Can Learnability Save New-Keynesian Models?

Journal of Monetary Economics 56 (2009) 1109–1113.  JME link .This is a response to Bennett McCallum’s “is the New-Keynesian Analysis Critically Flawed” which says yes. I think McCallum got it backwards -- the bounded equilibrium is not learnable, the explosive ones are learnable. Furthermore, I’m not convinced that a hypothetical threat by the Fed to take us to an “unlearnable” equilibrium is a satisfactory foundation for price level determination.

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Health-Status Insurance

Feb. 18 2009. In Cato's Policy Analysis No 633. If you get sick and lose health insurance you are stuck -- your premiums skyrocket or you may not be able to get insurance at all. The article shows how private markets can solve this problem. If you get sick, your health premiums go up but a separate "premium increase insurance contract" pays a lump sum so that you can afford the higher health premiums. The big advantage is freedom and competition: now health insurance can freely compete for all customers all the time. This piece is written for a nontechnical popular audience, with a lot of policy discussion. This paper explains the basic framework of Time-Consistent Health Insurance (next) and thinks through lots of real-world issues and answers to "what ifs." "What to do about pre-existing conditions" in the Wall Street Journal August 14 2009 and Health Status insurance Investors Business Daily (local link)  April 2 2009 are op-eds explaining the basic idea.

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The monster returns

Like a monster from an old horror movie, the Treasury plan keeps coming back from the dead. Yes, we are in a financial crisis that needs urgent, determined, and clear-eyed help from the Government. But this plan is fundamentally flawed.  It won’t even work, leaving aside its horrendous cost and long-lasting damage to the financial system. Every argument for it appeals at some point to magic. Buy a few mortgages and magically the value of all of them will rise. Spend $700 billion to "do something," without stating how that action will help, and by magic "confidence" will be restored. The additions and sweeteners in the Senate version, and those on the table in the house, are counterproductive, horrendously expensive, or a comical pinata. Counterproductive: protecting homeowners and renters may or may not be a good policy idea, but if you don't make people pay back mortgages, the value of those mortgages falls even further. Horrendously expensive: The bill mandates that purchases be made to preserve tha value of retirement accounts. The uncertainty that this bill introduces is already making matters worse.

A workable plan has to be based on fundamentally different principles: recapitalizing banks that are in trouble, including allowing orderly failures, and providing liquidity to short – term credit markets. These are not new and untested ideas; these are the tools that governments have used for a hundred years to get through financial turmoil.  However, they have to be used in forceful and decisive ways that will step on a lot of powerful toes. Since the bailout plan won't work, we will be back to these steps eventually. We might as well start now.

The problem

The heart of the problem now, as best as anyone I know can understand it (we are all remarkably long on stories and remarkably short on numbers), is that many banks hold a lot of mortgages and mortgage-backed securities whose value has fallen below the value of money the banks have borrowed. The banks are, by that measure, insolvent.  Credit market problems are a symptom of this underlying problem.  Nobody knows really which banks are in trouble and how badly, nor when these troubles will lead to a sudden failure. Obviously, they don’t want to lend more money.

A “credit crunch” is the danger for the economy from this situation. Banks need capital to operate.  In order to borrow another dollar and make a new loan, a bank needs an extra (say) 10 cents of its own money (capital), so that if the loan declines in value by 10 cents the bank can still pay back the dollar it borrowed.  If a bank doesn’t have enough capital – because declines in asset values wiped out the 10 cents from the last loan -- it can’t make new loans, even to credit-worthy customers.  If all banks are in this position (a much less likely event) we have a “credit crunch.”   People want to save and earn interest; other people want to borrow to finance houses and businesses, but the banking system is not able to do its match-maker job. 

Solving the problem

Ok, if this is the problem, then banks need more capital. Then the people, computers, buildings, knowledge, and so forth that represent the real business can borrow money again and start lending it out.  The core of any plan must be to recapitalize the banking system. How?

Issue stock, either in offerings, in big chunks as Goldman Sachs famously did with Warren Buffet last week, or by merging or selling the whole company.  There are trillions of dollars of investment capital floating around the world, happy to buy banks so long as the price is good enough. Banks don’t want to issue stock, because it seems to “dilute” current stockholders, and might “send bad signals.” Lots of sensible proposals amount to twisting their arms to do so.  In many previous “bailouts” the Government has added small (relative to $700 billion!) sweeteners to get deals like this to work.

Let banks fail, in an orderly fashion.  When a bank “fails,” we do not leave a huge crater in the ground.  The people, knowledge, computers, buildings and so forth are sold to new owners – who provide new capital – and business goes on as usual.  A new sign goes on the window, new capital comes in the back door, and new loans go out the front door.  Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back.  They complain loudly to Congress and the Administration – nobody likes losing money – but their loss does not imperil the financial system.  They earned great returns on the way up in return for bearing this risk. Now they get to bear the risk.

