Is Austan Goolsbee Betraying the Chicago Tradition? If So, is That Bad?

Greg Mankiw has a question for Austan Goolsbee:

George Stigler rolls over in his grave, by Greg Mankiw: Remember when the University of Chicago used to be the intellectual center of the deregulation movement? No more. A reader alerts me to this news:

Investment banks that obtain Federal Reserve Bank loans during a financial crisis should face much closer regulatory scrutiny, a key economic adviser to Democratic presidential candidate Sen. Barack Obama said.

Austan Goolsbee, an economics professor at the University of Chicago and one of Sen. Obama's closest advisers on economic issues, said the senator believed strongly in enhanced regulation of any financial institution that has access to the Fed's discount window.

"If you can borrow money from the U.S. taxpayer at a moment of crisis, that is a very sacred insurance policy underwritten by the U.S. taxpayer," said Mr. Goolsbee in an interview last week with Dow Jones Newswires. "We have the right to oversee anyone who is accessing that insurance policy."...

Mr. Goolsbee said that an Obama presidency would ensure that investment banks are regulated as closely as commercial banks.

Here's a question for Austan: Can an investment bank avoid such regulation if it promises never to use the discount window? Or is this insurance-regulation combo a mandate?

This story seems to confirm the fears of Vince Reinhart.

I agree that access to the Fed's lending facilities should come with regulatory restrictions. The question is whether banks should be allowed to move outside the regulatory umbrella if they voluntarily give up access to the discount window.

Isn't the problem credible commitment? A bank would also have to promise that it would not become "too big to fail" for the commitment from the Fed to prohibit access to the discount window to be credible. If a bank does become too big to fail, and if it runs into trouble and asks the Fed for help, then the Fed will be forced to bail them out if it wants to act in the best interest of the overall economy no matter what the prior agreement had been. Sending the economy into a tailspin and deep recession simply to honor a past promise to prohibit access to the window would not be the best policy at that point.

So, if banks can grow large enough to threaten the overall economy in the event of failure, I don't see how you avoid a regulatory solution. We either have to regulate the size of banks to make sure the threat to the overall economy does not exist, and then intervene if a bank grows too large. Or we need to allow banks to grow large enough to threaten the economy should they get into trouble, perhaps because large banks have desirable efficiency properties, but impose regulations to reduce the chances that they will need to be helped, and to limit their ability to damage the overall economy in the event that the help we can provide to a bank that is in trouble is not enough to prevent it from failing.

Update: Brad DeLong has a follow-up discussion.

Comments

[Rajesh Raut]

If the Federal Reserve is going to provide insurance to investment banks, we should avoid the unlimited commitment regime that we have for commercial banks. When a company secures a line of credit from a bank, they pay a fee to be able to access the credit when they need it. Investment banks should pay a fee to the Federal Reserve to allow them to access to the discount window up to some amount.

By publicly announcing the size of the liquidity commitment ahead of a crisis, the market can price in this access into bond and CDS prices. In effect, the market will decide if an investment bank needs more or less access by the pricing of debt for the bank.

[anon]

We've passed the point of no return.

Fed lending to major investment banks is now conceivable, because it has happened. Rules and commitments in either direction are therefore meaningless.

The necessary quid pro quo is regulation for investment banks in parallel with commercial banks.

[Matt]

" I don't see how you avoid a regulatory solution "

I do. Anybody that wants access to the discount window needs to issue monetary bonds which are tradeable. Each entity wanting the discount window must establish a reserve made of these independently issued monetary bonds.

Then we have a situation in which everyone shares the monetary risk. If a particular bond becomes weak, then to meet reserve requirements, the others will sell the weak and buy the strong.

The fed can control interest rates by open market operations on these bonds.

Essentially, open up the discount window to anyone who is willing to issue their own bond, and hold these bonds to meet reserve requirements.

Under this scenario, the fed need only hold enough bonds for its arbitrage, all the other participants become mini-feds, printing their own money.

[robertdfeinman]

If a bank is too big to fail that can only mean that it is being implicitly insured by the federal government. So why not take the next step and federalize the bank altogether?

