Saturday, 18 April 2015

Rediscovering old economic models

Krugman says we do not need new economic models, we just need to make better use of the ones we already have. Indeed, even very old models that we long since consigned to dusty archives can help remind us of things we have forgotten about. Financial crises, for example.....

In his response to my speech at Manchester University in February - which became the post that whipped up the "state of macro" debate to which Krugman responded - Andrew Lilico gave four examples of economic models that in his view form the foundation of modern economics and (he claims) have not been shown to be inadequate or wrong. Lilico's four models are these:

- Capital Asset Pricing Model
- Modigliani-Miller Theorem
- Efficient Market Hypothesis
- Black-Scholes Option Pricing Model

Hmm.Only the EMH would I think be regarded as a macroeconomic model - and even then, is it really more fundamental than Shiller's irrational exuberance? When I was doing my MBA, we covered the other three in corporate finance, not macroeconomics. And all four have been seriously criticised.

But finance is the heart of a modern monetary economy and financial economics should be part of macroeconomics. I might disagree with Lilico's choice of models - for example I would regard the quantity theory of money as more fundamental than Black-Scholes - but I don't disagree with his point. The problem is that models of the financial economy DON'T form the heart of macroeconomics.

So, since Krugman pointed me towards Diamond & Dybvig's model of banks, liquidity and deposit insurance, I got it out and re-read it.

For those of us used to endogenous money theory, there is an immediate and very obvious problem with Diamond & Dybvig's model. It is a loanable funds model with no central bank - which is odd, considering that by 1983 when it was written the world had been off the gold standard for more than ten years and every Western country had a central bank. But this is how banking is modelled all too often: banks as passive intermediaries channelling household savings to corporate borrowers. If only that were true. For the last decade or so the flow has been in the other direction - corporate savings channelled by banks to households in the form of mortgages against ever-rising property prices.

But the problem with loanable funds models is bigger than simple reversal of the savings flow. Loanable funds models are unable to explain how exuberance in credit creation results in the buildup of unsustainable leverage. Hyung Song Shin used a loanable funds model in his Mundell-Fleming lecture on the role of regulatory arbitrage in the credit boom leading to the financial crisis, which unfortunately managed to give the impression that the money lent to American and European banks by American households came from Mars. When I translated Shin's model into an endogenous money framework (though admittedly in a manner that was enormous fun and not at all rigorous) it became a dangerously unstable two-way leveraging spiral of credit creation and rising collateral prices, which is much closer to what we know actually happened. Loanable funds models do not adequately portray the role of credit creators in the modern monetary economy - banks, and things that aren't called banks but behave like them.

So Diamond & Dybvig's model needs to be used with some care. It can't simply be "taken off the shelf" and deployed in a crisis, as Krugman suggests. Apart from anything else, providing unfunded deposit insurance ex ante to everything that looks or behaves like a credit creator, regulated or not, creates moral hazard on an almost galactic scale. We already worry about implicit taxpayer subsidies to too-big-to-fail banks: but explicit taxpayer guarantees to too-big-to-fail asset managers, wealth funds, conduits, SPVs? Really, Paul?

Diamond & Dybvig's model is a multiple-equilibrium model, but it does not adequately model how leverage is created. It might be amusing to translate it into endogenous money terms, adding a central bank and establishing both the precedence of lending and the creation of deposits. This would of course make it a lot more complex, since endogenous money creation is by definition non-linear. It might make it a lot more fun, too. But does that mean it would necessarily be less rigorous, as Krugman seems to suggest? Surely not. "Fun" does not exclude rigour.  So, here is a challenge to a student econometrician who fancies a holiday project. Have some fun translating Diamond & Dybvig's model into endogenous money terms. But do it rigorously.

A bank run can be defined as sudden unravelling of bank leverage. And just as leverage creates money, so deleveraging destroys money. This is implied in Diamond & Dybvig's description of deposit insurance even though their model does not show it.

