I think I understand better what my main problem is with this article now. The story in the beginning is about using a real good, food, more efficiently. This is clearly good. But finance is about using an unit of account more efficiently. This is good when saving money corresponds to wasting less of things that we care about for their own sake like people’s time or trees or food or clean water or air.
But sometimes dollar savings do not represent doing anything else more efficiently. MBS don’t use real things more efficiently to build houses. They are just a way for investors to pool financial risk. This makes it cheaper to borrow, if and only if you are doing the kind of thing that can be securitized: something that a lot of people are doing the same way, that Wall Street thinks it understands. It also makes the system more fragile by correlating risks.
If interest rates were not managed by central planners, this sort of program might lead to more real investment. But in our world, if financial innovation lowers borrowing costs in one area, an active central bank is likely to respond by raising interest rates. This would crowd out other kinds of investment.
This is why I think it is so important to distinguish between money and the real resources it stands in for. Financial engineering lowers the borrowing costs of large centrally planned investments, relative to small heterogeneous investments executed by small autonomous agents with local knowledge.
If interest rates were not managed by central planners, this sort of program might lead to more real investment. But in our world, if financial innovation lowers borrowing costs in one area, an active central bank is likely to respond by raising interest rates. This would crowd out other kinds of investment.
This seems very far from obvious and needs more explanation even if it’s true. Suppose that interest rates fell simply because people became more patient and intrinsically lowered their time discount. Would central banks raise interest rates and force the level of savings/investment back to previous levels? I think no, at least not in the long run, because central banks ultimately care about inflation, not interest rates, and if people lowered their time discounts and as a result shift resources from consumption to saving/investing, that shouldn’t cause more inflation at least not as a first order effect. Maybe the central banks would raise interest rates a bit to counteract some second order effects but we should expect to end up with an equilibrium with lower interest rates and more saving/investing then before.
It seems to me that if financial innovation made it easier or more efficient to pool and redistribute risk for investing in some sector, so as to better match the preferences of investors, the results of that would be similar to the above. We should end up with an equilibrium where some resources have been shifted from consumption to investment in that sector, and overall more saving/investing then before.
I think you’re right that my account is incomplete. Thanks for pointing that out. Possibly I was wrong to think central banking is even relevant here.
The direct consequences of MBS (or further financial engineering in that domain) is to simultaneously lower borrowing costs for home-buyers, and raise yields for debt similar to MBS. HIgher yields makes borrowing more costly for other ventures, before taking into account any action by a central bank.
We should also expect it to increase financial investment relative to consumption, but my understanding is that demand for financial savings is pretty inelastic on current margins, so I’d expect that to be outweighed by the inflationary effect of reduced borrowing costs for the debtors whose debts are being securitized.
In this new account though, shouldn’t we expect MBS to be a good thing overall (modulo the initial growing pains)? I mean, if you reduce the cost of anything by making it more efficient to produce, you will often cause more of that product or service to be produced, and resources to be shifted towards that sector, and that’s usually a good thing. If MBS makes it more efficient to coordinate between investors and home buyers, makes mortgages cost less, and shifts resources from other sectors (even if the shift is more from other investments than from consumption), why is that a bad thing?
I don’t see why I should expect real costs to be lower here.
In cases where there are real savings, it’s usually pretty easy to point to the kinds of resources being saved. Efficiency gains in real goods, such as just-in-time supply chains, allow for less warehousing of goods, which means we don’t need to make as much stuff, in order to have stuff when we need it. I think the burden of proof here is on the claim that the financial savings in financial engineering correspond to real savings on net.
This kind of financial engineering allows banks to do something closer to just-in-time lending, reserving less against losses—the effect should be similar to lowering reserve requirements for banks. But with a managed fiat currency, it doesn’t cost any real resources to warehouse money, so there are accounting savings due to MBS but no less actual stuff being moved around and consumed or people employed per house financed.
In a world that’s exogenously liquidity-constrained, financial engineering on MBS creates liquidity, which can be very good. IIRC the original MBS were a US government backed program to achieve specific policy goals (government-guaranteed assets for banks to hold, more liquidity in the housing market) without massive overt subsidies. In a highly regulated banking industry with a fiat currency like the current US (and to a lesser extent global) system, it’s not obvious that arbitraging slight inefficiencies there via financial engineering solved any real problem, while it very clearly created systemic risk.
Insofar as there are real rather than just nominal savings here, they’re lower transaction costs for consumers and risk-pooling for investors, at the expense of reducing skin in the game, offloading to the US government the tasks of oversight and maintaining the underlying trust that lets the system work. These costs aren’t accounted for financially, and offloading them to an entity that has little in the way of short-run competition and gets little short-run feedback on whether it’s doing a good job seems likely to erode the relevant institutions in the long run.
I’m not saying we should never take advantage of economies of scale. I’m saying that if participation in large-scale activities is massively subsidized e.g. by the state, it’s not clear that the financial savings from increasing dependence on that system are meaningful.
Ok, I think this story of why MBS might not be a good thing makes a lot more sense. The question then becomes, how good is the US government at picking policy goals that have more benefits than costs (including implementation costs and increased risks). If it’s not very good, then the existence of a highly developed financial industry might make things worse by tempting the government into adopting more bad policy goals than it otherwise would have (i.e., by providing the government with a tool that it thinks it can use to do good). Does this seem right to you, and do you see any other major critiques of the financial industry that doesn’t fall into this category?