We saw this process in action last week. On Monday, we heard many predictions that the financial system would implode in a matter of days.  At the end of the week, JP Morgan took over Washington Mutual.   Depositors and loan customers didn’t even notice. As someone who argued publicly against the Treasury plan on Monday, I felt vindicated.

This process does need government intervention – “in an orderly fashion” is an important qualifier. Our bankruptcy system is not well set up to handle complex financial institutions with lots of short-term debt and with complex derivative and swap transactions overhanging.  Until that gets fixed, we have to muddle through.  An important long-run  project will be to redesign bankruptcy, delineate which classes of creditors get protected (depositors, brokerage customers, some kinds of short term creditors), and how much regulation that protection implies, and to design a system in which shareholders and debt holders can lose the money they put at risk without creating “systemic risk.”  But not now.

What is simple to describe economically –wipe out shareholders, write-down debt, marry the operations to new capital – is not straightforward legally and institutionally. If we just throw everyone into bankruptcy court, the lawyers will fight it out for years and the operations really will grind to a halt. In the heat of the crisis, we need the same kind of greasing of wheels and twisting of arms that went into the last few bank failures.

Fancy ideas.  The main point of any successful plan is to marry new capital with bank operations. There are lots of creative ways to do this, including forced debt-equity swaps, and various government purchases of equity. (My colleagues at the University of Chicago are particularly good at coming up with clever schemes. See http://research.chicagogsb.edu/igm/.)

The second part of the solution is to maintain liquidity of short-term credit markets. The Fed is very good at this. Its whole purpose is to be “lender of last resort.” We are told that “banks won’t borrow and lend to each other.” But  banks can borrow from the Fed. The Fed is practically begging them to do so. Even if interbank lending comes to a halt, there need not be a credit crunch. If banks are not making new loans, it is because they either do not have capital, or they don’t want to – not because they can’t borrow overnight from other banks.  (And the “other banks” are still there with excess deposits.)   If the Fed is worried about commercial paper rates, it can support those.

The one good part of the current proposals is a temporary extension of federal deposit insurance.  The last thing we need is panicky individuals rushing needlessly to ATM machines.

By analogy, we are in a sort of “run” of short-term debt away from banks. We have learned in this crisis that the whole financial system is relying to an incredible extent on borrowing new money each day to pay off old money, leading quickly to chaos if investors don’t want to roll over. It doesn’t make sense to threaten that overnight debt winds up in bankruptcy court, which is at the heart of the need for Government to smooth failures.  In the short run, guaranteeing new short-term credit to banks as a sort of deposit insurance could stop this “run.” If we do that, of course, we will have to limit how much banks and other financial institutions can borrow at such short horizons in the future.   

Banks vs. the Banking system

Banks can fail without imperiling the crucial ability of the banking system to make new loans. If a bank fails, wiping out its shareholders, and its operations are quickly married to the capital of new owners, the banking system is fine. Even if one bank shuts down, so long as there are other competing banks around who can make loans, the banking system is fine.

I think many observers, and quite a few policy-makers, do not recognize the robustness that our deregulated competitive banking system conveys.  If one bank failed in the 1930s, a big out of state bank could not come in and take it over.   Hedge funds, private equity funds, foreign banks, sovereign wealth funds didn’t even exist, and if they did there’s no way they would have been allowed to own a bank or even substantial amounts of bank stock.  If a bank failed in the 1930s, a competitive bank could not move in and quickly offer loans, or deposit and other retail services, to the first bank’s customers.  JP Morgan could not have taken over WaMu.  But all those competitive mechanisms are in place now – at least until a new round of regulation wipes them out. This is, I think, the reason why we’ve had 9 months of historic financial chaos and only now are we starting to see real systemic problems.

There is a temptation for regulators and  government officials to hear stories of woe from failing banks, their creditors, and their shareholders and mistakenly believe that these particular people and institutions need to be propped up. 

The Treasury Plan

The treasury plan is a nuclear option. The only way it can work to solve the central problem, recapitalizing banks, is if the Treasury  buys so many mortgages that we raise mortgage values to the point that banks are obviously solvent again.   To work, this plan has to raise the market value of all mortgage-backed securities. We don’t just help bad banks. We  bail out good banks (really their shareholders and debt holders), hedge funds, sovereign wealth funds, university and charitable endowments – everyone who made money on mortgage-backed  instruments in good times and signed up for the risk in bad times. This is the mother of all bail-outs.

There is a storm out on the lake, and some of the boats are in trouble. Commodore Bernanke has been helping to bail water from some boats until they can patch themselves up, encouraging other sound boats to help, and transferring passengers on sinking boats to others. But it’s getting tough and the storm is still raging. Someone has a great idea: let’s blow up the dam and drain the lake! Ok, it might stop the boats from sinking, but there won’t be a lake left when we’re done. That’s the essence of the Treasury plan.

