Dudley and Hubbard: Some Greatest Hits

Entering August 2011 we're still suffering through the aftermath of the financial crisis of 2007-2008. Indeed, we may not yet have seen the worst of it. Economies around the globe are suffering, millions are unemployed. Europe, the US, Japan seem to be competing to see who has the biggest problems.

So I thought it might be interesting -- or at least perversely entertaining -- to look back to the rosy days, before the crisis, when our wise academic economists and bankers were telling us how great things were going, mostly because of the wonders of modern financial engineering. Good examples can be found in thousands of reports and academic papers, but I chose a report issued in November 2004 and co-authored by economists R. Glenn Hubbard of Columbia University (formerly an economic advisor to the president) and William Dudley, then at Goldman Sachs and now, post-crisis, acting head (wouldn't you know!) of the Federal Reserve Bank of New York.

The report was happily entitled "How Capital Markets Enhance Economic Performance and Facilitate Job Creation." It is overflowing with wisdom and comforting messages about the nature of global capitalism and the manifold benefits that necessary accrue from vibrant capital markets.

Some highlights follow (anything in bold is my own emphasis). First, in an overview section:

"The ascendancy of the US capital markets — including increasing depth of US stock, bond, and derivative markets — has improved the allocation of capital and of risk throughout the US economy. ... The same conclusions apply to the United Kingdom, where the capital markets are also well-developed."

The consequence has been improved macroeconomic performance. ... Because market prices adjust instantaneously to new information, the development of the capital markets has introduced new discipline into policymaking.

The development of the capital markets has provided significant benefits to the average citizen. Most importantly, it has led to more jobs and higher wages.

The capital markets have also acted to reduce the volatility of the economy. Recessions are less frequent and milder when they occur. As a result, upward spikes in the unemployment rate have occurred less frequently and have become less severe.

The development of the capital markets has also facilitated a revolution in housing finance. As a result, the proportion of households in the US that own their homes has risen substantially over the past decade."

The two economists go on to argue for each of these points in some detail. To begin with, they point out that in the US and UK the financial markets have grown to take over much of the lending previously done by banks, especially when compared to other still bank-centric nations such as Germany or Japan. They then ask (and answer) the question: "Why are the UK and US ahead?":

"The shift from depository institution intermediation to capital markets intermediation appears to be driven mostly by technological developments. Computational costs have fallen rapidly. As technology has improved, information has become much more broadly available. This has improved transparency. As this has occurred, depository institutions have lost some of their ability to charge a premium for their intermediary services. Often, borrowers and lenders interact directly, as they find that the lender can earn more and the borrower can pay less by cutting out the depository intermediary as a middleman."

In short, it seems that the UK and US have simply let the free market work, and used technology to set it free. As a result, they've gained the benefits of more efficient allocation of capital from savers to borrowers, driving the beneficial advance of business and technology. At the same time, the authors note, the increased role of financial markets - especially through the derivatives markets -- has reduced risks:

...the development of the capital markets has helped distribute risk more efficiently. Part of the efficient allocation of capital is the transfer of risk to those best able to bear it — either because they are less risk averse or because the new risk is uncorrelated or even negatively correlated with other risks in a portfolio. This ability to transfer risk facilitates greater risk-taking, but this increased risk-taking does not destabilize the economy. The development of the derivatives market has played a particularly important role in this risk-transfer process.

Dudley and Hubbard cite several sources of data to support these claims -- such as higher returns in US and UK markets in recent years in comparison with Japanese or European markets. Also, they point to the apparently improved stability of the US banking system:

The rapid development of the capital markets over the past decade also appears to have made the US banking system more stable. ... As shown in [the figure below, Exhibit 6 from the paper], only 16 US commercial banks failed during the 2001-2003 period. Moreover, these banks were small, accounting for less than $3 billion in total assets. In contrast, at a comparable point in the business cycle in 1990-1992, 412 commercial banks failed, with assets totaling over $120 billion.

As mentioned above, the authors attribute this dramatic improvement in banking stability to the increased use of derivatives. In particular, they point out, the use of credit derivatives such as credit default swaps (CDS) has had marked beneficial effects on stability:

Credit derivative obligations have become an important element that has helped protect bank lending portfolios against loss. These instruments allow a bank to obtain protection from a third party against the risk of a corporate bankruptcy. This protection allows the bank to continue to lend. At the same time, the bank can limit its credit exposure to individual counterparties and diversify its credit exposure across industries and geographically. The decline in banking failures is evidence that derivatives have helped to distribute risk more broadly throughout the economy.

Finally, all this together has led to overall better macroeconomic performance and stability. The authors argue how this has played out in three significant ways:

First, because the capital markets use mark-to-market accounting, it is more difficult for problems to be deferred. As a result, pain is borne in real time, which means that the ultimate shock to the economy tends to be smaller. In contrast, when depository institutions get into trouble as a group, the pressure for regulatory forbearance increases. Deferral causes the magnitude of the problem to increase. Usually — as can be seen with the US saving and loan crisis and in the case of Japan’s decade-long banking crisis — this forbearance just creates a much bigger problem that poses a greater threat to macroeconomic stability.

In other words, the capital markets have made it much more unlikely to encounter large economic or financial crises, because they act rapidly to keep things in balance. They go on:

Second, by providing immediate feedback to policymakers, the capital markets have increased the benefits of following good policies and increased the cost of following bad ones. Good policies result in lower risk premia and higher financial asset prices. Investors are supportive. Bad policies lead to bad financial market performance, which increases investor pressure on policymakers to amend their policy choices. As a result, the quality of economic policymaking has improved over the past two decades, which has helped improve economic performance and macroeconomic stability.

Third, in the United States, the capital markets have helped make the housing market less volatile. With the development of a secondary mortgage market and the elimination of interest rate ceilings on bank deposits, “credit crunches” of the sort that periodically shut off the supply of funds to home buyers, and crushed the homebuilding industry between 1966 and 1982, are a thing of the past. Today, the supply of credit to qualified home buyers is virtually assured. The result has been to cut the volatility of activity in the economy’s most interest-sensitive sector virtually in half. This change is a truly significant improvement, because it means that the economy’s most credit-sensitive sector is now more stable.

One sentence in that last paragraph deserves repeating as it rises almost to the level of poetry:

...“credit crunches” of the sort that periodically shut off the supply of funds to home buyers, and crushed the homebuilding industry between 1966 and 1982, are a thing of the past.

To be fair I should mention that Dudley and Hubbard did mention Warren Buffet's famous warning that derivatives were "weapons of mass destruction," although they set it off against Alan Greespan's infamous reassurances that the market could be trusted to eliminate any real dangers. They sided with Greenspan.

To be fair also, I should also say that everyone makes mistakes. I assume Dudley and Hubbard wrote everything they did in good faith, based on their true belief that capital markets really are automatically efficient and stable. Just because the paper was a publication of the Goldman Sachs "Global Market Institute" doesn't necessarily mean it was intentionally manufactured as an advertisement for all the things Goldman Sachs and other financial firms do.