Economic academic research can be curious. In particular since the financial crisis, academics have focused on proving that free markets were inherently unstable and that government intervention was required to stabilise the economy.
While George Selgin incinerates a recent paper on Canadian private currency, I found three other recent papers that try too hard to convince us that markets aren’t perfect.
The first one, titled Short-termism Spillovers from the Financial Industry, attempts to demonstrate that large listed banks are subject to short-termism in order to meet quarterly earnings figures, and this that short-termism affects their behaviour towards their clients and in turn borrowers’ long-term investment policies. They conclude that short-termism is not optimal from an economic efficiency point of view.
In their words:
First, we find that lenders facing incentives to meet quarterly earnings benchmarks are more likely to extract material benefits from borrowers. Second, lenders with short-termism incentives push relatively high-quality borrowers into material covenant violations because these are precisely the borrowers from whom rents can be extracted. Because unhealthy borrowers are already selected for material covenant violations by lenders both with and without short-termism incentives, only relatively healthy borrowers are left to be targeted by incremental attention. Third, affected borrowers are more likely to reduce capital investment and research and development (R&D) expenditures. Given the selection of higher quality borrowers, it is particularly likely that these real investment effects on borrowers are value-destroying. Finally, we find that the market reaction to announcements of material covenant violations is 88 basis points lower among borrowers whose lenders face short-termism incentives, which suggests that the incremental attention from lenders with short-termism incentives does not improve shareholder value.
While they fall short of recommending government or regulatory intervention to maximise value-enhancing investments, the implication of their paper is clear: free markets do not optimally allocate capital. But don’t take their word for it. This paper is highly problematic for a number of reasons, outlined below.
First, they use equity analysts’ consensus earnings per share forecasts as a benchmark for short-termism, despite the highly inaccurate nature of those estimates. Indeed, those are constantly revised ; and banks are fundamentally very difficult to model due to the opacity of their balance sheet. As a result, analysts’ estimates are often wide off the mark and do not represent a reliable indicator. Sadly, the whole logic of this paper rests on this single benchmark.
Second, this paper makes rather strange assumptions about the utility of covenants in loan documentations. Covenants are usually agreed upon during the negotiations of the lending facility in order to protect the lenders by preventing the borrowers from fundamentally altering the nature of its balance sheet or of its business model. A breach of covenant is a contractual breach that is considered a serious event by the lenders as it implies a decline in asset quality. Yet this paper seems to argue that enforcing covenant is a bad thing, which ends up negatively impacting the borrower’s ability to grow in the long run.
They go as far as qualifying covenant enforcement as ‘extracting rents’ from borrowers. This is incredible: covenants are rules that are in place for a reason. Not to enforce them on a regular basis would undermine the effectiveness of those rules altogether and probably lead to much worse outcomes. Moreover, researchers qualify some of those covenant-breaching borrowers as ‘high-quality’ and ‘financially healthy’. I can assure you that, in the real world, covenant-breaching customers are anything but ‘high-quality’ and are usually flagged as ‘risky’ by bankers.
Third, even assuming their logic and methodology are correct, the effects they find is small: they calculate that borrowers affected by enforced covenant breaches are only 2.4% more likely to cut R&D spending and 4.9% more likely to cut capital expenditure. Borrowers are also only 1.4% more likely to switch lenders for their next loan and financial market reactions are marginal (88bp). Talk about a storm in a teacup.
But more importantly, my main concern is that the authors of this paper never ever benchmark their results. Or, more accurately, they benchmark the results they obtained against a hypothetical ‘social optimal’. As such, they fall in the Nirvana fallacy trap that Selgin also refers to his post: free markets are not perfect but no amount of government intervention could fix those admittedly minor shortcomings.
The second one is titled Macroeconomics of bank capital and liquidity regulations and studies the welfare effects of banking regulations. Or rather, it ‘models’ this welfare under very specific assumptions. So specific actually, that I dismissed the paper straight away.
In my view this paper exemplifies a lot that is wrong with today’s current economic research: it is based on a highly theoretical mathematical model with imbed assumptions and limitations that result in outcomes that do not nearly reflect the real world. Yet, those economists still managed to conclude that “capital and liquidity regulations generally mutually reinforce each other”, and that “the optimal regulatory mix consists of relatively high capital and liquidity requirements” (which they define as a very high 17.3% leverage ratio, more than ten percentage points above that of most banks today). They evidently conclude that their analysis provides broad support for Basel III’s regulatory framework, consequently seen as welfare-enhancing even though it doesn’t go as far as those economists would like.
