Federal debt and 1 percent wealth

"For every buyer there must be a seller, and for every lender a borrower. One man's expenditure is another's receipt. My debts are your assets, my deficits your surplus ... In the United States today one budget which is usually left holding a deficit is that of the federal government. When no one else borrows the surpluses of the thrifty, the Treasury ends up doing so."

In 1963 James Tobin wrote "Deficit, Deficit, Who's Got the Deficit?" for The New Republic.
The original article is hard to find but a nice summary is here. I was made aware of the article by a Sidney Winter Twitter post.

Atif Mian, Ludwig Straub, and Amir Sufi's more recent "The Saving Glut of the Rich and the Rise in Household Debt" (MSS, 2020)* can be partly seen as an exposition and update of Tobin's point that "Of course, many private households have financial deficits. They pay out more than their incomes for food, clothing, cars, appliances, houses, taxes, etc. They draw on savings accounts, redeem savings bonds, sell securities, mortgage houses, or incur installment debt. but deficit households are far outweighed by surplus households." MSS conclude that the saving glut of the rich has been "linked to the substantial dissaving and large accumulation of debt by the non-rich" and has also "been financing government deficits to a greater degree."

I was curious about the link between the increases in the wealth of the top 1% and the federal debt. As expected they're correlated. In the chart below,  the wealth of the top 1% of the wealth distribution is on the left hand side, federal debt is rhs.

*MSS measure the contribution to aggregate savings from different parts of the income distribution. They use Piketty et al.'s "Distributional National Accounts" (2018), and they test their results using income shares from the Congressional Budget Office and wealth shares from the Federal Reserve's DFA, which show assets by wealth percentile group.

Can I buy that house?

A favorite summer pastime is walking around Philadelphia just admiring cool houses (with a mask of course). Over 200 properties in and around Center City are listed at over $1 million, as shown in the Zillow map below. It led me to wonder (a) where is all this money coming from and (b) how affordable are homes for people (on average). A couple charts in response to (b), in which I aim to provide a sense of the scale of housing wealth and the mortgage market, are also below.

Chart 1 shows the value of owner-occupied real estate (housing wealth) and mortgages outstanding, each divided by disposable personal income. At the end of 2019 these amounts were roughly $29 billion, $11 billion, and $16.5 billion. Value of mortgages outstanding / DPI of 65% is significantly below the pre-financial crisis peak of 100%. We'd need about 1.8 years of disposable income, which includes all sources of income such as wages, investments, transfer payments, employer contributions to pension funds (not sure why that's included in disposable income), less taxes, to buy all the houses.

Chart 2 shows housing wealth divided by disposable personal income and by wage and salary income. It also charts wages and salaries as a proportion of DPI, which have decreased from over 70 percent in the 1960s to 56 percent today-- related to the labor share of output graphs which Robert Reich and others have shown. [In the data the decrease is driven by faster increases in transfer receipts and investment income]. Americans would need to work for over three years (without spending money on anything else), to earn the wages to buy all the houses.

Note: personal income data from BEA release Table 2.6: https://fred.stlouisfed.org/release/tables?rid=54&eid=155443. Housing and mortgage value data from Federal Reserve's Z.1 Financial Accounts.

Money market funds: $5 trillion

In March and April, over $1 trillion flowed into government MMFs, reflecting companies' and investors' shift into cash as worries about coronavirus mounted.

According to the Investment Company Institute, as of May 20, $3.9 trillion is in government MMFs (1.2 in Treasury & Repo, 2.7 in Treasury & Agency), $742 billion in prime MMFs, and $135 billion in tax-exempt (municipal) MMFs.

Chart based on ICI data (Note that OFR's numbers are slightly higher, for a total of over $5 trillion. Not sure what accounts for the discrepancy, but OFR shows retail funds which at least accounts for a good deal of the difference in size of prime funds):

Sources:
FSOC's Office of Financial Research: https://www.financialresearch.gov/money-market-funds/us-mmfs-investments-by-fund-category/
ICI: https://ici.org/research/stats/mmf
Crane Data: https://cranedata.com/ (top 10 money fund managers as of April 30: Fidelity $959 bn, JPMorgan $480 bn, Vanguard $473 bn, BlackRock $447 bn, Federated $396 bn, Goldman Sachs $383 bn, Morgan Stanley $227 bn, Schwab $210 bn, Dreyfus $210 bn, Wells Fargo $187 bn)
EPFR: https://www.epfrglobal.com/

Note- the shift from prime funds to government funds in 2016 is due to the SEC's MMF reforms mentioned in yesterday's post.

Federal Home Loan Banks (from FOMC minutes)

The minutes of the April 28-29 Federal Open Market Committee and Board of Governors conference call were released yesterday.

They're valuable for information/confirmation about how the Board views the financial and economic situation. A lot of the discussion focused on the uncertainty caused by coronavirus. One thing that stuck out to me was Lorie Logan mentioning that the Federal Home Loan Banks are "the dominant lenders in the federal funds market." So much ignorance. Here's what I learned today on (1) What are the FHLBs? (2) Why are they the dominant lender in the fed funds market? and (3) Does it matter?

A good source is a three-part series written by Stefan Gissler and Borgan Narajabad at the Fed. Links here: Part 1, Part 2, Part 3.

Also, good graphics and sources here https://www.clarusft.com/usd-fed-funds-and-the-fhlbs/.

What are the FHLBs?

The Federal Home Loan Bank system is a network of banks that provide liquidity to financial institutions to support community development and housing finance. According to the FHLBs' Office of Finance 2019 Annual Report, "The Federal Home Loan Banks (FHLBanks) are government-sponsored enterprises (GSEs), federally-chartered but privately capitalized and independently managed ... The FHLBanks serve the public by providing a readily available, competitively-priced source of funds to FHLBank members through advances. These funds may be used for residential mortgages, community investments, and other services for housing and community development. In addition, the FHLBanks may provide members and housing associates with a means of enhancing liquidity by purchasing home mortgage loans through mortgage programs developed for their members."

