Friday, July 4, 2014

The Rentier Would Prefer Not to Be Euthanized

Here’s another one for the “John Bull can stand many things, but he cannot stand two percent” files. As Krugman says, there's an endless series of these arguments that interest rates must rise. The premises are adjusted as needed to reach the conclusion. (Here's another.) But what are the politics behind it?

I think it may be as simple as this: The rentiers would prefer not to be euthanized. Under capitalism, the elite are those who own (or control) money. Their function is, in a broad sense, to provide liquidity. To the extent that pure money-holders facilitate production, it is because money serves as a coordination mechanism, bridging gaps — over time and especially with unknown or untrusted counterparties — that would otherwise prevent cooperation from taking place. [1] In a world where liquidity is abundant, this coordination function is evidently obsolete and can no longer be a source of authority or material rewards.

More concretely: It may well be true that markets for, say, mortgage-backed securities are more likely to behave erratically when interest rates are very low. But in a world of low interest rates, what function do those markets serve? Their supposed purpose is to make it easier for people to get home loans. But in a world of very low interest rates, loans are, by definition, easy to get. Again, with abundant liquidity, stocks may get bubbly. But in a world of abundant liquidity, what problem is the existence of stock markets solving? If anyone with a calling to run a business can readily start one with a loan, why support a special group of business owners? Yes, in a world where bearing risk is cheap, specialist risk-bearers are likely to go a bit nuts. But if risk is already cheap, why are we employing all these specialists?

The problem is, the liquidity specialists don’t want to go away. From finance’s point of view, permanently low interest rates are removing their economic reason for being — which they know eventually is likely to remove their power and privileges too. So we get all these arguments that boil down to: Money must be kept scarce so that the private money-sellers can stay in business.

It’s a bit like Dr. Benway in Naked Lunch:
“Now, boys, you won’t see this operation performed very often and there’s a reason for that…. You see it has absolutely no medical value. No one knows what the purpose of it originally was or if it had a purpose at all. Personally I think it was a pure artistic creation from the beginning. 
“Just as a bull fighter with his skill and knowledge extricates himself from danger he has himself invoked, so in this operation the surgeon deliberately endangers his patient, and then, with incredible speed and celerity, rescues him from death at the last possible split second….
Interestingly, Dr. Benway was worried about technological obsolescence too. “Soon we’ll be operating by remote control on patients we never see…. We’ll be nothing but button pushers,” etc. The Dr. Benways of finance like to fret about how robots will replace human labor. I wonder how much of that is a way of hiding from the knowledge that what cheap and abundant capital renders obsolete, is the capitalist?


EDIT: I'm really liking the idea of Larry Summers as Dr. Benway. It fits the way all the talk when he was being pushed for Fed chair was about how great he would be in a financial crisis. How would everyone known how smart he was -- how essential -- if he hadn't done so much to create a crisis to solve?


[1] Capital’s historic role as a facilitator of cooperation is clearly described in chapter 13 of Capital.

18 comments:

  1. Don't stocks and equity in general benefit from having low interest rates? It means investors aren't as willing to buy into bonds and other kinds of debt financing, and companies can borrow a ton of money cheaply and inflate stock price growth.

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    1. A fall in interest rates will raise the price of existing financial assets relative to currently-produced output. This capital gain is nice if your goal in holding assets is to finance future consumption. But if your goal is to exercise power, then low rates are a problem, because when borrowing is easy, borrowers don't have to worry much about keeping creditors happy. You can see this really clearly in discussions of public debt, where it's often said that a major cost of low rates is that they allow governments to behave "irresponsibly."

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  2. It may well be true that markets for, say, mortgage-backed securities are more likely to behave erratically when interest rates are very low. But in a world of low interest rates, what function do those markets serve? Their supposed purpose is to make it easier for people to get home loans. But in a world of very low interest rates, loans are, by definition, easy to get.

