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…..