Even in a democracy, it is believed that certain government functions should be placed beyond the control of democratic politics. The usual example is the judiciary (though most state judges in the United States are elected, this is a considerable anomaly). But another example is the central bank, which in the case of the United States is the Federal Reserve. A central bank has considerable, often decisive, influence over short-term interest rates, and, through them, over long-run interest rates as well. Typically (and to oversimplify), a central bank reduces short-term interest rates by buying short-term government securities, which pumps cash into the economy when the cash is deposited in bank accounts and then withdrawn and spent. Interest is the price that people or firms demand to part with cash--the more cash there is in the economy, the lower that price will be. In addition, by increasing the demand for these securities, the purchase increases their price, which in turn reduces their yield--the interest that they command. The central bank increases short-term interest rates by the reverse operation--selling short-term government securities, which sucks cash out of the economy, since the central bank can retire the cash rather than having to spend it.
Long-term rates tend to follow the path of short, both because of substitutability and because the more cash the banks have to lend, and so the less they have to pay for the capital that they lend, the lower the interest rates at which they will lend, including lending long term, because competition will tend to keep the spread between the banks' borrowing and lending costs from increasing just because their borrowing costs are falling.
The reason for making the central bank politically independent is that the bank's power over interest rates could be abused for political ends. Suppose the economy, though not in recession, is somewhat sluggish, and the government, perhaps because an election is looming, wants to juice it up. So it orders the central bank to reduce interest rates by buying government securities, thus pumping money into the economy. Reduced interest rates will stimulate lending, borrowing, and therefore economic activity, but the increase in the money supply can (since the economy is merely sluggish, and not in recession) create inflation. Very low interest rates in the early 2000s in the United States caused asset-price inflation, with destructive consequences, as we know.
Inflation can have other political objectives besides stimulating the economy in order to improve a government's popularity. It is a method of taxation. Suppliers are required by law to accept the official currency in payment of debts, so government can buy goods and services just by issuing money to its employees and other suppliers without having to raise the money by borrowing or by (explicit) taxation. The suppliers will respond by raising prices, but if the government refuses to pay (for example, refuses to raise wages), then the suppliers, to the extent dependent on the government for business (or employment), will have to accept the cheapened money.
In addition, inflation can be used to benefit some groups in society at the expense of others. Inflation benefits debtors, when debt is not indexed for inflation, and hurts creditors. A strongly pro-creditor central bank might even engender deflation, which would mean that debtors would be repaying their debts in dollars worth more in purchasing power than when they took out their loans. A central bank might do that (reduce the money supply, so that the purchasing power of a given quantity of money increases) in order to strengthen its currency, which would enable the country to buy imports more cheaply and increase the return on its foreign investments. (That was the ground on which Britain deflated by returning to the gold standard after having gone off it in World War I. That was a government decision; there was no independent central bank.)
Since the harms of inflation are now widely recognized, a central bank that focuses on limiting inflation will be reasonably popular; and since the value of its being independent of political influences so that it will limit inflation (and deflation) will be recognized, its independence will not be challenged. But the independence of the central bank in the United States, as in other countries, is not guaranteed by the Constitution, as the independence of the federal judiciary is. It is a matter of statute, and Congress could eliminate or reduce the Federal Reserve's independence from the normal political process at any time. Its independence is therefore legally precarious.
That is part of the reason why the modern Federal Reserve has focused on controlling inflation, and, specifically, why it did not prick the housing bubble of the early 2000s, as it could have done at any time by pushing up interest rates, until the bubble got completely out of hand in 2006 and 2007. Had it pricked the bubble earlier, precipitating a fall in housing prices with consequent defaults and foreclosures, at a time when it was unclear that the run up in housing prices was a bubble, it would have been blamed for causing a recession, because proof of a bubble is difficult.
But in retrospect the hit that the Federal Reserve would have taken by pricking the bubble would have done less damage to its prospects for continued independence than the current depression, and the Fed's response, may be doing. Had the Fed merely pushed down interest rates when it became apparent last summer that the economy was sliding into a recession or worse, it would have been doing something that it was expected to do: the converse of raising interest rates to prevent inflation is lowering interest rates to prevent recession, and this is consistent with stabilization, which is part of the Fed's explicit statutory mandate. The Fed did lower the federal funds (overnight bank lending) interest rate, which has become the conventional way in which it influences interest rates. That rate is now virtually zero, yet the reduction has not done the trick. The reason is that the impairment of the banks' capital (because of their heavy involvement in home mortgage lending) has discouraged the banks from lending, since lending is risky. And so the fact that they can borrow from one another at essentially a zero rate of interest to meet loan demands has not incited them to lend in amounts necessary to maintain economic activity at a normal level.
The Fed in some desperation therefore began last fall lending substantial sums to banks in an effort to increase their safe capital to a point at which they would increase their lending by relaxing their credit standards and reducing interest rates on their loans. The Fed also began buying up private debt (as distinct from government securities), for example credit card debt, in the hope that the sellers of the debt would use the cash they received for their debt from the Fed to issue more debt, that is, to lend more. It even has begun buying long-term private and public (Treasury) debt.
