What amounted to a statement of principles and a very few stakes in the ground from Timothy Geithner on financial reform got a largely hostile reaction from Congress (see Ed Harrison here and here for further detail).
The main criticism was that the notion of making the Fed the uber stability regulator/financial system overseer (officially, the systemic risk regulator, or SRR). was misguided. We agree with this concern, but even this criticism fails to engage the deeper issues, namely the lack of critical expertise anywhere in the regulatory apparatus, and the failure to do enough examination of the roots of the crisis to devise sound measures.
Those shortcomings are almost certainly features, not a bugs. As we have observed repeatedly, Obama is not inclined to spent his political capital engaging still-powerful financial lobby to push for root and branch reform. And picking Geithner and Summers, both badly captured by the industry, assures that outcome even if he were not predisposed to take at most modest steps here.
First to the role of Fed. Members on the Senate Banking Committee from both parties were unusually pointed in questioning whether the Fed as the right candidate for the job. For instance:
Mr. Dodd described himself as “open on the issue.” But, borrowing a quote from an economics professor, he went on to wonder aloud if giving the Federal Reserve more authority “is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.”
“The Federal Reserve system was not designed to carry out the systemic risk oversight mission the administration proposes to give it,” Senator Richard Shelby, the top Republican on the U.S. Senate Banking Committee, said at a hearing.
Concluding that the Fed is better qualified than any other government agency to handle such a job “represents a grossly inflated view of the Fed’s expertise.”
Shelby, unlike many other Republicans (at least until recently) has the sensibilities of an old-fashioned banker and believes in regulation to assure bank soundness. And his key point is well taken. The Fed is full of economists who worry about interest rate policy. What little enforcement and supervisory culture the Fed ever had was killed via neglect under Greenspan. Even the bank-friendly Office of the Comptroller of the Currency was far more serious about implementing the few and far between strictures imposed on banks pre-crisis, such as the Home Owners’ Equity Protection Act.
I am far less troubled by the skill gaps at the Fed (considerable) than its culture and priorities. It is, as Willem Buiter tartly observed, a victim of cognitive regulatory capture. Just as the Treasury-led stress tests were a charade, obviously too thinly staffed to make an independent assessment of what the banks served up, it’s almost a given that oversight by the Fed would be largely a matter of form. Supervisors at the Fed would continue to be second-class citizens, and too few in number to boot.
The second line of criticism of the idea of expanding the Fed’s powers is that it would compromise the Fed’s independence. This concern would be more accurately stated as “further compromise the Fed’s independence.” Greenspan traded on his Fed chairmanship; Bernanke constrained Fed autonomy further by allowing th Fed to be used by the Administration to circumvent budgetary limits and the need to seek Congressional approval for expenditures to rescue banks. Again, per Buiter, the Fed became a quasi-fiscal agent of the Treasury.
Former Fed economist Richard Alford wrote earlier about how much times had changed:
We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted. ….
Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.
Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.
Yves here. One must presume it was reappointment. Back to Alford:
Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.
While these are legitimate concerns, the contretemps about the Fed masks more serious issues. The first is, as mentioned above, the powers that be lack the competence to supervise the industry well. That is not insurmountable, particularly now that that Wall Street has shed jobs, particularly in the complex products that were the source of the trouble. But pretending the Fed as it is is competent will assure the needed skills are not developed. Note that regulators do not have to be state-of-the-art, but they do need to be sufficiently well versed to know where the dead bodies might lie, and confident enough not to be deterred by less than complete answers.
But the biggest gap is that the US is embarking on a program of reform without having done sufficient diagnosis of where the problems and vulnerabilities lie. By contrast, the securities laws passed in 1933 and 1934 were based on a detailed understanding of the chicanery and follies of the Roaring Twenties, and provided many specific mechanisms to prevent their recurrence. By the time the Bear Stearns crisis hit, it was clear that the financial system was not going to heal quickly, and that the eruptions were symptoms of far deeper problems. Yet every time, the authorities tried patching the patient up and hoping for the best in place of making a real diagnosis.
