Economist's View

Reaching into Bank Executives' (Deep) Pocketbooks Motivates Action

Daniel Gross says the threat of restrictions on how much executives can be paid has motivated banks subject to the limits to "get their houses in order":

It's Payback Time!, by Daniel Gross: One of the main criticisms of the massive bank bailouts was that the Feds didn't get sufficiently medieval on bank shareholders, including top executives who owned big chunks of stock. ... And yet, by design or dumb luck, it turns out that the government did have one powerful stick that has pushed banks and their shareholders to reform themselves sooner rather than later: the ability to regulate banks' compensation. ...

From the outset, healthy banks were eager to get out from under the TARP because they wanted to avoid discussions about appropriate levels of executive compensation. The investment banks that were capable of paying back did so in June, the month when lawyer Kenneth Feinberg was appointed as TARP's special master for executive compensation. Coincidence?

In October, Feinberg issued compensation guidelines for the companies receiving special assistance... That, and the approach of the bonus season, lit a fire under executives at the largest remaining TARP recipients. ... They cut costs, shrank their balance sheets, and raised capital from new investors.

Look what's happened in the past two weeks. First, Bank of America agreed to pay back $45 billion in TARP funds. Bank of America found that the pay restrictions were complicating the search for a new boss to replace Ken Lewis. It raised $20 billion from the public and agreed to sell $3 billion in assets. The smaller, leaner, better-capitalized bank was able to hire a new CEO on Wednesday.

Citigroup ... also sprang into action. Earlier this week, it announced it would pay back $20 billion in TARP funds... Citi raised $20.5 billion of capital, said it would give employees $1.7 billion in stock rather than cash for bonuses. Once the money was paid back to the Treasury, Citi noted, "it will no longer be deemed to be a beneficiary of ... TARP..." Translation: Ken Feinberg won't be allowed to tell us how much to pay our folks. Because of its desire to get out from under such scrutiny, Citi has aggressively cut costs (by $15 billion annually), shed assets, and vastly improved its capital position. ...

Also this week, Wells Fargo announced it would repay $25 billion in TARP funds by selling $10.4 billion of stock and selling off assets. It, too, will be a smaller, leaner, better-capitalized bank.

Among the three, that's $90 billion in repayments to the taxpayers in a week and more than $50 billion raised from the public. Of course, these offerings came at a cost. The banks essentially created new shares... They diluted existing shareholders, which is what is supposed to happen when companies suffer losses and need to raise capital. And because of these offerings, future earnings will be spread across a much larger share base. As ... much as anything else, the threat of the government having limiting bankers' compensation spurred the banks to get their houses in order.

Ben Bernanke's Final Exam

Ben Bernanke answers some questions:

Sen. Vitter Presents End-of-Term Exam For Bernanke, by Sudeep Reddy, WSJ: Earlier this month, Real Time Economics presented questions from several economists for the confirmation hearing of Federal Reserve Chairman Ben Bernanke.  Many of the questions were addressed at the hearing, though not always directly. Sen. David Vitter (R., La.) submitted them in writing and received the  responses from Bernanke, along with his own other questions.  We offer them here.

The Wall Street Journal reported on some questions that different economists felt that you should answer. Let me borrow from some of those and I will credit them with their questions accordingly:

A. Anil Kashyap, University of Chicago Booth Graduate School of Business: With the unemployment rate hovering around 10%, the public seems outraged at the combination of three things: a) substantial TARP support to keep some firms alive, b) allowing these firms to pay back the TARP money quickly, c) no constraints on pay or other behavior once the money was repaid. Was it a mistake to allow b) and/or c)?