By the end of 2019, FHLBs had assets of $1.1 trillion, of which $642 billion was advances. They're pretty highly levered, with 5% equity. FHLBs are regulated by the Federal Housing Finance Agency (FHFA), created by the Housing and Economic Recovery Act of 2008, signed by President Bush.

Why are FHLBs the dominant lenders in the fed funds market?

Explained by Gissler and Narajabad in Part 3:

"Finally, the FHLBs currently play a crucial role in the federal funds market, which represents a key source of liquidity for eligible depository institutions. FHLBs maintain a stable share of their portfolios in federal funds, mainly as their contingent liquidity buffer. As a result, their presence in the federal funds market has been stable. But the decline of the overall size of the federal funds market has increased the relative importance of the FHLBs in this market. On some days, FHLBs account for almost the entire supply of federal funds."

Does it matter?

Two answers here. One, yes I guess. To continue quoting from Gissler and Narajabad:

"Should an FHLB experience difficulty in rolling over its short-term debt, the FHLB would likely withdraw from the federal funds market, which has the potential to disrupt trading activity. Assuming most FHLBs would withdraw, the Federal Reserve Bank of New York might need to rely on contingency options for the publication of the fed funds effective rate. Such contingencies could be necessary given that the federal funds rate is used as the benchmark rate for a very large volume of financial products."

Contingency options are public -- for example, the Fed could just use a prior day's rate. But things could be messy.

Two -- Regardless of whether the FHLBs' dominance of the fed funds market matters, a broader question regards the FHLBs more generally. Here, the question is "do FHLBs matter to financial stability" and the answer is probably yes.

As G&N point out in Part 1,

"FHLBs have grown significantly over the past few years, and their total assets have surpassed pre-crisis levels. More recently, this growth coincided with two changes in government policies: The imposition of the Liquidity Coverage Ratio (LCR) in January 2015 for the largest U.S. banking organizations and the reform of U.S. money market funds in 2016."

The LCR stipulates that banks must hold enough high-quality liquid assets to cover cash outflows for 30 days: it provides preferential treatment for banks' medium-term borrowing from FHLBs. The money market fund reform requires prime money funds to implement a floating NAV and permits them to impose a fee on redemptions if assets that can be liquidated within a week fall below 30% of the fund. This caused $1.2 trillion to shift from prime money funds -- which fund the banks -- to government MMFs, which fund the FHLBs. Significant for a $2.7 trillion market as of 2016. $4.79 trillion $4.79 trillion as of May 20, 2020.

Essentially, the FHLB's implicit government guarantee as a GSE and institutional structure enables it to help banks get around certain regulations.

Here's the script:
Regulators, to banks: Be careful about your funding, make it a little less short term for lower risk of a bank run.
Banks: OK, we'll take medium funding. Where will we get it?
FHLBs: Here. And for maximum maturity transformation profit we'll take short-term funding.

So we're kind of back to where we started.

Additional questions and two charts

How does this interact (maybe not at all) with the volatility in the repo market in 2019?

FHLBs' assets and liabilities from the Annual Report:

Chart of the day: Net foreign buying of long-term US securities, and 10-year Treasury rates

Idea to look at foreign selling of US Treasuries from Brad Setser- https://twitter.com/Brad_Setser/status/1262402854666612737.

March 2020 saw $300 billion net sales of US Treasury bonds and notes by foreign investors (heavily from emerging market central banks, as Setser points out). The selling was all in Treasuries, not agency securities or corporate bonds.

The point with adding the 10-year Treasury note interest rate series (on right axis) is to show that despite this unprecedented level of selling, Fed purchases more than made up for it to push interest rates down.

There might be other factors, such as an increase in pension funds' bond holdings, but I think the fact that the New York Fed's Trading Desk was purchasing more than $75 billion of Treasury securities per day in late March explains the movement.

Note

• Left axis in billions of dollars.
• Historical data from the Treasury International Capital System (TIC) https://www.treasury.gov/resource-center/data-chart-center/tic/Pages/ticsec.aspx. Country-level breakdown of recent months https://ticdata.treasury.gov/Publish/snetus.txt.
• 10-year Treasury rate data from FRED (adjusted to monthly frequency).

Minsky on Uncertainty

In Stabilizing an Unstable Economy Hyman Minsky presents his financial instability hypothesis, which is that the nature of a capitalist system creates instability. Essentially, periods of sustained growth and tranquility (to use Joan Robinson's term) lead to the emergence of increasingly fragile and unstable financial / liability structures. When times are good, you want to invest for large expected future profits, accepting more and more debt to maximize success.

Since money is created through the process of borrowing and lending, this process has big effects on the economy. When perceived profit opportunities abound, entrepreneurs and bankers accept more and more debt financing as underwriting standards get lax, new forms of money are formed with financial innovations ... you've got high capital gains, more investment, more profit, things keep chugging along faster and faster ... phew! If it sounds too good to be true, it usually is. Through an investment boom the economy expands beyond its tranquil full-employment state, leading to accelerating inflation, financial and monetary crises, and debt deflations. This is all very reminiscent of Ray Dalio's summary of the economic machine.

Here I quote Minsky's summary on uncertainty, in the context of our world in which the decision to invest depends on investment supply (labor costs and short-term interest rates), investment demand (the price of capital assets), and the structure and conditions of internal (retained earnings) and external financing (bond or equity issues). Ultimately, the investment decision depends on the performance of the economy while the investment is "gestating".

"Thus, there is an element of uncertainty in the decision to invest that has nothing to do with whether the investment will perform as the technologists indicated and whether the market for the product of the investment will be strong. This element of uncertainty centers on the mix of internal and external financing that will be needed; and this mix depends upon the extent to which finance for the investment goods will be forthcoming from profit flows. 

"Since investment deals preeminently with decisions that involve time, in order to explain investment it is necessary to come to grips with the meaning and significance of uncertainty in economics. Uncertainty deals with that class of events for which the outcome of actions cannot be known with the same precision as the average outcome at a roulette table, or even of a mortality table, is known. In a word, uncertainty in economics does not deal with risks that are insurable or analogous to gambling risks. For example, the appropriate liability structure for holding any type of capital asset cannot be known in the same sense as the appropriate technology for manufacturing. Today's appropriate liability structure for holding any capital asset can be determined only on the basis of history and conventions. In the course of history there have been significant swings in the mix of internal and external financing of investment and much innovation in liability structures. Liability structures (and asset holdings by intermediaries) that were deemed safe when entered upon may turn out to be highly risky as history unfolds. 

