A comment in the Financial Times, “Our need to sustain the ‘great moderation’,”by Stephen Cecchetti, professor of global finance at Brandeis, set my teeth on edge. I suspect many readers will react the same way.
The US housing market has collapsed, placing severe strains on the financial system and, as a direct consequence, workers and companies are suffering. But the real concern is not that there will be a few quarters with below average real growth – it is that the period of the great moderation may be over.
We have a US financial system that has already been quasi-nationalized even though the credit crisis has at best run only half its course, runaway inflation in many developing countries, rising commodity prices that threaten to wreak havoc on faltering advanced economies and international trade, and grave difficulties in addressing these issues, since they require a coordinated international response and shared sacrifice. But Cecchetti fantasizes that all that is at risk here is the loss of a bit of growth and the financial stability of the last 20 years (oh, if you conveniently forget the steep but short US recession of the early 1990s. Avoiding disaster will be an accomplishment, and it will probably take years to work through a global realignment, particularly a currency realignment.
The past 20 years have brought extraordinary prosperity. Growth has risen the world over and this higher growth has come with a remarkable stability. Comparing the 1970s with the most recent decade reveals that the volatility of real growth in the industrialised world has reduced – the standard deviation of real gross domestic product growth has roughly halved
Actually, growth rates were higher in the 1950s and 1960s in the US, albeit with more volatility, so the “great moderation” is not the panacea that its advocates make it out to be.
Back to Cecchetti:
There are a variety of possible explanations for this unprecedented stability. It could be that a modern monetary policy, with its focus on price stability, is less destabilising. Alternatively, information technology has increased the flexibility of companies to adjust production and employment quickly to changes in the business environment. Or, it could be we have been lucky and faced fewer disruptive shocks. There is something to each of these but the one that I put most weight behind is that financial innovation has allowed companies and individuals to smooth consumption and investment in the face of fluctuations in income and revenue.
Thomas Palley has a different theory I find far more persuasive:
[T]here are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.
Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow.
With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic is exemplified by the housing bubble of the last eight years.
The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.
Given this, the Great Moderation could easily come to a grinding halt. Though high inflation is unlikely to return, recessions are likely to deepen and linger.
Palley may be proven wrong about high inflation, given that the loose monetary policy we exported via currency pegs by developing countries is now coming back to haunt us. But note his view is based on the lack of bargaining power by wage earners. Inflation is unlikely to lead to successful demands for increased pay, so it will not reach the level it otherwise would have.
Cecchetti, by contrast, sees wage smoothing (i.e., increased access of wage earners to debt) as a benign, indeed completely salutary, development:
Elementary economics teaches us that smooth consumption paths yield higher welfare than volatile ones. Intermediate economics notes that, in reality, for households to keep purchases smooth from month to month they need savings or access to loans, which many of them do not have. As a result of this constraint, consumption follows income more closely than the simple theory says it should. Advanced economics teaches that financial markets should provide consumption insurance, allowing individuals to borrow and lend, reducing the dependence of current expenditure on current income.
There is a parallel logic for business. Growth should be smooth, even as revenue waxes and wanes. But in reality, cash-strapped companies are forced to curtail investment plans, while cash-rich ones can splurge. Again, borrowing and lending through financial intermediaries should cut this tie, leaving investment and growth smooth.
Dunno about you, but I find the tone a tad condescending. Aside from that, Cecchetti remains entirely in the world of theory, failing to note that increased access to borrowing has led to greater, unsustainable leverage of consumer balance sheets, and a deterioration of corporate credit (roughly half of the US corporate bonds outstanding are now rated junk). Whatever virtues these developments may have had in theory now seem outweighed by disadvantages in practice. What good is two decades of longer expansions with an overall lower growth rate if the price is a US financial crisis and dollar debasement resulting from measures to reduce (in real terms) the value of the debt overhang? The depreciation of the dollar alone makes Americans poorer in global terms, more than offsetting whatever gains the longer growth periods may have produced.
Over the last 20 years we have seen exactly this sort of financial innovation. Securitisation and the ability to separate risk and payment streams have been the keys to the revolution in finance. Active secondary markets for home mortgages, car loans, consumer credit and business lending enable both collateralised and uncollateralised borrowing. This dramatically weakens the link between income and expenditure for households and businesses.
Um, I’d beg to differ about these “active” secondary markets, There are pretty moribund right now. And banks are now taking large credit losses due to the success in temporarily decoupling expenditure from income. This is supposed to be a virtue?
Back to the article:
It is hard to overstate the importance of these innovations. Looking at data for the US economy, in 1985 just over $500bn of the $1,600bn in home mortgages was in pools used to create asset-backed securities. By 2005, total mortgage debt was $9,500bn, of which $7,500bn was used for securities. Mortgage-backed securities went from representing one-third of a small number to more than three-quarters of a large number. Securitisation of consumer credit also went from zero in 1985 to 10 per cent at the start of this decade.
