More on MMT and risk

JKH commented on Perry Mehrling site about MMT and risk. That conversation migrated over here and JKH amplified his view in a comment, which was promoted to a post.

hbl commented on JKH's comment here and here, reposted below for the record and for those who may have missed it.

hbl said...

Since there is a new post and I only recently commented at the previous two posts, I'll move a copy of my [probably unread] comments here. In response to JKH's two comments listed above:



JKH,

Good comments! I replied to your comment at Perry Merhrling's (still awaiting moderation) before realizing there was a discussion and more detail here.



I largely agree with you here, but with two points I'd emphasize:



1. My personal view is that MMT is neutral on risk rather than weak on risk, and that individuals MMT authors treat risk in different individual ways (but maybe I've missed something)



2. I agree that the Fed's QE takes away interest rate risk from the private sector, but I think given the portfolio preference aspect of endogenous money that the effect is almost entirely borne by the financial sector, with the loss being a direct reduction in the net interest margin of the entire private financial sector (banks and non-banks). Whether this is "helpful" probably depends on the regulatory environment (how much forbearance is in play), the capital raising environment (something you allude to), and how this change in maturity transformation is shared between banks and non-bank financials.

My understanding is that after QE the non-financial private sector actually ends up with a slightly riskier asset composition (i.e., less treasuries relative to assets with credit risk) as it strives to regain its preferred portfolio duration mix.

January 5, 2012 3:03 PM

hbl said...

My reply to JKH (pending moderation) on the original Perry Merhrling post was before I read his two more recent comments posted above, with which I mostly agree. But that older comment references the Fed's ability to perform a quasi-fiscal role in absorbing credit losses from the private sector, which I'm pretty sure I've seen MMT authors discuss:

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JKH,

I'm not sure I agree that neo-chartalism is inherently weak on risk, though perhaps certain of its writers have especially unconventional individual perspectives.



Also, I think whether "the true effect of QE is to take risk out of the market" depends on circumstances. If the Fed buys private sector assets such as [possibly toxic] MBS, then yes, it's like government throwing itself on a grenade to limit damage to the private sector, and probably even reducing the size of the underlying explosion in the process.



But if the Fed buys treasuries as it did exclusively during QE2, what risk is being removed, other than interest rate risk?



And as we've discussed previously in the context of a post I did, endogenous money includes not only that loans create "money", but also that the private sector chooses its own portfolio duration mix by using the financial sector's maturity transformation role as the tool to this end. Ramanan recently posted a crystal clear quote from Kaldor from 1982 on this dynamic.



So after QE the non-financial private sector reclaims the duration mix that it "wants", in effect undoing the effect of QE. This will in some respects ADD risk because the non-financial private sector's long duration assets will include a relatively lower percentage of risk-free government bonds than prior to QE, with additional private sector assets (that have credit risk) taking their place.

January 5, 2012 3:06 PM

Anders then asked a question...

JKH - you make another point which is that QE does not provide additional purchasing power, on the grounds that purchasing power is already available by repo.



Surely the monetarist rerort is as follows.



"It's irrelevant that I _could_ have secured additional purchasing power by repoing my Tsy. I hadn't repoed it, and my purchasing power pre-QE reflected the fact that I hadn't repoed it. Now, QE gave me more purchasing power and liquidity than I wanted, and as I don't want this extra liquidity, I decided to buy another risk asset to try and shed the excess liquidity."

"
Not sure of the response to this.

Monetarists appear to have decent data attesting to the 'hot potato effect' for the asset management sector.

January 6, 2012 3:53 AM

JKH came back with this....

This is a very interesting subject for me and I wish I had the time to give it more justice right now. But just something quickly again on the Treasury bond risk issue:



Regarding the nature of risk on Treasuries, there was a classic book written in the early 1970’s called “Inside the Yield Book”. The entire book was applicable to the nature of risk in US Treasury bonds. It was written by two fellows from the New York investment bank Salomon Brothers, Sydney Homer and Martin Leibowitz. Warren Mosler would remember this book very well. The book was a must read back then for any serious trader of US Treasury bonds.

I don’t think the book actually used the word “duration”, but duration was the concept that was inherent throughout the book. Duration measures the relationship between the cash flow structure of a bond to risk in the price movement of a bond, based on the level of interest rates and the potential for change in the level of interest rates.

There are a number of interesting properties about duration:



a) The duration of a bond increases as term to maturity increases



b) The duration of a bond increases as the coupon rate (originally set) is lower



c) The duration of a bond increases as market interest rates decline



d) The price sensitivity of a bond increases as its duration increases



e) Duration and its relevance for the price sensitivity of a bond is one measure of the risk of that bond



Now put all that stuff together, and you have a fairly powerful statement about the nature of the risk that the Fed is taking out of the market when it swaps bonds for reserves. (The duration of reserves arguably is very short term, based on the interest rate sensitivity of the interest paid on reserves, which arguably will change whenever the Fed wants to change the funds target, which arguably it can do anytime it wants to.)



Now, you have to separate that entire discussion from another issue about risk, which is the way that risk works in a more general sense at the large institutional level.



Let’s take PIMCO as an example.



And let’s construct a make believe PIMCO scenario that is not entirely disconnected from historical fact, but that I’ve MASSAGED to a make-believe status in total, just to make a point.



Suppose that PIMCO decided to sell a whole slug of Treasuries at what turned out to be the wrong time – i.e. just before interest rates declined.