Short of that, it will not work. Suppose a bank is carrying its mortgages at 80 cents on the dollar, but the market value is 40 cents.  If the Treasury buys at 40 cents or even 60 cents on the dollar, the bank is in worse trouble than before, since the bank has to recognize the market value. Unless the Treasury pushes prices all the way past 80 cents on the dollar up to 90 or even 100, we haven’t done any good at all. And $700 billion is a drop in the bucket compared what that would take.

There is a lot of talk about “illiquid markets,” “price discovery,” and the “hold to maturity price;”  the hope that by making rather small purchases, the Treasury will be able to raise market prices a lot. This is a vain hope – at least it is completely untested in any historical experience.  Never in all of financial history has anyone been able to make a small amount of purchases, establish a “liquid market” and substantially raise the overall market price.

Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.

There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting, i.e. to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks know this and would lend anyway. We might as well just ban all accounting if we don’t like then news accountants bring.  No, we need more transparency, not less.

Many of the changes in new versions of the Bill make matters worse, at least for the central task of stabilizing financial markets. The Senate adds language to protect homeowners – “help families to keep their homes and to stabilize communities.”  That’s natural; a political system cannot hope to bail out shareholders to the tune of $700 billion dollars without bailing out mortgage holders on the other end. But it makes the bank stabilization problem much worse.  Mortgages are worth a lot less if people don’t have to pay them back. This will directly lower the market value of mortgages that we’re trying to raise. 

Yes, we need to do something. But “doing something” that will not work, with potentially dire consequences, is not the right course, especially when sensible and well-understood options remain.

State-Space vs. VAR models for Stock Returns

Manuscript July 24 2008. In a “state-space” model, you write a process for expected returns and another one for expected dividend growth, and then you find prices (dividend yields) and returns by present value relations. I connect state-space models with VAR models for expected returns. What are the VAR or return-forecast-regression implications of a state-space model? What state-space model does a VAR imply? I start optimistic. An AR(1) state-space model gives a nice return-forecasting formula, in which you use both the dividend yield and a moving average of past returns to forecast future returns. The general formulas leave me pessimistic however. One can write any VAR in state-space form, and we don’t really have solid economic reasons to restrict either VAR or state-space representations. Still, the connections between the two representations are worth exploring, and if you’re doing that this paper might save you weeks of algebra.

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Two Trees

(with Francis Longstaff and Pedro Santa-Clara), Review of Financial Studies 21 (1) 2008 347-385. We solve the model with two Lucas trees, iid dividends and log utility. Surprise: it has interesting dynamics. If one stock goes up it is a larger share of the market. Its expected return must rise so that people are willing to hold it despite its now larger share. Typo: Equation 39 (page 363), the numerator should read (1-s/(1-s))ln(s)/V, not 1-s/(1-s)ln(s)/V. Thanks to Egor Malkov.

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Bond Supply and Excess Bond Returns

May 2008. Comments on Robin Greenwood and Dimitri Vayanos’ paper for the IGM “Beyond Liquidity ” conference at the GSB Gleacher center, May 9-10 2008. The paper from Dimitri’s website . I learned two important lessons in reading and thinking about this paper. 1) When arbitrageurs are limited by risk-bearing capacity, “downward-sloping” demands depend on correlations. The paper and my comments have a lovely example in which arbitrageurs are asked to hold more long-term bonds and less short-term bonds. The result is that all yields go up! Why don’t long yields go up and short yields go down? Because risks are described by a one-factor model, so all that matters is how much overall duration risk arbitrageurs have to hold.  2) We’re probably doing a bad job of correcting for serial correlation in all predictive regressions. Typically, we think expected returns move slowly over time. The right hand variable also moves slowly over time, but doesn’t capture all of the expected return variation. This situation means that residuals have a slow-moving AR(1) plus an unforecastable component, which is the same thing as an ARMA(1,1).  This structure will be very poorly captured by standard “nonparametric” procedures such as Newey-West, since you’re unlikely to put in enough lags to capture the long-run component, and also poorly captured by parametric procedures like fitting an AR(1). “Short” samples make the problem worse. More in the comments. 

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Risks and Regimes in the Bond Market

April 2008. Comments on Atkeson and Kehoe’s paper for the 2008 Macroeconomics Annual. Risk premia are important for understanding interest rates, and monetary policy. I see no evidence for “anchored expectations” in interest rate data. Once you take account of risk premiums, expected long run interest rates are still very volatile. The yield curve has not become more downward sloping on average, as it should if inflation risks have decreased. If anything, risk premia in long-term bonds are increasing. Atkeson and Kehoe advocate a fascinating view that risk premia cause monetary policy, not vice versa.

