Arnold Kling  

Lectures on Macroeconomics, No. 9

Health Care, Education, Spendi... A Rating Agency Example...

The nonfinancial sector wants to hold risk-free short-term assets and issue risky long-term liabilities. To accommodate this, the financial sector does the opposite. If the financial sector suddenly contracts, the nonfinancial sector gets stuck with an asset mix that is riskier and more long-term than it wants and a liability mix that is less risky and shorter term than it wants. The reaction to this unwanted mix can cause a recession. That is how the financial sector affects the real economy.

Think of an economy where investment projects consist of fruit trees. It takes time for them to mature, and they are subject to risk, such as the risk of disease.

Other things equal, consumers would rather have riskless, short-term assets than shares in fruit trees. As a consumer, you might need money in a hurry. Or, you might not be able to deal with the loss of wealth that would come from disease ravaging fruit trees in your investment portfolio. Entrepreneurs, meanwhile, need long-term capital to back their fruit tree investments.

Ultimately, the market has to resolve the conflict between what Keynes saw as the propensity to hoard of consumers and what he called the animal spirits of the entrepreneurs. In the absence of financial intermediation, the growers of fruit trees have to persuade consumers to buy shares of stock in their enterprises. If consumers require a high expected return on these shares, then only a few fruit trees will be able to satisfy them. If they were willing to accept a lower expected return, then many more fruit trees would be profitable to plant.

Let us say that, given that consumers are wary of taking risk, the supply and demand for fruit tree investments are in balance when 100 fruit trees are planted. If fewer were planted, the expected returns would be so high that consumer would be willing to buy more shares in fruit trees. If more were planted, the expected returns would be so low that consumers would not be willing to hold shares in fruit trees.

Next, along comes a financial intermediary, which we will call a bank. Somehow (we'll explain the magic shortly), the bank holds fruit trees as assets and issues short-term, risk-free liabilities (demand deposits, also known as checking accounts). Consumers are much happier with demand deposits than fruit tree shares, so they put up a lot more wealth than they would if they had to invest in fruit trees directly. The bank invests this additional wealth in fruit trees, which causes the required return on fruit trees to go down. This results in more fruit trees being planted.

With a bank, let us say that the entrepreneurs are able to plant 500 fruit trees. Before the bank came along, there were 100 fruit trees, with the shares in the fruit trees making up the liabilities of the entrepreneurs and the assets of the consumers. With the bank, there are 500 fruit trees, with the shares in the fruit trees making up the liabilities of the entrepreneurs and the assets of the bank. Consumers' assets are demand deposits, which are the liabilities of the bank.

If consumers "see through" the bank, they will realize that their ultimate assets consist of shares in 500 fruit trees. They were not willing to hold that many shares before there was a bank, but now indirectly that is what they do hold.

How is the bank able to pull off this sleight-of-hand? On both sides of its balance sheet, the bank is using some combination of diversification, customer selection, and behavior modification.

Diversification means that the bank is counting on risks to be imperfectly correlated. For example, as a consumer, you have a risk that you will need your money to deal with a short-term crisis in your family, such as a medical emergency. The bank knows that, on average, only a fraction of its customers will be confronting emergencies. Perhaps on a typical day, 1 percent of customers need to withdraw their funds. On a really, really bad day, 10 percent of customers need to withdraw. So the bank decides to hold 10 percent of its deposits in a cash reserve, leaving the other 90 percent to invest in shares in fruit trees.

It is as if the consumers have gotten together and formed a mutual insurance company, under which they help each other out. When one consumer needs emergency funds, the others make the money available. Sooner or later, anyone is bound to have an emergency, but the emergencies do not all happen at once.

The bank could select its customers carefully. It might not want to have depositors who live hand-to-mouth and have a lot of money emergencies.