Well… the one huge issue with this paper rests on this particular assumption underlying the trade-off faced by regulators in their mathematical model:
On the one hand, banking regulation may reduce the supply of credit to the economy. On the other hand, it improves credit quality and allocative efficiency. Accordingly, regulation tends to result in less, but more productive lending.
This is my reaction to this sort of nonsense:
There is not a single glimpse of reality in believing that regulation is more effective than free markets at allocating capital in the economy. If anything, as I highlighted so many times before, regulation has diverted the allocation of credit from productive uses (i.e. commercial and industrial loans) towards unproductive ones (i.e. real estate), which has been economically damaging and one of the reasons behind the financial crisis.
As a result, this paper includes some of its own conclusions in its assumptions, leading to circular reasoning: banking regulation improves allocative efficiency, therefore we need banking regulation.
Finally, Bank Capital and Dividend Externalities highlights that banks fail to ‘internalise’ the effects of dividend payments and capital policy on the stability of the wider financial system. The researchers theorise that banks increasing their dividends harm the claims that its own bank creditors have on its balance sheet in a bankruptcy scenario, thereby weakening the financial strength of the whole network. In such a system, they state that bank capital becomes a ‘public good’. The logical conclusion to this lack of systemic coordination is obviously government intervention: regulators should put dividend restriction measures in place when necessary.
But, here again, this paper suffers from major design flaws:
– Bank creditors are the only ones considered, despite the fact that banks have a multitude of creditors, including depositors. If dividend payments harm bank and other money market creditors, they also surely impact depositors and bondholders.
– They assume that dividend payments decrease the value of the bank by lowering its probability of survival. They reject the signalling theory of dividend payments despite admitting it had some backing in the literature: reducing dividend is a negative signal about the financial health of the institution.
– Their empirical evidence is limited to a couple of data points taken during the latest financial crisis: a couple of banks increased dividends before collapsing. They do not take into account the fact that those followed Bear Stearns’ bail-out by the Fed, which sent a specific TBTF signal to both the market and bankers themselves.
– As often in the banking literature, they make a big deal of interconnectedness, yet seem to forget that all industries have interconnected members. The decisions made by a large automaker also affect its whole supply chain and their employees. I have yet to see tens, if not hundreds, of research papers arguing that automakers fail to ‘internalise’ the impacts of their decisions, which are not always ‘socially optimal’.
– More damning, they prove their theory by modelling a financial system that includes just two banks, consequently suppressing any opportunity for exposure diversification. This is completely unrealistic. Banks have tens of other banking counterparties and already factor in their counterparty assessment the possibility that capital policy might change. But thanks to the diversification effect, those changes usually only affect them at the margin. A two-bank model does not capture this critical point. To be fair, those economists do admit that their model is a simplified one. Yet this admittedly weak theoretical basis does not seem to make them think twice before making policy recommendations.
– Finally, this paper falls into the same Nirvana fallacy trap as the first one reviewed above: they do not make a convincing case that an effective alternative exists, and assume away Public Choice issues by relying on the actions of omniscient regulators.
This is the sorry state of affairs in current economic research. By focusing on highly theoretical mathematical models based on very limiting – if not totally unrealistic – assumptions, damaging policy recommendations are outlined and subsequently serve as justifications for regulators’ actions. Clearly, nothing much has changed since the days of Diamond and Dybvig’s flawed model (see White, The Theory of Financial Institutions, 1999). As I recently pointed out in the case of macroprudential research, this is a reminder that it is critical to read research papers’ body (and not only their abstracts and conclusions). Sadly few people seem bothered do so.
Update: a revised and extended version of this post was published on Alt-M here
The title of this post (and a reference to Milton Friedman’s famous quote) is also the headline of a recent speech by Klaas Knot, President of the Netherlands Bank, and to which he answers:
In the spirit of Pentti’s thinking my answer is: Yes – as long as we stay eclectic, pragmatic and flexible. And we take the interactions of monetary and macroprudential policies into account, and coordinate the two policies.
While there is some truth to the second half of his answer – that monetary and macropru do interact, I find myself very uncomfortable with its first half: if we are all macroprudentialists now, we are heading for disaster.