It works like this. A bank faced with sudden unexpected demand for cash withdrawals by depositors or investors is forced to sell assets to obtain the cash. This depresses the price of the remaining assets, destroying value on the asset side of the balance sheet and making it impossible for the bank to realise enough cash to satisfy depositor demand.

I say banks, but it is actually easier to see the "fire sale" effect when there is a run on a money fund, such as the run on Reserve Primary after the fall of Lehman. Reserve Primary was unable to guarantee return of par value to its investors because the value of its assets crashed. A bank facing a similar crash of asset value is also unable to return par value to its depositors. But instead of "breaking the buck" as Reserve Primary did (i.e. returning less than par to its investors), in the absence of central bank liquidity support and/or deposit insurance, the bank must close its doors (in Diamond & Dybvig this is "suspension of convertibility"). If the bank's balance sheet is very illiquid - for example, if it consists mainly of specialist loans for which there is no market - then doors will be closed earlier. Either way, the effect is the same. Deposit balances that cannot be withdrawn because the bank has closed its doors are effectively worthless.

Deposit insurance replaces the money destroyed in a run by drawing on future tax revenues (if unfunded) or drawing on money created by other banks ex post or ex ante. Central bank liquidity support does the same by drawing on future seigniorage. Without this, the economic effects of bank runs can be economically devastating. However, as Diamond & Dybvig point out, the essence of insurance is that it should not be called upon. The existence of credible deposit insurance and/or credible lender-of-last-resort support should be sufficient to prevent runs. In 2007, the run on Northern Rock occurred because deposit insurance was inadequate and it was not clear that lender-of-last-resort support would be forthcoming. In 2008, the most damaging runs occurred in the shadow banking network where there was no insurance or lender-of-last-support.

The fact that Diamond & Dybvig's model is framed in loanable funds terms means that it does not fully show the destructive economic effects of bank runs. After all, in their model, the money still exists, it has simply been converted into a different form (cash) which is equally useful. And nowhere do they state that their single bank can call in illiquid loans to pay depositors. If it can't, then investment is not suspended: the bank fails, but the borrowers still have their funds. Their assumption that production stops when money is removed from the bank is therefore questionable in terms of their own model, though it would be correct in a model that accurately modelled the destruction of money and the collapse of asset prices.

But this does not make the model useless. From the point of view of the depositors trying to remove their funds, whether those funds were created by the bank in the course of lending or came from Mars is irrelevant. What matters is whether depositors believe that they can convert their deposits to cash. And that, as Diamond & Dybvig note, depends on the depositors' view of the creditworthiness of the bank. If depositors believe that the value of the bank's assets is less than its liabilities, they will rush to withdraw their money: no-one will want to leave their money in the bank and risk not getting it back at all.

Deposit insurance in effect replaces the bank's own deposit guarantee, which in Diamond & Dybvig's "bad" equilibrium is not credible, with a guarantee from a more reliable source. In the past that has been the sovereign, though the public mood since Lehman has pushed regulators towards requiring the banking system as a whole to guarantee the deposits of each of its members and fund that guarantee at least in part ex ante. Those promoting full reserve banking might like to recall that bank funded guarantee schemes amount to full reserve banking for insured depositors. And those who think that deposit insurance schemes are about protecting depositors might like to think again. The original purpose of deposit insurance was to prevent banks failing.

Diamond & Dybvig explain that central bank liquidity support can have the same effect as deposit insurance, but with an important caveat: if depositors do not believe the bank is solvent then injections of central bank liquidity cannot stop the run. This is not just a theoretical effect. In 2007, injections of liquidity by the Bank of England failed to stop the run on Northern Rock. It took unlimited guarantees from HMG, including for wholesale deposits (which are more likely to run than retail deposits and can be far more destructive). This is the reason for Bagehot's dictum about lending to SOLVENT banks, although for a very large bank mitigating the destructive economic effects may justify lending even if it is believed to be insolvent. And in a systemic crisis it can be hard to decide which bank is alive and which is dead anyway: throwing money at everything is usually the best approach until the panic calms down, as I have explained before.

