from Peter Radford
I take slight issue with Krugman today. His blog at the New York Times has an entry about low cost funding from the Federal Reserve Board acting as a subsidy to the banks. He is too dismissive of the claim made by Axel Leijonhfvud that because the Fed is providing the banks with reserves at near zero interest rates, and because the banks can then go and invest those funds in US Treasury bonds at between 3% and 4%, that this represents a subsidy. A subsidy not voted upon by Congress no less. Krugman even ends his piece by using the deadly “alleged” word with reference to this subsidy, as if it were not a fact.
It is a subsidy, albeit not huge over the long term.
More to the point it is a deliberate subsidy, and not some by-product of an different macro-economic scheme.
Krugman is dismissive because he over thinks the problem. He argues, correctly, that since reserves are a short term loan and since US bonds are inherently a long term investment, that the subsidy can only exist temporarily. Why? Because as the economy recovers short term rates will rise, and the current positive spread will disappear and turn into a negative spread. Meanwhile, if the bank tries to disinvest the bonds in order to avoid the income loss on spreads it will face a capital loss on the bonds. Either way, over the life of the bonds the net effect is neutral or, possibly, a loss. Ergo, in Krugman’s mind, there is no subsidy.
Wrong. There is a small subsidy.
While Krugman’s analysis is impeccable with respect to the derivation of long term interest rates – they are, as he suggests, to a first approximation, an average of future short term rates – he ignores, as most economists do, the inner workings of the banks.
Despite all the folly and incompetence of the banking industry during the real estate bubble, when they wantonly threw overboard the basic elements of sound banking, they remain decent enough at managing their spreads. They have, after all, been in the business of intermediation forever.
Banks all borrow short and lend long. It is the very essence of banking. It is one of the two outstanding socially productive things they do. The other being managing the national payments system – i.e. clearing checks and taking care of the accounting of transactions. By being willing to manage interest rate risk, through borrowing short term money and lending it for long term purposes, banks grease the wheels of the economy. They create money. They enable business and household consumption and investment, and generally enhance social welfare. Or at least they’re supposed to.
Before you all attack me: I am not arguing they don’t do stupid insane and utterly anti-social things too. That’s why we should lock them up tight in restrictive regulations. But let them get on with intermediation.
Now, back to Krugman. He fails to take into account the active management of a bank’s net interest margin or NIM. That is the spread between its assets and liabilities. NIM is one of the features of a bank that gets very active and persistent management. Most banks have armies of people dedicated to the task. So, while Krugman is right in theory, he is wrong in practice. The will eke out what they can from the subsidy no matter what theory tells us.
The banks are facing a terrific yield curve currently. They can borrow at next to nothing and lend at decent rates. Low cost, or free, reserves simply add more bulk to their ow cost funding. So they are fattening up on profit. Banks love these steep yield curves. Flatter yield curves are a problem, but can be managed if they are stable. What banks dislike most is a yield curve in transition. That is when rates are being moved by the central bank in order to ease or tighten monetary conditions. So banks deploy all sorts of tricks to preserve the spread, and very few tie up much money in long term assets. The entire derivative debacle was based upon the urge at the banks to avoid holding long term assets. They wanted to package and sell such assets to other people who had bigger pools of long term liabilities – typically pension funds, insurance companies, and the like.
One consequence of this NIM management is that banks very rarely hold long term assets and so will not be squeezed by the rise in rates Krugman describes. Their profits will fall as they churn their portfolios, but the fall will be less than the entirety of the current spread they are earning.
So the subsidy is real and not just alleged. It is not as wide as 3% to 4%, but it is not zero either.
Besides, the real subsidy is more subtle than this. And it won’t go away.
That real subsidy, and the one I get riled up about, is due to the implicit government guarantee of bank risk taking. This is a consequence of “too big to fail”. Since everyone is acutely aware that the government will not, and cannot, allow large banks to fail – the payment system requires such a back stop – they can borrow at lower than free market rates.
Because the government guarantee lowers the perceived risk of a bank artificially below what the quality of its assets, its NIM management, and ability to raise liabilities would otherwise suggest. It is this subsidy that is pumping up bank profits right now, not the one stemming from zero cost reserves.
As I just tried to explain the zero cost reserve subsidy is real, but not substantial. Besides, as Krugman points out it could go away as the economy recovers. But the moral hazard subsidy persists and is permanent. No matter what level rates rise to, the big banks pay less,and so are subsidized for ever. Plus it gets larger in proportion to the bank’s size. The bigger the bank, the more it requires a safety net, the bigger the implicit guarantee, the larger the cost of funds subsidy. So the big banks have a built in incentive to keep growing and take balance sheet risks beyond the point an unsubsidized bank would. It is truly perverse policy behavior. It will cost us all a ton of money down the road. Again.
Policy makers are in denial of the inherent instability of banking. Why, I don’t know, given all the research. The only way to insulate taxpayers from losses is to limit bank size so that they can go out of business without dragging the entire world with them. If there’s one lesson from the recent crisis that should have been it. Did we learn it? Apparently not. So we muddle on with big banks and their constant subsidy. If you want to understand how damaging banks can truly be, take a look at Ireland or even the UK. They both had banks way out of proportion to their GDP size, and so they have had to take a greater, proportional, hit to their wealth to pay off the stupidity of their banks. There is a direct line from perverse bank bonus structures and actions and the austerity now in vogue to save those economies from “collapse”. The UK can at least print money to save itself. The Irish don’t have that luxury and so will pay for the bank disaster by slashing their standard of living.
The lesson is: don’t let banks get too big.
This is why I was an advocate of breaking the banks up. But I lost that fight a long time ago! Tim Geithner assures me that he has tied the banks down with paperwork. The bureaucrats will prevent another crisis.
Bank subsidies are very real. And dangerous.