Don’t underestimate the pivotal and persistent role of the banking crisis

Paul Krugman responds to Martin Wolf and John Cochrane arguing for narrow banking [allowing banks simply to take our cash and invest in risk free securities] in part by commenting that the banking crisis came and went quickly, and that the real problem lay elsewhere, in the debt overhang and deficient demand.  Therefore, the banking crisis was not decisive in bringing about the recession.  For that reason, don’t get so excited about the need to outlaw traditional banking.

Leaving aside the debate about how to regulate banks, this description of the crisis, although it’s an intriguing idea [if it’s just a matter of the occasional spike in spreads, why not run things as they are?] caused me some trouble.  Some reactions below.

1.  Although many spreads have normalised [accounting, I guess, for that normalisation of the St Louis Fed stress index Paul Krugman points to], I conjecture that the harm to banks is more persistent.  They have found themselves, in part pressured by their shareholder valuations, to delever.  This has constrained net lending, and aggravated the depth and length of the recession.

2.  Some markets remain closed, even now.  I guess these prices must be excluded from such a stress index.

3.  Weighing on banks’ behaviour has been the uncertainty about the long run regulatory regime.  And, in the UK, surrounding the regulators’ preferred path of getting the banks to that [uncertain] point.

4.  Also weighing is the desire not to crystallise losses, given current accounting and regulatory practices.  This has been talked about as an acute problem in Japan.  It’s an emerging one in the UK, with the FPC spending much effort pondering how much forbearance there is.

5.  Part of the normalisation of some prices is perhaps the expectation that the authorities will not allow a repeat of Lehmans’.  This is must surely be why peripheral EZ spreads have normalised:  banks are not really solvent, but with the ECB bluffing that it will buy whatever quantity of sovereign debt necessary, the sovereigns are solvent, and therefore they can credibly stand behind the peripheral banks.  It is probably also why similar measures are normalised for the UK.  This is less satisfactory as a description of the US, where it seems the Fed would be unable to repeat the bail out of Bear Sterns.  Unless we are to fathom that, in another crisis, the executive would find away to change course again, and Republican insistence on non-intervention could be won over.  Anyway, the point of this is to argue that the crisis hasn’t gone away, it’s just that the risk has been socialised.  And that socialisation of the risk is constraining fiscal policy to some degree, and that is contributing to a more protracted recession than we would otherwise have had;  and/or spending is weak because private agents worry about the long term health of their sovereigns, whom, ultimately, they stand behind.

6.  Although it may be true that the proximate cause of the protracted recession is household and corporate debt, the real reason may lie in the crisis in banking and intermediation.  Borrowers were offered debt at unsustainably low prices by a financial sector mis-pricing, over-optimistic about the future, or leaning on the state’s future support, or all three.  Now, with either normal or still abnormally high spreads, debt has to fall and demand is therefore weak.  If [excuse mixed metaphor] there was a magic wand to iron out surges and troughs in intermediation, we would not have had the debt build up, and would not be suffering a period of protracted weak demand as it was paid down.

Following this reasoning, it’s vital to sort out whether something can be done to get banks and other intermediaries to behave better.  And it may well be that their behaviour even now, with the immediate threat of deposit or market runs receded, is dragging on activity.

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If the central bank rate falls, does inflation rise or fall? The limits of verbal reasoning.

Noah Smith and Ryan Avent got his debate going again, a conversation whose last incarnation was an exchange between Steve Williamson and Paul Krugman, essentially, sparked by Steve asserting that inflation was too low because Fed rates were too low.  Chris Dillow has offered his own contribution.

The latest exchange, for my money, shows the limit of verbal reasoning about questions in monetary economics, and lack of prior exposure to the long past literature on this.  This literature isn’t necessarily right (about what would happen in the real world).  But it offers a menu of what ifs, a menu to which these blog posts are essentially trying to add.  Noah and Ryan wrestle with the impact of expectations on current prices.  Chris wrestles with different ‘mechanisms’.  All of them seem to me to get trapped by the pitfalls of the initial thought experiment.

