Category Archives: Finance

Some Wisdom from Henry Kaufman

Sometimes, when you write history, you can end up feeling old. I had that feeling a couple of weekends ago, when Henry Kaufman ventured to Baltimore to talk to the Business History Conference, an organization of historians.

I’ve known Kaufman for many years, and when my neighbor in the audience said, “I don’t know who this person is,” it was hard to explain how important he was on Wall Street in the second half of the twentieth century — how he, then head of research at Salomon Brothers, and Albert Wojnilower, the chief economist at First Boston, presciently warned in 1981 that Ronald Reagan’s economic policies would drive interest rates and the dollar sky-high, or how Kaufman’s pronouncement in August 1982 that interest rates had entered a long-term downward trend awoke the stock market from years of slumber. Since then, Kaufman has come in for a good bit of criticism: he was insufficiently bullish on the stock market in the 1990s, it is said, and as a board member bears responsibility for the collapse of Lehman Brothers, a venerable investment bank, in September 2008. He remains bitter about his experience with Lehman, and he blames the Treasury and the Securities and Exchange Commission for telling the directors Lehman should declare bankruptcy. “I think it was partly a political decision to allow Lehman to fail,” he says, recalling the pressure on the Fed and the Bush Administration to force someone on Wall Street to lose big.

Kaufman is 90 now, and he continues to cast a skeptical eye on the markets. He has always been a bond guy, and bond guys, by nature, worry about risks more than opportunities. His greatest worry is the financial system itself. He thinks that regulators missed the boat in the 1990s when they phased out the rules that separated commercial banking from investment banking; they expected deregulation would lead to greater competition among banks, he recalls, but instead it brought large-scale consolidation. The Dodd-Frank law and the other reforms that followed the 2008-2009 crisis, he thinks, have reinforced that trend. “It preserved the enormous financial concentration that had taken place and even accelerated concentration. That was a mistake,” Kaufman says. The result, in his view, is a system that is even riskier, with rules that are too complicated for bank supervisors to enforce.

His recommendation is to force financial institutions to specialize. The advantage in having companies that deal only in insurance, or consumer banking, or money management, he says, is that managers and regulators could better understand their finances. “I dare anyone to tell me they can go into a large financial institution [today] and tell me the details,” Kaufman insists. “You can’t,” he says, because the companies are too complicated to comprehend. The idea that “living wills” will enable them to disentangle their affairs in the event of crisis, as Dodd-Frank commands, is fatuous, Kaufman adds. Even with a living will, the markets will devalue a troubled institution’s assets, spreading pain widely.

Kaufman knows the world has moved on, and he is not optimistic about bringing the old times back. But he distinctly remembers how, back when Wall Street firms were partnerships for which partners bore personal responsibility, they behaved differently than they do today. When he was hired at Salomon in 1962, he recalls, he was told, “Go home and tell your wife you’re going to be liable for $2 billion.” Answering to shareholders isn’t the same thing at all.

My Housing Subsidy

It seems the new U.S. administration wants to make a major reduction in housing subsidies. From what I’ve read in the paper, though, it’s not planning to touch ours.

I’ve got to say that our subsidy is pretty generous. Last year my wife and I sold one apartment and bought another, and with it came a much bigger mortgage. Our monthly payments to the mortgage company went up — but our after-tax costs went down. The reason, of course, is that the U.S. tax code offers a generous deduction for mortgage interest, and lets us deduct our local property taxes from our income as well. By splurging on a more expensive property, we were able to cut our taxes quite a bit.

Looking at it another way, our government encouraged us to behave imprudently. Rather than having a relatively small debt that we could reasonably expect to pay off in a few years, we now have a relatively large debt that may well outlive us. Why the government should want us to go more deeply into debt is a puzzlement. I would not be shocked to discover that it has something to do with the lobbyists who ply their trade daily on Capitol Hill.

In my recent book An Extraordinary Time, I discuss the slowdown in productivity growth that has held back economic growth around the world for many years. I can’t help but wonder whether tax preferences for debts like my mortgage aren’t part of the story. While not all countries provide tax breaks for home mortgages, many countries do provide very favorable tax treatment to debt. In his excellent book Between Debt and the Devil, Adair Turner makes a persuasive case that such tax breaks encourage investment in existing real estate assets, which does nothing for productivity growth, rather than investment in the sorts of equipment and machinery that could make our economies more productive.