If I remember correctly Fannie Mae and Freddy Mac were set up as governmental agencies and performed their functions well. They only got into trouble when they were privatized. This knee-jerk reaction to anything smacking of government administration has gone too far.

Government run health care (Medicare and VA) is more efficient that private insurance, municipal electric companies have traditionally provided better services at lower costs, etc.

The fiction that private enterprise does things better is just that a fiction. What private initiative does best is promote entrepreneurship and innovation. This sort of thing doesn't come out of big bureaucracies, neither private nor public, that's why the model is always two guys in a garage.

If you don't like government administered banks then go back to mutual loan societies or credit unions. Where is the evidence that efficiency goes up when JP Morgan merges with Chase or the like? Unbridled capitalism has a lot to answer for in the current crises of resource limitations, food shortages and unregulated debt creation.

When will the wise economists stop trying to justify something that lurches from one excess to another and look for alternatives?

[OhNoNotAgain]

"So why not take the next step and federalize the bank altogether?"

Or, how about just "bust'em up" ? What efficiencies or economies of scale are being provided by these "huge" banks that can't be provided by just a "big" bank ? These banks are mainly in the business of data processing, anyways, which already has built-in efficiencies for even very small banks. And, isn't the point to promote competition, thus lowering prices for consumers ? Who thinks that we would see $2.00 ATM fees if there were twice or three times as many banks ?

[Winslow R.]

I'd agree with Greg.

As long as he agrees to this....

Only regulated counter-parties would be compensated in a Fed bailout.

Bear Stearns counter-parties that were unregulated by the Fed would not get a dime. Same goes for any commercial bank failure only regulated entities (u.s. taxpaying citizens) would be made whole.

You see, the ability of an unregulated investment bank (and unregulated citizens) to shift losses to a regulated corporation is conveniently ignored by Greg.

[bill]

I think Winslow is right.

Regarding credibility of the commitment etc. The Fed could have the ability to "save" an unregulated entity just like Bear Stearns was saved. Because, like Winslow essentially pointed out, BS wasn't saved or bailed out, its counterparties were.

[Bruce Wilder]

The situation is confused. Even commercial banks don't like to access the discount window, because of the signal it sends. As Lehman Bros. inches ever closer to dissolution, they are scrupulously avoiding accessing Fed Funds. So, what's the point of offering this option to IBs, if the IB most in trouble cannot use it?

And, what would the objective of "regulation" be? What's the shape of the regulatory regime? What are its levers? Its measures?

I am very disturbed by how vague and foggy economists opining on the subject of "regulating" the IBs are. There's a remarkable willingness among some to just kick the can down the road, to suggest some regulatory monolith, which would presumably work out the details at a later date.

anon is right: we are already past the point of no return. Status quo ante is not available. So, we need some powerful imagination to figure this out.

I commend Greg for at least venturing the industry structure question. In structuring regulation, you must structure the industry, creating categories and functions. If we are going to continue with the securitization of mortgages, then regulation will have to assign roles to the various players, and make the degree of equity and leverage transparent. If we are to have some financial entities free of close regulatory scrutiny, as the IBs previously were, that, too, will be part of the regulatory scheme. Glass-Steagall will rise from the dead in some form, because no regulatory regime can survive the monolithic power of universal banks.

Too often I see banking regulation imagined as the government second-guessing the risk-taking business decisions of the bankers. That's not exactly how it works. The FDIC/Comptroller of the Currency regime that applies to commercial banks establishes a system of audits and clear standards for declaring a bank insolvent. A bank is declared insolvent, and goes out of business literally overnight -- typically, insolvency is declared on Friday afternoon, and the bank's deposits, and often offices, are in the hands of another bank on Monday morning. That has little to do with the bank's business decision-making, except for largely removing the options of fraud and ponzi schemes. It has everything to do with reducing insolvency to a non-event, as far as the banking system and the general economy are concerned.

It seems to me that the issue with Bear Stearns was the prospect of a messy insolvency destablizing the system. If that's the problem to be solved, then a regulatory regime has to establish a system of audit and rules for declaring an institution insolvent. The derivatives market, in particular, may have to be brought indoors, into a public recordkeeping scheme, to make the affairs of the IBs, insofar as they impact system functioning, auditable by a regulatory agency.