First thing to say.  If expectations are rational – in the jargon this means if agents know how the model works, what the central bank is doing – then under either sticky prices, or flexible prices, a wide class of models gives the answer that if the central bank holds the interest rate down at a fixed level for ever (even for a long time) ANYTHING can happen to inflation.  You have what is known as ‘indeterminacy’.   There are infinitely many values for inflation expectations and thus inflation consistent with any given value for the shocks hitting the economy.    This has been known since Sargent and Wallace.  And was later studied by McCallum, Woodford, Evans and Honkapohja, Bullard and many others.

It may well be unrealistic to suppose rational expectations for an experiment like this.  If expectations follow processes generated by least squares learning, or similar, then holding the interest rates down for a long period, or forever, is highly likely to generate violent instability in inflation.  So, in a slightly different way, if we were to ask what inflation might turn out to be some time down the road, we would have to say : who knows, anything could happen.

Holding inflation constant, we can then only really ask questions about what would happen if interest rates were held temporarily lower than were dictated by a monetary rule that, once followed subsequently, were sufficient to guarantee determinacy or stability.  The answer to that question we know in a wide class of models.  Inflation rises if interest rates fall.  Temporarily.  Thereafter, interest rates rise to combat the unwanted loosening, and the rise in inflation, and eventually all settles back to steady state.  So far as I know, none of this depends on whether expectations are rational, or prices are sticky.

We can ask questions about what would happen if the inflation target were to change permanently.  If it were to fall, then in the long run, so would nominal interest rates, by the same amount [leaving aside, as most of the models I am subblogging [term coined to mean blogging without referencing properly, derived from subtweeting] do, the costs of inflation].  In the mean time, what happens to nominal rates depends on whether prices are sticky or not.  If they are flexible, then nominal interest rates would fall immediately, and correspondingly.  If sticky, then initially nominal rates would have to rise before settling back to a lower steady state.   I don’t think this result would depend on expectations.

I recall being mystified by Steve Williamson’s cryptic suggestion that the Fed is causing low inflation with low interest rates.  Because presumably he meant ‘despite telling everyone that their inflation target was 2 per cent, roughly’.   I was mystified because I know he understands the models I have just cantered through better than I do, where this isn’t true.  These models exclude models in which money is modelled in a way that would satisfy Steve and the other ‘new monetarists’.   I don’t know what happens in these models.  Or if versions of them have been developed that are sufficiently realistic in other respects to allow us to compare.

A final nihilistic contribution was made by Cochrane, in his JPE paper of a few years ago.  If I can offer the most ridiculously short summary of a long and hard paper ever attempted, I’d say that this paper says ‘even when modellers using the rational expectations sticky price model say that things are determinate, they may not be, though they are certainly not when they say they aren’t.’  Which means that you have to go back over what I said, and note that where I said we might get a definite answer, instead of ‘anything’, we might actually just get ‘anything’.

Anyway, that was a rather hurried post, offered really as an elaboration on a few tweets I have sent out.  I don’t pretend that they describe the real world, but I hope that they ring some alarm bells about the care that bloggers need to take when they pose and try to answer the question ‘what happens to inflation if the central bank cuts rates?’  You need to say:  for how long, and why exactly is it cutting rates?  Is that part of a revision of the monetary rule?  And you may have to ask yourself whether you can decide on whether prices are sticky or not, and on whether the change is comprehended or believed by the private sector.

Update.  [This is why I should stick to the Simon Wren Lewis rule of only posting what you wrote yesterday].

This discussion is not of purely academic interest, though it sounds nerdy and pointless.  Recall where it started.  Core inflation is sliding in the US and the ECB [and possibly in the UK too].  Does this mean that central banks should double down and keep rates lower for longer [this is how central bankers would see it, and this is how monetary econ as summarised above would have it], or is low inflation, by contrast, caused by the low rates?  It’s pretty crucial to settle this.

