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Tuesday, April 09, 2013

Solow: Has Financialization Gone Too Far?

Robert Solow has an essay that begins with lots of praise for Ben Bernanke:

How to Save American Finance from Itself: Has financialization gone too far?, by Robert Solow, TNR: Central banking is not rocket science, but neither is it a trivial pursuit. ... Running a central bank is in one way a little bit like flying a plane or sailing a boat: much of the time standard responses and small adjustments will do just fine, but every so often a situation arises in which fundamental understanding, knowledge of history, and good judgment can make the difference between riding out the storm and crashing. There was no such person in charge in 1929, and the result was disaster. There was one in 2008.
In his earlier scholarly life, Ben Bernanke, the chairman of the Federal Reserve Board, had been a careful student of the general interaction between the financial system and the real economy and especially of its working out in the Great Depression of the 1930s. So he had done his homework. His decisive and innovative actions at the Fed saved our economy from free fall with a possibly catastrophic end. ...

He goes on to review a book of four lectures Ben Bernanke gave on the role of the Fed:

In March 2012, George Washington University invited Bernanke to give four lectures as part of a course devoted to the role of the Federal Reserve in the economy. The lectures are now reproduced in book form, apparently from lightly edited transcripts. Each lecture ends with half a dozen questions from anonymous “students” and Bernanke’s answers. Some of the questions are smart, some less so, in which case Bernanke exhibits the professorial skill of seamlessly answering a slightly different question. ...
The lectures are consistently lucid and informal—maybe a little too anecdotal, but illustrated with many clear and informative slides—and above all intelligent and interesting. There are no revelations or recantations; even if Bernanke had any in mind, this would not be the place for them. A short book such as this has no room for a play-by-play account of the crisis. But it would be difficult to find a better short and not very technical account of what went wrong, and of how the Fed (and the Treasury) managed to keep it from getting much worse. ...

He then goes through a long, detailed discussion of the issues Bernanke addresses in these lectures, but I want to pick it up again near the end:

Bernanke's ... preferred answer is better and more system-oriented regulation. One has to ask then why regulation failed to see the crisis of 2007–2008 coming and take action to head it off. Bernanke suggests that regulators were lulled into inattention by the so-called Great Moderation...
For safeguarding financial stability in the future, Bernanke seems to count heavily on the provision in Dodd-Frank that establishes a committee of regulators charged with keeping an eye on “systemically important” financial institutions, whatever they look like, in order to warn them away from dangerously risky behavior and/or impose extra capital requirements. We will have to see how that works out...
He touches on it only obliquely in these lectures, but Bernanke has lingering worries that the size, the complexity, and the interconnectedness of today’s financial system strain the capacity of even improved risk-management techniques to protect the system against its inherent vulnerabilities. ...
All of which leads to a broader issue... Any complicated economy needs a complicated financial system: to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects. If these functions are not performed adequately, the economy cannot produce and grow with anything like efficiency. Granted all that, however, the suspicion persists that financialization has gone too far.
What would that mean? It would mean that the last x percent of financial activity absorbs more resources (especially intellectual resources) and creates more potential instability than its additional efficiency-benefits can justify. This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate. Yes, it is hard to imagine that the Hedge Fund Operator of the Year does anything that is remotely socially useful enough to justify the enormous (and lightly taxed) compensation that results; but that is not really an argument. Much more significant is the fact that the bulk of incremental financial activity is trading, and trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of. This is, you might say, the $64 trillion question. Maybe I shouldn’t wish it on Ben Bernanke. 

Given his worries about financial stability, I have to wonder if the praise for Bernanke shouldn't be a bit more qualified. I agree that the Fed did a pretty good job responding the the recession. It could have done better -- it was frequently too late and too timid, especially during the first few years -- but it also could have done a whole lot worse. But what we don't yet know is how well we have been insulated from future shocks. Is Bernanke's view correct about what is needed on the regulatory front, and has it been implemented? In my view, significant vulnerabilities remain within the shadow banking system (and I'm far from alone). If that's true and we do have another crisis down the road, then the effusive praise for Bernanke will diminish much as happened with Greenspan (anointed as the best Fed Chair ever only to have housing bubble crash dramatically change the view of his record). As Robert Solow says about Bernanke's views on safeguarding financial stability in the future, "We will have to see how that works out.

    Posted by on Tuesday, April 9, 2013 at 12:02 PM in Economics, Financial System, Monetary Policy, Regulation | Permalink  Comments (30)


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