Unrealised losses, high interest rates, and financial market distress

Cross-posted from substack.

I’ve been seeing a lot of the following around the place:

Looks pretty scary right – red columns go lower than during the Global Financial Crisis :O

However, these big red columns are a bit misleading. The data is true – financial institutions holding government bonds have made large unrealised losses on government bonds due to the surge in interest rates. But there is a reason that financial regulations don’t make banks recognise these losses.

Read more

Liquidity crises, wealth, and the government balance sheet

The events of the last two months have brought financial liquidity issues into sharp focus. As firms shut down for an indefinite period in response to the Coronavirus, the question on many people lips is “will this firm be able to survive without cash income?”

If they have large amount of cash in the bank, the answer is likely to be yes. Yet most firms don’t have a large amount of cash in the bank. Rather, they have large amounts of productive assets – sometimes physical assets like machinery and equipment, and sometimes intangible assets like good business routines, long standing customers, or patented technologies. These assets will produce them with cash incomes in the future – but only if they can survive until then. 

So how can we think about this issue?

Read more

The housing bubble: Why implicit insurance may well be the real driver of Piketty’s concerns

Alex Tabarrok at Marginal Revolution points out that, without the run up in house prices, we do not get Piketty’s trend of rising capital to output ratios in the data.  This is very true, and was one of the key reasons why I wasn’t convinced that Piketty’s explanation of his data was the best available.

Now Piketty expressly discusses capital gains in his book – and he points out that he does not view the current increase in the value of capital as a bubble, instead it is the value of capital returning to its “real” level.  In that way, he views the idea of saying that we have a bubble as both wrong and beside the point.

Say that we accept the implied assumption he works with – that there isn’t (and hasn’t been) a bubble in housing markets.  Given this, it is important at this point to consider the narrative he has for history.  He discusses a period (pre-WWI) where governments offered a high risk free rate of return, where wealth was (in some ways) heavily insured by government, and where (as a result) the value of capital was high and the private risk premium was low [best example of this was his discussion of the UK, where government debt offered a high risk free yield for those who could invest in it].  WWI and WWII – with the combination of war and the change in government policies (towards appropriation and direct regulation) changed this – the private risk premium was now a lot higher, and the value of capital dropped as a result.  Government protection and regulation is BUILT INTO the price of an asset!

In Piketty’s data we are looking at a situation where government policies have changed, and as a result so has the inherent private risk premium associated with assets, pushing up the price of assets.  This description suggests that, if there is a failure, it is due to an “implicit subsidy” by governments to capital owners – it is in essence the same policy failure that those in financial/macroeconomics have been discussing for years now (a quick look on the blog for recent posts gives these 1,2,3,4 – more importantly don’t forget this and suggestions by Cochrane to make the financial system run free and remove this implicit subsidy).

If this is the real cause of the changing capital to output ratios, then it suggests economists have already been investigating the key cause – and that there is no natural tendency for capitalism to head this way.  Even if we don’t deal with the inherent injustice, capital/output ratios shouldn’t intensify.  And furthermore, this would suggest that there is no need for a capital tax to deal with the perceived injustice – instead we just need to remove an implicit subsidy, and it make investigation into financial regulation even higher on the research agenda!

This is an incredibly important issue to investigate with respect to Piketty’s central thesis – his data set is incredible, but there is a lot of work to be done teasing out what it actually means, let alone defining what correct policy is.  Even while I was reading this book, I could not get this alternative hypothesis out of my head – and Tabarrok’s post has just increased my belief that this alternative hypothesis is the correct one.

Nobel 2013: Fama, Shiller, and Hansen

Yah, Nobel prize.  All guys that deserved it … I just wouldn’t have expected them to get it together.  To be honest, the reasoning makes sense though – they have all added significantly to the empirical analysis of asset prices, albeit in quite different ways 🙂

Still, don’t read me.  Read Cochrane (here, here, herehere, here).  And Marginal Revolution (here, here, here, here, here, here).

Also I enjoyed this.  And this post on why the Chicago school gets so many Nobel laureates is a good counter-measure to all the arbitrary bile that can be thrown around on the interwebs 🙂 .  I also enjoyed this post from Noah Smith.

I have a bias towards Shiller in all of this because of my interests.  He is a big proponent of trying to view economic phenomenon through a lens of history dependence (with the regulatory difficulties that entails) and has talked about how exciting neuroeconomics is – completely agree.  However, this has nothing to do with empirical finance in of itself, as this is not my field.  While I think some of the stuff is pretty cool (and remember really like GMM a few years back) I have nothing to say.  Hence why you should be going back and clicking those links to Cochrane and Marginal Revolution 😉

RBNZ misstep on macroprudential policy

I was hesitant to write this post, until I realised I was writing it on a personal blog that only a few lovely people read and no-one will be too concerned with what I say 🙂 .  Then I decided I may as well discuss how I actually feel about the speech from the RBNZ yesterday (where we discussed the summary here).

Not so long ago I wanted to note how to think about the causes of why we may move towards LVRs (maximum loan-to-value ratios on mortgage lending) in New Zealand.  I noted the following in terms of some quotes they had made:

Either these quotes miscommunicate the justification the Bank is using for such policies, I have completely misinterpreted the quotes, or they communicate it perfectly and I fundamentally disagree with the association they are using.

It is now clear that the RBNZ’s communication is crystal clear, and I fundamentally disagree with an element of their justification for LVRs.

Read more

LVRs are coming!

The RBNZ has now officially announced maximum loan-to-value ratios (LVRs) for the public in a speech here.

They noted that the run up in house prices has increased the probability of a sharp decline in house prices – an event that may in turn lead to instability in the New Zealand financial system.  Their thinking is:

“The LVR restrictions are designed to help slow the rate of housing-related credit growth and house price inflation, thereby reducing the risk of a substantial downward correction in house prices that would damage the financial sector and the broader economy.”

In this way it is pre-emptive – current credit growth is moderate, but they want to ensure they don’t lose control of credit growth in a way that makes the entire financial system (which is implicitly insured by government) fragile.

The Bank makes a specific point of saying that the concern is around mortgage borrowing, and a run up in house price expectations associated with already realised increases in house prices, that they are targeting with macro-prudential policy – as unlike an increase in the OCR which is targeted at broad demand, it is a specific lift in demand for housing that is driving current house price appreciation.  It is not that NZ households have become more willing to spend per se – the concern is that NZ households, and the banks willingness to lend to households, is focused excessively on housing assets.

I will admit that I am not completely sold on the argument they have put forward for LVRs, and I’m perplexed at why they are communicating it by discussing house prices (thereby mixing it with issues of affordability for the public) rather than simply stating that they are of the view that banks are taking on too much risk in terms of mortgage assets at present.

But they have clearly laid out their argument, and they have made sure that they communicate it rather than just doing it.  And this is great – I am alway impressed by how transparent our central bank is!  I think that this helps them when it comes to introducing specific, one-off, policies such as the current LVR limts.