Relatedly, the discussion connects with recent efforts by the Bank of Canada, Fed and the BoE to stimulate the economy by announcing that rates will be held low, and fixed, at their natural floors, for long periods of time, before eventually rising, a policy they have dubbed ‘Forward Guidance’.  We know that the rational expectations, sticky price models used by central banks behave VERY weirdly indeed as we vary the number of quarters for which interest rates are held fixed.  Work by my former colleague Matthias Paustian and coauthors shows, for example, that you can get that a loosening implemented this way can generate a massive inflation, or, if the number of quarters is changed just a little, a massive deflation.  One presumes that central bank modellers have found some kind of fix for this [or have decided to just ignore it].  But these results must leave us with some disquiet about i) whether the models are the final word on the matter and ii) whether the central bank policymakers really can say that they have a clue what will happen to the economy under Forward Guidance.

I will revise this post with links later tonight.

If I was devising a panics and bubbles course…

In a recent FT article, Claire Jones reported on the decision by Manchester University to reject a proposal for a course on ‘Panics and bubbles’, the initiative of the Manchester students’ pressure group ‘Post Crash Economics‘ and sympathetic academics.

On the limited evidence of the course reading list, I thought that the course missed a great deal.  I also thought that Claire’s article was a bit one-sided, implying that the decision to ditch the course illustrated the continued, ostrich-like stupidity of the economics profession.

Claire’s article invoked two wise spirits in favour of the Manchester course.  One was Wendy Carlin, who has led an Economic and Social Research Council-funded effort to overhaul the teaching of macroeconomics.  But Wendy’s (excellent effort) doesn’t urge binning the macroeconomics canon in favour of Austrian or informal analysis [as the PCE lot seem to advocate].  It’s centrepiece is to try to get the New Keynesian model used by central banks to be the focus of the undergraduate macro canon, rather than the older IS/LM model, harder to relate to contemporary debates (without the obduracy and genius of Paul Krugman).  This is decidedly mainstream (and welcome).

The other spirit invoked by Claire was Andy Haldane, outgoing Executive Director for financial stability at the Bank of England.  Claire quotes Andy as saying, in support of the PCE’s manifesto:  “The economy in crisis behaved more like slime descending a warehouse wall than Newton’s pendulum, its motion more organic than harmonic.”  Two points.  Take a look at Andy’s cv of papers and speeches, and you find them peppered with formal, mathematical, decidedly mainstream work, or references to them [more on this later].  Second, this metaphor from Andy could rather be taken to be a call to get more mathematical (and therefore ‘mainstream’), not less.  The inference is that the crisis is like a fluid dynamics problem [comment stolen from friend who has to remain nameless].  The study of fluid dynamics  is built from heavy-duty applied mathematics [more so than frontier economics, perhaps].  Students wanting to draw the analogy between the financial crash and organic processes had better stop chatting about Austrian economics and start crunching exotic nonlinear ordinary differential equations [or rather, starting the slow and painful process of learning how to do it].  Even if heterodoxy is to be the new orthodoxy, students are going to need suffer the trials of dynamic mathematics.

Looking through the reading list for the PCE Manchester course, and presuming that this list sketches its scope, it seemed to miss the grand flowering of mainstream financial macro and microeconomics.  If I were teaching a course on panics and bubbles, I would try to give a guided tour of it.  For example…

– I would take them through Diamond and Dybvig’s classic model of banks runs, how redeeming deposits on a first come first served basis causes runs on even healthy banks.  And I would take them through the analyses of moral hazard in the provision of public deposit insurance to stop these runs [for example, see the references in Sargent’s LSE lecture, or indeed Andy Haldane’s speeches].

– I would discuss with them Geanakoplos’ work on how leverage and bouts of optimism creates booms and busts in asset prices.

– I would devote time to discussing rational expectations, monetary, overlapping generations models of fiat money, in which one can see that money acts like a ‘bubble’, and which serve to explain in the purest sense what a bubble can mean, of the kind recounted in the famous conference volume edited by Karaken and Wallace.

– I would try to give a taste of the work of Angelotos and co-authors, Morris and Shin and Shleifer and Vishny who have sought to model how beliefs (eg about the value of an asset, or the likelihood of a future event) can spread and become self-fulfilling.  And I would talk about the foundational work too of Roger Farmer and co-authors establishing the macroeconomics of self-fulfilling prophecies in rational expectations models;  these insights showed how pure shocks to expectations [like waking up and feeling pessimistic for no reason] can cause business cycles.