"Uncertainty is largely a matter of dealing today with a future that by its very nature is highly conjectural."

Financial Times Debt Week

Like Shark Week, but without guaranteed liquidity.

FT writers published several articles about debt over the past few days. Not surprising for a week in which the Treasury announced "plans to boost U.S. borrowing from April through June by an unprecedented $3 trillion".

Articles include

• Monday: Robin Wigglesworth's A solution to the looming debt crisis in emerging markets
• Tuesday: Martin Wolf's How to escape the trap of excessive debt
• Wednesday: Robert Armstrong's Companies are dangerously drunk on debt
• Thursday: Martin Sandbu's Rebuilding better after Covid-19, part 2
• Friday: Robert Armstrong's Debt relief for US consumers leaves investors flying blind

^ The list is not exhaustive. I summarize Wolf's article below, with a couple notes on the other articles at the end. I should also note at the outset- Wolf writes so well that I struggle to summarize without just quoting the whole article.

How to escape the trap of excessive debt

"Debt creates fragility. The question is how to escape from the trap. To answer it, we need to analyse why today's global economy has become so debt-dependent. That did not happen because of the idle whims of central bankers, as many suppose. It happened because of an excessive desire to save relative to investment opportunities. This has suppressed real interest rates and made demand far too reliant on debt."

Princeton's Atif Mian, Chicago's Amir Sufi, and Harvard's Ludwig Straub (MSS) have two recent papers on this topic: The Saving Glut of the Rich and the Rise in Household Debt, which shows that the saving glut of the rich has been financing government deficits and the household debt of the non-rich, and Indebted Demand, which uses a two-agent OLG model to explain how debt overhangs weaken demand and lower interest rates in a feedback loop.

The rich save, the less rich dis-save

"Beyond a point, inequality weakens an economy by driving policymakers into a ruinous choice between high unemployment or ever-rising debt. Rising inequality in the US has resulted in a large increase in the savings of the top 1 percent of the income distribution, not matched by a rise in investment. The investment rate has been falling despite declining real interest rates. The savings surplus of the rich has been matched by consumption above income ("dissaving") of the bottom 90 percent.

"The savings of the rich might have led to a current account surplus, as in late 19th century UK [where net foreign assets reached 191 percent of national income in 1914 -- Piketty C&I p. 278]. But the rich of the rest of the world have sought to accumulate US assets [since the wealthy "cannot bank their money in the retail banking system", as Feygin and Leusder explain] , and so generated a persistent US current account deficit. Except when the pre-financial crisis housing bubble drove up private investment, this has also remained too weak. The chief users of excess foreign and domestic savings have been less well-off households and the government."

"There is a clear link between the saving of the rich and dissaving of the less rich, and the accumulation of credit and debt." The rich hold claims on the less rich not only via bank deposits but also through equity holdings in businesses that hold such claims. "This phenomenon of rising household debt and rising inequality is not unique to the US."

Why does the rising debt matter?

Wolf proposes three explanations for why the rising debt matters. First, David Levy argues that as borrowers become more overburdened, the economy becomes increasingly driven by finance and fragile. Second, MSS introduce the idea of "indebted demand": large household and government debt burdens lower aggregate demand and thus natural rates because borrowers and savers differ in their marginal propensities to save out of permanent income [a theory developed by Milton Friedman]. "When demand is sufficiently indebted, the economy gets stuck in a debt-driven liquidity trap, or debt trap." Third (similar to indebted demand) is Richard Koo's balance sheet recessions in which a debt-financed bubble bursts, and businesses and households realize that the value of assets they bought with borrowed funds have collapsed, while their liabilities are still on the books, so they have no choice but to pay down debt as quickly as possible. While this is the right thing for an individuals to do, we fall into a fallacy of composition [because if one person is saving or paying down debt, someone else must be borrowing and and spending the same amount for the economy to move forward].

Ultimately, "As debt soars, people are ever more unwilling to borrow still larger amounts. So interest rates have to fall, to balance supply with demand and avoid a deep slump." This is one mechanism driving what Lawrence Summers [borrowing from Alvin Hansen] has called"secular stagnation".

Wolf mentions that "We must focus on the US first, because that is where global demand and supply tend to balance." But he notes that rising inequality and savings are evident elsewhere such as China, which used to export excess savings to the US but now absorbs it in domestic investment, and Germany, which has driven its eurozone (and other) trading partners into rising debt.

How do we escape from the debt trap?

There are some short-term solutions: (1) diminish the incentive to finance businesses with debt rather than equity by eliminating the tax preference of debt, (2) shift from debt to equity financing of housing (suggested by Mian and Sufi), and (3) replace government lending to companies with equity purchases.

"Yet none of this would fix the ongoing dependence of macroeconomic stability on ever more debt. There are two apparent solutions." First, government can keep on borrowing, but this is likely to eventually be problematic. Alternatively, "shift the distribution of income, in order to create more sustainable demand and so stronger investment, without soaring household debt."

In the last paragraph Wolf quotes Marriner Eccles' 1933 Congressional testimony in making the case for reduced inequality: "It is for the interests of the well to do ... that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit."

Notes from other articles

Wigglesworth on emerging markets

For emerging markets facing a looming debt crisis, there's a proposal that the World Bank set up a "central credit facility", which would be topped up with money from the World Bank or IMF, who would then lend the money and debt payments directly "back to the countries at concessional rates." There are indications that the World Bank and IMF might be open to these types of solutions -- IMF managing director Kristalina Georgieva said the fund "may need to venture even further outside our comfort zone."