TARP capital purchase program investments were always intended to be limited in duration. Indeed, the step-up in the dividend rate over time and the reduction in TARP warrants following certain private equity raises were designed to encourage TARP recipients to replace TARP funds with private equity as soon as practical. As market conditions have improved, some institutions have been able to access new sources of capital sooner than was originally anticipated and have demonstrated through stress testing that they possess resources sufficient to maintain sound capital positions over future quarters. In light of their ability to raise private capital and meet other supervisory expectations, some companies have been allowed to repay or replace their TARP obligations. No targeted constraints have been placed on companies that have repaid TARP investments. However, these companies remain subject to the full range of supervisory requirements and rules. The Federal Reserve has taken steps to address compensation practices across all firms that we supervise, not just TARP recipients. Moreover, in response to the recent crisis, supervisors have undertaken a comprehensive review of prudential standards that will likely result in more stringent requirements for capital, liquidity, and risk management for all financial institutions, including those that participated in the TARP programs.

B. Mark Thoma, University of Oregon and blogger: What is the single, most important cause of the crisis and what s being done to prevent its reoccurrence? The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk?

The principal cause of the financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn.

This crisis did not begin with depositor runs on banks, but with investor runs on firms that financed their holdings of securities in the wholesale money markets. Much of this occurred outside of the supervisory framework currently established. An effective agenda for containing systemic risk thus requires elimination of gaps in the regulatory structure, a focus on macroprudential risks, and adjustments by all our financial regulatory agencies.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firm-wide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or system-wide, approach that should help us better anticipate and mitigate broader threats to financial stability.

Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as “too big to fail.” Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy.

Some observers have suggested that existing large firms should be split up into smaller, not-toobig- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.

C. Simon Johnson, Massachusetts Institute of Technology and blogger: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?

The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.

D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

Obama Says Banks Should Lend More

Obama tells bankers they should lend more to small businesses and homeowners:

Obama Tells Bankers That Lending Can Spur Economy, by Helene Cooper and Javier Hernandez, NY Times: President Obama pressured the heads of the nation’s biggest banks on Monday to take “extraordinary” steps to revive lending for small businesses and homeowners, drawing a firm commitment from one large bank to make more loans and vaguer assurances from others.

Meeting with executives from 13 financial institutions, Mr. Obama sent a clear message that the industry had a responsibility to help nurse the economy back to health and do more to create jobs in return for the bailout last year that kept Wall Street and the banking system afloat.

But ... Mr. Obama also confronted the limits of his power to jawbone the industry. ... The heads of three of the biggest firms — Goldman Sachs, Morgan Stanley and Citigroup — did not even make it to the White House meeting in person, having waited until Monday morning to travel to Washington and then being held up by fog.

“America’s banks received extraordinary assistance from American taxpayers to rebuild their industry,” Mr. Obama said in remarks after a midday meeting with bankers at the White House. “Now that they’re back on their feet we expect an extraordinary commitment from them to help rebuild our economy.” ...

Bank of America said after the meeting that it would increase lending to small and mid-sized businesses by $5 billion next year over what it lent to them in 2009.

Speaking outside the White House, Richard K. Davis, the chief executive of U.S. Bancorp,... said financial institutions would re-examine small business loans that had been denied, but he cautioned that banks had a responsibility to carefully evaluate the qualifications of each client. “We simply want to assure that we make qualified loans,” he said. ...

The tone for the White House meeting with the bankers was set Sunday night when CBS’s “60 Minutes” broadcast an interview in which Mr. Obama said “I did not run for office to be helping out a bunch of fat cat bankers on Wall Street.” ...

“We have to get them off the sidelines and get them to play a more active role in our economic recovery,” Rahm Emanuel, the White House chief of staff, said on Sunday. “They play an essential role in helping the economy grow.”