For instance, one of the assumptions of the current programs is that Something Must Be Done about too-big-to-fail institutions simply because we’ve just had to throw a lot of money at them. That may be a necessary part of any reform program, but is is complete? Doubtful. Bear Stearns would not have been on any list of systemically important institutions (it did not make the grade in the Bank of England’s April 2007 roster of “large complex financial institutions” deemed crucial for credit market intermediation). Yet the concern that it might be a big enough credit default swaps writer to take down a lot of the financial grid along with it led to Fed backstoping of its unwind. LTCM and AIG would not have been on a TBTF list prior to their implosions either.
That suggests that there needs to be not just an institution-based view of the financial markets, but probably also a product-based persepctive and increased attention to system dymanics. For instance, repos are very big source of non-bank funding for the investing community, and there is evidence that suggests that much higher haircuts on repo collateral played a significant role in the contraction of liquidity. Yet there are no official figures on the size of the repo market, and perilous little consideration of how it played into the crisis. As I read them, the proposals would not address this funding source, which some experts estimate at $10 trillion, comparable in size to the total assets of regulated banks (note there may be some double counting in the repo market size estimates, since it probably includes reverse repos).
Similarly, despite the rosy view we now have of exchanges being great ways to create separate centers of activity that can fail without taking down the financial system (yes, Virginia, exchanges do fail), that idea isn’t accurate. Fro instance, in the 1987 crash, the Chicago options exchange was within three minutes of failing, saved only by the personal intervention of Chase CEO Tom Theobald, who authorized a badly-needed overdraft. The equity exchanges, which were separate organizations, came to function as a single market in the crisis. If Chicago had failed, it is pretty certain the NYSE would not have opened. And many observers believed that if it did not open, enough specialists would fail, it might never open (this is a simplification of a discussion from Donald MacKenzie’s book An Engine, Not a Camera).
But economists don’t do systems dynamics. Nor do they have a theory of financial systems (they have theories that address particular elements, like financial economics, and some relevant constructs, like principal-agent and information asymmetry).
It’s bad enough that policy is typically made by looking at a rear-view mirror. But in this case, the authorities haven’t even bothered adjusting it to get a good look at the roadkill behind them.
15 comments
Comments are closed.
The Obama plan is exactly backwards in its approach to systemic risk. It will increase systemic risk.
As pointed out by one of the leaders of econophysics, Eugene Stanley (here), one of the prime results in the exploding field of network theory is that densely connected networks are chaotic and unstable compared to sparsely connected networks.
This only makes sense. If every part of a network affects every other part of a network it becomes very easy for large perturbations to propagate through the network, and rebound, and so on.
The Obama-Summers-Geithner solution to our problem of systemic risk is evidence of an intellectual obtuseness that is breathtaking.
The Fed created or permitted by neglect of its duties the systemic risk that caused this crash, and the Great Depression before it. Mish got this right.
The obvious solution given that systemic risk is a characteristic of the structure of the financial system is to change the structure of the system to reduce systemic risk. Break up investment banks and commercial banks. Eliminate financial institutions that are big enough to create systemic risk all by themselves (no more "too big to fail"). Make it impossible for the system to become densely connected by limiting leverage. The plan does increase capital requirements but not enough. And it leaves the trading of CDSs, the densely-linked network of derivatives that largely caused the supposed near melt-down of the system last fall, lightly regulated and less than transparent.
You can't leave the TBTF institutions in place, or they will capture the regulators again. Or perhaps it's better to say they're not letting them go at this time.
Glass-Steagall and the other laws that the neocons undid over the past thirty years worked. They kept the system stable for sixty years.
At a minimum, let's bring them back. And fully disclose and regulate CDSs.
http://animalspiritspage.blogspot.com/2009/06/how-to-compound-systemic-riskthe-obama.html
@Yves…a lot of gentleman's favors/agreements being tested, decades of back scratching being unwound [?]
