Debt & Disequilibrium

UFM Market Trends

Guatemala 23 March 2017

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Alejandro Jenkins

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Les querelles ne dureraient pas longtemps, si le tort n’était que d’un côté.

– La Rochefoucauld, maxime 496

UsuryDa queste due,* se tu ti rechi a mente lo Genesì dal principio, convene prender sua vita e avanzar la gente; e perché l’usuriere altra via tene,per sé natura e per la sua seguace dispregia, poi ch’in altro pon la spene.

– Inferno XI * (natura e arte)

• Weber: prevalence of debt slavery → Abrahamic prohibition of interest

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Dalí, The Usurers (1951-60)

Interpretations of the Great Depression

• Hayek: monetary expansion induced malinvestment

• Keynes: excessive saving depressed aggregate demand

• Schumpeter: adjustment of the market to technological change and other exogenous shocks

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Great Depression, cont.• Fisher: debt need not be

macroeconomically neutral

• Schumpeter, Friedman, Tobin: “greatest economist the US has ever produced”

• Smith: “A student once asked Leontief why there was no Fisherian school. Leontief said: ‘He wrote too clearly’.”

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Irving Fisher (1867-1947)

Vernon L. Smith (n. 1927)

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Rien ne persuade tant le gens qui ont peu de sens, que ce qu’ils n’entendent pas.

– Retz, Mémoires III

Equilibrium• In microeconomics, efficient outcome is one in

which all possible gains from voluntary exchange are realized

• No one could be better off without making another worse off

• Also Pareto optimality or, in a pricing context, general equilibrium

• Refers only to exchange

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Equilibrium, cont.• Worked out by Fisher,

Samuelson et al. by analogy with thermodynamic equilibrium

• Directly influenced by statistical mechanics of Willard Gibbs (1839 - 1903)

• Arrow-Debreu welfare theorems (1951, 59) assume complete markets & perfect information

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Assets• Consumption market: good or

service exchanged once (e.g., hamburgers, haircuts)

• Asset market: same good exchanged many times (e.g. capital stock, real state)

• Bachelier (1900), Mandelbrot (1963) & Samuelson (1965) showed the efficiency asset prices follow random walks (sub-martingales)

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Assets, cont.• Smith et al. find experimentally

that consumption markets equilibrate very robustly

• Not the case for assets

• Debate on asset market efficiency reflected in 2013 Nobel Prize for Fama, Hansen & Shiller

• In an efficient asset market, risks would be correctly estimated

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Fuente: http://www.uchicago.edu/features/what_makes_nobel_speeches_endure/

Modigliani-Miller (1958)• In equilibrium, firm’s value must be independent of its

capital structure

• Investor could cancel her share of the firm’s debt with money borrowed on her own account, without gaining or losing anything (no arbitrage)

• “In retrospect, it is clear that macroeconomists —both inside and outside central banks— relied too heavily during that period on variants of the so-called Modigliani-Miller theorem, an implication of which is that the details of the structure of the financial system can be ignored when analyzing the behavior of the broader economy.” – Ben Bernanke, 2013

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Monetary paradox• Friedman rule: in equilibrium, private opportunity cost

of holding liquidity should equal social cost of providing it

• Cost to central bank of providing liquidity is negligible

• → optimum would be 0% nominal rate on riskless bond

• → deflation equal to real interest rate

• Not even Friedman took this seriously as policy (cf. his “k-percent rule”)

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My pulse, as yours, doth temperately keep time, And makes as healthful music: it is not madness

That I have utter’d. – Hamlet III, 4

• “If statistical observation leads us to believe that a given magnitude varies periodically, and if we look for the cause of those oscillations, we may suppose that that magnitude executes either

• (a) forced oscillations, or

• (b) self-oscillations, which may be either sinusoidal [weakly nonlinear] (bα) or of relaxation type [strongly nonlinear] (bβ).”

- Econometrica 1, 328 (1933)

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Self-oscillation

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http://www.youtube.com/watch?v=eAXVa__XWZ8

Credit: M. de Pablo

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• AJ, “Self-Oscillation”, Phys. Rep. 525, 167 (2013), [arXiv:1109.6640 [physics.class-ph]]

• Micro-dynamics of markets totally different from physical systems

• …but uses & limitations of macroscopic equilibrium have similarities in statistical mechanics and economics

• AJ, “Towards a Microeconomic Theory of the Finance-Driven Business Cycle”, Laissez-Faire 42, 12 (2015) + refs.

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https://arxiv.org/abs/1312.0323

Edward Hopper, The “Martha KcKeen” of Wellfleet, oil on canvas (1943)Museo Thyssen-Bornemisza, Madrid

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Rayleigh - van der Pol

10 20 30 40 50 60 t

-2

-1

1

2V

V (0) = 0.1 , V̇ (0) = 0

10 20 30 40 50 60 t

- 3

-2

-1

1

2

3

4V

V (0) = 4 , V̇ (0) = �4

V̈ � 0.2�1� V 2

�V̇ + V = 0

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Relaxation

5 10 15 20 25 30 t

-2

-1

1

2V

V (0) = 0.1 , V̇ (0) = 0

5 10 15 20 25 30 t

-2

-1

1

2

V

V (0) = 2.2 , V̇ (0) = �12

V̈ � 5�1� V 2

�V̇ + V = 0

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Macro models• Linearly unstable relation between income,

capital & investment introduced in 1930s by Kalecki, Hansen & Samuelson

• Non-linear models with relaxation limit cycles by Goodwin, Kaldor, Hicks, et al.

• Lucas critique: anticipation of a regular cycle would make it go away

• Is business cycle efficient?