This is meaningless in proving his thesis. You’d need to look at total credit extended via banks through on-balance sheet lending vs. via securitization, and establish that it led to greater lending. I have no doubt it did (securitization is cheaper due primarily to the lack of the cost of holding equity + the cost of deposit insurance) but his paragraph does not prove his point.
We return to Cecchetti:
Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing. After all, pricing a security requires an accurate assessment of the default probability regardless of what that probability may be. Once something can be priced, it can be traded. While we have less data for other countries, there is a clear sense that financial innovation has been responsible for reducing the previously direct relationship between consumption and income. With smoother growth in household expenditure comes less volatile real growth.
Oh, so here he admits to having no proof, merely a “clear sense”. And he further assumes the accuracy of pricing. Lordie.
The article once more:
This brings us to the long-run risks posed by the financial crisis. There was a failure to provide sufficient information about borrowers or align the incentives of the loan originators with the investors in the resulting securities. By separating financial instruments into their fundamental pieces the system allowed risk to be bought and sold, allocating it to those willing to take it on for the lowest price.
The result of the last 20 years of financial innovation is that we can insure virtually anything and engage in activities we would not have undertaken in the past. As a result growth has been more stable and business cycles have been less frequent and severe.
While we need to clean up the present mess – aligning the incentives of securities issuers and ultimate investors and providing the information they need to price the risks they face – the fundamental innovations should remain. As we think about how to adjust the financial regulatory system, it is important that we do not stop what is going on, just that we do it better. Otherwise, I fear the great moderation will be over.
As Paul Jackson of Housing Wire noted after the downbeat annual meeting of the American Securitization Forum, many of the so-called innovations depended on credit enhancement. And now that some of those risks are better understood than they once were, third-party credit enhancement has become sufficiently scarce and costly so as to greatly shrink the market for securitized credit. Jackson wrote:
While the monoline business may or may not be less important in the municipal bond markets due to the unbelievably low incidence of defaults, the guaranty business is actually far more important to the MBS business than most have given attention to thus far — precisely because defaults can and do happen.
For secondary mortgage market participants, resolving this crisis isn’t just a piece of the puzzle; it might be the puzzle. At the American Securitization Conference in Las Vegas last week, many investment bankers suggested on panels and in hallways that the bond insurer mess is the single largest issue keeping the private-party market from having a chance at establishing any modicum of recovery going forward.
Since the monolines are no longer in the business of providing credit enhancement for securitized credits (indeed, that business proved to be their undoing), this calls Cecchetti’s cheery view that many of these innovations had a viable economic foundation, meaning they “worked” for all the participants. Clearly, they did not (to a significant degree) for some key players (the guarantors plus investors in certain tranches). The problems thus appear more fundamental than bad incentives and incomplete information. This view is confirmed by the fact that the housing securitization market remains dependent on credit enhancement, but now Freddie, Fannie, and the FHA have stepped up, and in toto are now either providing or insuring 90% of residential mortgages.
So much for private sector innovation…..
Larry kudlow was on TV tonight reading a script from the fed. He could not get over that gold prices were down today in spite of oil being up. Quite clearly the Fed has decided that it simply has no hope of manipulating that oil market and has shifted its emphasis back to gold. Then they call shills like Kudlow and feed him this story how the market suddenly realized that thre Fed is going to put out a “tough” statement…with absolutely zero ability to do anything. It is becoming more obvious by the day that a cornered animal will do just about anything.
The great mooderation did nothing but defer volitility, not erase it. Shameful that someone like this is given a microphone. Innovation, like those 63 trillion of CDS I guess…
Firt of all innovation is the worng word. Opportunistic scavaging, but innovation no. Innovation withstands the test of time. The investment banking model (structured finance here) and the garbage it spouts out has failed miserably. There was absolutely nothing innovative about turning chicken liver into Chicken crap with a fancy model and sales pitch, both of which lacked any semblence of merit.
It would be really nice for once to see someone push back against this absurd narrative about wage inflation. Has wage inflation caused the current 10% unemployment rate ( I use the alternative measure). Of course not. The Fed is out pushing this agitprop that somehow it is good for you if wages don’t go up. Let’first highlight that corporate profits are at a record percent of GDP [but wage inflation is not a good idea]. You only buy this wage inflation nonsense if you are a corporatist. Otherwise it is best left for the CNBC bafoons to cheer about.
The great mockery of labor negotiating power may indeed be correctly accepted truth, but maybe not. A better balance between captial and labor is sorely needed. The only question is has the pendulum swung so far to the right that it is unhinged. With moronic debates over wage inflation and spiraling expectations, it would seem to be the case.
Yes, I cringed this morning upon reading that morsel.