– I would give some time over to explaining the work of Hansen, Sargent, Cogley, Colacito, Ellison and other collaborators who have shown how asset prices can rise and fall as investors, doubtful of their own models of the dividends from holding an asset, revise their forecasts, and adjust their portfolios to prepare themselves for the worst.  [And, using similar techniques, how monetary policymakers may have aggravated booms and bust, weighing up the signals from competing models of the economy].

– I would make students read the literature on learning in macroeconomics, from its origins in Bray and Savin [and earlier], Marcet and Sargent, through to more recent applications by Adam and Marcet, who showed how cycles in share or house prices can be induced by learning agents revising forecasts of the value of the assets they hold.

– I would try to introduce the economics of networks;  related modern models of money whose value comes about as a way to economise on search for exchange partners, and which give one clear insight into the meaning of ‘liquidity’, (and thus into how liquidity can appear and disappear).

And having done all that, I would regret that there wasn’t time to devote a whole degree to the topic, and I would stuff the reading list with reams of papers I hadn’t even properly read myself, perhaps sentimentally hoping to entice a student to come back for more in postgraduate study.  I’d list Brunnermeir and Sannikov’s work [A survey by the former did make the reading list, as Claire Jones pointed out to me]; I’d tantalise them with the Clarendon lectures of Shin, and John Moore.  I’d offer the collected works of the Kiyotaki-Moore collaboration.  I’d retrospectively regret that I hadn’t had time to lay out standard models of macro-finance and their failures, set out in the sequence of papers by Lucas, Svensson, Mehra and Prescott, Campbell and Cochrane, Epstein and Zin, Fama, Shiller and many more, and, not knowing what to do about it, I’d slap them down in the reading list to perplex the students further.  And, in the same vein, I’d regret that I hadn’t yet set out the standard ways of including banking and finance in macro [due to Bernanke, Gertler, Gilchrist, Carlsrom, Fuerst, and others], where no bubbles and panics prevail, but one gets insight into how to formalise what finance does, and how it can amplify business cycles.  So I would shove all of those into the reading list too, wishing instead that another module could be taught on that.  And then, right before signing off and sending it out to the Faculty Committee responsible for approving the course, I’d fret that there was nothing on empirical macro.  After all, we might talk about panics and bubbles causing booms and busts, but how have people rolled up their sleeves to figure out what did cause business cycles?  And then another alarm bell would go off, worrying that students could hardly be expected to make sense of this without a proper introduction to game theory.  And then another, warning that we had not touched on the economics of financial regulation, or its political economy…

I don’t really know why the proposal for the Manchester course on panics and bubbles was rejected.  But, if it were me, I would have ditched it too, in favour of a course that looked more like the above.

 

The flaws in Osborne’s ‘I told you so’ speech in Washington

UK Finance Minister George Osborne’s Washington ‘I told you so’ speech  has prompted a thorough going over of the issue of what the recovery in the UK does or does not prove regarding the Coalition’s ‘austerity’ fiscal policy, by Chris Giles, Jonathan Portes, and Simon Wren-Lewis.

I want to add one point to this.  One of the challenges for what Osborne calls the ‘fiscalist’ position [the position that it was tight fiscal policy that aggravated the recession, and that it was its gradual loosening that caused the recession to wane] is that they purportedly need to show that the pace of consolidation slackened, causing the subsequent pick up in growth.

Jonathan Portes’ patient review of the facts showed that indeed the pace of consolidation, measured by the speed at which the cyclically-adjusted, structural deficit falls, did indeed drop off, a bit.  So, if this were a correct challenge, Portes shows that it was met.