Diversification also works on the investment side. Suppose that fruit tree risk consists of "market risk" (the chance that every tree will be struck by disease) and "idiosyncratic risk" (risk that is specific to each fruit tree). For example, market risk could be 1 percent, meaning that there is a 1 percent chance that a disease will come along that damages every tree. Idiosyncratic risk might mean that each tree has a 20 percent chance of being struck by a disease that will not affect any other trees.

If you could only invest in one tree, then the risk of a damaged tree would be 1 percent plus 20 percent equals 21 percent, adding together market risk plus idiosyncratic risk. On the other hand, if you invest in two trees, then the chances of both trees falling to idiosyncratic risk is (0.2)(0.2) = 4 percent, so your risk of being totally wiped out is 1 percent + 4 percent = 5 percent. As the bank invests in more and more trees, the idiosyncratic risk gets smaller and smaller. Thus, the bank's assets, while not completely risk-free, get to be quite safe. Moreover, the bank can protect depositors against the nondiversifiable market risk by holding capital.

Another strategy for the bank is underwriting, which is customer selection on the asset side. Individuals find it very costly to examine the prospects for each fruit tree, so they have to take a very conservative view of investing in fruit trees. The bank has an experienced, professional staff to examine trees. (Or, if you will, think of a bank that makes mortgage loans, using a professional staff to evaluate the borrower's ability to repay and to appraise the home.; or think of business loans, with the staff evaluating the financial prospects of the business.) The skills and experience of its underwriting staff enable the bank to obtain shares in trees that have higher returns and lower risk than the trees that the average uninformed consumer could find to invest in.

Finally, the bank can use behavior modification. If it foresees a lot of demand for liquidity by its consumers, it can try to work with entrepreneurs to improve the short-term cash flows from the trees. On the consumer side, the bank can increase the penalties for sudden cash withdrawals and increase the rewards for consumers who maintain a high minimum balance in their accounts.

With all of these tools at its disposal--diversification, underwriting, and behavior modification--the bank works pretty well most of the time. When it works well, consumers develop confidence in the bank, and it is able to get by with greater leverage, meaning lower cash reserves and less capital.

Unfortunately, stuff happens. The bank may suffer a solvency shock, because of a really bad disease outbreak. Or, the bank may suffer a liquidity shock, because of an unusually high rate of withdrawals. It is easy imagine a slight solvency shock leading to a liquidity shock, because depositors may believe that the last one to withdraw will find that the bank is out of money.

If stuff happens, then the financial sector (the bank) will contract suddenly and sharply. This means that we no longer want 500 fruit trees, owned by a bank. Instead, the market tries to get down to a lot fewer fruit trees. Tobin's q, which is the price of a fruit tree relative to the cost of planting a fruit tree, goes way down. That tells entrepreneurs to stop planting fruit trees.

Reconfiguring the economy to plant fewer fruit trees and instead to do something else is a long, painful process. While fruit tree planters look for other jobs, they cut back on consumption, creating multiplier effects. The economy goes into recession. Eventually, after enough wage reductions and enough workers have changed occupations, the economy returns to full employment. But that can take a long time.

What can government policy do about this? That is a good topic for a later lecture.

Comments and Sharing

CATEGORIES: Macroeconomics

COMMENTS (9 to date)
TA writes:

This lecture, I think, has the seeds of brilliance. Let's have the next one.

blink writes:

I agree with TA that this is a great post. I think the end of the story is a bit ambiguous, though: Does "stuff" mean real effects, like the 1% disease? Can it include psychological factors? If so, could it be that reconfiguring to plan fewer fruit trees could actually be counter-productive?

Andrew Garland writes:

This is a clear, interesting article.

So, the bank fools many of its investors (depositors) into financing far more fruit trees than they would really like to, given their actual risk/reward and dividend preferences. By dividend, I mean that many depositors want a quick return, not the 10 year delay of the fruit trees.