And then there is the matter of fairness. After finishing up our federal income tax return, I can report that the federal housing subsidy for my wife and myself is as large as the subsidies for some of the residents of the public housing complex near our home. Their subsidies are apparently on the chopping block because they are deemed government give-aways. Our subsidy, on the other hand, seems quite secure.



Economic Illusions

In my book An Extraordinary Time, I document the hubris of economists who thought they had discovered the key to economic stability during the postwar Golden Age. Esteemed experts such as Walter Heller, chairman of the President’s Council of Economic Advisers under presidents Kennedy and Johnson, and Karl Schiller, West German economy minister and then finance minister as well, believed economists knew enough to tell presidents and prime ministers how to assure strong economic growth and low unemployment. It was a seductive vision. It also proved to be an illusion: when economic crisis arrived at the end of 1973, the experts were unable to deliver the prosperity they had promised, leaving citizens frustrated and angry.

A reader recently asked whether talk of a “Great Moderation” in the late 1990s and early 2000s was a similar display of hubris. As was the case during the boom of the 1960s, those involved in economic policy in the late 1990s seemed to think they had conquered the business cycle. They had many admirers. Journalist Bob Woodward feted Alan Greenspan, then the chairman of the Federal Reserve Board, as “The Maestro” for orchestrating the economy’s smooth performance. Of course, the Great Moderation ended in the deepest economic crisis since World War II — a crisis that is long since over in the United States, but has yet to come to an end in parts of Europe.

While macroeconomists displayed no lack of hubris in boasting of the Great Moderation, I would submit that there was an important difference between the economic policies of the 1960s and early ’70s and those of the Greenspan era. Walter Heller and his contemporaries didn’t pay much attention to monetary policy. Their version of fine tuning involved manipulating instruments under direct government control, mainly taxes and government spending, to achieve a desired economic outcome. The Fed was an afterthought. This approach to fiscal policy was badly discredited by the economic failures of the 1970s and has never come back into fashion.

During Greenspan’s time at the Fed, in contrast, fiscal policy was in disarray. Deep divisions between Democrats and Republicans and between Congress and President Clinton rendered the U.S. government incapable of changing tax rates and federal spending to achieve any particular economic goal; although the federal budget went into surplus at the end of Clinton’s presidency, this was more the result of unexpectedly high tax receipts during the Internet boom than any deliberate purpose. Greenspan himself was no fan of fine tuning. Rather, he was among the very large number of economists who believed the central bank should use its control over short-term interest rates to achieve price stability, and that other important factors affecting employment, the rate of economic growth, and the prices of financial assets were beyond Fed control.

Yet this point of view involved hubris as well. Macroeconomists in the 1990s overwhelmingly believed that the prices that mattered to the economy’s performance were those paid by consumers. The Fed, they said, didn’t need to worry about certain other prices, such as those of stocks and real estate, because these would not have much effect on employment, incomes, and voters’ other economic concerns. As we learned at considerable cost, that conventional wisdom wasn’t right. The sharp drop in asset prices that began in 2008 left millions of households with depleted retirement accounts and upside-down mortgages, forcing them to pull back spending, leading in turn to a sharp rise in unemployment. By and large, economists missed this connection between the financial economy and the real economy.

Of course, saying that the Fed should worry about asset prices as well as consumer prices still leaves the central bankers to determine when stock prices are reasonable and when they are soaring unjustifiably. Either way, economists must pretend to know something that cannot possibly be known until after the fact. In his masterful biography of Greenspan, Sebastian Mallaby wrote that “The delusion that statesmen can perform the impossible—that they really can qualify for the title of ‘maestro’—breeds complacency among citizens and hubris among leaders.” Unfortunately, he’s right. One of the great challenges facing modern democracies is that their citizens expect more than their governments can possibly deliver.