The point of all this is that models don't have to model everything, and even "wrong" models can be helpful if used in the right way. And narrative has its uses too. Diamond & Dybvig's paper has some interesting insights into the behaviour of banks and their customers. I particularly like this:
If the technology is risky, the lender of last resort can no longer be as credible as deposit insurance. If the lender of last resort were always required to bail out banks with liquidity problems, there would be perverse incentives for banks to take on risk, even if bailouts occurred only when many banks fail together. For instance, if a bailout is anticipated, all banks have an incentive to take on interest rate risk by mismatching maturities of assets and liabilities, because banks will all be bailed out together.
Perverse incentives and moral hazard. This presumably is one of Krugman's "self-fulfilling prophecies". What a pity we forgot about it....

Then there is this:
Internationally, Eurodollar deposits tend to be uninsured and are therefore subject to runs, and this is true in the United States as well for deposits above the insured limit.  
Uninsured deposits have a tendency to run. You don't say. In the rush to limit taxpayer liability in a crisis and ensure that senior creditors - including large depositors - share in the losses, has everyone forgotten this?


  1. The “endogenous money theory” lot have got too uppity of late, at least in that they seem to think “loanable funds theory” can be totally discarded. Consider this.

    If an economy is at capacity (aka full employment), and one person or firm wants to borrow £X and spend it, then someone else has to ABSTAIN from spending £X, i.e. “save” £X - else demand becomes excessive.

    Thus if private banks DO CREATE an extra billion or two out of thin air and lend it out (at full employment), then the central bank will have to react by raising interest rates (or doing something else to damp down demand). Net result (roughly speaking): no extra lending. In doing that, the central bank is pretty much doing what would happen in a totally free market. That is, given an increased demand for borrowed funds, interest rates would rise.

    1. So, Ralph, why do we need a central bank?

    2. Luc,

      Good question. Advocates of so called “free banking” like George Selgin claim we’d be better off without a central bank. Personally I think that while market forces IN THEORY work very well, in the real world they just don’t. E.g. market forces do EVENTUALLY get us out of recessions, but to judge by the 1800s, they’re not very good at doing so. I thus favour government having the power to implement stimulus, and that requires some sort of state issued money, and that in turn pretty much implies a central bank.

      George Selgin might answer that by saying that economists advising governments and running central banks are so incompetent that we’re better off without them. I take a slightly less cynical view, but only SLIGHTLY less cynical!!

    3. Ralph, that is incorrect, as you know very well. Savings are a consequence of lending, and saving is the residual of income after desired consumption and required taxation. If person A borrows, then person B does not have to "abstain" from consumption: if person B's consumption desires are met prior to person A's borrowing, then the increased money supply arising from person A's loan adds to the stock of savings not because person B is consuming less but simply because he does not want to consume more. If the increased money supply from lending simply adds to the stock of savings rather than increasing consumption, then the effect is to depress rates, not raise them.

    4. Frances,

      If A borrows, then A will spend approximately the amount borrowed – people and firms borrow so as to SPEND on something, usually an investment item like a new car or house, or in the case of a firm, a new machine.

      So assuming all else equal, i.e. assuming constant GDP, or if you like, assuming GDP must remain constant because the economy is at capacity, then someone else absolutely must cut their spending / consumption, else the latter “all else equal” assumption is broken. I.e. demand will become excessive.

      And what adds force to my point, is that exactly the same applies in a simply barter economy. E.g. if Robinson Crusoe wants to invest in a new fishing rod (assuming constant GDP in the desert island economy) then Crusoe or someone else on the island has to abstain from consumption (e.g. they might spend a day cutting down a tree and supplying Crusoe with wood for the fishing rod rather than use the wood for a fire to do their cooking (an example of consumption)).

