One of my favorite lines from recent economics papers is the following one from this paper by Thomas Phillipon, who in talking about the performance of the financial sector suggests that “the unit cost of intermediation is higher today than it was a century ago, and it has increased over the past 30 years. One interpretation is that improvements in information technology may have been cancelled out by increases in other financial activities whose social value is difficult to assess.”
The claim that the financial sector has been ‘functionally inefficient’ was made 30 years ago by James Tobin, and it’s great to have a quantitative basis to make this sort of judgment. Another way to have some sort of handle on the degree to which intermediation has become more expensive is to look at the spread between funding costs and lending rates.
To revisit a theme expressed before on this blog, if one takes a long-term perspective, the idea that inflation adjusted interest rates were especially low in the 2000s is simply mistaken, and there were long periods in the post war to 1980 period that saw very low interest rate facing end borrowers (consumers and non financial corporations). Given the fact that short policy rates—the federal funds rate—were indeed at historical lows in the early 2000s suggests that there have been rising spreads. The figure below—from the latest draft of a paper by JW Mason and I– is the 10-Year Treasury and BAA Corporate Bond rates relative to the 10-Year Ahead Average Federal Funds Rate. It’s asking how much interest a financial intermediary could make borrowing at the Fed funds rate over 10 years and lending to Treasury and corporates. I suppose we could have done some sort of structural break analysis, but really, it’s all there in the graph. After 1980, in the Brave New World of Neoliberal Finance, the 30 years that Phillipon writes about saw a sharp increase in spreads compared to the period before.
This in itself is of course not enough to suggest that intermediation has become less efficient. Certainly, it is possible that these rising spreads might be because of increased perceived or actual default risk. Well maybe, but the following figure gives some reason to doubt that story.
The graph shows the difference in spreads between corporate bonds with AAA ratings from Moody’s at the time of issuance and the 10 year treasury bond rate. The spread between the AAA corporate yield and the 10 year bond rate also began to rise around the same time (i.e around 1980). Since 1980, however, the annual default rate on bonds of corporations with AAA ratings at issuance, has been approximately 0.05 percent. Given an average recovery rate of around 50 percent, the default losses have been about half that. But the premium of AAA bonds over 10-year treasuries has been 1.2 percent (i.e. more than 40 times the expected annual default loss).
This is an example of the “credit spread” puzzle. We chose AAA bonds as a comparator, but the same pattern exists across different classes of Bonds. The spread on triple B bonds (as the link suggests) was 8 times the default on those loans.
So what is behind these spreads? Josh and I are agnostic. Several candidates spring to mind, but one in particular seems most interesting, especially from a Minskyian/Post-Keynesian point of view. From such a starting point, asset holdings are not driven by households maximizing their expected utility from consumption through the solution of an Euler equation. Rather, the impetus for any agent to hold an asset is to achieve positive returns while keeping the probability of being able to meet all current obligations above some threshold. In this sense, the importance of holding liquid assets is to protect against bankruptcy if contracted cash payments cannot be made. The implication of this position is that the demand for liquidity will depend strongly on how likely lenders believe they are to face the risk of insolvency. The broader implication is that the observed credit spread may depend critically on the the probability assigned by banks and other financial institutions of falling short on cash to meet obligations, and thus the greater premium they will pay for liquid assets such as government bonds, thereby increasing spreads between those and other long rates.
This is not an explanation, of course of why treasuries have higher rates after 1980 than before and for that we’ll need additional explanations.
Do readers have other hypotheses/thoughts?
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