You have to think about what’s going on at an institution like this when such a decision is made. That decision is the result of a strategy in terms of how they’re looking at the risk in the market in terms of interest rate scenarios, and the risk inherent in their own portfolio in terms of how its value would react in such various scenarios. In this case, they looked at the market and they looked at their portfolio, and they didn’t like what they saw.



Now, it is very important to visualize roughly what they saw in their portfolio.



Cont’d...

January 6, 2012 8:32 AM



JKH said...

...

What they saw was their bonds, but they also their risk reports.



And what their risk reports would show in this case is, among other things, the price sensitivity of those bonds, based on a measure of duration (or based on some sort of mathematical transform measure of the duration concept, because the duration concept is at the heart of measuring all types of interest rate risk on bonds).

And they would have come to a judgement (it turned out wrongly) that what they saw as the threat that rates might move back up was simply too much for them, given the heightened sensitivity of bond prices at such a low level of interest rates, and given that they saw better opportunities to deploy capital on a risk adjusted basis.



And so, in this adjusted make believe scenario, they sold their bonds, at what turned out to be the wrong time.



And the Fed bought them, at what turned out to be a good time for them.



But the point is not who won and who lost here; the point is how the world at large is viewing bond risk. And there are bulls and there are bears, but they all have risk reports, and they all decide on “risk on” or “risk off” at various points of time.



And given the reality of those risk reports out there, and given the reality that 21st century financial institutions allocate scarce capital to all types of risk – including interest rate risk – it is indisputable that the Fed has taken risk out of the market by purchasing Treasuries and offsetting them with reserves.



And finally, it’s very important not to get caught up in a fallacy of composition here. Because the fact that the liquidity of the Treasury market would have allowed even PIMCO to download its Treasury portfolio into that market doesn’t change the other fact that in doing what it did, the Fed pulled aggregate interest rate risk out of the market. Just sum up all the risk reports on Treasuries before and after the Fed’s extraction, and that’s the conclusion.

January 6, 2012 8:37 AM

hbl responded here....

JKH,

Interesting details, thanks!



"it is indisputable that the Fed has taken risk out of the market by purchasing Treasuries and offsetting them with reserves"

Yes, that is the initial macro effect. However, if you agree with the endogneous money dynamic that RSJ and I have both written about and that I now see seems to be consistent with Kaldor (1982), then this initial effect is temporary. Remember, QE1 and QE2 had very little visible effect on levels or trends in broad money supply (such as MZM).



Bottom line (and granted this is *not* a dynamic that I've seen embraced by any MMTers, and as I said before I don't think MMT as a discipline either adds or detracts from best practices in macro risk analysis, it just seems to be [mostly] silent on them):



1. Post QE, the financial sector probably does have its interest rate risk reduced.



2. The non-financial sector gradually reclaims at a macro level the duration it "desires" via a menu of possible transformations of financial assets and liabilities, and is now forced to hold a higher percentage of private sector financial assets instead of risk-free treasuries. Thus QE most likely adds CREDIT risk to the private sector in places it did not exist before.



The simplest example for #2 (though I could give others) would be that banks replace some deposit liabilities with bond liabilities to satisfy the non-bank desire to restore its portfolio duration... now the non-banks hold bonds that include both credit risk and interest rate risk instead of treasuries that had only interest rate risk.

That said, I'm not sure whether it's possible to determine whether the net effect of the two would be a positive or negative for the private sector overall.

January 6, 2012 9:42 AM

JKH responded to hbl here...

hbl,

The Fed's removal of risk allows the financial sector to redeploy risk capital in other ways . That's part of the intended effect of QE. It's stimulative as far as the financial sector is concerned, although it has nothing to do with lending because of additional reserves, of course.



Not sure about the non-financial sector. Doesn't seem that intuitive to me, but haven't really considered it.

January 6, 2012 11:37 AM


hbl said...

JKH,



I'm not clear on how the financial sector would "redeploy risk capital in other ways". I understand that risk-weighted capital ratios might be improved as a short term effect, but I'm not convinced that capital is really any kind of non-temporary limitation to the financial sector's activities, especially when it comes to supporting genuine expansion of economic activity (funding businesses and such) 

I agree with Warren that capital is always available and it's only a question of price. Even if QE contributed to a lower price of capital, I'm not sure that necessarily drives the larger economy in any meaningful way. I would happily be corrected on this as I have no direct experience here.



Of course you might be correct that this was a policy GOAL of QE, I'm just questioning the actual effects.



By the way, I don't remember seeing others state it this way, but I think it's reasonable to say "loans [can] create capital" in the same way that "loans create deposits" -- there is just an extra step or two to get from deposits to capital. (i.e. - Borrower spends loan proceeds, a saver "downstream" in the circular flow of spending buys bank capital, essentially converting the transferred deposit to capital). But the point is capital should never be a lasting constraint on anything at the macro level, outside of a national financial panic / credit crisis.



In case you're curious when you have more time, here is the Kaldor quote I referred to (via Ramanan):



http://www.concertedaction.com/2011/12/24/merry-christmas/



and in here are a few graphics I put together reflecting one aspect of this endogenous money dynamic (scroll to the middle) though a more complete list of possible adjustment dynamics is at the end:



http://www.thoughtofferings.com/2011/06/visual-guide-to-endogenous-money-and.html



I should probably clarify these points with another post though, as the long duration assets held by the non-bank sector aren't shown explicitly in those graphics.

January 6, 2012 12:02 PM

(I took the liberty of breaking up some of the longer paragraphs for easier reading. tjh)