The dangers to the Federal Reserve's independence that are created by such activities are twofold. First, the scale of the Fed's intervention is so great as to create a serious risk of a future inflation, albeit a risk that, at present, the bond markets (judging from long-term interest rates) do not consider large. The Fed in the last year has expanded the supply of money by about a trillion dollars, and is intending to expand it further. In principle, it can reverse the expansion process by selling Treasury securities (and the other debt that it has bought) and retiring the cash it receives from the sale. The problem is that a sudden large withdrawal of cash from the economy could cause interest rates to spike, bringing on a recession, as when the Fed reduced the money supply in 1979-1982 to break the 1970s inflation, which was getting out of hand (it reached 15 percent in 1979). A gradual withdrawal might be too slow to prevent inflation.
It is true that when the Fed buys short-term debt, such as credit-card debt, the transaction unwinds naturally in a short time: the debt is paid by the debtors, and the cash received from them can be retired. But this assumes that the debt is paid in full, which it may not be, and that the Fed does not immediately buy more short-term debt, and perhaps feel obliged to continue doing so, because the market has become dependent on its participation. And the Fed as I said is buying long-term as well as short-term debt, and that does not unwind automatically in the short term; it can be sold but it might be sold at a loss, depleting the Fed's balance sheet and leaving excess cash in the economy to create inflation.
If the Fed's actions precipitate inflation or have other untoward consequences, there is likely to be a political backlash against the Fed. We live at present in a blame culture, and really the Fed is lucky that so far most of the public's and the Congress's and the media's ire has been directed at the bankers rather than at Greenspan or Bernanke.
Second, and perhaps more ominous, the types of intervention that the Fed is now engaged in can create an impression of politicization of financial policy or even of impropriety. If the Fed merely issues an offer to buy some specified quantity of Treasury bills, or an offer to sell some specified quantity of those bills, it is not picking and choosing among companies or industries. But if it decides, or participates in deciding, whether Bank X should be allowed to fail while Bank Y receives a huge bailout, or when it uses its position as a bank's creditor to alter its management or influence its business decisions, it invites accusations of favoritism or worse. (Or when it decides to buy one type of private debt rather than another.) The latest portent is the allegation that Bernanke, the Fed's chairman, participated with Henry Paulson, the then Secretary of the Treasury, in pressuring Bank of America last December not only to go through with its planned purchase of Merrill Lynch but also to conceal Merrill Lynch's immense losses from Bank of America's shareholders. I have no idea whether the allegation is true; but that it should be made at all is an example of the political danger to the Federal Reserve if it becomes involved in the operation of individual banks.
I am not suggesting that the Federal Reserve is wrong to take radical measures to combat a depression. The Fed's "easy money" monetary policy may have warded off a deflationary spiral, which would have been disastrous (there is still a mild deflation--the Consumer Price Index for example is below what it was a year ago--and it could still get worse). And the Fed's bank bailouts may well have limited the decline in lending touched off by the near collapse of the banking industry last September. I merely contend that such measures pose greater threats to the Fed's political independence than would early intervention to prick the housing bubble and by doing so perhaps have prevented the grave economic situation in which the nation finds itself.
Most richer nations nowadays, and many developing nations, have "independent" central banks, such as the European Central Bank and the Federal Reserve Bank. "Independence" cannot be precisely defined, but it is supposed to indicate that the central bank of a country has the freedom to make decisions which the government, represented by the Treasury in the United States, does not like. The purpose of independence is to allow monetary policy to be decided independently of fiscal policy, although obviously even independent banks and governments may respond in consistent ways to broad economic events, such as the present recession.
The motivation for having an independent central bank is the many occasions in the past when subservient central banks accommodated the government's desire to spend more without raising additional taxes. Central banks accommodate fiscal authorities essentially by buying government securities that help finance government spending. In return for receiving government debt, a central bank would either directly print additional currency that governments can spend, or it would create reserves in commercial banks that lead to an expansion of bank deposits and monetary aggregates, such as M1. Either way, inflation would result from this monetization of the government debt, often severe inflation and even hyperinflation. Hostility to rapid inflation led to the political support behind giving central banks much greater independence from fiscal authorities.
The history of the Federal Reserve's transition in and out of independence is illuminating (see Allan Meltzer's book, A History of the Federal Reserve, 2003). The Fed fully and enthusiastically compromised its independence from the Treasury during World War II. It bought large quantities of government debt to help the government finance the large wartime deficit. Inflation from the resulting big expansion of the money supply was suppressed through wage and price controls. This inflation became open after removal of these controls at the end of the war.
For a half dozen years after that war was over, President Truman and the Treasury pressured then much more reluctant Fed officials into maintaining the Fed's subservience. Eventually, however, the Fed regained its independence in the famous Accord reached in March 1951. Nevertheless, the Vietnam War, the Great Society Program, and the reinstitution of wage and price controls by Richard Nixon in the early 1970s led to later erosions of the Fed's independence.
Even during normal times, central banks, whatever their nominal independence, are under strong pressure to accommodate expansionist fiscal policy, especially as elections approach. During extraordinary times, whether in peacetime or during wars, this pressure usually becomes too powerful to resist. So the rather complete bending of the Fed to the Treasury's wishes during the present worldwide recession is not surprising. Still, that does not make it right, and I have some doubts about the Federal Reserve's recent behavior.