Armstrong on corporate debt

US non-financial corporate debt was $10 trillion at the start of the crisis -- a record high at 47% of GDP. Since debt is cheap and tax deductible, using more boosts earnings. The government is helping, with the Fed announcing purchases of $750 billion in corporate debt and $600 billion in lending to midsized companies through its Main Street Lending Program. Moral hazard is obvious [especially considering Ruchir Sharma's estimate that 16% of companies are "zombies"]. You can't contain corporate debt by regulating banks because then that risk-taking shifts to the shadow banking sector -- more promising to end the tax deductibility of interest.

Solving these problems won't be easy:

"The main reason debt is cheap is not central bank policy but low growth. As the world ages and productivity slows, there are more savings and less demand for investment. Savers can charge less for lending their money."

Sandbu on rebuilding

Sandbu summarizes Wolf's concern about inequality driving debt resulting secular stagnation -- perenially inadequate demand resulting in weak growth. But he points out that the causal relationship also runs from debt to inequality.  "The rapid liberalisation of finance from the 1980s was a significant cause of credit and debt growth, which in turn fuelled both asset price inflation and a greater need for people to indebt themselves to own a house. Much of the increase in inequality came from higher rental or capital incomes. Increased financial intermediation also led gross debt to increase more than sectoral net indebtedness."

He also points out that because of falling interest rates, debt burdens (service costs as a ratio to disposable income) are at their lowest level since 1980, although that doesn't take away from the point that large debt balances create fragility, since "a smaller proportionate change in economic prospects suffices to cause cascading insolvencies, with all their legal and economic repercussions" such as a debt deflation, a debt overhang, and lower mobility of workers and capital.

Chart: Level of consumer credit and mortgage debt, and debt service payments
https://fred.stlouisfed.org/graph/?g=qUuX

Sandbu suggests making financing (including the financing governments are now directing at companies) more equity-like due to the problems inherent to debt financing:

"That is the great paradox of debt finance: individuals choose it for its predictability, but collectively it makes for greater instability."

Armstrong on consumer debt

"Forbearance and federal support programmes disguise how badly Americans have been hit."

There was $14.3 trillion consumer debt on the eve of this crisis, according to the NY Fed's quarterly Household Debt and Credit Report. As Sandbu pointed out as well, the debt burden (~10 percent of disposable income) was historically low at the start of the crisis, but auto loan and credit card delinquencies had been ticking steadily up for a couple of years.

Visa reported credit card spending down 30 percent in April. Unsecured consumer loans 8 percent lower than six weeks ago, erasing two years of growth. 6% of mortgages held at banks are in forbearance (source: Autonomous Research) [but I think 70% of mortgages are backed by GSEs and maybe not covered by this stat? GSE's are slightly higher, Ginnie Mae, the highest, is already over 10%]

Final notes

Nice summary of economic, Fed, and Treasury calendars at the bottom of this article:
https://www.bloomberg.com/news/articles/2020-05-03/treasury-s-4-trillion-funding-task-signals-record-auction-slate?sref=FayydLbB.

Merryn Somerset Webb's article from last week on converting government loans to equity, and the Reconstruction Finance Corporation, deserves its own post: https://www.ft.com/content/1eaec3b2-8b90-11ea-a01c-a28a3e3fbd33.

As companies try to shore up balance sheets, Carnival and Southwest made April the highest month of convertible bond issuance ($13 billion) in a dozen years https://www.ft.com/content/15dc5dcd-89a4-4047-9a56-24b808e2dcf5.

Federal Reserve balance sheet: Two charts

Today's H.4.1. data release Factors Affecting Reserve Balances  shows that the Federal Reserve's balance sheet has grown to nearly $6.7 trillion as of May 6, 2020.

Of course this does not come as a surprise.. it was $6.6 trillion a week before, and the Fed has recently implemented facilities for markets including primary dealer credit, money market mutual fund liquidity, paycheck protection program liquidity, and commercial paper funding. But the main driver of the balance sheet increase is Treasury securities, which have increased to $4 trillion [first chart below]. On March 23 the Fed announced that it was directing its Open Market Trading Desk to increase the System Open Market Account holdings of Treasury and agency mortgage-backed securities by "amounts needed to support the smooth functioning of markets" for these securities. The Operational Details page is a good reminder of how big these operations are. For example, in late March (3/19-4/1) the Fed was purchasing nearly $75 billion of Treasury securities every day. This week (5/4-5/8) the Fed plans to purchase $8 billion per day.

To compare to recent deficit projections... If we multiply $75 billion of daily Treasury purchases by the 252 working days in 2020, the Fed was purchasing securities at a rate of $18.9 trillion -- five times higher than the CBO's latest estimate of a $3.7 trillion federal budget deficit for FY2020. I'm not saying $3.7 trillion isn't a big deficit.. but we've shifted to MMT-like financing of the economy very quickly. As Peter Bofinger wrote "now is the hour of Modern Monetary Theory." This pandemic is a huge challenge for our societies and economies. To say nothing of the problems existing before the virus, we now face a massive health threat, potential runaway inflation (for example if we have a resurgence of demand and broken supply chains), and a potential breakdown in social stability if things worsen. But we don't face financial restrictions (This other article of his is helpful too https://www.socialeurope.eu/modern-monetary-theory).

Last note- despite the rapid increase in the Fed's balance sheet, it's probably best to not stress and remember Japan [second chart below]. The Bank of Japan owns 43% of outstanding Japanese government bonds [I think it's closer to 50% now] -- equivalent to the Fed owning ~$9 trillion in Treasury securities. And total assets on the BOJ's balance sheet are greater than Japan's level of GDP.

Chart 1: Federal Reserve assets: US Treasury securities
https://fred.stlouisfed.org/graph/?g=qVbV

Chart 2: Fed total assets / US GDP vs. BoJ total assets / Japan GDP
https://fred.stlouisfed.org/graph/?g=qVbY

Note- these charts go to the last date available. This post was written on May 7, 2020.

Collateral in a market-based credit system

In 2012 Cardiff Garcia wrote a nice summary of a Credit Suisse research note. The research note is a good explanation of the market-based credit system and implications for policy. Here I make some notes for myself, summarizing the article, part of an eventual post(?) about money creation and the efficiency of private money allocation vs. the resilience (stability?) of public money creation.