The bank's depositors "other things being equal, would rather have riskless, short-term assets than shares in fruit trees." So, why will such people put their deposits into the bank? Only because the bank offers an FDIC deposit guarantee. The "taxpayers" are guaranteeing the accounts, and most of them are wealthier than the average depositor. As you say, when events are unlucky, the depositors need their money and can't afford to finance the fruit trees. Then, the wealthier taxpayers are put on the hook supplying capital at a low rate of return, or even as a gift, to make up the loss when the bank is forced to sell the then low-valued fruit trees.

The banks are supposed to be paying premiums for this deposit insurance, but the insurance rate is set by a biased government, and we don't know what the market rate would be. Even if the insurance fee is at market rate, "taxpayer insurance" is absolute, so no depositor has to evaluate the risk.

Why should we be arranging all of this complexity? It is not clear to me that the profits earned by the bankers and tree growers outweighs the losses to the taxpayers that occur when there are tree diseases and recessions. Even if there is a positive net result, profits are not going to the groups that are supplying the guarantee, only the losses.

"In the absence of financial intermediation, the growers of fruit trees have to persuade consumers [investors] to buy shares of stock in their enterprises." This is exactly as it should be. The number of trees planted would correspond to the actual capital available, with eyes open to the risks, returns, and dividend period. That rate of return would be higher than the "riskless" rate charged by the bank and depositors.

We would still see financing of fruit trees with diversification of risk, but it would be through funds rather than banks, without public guarantees.

Currently, the banks can outbid the taxpayers (wealthier people) who are guaranteeing the investment. The banks are using the capital of the taxpayers for their deposit guarantee, then demanding a lower rate of return on the investment than those taxpayers would do privately. The banks win out, the taxpayers are deprived of the private profits that they should get, and the depositors (and everyone else) are subjected to recession shocks where they have to change jobs and suffer fruit tree price losses.

The banks get a sweet deal, paid by the taxpayers, and assets are misallocated, causing periodic realignments called recessions.

Grant writes:

Simple and informative, thank you Arnold.

Reconfiguring the economy to plant fewer fruit trees and instead to do something else is a long, painful process. While fruit tree planters look for other jobs, they cut back on consumption, creating multiplier effects.
This is where I'm semi-disagreeing. I know they sometimes yell it from the rooftops, but I think Austrians could stress this point more: Consumers cut back on current consumption in favor of later consumption. Obviously a massive, unexpected shift in time-preference (as we see in recessions) would cause the economy to reconfigure itself even without a housing bubble or large financial firms failing.

So we know reconfiguration is costly, and shifts in time-preference require reconfiguration. But shifts in time-preference can also be totally rational (e.g., college suddenly becomes more expensive, or someone cures aging so people no longer save for old age). Are shifts in time-preference during recessions irrational? If consumption habits didn't shift with time-preference, would the economy be able to deliver what was desired of it? Where does the multiplier effect fit in?

Bill Woolsey writes:

This story includes base money. The banks are holding fractional reserves of it. The recession is triggered by an increase in the demand for it by the nonfinancial sector.

Does the market for base money clear? What happens to the quantity of base money? Does the price level adjust so that the real quantity of base money equals the increased real demand? What happens if prices are sticky?

The story about fruit trees and fruit might be interesting. And that people don't want to hold fruit trees because of a change in risk preference (or perception) certainly seems possible.

And that this might result in an increase in the demand for base money is plausible enough. But then what?

This story appears to have people equate holding base money with not spending on anything, and then "recovery" requires that fruit tree growers now produce some other good. The possibility of changing the nominal quantity of base money, or the role of the price level in clearing the market for base money is missing.

And, by the way, medical emergencies require what? Fruit? Or some other good that we are forgetting?

The basic insight of Say's law is that people sell in order to buy, but always remember that people can "buy" money--accumulate money balances. Walras' law is that the sum of the excess demands must be zero. A shortage of money must be matched by surpluses of other goods. A net surplus of all goods other than money must be matched by a shortage of money.

