Robert E. Lucas and Nancy L. Stokey have a lovely readable article in the June 2011 issue of The Region, published by the Federal Reserve Bank of Minneapolis, on "Liquidity Crises." The paper offers a readable overview that connects the main themes of high-profile academic theory papers in this area to what actually happened. A few highlights:
"Any one bank, no matter how large and respected, can go out of business almost without a ripple. Anyone living in an American city can list the downtown banks he grew up with that vanished in the merger movement of the 1990s. Who misses them? Indeed, who misses Lehman Brothers, for generations one of the most respected financial institutions in the world? Its valuable assets, both physical and human capital, were quickly absorbed by surviving banks without notable loss of services. It was the signal effect of the Lehman failure, whether a signal about the situations of private banks or about the Federal Reserve’s willingness to lend to troubled banks, that triggered the rush to liquidity and safety that followed."
"We will argue here that what happened in September 2008 was a kind of bank run. Creditors of Lehman Brothers and other investment banks lost confidence in the ability of these banks to redeem short-term loans. One aspect of this loss of confidence was a precipitous decline in lending in the market for repurchase agreements, the repo market. Massive lending by the Fed resolved the financial crisis by the end of the year, but not before reductions in business and household spending had led to the worst U.S. recession since the 1930s."
"As deposits moved out of commercial banks, investment banks and money market funds increasingly provided close substitutes for the services commercial banks provide. Like the banks they replaced, they accepted cash in return for promises to repay with interest, leaving the option of when and how much to withdraw up to the lender. The exact form of the contracts involved came in enormous variety. In order to support these activities, financial institutions created new securities and new arrangements for trading them, arrangements that enabled them collectively to clear ever larger trading volumes with smaller and smaller holdings of actual cash. In August of 2008, the entire banking system held about $50 billion in actual cash reserves while clearing trades of $2,996 trillion per day. Yet every one of these trades involved an uncontingent promise to pay someone hard cash whenever he asked for it. If ever a system was “runnable,” this was it. Where did the run occur?"
Lucas and Stokey answer that the run occurred in repo markets, and offer an intriguing table that shows while cash, private demand deposits, and money market funds all had more money in January 2009 than they had in January 2008, repo contracts held by primary dealers dropped substantially.
The Council of Economic Advisers has a short summary of "U.S. Inbound Foreign Direct Investment." This seems to be defined in the report as "U.S. affiliates of foreign-domiciled corporations." I see a lot of commentary that mentions foreign ownership of U.S. portfolio assets, like U.S. Treasury bonds, but much less on FDI in the United States.
The CEA says: "The United States continues to receive the most foreign direct investment (FDI) of any country in the world. ... U.S. “majority-owned” affiliates of foreign corporations owned $11.7 trillion in U.S.
assets and had $3.5 trillion in annual sales in 2008, according to the most recently available data from the Bureau of Economic Analysis. Their value-added production within the United States was $670 billion in goods and services, which accounted for 5.9 percent of total U.S. private output. These firms employed 5.7 million U.S. workers, accounting for 5.0 percent of employment in the U.S. private workforce. ... The U.S. affiliates of multinational companies are typically high-productivity firms that are major private-sector contributors to national efforts to innovate and build."
Here's a bar graph putting the activities of U.S. affiliates of foreign corporations in the context of the U.S. economy.
Here's a figure showing stocks of inbound FDI, where the U.S. clearly leads the world by a lot. It also shows the Foreign Direct Investment Restrictiveness Index from the OECD. The U.S. isn't much above the OECD average on this restrictiveness index, but it's interesting to me that it is above the average at all.
A couple of days ago, I posted about consequences of restricting payday lending, and how it serves as a modern example of the impulse that once produced usury laws. Payday loans charge a "fee," rather than "interest." But historically speaking, actual term for "interest" on a loan grew out of fees. Joseph Persky explained this point in an article in my own Journal of Economic Perspectives a few years ago: "Retrospectives: From Usury to Interest."