One concern is the somewhat arbitrary choices the Fed made about which banks to bailout and which ones to close or merge into other banks. This added significantly to the enormous uncertainty already prevalent in financial markets. I am also worried about the Fed's support of the huge federal deficits generated by the sharp expansion in federal spending. I understand such actions are necessary to help governments fight wars, but why help finance so much spending during this recession, particularly spending that has dubious stimulating potential? One example is the almost $800 billion so-called stimulus package that will do little to stimulate the economy, but will greatly raise long term government spending in directions desired by the President and Congress (see the posts on January 11 of this year). Another example of dubious government spending that the Fed seems willing to help finance is the ill thought out Treasury plan for hedge funds and other financial institutions to buy toxic bank assets (see the criticism of this plan in my posts on March 29 and 31).
The huge increase in bank reserves is a major consequence of the Fed's monetization of the government's large spending programs. Reserves went from about $8 billion in early Fall to around $800 billion, or a hundred fold increase in only 6 months. The recession rather than the wage and price controls imposed during prior periods is keeping inflation suppressed at present. Once the economy begins to recover, the inflationary risks will be enormous. In order to soak up these reserves, the Fed would have to sell large quantities of its government securities back to the private sector. These sales would put downward pressure on security prices- that is, upward pressure on interest rates- that will slow the economy's expansion at that time. For this reason, any government in power then, whether Democratic or Republican, will vigorously resist such Fed actions.
Hence it is not obvious that the Fed will be able to conduct these sales sufficiently smoothly to prevent either a recession or a serious bout of inflation. These are not pressing concerns when a serious recession is the immediate problem, but they will become major challenges down the road.
Repayment of Tarp Bank Loans-Becker
Six months ago essentially all large American banks and many smaller ones received loans from the federal government to help shore up their capital base as they tried to weather the financial storm. Some banks would likely have failed during the severe strains in the capital market last September and October were it not for these loans. This past week, however, the two strongest large banks, Goldman Sachs and JPMorgan Chase, indicated that they wanted to, and were able to, repay their loans. Should they be allowed to do so?
It appears that not all banks wanted to take government loans in October, but some large banks were apparently "forced" to as part of the TARP loan program devised by then Secretary of the Treasury Henry Paulson. According to some accounts, the government exercised this pressure in order to avoid disclosing which banks were the weakest and needed these loans to survive.
This explanation of the government's behavior is strange since generally participants in financial markets do not have an excess of information about the financial viability of different banks, but rather they do not have enough information. It is wrongheaded for the government to try to mislead markets about which banks are weak. Indeed, the purpose of disclosure requirements mandated for banks and other companies is to raise the degree of public information available about different companies in order to assist participants to make wiser decisions. In any case, most firms and individuals active in financial markets already had a fair idea of which banks were stronger and which ones were weaker.
Many of the banks worse fears about the strings attached to these loans have been realized. The resulting government intervention in bank managerial decisions include the well-publicized restrictions on bonuses and other pay to executives, restrictions on banks' ability to hire foreigners, and frequent demands to appear before Congressional committees to justify what they are doing. Less onerous interventions include Congressional and the media's opposition to banks holding expensive golf and other outings, bank use of private planes, and meetings at luxurious resorts. Goldman, JPMorgan, and other banks want to repay their government loans primarily to eliminate these and potentially other government restrictions on managerial decisions. I see no compelling reason why they should be prevented from repaying their loans.
One argument made against allowing them to repay is the same one used to justify requiring the relatively strong banks to take the loans in the first place; namely, that the weaker banks would be exposed if the stronger banks repaid at this time. However, they are already exposed since the major participants in financial markets already know that banks such as Goldman and JPMorgan are much stronger than say Citi and Bank of America.
A more sophisticated version of this argument is that if the strong banks were allowed to repay now, the weak banks would also try to repay, and thereby become still weaken, since they do not want to appear weaker than their competitors. However, weak banks are unlikely to try to repay if that would so further weaken them that they would soon require even larger government bailouts before long. Moreover, repayment by strong banks would be a good motivator if it gave weaker banks stronger incentive to get into a financial position whereby they too could repay without damaging their viability.
Another argument advanced against allowing any repayment at this time is that this would weaken the capital position of repaying banks (even those that claim to have enough capital to repay). Yet especially the stronger banks would not want to repay the Tarp loans if that means that before long they have to ask the government for additional loans. Goldman has raised an additional $5 billion in equity to help finance their repayment, and the company has reduced its assets to 14 times its capital compared to 26 times at the end of 2007. JPMorgan claims to be able to repay their loan without having to raise any more capital.
In any case, the Treasury is soon releasing results of the stress tests they have given to all major banks. We will then have better information to determine if the banks that want to repay now can comfortably pass these tests. I am confident that these banks will rank quite high, which would help explain why they are eager to repay.
If Goldman and JPMorgan were simply allowed to repay their TARP loans, they would still have the sizable benefits of the Temporary Lending Government authority (TLGP) that provides FDIC guarantees on bonds issued by covered banks. These guarantees stem from Goldman 's conversion into a bank holding company last fall-JPMorgan was already such a company. Goldman has borrowed about $28 billion under TLGP. This would be the right time to start reducing these guarantees for Goldman and JPMorgan as a condition for these banks being allowed to reduce government controls over their decisions.