However, seen through the lens of a modern macro model, Osborne’s challenge to the ‘fiscalist’ position may be false.   We might guess that what happened in May 2010 was a switch between two fiscal rules, towards one that entailed a less generous use of deficits to counter recessions, and a lower average debt to GDP ratio.  When people in the economy realised that this switch was going to happen, and what it entailed [a process that probably began some time before the election, as it was clear that Labour were not going to hold on to power, but was not complete until well after it, when the fog cleared on Treasury plans], they cut back their own spending, say, anticipating higher taxes and lower disposable income.  However, as the rule was followed through, no further belt-tightening by the private-sector was needed.  Although taxes and spending were doing what they needed to do to bring about the lower [relative to Labour plans] final debt to GDP ratio, private sector spending did not need to adjust further on account of these plans being followed through.

Actually, in the language of these rules, one might argue that fiscal policy loosened relative to the first post-2010-election plans, as the time over which the deficit was to be closed was lengthened.  [A rules-based echo of the ‘ever smaller fiscal shocks’ hypothesis that Osborne puts in the mouth of the ‘fiscalists’].  This actually works in favour of what Osborne called the ‘fiscalist’ position.  On account of this  loosening (relaxation of the pace of structural deficit elimination) one might expect some stimulus to private spending:  belts did not need to be as tight as consumers and firms had chosen to fasten them.  So consumers could treat themselves.

The key point here is that changes in the structural deficit may be anticipated to some extent, since they are pre-announced and part of an overall design [=’rule’] so these changes don’t measure fiscal impulses or shocks whose effect we then go looking for in private sector spending.

The argument above has been drastically simplified [believe it or not] to make a point.

For instance, you might wonder at the notion that we should assume that the private sector understands government plans.  [Osborne has repeatedly tried to confuse and disempower his audience, not least in this latest speech, with his claims for austerity’s supposed stimulus, or by denying that there was any change in plans].  Perhaps it took time to sink in, so each change in the structural deficit was felt like a new disruption to their own private plans.  If this were the case, then the Osborne challenge is less incorrect.  [But recall that Jonathan Portes answered it.]

Or, by contrast, perhaps we should think of the private sector as rational and sceptical;  never in the first place believing that Osborne would have the stomach to see such plans through to the extent announced.  In this case, the logic I sketched is still right, and the Osborne challenge is false.  So long as the private sector’s guess at the final path for fiscal outcomes [strictly speaking fiscal intentions] doesn’t change, no further readjustments in private spending plans would be needed.

The other big simplification is that there were lots of other things going on at the time.  Confidence in the UK [and around the world] was rescued by apprehending that the US fiscal stimulus was working, and that, bit by bit, the Eurozone authorities were getting to grips with their sovereign debt crisis, and that steps by the UK authorities to shore up the financial sector had worked and would hold.  It is possible [indeed surely most likely] that this is the dominant reason why growth recovered in the UK.  Even if the Osborne challenge to fiscalists were sound [that you can measure the extent of fiscal shocks by the profile of the structural deficit] their impact could easily be swamped by changes in demand induced by the private sector response to these global events.  This final appeal to the notion of the counterfactual might seem repetitive, but it seems appropriately repetitive, since George Osborne has so frequently try to abuse it.

The BoE should follow the Fed and make its model downloadable and forecast judgements open to scrutiny

The Fed recently made its workhorse model FRB-US downloadable, with a dataset, code, everything you need to take a close look at what Governors say and what the staff have been doing for them.  The Bank of England should do the same.

Recently, they published a working paper which includes an equation listing for its new COMPASS model, and an account of how this model sits within the so-called ‘suite’ of models.  On the face of it, you might say ‘Great!  How generous and transparent of them!  What a forward-thinking helpful central bank!’

But, hang on a moment.

They publish the equation listing to set someone the challenge of coding the model up and solving it using their own software?  Why?  To the cynical it looks just like a device to make it look like they are being transparent, while hoping that no-one will find it worth the trouble.  And coding up the model and solving it is the easy part.  Then there is the difficulty of collecting all the data and following the complex data transformations used by the staff.  And then replicating the delicate steps used to estimate it.  And then figuring out the judgements that the MPC have layered on top of the model, derived from their own wisdom, or insights from the ‘suite’.  We’ve nothing to hide, they might say.  It’s all there.  Well, if not, why try to discourage people from checking?