Main points

Liquid collateral is the lifeblood of the modern economy -- the main form of money for large firms, asset managers, and financial institutions. The collateral-based financial system reduces the need for the bank deposit system. As with any credit system, the velocity of money & collateral and the cost and availability of credit tends to be pro-cyclical.

Higher levels of economic activity make all forms of collateral more liquid, fostering optimistic expectations about future returns, leading to asset price bubbles [Minsky-esque]. And vice versa -- when a credit bubble busts, collateral shrinks, haircuts rise, LTV ratios fall. After major shocks the velocity of money and collateral falls steeply.

In response to these shocks, central banks must provide liquidity and/or the government must sell money-like collateral on a vast scale to preempt and prevent deflation. The fragility of the financial system as it de-levers leaves a deflationary undertow that can flare up quickly in response to new shocks [we saw this in the repo market as the Fed started decreasing the size of its balance sheet in 2019].

Collateral as lifeblood

Central banks have been undertaking credit and maturity transformation on a large scale (as well as their traditional role of assuring funding liquidity) to prevent a deleveraging of the financial system that would lead to a deflationary cascade of shrinking money, credit, and output.

"In our view, that is the response to a classic information problem after a credit shock -- heightened uncertainty as to who is solvent or not, and thus an excessive contraction in the natural stock of safe liquid collateral on which so much financing and funding now depends." [emphasis mine]

The stock of liquid private collateral not growing is the modern monetary equivalent of a large output gap. It's "not some arcane technical point; it is above all about jobs, hardship, and hope in the high foreclosure counties and states, where recovery in income, spending, and collateral values have clearly lagged the rest of the country."

Households' most valuable source of collateral is the house, also cars and other valuables. The household sector owned $20.8 trillion of real estate in 2007, $16.0 trillion in 2012. [links between this section and Mian, Straub, Sufi's 2020 Saving glut of the rich]

In financial markets, debt securities are the most common collateral. These include corporate bonds, money market securities (more info here), asset-backed securities (cards, cars, and student loans), and exclude agency mortgages (I think just for the purpose of summing values. The outstanding value was over $15.4 trillion in 2007 and below $13.6 trillion in 2012.

Debt securities serve most often as collateral in financial markets. For collateral, three factors matter:

1. Value: how much is your house worth,
2. Haircuts: how much can you borrow against your home equity, and
3. Velocity: how many times can your house be used as collateral, i.e., rehypothecated

Shadow money

The IMF's Manmohan Singh estimated that collateral had a velocity or churn factor of roughly 3 in 2007 and 2.4 in 2012. This makes a big difference in the level of "Total Dealer Received Collateral" generated from a given amount of "Total Source Collateral".

The paper defines "shadow money" as the pool of debt securities that can easily be borrowed against. CS estimates shadow money based on the total outstanding value of various classes of debt, adjusted by each market's average repo haircut. If you've got a $100 bond and can easily borrow against it at a 5% haircut, you have $95 of shadow money and might not need to hold as much cash as you would if the haircut had been 10%. There was a negative correlation between levels of available HELOC credit and checking account balances -- as households had more credit they held less money.

The paper distinguishes between public and private shadow money. Public shadow money is based on the value of Treasury, mortgage-backed, and agency securities . Private shadow money is based on the value of corporate bonds, asset-backed securities, and non-agency mortgages [I think ~30% in 2020].

In 2008, private shadow money collapsed -- with negative net debt issuance, falls in the market value of debt, and sharp increases in repo haircuts. The S&P 500 moved in line with the level of private shadow money because equity prices are sensitive to deflationary risks. The drop also damaged real economic activity by tightening trade and inventory finance globally and causing a fall in business confidence.

Government then created a flood of safe collateral, sending the value of public shadow money soaring and offsetting the contraction in private shadow money. Central banks lowered interest rates and worked on other ways to improve the liquidity, value, and moneyness of public and private collateral through balance sheet operations.

"We believe this perspective [shadow money and market-based credit driving policy behavior more than the simultaneous shock to growth] shows a far more accurate and complete view of the money and credit dimension of this cycle, and offers a stark alternative to the traditional bank and money multiplier-based approach many people still use."

Effective money

CS defines "effective money" as shadow money + M2

• Public effective money = public shadow money + Monetary Base
• Private effective money = private shadow money + M2 - Monetary Base

(Note- not a big deal but I think this isn't perfectly consistent, since MB includes notes and coins in circulation, notes and coins in bank vaults, and Federal Reserve Bank credit (required reserves and excess reserves not physically present in banks), while M2 includes notes and coins in circulation but not in bank faults or FRB credit, as well as checking and savings accounts, and other types of deposit accounts and CDs worth less than $100,000.)

"Crucially, this chart and the shadow money perspective allows one to see that there has been (1) a huge and necessary change in the composition of the effective money stock, (2) a big reduction in the velocity of circulation of liquid collateral, (3) a sharp reduction in the value of illiquid collateral (houses [maybe today CRE to a greater extent]), (4) an increase in the "haircuts" on illiquid collateral (higher LTV ratios), and (5) a  big increase in precautionary demand for money by firms and households."

It seems to me that only (1) is a policy response. (2) through (5) are driven by the private sector driven, even if policymakers eventually require things like higher LTV ratios. And (5) goes back to Keynes -- the precautionary motive as "the desire for security as to the future cash equivalent of a certain proportion of total resources" (GT p. 146).

"The net result cannot be reasonably characterized as posing a major inflationary threat -- at least until such time as financial system deleveraging is more complete, collateral values, especially house prices have recovered substantially, and overall private sector credit demand is growing strongly."

Key takeaways

Until output gaps close and private collateral begins to grow again

1. Underlying deflation risks will persist.
2. Central bank balance sheets and fiscal debt may need to expand further.
3. Interest rates will stay in an historically low range, though not always as low as now.
4. The more macroprudential regulation is driven by hostility to shadow banking (money and credit chains backed by safe liquid collateral) the longer the conditions above will last.