Last fall the federal government lent hundreds of billions of dollars to major banks and other financial intermediaries pursuant to a program called the Troubled Asset Relief Program (TARP). Some of the recipients, notably Goldman Sachs and JPMorgan Chase, want to repay the money. Essentially that means buying back the preferred stock that the government received in exchange for the loans; they thus were loans without a maturity date.
I do not know whether, as a matter of law, the government's consent to repayment is required, although it would not be surprising if it were, since, as I said, the government received preferred stock for the loans rather than just a promise to repay. But maybe there's something in the loan contracts that entitles the banks to repay when they want to; I do not know, but I'll assume that the government's consent is required and consider whether that consent should be given.
The answer depends in part on an understanding of why the loans were made. Last September it appeared that most of the nation's major banks and related financial intermediaries were either insolvent or in danger of becoming so; TARP was designed to save them. Had the banks been allowed to go broke, the depression in which we now find ourselves would be even more severe than it is; think of the chaos that ensued when Lehman Brothers, one of the lesser financial intermediaries, was allowed to fail that month. No private investor was willing to step in and save the tottering banks, so the federal government stepped in instead.
TARP proved highly unpopular with Congress and the general public. The main reason was that the banks were seen to be "hoarding" the money they had received from the government, rather than lending it. TARP had been sold to a public suspicious of "Wall Street" (an echo of age-old hostility to finance as "sterile," rather than "productive" like making a physical product) in part as a way of stimulating economic activity by enabling banks to increase their loans. The idea was that the hundreds of billions of dollars fed the banks by the government would go out as loans to the bank's customers. And loans do stimulate economic activity. Many businesses rely on bank loans to bridge the gap between incurring costs of production or distribution and later receiving revenues from the sale of goods and services; and both businesses and consumers use borrowing to bring production and consumption, respectively, forward--borrowing to spend means consuming more today and less in the future (the eventual repayment of the loan will reduce the amount of money that the borrower has for spending on investment or consumption). A depression is a severe contraction of output, and borrowing is a way of increasing output by increasing the amount of money that people and firms have for immediate spending.
The hoped-for expansion of lending did not take place. Contrary to myth, at no point did banks cease to make loans, although they came close to doing so last September and October. But they did reduce their lending, both by raising interest rates and by increasing credit standards and, in some cases, by refusing to lend to other than their best, established customers. The money that the banks received from the government was mainly either hoarded quite literally, or used to buy bonds or other assets (including in some cases other banks). By literal hoarding I mean keeping the money received from the government in cash or a cash equivalent, such as a bank account in a federal reserve bank. Banks are required to keep a modest percentage of their demand deposits in cash; these are their "required reserves." Any excess cash they have is called "excess reserves," and since cash does not earn interest, banks usually try to minimize their excess reserves. In 2007 their excess reserves amounted to only about $2 billion; today, they are almost $800 billion. When banks are worried,"excess" reserves are not really excess.
Why did the bankers not lend the money they received from the government? There are five reasons: (1) because banks were undercapitalized, as a result of being overinvested in assets that had lost much of their value, such as mortgage loans and interests in mortgage-backed securities; (2) because they anticipated big losses from their outstanding credit card and commercial real estate loans, and perhaps from other loans as well (this is related to the next point); (3) because lending in a depression is highly risky--the default risk is high, and if the lender tries to compensate for the risk by charging a very interest rate this will increase the risk of default, because interest is a fixed cost of the borrower, that is, invariant to his revenues; (4) because as businesses reduced their output their need for borrowing fell and the risk of default (as I just mentioned) rose, making them reluctant to borrow; and (5) because consumer borrowing fell as a result of consumers' being overindebted as a consequence of the fall in house and stock values, the principal source of their savings. Of course failing businesses and unemployed or otherwise necessitous consumers might want desperately to borrow, risky as their borrowing would be. But they are unattractive customers for banks, especially when the banks, because they too are overindebted, are trying to reduce the riskiness of their loan portfolios.
These reasons for the banks' reluctance to use federal money to make loans are perfectly good reasons, and do not invalidate the TARP because without the additional capital that the program contributed the banks would have been even more chary about lending. But the reasons that despite TARP bank lending is continuing to decline were never adequately explained to the Congress or to the public, and as a result the failure of the banks to lend more was and is seen as sinister. And when it turned out that banks were continuing to pay high bonuses and other generous-seeming compensation to their employees, Congress and the public accused the banks of being a conduit between the federal taxpayer and the "stupid, greedy, reckless" bankers who had brought down the banking industry and, with it, the nonfinancial economy.
Again, no one explained that (1) bankers are smart, and the collapse of the industry last fall was due to a combination of dumb Federal Reserve interest-rate policy in the early 2000s and the excessive deregulation of financial intermediation, beginning in the 1970s; (2) bonuses are a more efficient form of compensation than salary, because they are more closely aligned with performance; and (3) the problem of overcompensation is a problem of senior management, because of its de facto control, in a large, publicly trade corporation, of the board of directors; most recipients of bonuses in financial intermediaries are not part of senior management. Somehow Congress and much of the public got into its head that the banks had hired dopes and deliberately overpaid them, which would make no sense from the standpoint of senior management.