If you assume there is no shortage of money, the sum of the excess demands for everything else must equal zero. We can have a surplus of some goods, but it must be matched by shortages of other goods. In my view, this matching of surpluses and shortages is the key characteristic of macroeconomic equilibrium. The movement of resources from less values to more valued uses (from surpluse to shortage sector) is what microeconomic equilibrium is all about.

When we only have fruit trees and fruit, it is hard to show a change in the composition of demand requiring ajustment between sectors of the economy where the shrinking sectors can shrink faster than the growing sectors can grow. This would be a situation where current output would shrink and only recover as the sectors with increased demand being able to expand output.

While there may be multiplier effects in shrinking sectors, there are opposite effects in growing sectors. But these effects involve changes in spending. What is happening to the supply, and especially the demand, for money?

An interesting story is similar to that told by Hayek. People want more fruit and less fruit trees. We know that this unwillingness to hold fruit trees is going to result in less fruit in the long run. Given appropirate ceteris paribus assumptions, real income has to fall.

Or, perhaps, because todays income depends on the amount of fruit the trees are expected to generate in the future, if that new variety of trees doesn't generate the extra fruit expected, then people are poorer now. Real incomes must fall now. (Can a speculative bubble create this effect--I think so.)

However, if growth rate of nominal income is targeted (I rather like final domestic sales) then these even if real incomes must fall, this would occur in the context of nominal incomes growing more or less like usual, and inflation to a somewhat higher price level. Fruit is more harder to come by, so its price rises.

While there can always be an inability to sell in some some sectors, there will be other sectors where production is inadequate. With nominal income (or final sales) targeted, the shortage sectors have higher prices, and the price level rises, and then gently falls as these sectors with increased demand can expand production.

But, of course, what if nominal income grows below target--or shrinks. Why would that happen? Well, yes.. because the demand for base money grows faster than the supply.

In an extreme case, this requires everyone to lower their prices. That includes resource prices--nominal incomes.

The market signal that people generally get that they need to lower prices is that they can't sell as much as they would like at current prices.

That means surpluses pretty much accross the board. Usually, the proper response to a surplus caued by reduced demand is to cut production and lower prices (becaues this usually is a signal that production is too high in a particular sector.)

But, if the problem is a shortage of base money, everyone needs to adjust their nominal prices (and incomes) down to clear that market. I am not surprised that falling demand across the ecnomy is assocated with reduced production and employment acresso the economy, even if the correct "market adustment" is for a delfation of prices and nominal incomes with production and employment remaining unchanged.

Krugman is claiming that we are now, or soon to be in a liquidity trap so that the demand for base money is effectively infinite. No decrease in the price level or increase in the quantity of bse money could meet that demand. The only answer, then, is for government to spend more. I don't think it is plausible.

Where is this in this story about banks and fruit trees? A story about how the demand for base money could increase. A good start.. but it is only there that the key issues of macroeconomics start.

Identifying the demand for base money as "not spending".. I think that is horribly naive.

Pietro Poggi-Corradini writes:

It sounds like banks are playing the role of experts and that trust in these "experts" is essential for a functioning system. To solve a similar problem in the market-place of ideas people have suggested the use of prediction markets. I wonder then if banks should make more use of prediction markets and become, in a sense, more transparent.

winterspeak writes:


I'm disappointed in this post. In your model, banks are inherently unstable. They *will* fail as a certainty.

"If it foresees a lot of demand for liquidity by its consumers, it can try to work with entrepreneurs to improve the short-term cash flows from the trees. On the consumer side, the bank can increase the penalties for sudden cash withdrawals and increase the rewards for consumers who maintain a high minimum balance in their accounts"

And how do they manage any of that? Tell customers "no, you cannot have your money because because someone else asked for theirs first and we cannot satisfy you both"? Why not just put up a big sign that says "please run on me"?

fundamentalist writes:

Kling: “Unfortunately, stuff happens.”