Making It Hard to Save

Americans are famously unable to save money. The personal saving rate is a scant 5% of disposable income, and while two in three adults told Federal Reserve researchers last year they were “living comfortably” or “doing okay,” many of those same people apparently have no savings: 46% of respondents to the Fed survey said they did not have the cash to cover an emergency expense costing $400. Among people with household incomes below $40,000, only one in three said they could come up with $400 in cash.

Last month, I got an unexpected taste of why it’s so hard for people to save. My District of Columbia income tax return had an error. Rather than refunding my overpayment by check, the DC finance department sent me a Citibank debit card. I’d never used a prepaid card before, and the experience was educational. Moving the money from the card into my bank account, which is not at Citibank, turned out to be a major ordeal.

In theory, according to Citibank, it’s possible to set up a password on the Internet to transfer money from card to bank account. I followed those instructions, to no avail. The only way to get my money, it seemed, was to go to the bank.

But not to my bank, which wanted a fee to turn Citi’s debit card into cash. To avoid the fee, I had to take the card to a Citibank branch. I did so–to be told that the amount on the card exceeded Citibank’s daily cash withdrawal limit. I took what Citi would give me, cautiously walked the cash down the street to my bank, and deposited it. The following day, I repeated the process. All told, between my attempt to set up an Internet password and my five visits to bank branches, it took two hours of my time to gain access to money that was already mine. Had the two branches not been close together, the transactions would have taken far longer, and I would have had to stroll through Washington carrying uncomfortably large amounts of cash.

This is the situation facing the millions of American workers, mainly in low-wage jobs, who now get their pay on a debit card rather than having it deposited into a bank account. Yes, I understand that paying wages via debit card may be useful to people who don’t have bank accounts, and I imagine debit cards are cheaper for employers or they wouldn’t use them. But as my experience showed, when you receive your pay on a debit card, you may well have a difficult time saving money in the bank. Which could leave you in a tough spot the next time you need $400.

No Time for Nonsense

The first time I met John Makin, back around 1985, we had lunch in the dining room at the American Enterprise Institute in Washington. There was a large round table in the middle, at which a bunch of pompous know-it-alls — if you’re old enough to remember those days, you’d recognize their names — held forth with the answers to all of the world’s problems. At a smaller table off to the side, John tutored me on the shortcomings of the Reagan Administration’s economic policies. He was a Republican, and AEI was home base for the Ronald Reagan Fan Club. That made no difference to him. John didn’t have much time for economic nonsense, and he felt no need to justify it just because it happened to be the current Republican Party line.

If pressed, John would describe his ideology as conservative Keynesian, a term that is now long out of fashion. Ideology, though, wasn’t really his interest. He had equally little respect for politicians who pontificated about balancing the federal budget, politicians who claimed lower tax rates would bring in more revenue, and politicians who fancied that more government spending could provide everyone a job. What intrigued him was not what politicians said, but how interest rates and hence exchange rates responded to what politicians and central bankers did, and how that response affected economies around the world. His ear was well tuned to the nuances of Japanese and European monetary policy. He knew what he was talking about, and for many years he spent much of his time helping a hedge fund make money from his ideas.

John spent three decades at AEI, turning out thoughtful work rather than predictable talking points. In a city in which many people devote their lives to twisting the facts in order to support some political view, he was an independent thinker and a straight shooter. His death last week leaves a void.

Keep It Simple(r)

In the last couple of weeks, banking regulators in the U.S. and Europe have tightened rules concerning a financial measure known as a leverage ratio. The rules should make the banking system stronger, but that is only part of their appeal. One of their virtues is that they reverse half a century of increasingly complicated regulation by asserting a new idea: keep it simple.

A bit of background. Starting in 1974, regulators from a dozen countries came together in Basel, Switzerland, to find ways to make the world financial system safer. One of the subjects they discussed was capital, which is shareholders’ funds that are available to repay depositors and trading partners if the bank goes bust. Capital doesn’t produce a return for shareholders, so banks have an incentive not to hold a lot of it. By the 1970s, many banks, especially in Japan, had very little, and regulators responded by requiring banks to hold more, measured as a percentage of their assets.