    Well, there is the problem Minsky identified, of chasing yield from prudent standards of risk-taking into ponzi schemes. There's is a question of whether the hierarchies evaluating credit-worthiness are still playing a gate-keeping role. If they are not, then, one may suspect the economy is self-poisoning itself with the creation of toxic assets. Or, that usury and the privatisation of public wealth will crowd out productive investment as rentiers-at-scale, a la Piketty, seek to maintain their rate of return, using the carry trade as a leverage point. Meanwhile, the distorted skew associated with very low rates over a long period (see our friend, windyanabasis) starves genuinely productive, but genuinely risky investment in increasing output.

    It seems to me that one can "renounce illusion, and find peace and content in that simplest, sublimist of truths, six percent" (Nicholas Biddle), and still think that the rentier, if not euthanized, should be tamed and contained.

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    1. I don't understand what you're saying. The "distorted skew associated with very low rates" is what exactly? And how does it "starve genuinely productive, but genuiely risky investment in increasing output"? What's the mechanism?

      I don't get how low rates tie into what Minsky was pointing out. Wasn't Minsky's point that the longer a boom goes, the more complacency sets in and risk management suffers as people become careless and reach for higher yields. People jump on the bandwagon as we saw with the housing bubble.

      Rates go low after the Minsky moment when the bubble pops and risk has been shown to be underpriced. Rates go low as central banks seek to increase demand and bring about recovery.

      I see real rates going lower and lower because monetary policy has been asked to shoulder the burden alone with incomes stagnating; the absence of post-Minsky moment debt restructuring; fiscal austerity; and absent trade/currency policy.

      As Mason says "You can see this really clearly in discussions of public debt, where it's often said that a major cost of low rates is that they allow governments to behave "irresponsibly.""

      The BIS writer argues "This alternative perspective puts into sharper focus the trade-off inherent in ultra-accommodative monetary policy." But the neomonetarists/market monetarists say monetary policy isn't loose, it's tight. Rates have been lower longer because of overly tight fiscal/monetary policy.

      What changed in my mind and helpded the Minsky moment along was the rise of neoliberalism/ the Reagan revolution, which redistributed wealth upwards and deregulated the financial sector. (Actually the shadow banking system arose in the absence of regulation and hence was subject to a bank run.) Greenspan was "loose" on macroprudential policy which is I was glad to see Yellen emphasizing it instead of talking about raising rates as the BIS wants. What would Minsky make of "macroprudential policy"?

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    2. With regard to skew, I appropriate the words of the blogger, windyanabasis:"As a simple example, if you had a choice between purchasing a firm that pays out $1 per period if alive, but has a 10% chance of dying every period, OR purchasing a consol that pays out $1 per period guaranteed, then even assuming quadratic utility, if the risk free rate were 5%, the risky firm would be worth 0.3 consols, but if the discount rate were 1%, the risky firm would only be worth 0.08 consols. Similarly, at a 5% discount, a firm that has a 15% chance of dying each period is worth 0.71 times the firm with the 10% death rate. But at a 1% discount, the riskier firm is worth only 65% of the less risky firm.

      "In other words, in a low rate environment, we must peer farther out in the future, and value stable cash-flows more relative to the uncertain cash-flow. As a result, investments that offer more stable returns (such as land) are given more preferential lending terms to investments whose distant returns are more speculative."

      Re: I don't get how low rates tie into what Minsky was pointing out. Wasn't Minsky's point that the longer a boom goes, the more complacency sets in and risk management suffers as people become careless and reach for higher yields. People jump on the bandwagon as we saw with the housing bubble.

      I think you're making a distinction where there's no difference. In the Minsky story, it's two-sided: there's pressure behind the reaching for higher yields as the available rates of return on less-risky investments fall. As in the housing bubble, the bubble, itself, by bidding up the value of assets relative to income flows first creates higher returns (from appreciation), but also creates subsequent conditions, in which income flows are a much smaller return relative to the asset price or loan value.