      The point you seem to be making (and I may have got you wrong) is that when a bank creates £X out of thin air and lends it to A, then the total stock of “savings” (in the sense of “money regarded by its holder as allocated for investment rather than current consumption”) will rise. That’s true. And it remains true where B, C, D etc are happy with their existing incomes, expenditure, amounts saved, etc etc.

      But the problem comes as soon as that £X is SPENT. At that point demand rises. And that’s not permissible, assuming demand is already as high as is possible.

    5. Ralph,

      Still a logical fallacy, I'm afraid.

      If A borrows in order to spend, we must assume that he is not currently fulfilling all his consumption desires. Therefore demand is not "as high as possible". You seem to think that spending is somehow a zero-sum game - that if one person spends more, another person must spend less. That is not true.

      Let's suppose we have a economy with two people, A and B, and a bank which creates money when it lends, C. A borrows money from C to buy a lawnmower from B, thus fulfilling his need for a lawnmower. B has no immediate use for the money, because he has already done all his desired consumption for that period, so he puts the money in C. C now has a loan to A (asset) and a deposit from B (liability) which match exactly and BOTH were created by lending. The money created by lending was spent, yes, but it then became part of the stock of savings. The increased spending A puts upwards pressure on interest rate, but the increased saving by B puts downwards pressure on interest rates. In this example, therefore, it is a wash. There is no change in interest rates.

      I'm also not very into "lump of production" theories. Increased demand tends to lead to increased supply. If it doesn't, then yes prices would rise and a rise in interest rates to deter borrowing might be wise. But usually there would be an increase in output. I think "full capacity" as a constraint on supply growth in response to demand is a myth.

    6. Frances,

      Re your A,B,C, and lawnmover scenario, I do appreciate people who produce simple hypothetical scenarios that get to the root of problems. And that scenario very neatly gets to the root of the problem.

      But seems to me that that scenario supports my point. That is, the loan enables A to spend more, but that is matched by B saving more. That is, assuming the ABC economy was at capacity before the loan, then B cannot just go out and spend that new money. The money has to be saved.

      I don’t agree with your last para which seems to claim there are no constraints on output. I agree that increased demand CAN SOMETIMES increase supply: e.g. after a long recession and inadequate investment, a rise in demand would probably induce more investment. But have made those investments, there is then an absolutely cast iron constraint on additional output, for a given level of technological development. (Technology can of course be improved in the LONG TERM, but not by limitless amounts in the short term.)

      As to interest rates, I agree there is little or no effect on interest rates. Anyway interest rates are not what really concerns me. What DOES CONCERN me is my above points about aggregate demand.

    7. If there were commercial banks operating without a central bank and without a concirn for infaltion then those banks would not have an inentive to increase interest rates. They would not not want to stop there buisiness of lending. There wold be no incentive., no upward pressure on interest rates to the point that the bank's buisiness was reduced.

    8. I think Ralph is technically wrong here, but I think his original point is valid if properly stated. In the lawnmower scenario, B is not in fact saving anything: she is merely changing the form of her savings from physical capital (or inventory, depending on how you classify a lawnmower) to money. So, yes, bank loans can be used merely to transfer physical assets from one person to another, and if the seller is happy to hold assets in the form of money (which might be the case if interest rates are very low), then, even at full capacity, a marginal bank loan does not necessarily result in a need for some policy offset in the form of higher interest rates or tighter fiscal policy.

      However, here I think it becomes misleading to talk about one individual borrower. In a real world situation, there will be many marginal borrowers, and at least some of them will be contemplating borrowing to purchase items that are either as-yet unproduced or likely to be replaced immediately in sellers' inventories. In that case, collective borrowing does have a limit, because it puts an additional demand on already fully employed resources.

      Now one could get more precise and talk about different shocks that have different effects. Some shocks, perhaps, only affect transfer-borrowing, and if one of those shocks hits at full capacity, then you're fine, with no need for a policy response. But other shocks will affect borrowing to buy newly-produced output, and if one of those shocks hits at full capacity, it will require a policy response (or cause inflation).

    9. "I don’t agree with your last para which seems to claim there are no constraints on output. I agree that increased demand CAN SOMETIMES increase supply: e.g. after a long recession and inadequate investment, a rise in demand would probably induce more investment. But have made those investments, there is then an absolutely cast iron constraint on additional output, for a given level of technological development."

      It depends what's being supplied, of course. But I would have thought that the marginal cost of extra capacity is extremely low on a large swathe of goods. At one end, for software it's virtually zero, the service industry has massive under-employment, consumer manufacturing (iPads, cars) uses high productivity or large reservoirs of foreign labour. Then there's the famed "productivity gap".

    10. Interesting comments. Ok, a couple of points.

      Ralph, B does not increase consumption, but s/he doesn't reduce it either. The extra saving is ADDITIONAL. It is technically wrong (as Andy says) to regard debt-funded consumption as zero-sum.

      Andy, yes my example is too simple. However, if we assume that the global economy is never at full capacity even if individual countries may be, then if there are no barriers to trade, borrowing to consume in a country that is at full capacity will suck in imports. The effect would be felt as a growing trade deficit rather than rising inflation.

    11. Good point about global capacity. It certainly seems that the global economy is very rarely, if ever, at full capacity. But there's a wrinkle in terms of how one defines capacity. A closed economy can be "at full capacity" for macroeconomic purposes even if some sectors have excess capacity, if that capacity cannot readily be used to satisfy marginal aggregate demand. Globally, to the extent that nations specialize, the same issue may arise, where it will appear that demand is quite slack in some places but their resources cannot be readily shifted to the production necessary to satisfy marginal global aggregate demand. When I think about it this way, the assumption that global capacity constraints never bind seems less clearly consistent with experience.

    12. Andy, this may be heresy, but.... During the Great Moderation, inflation remained low and stable despite buildup of consumer credit and growing trade deficits in many developed countries. I think this had far more to do with lowering of trade barriers and development of global supply chains than central bank monetary policy. In other words, I think that if enough countries are below capacity, lowering trade barriers moderates inflation in those that are at full capacity. But it does create trade imbalances, which have a tendency to unwind viciously when the associated debt becomes too large.

    13. Does anyone agree with this new law of banking? (That’s “new” as in “someone probably thought of it 100 years ago, but yours truly hasn’t read enough about the subject to be aware of the fact”).

      “If the economy is NOT AT capacity, then additional loans can be made WITHOUT any corresponding savings. In contrast, if the economy IS AT capacity, then new loans must be matched by corresponding saving.”

      To expand on that, in the first scenario, the new loans increase aggregate demand, but that shouldn’t matter as the economy can accept the additional demand. As to the second scenario, additional demand is permissible, so either interest rates will rise of their own accord, or the central bank will raise them so as to choke off the extra demand.

    14. Ralph,

      As usual you are thinking in closed-economy terms. We don't live in a closed economy. If there are no barriers to trade, then rising credit does not necessarily lead to rising inflation even if the domestic economy is at full capacity. You are also falling into the "lump-of-labour" fallacy - indeed I would argue that "full capacity" if it means "full employment" is intrinsically a lump-of-labour fallacy. Have you never heard of immigration?

      Regarding lending and saving, you have the precedence wrong - which is odd, considering that you are an avowed MMT supporter. I can only think you don't understand them. Savings are not required for lending to occur. They are a consequence of lending, not a determinant of it. And be careful about stocks and flows, too - you have a tendency to use saving and savings interchangeably. Saving is a flow, savings are a stock. In economic terms, lending (flow) enables spending (flow) which results in saving (flow). This adds to savings (stock).

      Andy H expresses the flow sequence slightly differently: he says investment drives saving (i.e. S=I, though as this is an identity we have to be a little cautious with assumed predecence). But it's the same thing, really.

    15. Andy,

      You seem to agree with me when you say “…collective borrowing does have a limit, because it puts an additional demand on already fully employed resources.”

      A more precise statement of that idea is my “law” (see below). To re-state it with different words, WHERE an economy is fully employed (aka at capacity), or TO THE EXTENT THAT it is at capacity, borrowing is limited. I.e. borrowing has to be matched by saving. Alternatively, where or to the extent that the economy is NOT AT capacity, borrowing DOES NOT need to be matched or constrained by saving.

    16. Frances,

      The availability of imports and immigrants certainly ALLEVIATES excess demand, on the other hand they certainly don’t always provide a complete solution for excess demand: if they did, there would never be such a thing as demand pull inflation. And most economists agree that there is such a thing as demand pull inflation from time to time, i.e. they agree that the economy hits capacity from time to time.

      Re your claim that “Savings are not required for lending to occur”, that’s precisely the point at issue. I claim that savings ARE REQUIRED where the economy is at capacity, else demand becomes excessive.

  2. This is getting hot. Let me add that an important part of borrowing funded from "thin air" goes to acquisition of past production

    1. Why "past" production? It's common for a firm or household to get a loan with a view to buying something that has NET YET been produced, isn't it?

    2. What, so firms never get loans lined up to fund the purchase of a machine that hasn’t yet been produced? And people who build their own houses (or house extensions) never get loans lined up before firing ahead with the construction?

    3. 1) Even taking in account individual contracts cash advances represent a smaller share. 2) concerning Central Banks I wonder the omission of the function of powerful clearing house (function not guaranteed by private clearing houses)

  3. Banks, in aggregate , are leveraged. That fact alone , to me , disabuses one of any notion that there is some kind on one-to-one borrower/lender relationship as suggested by "loanable funds".

    As Summers emphasized at the IMF just recently , the big reason the debts of Greece and other such unpayable debts ( he used the Mexican peso crisis as one particularly relevant example ) were not simply written off is due to the cascading effects that would arise in those leveraged banks.

    Yes , the global economy is a closed system. Yes , assets and liabililties match. None of that matters. Credit-out-of-thin-air still blows up national economies. History is replete with examples.

  4. Endogenous eurodolars? Is that a juicy one?

    I think the definition of eurdolars are deposits in non American banks with a dollar unit of account, cash and ownership of credits (on the asset side) and credits on the liability side. Sounds like any bank can make loans in any other countries unit of account.

    And, what would are the leverage ratio regulations for credits created in a foreign unit of account?

    1. correction:
      And, what are the leverage ratio regulations for credits created in a foreign unit of account?

  5. Worth noting in regard to your next blog entry about Switzerland banks refusing to allow withdrawals: deposits where you can't withdraw them in legal tender are effectively uninsured deposits, and uninsured deposits from a bank which has reneged. They are *guaranteed* to cause a bank run. Probably a multiple-bank run if multiple banks pull this nonsense.

    1. 1) New Zealand does not have deposit insurance. Where are the bank runs?

      2) As the pension fund was attempting to withdraw funds in physical cash above the insurance limit, the insurance point does not apply. However, read my point about money laundering rules. Banks can and do refuse or delay physical cash payments even on insured deposits without triggering bank runs.

      3) The bank has not reneged on payment. It has simply restricted the form in which the payment may be made.

      I realise that you are shocked and horrified at the thought that a bank may refuse to allow some depositors to withdraw physical cash, but you really need to think this through. We are not talking about universal denial of service. We are talking about denial of physical cash to a small number of very large depositors who arguably should not be keeping money in banks anyway.

      The progressive dismantling of European government support for banks means that pension funds and other investors can no longer assume that very large sums of money in banks are safe. They are not insured and there is no longer any public appetite for bank bailouts. Really this latest development should be seen as part of the general pressure on European investors to change their ways.