It’s no wonder that truth is stranger than fiction. Fiction has to make sense.

– Mark Twain

Several days ago I read Tyler Cowen’s piece in The American Interest. It deals nominally with inequality but is mostly about financial profits. I have been mulling it over ever since. Today, I read this by Krugman in response to the current obsession over European debt levels.

A lot of this is self-serving, of course. But there’s also a strong element of trying to shoehorn whatever happens into an ideological frame; it must have been about fiscal irresponsibility, because isn’t everything?

In the wake of Cowen’s piece Will Wilkinson wrote this

I’ve long had the sense that folks in finance are getting spectacularly rich by somehow gaming the system, but the nature of the system is too inscrutable for me to formulate a sufficiently informed hypothesis on my own. But it’s not so inscrutable to Mr Cowen. He offers what sounds to me a quite plausible story about the way the financial-regulatory-political system has been, and continues to be exploited and destabilized.

Both Krugman and Wilkinson are keying off of the same phenomenon. The world is extremely complicated and doesn’t make sense – at least not in the way we want it to. We don’t want to understand the world simply by following some complex routine of intellectual gymnastics. We want it to makes sense intuitively. We want it to bound up in a single completely digestible ball. The world, sadly, does not always comply.

So we build miniature models of the world in our minds – fictions that do make sense. When we run into a part of the world that doesn’t co-operate we either shoehorn our observations into that miniature model or tear through, blogs, articles and books until we find someone who can.

The statement “it makes sense” is, however, a statement about how pleased we are with our efforts to shoehorn observations into our miniature model. It is not a statement about our understanding of the world.

To check our understanding of the world we have to ask not “does it make sense”, but “how would I know if I was wrong?”

I’ve been asking myself that about Cowen’s piece, which sits well with me on an intuitive level. There are a couple of things that I see.

Cowen’s thesis seems to be summed up in this paragraph

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

He goes on to explain how the strategy of going short on volatility works. What’s not so clear is how the losses get socialized.

One simple explanation would be that the government bails out the banks. Then the taxpayers support the government. Thus the excess financial returns are simply a transfer from taxpayers to bankers. However, this requires that the government loose money on its bailout and from the looks of it the government stands to gain money. Its clear how the bankers won, but its not clear how the taxpayer lost.

If it is the case that the banker’s won but the taxpayer was held harmless then this a Pareto optimal move. This is the kind of win-don’t lose scenarios that economists search for. Indeed, it could be transformed into a win-win simply by taxing the salaries of hedge fund managers a bit more.

A more complex version of socializing the losses might come through the actions of the Federal Reserve. Cowen says

Furthermore, the Federal Reserve System has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. This type of implicit bailout brings high social costs by slowing down economic recovery (the interest rate spreads require tight monetary policy) and by redistributing income from the Treasury to the major banks.

Yet, this doesn’t seem to accord with Fed policy. Paying interest on reserves has long been advocated, originally by Milton Friedman, who felt failure to do so constituted a tax on banks. However, in the last decade or so paying interest on reserves has been advocated as a way to allow the Central Bank to engage in Qualitative Easing, the goal of which is to lower the interest rate spread.

Paying interest on reserves allows the Fed to print money, use that money to effectively make loans and then have that printed money sit on the balance sheets of the banks. That’s how the monetary base was able to skyrocket without sending tons of cash flooding into the system.

The loans the Fed made were not primarily to banks but to homeowners in the form of buying new Fannie and Freddie debt and to other central banks in the form of currency swaps.

One may or may not view this as wise policy but it was done to lower interest rate spreads not to widen them and to date it has increased Fed profits.

It also may be the case that the Fed is too tight – I tend to think so – but its not exactly clear what this has to do with bailing out banks.

Lastly, we could say that there is an inherent interplay between financial stability and macroeconomic stability. By increasing taking on too much risk in the capital markets the bankers imposed to much macroeconomic risk. In this telling its not that the bankers took anything from us directly.

Instead it is that there is an inherent tradeoff between volatility and return. The higher the volatility, the higher the return. Only the banks arranged it so that they got all the higher return and the macroeconomy – the rest of us – got all of the volatility.

If this is the story then you are accepting that no Fed policy, not NGDP targeting, not price level targeting, not a higher inflation target, would have prevented the collapse. The collapse was inherent in the bankers risk.

The jury is, of course, still out on whether anything could have been done in to stop this recession and whether the real problem was in fact all nominal.

Without that link I don’t see how we square the circle on bankers taking excess profits at the expense of the general public.