American Exceptionalism: A Sequel

A few posts ago, I wrote about American Exceptionalism. For economic historians, this typically refers to the United States' industrialization and efficiency gains in the second half of the nineteenth. Economic historians refer to the first two thirds of the twentieth century  as the "American Century," due to the United States' considerable edge in productivity and wealth over the rest of the world. The American Century is thus the conceptual and chronological sequel to American Exceptionalism.

I previously explained how the concept of American Exceptionalism had become a rallying cry for Republican politicians. So too for the American Century. Here's Mitt Romney:

In 1941, Henry Luce called on his countrymen -just then realizing their strength - "to create the first great American century." And they succeeded: together with their allies, they won World War II, they rescued Europe, they defeated Communism, and America took its place as leader of the free world. Across the globe, they fought, they bled, they led. They showed the world the extraordinary courage of the American heart and the generosity of the American spirit...

Like a watchman in the night, we must remain at our post - and keep guard of the freedom that defines and ennobles us, and our friends. In an American Century, we have the strongest economy and the strongest military in the world. In an American Century, we secure peace through our strength. And if by absolute necessity we must employ it, we must wield our strength with resolve. In an American Century, we lead the free world and the free world leads the entire world.

Again, economic historians have to look for explanations other than the "extraordinary courage of the American heart and the generosity of the American spirit." Explanations of American Exceptionalism in the late nineteenth century largely focus on factors within the U.S.: factor endowments, technological development, railroadization, education, and so on. For the American Century--which included both world wars and the Great Depression-- international explanations are in order.

A few other grad students and I currently have a book club on Barry Eichengreen's "Golden Fetters." We read and discuss a chapter per week, and are on chapter 9 now. It has me convinced that the international monetary system, and especially the gold standard, is a key thread to understanding those remarkable decades. The pre-WWI gold standard worked well because of credibility and international cooperation. Eichengreen's intuition for political economy is strong, and he carefully traces why credibility and cooperation were sustainable before WWI but not in the interwar period.

The war greatly strengthened the U.S. balance of payments. Germany paid reparations to the Allies, who in turn repaid war debts to the U.S. American lending to Central Europe and Latin America rounded the circle of capital flows. But the balance of the whole system hinged on the U.S. keeping domestic interest rates low to encourage American gold to flow abroad. And for awhile, this worked just fine. The U.S. was more than happy to maintain low interest rates when it was also convenient for their domestic goals. However, starting in 1928, around the time of the Wall Street boom, Federal Reserve officials decided to tighten monetary policy, which curtailed foreign lending. To stay on the gold standard, other countries had to respond drastically, causing the U.S. downturn to both spread and deepen. The "golden fetters" also prevented policymakers from injecting liquidity into the banking system to contain bank runs. I strongly recommend reading at least the first chapter of Golden Fetters for more. The book is filled with examples of cooperation and coordination failures in the interwar period.

Anyhow, by the mid 1930s most countries dropped off of the gold standard and finally began to recover. The U.S. economy grew rapidly, save for a downturn in 1937-38. After that, monetary expansion in the form of huge gold inflows stimulated the economy. The gold inflows were at least in part due to fears of another war on European soil, causing capital flight from Europe. After WWII, the dollar was the dominant currency for international transactions and reserves. The Bretton Woods agreement of 1944 established a system of fixed exchange rates based on gold valued at $35 per ounce. Both world wars, then, were inadvertently beneficial to the United States relative to other countries. And our Great Depression was detrimental to the rest of the world. So it is hardly surprising that the United States' relative productivity and wealth grew in this era. Or that by the mid 1960s, Japan and Europe began to narrow the gap, and that Bretton Woods collapsed by 1971.

I will try to add more in future posts about what was going on in the American Century. So far it is not apparent that we want to repeat it. But maybe there are some features of the American Century worth striving for. For now I need to get back to studying for my economic history field exam on Wednesday. Today was macro-- quite difficult, a heavier than expected emphasis on stochastic dynamic programming.

The Economics of Structured Finance

For anyone interested in the financial crisis, I thought I'd try to summarize a paper I just read for my Empirical Macroeconomics and Finance course. The paper is called "The Economics of Structured Finance," by Coval, Jurek, and Stafford, 2009, in the Journal of Economic Perspectives, Volume 23, Number 1.

Structured finance is the pooling of economic assets and subsequent issuance of a prioritized capital structure of claims, called tranches, against these collateral pools. The prototypical example of a structured finance security is a collateralized debt obligation (CDO).

A reason that the practice of structuring securities arose was to allow the tranches to be rated by the credit rating agencies so that they could be comparable with single-name securities or corporate bonds. Securities involve a complex mix of risks. Adding the prioritization structure creates “safe” assets at the high priority senior tranches. Senior tranches only absorb losses after the junior claims have been exhausted, which allows senior tranches to obtain credit ratings in excess of the average rating for the whole collateral pool.

For example, consider two bonds, both with default probability p. Both pay $0 in case of default and $1 otherwise. You could pool them into a $2 fund, and then form a junior and senior tranche. The junior tranche pays $1 if both bonds avoid default and $0 if either bond defaults. The senior pays $1 if neither bond defaults or if only one out of two bonds defaults; it pays $0 if both bonds default.

The recent financial crisis involved the discovery that the “safe” manufactured tranches were actually far riskier than advertised. Even AAA rated securities defaulted with reasonable likelihood. When this was finally realized, in late 2007 and 2008, investors stopped buying structured finance products. How did the credit rating agencies get it so wrong?

Notice that in the example above, the risk of default for the senior tranche depends on the correlation between bond defaults. If the bond default probabilities are uncorrelated, then the senior tranche defaults with probability p²

Next, the authors look at the relation of structured finance to subprime. Government- sponsored agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae were chartered to purchase mortgages originated by local banks that satisfy certain size and credit quality requirements. They repackage these conforming mortgages into mortgage-backed securities to be resold in capital markets with the implicit guarantee of the U.S. government. Mortgages that fall below the credit standard (“subprime”) were packaged into “private-label” mortgage-backed securities, which in turn were resecuritized into structured finance CDOs. So there were two levels of structuring, and a lot more correlations to worry about, which were not properly accounted for. The ratings also didn't take into account systemic risk, which structured finance was particularly susceptible to. Typically, securities that are correlated with the market as a whole should offer higher expected returns, since it is less valuable to have an asset that will pay well when times are good and pay poorly when times are bad, than vice versa. The systemic risk of the structured finance products was underestimated.

The authors don't place all the blame on the credit rating agencies. They partly blame some perverse incentives, and also a regulatory guideline saying that banks holding AAA-rated securities were required to hold only half as much capital as was required to support other investment-grade securities.This distorted the demand for AAA-rated securities, and fueled a lot of the effort to create an imprudently large volume of structured financial products.