There are hurdles to get over on both the demand and supply side of the equation. Because of the recession, the demand for loans for new investment and for other purposes is down, but when firms do apply for credit, they are less likely to get it because banks assess credit worthiness partly based upon current economic conditions. The poor state of the economy has led them to conclude that many loans that might be made in better times are too risky to make right now

On the demand side, tax cuts and other incentives would help, but the supply of credit has to be addressed too. Yes, there's plenty of liquidity available, bank vaults are overrun with funds, but banks are reluctant to lend in this environment (particularly small and medium sized banks who face lots of uncertainty over their exposure to commercial real estate loans that may or may not be paid off). A solution to this is for the government to insure the loans in some way through tax write-offs, direct loss sharing, subsides, etc., there are lots of ways to do this, but it's hard to imagine anything like this happening in the present political environment, and the desirability of encouraging risky loans as a solution to our problems is questionable in any case (the money may be better spent on public projects with a high social return). However, if the government wants to encourage more lending in the private sector, something along these lines will need to be done. I don't see how speeches and meetings with bank executives asking them to lend more will do much to solve the problems, particularly the problems at smaller banks.

Paul Krugman: Disaster and Denial

Will centrist Democrats in the Senate support financial reform?:

Disaster and Denial, by Paul Krugman, Commentary, NY Times: When I first began writing for The Times, I ... actually believed that influential people could be moved by evidence, that they would change their views if events completely refuted their beliefs.

And to be fair, it does happen now and then. ...Alan Greenspan ... has admitted that he was wrong about the ability of financial markets to police themselves.

But he’s a rare case. Just how rare was demonstrated ... last Friday in the House of Representatives, when — with the meltdown caused by a runaway financial system still fresh in our minds, and the mass unemployment that meltdown caused still very much in evidence — every single Republican and 27 Democrats voted against a quite modest effort to rein in Wall Street excesses.

Let’s recall how we got into our current mess.

America emerged from the Great Depression with a tightly regulated banking system. The regulations worked: the nation was spared major financial crises for almost four decades after World War II. But as the memory of the Depression faded, bankers began to chafe at the restrictions they faced. And politicians, increasingly under the influence of free-market ideology, showed a growing willingness to give bankers what they wanted.

The first big wave of deregulation took place under Ronald Reagan — and quickly led to disaster, in the form of the savings-and-loan crisis of the 1980s. ...

But the proponents of deregulation were undaunted, and in the decade leading up to the current crisis politicians in both parties bought into the notion that New Deal-era restrictions on bankers were nothing but pointless red tape. ...

And the bankers — liberated both by legislation that removed traditional restrictions and by the hands-off attitude of regulators... — responded by dramatically loosening lending standards. The result was a credit boom and a monstrous real estate bubble, followed by the worst economic slump since the Great Depression. ...

Talk to conservatives about the financial crisis and you enter an alternative, bizarro universe in which government bureaucrats, not greedy bankers, caused the meltdown. It’s a universe in which government-sponsored lending agencies triggered the crisis, even though private lenders actually made the vast majority of subprime loans. It’s a universe in which regulators coerced bankers into making loans to unqualified borrowers, even though only one of the top 25 subprime lenders was subject to the regulations in question.

Oh, and conservatives simply ignore the catastrophe in commercial real estate: in their universe the only bad loans were those made to poor people and members of minority groups, because bad loans to developers of shopping malls and office towers don’t fit the narrative.

In part, the prevalence of this narrative reflects the principle enunciated by Upton Sinclair: “It is difficult to get a man to understand something when his salary depends on his not understanding it.” As Democrats have pointed out, three days before the House vote ... Republican leaders met with more than 100 financial-industry lobbyists to coordinate strategies. But it also reflects the extent to which the modern Republican Party is committed to a bankrupt ideology, one that won’t let it face up to the reality of what happened to the U.S. economy.

So it’s up to the Democrats — and more specifically, since the House has passed its bill, it’s up to “centrist” Democrats in the Senate. Are they willing to learn something from the disaster that has overtaken the U.S. economy, and get behind financial reform?

Let’s hope so. For one thing is clear: if politicians refuse to learn from the history of the recent financial crisis, they will condemn all of us to repeat it.