The uproar over the banking industry has led to legal restrictions on compensation, proposals for other highly intrusive forms of regulation, even threats to "nationalize" major banks (that is, confiscate them), congressional witch hunts, interference with banks' use of private aircraft and with promotional activity at resorts, adverse publicity, and other inroads into the autonomy and efficiency of financial intermediation. So naturally the banks are scrambling to repay the TARP money as fast as they can, in the hope of getting the government, the public, the politicians, and the media out of their hair.
I can't see a good reason not to allow them to repay the loans. Repayment will go some distance toward reducing the astronomically mounting federal deficit and will allay, to some extent at any rate, the public and legislative hostility to banks and bankers. That hostility is counterproductive. By increasing the uncertainty of the banks' business environment, the attacks on the banks increase their incentive to hoard cash or to make safe investments rather than to make loans. (So who is being stupid and reckless?) There is I suppose a danger that some banks would repay prematurely, that is, before the risk of insolvency has been dispelled, but that is unlikely. As Becker points out, a bank would be reluctant to repay its government loans if it anticipated a significant probability of having to return soon to the government, hat in hand, for a further loan because it has gotten into more financial difficulties.
The Dow Jones Industrial Average peaked at 14,200 on October 9, 2007, fell to 9,600 on November 4, 2008 (election day), kept falling, to 6,400 on March 6, 2009, and since then has risen sharply, to 8,100. (I have rounded to the nearest hundred. I use movements in the DJIA rather than in the S&P 500 because the DJIA is composed of heavily traded stocks and thus gives a clearer view of market-price changes.) What explains these gyrations? The housing bubble had already burst when the market peaked. Yet stocks of financial firms heavily invested in housing were flying high, and have now lost much of their value.
The stock market was overpriced in October 2007, just as it had been at the peak of the dot-com bubble in the late 1990s, and on the eve the stock market crash of October 1929, and at other times as well. This raises the question whether and in what sense the stock market is an "efficient" market.
It was Mark Twain who first, more than a century ago, advised investors to put all their eggs in one basket and watch the basket. His advice was picked up by businessmen like Andrew Carnegie and Bernard Baruch and became conventional investment wisdom. Modern finance theory demolished that conventional wisdom by showing that it is virtually impossible, certainly for the vast majority of investors, including professionals such as mutual fund managers, Wall Street gurus, securities analysts, and finance professors, to beat the market, in the sense of consistently identifying overpriced stocks to sell and underpriced ones to buy. (For a valuable collection of articles on this theme, see www.cxoadvisory.com/blog/internal/blog-analysts-experts/.) Much more sensible is a strategy of buying and holding a diversified portfolio of stocks (and other securities as well), thus minimizing trading costs and other transaction costs, along with variance, which investors who are risk averse, as most investors are, do not like. Even if the expected value of a particular stock is equal to the expected value of a diversified portfolio, the risk of being wiped out is much less if one holds a diversified portfolio than if one owns a single stock.
Of course, some active traders (stock pickers or market timers) are lucky, just as some gamblers are, and earn supernormal returns from active trading. Others obtain supernormal returns in up markets by investing borrowed money (leverage)--and incur supernormal losses in down markets if they are investing with borrowed money, since the cost of that money is fixed, which is why investing with borrowed money yields supernormal returns if stock prices bought with the borrowed money are rising. More important, supernormal returns are possible for some investors as a matter of skill or sharp tactics when trading on private information is permitted (or done anyway), or when markets are illiquid or rigged, or when few analysts study the companies whose stock is traded.
The difficulty of beating the market other than by luck or leverage or the market deficiencies just mentioned, whether by active trading of particular stocks believed to be overpriced or underpriced by the market or by trying to time market turns, suggests that when investors trading on public information--information that, by definition of "public," is equally accessible to all of them--will obtain only a normal profit. That is one definition of an efficient market: a market in which competition is so effective that it squeezes out economic rents, which is to say returns in excess of costs.
There is good evidence that organized exchanges in mature economies are efficient in that sense, as most modern finance theorists believe. But how can their belief be squared with the frequency of investment bubbles? Investors in October 2007 may have had equal access to all available public information about banks and other firms, but they seem not to have drawn a correct inference from that information. Bubble behavior is exhibit number 1 to the claim by some behavioral economists that stock market investors often act irrationally. For example, buying in a rising market or selling in a falling one (both illustrating what is called "serial momentum" or "momentum trading") is said to illustrate "herding" behavior.
I do not agree. Nor do I think investors should be criticized for the behavior that has led to the stock market gyrations that I mentioned at the outset. What is missing in the behavioral analysis is the distinction first made by the University of Chicago economist Frank Knight, in the 1920s, between calculable risk, that is, a risk to which an objective probability can be attached, and uncertainty, which is a risk to which such a probability cannot be attached. Insurance is based on calculable risks; an objective, quantitative estimate of the risk of an accident or other insured event enables the fixing of an insurance premium, a price equal to (if one ignores administrative costs) the expected cost of the loss insured against. The estimates of probable loss used to calculate insurance premiums are based primarily on past experience (frequencies), and if the future differs unpredictably the insurance company may incur windfall gains or losses. So there is some Knightian uncertainty even in insurance markets, but it is generally much less than in the stock market.