I think this is the main problem. And for domains like finance that concentrate wealth a lot (enabling capture of the political decisionmaking system), the system has to be designed extremely well to avoid runaway alignment problems.
I think I understand better what my main problem is with this article now. The story in the beginning is about using a real good, food, more efficiently. This is clearly good. But finance is about using an unit of account more efficiently. This is good when saving money corresponds to wasting less of things that we care about for their own sake like people’s time or trees or food or clean water or air.
But sometimes dollar savings do not represent doing anything else more efficiently. MBS don’t use real things more efficiently to build houses. They are just a way for investors to pool financial risk. This makes it cheaper to borrow, if and only if you are doing the kind of thing that can be securitized: something that a lot of people are doing the same way, that Wall Street thinks it understands. It also makes the system more fragile by correlating risks.
If interest rates were not managed by central planners, this sort of program might lead to more real investment. But in our world, if financial innovation lowers borrowing costs in one area, an active central bank is likely to respond by raising interest rates. This would crowd out other kinds of investment.
This is why I think it is so important to distinguish between money and the real resources it stands in for. Financial engineering lowers the borrowing costs of large centrally planned investments, relative to small heterogeneous investments executed by small autonomous agents with local knowledge.
This seems very far from obvious and needs more explanation even if it’s true. Suppose that interest rates fell simply because people became more patient and intrinsically lowered their time discount. Would central banks raise interest rates and force the level of savings/investment back to previous levels? I think no, at least not in the long run, because central banks ultimately care about inflation, not interest rates, and if people lowered their time discounts and as a result shift resources from consumption to saving/investing, that shouldn’t cause more inflation at least not as a first order effect. Maybe the central banks would raise interest rates a bit to counteract some second order effects but we should expect to end up with an equilibrium with lower interest rates and more saving/investing then before.
It seems to me that if financial innovation made it easier or more efficient to pool and redistribute risk for investing in some sector, so as to better match the preferences of investors, the results of that would be similar to the above. We should end up with an equilibrium where some resources have been shifted from consumption to investment in that sector, and overall more saving/investing then before.
I think you’re right that my account is incomplete. Thanks for pointing that out. Possibly I was wrong to think central banking is even relevant here.
The direct consequences of MBS (or further financial engineering in that domain) is to simultaneously lower borrowing costs for home-buyers, and raise yields for debt similar to MBS. HIgher yields makes borrowing more costly for other ventures, before taking into account any action by a central bank.
We should also expect it to increase financial investment relative to consumption, but my understanding is that demand for financial savings is pretty inelastic on current margins, so I’d expect that to be outweighed by the inflationary effect of reduced borrowing costs for the debtors whose debts are being securitized.
In this new account though, shouldn’t we expect MBS to be a good thing overall (modulo the initial growing pains)? I mean, if you reduce the cost of anything by making it more efficient to produce, you will often cause more of that product or service to be produced, and resources to be shifted towards that sector, and that’s usually a good thing. If MBS makes it more efficient to coordinate between investors and home buyers, makes mortgages cost less, and shifts resources from other sectors (even if the shift is more from other investments than from consumption), why is that a bad thing?
I don’t see why I should expect real costs to be lower here.
In cases where there are real savings, it’s usually pretty easy to point to the kinds of resources being saved. Efficiency gains in real goods, such as just-in-time supply chains, allow for less warehousing of goods, which means we don’t need to make as much stuff, in order to have stuff when we need it. I think the burden of proof here is on the claim that the financial savings in financial engineering correspond to real savings on net.
This kind of financial engineering allows banks to do something closer to just-in-time lending, reserving less against losses—the effect should be similar to lowering reserve requirements for banks. But with a managed fiat currency, it doesn’t cost any real resources to warehouse money, so there are accounting savings due to MBS but no less actual stuff being moved around and consumed or people employed per house financed.
In a world that’s exogenously liquidity-constrained, financial engineering on MBS creates liquidity, which can be very good. IIRC the original MBS were a US government backed program to achieve specific policy goals (government-guaranteed assets for banks to hold, more liquidity in the housing market) without massive overt subsidies. In a highly regulated banking industry with a fiat currency like the current US (and to a lesser extent global) system, it’s not obvious that arbitraging slight inefficiencies there via financial engineering solved any real problem, while it very clearly created systemic risk.
Insofar as there are real rather than just nominal savings here, they’re lower transaction costs for consumers and risk-pooling for investors, at the expense of reducing skin in the game, offloading to the US government the tasks of oversight and maintaining the underlying trust that lets the system work. These costs aren’t accounted for financially, and offloading them to an entity that has little in the way of short-run competition and gets little short-run feedback on whether it’s doing a good job seems likely to erode the relevant institutions in the long run.
I’m not saying we should never take advantage of economies of scale. I’m saying that if participation in large-scale activities is massively subsidized e.g. by the state, it’s not clear that the financial savings from increasing dependence on that system are meaningful.
Ok, I think this story of why MBS might not be a good thing makes a lot more sense. The question then becomes, how good is the US government at picking policy goals that have more benefits than costs (including implementation costs and increased risks). If it’s not very good, then the existence of a highly developed financial industry might make things worse by tempting the government into adopting more bad policy goals than it otherwise would have (i.e., by providing the government with a tool that it thinks it can use to do good). Does this seem right to you, and do you see any other major critiques of the financial industry that doesn’t fall into this category?
I think this is the main problem. And for domains like finance that concentrate wealth a lot (enabling capture of the political decisionmaking system), the system has to be designed extremely well to avoid runaway alignment problems.