Yves,
Excuse my naivite, but I'd love to get your view point on why an "independent" central bank is such a holy grail in political systems.
Surely the mess we have seen in the West has shown there is no possible reality of truly separating these institutions from the political systems.
My leanings are with Ron Paul: bin the Fed, (and the BOE as well) and have the market truly set rates. But this is gut instinct: I figure you have a better reasoning on this.
Any thoughts?
► Benign Brodwicz said…
Glass-Steagall and the other laws that the neocons undid over the past thirty years worked. They kept the system stable for sixty years.
~
► President Barak Obama in his Wednesday speech announcing the economic reforms said:
A regulatory regime basically crafted in the wake of a 20th century economic crisis — the Great Depression — was overwhelmed by the speed, scope and sophistication of a 21st century global economy.
~
http://www.nytimes.com/2009/06/18/business/18regulate.html?em
► Hannah Arendt said:
[S]ince the ideologies have no power to transform reality, they achieve this emancipation of thought from experience through certain methods of demonstration. Ideological thinking orders facts into an absolutely logical procedure which starts from an axiomatically accepted premise, deducing everything else from it….
~
–Hannah Arendt, The Origins of Totalitarianism
~
President Obama–intelligent, polished and consumately articulate–is an extremely effective public liar.
Antonia Grunenberg explains Arendt's theory of the "modern lie" which has become so prevalent in modern democratic societies:
[T]he peculiarity about modern lying is that it destroys reality and replaces it with an image of reality… The image no longer belongs to the original; it belongs instead to political propaganda.
~
http://findarticles.com/p/articles/mi_m2267/is_2_69/ai_90439536/?tag=content;col1
According to Gruenberg, Arendt believed that "the systematic creation of 'image reality' is in no sense harmless:"
A modern lie is not an obvious lie because it no longer relates to an individual action but to the entire political sphere. Its purpose is to confuse citizens to such a degree that they no longer feel capable of making judgments. Even more, image-reality tempts citizens by asking for their confidence and belief (for example, in democratic elections citizens trust their representatives and give them executive powers). Those pursuing the strategy of an image-reality have the intention of convincing people that unreserved confidence must be placed in the executive authorities and in the so-called experts.
To use a term coined by the French philosopher Jacques Derrida, a "counter-truth" is spread, created to mislead the public. A prerequisite for the creation of a "counter-truth" seems to be that the common sense distinction between right and wrong is confused, not only within individuals but also in the political sphere. Thus, truth becomes a "performative act."
The goal is to suspend the ability of citizens to judge. Arendt describes this modern type of lying as "destroying" and she gives two reasons for this: first, because it damages people's confidence in the political body, and second, because it attacks the fundamentals of the polity: the citizen's ability to judge and to act.
The counterpart of the lie is the "internal self-delusion" of the liars: that is, presenting something as true although they know that it is untrue. The liars know that they tell lies, but they give the impression that they believe their lies are true. Arendt calls this "organized lying dominating the public realm" typical for modernity. It means that an outside matter is transformed into an inside issue. As a result, truth becomes a matter of opinion.
There are similar mechanisms in the world of lies and in the world of ideology. However, the main difference is that totalitarian ideology is linked to systematic terror whereas lying in democracies belongs to acting. A totalitarian regime leads to a regime of evil; a democracy is able to unveil the network of lies in order to bring the executive power under control and restore the body politic.
Yves,
As I recall, the Fed is a strange public/private partnership with the major banks having "shares" of it. Is that more or less correct?
So, now they want the Fed to regulate its shareholders? Isn't that awfully similar to the self-regulation that has been shown to not work over and over in a dozen different industries?
I don't get this one at all. Or maybe I just don't to know…
Again, per Buiter, the Fed became a quasi-fiscal agent of the Treasury.
That has been Congress' desire since Nixon's time. And pretty much the reason why the leader of the NY Fed was put in charge of the Treasury.