[Bruce Wilder]

Winslow is exactly right: it was the counterparties, who were rescued in dissolving Bear Stearns. Which is, again, why credit default swaps, and the similar derivatives trading, which, apparently, no public figures understand, (I certainly don't, though I keep asking people for explanations.) have to be brought into some kind of public institution for recordkeeping and monitoring.

I seriously doubt that the banking system could continue to function if the Fed willy nilly guaranteed counterparty risk in CDS and the like.

[Gerard MacDonell]

It strikes me that this issue is complex and probably requires a compromise that tries to limit both efficiency loss and systemic risk. It is a tough one over which reasonable people might disagree. But I doubt it is best approached throught the simplistic framing offered by Mankiw. Indeed, I find it hard to believe that an economics professor at Harvard would choose to express himself that way. He is caught up in the silly season.

[Brad Setser]

Mark -- I think you got this exactly right. An investment bank that commits not to access the fed is not making a time consistent commitment. If it gets into deep trouble, it will change its mind. Bear and Lehman both would have opted for no regulation in good times, and then said that they would rather have access to the fed's liquidity rather than get into deep trouble in bad times. You can say that the Fed then should say no, but that gets to the second problem -- the fed didn' t step in because it wanted to, but because it feared the consequences of not acting.

A systemically important institution that opts out of regulation is in theory committing the fed not to help it even if that means the system will come crashing down. That isn't a credible commitment for the fed to make -- and certainly isn't something that a private institution should be able to bind the fed to do. this only works if the institution in question also promises to remain small enough to fail -- and perhaps also commits to be so simple that it could be shut down (if too big to fail is really too complex to unwind ...)

[ndd]

Spot on, Prof. Thoma.

What I find interesting is that while there is generalized agreement about the need for i-bank regulation, to my knowledge there hasn't been a peep of anything substantive out of Washington. Nor will there be for 7 months, and most likely nothing thereafter either if McCain is elected. Privatize gains, socialize losses. Wash, rinse, repeat.

[gordon]

In finance, three months can seem like a geological era. I remember when (about March) everybody was saying that the real subprime risk was that lack of liquidity would cut off credit to creditworthy entities in the “real economy”. Then came Bear Stearns, and suddenly everybody was talking about the risk of “destabilising the system”. I don’t remember anybody saying that Bear Stearns’ failure by itself would have had any effect on the “real economy”.

Bear Stearns was an investment bank. Since Glass-Steagall was repealed, regulators can no longer distinguish (as it were) between investment banks and commercial banks. Maybe the best single regulatory move would be just to re-enact that useful piece of the New Deal.

[Joe]

What are Citibank, Wachovia and Bank of America? commercial banks or investment banks?

I think they are both.

The elimination of Glass Steagle brought to you by Phil Graham, John McCain's economic adviser and also husband of Wendy, Enron Board Member. The storm clouds just keep coming and comiong.

And their demand deposits up to $100,000 are insured by the FDIC which I understand is in the end backed up by the Federal Gov't.

Money supply = cash in circulation + Demand deposits = M1.

MV = PQ = GDP. Bank fails, M decreases, GDP Decreases. or
Bank fails and short a Bernanke operation executed with aplomp = lost of confidence, banks pull in their loans (sound familar, see TED spread) and M decreases. Reference Great Depression for more details.

Their was a reason Glass Steagall was effected and commercial banks loan portfolio's were proscribed.

Does Citibanks balance sheet have a firewall between their commercial bank liabilities and their investment bank liabilities. I doubt it and not that it would even matter when your debt to equity ratio is in the neighborhood of 17 to 1.

The Chicago School's most famous policy prescription, originated by Milton Freidman himself, was that the money supply should only grow at a constant and expected rate. Later in life, Milton, regarding that prescription reconsidered and in his best rosann rosanadana impression, stated never mind.

I don't know alot about Mankiw other then he went to work for an administration that fired one of his predesessors because he made an incompetent budget projection that wasn't incompetent enough and also stated that by far the vast majority of their tax cuts go to the middle class.

How about long term capital management (leverage = 100 to 1).
How about Bear Sterns 30 to 1.