According to Cecchetti’s view, the smoothing of consumption in no way increases that rate of consumption, thereby making the smoothing an aberration (i.e. causing a greater slope than should exist, created from a credit bubble). Financial innovation is the favored tool of mass inflationists.
And apparently you must use your brain to imagine such dislocations. Too much for Mr. Cecchetti.
Love your blog, Yves, one of the best!
Congrats for making it on NPR the other day. I was so relieved that people are catching on to what you have to say. Mumbo-Jumbo buzz words like the “Great Moderation” need to be translated to the public as even with my poli sci degree which got me no where fast, I need a hefty log like yours to keep up with the news (usually for me via radio, NPR being that I am not on-line much of the day).
I read the Conservative blogs occasionally and am amazed at their historical inaccuracies and ideological blindness. You give me hope that sanity can prevail. I think you handled Tom Ashbrook’s On Point radio show well by being neutral about wall street’s analysts not being intentionally mean to the public good but that they are just focused on their little picture before them. Your objectivity gave the program a gravity that I am sure those on the “Right” wouldn’t allow you.
Having watched the political world take a hard turn towards the Right-wing in the USA for the last 40 years, it’s just proof that my fears of how this comes out for the lot of us in the ‘middle’ and lower incomed ‘classes’ is now being borne out. Many of us baby-boomers are looking at retirement with little else than social security checks to sustain us.
I forgot to add the program that I referred to above that Yves was on: last week’s Debt Nation program.
Thanks so much for your feedback. I listened to the program before I came on, and was a little taken aback at how one-sided it turning out to be, even though I thought the general thrust (Americans borrow too much due to a shift in values and lack of institutional support for savings) was valid.
It takes a special hubris to canonize a Ponzi scheme as “The Great Moderation” but I’m afraid that is what it has been, and we will pay for it dearly.
I’m no expert but you might want to check this issue with someone who is: I think that credit enhancement was extremely important to synthetic CDOs, but that standard CDOs and MBSs can be — and in many cases were — structured without it.
It’s not clear that plain vanilla one-level securitizations will go the way of the dodo bird — nor that they should.
Standard CDOs and structured MBS (the tranched kind, as opposed to simple pass throughs) all require credit enhancement. You can’t get the AAA rating on the top tranche without it, and the AAA tranche is necessary, at least in the structures used conventionally, for the deal economics to work.
There are three ways to achieve the credit enhancement: credit default swaps, typically written by banks, investment banks, and hedge funds, guarantees from monolines (they are called credit default swaps, but that nomenclature is somewhat misleading, because some key terms differ from the credit default swaps from banks et al.) and overcollateralization.
CDS protection writers have cut back on writing new CDS, so they are scarce and costly, so the deal economics don’t work. Monolines don’t have AAAs (except for FSA), do their policies wouldn’t work even if they were still in a position to write new business, so the only route left is overcollateralization. I have not idea how and when it can work as well as the other two methods.
The fact that Fannie and Freddie have doubled their market share attests to how important having a guarantee or some form of credit enhancement is to selling structured mortgage paper.
I always like your blog though I often disagree. In this case I get the feeling that you may be trying to write economic history a bit too quickly. Don’t take it personally, it’s a curse of the times.
Perhaps a bit of a wait is in order before we confine securitization and other innovations to the dustbin. After all the automobile was considered next to useless when first invented and Harry Truman was laughed at for years after he left office. Obviously, in both cases instant analysis proved to be faulty.
Sometimes it takes to take a deep breath and say I don’t know for sure. Let’s see how it works out and maybe there was some good there we can salvage.
Just a thought. And by the way, though I disagree, it was a well written and thought provoking post.
Sorry, should have said it pays to take a deep breath.
Just move too fast on these comment pages.
It takes a long time to form a major aquifer, or a large
petroleum basin. For most Americans, it takes a long time to accumulate equity. When circumstances change, and wages stagnate or decline in real terms, it’s an understandable impulse to try to keep up old
patterns of consumption, if there is an easy reservoir
to tap. The equity reservoir built up in homes did so
precisely because it had been hard to tap until financial innovation (enhanced drilling techniques) came along. Well, now we have Peak Equity. Unless
there is something else left to tap, the great moderation is over.
This has been one of a number of articles since the credit crisis struck in which Cecchetti has been uncritical of recent policies and reassuring about the future. Does anyone else think that he might be positioning himself for a place on the FOMC?
“Does anyone else think that he might be positioning himself for a place on the FOMC?”
He is joining the BIS on july 1st [basel.gnomeland]
Thanks for that interesting piece of information.
Yves, I was forgetting that overcollateralization is actually considered a form of credit enhancement. Since its only third-party credit enhancement that has disappeared, there may a little life in structured finance left.
I think the real question is whether in a decade or so — i.e. once we’ve gotten back to more normal credit conditions — there’s a market for the equity and B grade tranches. If nobody has faith in the quality of underwriting, there won’t be.