of debt to money market funds today, only two are nonfinancial firms; the rest are banks and other financial companies, many of them foreign.
Once upon a time, before the financial crisis, money-market funds were a mechanism whereby individual investors could make safe, short-term loans to big corporates, disintermediating the banks. But all that has changed now. For one thing, says Davidoff, “about two-thirds of money market users are sophisticated finance investors”. For another, the corporates have evaporated away, to be replaced by financials. In the corporate world, it seems, the price mechanism isn’t working any more: either you’re a big and safe corporate and don’t want to run the refinancing risk of money-market funds suddenly drying up, or else you’re small enough and risky enough that the money market funds don’t want to lend to you at any price.
I'm sorry, but I don't think that's right.

Reading Felix, you get the clear impression that before the crisis, or anyway not too long ago, most borrowers in the commercial paper market were nonfinancial corporations. It has only "become an entirely financial market" relatively recently, he suggests, as nonfinancial borrowers have dropped out. But, to me at least, the real picture looks rather different.

Source: Flow of Funds

The graph shows outstanding financial and nonfinancial commercial paper on the left scale, and the financial share of the total on the right scale. As you can see the story is almost the opposite of the one Felix tells. Financial borrowers have always dominated the commercial paper market, and their share has fallen, not risen, in the wake of the financial crisis and recession. Relative to the economy, nonfinancial commercial paper outstanding is close to where it was at the peak of the past cycle. But financial paper is down by almost two-thirds. As a result, the nonfinancial share of the commercial paper market has doubled, from 7 to 15 percent -- the highest it's been since the 1990s.

Why does this matter? Well, of course, it's important to get these things right. But I think Felix's mistake here is revealing of a larger problem.

One of the most dramatic features of the financial crisis of fall 2008, bringing the Fed as close as it got to socializing the means of intermediation, was the collapse of the commercial paper market. But as I've written here before, it was almost never acknowledged that the collapse was largely limited to financial commercial paper. Nonfinancial borrowers did not lose access to credit in the way that banks and shadow banks did. The gap between the financial and nonfinancial commercial paper markets wasn't discussed, I believe, because of the way the crisis was seen entirely through the eyes of finance.

I suspect the same thing is happening with the evolution of the commercial paper market in the past few years. The Flow of Funds shows clearly that commercial borrowing by nonfinancial borrowers has held up reasonably well; the fall in commercial paper lending is limited to financial borrowers. But that banks' problems are everyone's problems is taken for granted, or at most justified with a pious handwave about the importance of credit to the real economy.

And that's the second  assumption, again usually unstated, at issue here: that providing credit to households and businesses is normally the main activity of finance, with departures from that role an anomalous recent development. But what if the main action in the financial system has never been intermediating between ultimate lenders and borrowers? What if banks have always mostly been, not to put too fine a point on it, parasites?

During the crisis of 2008 one big question was if it was possible to let the big banks fail, or if the consequences for the real economy would be prohibitively awful. On the left, Dean Baker took the first position while Doug Henwood took the second, arguing that the alternative to bailouts could be a second Great Depression. I was ambivalent at the time, but I've been moving toward the let-them-fail view. (Especially if the counterfactual is that governments and central banks putting comparable resources into sheltering the real economy from collapsing banks, as they have into propping them up.) The evolution of the commercial paper market looks to me like one more datapoint supporting that view. The collapse of interbank lending doesn't seem to have affected nonbank borrowers much.

(Which brings us to a larger point, of whether the continued depressed state of the real economy is due to a lack of access to credit. Obviously I think not, but that's beyond the scope of this post.)

An insidious feature of the world we live in is an unconscious tendency to adopt finance's point of view. This is as true of intellectuals as of everyone else. An anthropologist of my acquaintance, for instance, did his fieldwork on the New York financial industry. Nothing wrong with that -- he's got some very smart things to say about it -- but you really can't imagine someone doing a similar project on any other industry, apart from high-tech internet stuff. In our culture, finance is just interesting in a way that other businesses are not. I'm not exempting myself from this, by the way. The financial crisis and its aftermath was the most exciting time in memory to be thinking about economics; I'm not going to deny it, it was fun. And there are plenty of people on the left who would say that a tendency, which I confess to, to let the conflict between Wall Street and the real economy displace the conflict between labor and capital in our political language, is a symptom -- a kind of reaction-formation -- of the same intellectual capture.