I need to know more to know whether I agree with all these takeaways, but overall they seem reasonable.

Coda

Perry Mehrling proposes a new regime for monetary policy in "Three Principles for Market-based Credit Regulation". Mehrling observes three fundamental risk exposures that the Fed is taking on now: "a kind of overnight index swap, a kind of interest rate swap, and a kind of credit default swap. In all three dimensions, the Fed is operating to support market liquidity, much as our idealized Global Money Dealer and Derivative Dealer do in their balance sheets. In all three dimensions, the Fed can be seen as adapting to its new role as liquidity backstop for the emerging new market-based credit system."

This is a new notion of a central bank. Instead of manipulating the level of bank reserves, policymakers now stand as guardians of collateral and collateral liquidity ... This is Bagehot for the collateral-based financial system".

In conclusion, shadow banking is not well understood but is "a core part of the complex ecosystem of fund flows that is the financial foundation of modern global capitalism." How much better do we understand it today?

Final final note

In today's FT Stephen Roach wrote that inflation may be the only way out. But I wonder- given the importance of collateral to money markets today, how much more destabilizing will it be when the bond markets that provide so much of the collateral "tremble" in response to eventual inflation.

https://www.ft.com/content/5f4ef4f6-8ad6-11ea-a109-483c62d17528

How the economic machine works

In 2013 Ray Dalio published How The Economic Machine Works.

Summary

The economy is made up of transactions, which are driven by human nature. Transactions create the three main forces that drive the economy: (1) productivity growth, (2) the short term debt cycle, and (3) the long term debt cycle.

Transactions

The transaction is the building block of the economic machine. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets. Markets consist of the buyers and sellers for things such as wheat, cars, and steel.

Credit spends just like money. Credit + money = total spending, which drives the economy. Total spending / total quantity = price. If you add up total spending and total quantity of goods and services sold you have what you need to understand the economy.

Government

The biggest buyer and seller is the government, which comprises the central government and the central bank, which controls the amount of money and credit in the economy via interest rates and printing money. The central bank is an important player in the flow of credit, which is the most important part of the economy since it is the biggest and most volatile part.

Credit: borrowing creates cycles

Any two people can create credit -- which happens when borrowers promise to repay and lenders believe them. In contrast to money, which is used to settle transactions, credit is more like a bar tab. Most of what people call money is actually credit ($50 trillion vs. $3 trillion). In an economy without credit, the only way to make more money is to produce more.

When a borrower receives credit, he can increase spending, which drives the economy. Because one person's spending is another's income, increased income --> increased borrowing --> increased spending --> increased income --> and so on. Credit sets in motion a series of mechanical predictable events. We have cycles because we borrow.

As soon as credit is created, so is debt. Debt allows us to consume more than we produce when we acquire it and vice versa. An economy with credit has more spending and allows incomes to rise faster than productivity in the short run. Credit is fine when it finances investment in productive resources like a tractor and bad when it finances over-consumption that can't be paid back.

Productivity, Short-term debt cycle, Long-term debt cycle

Productivity creates long run growth. The overall trend of economic growth is positively sloped because of slow, steady productivity growth. Fluctuations around the trend are caused by short-term and long-term debt cycles (as mentioned- caused by borrowing).

The short-term debt cycle lasts 5-8 years. In the expansion phase, spending rises more than quantity produced. Eventually inflation picks up, and in response the central bank raises interest rates, leading to a contraction in which spending decreases faster than quantity produced.

The long-term debt cycle lasts 50-75 years. The ratio of debt to income -- the debt burden [private and public debt burdens] -- builds up over time through the short-term debt cycles. Eventually, the debt burden is simply too high and must come down. The long-term debt cycle ends in a deleveraging.

Deleveraging

At the end of a long-term debt cycle, a vicious cycle begins: Less spending -> less income -> less wealth -> less credit -> less borrowing

Lower interest rates stimulate borrowing in a recession but not a deleveraging because interest rates are already low. Rates hit 0% in the deleveraging of the 1930s and in 2008. Borrowers' debt burdens have gotten too big and can't be relieved by lowering interest rates. Lenders realize that debts have become too large to pay back, borrowers don't even want more debt, the entire economy is not creditworthy.

Four things happen in a deleveraging: (1) cut spending, (2) reduce debt, (3) redistribute wealth, and (4) print money. We saw all four in 1930s US, 1950s England, 1990s Japan, 2010s Spain and Italy.

(1) Cut spending: Spending is cut first. Austerity is deflationary because incomes fall faster than debts are repaid.

(2) Reduce debt: Next, banks get squeezed and we enter a depression where people discover that what they thought was their wealth isn't really there. At this point we need to default or restructure. Lenders don't want their assets to disappear (default) so eventually they agree to debt restructuring. Restructuring happens in one of three ways -- lower principal, lower interest rate, or extended maturity. Even though debt disappears, restructuring causes income and asset values to disappear faster, so the debt burden gets worse.

(3) Redistribute wealth: All of this affects the central government through lower tax revenues and higher unemployment spending. Governments need to raise taxes or borrow -- who does money come from? The rich [MMT might disagree..]. It facilitates redistribution from haves to have nots. The haves and have nots begin to resent each other. Tensions can arise not just within countries but also between debtor and creditor countries.

(4) Print money: People are desperate for money, and the central bank can print it. Printing money is inflationary and stimulative. The central bank prints money to buy financial assets and government bonds (over $2 trillion worth after the 2008 crash). Buying financial assets drives up asset prices, making people more creditworthy (the rich who already own financial assets). The central government on the other hand can buy goods and services. By buying government bonds, the central bank lends money to the government, allowing it to run a deficit and increase spending on goods & services (stimulus) and unemployment. This increases government debt but lowers the overall debt burden.

These deflationary and inflationary responses need to balance together for A Beautiful Deleveraging, in which (1) debts decline relative to income, (2) real economic growth is positive, and (3) inflation isn't a problem. It is achieved by having the right balance.

Inflation

Will printing money raise inflation? Not if it offsets falling credit, since a dollar in spending paid for with money has the same effect on price as a dollar in spending paid for with credit.