A vast number of decisions that people make, including investors, are decisions under uncertainty in Knight's sense. When one has to choose between on the one hand marrying one's present girlfriend or boyfriend and on the other hand continuing to search for a "better" marriage partner, one cannot base the choice on a quantitative estimate of the probability that one choice will have better results than the other. A businessman who has to decide whether to invest in a project that will not yield revenues for several years is likewise making a decision under uncertainty because he cannot estimate the probabilities of many of the contingencies that, if they materialize, will make the project profitable or unprofitable. And an investor who decides to put more of his savings in the stock market, or shift some of his stock to an alternative investment, cannot estimate the probability that the price of the stock will rise or fall, and within what interval of time, and how far.
He knows, moreover, that what moves stock prices is not the best estimate of future corporate profits as such, but the behavior of the investing public, which is influenced by other things besides beliefs concerning the future course of such profits. For example, when stock prices begin to fall, the market value of savings invested in the market falls and this may make cautious investors move their money into safer forms of saving to make sure they have enough protection against a rainy day--a decision that has little or nothing to do with predicting future stock prices. This precautionary motive has almost certainly been a factor in the steep fall of stock prices in the current economic downturn. The personal savings rate had plummeted in the early 2000s, and the housing collapse depleted the savings of many people, especially those whose principal investment was their house, so that when stock prices fell many of these people reduced their spending and increased their precautionary savings. This pushed down economic output, increased the rate of unemployment, reduced corporate profits, and so caused the stock market to fall even farther. But the impetus for the market decline, in this analysis, was not a judgment about corporate profits but a desire for safer savings.
But what about stock market bubbles? The explanation may lie in the fact that under Knightian uncertainty, often the best, though not a good, predictor of the future is the immediate past. If there is no weather forecasting, probably the best guess as to tomorrow's weather is that it will be similar to today's. If stock prices are rising, this suggests that something is happening to make people think that corporate profits will be greater in the foreseeable future. One might counter by asking why, if investors are expecting stock prices to continue rising, prices don't immediately jump to their peak value. But there is some inertia in trading, and, more important, no one can know the market peak in advance; for if everyone knew that, no one would sell at the current price or buy at the peak price, and trading would come to a halt.
So suppose that in 2007 you had money to invest. You could buy a CD, a Treasury security, mutual-fund shares, etc. Why would you think that the fact that stock prices had been rising made them a poor investment, so that rather than buy stocks you should sell them short?
Yet I believe that the Federal Reserve should have lanced the housing bubble no later than 2006 by raising short-term interest rates (which would have pushed up long-term rates as well by increasing the borrowing costs of banks and other financial intermediaries and thus the rates they would have to charge for lending their borrowed capital), and if this did not burst the stock market bubble (the bubble that reached its maximum expansion in October 2007) to lance that bubble as well, by increasing margin requirements. But how can this suggestion be squared with my argument that buying stock (or, I would add, houses) in a bubble is rational behavior? The answer is that an individual investor in making an investment decision does not consider the effect of the decision on the economy as a whole; that is not his business, and anyway an individual investment decision is unlikely to have economy-wide effects. Protecting the economy is the business of government. Even if the Federal Reserve could not have spotted the housing or credit or stock market bubbles before they burst, it knew or should have known that these booms could be bubbles and that if so they would burst and when they burst they could bring down the economy. This made the expected cost of the booms high, even though that cost could not be quantified (another example of Knightian uncertainty)--high enough to justify intervention, or, at the very least, the formulation of contingency plans to deal with worst-case scenarios.
It is very difficult for either amateur investors or even professional money managers to do better picking their own stocks than the performance of the major stock indexes, such as the US Dow Jones Industrial Average (DJIA) or the Japanese Nikkei Index. In fact, most investors in active funds do worse than broad stock averages, after netting out what is paid to fund managers. Funds that do better than stock averages for several years are usually taking sizable risks that eventually catch up with them through sporadic sharp falls in the values of their portfolios. This happened to many exotic funds during the present financial crisis. This difficulty in "beating the market" is behind the development of index funds that simply hold a broad portfolio of stocks whose price movements mimic that of the overall indexes.
While the difficulty of beating market averages suggests that stock markets are reasonable efficient, conclusions about efficiency are far more complicated when the criterion is whether stock prices are determined by market fundamentals: present and future earnings, interest rates, and the degree of risk associated with earnings and interest rates. On the one hand, prices of individual stocks do very much depend on their present and expected future earnings, interest rates, and their systemic risks- the betas in finance theory.
On the other hand, prices of both individual stocks and of aggregate indexes often fluctuate in ways that deviate from the fundamentals. For example, during the Internet bubble, shares of many Internet companies sold for more than $50 or even $100 a share, even though these companies were not only losing money, but had no significant sales. These high prices were supported by radically wrong expectations about the future prospects of these companies. Many of these stocks became worthless, while most surviving Internet stocks lost almost all their prior market value. Even many non-internet stocks were excessively priced during the bubble years, as the stocks in major stock indexes were selling for a while at well over 20 times their earnings.