      The part of the Minsky story that particularly interests me is the part where the pressure for higher yield becomes pressure on the integrity of administrative or regulatory functions. There are formal, bureaucratic procedures behind the extending of credit; interest rates are not simply valves on the credit pipe. Whether it's the underwriting of mortgages, the appraisal of houses or other assets, credit-rating agencies, bond rating agencies and insurers, etc. etc., there's a lot of activity that goes into classing loans. JWM is asking what is the function of the market for, say, mortgage-backed securities, when interest rates are very low and liquidity is abundant, and I taking that, and running with it. What happens when those functions are not funded and don't happen? I'm guessing that the funding of resources for those functions comes out of the differences in return on different funding streams. (Banks famously borrow short and lend long.) What happens when differences in rates are compressed?



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    3. "(Banks famously borrow short and lend long.) What happens when differences in rates are compressed?"

      The banks that are borrowing short have to pay less and can pass that savings on to the consumer or borrower if their working in a competitive market. The Fed lowers its Fed Funds and interbank loan rate which work their way down to the consumer, who in turn can use the savings to pay down their debts or consumer more in the economy. It's works the other way too: when Bernanke said they would start tapering QE last year, mortgage rates went up.

      But also when the Fed lowers rates, savers and rentiers see their returns come down. That's what the BIS writer Mason links to is going on about. The return on safe assets comes down. The stock market goes up but it's not safe.

      The macroprudential rules of classing loans and managing risk at financial institutions via leverage etc are a matter of government policy and rules. Greenspan argued that the market would police itself and not get too risky. So didn't Minsky mostly talk about the mechanism of the market and how it would become complacent? He didn't discuss how discuss how an empowered free market, neoliberal movement would strip away safeguards with the reasoning that the market would police itself?

      What happened with the Savings and Loan industry? Volcker's high interest rates (which compressed the spreads) made it difficult for the industry so Reagan deregulated making it easier for them to make money and we got the crisis.

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    4. The banks that are borrowing short have to pay less and can pass that savings on to the consumer or borrower if their working in a competitive market.

      You mean like the market for credit cards? Oh, wait . . .

      Not to give you too hard a time, but people often thrown out, "if . . . in a competitive market" without a moment's thought about what a "competitive market" would look like, what its institutional prerequisites might be, or even why obvious examples like credit cards do not resolve into competition lowering the rates charged on credit.

      Money is not some viscous liquid and interest rates are not valves controlling its quantity of flow.

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    5. Well, there is the problem Minsky identified, of chasing yield from prudent standards of risk-taking into ponzi schemes.

      This is a really common misunderstanding of Minsky, and it's his (and Charles Kindleberger's for endorsing it) fault for selecting a needlessly and misleadingly pejorative set of names for his financial structures.

      A "Ponzi" project in Minsky's terminology isn't a Ponzi scheme, and it has no built in tendency to collapse. It's just a project that, for a meaningful period after its inception, doesn't generate enough cash flow to cover interest payments and so has to increase its debt to keep going.

      So, an example of a "Ponzi" project in Minsky's terminology might be ... going to university. College students don't generate cash flow and increase their debt to cover operating expenses.

      And note, of course, that the classification of projects as hedge, speculative or Ponzi depends entirely on the term of the lending. There's no necessary connection between the riskiness of a project and its financing profile. For example, building a toll road between two highly-populated cities would be very likely a Ponzi project, but it is a very low risk loan indeed (similarly, shipping finance has this characteristic). Minsky had a Financial Instability Hypothesis, not a Real Instability Hypothesis, and most of the "risky" projects that he talks about are only really risky because they are exposed to the very liquidity risk that Josh (correctly) notes is reduced in an environment of surplus liquidity. It's a real misreading of Minsky to re-profile him as a theorist of Austrian-style malinvestment.

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    6. Yes, agree completely.