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Decomposing the Yield Curve

Manuscript, first big revision, March 14 2008. With Monika Piazzesi. We work out an affine term structure model that incorporates our bond risk premia from “Bond Risk Premia” in the AER. There are lots of interesting dynamics – level, slope and curvature forecast future bond risk premia, and we discover that market prices of risk are really simple. We use the model to decompose the yield curve – given a yield (forward) curve today, how much is expected future interest rates, and how much is risk premium? How does the yield or forward rate premium correspond to the term structure of expected return premia? Was the conundrum a conundrum? Slides from 2010 AFA meetings Data and Programs.

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Financial markets and the Real Economy

In Rajnish Mehra, Ed. Handbook of the Equity Premium Elsevier 2007, 237-325. Everything you wanted to know, but didn’t have time to read, about equity premium, consumption-based models, investment-based models, general equilibrium in asset pricing, labor income and idiosyncratic risk. 

This article appeared four times, getting better each time. (Why waste a good article by only publishing it once?) The link above is the last and the best. The previous versions were NBER Working paper 11193,  Financial Markets and the Real Economy Volume 18 of the International Library of Critical Writings in Financial Economics, John H. Cochrane Ed., London: Edward Elgar. March 2006, and in Foundations and Trends in Finance 1, 1-101, 2005.

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What ends recessions?

By David and Christina Romer, 1994 NBER Macroeconomics Annual 58-74. JSTOR What are monetary policy shocks? The fed never says “and another 50 bp for the heck of it.” This led to “What do the VARs mean?”

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Daily Monetary Policy Shocks and the Delayed Response of New Home Sales

By James D. Hamilton. April 2007  Comments given at NBER Monetary Economics program meeting, NY. Includes some new thoughts on what a monetary policy shock is.

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Portfolio theory

Feb. 20 2007 This is a draft of a portfolio theory chapter for the next revision of Asset Pricing. I (of course) take a p = E(mx) approach to portfolio theory before covering the classic Merton-style direct approach. I emphasize the importance of outside income.

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“The Returns to Currency Speculation”

by Craig Burnside, Martin Eichenbaum, Isaac Kleshchelski and Sergio Rebelo. Comments given at Jan 2007 AEA/AFA meetings. (Slides only)

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‘Macroeconomic Implications of Changes in the Term Premium’

By Glenn Rudebusch, Brian Sack and Eric Swanson. Comments given at the conference “Frontiers in Monetary Policy Research” at the St. Louis Federal Reserve, October 19 2006. Of course, I can’t stick to the topic and offer a survey instead. In particular, lots of salty comments on the “conundrum” in long bond prices (silly, in my view).  The paper from the St. Louis Fed website.

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The Dog that Did Not Bark: A Defense of Return Predictability

Review of Financial Studies 21(4) 2008 1533-1575. Taken alone, returns may not look that predictable. However, price-dividend ratios vary, so either returns or dividend growth must be forecastable (or both). Implications for dividends, and long-run forecasts give strong statistical evidence against the null that returns are not forecatsable. I address the Goyal-Welch finding that forecasts do badly out of sample, and the long literature criticizing long-run forecasts.   The most important practical takeaway: even if you assume that all variation in market p/d ratios comes from time-varying expected returns, and none corresponds to dividend growth forecasts, you will typically find that market-timing strategies based on fitting the regression don’t work. Corrected Table 6. Three numbers were wrong in the published version. Thanks to Camilla Pederson for catching it.

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International Risk Sharing is Better Than You Think, Or Exchange Rates are Too Smooth

With Michael Brandt and Pedro Santa Clara. Published Journal of Monetary Economics 53 (4) May 2006 671-698. Original July 2001 (NBER WP 8404) The equity premium means that marginal rates of substitution are very volatile, with more than 50% standard deviation. Exchange rates are the ratio of marginal rates of substitution, and they only vary by about 12%. Therefore, marginal rates of substitution must be highly correlated across countries. Risk sharing is better than you think.

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Financial Markets and the Real Economy

Volume 18 of the International Library of Critical Writings in Financial Economics, John H. Cochrane Ed., London: Edward Elgar. March 2006. Edited volume of collected articles with an introduction surveying the field.

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Time series for macroeconomics and Finance

Lecture notes for PhD time series course.  This revision finally includes the figures!

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Writing tips for PhD students

May 2005. Some tips on how to write academic articles. Do as I say, not as I do. Chinese Translation, 2013. (Original source of chinese translation. Thanks to Shihe Fu)

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Money as Stock

Journal of Monetary Economics 52:3,  (2005) 501-528. Revision of NBER Working Paper 7498 Feb. 2000. The fiscal theory of the price level made simple. The `government budget constraint' is not a constraint. I reopen the security market at the end of the day in a cash in advance model, and show that the price level is still determinate. I also resolve the criticism that the fiscal theory mistreats the "government budget constraint." 

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