This is a very good analogy. It explains a great deal of what has happened in this particular crisis. But it lacks something in its ability to generalize to all financial crises. Questions I would ask are why do these things, the “stuff”, happen? And why do they happen on a regular basis? The disease outbreak is understandable. We have had many crises in the past related to weather, crop disease (the Irish potato famine) and war. We understand those. What we don’t understand is why crises happen when those things don’t occur. Why would banks suffer an unusually high rate of withdrawal? Why are the crises occur so regularly over the past 300 years?

The Austrian answer to these might be that when the bank issued loans to growers it issued too many and as a result, growers planted too many trees and produced more fruit than consumers wanted. Or more accurately, they produced too much of a particular fruit. The growers who produced the unwanted fruit went broke and defaulted on their loans. The loss of revenue from those growers cut into the bank’s ability to pay depositors who wanted to withdraw money.

Another scenario might be that the expansion in the number of fruit trees took too long to produce fruit. The bank has loaned out the money, but it might take ten years for some growers to get a harvest and have revenue to repay the loan. Meanwhile, customers are still demanding money from the bank to pay bills and cover emergencies.

Here’s another scenario. First, we’ll have to disaggregate the economy. Instead of just fruit growers who also sell their fruit, let’s assume that we have some companies that plant and grow the fruit, others that specialize in harvesting, and still others that process and sell the fruit retail. Some companies may be fully vertically integrated while others specialize.

The economy is in equilibrium at 100 trees when the bank issues loans to growers to plant 400 more trees. Say it takes five years for the newly planted trees to produce a crop for sale. Now the fruit growers employee idle workers to plant the trees and unemployment drops. Suddenly the demand for fruit surges because more workers are chasing a fixed amount of fruit produced by the original 100 trees. The price of fruit goes up and profits in the retail and processing industries soar. As a result they demand more labor and unemployment falls further. This is the boom stage.

Meanwhile, profits in the planting and growing industries remain flat or fall because they still have not seen an increase in crops to sell (they’ll have to wait another 3-4 years) and they have to make payments on the loans. Higher profits in the processing and retail sectors mean that the owners switch investments from the planting of trees to the processing and retailing segments. As a result, many of those workers who used to plant trees become unemployed. In a perfect economy, those workers would find employment in the processing and retailing sectors that have experienced increased demand, but in the real world, the skills needed for planting are too different from those needed for processing, so the unemployed growers remain unemployed. This is the beginning of the downturn.

The downturn gets worse because the demand for more labor in the processing/retail sectors has caused wages to rise relative to output and profits to fall. And the increased unemployment in the planting sector reduces demand for fruit, so revenue falls and further squeezes profits. In response, the processing/retailing sector gets rid of its second shift and overtime pay. This further reduces demand for fruit. Now the economy has hit bottom.

floccina writes:

The way that I see it is that having fractional reserve/maturity transforming banks might be a net positive if people are less risk taking than is optimal. This is because banks can hide the true risk for a very long time.

Other comments:

Today we have the ability through mutual funds markets to engage in various age trees. So the tree planter does not need to hold to maturity. In fact agricultural markets amaze me in this regard. Nursery men start trees and pass them on to people who may grow them 2 more years and then sell them and on. Some people have cow and cafe operations and sell the caves others, who hold them for a year and sell them to a feed lot. The specialization is amazing.

As real interest rates have been falling since the industrial revolution IMO it should get to the point where it is less efficient to use banks because the overhead of the bank takes up a bigger percentage of loan’s yield. E.G. if I want to retire in 20 years and so I have money to lend for 20 years, I can make more money holding the mortgage on my children’s homes than I can investing and they can pay a lower rate on the loan despite the fact the bank pays no interest on the money that they loan. Also with mass communication bond funds can out yield banks even while explaining the bond assets to millions of investors. So, I am thinking that banks are becoming less important.

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