But that is perhaps over-broadening the point, which is just this: That someone as smart as Felix Salmon could so badly misread the commercial paper market is a sign of how hard we have to work to distinguish the state of the banks, from the state of the economy.


  1. that banks' problems' are everyone's problems is taken for granted, or at most justified with a pious handwave about the importance of credit to the real economy.

    The virtue of the standard/finance point of view, at least for a layman like me, has been its handy way of explaining how the financial crisis became the recession: the CDO implosion caused the credit crunch that slowed the economy. Put it another way, the banks' intermediation function was the vector by means of which the financial crisis became an economic crisis.

    But if, as you suggest, the banks were only ever superfluous to the functioning of the real economy, then what's your explanation for how the contagion spread? Or is it your view that that question presumes too much about the causes of the recession? (E.g., maybe you think the recession would have hit with or without the financial crisis?)

    1. This is a very good question. I wish I had a good answer.

      Let's at least distinguish two sets of questions. First, (how much) did credit constraints cause (or contribute to) the initial downturn in business investment, vs. (how much) are credit constraints responsible for the continued depressed level of business investment. And second, vs. those, would the outcome for the real economy have been (or will be) much worse in the absence of interventions to prevent the failure of major banks? In general, most people (e.g. Dean Baker) who think that the financial crisis was not a major cause of the downturn in real activity, also think that the bailouts were not needed; but in principle the two questions are logically independent.

      The thing I am most confident about, personally, is that lack of credit is not *today* a major factor holding back business investment. This is not an especially radical view -- Paul Krugman would agree -- but it's perhaps not quite a mainstream one either, at least in policy circles. In any case that's the view this post is supporting. I'm pointing out that the failure of the financial commercial paper market to recover post-crisis cannot be taken as a sign that there is a continued credit shortage facing nonfinancial businesses. In that sense Felix Salmon has been snookered.

      On the policy side the conclusion is obvious -- and again a liberal as well as radical one -- that interventions to improve the balance sheets of financial institutions are insufficient. To raise output and employment -- assuming that's the goal; I've argued it's not, necessarily, in Europe at least -- interventions will need to directly raise final demand, i.e. be fiscal. Implications for economic theory too.

      I appreciate the value of a clear story. I'll come back to this in another post soon, I hope.

  2. Are you including Asset Backed CP in Financial CP? This grew enormously pre-Lehman, and then of course was the first to collapse in Fall 2007. You are right that financial CP has collapsed, as the crisis has mainly taken the form of collapse of the wholesale funded shadow banking system, ABCP in particular.

  3. Banking is a sheer cash-flow business, borrowing short and lending long and making the vig from the interest spread, so it's not surprising that most of the CP market is financial, (not to mention, along with tom m, that it was funding much of the non-bank banking activity and off-balance-sheet vehicles comprising the "shadow banking system"). For non-financial businesses CP is just trade credit for managing cash-flow and other short-run contingencies. On the other hand, it's mostly the SME's that depend on bank credit, not the oligopolies, and that's where the credit crunch effects hit the economy most of all.

    As to the proximate causes of the crisis and the severity of the recession,- (actually a semi-depression, which is still going on),- it wasn't the excessive borrowing or over-investment of the corporate sector at fault, since they had been dis-investing for a while and were flush with excess cash, but rather the excessive debt in the household sector, partly due to the housing bubble and the huge amount of embedded leverage that had built up in the financial sector, rendering it ever more fragile, to the point that there were immense losses to be realized, which Mr. Market gradually, then suddenly, came to recognize. The damage to the real economy came not from a shortage of investment demand, (which, as per above, wasn't new), but from a collapse of financial wealth effects and ordinary consumption demand, (which had previously been debt financed). Not so hard to figure. Collapsing investment follows in suit as a consequence, not because of the collapse in credit. But the collapse in credit disrupted much ordinary trade credit and payments,- (e.g. letters-of-credit for international shipping, which in some form must be centuries old and long taken for granted),- thus the rapid free-fall.