The central bank needs to print enough money to get the rate of income growth above the rate of interest, but it needs to avoid printing too much money, creating unacceptably high inflation.

Three rules of thumb

1) Don't have debt rise faster than income (because your debt burdens will eventually crush you)
2) Don't have income rise faster than productivity (because you'll eventually become uncompetitive)
3) Do all that you can to raise your productivity (because in the long run that's what matters most)

Notes

I have not seen a better 30-minute introduction to the economy. Of course I have some thoughts and mini gripes

• Minsky characterized the economic system as a system of interlocking balance sheets. Dalio's transactions focus is the "flow" version of that?
• Curious about the relative size of private and public debt burdens (usually I see these statistics as the assets/liabilities as a percent of GDP, not a comparison of the debt service coverage ratios)
• What's the link between the debt cycle and natural rate of interest (i.e., does it account for the decrease in interest rates due to the accumulation of capital and lack of investment opportunities)
• Makes austerity sound like a necessary -- I don't know if that's the case, although it is usually demanded first by creditors
• Rule of thumb number 3 --> ties into innovation policy

Economic Welfare and the Allocation of Resources for Resilience

In 1959 Kenneth Arrow wrote "Economic Welfare and the Allocation of Resources for Invention"

Economic Welfare and the Allocation of Resources for Invention published as part of a 1962 NBER publication The Rate and Direction of Inventive Activity: Economic and Social Factors. Arrow's framework can be used to think about how we allocate resources to create a more resilient economy and society. Here I quote his main points in the context of critical resources and resilience rather than information and invention.

Arrow starts with the classic question of welfare economics: "to what extent does perfect competition lead to an optimal allocation of resources?" ... "competition insures the achievement of a Pareto optimum under certain hypotheses", but a core assumption is that "there is no uncertainty in the production relations and in the utility functions."

Uncertainty is one of the three classical reasons for the possible failure of perfect competition to achieve optimality in resource allocation. Indivisibilities and inappropriability are the other two. If firms can't relieve themselves of all risks (they can't), then any unwillingness or inability to bear risks will give rise to a nonoptimal allocation of resources since there will be discrimination against risky enterprises ... "The inability of individuals to buy protection against uncertainty similarly gives rise to a loss of welfare."

"Unfortunately, it is only too clear that the shifting of risks in the real world is incomplete ... There are a number of reasons why this should be so, but I will confine myself to one, of special significance with regard to invention resilience. In insurance practice, reference is made to the moral factor as a limit to the possibilities of insurance." .. "A fire insurance policy, even when limited in amount to the value of the goods covered, weakens the motivation for fire prevention. Thus, steps which may improve the efficiency of the economy with respect to risk bearing may decrease its technical efficiency."

"The main conclusions to be drawn are the following: (1) the economic system has devices for shifting risks, but they are limited and imperfect: hence, one would expect an underinvestment in risky activities; (2) it is undoubtedly worthwhile to enlarge the variety of such devices, but the moral factor creates a limit to their potential."

If any particular item of information critical resource has differing values for different economic agents, this procedure will lead both to a nonoptimal purchase of information resources at any given price and also to a nonoptimal allocation of the information resource purchased.

"It should be made clear that from the standpoint of efficiently distributing an existing stock of information resources, the difficulties of appropriation are an advantage, provided there are no costs of transmitting information resources, since then optimal allocation calls for free distribution. The chief point made here is the difficulty of creating a market for information resilience if one should be desired for any reason."

Information Resources should be transmitted at marginal cost, but then the demand difficulties raised above will exist. From the viewpoint of optimal allocation, the purchasing industry will be faced with the problems created by indivisibilities; and we still leave unsolved the problem of the purchaser's inability to judge in advance the value of the information resource he buys. There is a strong case for centralized decision making under these circumstances.

To sum up

Arrow writes "we expect a free enterprise economy to underinvest in invention and research resilience (as compared with an ideal) because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use. This underinvestment will be greater for more basic research more infrequent events. Further, to the extent that a firm succeeds in engrossing the economic value of its inventive resilience activity, there will be an underutilization of that information as compared with an ideal allocation."

To paraphrase in the context of pandemic preparedness: we expect the market to underinvest in necessary resources like masks and ventilators because (1) it is unknown when they'll be necessary (due to uncertainty), (2) if they become necessary companies won't be able to charge prices sufficient to make a century of mask-stockpiling worthwhile, and (3) masks, like vaccines, have increasing returns in use (the more people wearing them the better for everyone). Further, to the extent that a firm succeeds in price gouging, not as many masks and ventilators would be distributed as we would want.

Over 90 percent of the masks and 80 percent of the PPE used in American hospitals today are not manufactured in America. Arrow, who set out the general equilibrium equations showing that competitive markets are efficient, gives us a framework for thinking about a more thoughtful industrial policy that relies a little less on an "invisible hand" and more on common sense and strategy.

Government has a revenue problem, not a spending problem

I do not accept the premise of this blog post.

Government debt today is not a bigger problem than collective under-investment in our health, education, infrastructure, and environment. And fortunately, there does seem to be at least a short-term consensus that government should spend what is necessary to protect us during this crisis.

However, policymakers are already preparing for the debt battles to come. Robert Rubin recently wrote that "Congress should commit now to address -- when conditions allow -- the increase in debt as a share of our economy, which was already seriously worsening before the crisis." He recognizes that "There will be ample room to increase revenues, on a highly progressive basis, for example, by increasing corporate taxes, restoring individual rates, repealing pass-through preferences and imposing a financial transactions tax."

Every 18 months or so the Congressional Budget Office publishes an Options for Reducing the Deficit report. It shows how much the CBO estimates that government could save by implementing various policies. A quick glance makes it pretty clear that anyone pushing for deficit decreases without pushing for at least some tax increases is probably not being entirely serious.

The top 10 options for raising revenues result in savings almost four times as great as the top 10 options for cutting spending. Not to mention that policies to increase revenues generally don't have much impact beyond slightly smaller numbers in the personal finance spreadsheets of comfortable Americans, while policies to decrease spending generally affect the least fortunate or do not solve problems -- for example cutting Medicaid costs and shifting parts of it onto state budgets.