As highlighted on this blog a number of times:
- There is barely any evidence that macropru has any effect (see also here and here) but on the other hand it ‘leaks’ and does have distortive impacts on the allocation of credit in the economy.
- It cannot counteract the effect of monetary policy.
- It opens the door to ‘bureaucratic tyranny’ (as John Cochrane said) and assumes away all Public Choice issues.
- It assumes omniscient regulators and rejects the conclusions of the socialist calculation debate or the insights of Hayek’s concept of knowledge dispersion.
But as research pieces presented last September at the BIS/Central Bank of Turkey seminar on macroprudential regulation demonstrate, group think is widespread: economic researchers include many, many important and explicit caveits and limitations within the core text of their papers; yet seem to suddenly ‘forget’ them once it is time to write both the abstract and the conclusion of the same papers.
Out of 19 papers, only one refers to some of the issues listed above and questions some the fundamentals behind macropru reasoning (Bálint Horváth and Wolf Wagner’s Macroprudential policies and the Lucas Critique, an interesting read). Many others, on the other hand, question the very fundamentals of a market economy: each agent fails to ‘internalise’ the damages that his/her actions have on the market and economy as a whole. Therefore, an external regulator needs to intervene in order to control the agent’s actions and stabilise the overall economy.
This is absurd. The same reasoning could be applied to any good: an agent overproducing a certain good fails to ‘internalise’ the damages it causes to the market and his industry. As a result, this industry needs a central planner to organise it in the most efficient way. We know the fallacy of this logic: government failures are worse and more systematic than market failures. Yet this view prevails in today’s macropru theoretical foundations.
This makes me think that Knot’s speech is an example of moderation in today’s central bank school of thought. Take this recent speech by Alex Brazier, Executive Director for Financial Stability Strategy at the BoE, during a financial regulation seminar at the London School of Economics. It is quite remarkable in the way that it manages to avoid referring to any of the issues listed above (and even contradicts point 2 despite the evidence), depicts macropru as an almost ideal framework, and exemplifies central bankers’ fundamental distrust in free markets.
See this statement for instance:
It’s well known, for example, that banks would choose to have too little capacity to absorb losses – too little equity capital – because their current shareholders don’t bear the full economic costs of their failure or distress. The economy needs better capitalised banks than the free market would deliver.
“Well known”? This makes little sense. This statement is a negation of all historical experiences of stable financial systems during which there was no regulator in place dictating capital requirements.
More perplexing are his later statements about capital buffers:
The results have been transformative. A system that could absorb losses of only 4% of (risk weighted) assets before the crisis now has equity of 13.5% and is on track to have overall loss absorbing capacity of around 28%.
This is wrong. As we recently saw, banks had regulatory Tier 1 ratios of 8 to 9% before the crisis. Not 4%, which was the regulatory minima. Mr Brazier is therefore comparing the pre-crisis regulatory minima to bank’s current average capital buffer.
More surprisingly, Brazier’s speech includes a whole part attempting to convince us that “clairvoyance is not a reasonable standard to be held to”, and that “[regulators’] mandate is to break free of the shackles of forecasting, to free us from trying to predict if the economy will turn down, and to apply economic analysis to the question of how bad it could be if it did.”
Macroprudential tools are discretionary policies that are supposed to be applied in a countercyclical manner: they are set in such a way to specifically reflect regulators’ forecasts (or beliefs) about where the economy – or certain segments of the economy – is going. Therefore, how on Earth is macropru supposed to work if regulators do not even attempt to understand how the economy is evolving or where the imbalances are building up in the first place? This is all very confusing.
And this is the issue. It is bewildering to see some economists, and virtually the whole central banking and bank regulatory profession, tell us that, despite all its shortcomings, unknowns, internal contradictions and inherent risks and distortions, macroprudential regulation is the way forward. (and to make things worse, macropru tools are not new and have been used for a while now, especially by emerging markets, with limited effectiveness – see chart below, taken from one of the seminar papers)
I know we apparently now live in an ‘alternative facts’ world, but academia is supposed to focus on evidence. The amount of research attempting to find a way to control the economy and financial markets through discretionary fluctuations of macroprudential tools is reminiscent of the post-WW2 Keynesian push which, as we know, didn’t end well.
Milton Friedman would have certainly not taught his students that “we are all macroprudentialists now”.
PS: thankfully Kevin Dowd is also supposed to speak at this seminar later this year, which should dispel some of the myths that are being spread