Miles Looks Back

David Miles, retiring from the Monetary Policy Committee of the Bank of England, gave a fascinating speech on the occasion.  (Pdf with graphs here.) David's voice is particularly interesting since he's a real-world central banker, not an ivory-tower academic who can afford to have radical views. Many central bankers seem to evolve to the view that yes, they can push all the levers and run things just right. Not David.

Looking back: lessons from the global financial crisis

..the simplest, and arguably most effective, policy [to avoid financial crises] may well have low long run costs. That policy is to gradually change the funding structure of banks so that they are much better able to deal with shocks by relying less on debt and more on equity...

There are two fundamental reasons why having financial intermediaries fund their acquisition of assets with significant amounts of equity makes sense. First, it directly addresses the problems of improving incentives and preventing even limited falls in expected asset values triggering big rises in perceived risks of insolvency. Consider why the very large fall in asset values after the dot.com bubble burst did not have such devastating effects on the US economy. It was because all that frenzied activity was largely financed by equity and not debt. People who had funded much of the dot.com bubble lost money, but this did not trigger a whole series of insolvencies in the financial sector and disrupt the flow of credit to the wider economy.

Second, the long run cost of even rather big increases in the amount of equity funding of financial intermediaries is plausibly quite small. Substantial changes in the use of equity funding have already taken place since the crisis – and on some metrics required capital is as much as ten-times greater than pre 20087. And yet there is little evidence that the overall cost of bank funding has increased substantially. The paths of bank lending rates, both in absolute terms and relative to Bank of England Rates, have tended to fall (charts 2 and 3). And direct measures of the cost of bank funding have been on a steady declining path as capital ratios have risen (chart 4).

But won't the cost of capital rise and thus the cost of loans rise?

Simple finance theory suggests why, starting from very low levels of equity (high debt leverage), the impact of large proportionate changes in the use of equity on the overall cost of funds is likely to be small.

Consider the impact of doubling capital – or halving leverage – using the simplest possible back of the envelope calculation of a bank’s weighted average cost of funds. Suppose we start with leverage of 40 and cut it to 20 (that is with equity initially of 2.5% of total assets rising to 5%). Let’s imagine that the cost of debt financing is 5% and the required return on equity (its cost) at the original level of capital is 15%. First, if we assume that these costs will not change (a pretty big and unrealistic ‘if’ for a dramatic change in leverage), this will lead to total cost of financing increasing from 5.25% (0.975*5%+0.025*15%) to 5.5% (0.95*5%+0.05*15%), a rise of only 0.25pp. 25 basis points is what people used to think of as one typical MPC rate change at its monthly meetings.

And this is an extreme case in which the costs of equity and debt do not change. Theory suggests they should change so as to reflect the shift in riskiness as equity rises – debt becomes safer and equity returns less variable. At the extreme (and if the conditions for the famous Modigliani-Miller (MM) theory hold) there would be no change in the weighted cost of funds.

I hadn't thought of this. Even if MM is completely false for banks, the actual rise in costs of capital is small.

A combination of the limited liability of shareholders and deposit insurance almost certainly makes MM not hold for banks. But many of these factors may mean that while MM does not hold, the private cost of banks using more equity is not a true social cost.

In simpler terms, equity financed banks may face a higher cost of funds, because our governments subsidize debt. That fact does not mean that society as a whole as a higher cost of borrowing through equity-financed banks.

David goes on to an interesting question: Let us compare equity financed banking to the current rage, using monetary policy to identify and prick asset price "bubbles."

Might it then be that a better way to control risk taking and financial fragility is to use ...changes in the general level of interest rates ...

My own view is that skewing monetary policy towards trying to stop financial instability problems is, in general, unlikely to be the right answer. Yet many seem to think that the crash showed that having narrower aims of monetary policy – centred around an inflation target – was somehow proved wrong. I think that view fails to look at the deep reasons for the crash, which to my mind were the existence of excess leverage (too little equity funding) in banks. Excess leverage is not something effectively countered by a general rise in the level of interest rates. Higher interest rates will tend to increase required returns on both debt and equity and so it is not at all clear they encourage the use of relatively more equity. Capital requirements – a macro prudential tool – get to the heart of the problem.

I'm less in love with the "macro prudential" agenda, but in this case I cheer.

David makes another interesting point:

..bankers are right to say: For them raising equity is costly; and imposing a higher capital requirement will reduce aggregate lending.

Both statements are correct. But both miss the point. There may be too much lending in the unregulated state. Equity may look costly to banks but it has an overall beneficial side effect in better aligning the interests of shareholders with those of other claimants on the bank. To put the point another way: there is an inherent tendency in banking markets for there to be excessive risk taking. 

This is a nice point, which had not occurred to me. If the cost of debt financing rises, borrowers may choose equity financing instead. It's not obvious that the total amount of investment declines, or that it declines in a socially inefficient way. There is such a thing as too much debt!

Lessons about Monetary Policy: QE, ZLB and deflation

The global recession led many central banks to lower their policy rates to near zero. With the exception of in Japan, this was pretty much unchartered territory for monetary policymakers...

...the predictions from mainstream theoretical macroeconomic models for what would come next were not comforting... [For example] Eggertsson and Woodford (2003, EW) had analysed what happens at such low levels of policy rates and the likely effectiveness of asset purchases. They suggested that on hitting the lower bound an economy could suffer a deep deflation and recession and that asset purchases were not likely to help much. Their analysis suggested that the effective way to avoid deflation in such circumstances would be to commit to future inflation overshooting the target.

I found these predictions somewhat unrealistic, ...

I also doubt that there is a deflation cliff at the ELB. The evidence for thinking that deflation risks become great at the ELB is actually quite weak. There were no dramatic deflations among OECD economies (except for Ireland, which saw an exceptionally sharp fall in economic activity), and there was no clear difference in the change in inflation rates between countries that were constrained by the ELB and those that were not. Inflation fell in most OECD countries in 2009, but only a few experienced outright deflation.

... Neither actual nor expected inflation displayed the deflation cliff at the effective lower bound.

He's not quite "neo-Fisherian." But clearly the prediction of a deflation "spiral" or "vortex" at the zero bound troubled him at the start -- as it should have -- and no longer sits well.

I disagree mildly on the effectiveness of quantitative easing. David seems to think it worked. And his story for the absence of deflation seems to be in part that QE stopped it. But, he acknowledges Ben Bernanke's famous quote, "the problem with QE is that it works in practice, but it doesn’t work in theory." I'm reluctant to really believe anything works until we have at least a vaguely plausible understanding of how it works. Doctors believed in bleeding for a long time. One can see though how practical experience and academic reserve might differ here.