"We Face a Real Challenge in Dealing with that Feeling that the Crisis is Over"

Paul Volcker is interviewed:

Interview with Paul Volcker, by Gabor Steingart, Spiegel: ...Spiegel: ...[E]ven though there are still more people being fired than hired,... Ben Bernanke is saying that the recession is technically over. Do you agree with him?

Volcker: ...We had a quarter of increased growth but I don't think we are out of the woods. ... The recovery is quite slow and I expect it to continue to be pretty slow and restrained for a variety of reasons and the possibility of a relapse can't be entirely discounted. ... We have not yet achieved self-reinforcing recovery. We are heavily dependent upon government support so far..., both in the financial markets and in the economy. ...

I think we ... have a challenge... There is concern in our recovery advisory group about how to rebuild the competitiveness of the United States, which inevitably means rebuilding, in part, the manufacturing sector of the economy.

Spiegel: What part of the manufacturing sector do you envision?

Volcker: I think there are a lot of opportunities in the so-called green economy for taking leadership. ...

Spiegel: Outsourcing and off-shoring have been the key words of the last decades. You don't think that the times of "made in America" are over forever?

Volcker: That has been the mentality and we have to change that somehow. I think it's self-correcting in part. The glamour of going to Wall Street is not as great today as it was a few years ago.

Spiegel: Are you sure? The Wall Street businesses are doing well. The big bonuses are back.

Volcker: It's amazing how quickly some people want to forget about the trouble and go back to business as usual. We face a real challenge in dealing with that feeling that the crisis is over. The need for reform is obviously not over. ...

Spiegel: But the American government seems to have lost some eagerness in setting a tougher regime of rules and regulations to control Wall Street. Everything is being watered down. Why?

Volcker: I will do the best I can to fight any tendency to water it down. What we need is broad international consensus to make things happen. ...

Spiegel: During your tenure as chairman of the Federal Reserve, the bank was always part of the solution. Today..., many experts see it as part of the problem. ... Lawmakers on Capitol Hill are thinking about tougher controls over the Federal Reserve.

Volcker: I think the loss of independence and authority of the Federal Reserve would be a very serious matter for the United States. Not just in terms of monetary policy but in terms of our place in the world. People look to strong, credible institutions and I think the Federal Reserve has been such an institution. If that's lost or too hamstrung by legislation I think we will regret it.

Spiegel: But is the Fed still the same kind of institution as during your tenure as chairman? Or is it now more of a governmental instrument? The Fed is managing the TARP program and is also buying government bonds.

Volcker: In some sense the Federal Reserve is always an instrument of the government. It is a government body but it is independent within government. But you are right in the sense that part of the concern is that they have involved themselves quantitatively in entering markets and in that process, you are supporting some markets and not others. That is an area in which the Federal Reserve has never wanted to get into and one that most central banks don't want to get into. If you are going to maintain your independence you have to avoid that. To intervene in particular sectors of the market is not the proper role for the central bank over time. It could be justified only by extreme emergency.

Spiegel: So what do you expect in the very near future?

Volcker: As an American, I have to be an optimist. But we have got a big challenge and we have to face up to it. And as you know, there is a lot of concern about the dysfunction of the political system. ...

I think he's right that the Fed's support of the financial market and financial institutions made it appear that it favored some markets and some firms over others, and that has been a problem. But I don't think the Fed had a lot of choice. It lacked the authority to dismantle large financial institutions outside the traditional banking system, it lacked the plans to do so even if it had the authority, and the fact that regulators allowed these institutions to become such a threat to the economy if they failed meant the Fed had to intervene. That's why, going forward, three things need to happen. Regulators need to reduce the threat these banks pose, they need to have plans ready if a threat develops anyway, and legislators need to give regulators the authority to take control of troubled institutions outside the traditional banking system.