Joe wrote: "Canon law in the Middle Ages forbade usury, which was generally interpreted as a loan repayment exceeding the principal amount. Our modern word “interest” derives from the Medieval Latin interesse. The Oxford English Dictionary explains that interesse originally meant a penalty for the default on or late payment of an otherwise legitimate, nonusurious loan. As more sophisticated commercial and financial practices spread through Europe, fictitious late payments became an accepted if disingenuous way of circumventing usury laws. Over time, “interest” became the generic term for all legitimate and accepted payments on loans."
One of the big trends in modern banking and finance it seems to me, is a move toward making a greater share of revenues based on fees. Whether it is fees for bank overdrafts, making a late payment on a bill, going over your credit card limit, the example of payday loans in my earlier post, or in a number of other ways, many of us tend to accept as reasonable a level of "fees" that we would find intolerable if they were phrased in terms of an annual rate of interest being charged.
Kochar writes: "The recovery from the Great Recession is the first since 1970 in which women have lost jobs even as men have gained them. ...It is not entirely clear why men are doing better than women in the current recovery....The more notable developments are that men have found jobs in sectors where women have not, and that men made stronger advances than women in other sectors."
The Philanthropy Action website has an extended interview with Abhijit Banerjee and Esther Duflo. "Over the course of the interview we discuss microcredit, microenterprise funding and growth, labor markets in developing and developed countries, the evidence for focusing on women and girls with aid programs, the debate over RCTs [randomized controlled trials] and how they think about their own impact on changing the world." I found their thoughts about the crisis in microfinance, and how microfinance institutions get 90% repayment rates, to be especially provocative.
Esther Duflo: The Grameen Bank has been around for many many years and their loans are still very very small. Just forget about subtle impact evaluation or whatever; it’s been staring us in the face that these businesses are not growing, and the vast majority of people are not growing out of poverty or anything like that. If we had not been obsessed by the romantic idea of microcredit then maybe there would have been an earlier realizing of what microcredit does and what it doesn’t do. I think people are coming to that, to a small extent maybe because of our work stirring the pot. To be honest, it maybe would have happened anyway. But there’s been a lot of delay given that the facts were pretty obvious. Abhijit Banerjee: I just gave a talk at the World Bank on exactly this topic. The crisis in microfinance is a result of the 3 C’s: credulity, cupidity and corruption. The politicians were corrupt, we were all credulous, and the microfinance people were greedy. Put them together and you get the crisis. Our credulity was significant. Somehow we believed that all repayment happens in microfinance due to some magic which made no economic sense. We knew it didn’t make economic sense. And then suddenly one day wake up to the fact that the actual loan officers would come to your house, maybe they don’t beat you up, but they do harass you.
You don’t need to do an evaluation to start asking questions. You just need to think about it for 10 minutes. These are desperate people with lots of financial demands. People in the family are sick, people lose jobs, the daughter needs to get married. ED: But they repay anyway. Someone must be very convincing. AB: But 90 percent repay. What is going on? How could we believe this was because of some tweaking of economic incentives? As economists I think we were basically inept in thinking about it or we would not have believed it. The core fact was staring us in the face. There was some amount of—I won’t say coercion, I think they are careful not to actually threaten—but there’s a lot of harassment. They come to your house, they call up your friends. I don’t think there’s anything wrong with it. It’s a moneylending business, it’s risky. But if the rest of the world thinks these are awful things to do, then you can’t expect better than a 90% repayment. And we didn’t look at this, we evaded the gaze of these facts that were looking back at us.
When teaching about price ceilings and price floors, I often toss in a bit about usury laws as an example of a price ceiling. But the usury example never seemed to me very pedagogically effective: it has a whiff of anachronism. A much better example for connecting with students is to discuss payday lending. Kelly Edmiston of the Kansas City Fed raises many of the key issues in: "Could Restrictions on Payday Lending Hurt Consumers?"