I know that the BoE worries about making this code and data downloadable.  They worry about this leading to them assuming a software and data support role that they don’t want.  So what?  Of course the Bank should assist those who are to hold it to account.  They also worry that it poses operational risks [what if they cock it up?].   And they worry about the scrutiny of the forecast it would bring.  Wouldn’t disclosing the model and judgement just help those who want to make mischief make it?

These concerns are flimsy set against the many arguments for it.  Such a large public body  with so many important powers has to be held to account, and anything that can help that process is vital for the democratic process and for the credibility of policy itself.  If you doubt that, reflect for a moment that there are many occasions when it would serve the MPC well to layer on a heavy judgement to make it look like inflation is going to come back to target when their model’s say it is not.  Purely hypothetically:  imagine an economy seemingly stuck at the zero bound,with inflation drifting slowly below target.  Its models might say [as the Bank’s New Keynesian model could well say] help!  Inflation is heading down to the liquidity trap steady-state and there is nothing but loose fiscal policy that will get us out of it!  The temptation to hide this with a healthy dose of judgement tweaking inflation firmly back towards target would be very hard to resist.

Further, it’s taxpayers ultimately that have funded the building of the model.  [Have a look:  it’s there as a chunky few million quid in the BoE annual Reports].  It seems perverse to make them pay again to get any use out of it [by forcing them to fund their own efforts to replicate the BoE model].

Keeping the code, toolkit and data locked away is against the spirit of modern scientific ethics, contrary to the hints in the new BoE structure that aspires to prioritise research.  Journals now insist that researchers deposit data and code so that research can be replicated and challenged.  The BoE isn’t a journal.  But it is hoping it gets kudos from using this big beast of a DSGE model, and trumpets the beauty of its suite software, so it should allow others to scrutinise it to check just what this thing that cost so much is being used for.  If we had past vintages, we could take a close look at past miracles, like how the switch from one model [BEQM] to another [COMPASS] took place without a bobble or a quiver in the Inflation Report forecast profile.  [It’s easy to hazard a guess:  the judgement is pivotal, and was modified to make sure that the signal from the model had little or no effect on the profile.]

Almost of all of the knowledge in the model has been lifted from research done by others outside the bank, in academia and in other central banks.  [DSGE models trace a lineage from Lucas, Kydland, Prescott, Christiano, Eichenbaum, Evans, Smets and Wouters.  The technology to estimate them comes from Kalman, Sargent, Sims, Schorfheide, Gibbs, Metropolis and Hastings].  The Bank has borrowed enthusiastically from free open source code libraries to hone its own toolkit for solving COMPASS and the other models.  It is odd that having taken so gladly, that it chooses to keep that toolkit from the community it relied on to produce it.

Having this transparency would be particularly important now.  The MPC is making a lot of its ability to manipulate expectations of future rates, via forward guidance.  This throws a particularly keen spotlight on the forecast.  The MPC is using what looks like a model of rational expectations:  a model in which agents inside the model can manipulate and compute its equilibrium.  This is somewhat ironic, since the BoE withholds the means for people to do just that!  Is it relying on the properties of RE for its estimates of the impact of forward guidance?  How has it dealt with the known pathologies of these models under fixed interest rates [the models frequently go haywire, unless arbitrarily fixed to stop it, generating alternatively massive inflations or deflations for small changes in the horizon at which rates are fixed].  Why rely on rational expectations in this case, embarking on a new policy, in novel economic circumstances, precisely those when this should be the worst possible approximation to how expectations would actually behave?  ‘Ah, we’ve dealt with all that with our wise judgements’, the MPC might say.  ‘We don’t take the model so literally.  It’s just one of many [indeed a suite] of sources of information.’  Well, to make sense of this, and to understand what this judgement is doing, we would need to know more about it.  Otherwise we might assume it’s all smoke, mirrors and bluff.

So, in short, the Bank should follow the Fed, make the code, dataset and software available.   Senior management in the Bank often complain at how lethargically the academic community engages with the issues that policymakers are grappling with.  These would be steps that could encourage such engagement.  Who knows, doing so might generate insights that the Bank’s economists could use that they would not otherwise get.