But I have to admit that "the dysfunction of the political system" makes me wary of what will happen once the legislative process begins. Things could get worse rather than better, and reducing the independence of the Fed is but one of many ways that could happen. Even so, the need for reform of the financial sector is sufficiently strong to justify taking that chance.

House Passes Bill on Financial Regulation

The House passed legislation today on regulation of the financial industry:

House Passes Far-Reaching Bill Tightening Financial Rules, by Carl Hulse, NY Times: The House on Friday approved a Democratic plan to significantly tighten federal regulation of Wall Street and the financial sector...

The bill’s principal provisions establish a process for dismantling large, failing financial institutions; set up a council to identify and regulate firms that are so big, interconnected or risky that they need heightened supervision to keep them from bringing down the whole financial system; create a new consumer financial-protection agency to squelch unfair and abusive practices; and for the first time, regulate over-the-counter derivatives markets. The bill also contains provisions on executive pay, investor protection, credit ratings, hedge funds and insurance.

However, the bill still has to pass the Senate:

Despite the House action, final legislation is not imminent. The Senate is still developing its own measure for debate early next year and any Senate bill is likely to have substantial differences from the House measure, necessitating further negotiations. ...

And the legislation still has to get by an important constituency for politicians:

In preliminary votes ahead of the measure’s approval, lawmakers scaled back the bill’s ambitions slightly in ways that may increase its chances of overcoming objections from powerful financial interests. ...

I'll keep my hopes up, but given lawmakers attention to "powerful financial interests," something that will certainly (and disconcertingly) influence the Senate bill as well, I'll wait to see what emerges from the Senate before concluding that this is the road to any type of fundamental regulatory change.

"How Have Quantitative Financial Models Been Used and Misused?"

A recent symposium on Financial models and financial innovation at Columbia University wonders "Why all the Fuss?":

Financial Models: Why All the Fuss?, by Catherine New: The research symposium “The Quantitative Revolution and the Crisis: How Have Quantitative Financial Models Been Used and Misused” at Columbia Business School on December 4 explored the causes and effects of the proliferation of quantitative finance. Donald MacKenzie, a professor of sociology at the University of Edinburgh, gave the keynote speech (PDF).

Professor Bruce Kogut, in his opening remarks, acknowledged that financial engineering and innovation have received an onerous rap in the fallout from the financial crisis. However, he suggested that the field was ripe for public debate.

“It might be easy to leap to the conclusion that the subtext of today is that financial models created the crisis and hence innovation is bad. But such a deduction is in fact deeply complex and largely suspect,” he said. “Why is there such debate over financial innovations? After all, innovation is a driver of economic growth and wealth, so why all the fuss?” Kogut suggested three possibilities, including the disparity between private and social value, unanswered questions about systemic risk and the speed at which innovation takes place.

Professor Paul Glasserman pointed to popular media portrayals, like WIRED’s “Recipe for Disaster: The Formula That Killed Wall Street” (Feb. 2009), which excoriated the financial industry’s use of models, as perpetuating misunderstanding about the uses and capabilities of quantitative finance.

“The article sets the record for the most incorrect statements packed into a title,” Glasserman said. “In a very short time there has been a dramatic shift in perception of quantitative finance.”

Glasserman moderated the panel “Does the Practice of Quantitative Finance Need to Be Changed?”...

Much of the panel’s discussion focused on when models are useful — and not useful — in financial markets. Derman, author of My Life as a Quant, led the discussion and offered a discourse on what models are and how they can be applied (download presentation PDF). He cautioned that there is never a “right” model but rather ”somewhere north of common sense and south of hubris lies the appropriate use of models.”

Beunza, formerly a visiting professor at the Business School, cautioned that the use of models is a “doubled-edged sword”; his research shows that they lead both to increased arbritrage and better reflexiveness.

Goldman Sachs’ research director Kent Daniel argued that models benefit many fields, such as airline safety, and not only financial markets. However, he cautioned that exacting data was fundamental to the use of models. “A successful quant model has to be subjected to every kind of scrutiny you have,” he said. “If your organization doesn’t do that, you’ll have a failure.”