It's ingrained in the Federal government for two generations now. It'll take a radical act to undo the arrangement now.
Krugman's blog post this morning is spot on. Systemic risk is not about size per se, it's about interconnectedness. Thus, reforms need to be STRUCTURAL in nature, not simply about saying that firms over a certain size will get broken up or get higher capital requirements.
The first structural reform HAS TO BE re-instating Glass-Steagal. 1) Separate commercial banking from everything else, because it's DIFFERENT and has the capacity to bring the entire system down overnight. 2) Recognize that the shadow banking sector (especially MMMF and CP) is banking and needs to be regulated as such. 3) Eliminate the bank SIV and Conduits whose only purpose is to avoid regulation and transparency. 4) Elminate bond insurance (e.g. MBIA) and CDS entirely. Interest rates are supposed to reflect risk premia and these insurance devices break that relationship. 5) Require ALL money managers, hedge funds, etc. to be registered regardless of size and regulate them from the standpoint of leverage and maturity mismatch.
–RueTheDay
YS:
I love this post. I love your choice of words. Amen!
Ror:
I am one of the few people who goes further than worry about Fed "independence". I say the Republic survived from 1792-1913 without a Fed. Kill this beast.
@The Ror
There are two competing political traditons at work in our culture. One is that of Aristotle. It holds that the rank and file are capable of self-rule and places sovereignty in the hands of the people. Free speech is its truth-finding process, perhaps in no place more eloquently expressed than in the Virginia Staute of Religious Freedom, written by Thomas Jefferson:
[T]hat truth is great and will prevail if left to herself, that she is the proper and sufficient antagonist to error, and has nothing to fear from the conflict, unless by human interpositon disarmed of her natural weapons, free argument and debate, errors ceasing to be dangerous when it is permitted freely to contradict them.
~
The other is a more elitist political tradition that comes down to us from Plato and the stoics. As Reinhold Niebuhr points out in The Nature and Destiny of Man, its "philosophers were optimistic in their confidence that the wise man would be virtuous; but, alas, they had no confidence that many could be wise." Perhaps Seneca summed up the sentiment best when he prays "forgive the world; they are all fools."
Since Plato had no confidence in the common man's ability to self-rule, he called for a class of "philosopher kings" to preside over the hoi polloi. Niebuhr speculates that Plato's "philosopher kings" have evolved into today's "scientist kings," Geithner, Summers, Bernanke and Greenspan being modern-day examples.
Plato did not believe in the merits of free speech nor of the general public's ability to discern truth from untruth. Hannah Arendt elaborates further:
The chief difference between Plato and Aristotle in their political philosophies is that Plato, writing consciously in opposition to the political life of the decaying Greek city-state, no longer believed in the validity of the kind of speech that accompanied–in the sense of being the other side of–political action. To him, such speech was mere opinion, and as such opposed to the perception of truth, unfit either to adhere to or express truth… Persuasion had become to him a form, not of freedom, but of arbitrary compulsion through words, and in his political philosophy he proposed to substitute for this arbitrary compulsion the coercion of truth. Insofar as this truth was essentially speechless and could be perceived only in the solitude of contemplation, Platonic man was already not a "speaking" but a rational animal, that is, a being whose chief concern and enlightenment lay in himself, in his own reason, and not in the faculty of speech, which by definition presupposed his living among and managing his life together with his equals. When Aristotle connected speech and freedom, he was on the firm ground of a then still existing tradition rooted in experience. Yet in the end Plato remained victorious because of the fact that the Greek city-state was decaying beyond remedy–something that Plato who, as a full-fledged Athenian citizen, unlike Aristotle, knew and whose influence he suffered severely–and whose ultimate ruin he feared and tried to prevent.
http://findarticles.com/p/articles/mi_m2267/is_2_69/ai_90439534/pg_14/?tag=content;col1
Thanks Yves,
Your point about the shortcomings of the Obama administrations regulatory reform proposals being features and not bugs is well taken. I missed the linkages between Obama spending his political capital pushing back on the financial industry with serious reforms.