The futility of hoping for a reset of finance’s ‘moral compass’

This post is prompted by reading in my twitter feed that Martin Wheatley of the UK’s Financial Conduct Authority had said that finance had ‘lost its moral compass’.  Sermonising like this is completely unhelpful in my view.

Almost all in every era in every field of activity were guided by self-interest.  I doubt that financiers of days gone by had more tender hearts.  Or that the £ signs light up any less fiercely in the eyes of non-finance business people.  All that differentiates business from finance is that the consequences of selfishness for the wider economy are less serious.  Business selfishness is less likely to lead to systemic fragility.  All that differentiates past financiers from those of today is the possibilities for money-making afforded by innovations (internet, credit scoring, securitisation), new clients (newly wealthy emerging market investors) and new regulations.  Financial leopards won’t change their spots.  So no moral compass now means none ever.

Campaigning for moral finance is a distraction from the task of actually doing something useful to prevent another crisis from happening;  like understanding what really caused the crisis [why the consequences of ubiquitous selfishness were so acute in finance], and what activities could be regulated and how.

How would you ever objectively measure financial morality anyway?  And who would ensure the moral compass of the moral compass inspectors?

Moral compass sermonising misses one of the key points about the crisis.  Let’s imagine that it culminated in one gigantic bank run.  It wasn’t all about retail banks, of course, but the other non-bank intermediaries perform very similar functions.  There came a point where everyone wanted to pull their money out because they thought (correctly) that everyone else did.  Suppose we could somehow persuade all these investors that when they cash in, they should give their entire wealth to charity [achieving a kind of Wheatlian moral bliss].  If they feared for their investment, they would still pull out, and bring the market/banks crashing down.  Because if they didn’t, they would not get their money back, and their hearts would bleed.   Resetting everyone’s moral compasses in this way would not stop runs.

I suppose you might say that if we could hard wire their compasses with an ‘after you’ instruction that would cure bank runs.  True.  But no-one is ever going to manage that.

To some extent, the damage is done.  It’s already de rigueur to try to stress how nice you are in your advertising if you are a financial services company and is a standard part of the PR budget.  Just as for other companies they have to spend to pretend to be greener than they are, or pretend to be cooler, or not to be advertising when they are, or to be selling stuff because they like it, or to be representing you in Parliament because they feel it is their calling [or to be blogging because they think it might be useful].

Pensions reform: adverse selection, our future selves, and intergenerational risk sharing

The Government has announced plans to drop the requirement that pension holders be forced to purchase annuities when their pension plans mature.  This will have the positive benefit of allowing people to have more control over their savings, to be valued in a society predicated on allowing people as much self-determination as possible.  However, there are some downsides.

1.  It will allow people more control over their savings!  Annuities insure us against the uncertainty we face in predicting how long we are going to live without being able to or wanting to work to feed ourselves.  Peversely, annuities help in the unfortunate event that we live longer than we guessed we might, paying us the savings someone else accrued who lived less than they thought they might.  It is an insurance against risk that our future selves face.  Unfortunately, there is abundant evidence from the experimental and other empirical literature in behavioural economics and finance that we are i) terrible at paying proper attention to the wants of our future selves [usually neglecting them] and ii) terrible at responding rationally to risk.  Allowing us to make decisions for ourselves is therefore likely to lead to suffering.  Our present selves may love it, driving to retirement coffee mornings, or our self-funded Physics PhD, or going on cruises.  But our decrepid far future self will regret that, cowering without the heating on.  To the extent that we differ in how we neglect our future selves, there will be a subsidy going to the most stupid, who run out of money and fall back on the state for assistance.

2.  There is a risk of inducing adverse selection in the annuities market.  Adverse selection occurs because in a voluntary annuities market, insurers guess that those who knock on their doors for an annuity are those who know from the history of their relatives that they have a fair chance of getting one of those Telegrams from the monarch when you reach 100.  So they charge more for the service, anticipating having to pay out for longer.  And this thins out the customer base further, to those expecting to get into the Guinness Book of Records for longevity, and so on, until the market disappears.  Is that why the share prices of annuity providers dropped as the 2014 Budget was read out?