A payday loan typically involves a borrower writing a check for, say, $200, and then receiving $170. The lender promises not to cash the check for a couple of weeks. As Edmiston says: "While payday lenders often charge fees rather than interest payments, in effect these charges are interest. Comparing the terms of varying types of loans requires computing an effective, or implied, annual interest rate. For payday loans, this computation is straightforward. A typical payday loan charges $15 per $100 borrowed. If the term of the loan is two weeks, then the effective annual interest rate is 390 percent."
Many states have regulated or banned payday loans. "By the end of 2008, 10 states and the District of Columbia had instituted outright bans on payday lending. Other states have passed regulations that indirectly ban payday lending by making it unprofitable. For example, in Massachusetts, the Small Loan Act Caps interest at 23 percent per year. In states that allow payday lending, regulations may indirectly restrict or effectively ban the practice. A variety of such regulations exists. Most states legislate maximum loan amounts, usually from $300 to $500. The limits that states impose on fees vary widely."
The key point for public policy in this area, and a useful theme for teaching about price ceilings and regulation, is that banning or limiting payday lending doesn't alter the underlying reasons why people seek out such loans. Restricting payday loans pushes users to other options, which have tradeoffs of their own. For example:
Running down available cash balances in a bank savings account is surely cheaper than a payday loan in the short run. But it leaves people exposed to other risks--like not being able to pay the rent. "Some researchers argue that households recognize a need to have money readily available when using a credit card is not an option—for example, when making rent payments ... Similar logic may explain why some borrowers resort to payday loans even if they have credit cards."
Cash advances on credit cards are pricey, too. "Most credit card fees on cash advances, if considered short-term loans, are costly as well. The fee for cash advances on many credit cards has recently climbed to 4 or 5 percent .... In addition, higher interest rates, which average 25 percent, generally apply to cash advances ... Thus, on a two-week loan, the effective annual interest rate would average from 129 to 155 percent. In addition, cash advances are typically not subject to the interest grace period associated with purchases."
Without a payday loan, the would-be borrower may end up paying late charges on other bills--or having to pay extra to have electricity or heat reconnected. They may exceed their limits for credit card borrowing and face penalties. They may bounce checks and face those fees. "In 2010, bounced check fees averaged $30.47. ... One study calculated the median interest rate on these loans to be well in excess of 4,000 percent, or up to 20 times that of payday loans. ... The highest rates result from bouncing multiple checks for small amounts, where a fee is charged for each bounced check. Further, knowingly passing a fraudulent check is illegal and could result in substantial civil and criminal penalties."
Loan shark often charge 20% per week, along with threats of violence.
Pawnbrokers are costly, too. "A 2006 analysis of pawnbroking compiled a list of monthly interest rate ceilings for all 50 states and the District of Columbia. ... The median cap on interest rates was 15 percent monthly, which is similar to the typical payday loan charge. Many of the caps were much higher, however."
Payday lenders typically don't report to credit agencies, so being slow in paying back a payday loan, or defaulting on such a loan, won't affect your credit score. Being late or defaulting on many other payments will.
Payday loans are much more convenient than trying to get a bank loan, or dealing with many of hese other alternatives
Of course, these tradeoffs don't prove that banning or regulating payday loans in various ways is a bad idea. But they do suggest that advocates of regulations need to consider with brutal honesty what is going to happen if payday loans are less available or unavailable.
The lower-risk reforms of payday loans would be to increase information and options. For example, there is a suspicion that for a lot of people, paying 15% on a loan of $100 probably like 15% interest. But of course, a two-week interest rate is not an annualized rate! Requiring more clear information might help. In addition, helping low-income people build a better connection with the banking system, so that they have some flexibility to get short-term liquidity loans through their bank, would probably come at a lower cost than most payday loans. There may also be other options, like emergency assistance programs from the government in certain situations, or advances from employers, or alternative payment plans. Expanding the information and the choice set is often a more reliable way of having a positive result than limiting choices.
Over the last 2010 years, 55% of total economic output happened in the 20th century, and an additional 23% of the total in just the first 10 years of the 21st century.
About 28% of the total years of human life lived in the last 2010 years happened during the 20th century, and about 6% of total years of human life lived in the last 2010 years happened in the first 10 years of the 21st century.