Shelby has always been a great vigilante during this crisis and folks should pay more attention to the sensible old crow.
Alfords point about the Fed not having the political will to incur short term costs to achieve financial stability yet having the political will to incur short term costs to curb inflation is an outstanding observation.
The need to look at reform from a products based perspective is key as well. Dallas Fed Jeffrey Lacker addresses re-implementing a maximum loan-to-value regulatory framework and limiting banks exposure to commercial real estate CRE loans on
their balance sheets. Lacker points out that teh 50 banks that have failed since 2007 had construction loans in excess of capital near 280% on average.
Fisher's piece can be read at ZeroHedge http://zerohedge.blogspot.com/2009/06/dallas-fed-on-curbing-irresponsible.html
Also, at ZeroHedge today is a proposal written by me that calls for a regulatory overhaul of the financial system that entails doing away with the TBTF doctrine altogether http://zerohedge.blogspot.com/2009/06/guest-post-proposed-grayson-glass.html
Is it possible to blame everything on the FED.
Consider some retro positions. Up until early this year, I considered the FED to be responsible for the Great Depression by keeping (then nominal) interest rates too high. In view of that policy one must take a critical view of today's activities:
1- Which of the eight presidents that faced a depression actually solved it without stagflation or depression (Harding, Hoover, FDR, Johnson, Carter, Reagan, Clinton, Bush). Answer Harding. Why, he cut BOTH government spending AND taxes. Each of his successors did one but not the other.
2- The progressive era has left us with a system of government where someone else (the rich, the corporations) pay your taxes. Why are they so willing to pay up? Answer, because they transfer their risks to the government in the form of regulation, retirement, social security, etc.
3- What happens when the money interest (the rich and corporations) won't or can't pay their expected level of taxes (according to Misha's economic analysis, income tax revenues could be down by as much as 40% this year alone)? Answer: more borrowing. Toss up question, what happens when the government needs to borrow more? Answer: investment is crowded out of the economy, pensions, stock market collapse as companies earn less and less.
4- The progressive economy was built on the new Science of macro economics. Is macro economics a science? Answer: After the equation of GDP = MV (money times velocity) = PQ (price times quantity), there is no macro. The use of mathematical derivatives to derive scenarios for 'managing' an economy by the fed or the government is NOT possible, as there is always arbitrage which takes away any advantage to the regulator. Money velocity peaked (again according to Misha's analysis) in 1997 at 2.2. This was Greenspan's finest hour as he prevented a World economic collapse at that time. Banking deregulation actually allowed the system to teeter along for another ten years or so, but the arbitrageurs finally had their way in 2006 and here we are today facing a depression. This is the second depression in the progressive era, there was one in America during the classical era from 1871 to 1894 as America dealt with the post Civil War government debt and subequent deflation.
5- What can be done? Follow the Harding plan, eliminate the progressive tax system, except for Government mandates such as defense spending. All other taxes should be paid by the user either as fees or as excise taxes. Cut government spending to match revenue. Let the insovlent banks fail and close them. Eliminate the Fed and introduce a Free Banking System. Require the banks to buy deposit insurance to protect depositors to a minimum amount. Require bank depositors to buy additional insurance to cover their deposits above the minimum ceiling. The insurance must be payable on demand. Will this be done? No, so welcome to a depression. It won't feel like one, but I do anticipate an unemployment rate in the mid teens by 2015, causing all of us a great deal of pain.
6- Money velocity is currently well above 1.7. During the depression it fell to around 1.1 as the population held on to cash, before a recovery took place. This implies the economy will shrink by another 30-40% before things begin to improve. welcome to your future.
Joshua brown over on the reformed broker in his article "How’d They Get Too Big To Fail In The First Place?" tells us none of us gets it. His argument being that regulators discriminated between different firms depending on size and influence. While there is undoubtedly an element of truth in that regulators were loath to face an army of lawyers, I think Yves is probably on the right track with product based perspectives, but I alsofind myself having sympathy with Krugman's arguments for once.