It’s not all bad, of course.

Annuity providers may be lazy through lack of competition, or capricious and sell people more insurance than they need, confusing people with a proliferation of hard to price options. [Perhaps that’s why the share prices of annuity providers dropped as the 2014 Budget was read out!].  And we don’t all face the same amount of risk.  Single people face more of it than the married.  Spouses can agree to leave their money to the other, giving them a payout if they are unlucky enough to outlive them.  And some of us like risk.  Boris Johnson celebrated that people could become buy-to-letters.  Sure.  Provided we can pay someone to run it for us [remember we are thinking of a time when we can’t work here] that would generate an annuity, just more risky, since it would rise and fall with changes in the relative yield on houses.

Another reason that private sector annuities are not the perfect solution, is that their providers, though they can, in principle, pool longevity risk across their customers [adverse selection aside], they cannot do anything about aggregate longevity risk.  Mervyn King’s British Academy lecture in 2004 documented the extraordinary increases in life expectancy that mounted through the 1970s, 1980s and 1990s, much of which took the industry by surprise, leading to hardship given the defined benefit based promises they had made with their customers.

The only way to deal with that risk is for the state to pool it across generations.  A generation that lives longer than forecast gets a handout through the Government borrowing, and future generations that live less than forecast pay out.  Intergenerational risk sharing of this sort is not radical.  It goes on the time.  That’s what Krugman, Wren-Lewis and the others urging much looser fiscal policy during the crisis were advocating.  Borrow now, and future generations can pay back.  We are sharing in the generational risk that crystallised in the form of the second world war.  (Well, thankfully only some of it.)  The Government borrowed to finance defeating the axis powers, on the understanding that baby-boomers and their children would foot some of the bill.

The difficulty with intergenerational sharing, of course, is that today’s generation can change its mind and not keep the bargain made for it, perhaps even before it was born.  In fact, if it suspects that some future generation might vote down the state pension just as it comes to draw it, why would today’s generation agree to pay taxes to fund today’s old?  We have a state pension, you might say, isn’t that evidence that the system works?  No, because it might be much higher if we could somehow constitutionally guarantee that it would never be ditched, so we would all share in its benefits, without worrying about selfish youngsters abolishing it just as we had got too tired to work.  The shift from defined benefit to defined contribution pensions amounts to a reduction in intergenerational risk-sharing, and reflects the difficulty of designing systems by which society can, in a time-consistent and predictable fashion, substitute for the private sector’s inability to do it.

Simply giving people the choice not to buy these private annuities isn’t a solution, of course.  That would have to be solved by either i) the state providing more than it does, or ii) equivalently, the government issuing ‘longevity bonds’, which annuity providers would buy.  These would be bonds that paid out more to their holders if life expectancy turned out greater than forecast, so the annuity provider holders could pass these on to the wizzened-old, record breaking wrinklies.  [And thanks to Dan Davies for reminding me that i) and ii) are in principal the same].

One of the cheers for the new reform was from the savers lobby.  In particular, I picked up tweets from Ros Altman, who rails constantly against the long period of low nominal interest rates, which she and others think have harmed savers.  So now, the government is doing something to compensate savers for that.  That is a silly argument.  For a start, savers’ livelihoods depend on the real rate.  But of course real rates have also been extremely low in recent years.  However, in the medium to long run, there is nothing governments can do about that rate.  It’s determined by growth, demography, things outside government control.  All governments can do is pool the risk across time periods in the way I described above.  So generations experiencing low real yields could justifiably claim against those who might get higher real returns.  The authorities can do something about the very short run real rate.  But if that were to be increased, by the central bank raising the nominal rate it controls, that would likely cause a huge, further, long-lasting recession and a collapse in asset values;  ultimately, savings returns are paid out of the returns of economic activity which would be devastated by the use of the nominal rate for anything other than inducing inflation and output gap stability.

[Update:  see also Simon Wren Lewis’ post on this topic.  In particular, he fills in a gap I left by pointing out that it’s not just the stupid who would end up falling back on state annuities, failing to save enough for themselves, but the calculating, since they would calculate that the government would back down and help them out.]