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Bubbles• Self-driven, but unsustainable, rise in asset price

• V. Smith et al. easily generate bubbles in controlled experiments, even with experienced traders

• Max Weber on Mississippi & South Sea Co. bubbles (1710s): “can be explained only by the fact that short selling was impracticable, since there was as yet no systematic exchange mechanism” (General Economic History, 1923)

• Incompleteness may persist in finance

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Relaxation oscillations are commonplace not only in physics, but also in physiology (heart beats) and economics (business cycles) as well. In fact, the expression ‘history repeats itself’ is probably a description of a large-scale integrated relaxation oscillation phenomenon.

– Sargent, Scully & Lamb, Laser Physics (1978)

Ingredients1. Leverage cycle

2. Liquidity crisis (financial panic)

3. Debt deflation

4. Debt overhang & flight to quality

5. Household deleveraging & liquidity trap

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Leverage cycle

• John Geanakoplos (2010): market determination of leverage for buying an asset on credit, as in mortgage

• More leverage allows more optimistic investors to set price

• Higher asset price improves collateral, promoting credit

• Positive feedback between leverage and price24

leverage =

(purchase value� down payment)

down payment

Leverage, cont.• Credit default swaps (CDS)

complete market by allowing pessimist to leverage their bets.

• CDS standardized for US secondary housing market towards the end of 2005

• see The Big Short

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Information• Optimism & pessimism wouldn’t exist under perfect

info.

• Hayek, Stigler, et al. stressed that economically relevant info. is not given, but emerges through market process

• Absence of CDS pre-2006 relevant not just as incompleteness per se

• Prevented info. held by pessimist potential investors from being incorporated into asset prices in a timely way

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Liquidity crisis• Bubble followed by rapid fall in asset prices

• Widespread defaults among leveraged buyers

• Losses to banks, which also carry asset in their balances

• Depositors withdraw funds, forcing hasty liquidations (fire sale)

• Asset prices fall further; financial institutions may grow illiquid

• Financial panic: joint defaults, counterparty credit risk, etc.

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Debt overhang• Borrowers end up as owners of depressed asset; lenders end up

as owners of debt

• Wealth transfer from net borrowers (‘households’) to net lenders (‘banks’)

• Fisher: net lenders have lower marginal propensity to consume

• Smith: borrowers may end up with negative equity (‘underwater’)

• → households can’t enjoy most of their new income

• Principal-agent problem between banks and households causes investor’s flight to quality

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Debt deflation• Fractional reserve banking

causes spike in demand for liquidity to contract monetary supply (money’s ‘perverse elasticity’)

• Deflation aggravates debt overhang

• Can be combatted by increased supply of liquidity (quantitative easing)

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(1936)

Keynesianism• Debt overhang and principal-agent problem could

help explain Keynes’s excessive saving

• Underwater households can’t spend or invest at normal levels

• → fall in aggregate demand

• Money paid to households goes quickly to bank

• Bank won’t lend back while household is underwater → liquidity trap

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Keynesianism, cont.• Inflation relieves debt overhang, but has other

undesirable consequences

• Government’s deficit spending even more problematic

cf. Eggertsson & Krugman (2012)

• Wiping out savers harmful in the long run, even if it relieves crisis

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Source: S. D. Gjerstad y V. L. Smith, Rethinking Housing Bubbles (Cambridge U. P., 2014), p. 258

Statistical mechanics• Theoretical physics suffers very analogous blind spot

• ‘Non-equilibrium thermodynamics’ usually focused on stochastic fluctuations about equilibrium

• Mostly fails to describe dynamics of engines (self-oscillators)

• Engines are powered by external gradient of temperature or chemical potential

• e.g., life on Earth maintained by temperature difference between Sun’s surface (6,000 K) & Earth’s surface (300 K)

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Debt dynamics• People save some of their income, even at negative rates

• Banks exist because of info. problems in finding efficient use for these savings

• Fisher & Rothbard’s mistake: Equilibrium yield curve (rate v. term) not determined by deposit contracts alone

• There’s usually scope for arbitrage of terms

• i.e., pay low rate on short-term deposit one expects to be renewed, while lending out that money at higher rates and longer terms

• Why free markets disfavor 100% reserve banking

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Debt dynamics, cont.• Maturity mismatch makes liquidity crises possible,

but it’s partly a free-market phenomenon

• Financial markets probably remain far from equilibrium

• This may explain many macroeconomic paradoxes

• Yield curve doesn’t translate into structure of production (Hayek’s mistake)

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Sustained non-equilibrium• Savings analogous to

reservoir of chemical energy in biological cell

• E. Moreno: “the economy is alive”

• No savings → no business cycle

• but also far lower living standard!

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Confusion’s cure lives not in these confusions

– Romeo & Juliet IV, 5

Outlook• Post-2007 policies have responded only to liquidity

crisis & debt deflation (monetarism)

• Slow deleveraging of households has depressed consumption & investment

• Worsened in Spain by “personal collateral” for residential mortgages

• Uncertainly about regulatory, monetary, and fiscal policies obstructs voluntary debt-relief negotiations

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Outlook, cont.• Bailing out “solvent but illiquid” financial institutions

involves grave risk of corruption

• e.g., deep & long-lasting damage to efficiency of Japanese banking post-1992

• Monetary expansion (zero interest, quantitative easing) meets banks’ elevated liquidity demand

• Inflation & deficit spending weakly focused on problem of underwater households, while involving grave unintended consequences

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Solutions• Regulate leverage? (Geanakoplos)

• Universalize margin requirements? Smith justifies it as defining property rights when betting with others’ money

• Simply completing financial markets?

• Shouldn’t be so much harder to bet against asset

• Smith: Owners of bad debts should face ‘haircuts’

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