Stock markets are not performing efficiently when stock prices are either too high or too low relative to risk-adjusted discounted earnings. Sometimes, however, it is not easy to determine whether and how much prices deviate from fundamentals. For example, corporate profits were very high when the DJIA peaked in 2008 at 14,200, so that if these profits had continued, this price level did not imply excessive price-earnings ratios. The sharp fall of this index to its present value of about 8000 has been associated with a plummeting of actual and expected earnings, which led to a collapse in financial stocks and in prices of other stocks as well. Perhaps it should have been clear that profits in 2004-07 were too high to be sustainable, but it surely was not apparent to the vast majority of participants.
Can one say that individuals and funds are behaving irrationally if they are not shorting stocks, or are not mainly invested in bonds and other assets, when stock prices are much too high relative to fundamentals? Similarly, are investors rational when they are shorting stocks, or investing in other assets than stocks, when stocks are too low relative to fundamentals? The answers are not clear without further information since stocks may remain high (or low) relative to fundamentals for quite a while. Therefore, going long (or short) may also be profitable for a while.
To be sure, at some point the day of reckoning always comes when stock markets move much closer to fundamental levels. At that time, persons and funds lose a lot if they are long on stocks when they fall back sharply toward levels determined by fundamentals, or short on stocks when they rise sharply. However, predicting when the reckoning comes may be extremely difficult even for highly rational and far-sighted persons with extensive knowledge.
Interesting research years ago by Benoit Mandelbrot, that has been made more popular by Nassim Taleb's book The Black Swan, analyzes the incidence in stock markets (and elsewhere) of very small probability long tail events that give rise to large upward or downward movements in stock prices. By their very nature it is extremely difficult to forecast the timing of these low probability events. This is one reason why even most experts' forecasts of the large movements in stock prices are usually so bad. One can then hardly expect even reasonably rational stock market participants to be able to predict major turning points in stock prices.
A "rational" stock market bubble would be a situation where stock prices reflect present earnings and the expected future earnings of the large majority of market participants, and where future earnings are expected to rise over time. Then equilibrium stock prices would also rise over time. These earnings expectations eventually deviate far from the earnings that would be determined by sales, costs, and the like. In this scenario, more or less every participant is acting rationally relative to his expectations, yet the market is not behaving efficiently. Considerable frontier research in finance and macroeconomics is trying to determine whether much credence can be placed in the real world relevance of such rational price bubbles.
I reply to a comment on the following passage in my posting last week on housing: "The reallocation of income from consumption expenditures to very safe forms of savings reduces current consumption without increasing productive investment significantly, and so contributes to the depression." The commenter states: "surely much of the conservative savings are going into FDIC-backed bank accounts where each $100,000 backs over a million bucks of lending capability. So current consumption is reduced by one unit while lending in enhanced by 12 units?"
The error in the statement is the assumption that every dollar in an FDIC-insured bank account (or any other bank account, for that matter, according to the logic of the statement) is lent. Banks do not lend all their capital, especially in a depression. If a bank is undercapitalized, if it is worried that borrowers will default at an unpredictably higher rate (and that charging them a sky-high interest rate to compensate will increase the default rate), or if the demand for borrowing is down because many consumers and producers are overindebted and have to curtail their spending and avoid taking on more debt, then the bank will hoard most or even all of any cash it receives. Excess bank reserves, which are cash or equivalent (balances in the bank's account with a federal reserve bank), rose from $2 billion in August 2008 to $725 billion in March of this year. That is money the banks could lend (a bank is not permitted to lend its required reserves), but is not lending. This is rational hoarding, but it means that people who are depositing their money in bank accounts are not doing much if anything to increase lending and thereby stimulate economic activity.
The widespread and sharp rise in housing prices during the early part of this decade in the United States and many other countries is said to have contributed to the worldwide economic boom through wealth effects that induced greater consumption. Similarly, the still steeper fall in these prices during the past few years is supposed to have reduced world consumption and helped induce the sharp downturn in world economic activity. Yet even sharp rises and falls in housing prices are likely to produce only modest wealth effects on consumption to the extent that changes in interest rates are responsible for the housing price changes (I am indebted to Kevin M. Murphy for many discussions of the determinants of housing prices and their effects).
Both long term as well as short term interest rates have been low since most of the period after 2001 (whether due to a deliberate low interest rate policy of the Federal Reserve or large savings by China and other Asian countries is not crucial for my discussion). These low interest rates were an important, although not the only, force behind the boom in housing prices in the United States and many other countries-e.g., expectations about future housing prices were also important. The prices of durable assets like housing are negatively related to interest rates, as long as the service flows from the durables are unchanged. Families buy houses instead of renting space mainly because they believe that ownership is a better way to consume housing services than renting. Therefore, if housing services were unchanged, the flows of utilities to homeowners over time would also be unchanged.
The high and rising housing prices in United States are supposed to have produced a positive wealth effect to individuals who owned homes that increased their consumption and reduced the US savings rate. Similarly, the steep drop in housing prices since 2006 is often claimed to have induced a negative wealth effect that contributed to the drop in aggregate consumption and rise in the aggregate savings rate. This wealth "loss" comes to several trillion dollars. Although these effects seem obvious and important, a closer analysis raises serious questions about the magnitude of any wealth effect on consumption.
Consider a very simple lifecycle and bequest story to bring out the main points. Suppose there are two periods of adult life: young and old. All young individuals buy homes at a given price that is determined by the quality of the homes and interest rates. For simplicity, for the moment I assume only one type of house quality. Older adults live in their homes until they die, and they then bequeath these homes to their children. The children then live in their inherited houses until they die, and then bequeath them to their own children. In fact, houses are the main assets that most middle class US families bequeath to their children.
