JKH on MMT and Risk

This post brings together several disparately placed comments on the same topic for convenient reference, and for those that may not have seen the comments.

Initially, JKH commented on a post by Perry Mehrling at The Money View  concerning the recent article at The Economist on heterodoxy that mentions MMT. I posted both here. Hugh Heden asked for clarification here. JKH responded in the following comment. (I've adjusted the paragraphing with more white space for easier reading.)

JKH said... 

I made that comment very quickly so it was a bit sloppy.

First, I’m thinking of QE in the broadest sense – being an expansion of reserves on the right hand side of the balance sheet and an expansion of assets on the left.

Thinking about risk in the broadest terms, you have such categories as credit risk, liquidity risk, interest rate risk, and foreign exchange risk. All of these elements are involved one way or another when the Fed intervenes so broadly in the market. Some of the earlier programs involved more credit risk for example.

In the case of their treasury purchases, there is certainly an element of interest rate risk. People may not think there’s much interest rate risk these days due to the environment, but it exists as a risk, and different portfolio managers have different views on it. Bill Gross was famously wrong on his call of course.

One of the interesting things about interest rate risk in this environment is that marked to market risk (or present value risk) increases dramatically, the lower rates go, for a given absolute move in interest rates. That’s because lower rates increase the “duration” measure of bond risk. The low rate of discount used in the PV formula makes the longer term cash flows of a bonds super sensitive to very small interest rate moves.

Anyway, you can assess the amount of interest rate risk that’s been taken out of the market by doing a detailed analysis of what the interest rate risk might be on the Fed’s balance sheet, not only in present value terms, but in running interest margin terms. It’s a very complicated exercise and I won’t get into it here.

But basically you have the Fed now running a massive “short funding” position on its balance sheet, due to the longer duration of its assets against the immediate interest rate sensitivity of many of its liabilities – i. e. the reserves that are priced essentially off the Fed funds target according to the interest on reserves. While the risk of increases in the Fed funds rate may seem benign now, it may not be the case at some point in the future.

But the most important aspect is the duration risk that’s been removed from the market, since much of that would be marked to market had it remained in street portfolios, where as I say it becomes super sensitive to even small interest rate moves when rates in general are so close to the zero bound.

Cont’d...
January 5, 2012 8:42 AM 

JKH said... ....

But my point really was about risk in broad terms. The Fed has removed risk from market portfolios, other things equal, and these market portfolios would have required equity capital allocation to bear such risk – and that includes equity capital allocated to support interest rate risk. So it makes a difference. And there have been issues in credit risk earlier on, etc.

And one of the important points here is that the Fed indeed has the capacity to remove gargantuan amounts of risk from the market, if it chooses, simply due to the (MMT) insight that it can fiat that transfer of risk with ease. And it can do this without having to worry about marked-to-market risk, because in all cases it has the inherent balance sheet strength to hold out until maturity of its assets.

And it doesn’t really use marked to market accounting for its bonds portfolios, for the most part, for that reason. And finally, when MMT makes the point that the Fed is removing interest income from the market, we should just bear in mind that there is a “risk/return trade off” involved. It’s also removing risk from the market. And the pricing of the transactions reflects that risk.

And the additional income the Fed has earned so far, while being income that has been removed from the market, is income that compensates the Fed for the risk it has removed from the market. And it was the sellers to the Fed that sought the removal of that risk from their portfolios.

The other thing I’d like to say is that my comment was quick and sloppy in a way (and this one is also quick), but to make a point. I do believe MMT is incredibly strong (as a competitor for academia) in its understanding of the monetary system and the banking system, and that’s critical to its essence – as per recent discussions.

My own personal view that MMT is “weak” in risk (and I might have added, weak in capital, in the sense that bank capital allocation is inextricably linked to risk management) is exactly that – a personal view on where MMT’s unusual strength in monetary operations and the subject of reserve management isn’t particularly well balanced with the other essential technical banking functions of risk management and capital management.

But I’d also like to say that I didn’t give MMT fair comparison against either MM or Austrian in that sense. If anything, MMT is probably still much better than those two in these areas of risk and capital management – and Warren Mosler is up to speed on this stuff of course, although I’m not sure how closely familiar he is with large bank operations in these areas.

Finally, you can measure the relative strength of MMT in monetary operations against the other two schools only if you go off the charts to do so, because there is just no comparison - and the subject matter is critically important to understanding economics more generally, in my view.

January 5, 2012 8:46 AM