How about credit default swaps. For Delphi the notional value was 10? 12? 30? times the amount of bonds outstanding.
The latest total notional value for the market as a whole is up to $60 trillon but don't worry; everything should turn out fine.

I don't know about you but if I am going to make a bet that has little economic benefit to anyone, I prefer my La Costa Nostra affliated bookie.

Before the uncivilized Rethuglicans (a moniker for which probably fills them with pride) took over you couldn't bank accross State lines. That was in effect till when? the late 80's. America couldn't get anything right before we changed that. Right.

Nah we should listen to Friedman, Graham, Mankiw and Greenspan. We don't need no stinkin oversight. Anarchy should do just fine. What could go wrong? You would think we were going to have a sudden couple trillon dollar asset value meltdown that would put the economy in the crapper, that the federal reserve would have to smooth over at the cost of inflation and dollar devaluation. While the authors of the meltdowns walk away with hundreds of million dollar golden parachutes (mozillo et al) and their enablers advocate for self regulation.

The S&L meltdown was not a lesser example of what could happen and don't believe any lilli livered, less then super rich, middle class supporting, civility wanting, bleeding heart regulation proliferating liberal tell you different.

Better looting and plundering is the ultimate goal. Didn't see that little clause our lawyer's inserted in that 30 page contract. Sorry about that. Pay up.

I think I better change my attitude to one of a citizen in a South American Oligopoly type nation. I quess my goal should be reoriented to making some rethuglicans my bitches before they get the drop on me and make me theirs.

If we keep going down Mankiw recommended path that is what it is going to come to. Hopefully if it comes to that we can at least sell our soul to Bush, Cheney et al.

Do these people have a hint of rationality, any appreciation of nuance? Are they san...never mind.

[JKH]

No IB can make a commitment not to access the Fed, because it cannot guarantee that its own risk management won't pose a systemic risk at some point. Bear Stearns is example of this, where the commitment was implicit due to lack of precedent.

The 'small enough to fail' criterion also doesn't quite cut it. Small but opaque IBs may end up having disproportionately large risk exposures that pose the same type of systemic risk.

Regulation is required regardless of "good intentions". “Trust, but verify”, so to speak.

The primary purpose of regulation in this context is to make IB risk management transparent to the lender of last resort.
Why on earth should IBs have some preferential treatment over commercial banks when it comes to cowboy financial capitalism?

Regulation should drive the right to open up shop, and then maybe the right to access the Fed, not the other way around. The jury's in. There’s no way around it.

says...

Any investment bank that gives up access to the Fed window will be at a competitive disadvantage. Nobody would trade with them.

Banks are incapable of assuming these increasing risks on their own. Increased oversight, maybe through a clearinghouse house is inevitable.

[mf]

Joe --- you nailed it, for sure... Unfortunately, most people in the U.S. don't have a clue.

[Joe]

Credit Default Swap is a bet, nothing more nothing less PERIOD.

You pay me a certain amount of money and if an event happens (a company defaults on their bonds) I will pay you a certain amount of money.

And the best thing is you don't have to actually buy the company's bonds to make the bet because all we are doing is MAKING A BET, PERIOD.

Notional value = the amount that will be paid off if event happens. In case of Delphi Automotive = 10? 12? 30? times amount of Delphi bonds outstanding

The Investment Banks have a sideline in running a casino but don't need any regulation. You trust Graham, Friedman, Mankiw and Greenspan? Don't you?

[Uncle Billy Climbs Mont Pelerin]

Humble question time:

1) If institutions have become too big to fail, and this is a large part of our problem, can't we legislate and keep them from getting too big?

2) Why do we need swaps and cdo's and derivatives and auction rate securities in general? I understand that certain people make tons of money from them, but...

[Joe]

Greenspan ignored Gramlich when he warned him years ago about the problems with mortgage underwriting.

Several State Attorney Generals tried to band together and do something about the mortgage underwriting problem and the anarchist in the Bush Administration pulled some mid 19th century statute out of their hat to preclude any regulation.