Now introduce an unexpected fall in interest rates that increases the price of houses. Everyone who owns a home gets a windfall increase in their wealth because their homes are now more valuable. However, if they still want to bequeath their homes to their children, their opportunities to consume would not become more favorable, as long as other opportunities are not affected by the fall in interest rates. Their children in turn inherit a more valuable asset, but that asset does not bring any more housing services than before the price increase. Hence, children's consumption would also be unaffected since they simply hold their houses until they bequeath them to their children in the succeeding generation.
This example with inheritance of homes brings out the essentials most clearly, but the basic analysis would be unchanged if young adults were unrelated to older ones, or if they received no bequests from their parents. While older adults would then get a windfall when interest rates go down, they still have no extra resources to increase their consumption of other goods, if they want to consume the same amount of housing services. The only elderly gaining from higher home prices are those who want to downside their living space. Younger adults find housing services more expensive, so if anything they are made worse off by the higher housing prices. Yet as with older adults, the apparent change in the position of the young is largely illusionary since their houses would also be worth more after they own them.
More complicated analyses might produce larger wealth effects of higher housing prices due to lower interest rates. For example, higher house prices may give owners the opportunity to take out larger mortgages that help them finance purchases of other durables, including education for children. At the same time, however, higher prices make it more difficult for young persons to afford housing. Recent media reports suggest that first time homebuyers are taking advantage of the fall in housing prices to buy foreclosed and other cheaper property. Higher house prices due to lower interest rates may induce some people to substitute toward larger homes, as happened during the housing boom, and toward reduced consumption of other goods. This is because higher prices induce additional construction of houses that lowers the cost of housing services. Yet even with a substitution toward larger homes, total consumption may not change, but only its composition between housing and other services.
Lower interest rates may have other effects on the tradeoff between present and future consumption that do not come from the housing market. These effects would closely depend on what caused interest rates to fall. To discuss these causes would take me far beyond an analysis of the wealth effects of changes in housing prices.
The message of my discussion is not that higher housing prices have no wealth effects, but rather that any such effects are likely in the aggregate to be much smaller than what is often claimed. Perhaps this explains why empirical estimates of the housing wealth effect often differ greatly. It also suggests that while the rapid declines of house prices during the past few years may have had large effects on apparent wealth, it probably was not much of a drag on aggregate consumption, nor much of a stimulus to the savings rate.
The Federal Reserve's unsound monetary policy in the early 2000s pushed down interest rates excessively, resulting in asset-price inflation, particularly in houses because they are bought primarily with debt. Eventually the bubble burst and house prices fell precipitately; they are still falling.
Becker's interesting post argues that the boom and bust in housing have not had as large an effect on consumption (and hence, this implies, on the nonfinancial economy) as the size of the price fluctuations might suggest. He illustrates with the example of a homeowner who has a bequest motive: if people intend to leave their house to their kids, changes in the value of the house will affect the size of the bequest rather than current spending by the owner-parent. More generally, an increase in home values increases the cost of housing by the same amount. If all house prices double (and assume no other prices change), but the owner is not intending to downsize, he cannot "spend" the increased value of the house.
However, although increased home values are unlikely to be translated into equal increases in consumption spending, those increased values are likely to have a strongly positive effect on consumption. To begin with, a significant amount of borrowing during the bubble involved the refinancing of existing mortgages rather than the financing of home purchases, and often the incentive for the refinancing was to obtain cash for consumption. Furthermore, some people may downsize, or even become renters, because they want to increase their consumption expenditures, as they can do if they cash out some of the increased market value of their house. And if people feel wealthier because the market value of their savings (which includes the value of a house) is rising, they may reallocate more of their income to consumption, which they can do without impairing the expected value of their savings if their houses are worth more. In other words, a house is a "store of value" (as economists say) rather than just a home, and even if one has no intention of downsizing, the fact that one has a valuable house that could be sold if one needed cash provides a store of value that may persuade you that you can afford to consume more. As a form of savings, a house is illiquid and risky relative to cash, but it is still savings, in the sense of an asset that one could turn into cash if necessary, to increase consumption in the future. And if one's savings shoot up because of an increase in the price of one of one's assets, one may decide to allocate a portion of the increased savings to current consumption.
These considerations persuade me that the run-up in housing prices probably did increase consumption significantly. More important, the collapse of those prices, together with the fall in the stock market, has almost certainly had a significant negative impact on current consumption expenditures. Because of rising house and stock prices, the market value of people's savings rose during the housing and stock bubbles and as a result people reduced their savings rate, to the point where it actually was negative for a period during the early 2000s and was no higher than about 1 percent before the crash last September. (This is related to the "store of value" point.) The personal savings rate has since risen to more than 4 percent. The fall in house and stock prices, combined with increased unemployment and fear of unemployment, convinced many people that they didn't have enough precautionary (safe) savings, and so their current savings are heavily weighted toward cash and other riskless, or very low-risk, forms of savings. The reallocation of income from consumption expenditures to very safe forms of savings reduces current consumption without increasing productive investment significantly, and so contributes to the depression.