I do see some evidence of sensible policy in making dark pools more transparent and fiduciary responsibility for brokers, but doubt whether the tangled chains of consequences have been followed through. Paul kedrosky over on growthology argues that the requirement for funds to register with the SEC will cause problems for venture capitalism for instance. Interestly clusterstock is reporting a rather frosty reception of the regulatory changes by Sheila Bair at the FDIC, so it seems a few feathers have been ruffled.
…yves, good work…
pedantic me says…post title has a typo Geithner not Geither
Yves: "But the biggest gap is that the US is embarking on a program of reform without having done sufficient diagnosis of where the problems and vulnerabilities lie." In my view, the US Guvmint is embarking on a program of pseudo-reform just so that no diagnosis, or remedy, of where the problems and vulnerabilities lie is done whatsoever. This white paper is a political document to blunt legislation rather than a policy document to enable legislation. Nuff said.
Regarding Kurgman's view of TBTF, Who Cares, I find it perfectly understandable while wearing bifocals, but bafflingly obtuse when I take of the econo-specs and look at the real world. Yes, systemically things are sufficiently complex that we can never be sure which institutions would, by their collapse, pose a systemic threat. This is in essence the same point Yves makes here with, I may say, rather greater clarity.
"Who knew?" will always be the question it may be better not to ask. Most who read here will recall the argument of March 08 that a failure of Bear might lead to a failure of JPM, and a failure of JPM might lead to an uncontrollable cascae of credit default swaps; hence Bear had to be backstopped. Let's assume that this is true then, that we can never be sure whose failure will be devastating and hence no large failure should be allowed. . . . Or rather, no _uncontrolled collapses_ should be permitted. Yes, seize AIG, fire management, and dictate a settlement. Please. (I mean it hasn't happened YET, so this is still an unmet condition.)
But the argument Krugman seems to be waxing smooth here is a false opposition, which he has to know: Either prevent institutions growing too large or do controlled demolition when failures occur. What is to prevent doing BOTH? Nothing, except a lack of political will. The argument against 'Too Large' is not principally about systemic risks of failure; that is a misunderstanding. It is about systemic distortions PRIOR to failure. It is about Too Big To Regulate. It is about market dependence upon a handful of players who exploit their position in ways to the loss of everyone else and all of society. It is about perverse market behavior because the incentives of a few mammoth firms do not align either with their counterparties, their markets, or their country of origin (or any country). It is about, to put it simply, preventing cancerous malignancies. Yes, behemoth financial big boys create massive systemic risks, and should be wound down in a controlled rather than a catastrophic fashion. But they pose those risks only after fouling the markets and the countries in which they operate: they warp the financial system to their own benighted purposes. Even when they may not intend to, a separate point.
There is not regulatory arrangement which will prevent a) chicanery (to be kind), or b) institutional bankruptcies. Cleaning up the eruction of institutions will be far more feasible where those institutions have a mandatory maximum size: This is a return of the trust-busting, and must become a primary political issue of the next ten-twenty years. The Financial Big Boys are the equivalent of the late nineteenth century trusts, the Dystrusts. They have completely captured the government, but failed in their own industries, producing massive short-term profits for themselves at the expense of any real growth for their societies, and most of their profits are generated through leverage and speculation rather than through actual production or investment, of which they produce very little.
Bust the trusts. Paul, can you get your head around _that_?
All blather. You all dance around the basic reality enunciated starting about 4:30 into prof Michael Hudson's interview at http://www.youtube.com/watch?v=3pwAFohWBL4&NR=1
Our political/financial system is steeped in fraud made possible by a government fueled by pay for play. "Bezel" some have called it. And until that aspect is addressed. The GS JPM Gordon Gekko pigs will continue to control all– and destroy us all, themselves included, in the process.