Predictably, banks objected to this idea. One objection was that setting a higher capital-to-asset ratio would create a perverse incentive for banks to own riskier assets, such as loans to dodgy borrowers, which yield much higher interest rates than government bonds. If regulators were going to treat all types of assets the same way, the banks argued, banks would inevitably favor junkier borrowers to earn more money with a given amount of capital, and this would make the financial system less stable, not more.

The regulators came up with a compromise: the amount of capital required would depend on the types of assets a bank owned. At one end of the spectrum, loans to most businesses were deemed to be high-risk and had to be backed by a lot of capital. At the other extreme, loans to rich-country governments were deemed low-risk and required no capital at all. Over time, this seemingly sensible idea was taken to remarkable extremes. “Risk-based” standards were put in place, and were applied to banks’ trading businesses as well as their lending. This got so complicated that banks were allowed to figure out for themselves how much capital they should have, and clueless regulators couldn’t do much more than say “amen.” For more about this unfortunate development, you can see an article I wrote a couple of years ago.

Then, when the crisis came in 2008, regulators and bank investors discovered that banks had much less capital on hand than they were thought to have. The problem became acute in 2010, when Greece was unable to service its bonds. French and German banks had gorged themselves on Greek bonds precisely because they did not need to hold capital against which had been deemed “low risk” government debt. Had Greece not received an international bailout in May 2010, several big European banks could have gone bust.

The new rules on leverage ratios are meant to stop banks from gaming the system. They require most banks to add up their loans, their exposures to credit derivatives, and certain other commitments, and then to hold a certain percentage of that amount in capital, without adjusting for risk. The biggest banks will have to hold even more. This means that banks can’t get away with minimal capital by claiming they have low-risk businesses. Owning dubious Greek debt in order to avoid capital requirements will no longer make sense.

You’ll hear words like “crude” and “imprecise” thrown around by critics of the new leverage ratios. And there’s no question: they are crude. But what matters more is that they are relatively simple to enforce and harder for banks to manipulate. Banks businesses will continue to be very complex, but having some simple regulatory limits is worth a lot.

What’s a stock exchange?

As the sixth edition of my book The Economist Guide to Financial Markets is published this week, I’ve been thinking about how financial markets have changed since the first edition was published in 1999. One of the most remarkable changes involves exchanges. Although computerized trading was already quite important at the time, there were three distinct types of  exchanges that traded financial products: stock exchanges, futures exchanges, and options exchanges. To be sure, there was some overlap, but not much; the Chicago Board Options Exchange traded options contracts but not futures contracts, and the Brazilian Mercantile and Futures Exchange traded options and futures but not stocks. The New York Stock Exchange, right there on Wall Street, was indisputably the most powerful of the world’s financial markets.

Today, matters are quite different. Then, most exchanges still had trading floors populated by specialists who kept the market moving; whether you wanted to buy orange juice futures or sell IBM common, someone at the exchange, usually attired in a distinctive vest, would take the other side of your trade if no other customer was at hand. These days, only a handful of exchanges still have trading floors, and the even there most business takes place off the floor. The specialists whose personal interaction made exchanges so fascinating are largely gone. Modern exchanges are essentially computer systems that bring buyers’ and sellers’ orders together, confirm trades, and make sure money and financial assets are credited to the correct accounts. And once the exchange has gone to the trouble of building its technological infrastructure, it can trade almost anything. NASDAQ, the Korea Exchange, and the National Stock Exchange of India all are heavily involved in futures and options trading as well as share dealing. Last year, the venerable New York Stock Exchange, dating to 1792, was gobbled up by IntercontinentalExchange, or ICE, an all-electronic upstart that began by trading energy options in 2000. ICE owns 23 different exchanges, so it can get an awful lot of bang for its technology buck.

Large and sophisticated as they are, these far-flung exchanges face some challenges of their own. Their systems are being overwhelmed by buy and sell orders placed by the computers of high-frequency trading firms; in many cases, those orders are placed to confuse the market and then quickly withdrawn before being executed, so an exchange may collect no revenue from posting them. Meanwhile, a large and growing share of trades, especially in stocks, is being arranged privately, through so-called dark pools owned by investment banks or others, rather than on exchanges subject to public disclosure requirements. I have a hunch that by the next time I revise The Economist Guide to Financial Markets, the world of financial exchanges will have changed a good bit more.