Oh the missed opportunities. If only...the dollar would be stronger and therefore gas cheaper. But hey look at the bright side, gay guys had a harder time consumatting a contract to marry their lives together and that is more important then feeding our children. Family values don't you know. I know the thought of what two gay guys are doing in private behind closed doors makes some people very apprehensive to the point of distraction.

This is a Democracy and we can arrange it anyway we want.

First principle of a free market: Many buyers and sellers or in other words competition. No one is a price maker and the market makes us all price takers.

Let's do some conmsumer protection also. Let's have a standard federal mortgage contract. The standard meaning will eventually become second nature to most literate people. You can vary from the contract as long as you list the exceptions to the standard in a very conspicious manner. same with all consumer contracts How about them credit card contracts too.

[Joe]

The reason for different financial products cuts both ways in many cases. Options maybe started off as a way for a food processor or farmer to eliminate risk (i.e transfer the risk) ionvolved with their respective business's.

I don't know if you can or should prevent someone from borrowing a stock and selling it to someone else.

I don't know if you can or should stop someone from hedging.

Though I am not convinced that there is any social redeemable benefit in investment houses taking bets on whether a company is going to go Chapter 11.

I do think that the investment banks, due to the problems they have caused, have foregone the right to protest someone looking over their shoulders or reasonalble regulations.

[gordon]

Uncle Billy, I would take it as a useful rule of thumb that anything "too big to fail" should be part of the Govt. which will be called on to bail it out. Any such entity has the Govt. by the short hairs anyway, so it may as well be part of it.

[dd]

"We can reduce risk in the financial system"
By Timothy Geithner
excerpt:
"Fourth, we need to streamline and simplify the US regulatory framework. Our system has evolved into a confusing mix of diffused accountability, regulatory competition and a complex web of rules that create perverse incentives and leave huge opportunities for arbitrage and evasion. The blueprint by Hank Paulson, Treasury secretary, outlines a sweeping consolidation and realignment of responsibilities."
snip
"As we reshape the incentives and constraints for risk-taking in the financial system, we have to recognise that regulation has the potential to make things worse. Regulation can distort incentives in ways that may make the system less safe."
http://www.ft.com/cms/s/0/807c8a64-355a-11dd-998d-0000779fd2ac.html

Supervision not regulation. Opacity is the order of the day. For example, there will be no regulation of the OTC derivatives market or transparency but further consolidation with profits going to the major WS entities.
"June 9 (Bloomberg) -- Goldman Sachs Group Inc., Morgan Stanley and 14 banks and brokerages dealt a blow to futures exchanges in the battle to shift trading in the $62 trillion credit-derivatives market to a model the Wall Street firms control."
http://www.bloomberg.com/apps/news?pid=20601087&sid=ag_DZhUli8g4&refer=home

The real issue is the eroding safe haven that corporate bonds once represented; but the banks must be recapitalized and bondholders will eventually find themselves in the same position as homeowners except without having had the benefit of the leverage on the asset:
"Banks and brokers could have earned a $31 billion profit on the $62 trillion of outstanding credit-default swaps, assuming a 5 basis point spread between bid and ask prices. (snip) "The market for credit-default swaps has doubled in each of the previous three years as traders use the derivatives as a cheaper and easier way to invest in corporate debt." (see Bloomberg article above).

[Eric]

Two thoughts:

1) anybody out there a regulator, or working for a regulated financial institution? With some experience in the field I'm comfortable stating that regulation will work ONLY if the political will exists to enforce the existing regulations. That was definitely lacking this time out (as observed by a few above) - a lot of very smart, good people knew banks were behaving in a potemtially "unsafe and unsound manner" (to use regulator-speak) but no one was willing to take the punchbowl away from the big banks while they seemed to be making so much money.

2) counterparties - gee, who do you think were the counterparties to Bear Stearns? JP Morgan comes to mind. Is it possible that the Fed's actions were taken to protect the regulated banks from their own stupid investments?

Ultimately, none of this will be solved by new regulations, unless there are disincentives for individuals, not institutions, that are at least as strong as the incentives.

The real problem is that people like Robert Rubin and Charles Prince had absolutely no idea of the risks their people were taking. Some would call that "criminal negligence" - but the system PAYS Prince to go away.

Aren't getting incentives for individuals right a key element in good economics?