  4. As to whether the financial system should have been allowed to collapse rather than being bailed out, well, beneath the system of credit is a payments system, which couldn't be allowed to collapse else it would have been the formal analog to an electricity black-out and everyone would be left to move about in the dark. So the payments system being held hostage by the credit system was used as an excuse for bailing out the financial sector. But there was a third alternative between allowing a collapse, (which due to the excessive inter-connectivity of the system and its high degree of embedded leverage, would have been total), and bailing it out without exacting any quid pro quo. Namely, insolvent mega-banks and hi-fi outfits should have been put into public receivership, i.e. nationalized. The incumbent boards and management would have been thrown out and replaced, the bad assets taken off the books and put into a bad bank, bondholders would be converted into equity holders and given ownership of the bad bank (and whatever share of the good bank remains after recoveries), and the banks would be recapitalized with public funds, (and re-regulated, broken up and down-sized). The only issue amongst us subaltern blog commenters was whether the government should just bypass the banks or take them over, and my view was the personnel, outlets, administration was already in place with the take-over, whereas it would have to have been generated from scratch otherwise. Amongst the "pros" the debate was over whether bondholders should have to bear some of the cost or whether they should be guaranteed to prevent further contagion, as DeLong argued. (Obviously not, only new issues should have been guaranteed, though with the gov. in charge that would be largely superfluous.) There then would have to have been secondary bailouts of pension and insurance funds. But there is little doubt in abstract economic theory, (cf. Ken Rogoff), that that would have been the most efficient cost-effective way of dealing with the crisis and mitigating its damage to the "real" economy. The only problem is that the obstacles to such a course of action would not just have been ideological, but legal, logistical and administrative: i.e. the regulatory authorities and policy makers would have to have been prepared in advance, whereas obviously for the prior 2 decades they had been just sniffing glue. And the upfront cost in swelling the fiscal deficit would have been enormous, though the long-run cost, both in ensuring orderly write-downs of bad "assets" and mitigating economic damage and fostering recovery/restructuring, would have been vastly less than what we got.

    In the event, we got $14 trillion in loans to provide "liquidity", +$2 trillion in qE to prop up financial "asset" prices fictitiously together with ZIRP and "regulatory forbearance". The interesting bit was that TARP funds were allowed to be repaid quickly to avoid regulatory interference with bonuses, which suggests not just official collusion, but that such excess capital injections were unneeded in the light of all that excess "liquidity", (so the monetarists must have gotten something right). But we'll be paying for the result for years, if not decades to come.

    "And there are plenty of people on the left who would say that a tendency, which I confess to, to let the conflict between Wall Street and the real economy displace the conflict between labor and capital in our political language, is a symptom -- a kind of reaction-formation -- of the same intellectual capture."

    No, not me at least. But the inter-linkages between the two complexes require a more complex account.

  5. Excellent analysis! The short term borrowing is primarily by the financial sector. Occasionally non-financial firms may tap this market for inventory financing, but it is rare. Generally non-financial firms and households participate as lenders to financial firms, because they cannot borrow on the same terms that financial firms can borrow.

    Take a non-financial firm with the same level of leverage, debt to equity ratios, and stability of earnings. It would have a junk bond rating. The financial firm has a AAA. Why? Implicit government guarantees as well as institutional guarantees.

    Tiny little Primus Guarantee had a AAA (before the crisis, when it was still listed), which was a an outfit based in Bermudas with what, 10 employees, selling huge amount of credit default swaps.

    On the other hand, General Mills does not have a AAA. Neither does the U.S. There is a massive institutional bias against all non-financial borrowers (and particularly government borrowers) and in favor of financial borrowers. This bias allows the borrowers lend at high rates and borrow at low rates, making themselves more profitable than the non-financial borrower with a similar balance sheet, which validates the institutional bias ex-post.

    1. Hey thanks.

      The point about ratings should get more attention. I remember around the time of the financial crisis there was some attention to the inconsistent standards applied to different kinds of issuers. I was working for the NYC Independent Budget Office then and there was some talk of trying quantify the costs to the city of the inconsistent scale for ratings. You'd think someone would do this -- it;s a very straightforward empirical question -- the default experience over the next N years of different classes of borrowers with the same bond rating. Someone must have done this, right?

  6. Hey there is a question about UMass on EJMR maybe you can answer it.

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  8. The Flow of Funds shows clearly that commercial borrowing by nonfinancial borrowers has held up reasonably well; the fall in commercial paper lending is limited to financial borrowers.The idea in this blog good.

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