      One reason Minsky introduced these distinctions was to highlight the effects of changes in financial conditions on existing balance sheet commitments. In particular, since the line between speculative and Ponzi finance depends on a unit's ability to make current interest payments, where the line falls depends on the interest rate. "A speculative financing arrangement can be transformed into a Ponzi finance scheme by a rise in interest ... if earnings are better or costs, especially interest rates, fall, Ponzi financing may be transformed into speculative financing." The idea that low rates encourage risky financial commitments implicitly assumes that interest rates are known in advance, before the commitments are made. But in the real world, the effect of interest rate changes on the riskiness of existing commitments is more important.

      This is the big argument of my "Fisher dynamics" papers -- the rise in interest rates under Volcker moved the aggregate balance sheet of the US household sector from speculative to Ponzi, despite a reduction in expenditure relative to income. (Although neither Arjun or I thought of using that language -- I'll have to add it to the next version.) As DD says, if you take Minsky seriously, then a concern with financial fragility favors keeping rates low, even if that does encourage taking on more "real" risk.

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    7. There's another important point in D^2's comment: terms.

      Although the interest rate and the term of a loan are distinct phenomena, they have the same effect - shorten the term and the draw on the borrower's cash flow increases, as if interest rates had risen, extend(-and-pretend) and it falls, as if they had fallen. But there is no such thing as a "policy term". Financial stringency can occur without interest rates rising if terms change, i.e. loans are called in.

      You can see this at the level of the banking sector - as the crisis hit, banks increasingly relied on shorter and shorter funding, eventually down to overnight.

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    8. Minsky was a supremely articulate man, and I am sure he chose pejorative labels, advisedly.

      D^2's example of a project to build a toll road, with its heavy element of construction financing, is a terribly misleading way to present Minsky's concept of Ponzi finance. Minsky's idea is not that some possibly worthwhile investment projects are Ponzi projects, but that the overall standard for fixing leverage ratios, in financing the nominal ownership and control of business assets, can shade over time, from predominately Hedge finance to Speculative finance, as conventions and expectations are shaped by recent experience.

      For Minsky, Hedge finance, Speculative Finance, and Ponzi finance were three Ideal Types, corresponding to progressively greater debt to income ratios, that is, greater leverage, and possibly representing successive stages in the dynamic capital development of an economy progressing thru a cycle.

      His notion was that one or another could be said to prevail in the economy at any one point in time, as conventional standards of what constitutes shrewd, but prudent judgment in borrowing and lending evolve, with common experience and expectations. When Hedge finance predominates, the economy as a system, in Minsky's view, is likely to be resilient, and apparently self-stabilizing in response to exogenous shocks or policy interventions, like a change in policy interest rates.

      Experience with such stability, however, is likely to lead to greater and successful risk-taking by bankers and entrepreneurs, taking the economy toward a state in which speculative finance predominates, there is more debt introduced into the economy and higher leverage, which may take the economy into a sustained boom, and even to a state in which Ponzi finance predominates.

      An economy in which speculative finance predominates may not be as resilient, and an economy in which a standard of Ponzi finance prevails, may be at hazard of crisis and debt-deflation.

      The ownership and control of a toll road could be financed to any of the three standards -- hedge, speculative or ponzi. The ultimate point of Minsky's scheme, though, is the dynamics by which such a business could be shifted, along with the economy as a system, along a continuum from one state to the next, from the cautious conservatism of hedge finance, through a heady period in which appreciation feels like growth in revenues, to pondering disinvestment as a way to channel more of the quasi-rents to debt or equity payments.

      I think the term, Ponzi finance, was very much chosen to highlight the inevitability of collapse inherent in such a standard of finance.

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    9. According to Wikipedia:

      "The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset [as in housing] will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value [as in housing] can keep the Ponzi borrower afloat.

      If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments."

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    1. Fascinating evidence for the superabundance of loanable funds right here.

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      ;-)

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    3. Burroughs was such a genius. It's a shame he wasted so much time on that cut-up writing crap.

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    4. Oops, that was meant for the main thread.

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