PS: certain economists might say that the CBO estimates do not account for macroeconomic feedback and incentive effects. This is correct. However, those impacts are much less conclusive than is assumed in mainstream macroeconomic models, and in fact sometimes go the opposite way.

Additionally, the CBO document (and therefore the chart above) does not include estimates for recent larger revenue plans such as a wealth tax, which could raise more than $3 trillion over 10 years.

PPS: Olivier Blanchard basically said as much in his concluding remarks in November 2019 House testimony, Reexamining the Economic Costs of Debt -- government has a revenue problem, not a spending problem.

M2 vs. inflation

The federal government's $2.2 trillion stimulus package* has raised the question of whether we'll face excessive inflation over the next months and years.

One preliminary data point: from the start of 1983 through March 2020, there has been a slight negative correlation (-0.16) between year-over-year changes in the broad money supply (M2) and inflation as measured by the consumer price index (CPI). The following charts all show the same M2 and CPI data -- by levels, changes, and a scatter plot of changes.

The alleged crowding out effect

Let's talk about crowding out. Before our economy recovers, some prominent economists -- America's "serious people" -- are going to be speaking about the risk of government debt crowding out productive private investment in America's economy. They will sound serious and maybe even credible. If they are listened to, millions of Americans will suffer unnecessarily.

Jamie Powell at FT Alphaville introduces the topic nicely:

If you've had the misfortune of having to learn economics, you may remember the theory of the "crowding out effect" from your studies. Popularized in the 1970s, the idea is that an increase [in] public sector investment, and therefore borrowing, has the rather undesirable effect of displacing the private sector's planned borrowing and investment.

Essentially, the theory goes like this: If government finances programs by issuing bonds (i.e., with higher deficits), then interest rates will rise, the projects the private sector is planning will become less profitable due to a higher cost of capital, and some of those projects won't go ahead. The result is lower overall private sector investment, which means lower growth and productivity, ultimately resulting in lower long-run GDP. Fine in theory (with certain very strong assumptions, to be described in a later post), but it doesn't describe reality.

As one example of the fantasy foundations of crowd out theory, Powell quotes a new working paper by Enrico Moretti, John Van Reenen, and Claudia Steinwender. They find that public sector R&D expenditure -- directly or through subsidies -- leads to an increase in private sector spending in R&D, a "crowding in" effect. To those who have followed the work of Mariana Mazzucato and Bill Janeway (and, more recenty, the Council on Foreign Relations), this result will not come as a surprise. A quick glance at the development of industries such as information technology (core technologies of the internet, computers, iPhones, etc. all came through government-sponsored research and were supported by government as an early-stage customer), pharmaceuticals (over 75 percent of new molecular entities -- the truly novel drugs -- are discovered by government-funded researchers), and trains in the 19th century (the railroad boom was made possible in part by government granting 9 percent of US land to corporations) makes clear that there is more to crowd out than the neoliberal story of supply and demand for a fixed amount of national savings in an economy operating at full capacity in which the technological innovations that lead to productivity growth and the corresponding increases in per capita wealth magically occur .

I have nothing to add on those points beyond what is described by economists such as Mazzucato and Janeway. But here I point out one more thing: crowd out theory was created a couple of centuries before it was popularized in the 1970s, when money and taxes were very different from today. Here is Thomas Piketty summarizing 18th tax receipts in Capital and Ideology (p. 364)

In the centuries that followed these sums [tax receipts] would grow spectacularly, mainly due to the intensifying rivalry between England and France: both countries were taking in 600-900 tons of silver in 1700, 800-1,100 tons in the 1750s, and 1,600-1,900 tons in the 1780s, leaving all other European powers far behind. Importantly, Ottoman tax receipts remained virtually unchanged from 1500 to 1780: barely 150-200 tons.

Two points from this:

1. When people say that government spending will "crowd out" public investment, they are reasoning from an intellectual framework developed in the 18th century, when countries measured their tax receipts in tons of silver. That framework has not been updated for today's market-based model of banking and money creation.
2. The empire with the least amount of government spending and hence "crowding out" (even when the theory was more relevant) was the declining one. I don't explore this point further in this post, but there's a chance it's not insignificant.

Following up on the first point, here is one example of the differences. When the English Crown took in ~1,000 tons of silver from its subjects in 1760, there were 1,000 fewer tons of silver for (a) England's banks to issue currency, (b) its merchants to invest in sailing to India for tea and spices, and (c) its early industrialists to invest in building new textile mills. If King George collected silver to build a new summer palace at the expense of a new textile mill, crowd out was real! Today, if the US Treasury decides to send $1 trillion to Americans, there are not 1 trillion fewer dollars for productive private investment (and, I would argue, this is a better use of money than a new summer palace for George, but that is beside the point here). [I'm still trying to find out if anyone is operating with an updated framework for these types of questions].

Of course, we have to manage our nation's finances wisely. We (probably) can't exceed our productive capacity indefinitely. Eventually, inflation would increase and/or we would face other issues. But that is a discussion for later.

The point here is, if someone says crowd out with a straight face, do not take them seriously. Unless, of course, that person is a "serious person" who many people listen to. In that case, take him/her very seriously: she's dangerous.

Homebase and consumer spending

Two things today:

1. Homebase

Discovered Homebase data. Homebase provides a scheduling and time tracking tool, and they've made a dataset publicly available that comprises 60,000 US businesses and 1 million hourly employees. It's the most impressive high frequency economic dataset I've seen, and the numbers are jarring. Relative to median hours for a given weekday during Jan. 4 - Jan. 31, 2020, 66 percent fewer local businesses are open and 75 percent fewer hourly employees are working as of April 12, 2020. The beauty and personal care industry has been the hardest hit, with only 4 percent of firms still open on April 12, followed by leisure and entertainment (84 percent). Groups such as the Rustandy Center at Chicago Booth have conducted some useful analyses with this data.

The chart below, provided by Homebase, shows a time series of hours worked by hourly employees through April 11: