Month: September 2012

Scott Brown: ATM For The Big Banks

By Simon Johnson

During the Dodd-Frank financial reform debate in early 2010, newly elected Senator Scott Brown of Massachusetts was referred to as an ATM for the bankers – meaning that whenever they needed some more cash, they would stop by his office. It was not paper money he was handing out, of course, it was something much more valuable – rule changes that conferred a greater ability to take on reckless risk, damage consumers, and impose higher future costs on the taxpayer.

Mr. Brown had this ability because he represented the final vote needed to pass Dodd-Frank through the Senate. He could have asked for many things – including greater consumer protection, a more thorough investigation into mortgage practices, and reforms that would have cleaned up unscrupulous lenders. He asked for none of those changes – or anything else that would have made the financial system safer and fairer.

Instead, Senator Brown’s requests were designed to undermine the Volcker Rule – i.e., he was opposing sensible attempts to limit the ability of big banks to place highly dangerous bets (and to blow themselves up at great cost to the rest of us). Mr. Brown seems to have been particularly keen to allow big banks to invest in hedge funds of various kinds – and the Boston Globe reported recently that he has continued to push in this direction behind the scenes. Continue reading “Scott Brown: ATM For The Big Banks” →

Thomas Hoenig Read All of Basel III . . .

By James Kwak

. . . and doesn’t like what he sees. In a post for the Harvard Law School Forum on Corporate Governance and Financial Regulation, the former president of the Kansas City Federal Reserve Bank echoes some of the issues raised by Andrew Haldane, which I discussed earlier. The core problem, for Hoenig, is that Basel III “promises precision far beyond what can be achieved for a system as complex and varied as that of U.S. banking.” Banks were able to arbitrage the risk-weighted capital requirements of Basel II? Well, we’ll close all of those loopholes, one by one. But this cannot be done, given the incentives and power imbalances at work: “Directors and managers . . . will delegate the task of compliance to technical experts, and the most brazen and connected banks with the smartest experts will game the system.”

Continue reading “Thomas Hoenig Read All of Basel III . . .” →

Restoring The Legitimacy Of The Federal Reserve

By Simon Johnson

The Federal Reserve has a legitimacy problem. Fortunately, a potential policy shift is available that offers both the right thing for the Fed to do and a way to please sensible people on both sides of the political spectrum: raise capital requirements for megabanks.

As the election season progresses, Republican politicians are increasingly criticizing the monetary policy of Ben Bernanke and his colleagues on the grounds that they are exceeding their authority, particularly by buying assets and trying to lower interest rates in what is known as “quantitative easing.”

There is growing concern in Republican circles that the Fed is tipping the election toward President Obama, and Mitt Romney repeated unambiguously in August that he would not reappoint Mr. Bernanke (a Republican originally appointed by President George W. Bush).

At the same time, a significant number of people on the left of American politics are concerned about how the Fed acted in the period leading up to the crisis of 2008 – blaming it for a significant failure of regulation and supervision – and about how much support it currently provides to big banks. Continue reading “Restoring The Legitimacy Of The Federal Reserve” →

Masters or Trend-Followers of the Universe?

By James Kwak

There is an image that underlies the theory of efficient markets. The image is of a pack of hyper-intelligent, hyper-competitive, voracious traders (working at hedge funds, at bank prop trading desks, in their basements, whatever), relentless scouring the markets for pricing inefficiencies and pouncing on them, trading them out of existence before moving on to the next one. The archetype is the quantitative trading desk at Salomon Brothers in the late 1980s, led by John Meriweather, exploiting arbitrage opportunities between on-the-run and off-the-run Treasury bonds. In finance theory, these sharks are contrasted with the “noise traders” who don’t know what they’re doing, and the question is whether the noise traders are enough to upset market efficiency.

But how good are the sharks anyway? That’s the question that came to my mind on reading the Economist‘s summary of a paper by Lauren Cohen, Christopher Malloy, and Karl Diether on stock market responses to legislation affecting specific industries. They found that you could make money by buying stocks of companies likely to be helped by new bills, and you could identify those companies from the voting records of senators and the incidence of keywords in the bill text.

“The mystery,” according to the Economist, “is why the broader market is so slow to recognise the effect of legislation.” That’s the classic way of thinking about the problem. Shouldn’t the hedges have figured this out already? But this isn’t the only case. A recent column by Lucian Bebchuk reminded me of another example: Up until the 1990s, you could have made money by buying stocks of companies with good corporate governance practices and shorting those of companies with poor practices.

These are patterns that were discovered by academics, who have limited research budgets and little financial incentive involved. (Academic prestige counts for something, but, according to theory at least, not as much as the billions of dollars in fees brought in by top hedge funds.) How come they were discovered by Bridgewater and Renaissance and all of those guys who have huge piles of money to invest in research?

One possibility is that Renaissance has discovered this and other trading strategies and has figured out a way to milk them without making the arbitrage opportunity go away entirely. The other possibility is that the sharks really aren’t so terrifying and ruthless as popularly believed, and instead they just stumble around copying each other to try to reduce their variance from the competition.

Or more likely it’s some combination of the two. A handful of firms come up with their own superior trading strategies, but most simply copy whatever they hear other people are doing. That’s why the corporate governance anomaly seems to have been traded away, and why everyone is doing high-frequency trading these days. The problem is that most investors’ money is going to the followers, which is why they are getting low returns and high costs. But it’s good for the entire industry that laypeople are in such undeserved awe of hedge fund managers as a class.

Voters: Not So Stupid?

By James Kwak

In July, a New York Times article on Priorities USA Action mentioned a focus group in which participants refused to believe that any presidential candidate could be in favor of “ending Medicare as we know it” (replacing guaranteed coverage with vouchers that will pay for an unknown percentage of guaranteed coverage) and tax cuts for the rich. At the time, I called this no less than “the problem with American politics.”

But perhaps the problem isn’t so bad. Here are some results from recent Times/Quinnipiac polls of swing states (click on the image for a bigger version):

Continue reading “Voters: Not So Stupid?” →

The Gift That Keeps on Giving

By James Kwak

By now most of you probably know about the video of Mitt Romney at a fund-raiser for rich people dissing 47 percent of Americans, including seniors, one of his core constituencies. (Many seniors don’t pay income tax because they don’t have enough income, since Social Security is not taxed except for high-income households. For more on the “47 percent,” see here.)

Continue reading “The Gift That Keeps on Giving” →

Musical Pseudo-Science

By James Kwak

A friend sent me to an article in The Economist titled “The Science of Conducting” summarizing a study by a number of researchers (including apparently at least one real musician). The Economist’s conclusion:

“The findings are in harmony with what conductors knew all along: that baton-toting despots, like the late Herbert von Karajan, do add value—but only if they rein in the uppity musicians in front of them.”

This is more or less what the paper itself claims:

“We propose that the conductor will significantly change the perceived quality of a piece when s/he both increases his/her influence on musicians and, at the same time, expresses a personality able to overshadow the inter-musician communication. In simpler terms, this might be the essence of leadership.”

Continue reading “Musical Pseudo-Science” →

Simple or Complex?

By James Kwak

Ever since the financial crisis, there has been an on-again, off-again debate over the right model for financial regulation. On the one hand are those who favor simpler rules—such as a simple leverage limit based on total unweighted assets—on the grounds that they are easier to monitor and tougher to game. On the other hand are those who favor complex rules—such as the Dodd-Frank Act, which has so far generated over 8,000 pages of rules—on the grounds that the world is complicated so we need complicated rules. For the most part, this has been a shouting match over broad principles.

A friend sent me Andrew Haldane’s paper from Jackson Hole a couple of weeks ago, “The Dog and the Frisbee.” (The title refers to the ability of a dog—or a child—to catch a frisbee by following a single visual heuristic, ignoring factors such as the rotational speed of the frisbee or wind currents.) Now we have evidence.

Continue reading “Simple or Complex?” →

Introducing The Latin Euro

By Peter Boone and Simon Johnson

The verdict is now in: traditional German values lost and the Latin perspective won. Germany fought hard over many years to include “no bailout” clauses in the Maastricht Treaty (the founding document of the euro currency area), and to limit the rights of the European Central Bank (ECB) to lend directly to national governments. Last week, the ECB governing council – over German objections – authorized purchasing unlimited quantities of short-term national debts and effectively erased any traditional Germanic restrictions on its operations. (The finding this week by the German Constitutional Court — that intra-European financial rescue funds are consistent with German law — is just icing on this cake, as far as those who support bailouts are concerned.)

With this critical defeat at the ECB, Germany is forced to concede two points. First, without the possibility of large-scale central bank purchases of government debt for countries such as Spain and Italy, the euro area was set to collapse. And second, that “one nation, one vote” really does rule at the ECB; Germany has around ¼ of the population of the euro area (81 million out of a total around 333 million), but only one vote out of 17 on the ECB governing council – and apparently no veto. The balance of power and decision-making has shifted towards the troubled periphery of Europe. The “soft money” wing of the euro area is in the ascendancy. Continue reading “Introducing The Latin Euro” →

No There There

By James Kwak

On the one hand, over in Romney headquarters, they can take heart from the fact that the economy continues to sputter, as evidenced by the latest jobs report. On the other hand, as the election draws near, people will only ask more questions about what President Romney would actually do. For months now, the campaign has whispered one thing to the base (e.g., “severely conservative”) while being purposefully vague to everyone else, hoping that independents will assume he is still the moderate who introduced universal health care to Massachusetts. Now that strategy is breaking down.

Exhibit A is yesterday’s comical back-and-forth-and-forth-and-back on the Affordable Care Act. But the more important Exhibit B is the Romney “tax plan”—you know, the one that cuts rates for everyone by 20 percent, yet does not reduce revenues, does not increase taxes on the middle class, and achieves this miracle by eliminating tax expenditures, but without touching the preferences for investment income or the mortgage interest tax deduction.

Continue reading “No There There” →

The Problem with Bankers’ Pay

By James Kwak

From today’s WSJ:

“At J.P. Morgan, the biggest U.S. bank by assets, directors are considering lower 2012 bonuses for Chief Executive James Dimon and other top executives in the wake of a multibillion-dollar trading disaster, said people close to the discussions. But they also are grappling with the question of how to do that without drastically reducing the executives’ take-home pay.”

Huh? Isn’t reducing their take-home pay the point?

Who Built That?

By Simon Johnson

Perhaps the biggest issue of this presidential election is the relationship between government and private business. President Obama recently offended some people by appearing to imply that private entrepreneurs did not build their companies without the help of others (although there is some debate about what he was really saying).

Mitt Romney’s choice of Paul D. Ryan as vice presidential running mate is widely interpreted as signaling the further rise of the Tea Party movement within the Republican Party – with the implication that the private sector may soon be pushing back even more against the role of government.

For most of the last 200 years, national economic prosperity has been about creating and sustaining a symbiotic relationship between government and private business, including entrepreneurs who build businesses from scratch. This symbiosis was long a great strength of the United States, something it got right while other nations failed to do so, in various ways.

Is the partnership between government and business now really on the rocks? What would be the implications for longer-run economic growth of any such traumatic divorce? Continue reading “Who Built That?” →

Dominos

By James Kwak

So, as everyone knows, the ECB came out yesterday with its latest plan to stem the creeping European sovereign debt crisis. This one involves potentially unlimited ECB purchases of sovereign debt, so long as its maturity is less than three years (presumably so that the ECB can pull the plug within three years on non-complying governments) and the country in question agrees to comply with fiscal policy reforms (i.e., austerity).

I don’t have any particular ability to forecast whether this will succeed or fail. My inclination is that it will succeed for a while and then turn out to be insufficient, for the reasons that others have identified. Central bank bond-buying will enable governments to borrow money at manageable yields, so their national debt will not spiral out of control solely because of climbing interest rates. But to bring debt levels down will require actual economic growth, and more austerity—even if it isn’t quite as austere as that imposed on Greece in the past—will not generate growth. In addition, the ECB’s promise to “sterilize” its bond purchases—I believe by selling other assets to raise the cash for bond purchases, so the net effect will not be to create money—means that this is not a particularly expansionary form of monetary policy.

This is as good an occasion as any, however, to ask a question I’ve been wondering about for, oh, years now. Every discussion of the European crisis includes the following domino theory (although no one calls it that anymore, for reasons I’ll get back to): If Greece leaves the Eurozone, that proves that it is possible to leave the Eurozone—or, put another way, that the powers that be cannot keep the Eurozone intact. If people realize that it is possible, then bond markets will bet even more heavily against Spain and Italy, which will force them to leave the Eurozone, which would be terrible. Hence Greece cannot leave the Eurozone.

Continue reading “Dominos” →