There are important uses for financial products, even complicated ones, so I don't want to impugn innovation generally, but I also don't want to adopt the position that it was all useful - it clearly wasn't and stronger regulatory oversight is needed. As for the defense of financial models and innovation described above, the statement that innovation generally is the source of economic growth, therefore financial innovation must also be good, isn't much help. Similarly, if saying "models benefit many fields, such as airline safety, and not only financial markets" is the best defense of risk models available, that's telling.

[For those of you tempted to cite or that already have cited Paul Volcker's recent statement that ATMs are the only useful thing to come out of the financial industry in recent decades, I'd be more comfortable with your citing him as an all-knowing authority if you also adopted his position against auditing the Fed, and his position that the Fed ought to be the primary systemic risk regulator. But rather than listening to Volcker and others you have found to be trustworthy and wise in the past, many of you seem to find the arguments of people like Ron Paul and Jim DeMint compelling, and you have thrown your support behind their positions (something you'd be unlikely to do in any other context -- that alone ought to cause you to rethink this -- whose interests do you think people like DeMint are promoting?). If you get your way and congress, and by extension the financial industry, begins to have a strong influence over both policy and regulation, I hope you get the results you were hoping for. But I don't think you will.]

Stiglitz: Too Big to Live

When Ben Bernanke was asked about the "too big to fail" problem not too long ago, the WSJ Economics blog reports:

Federal Reserve Chairman Ben Bernanke voiced skepticism that breaking-up big banks is the way to solve the so-called too big to fail problem...

Asked for his thoughts on Bank of England Gov. Mervyn King’s recent speech that advocated breaking up banks that were so large that their failure would represent a risk to the broader financial system, Bernanke said that making banks smaller would not necessarily be the solution to the problem. Smaller banks can also play important roles in financial systems, he said. He noted that during the 1930s, the U.S. didn’t have too many large bank failures, but the country suffered thousands of failures of smaller banks that added to the woes of the Great Depression. “I don’t think simply making banks smaller is the way to do it,” he said.

Still, more than once during his comments to the Economic Club of New York, Bernanke emphasized that it is crucial that large financial firms be allowed to fail in order to return market discipline to the financial system.

It is not at all clear to me that breaking large banks into smaller pieces addresses the connectedness issue. Smaller banks can be just as interconnected as larger banks, and hence simply breaking banks up without examining the effect it has on the underlying financial network connections may not reduce systemic risk.

Joseph Stiglitz says break them up whenever possible, regulate them heavily when it's not possible:

Too Big to Live, by Joseph E. Stiglitz, Commentary, Project Syndicate: A global controversy is raging... Mervyn King, the governor of the Bank of England, has called for restrictions on the kinds of activities in which mega-banks can engage. ... King is right to demand that banks that are too big to fail be reined in. In the United States, the United Kingdom, and elsewhere, large banks have been responsible for the bulk of the cost to taxpayers. ...

The crisis is a result of at least eight distinct but related failures:

• Too-big-to-fail banks have perverse incentives; if they gamble and win, they walk off with the proceeds; if they fail, taxpayers pick up the tab.
• Financial institutions are too intertwined to fail...
• Even if individual banks are small, if they engage in correlated behavior – using the same models – their behavior can fuel systemic risk;
• Incentive structures within banks are designed to encourage short-sighted behavior and excessive risk taking.
• In assessing their own risk, banks do not look at the externalities that they (or their failure) would impose on others, which is one reason why we need regulation in the first place.
• · Banks have done a bad job in risk assessment – the models they were using were deeply flawed.
• · Investors, seemingly even less informed about the risk of excessive leverage than banks, put enormous pressure on banks to undertake excessive risk.
• · Regulators, who are supposed to understand all of this and prevent actions that spur systemic risk, failed. They, too, used flawed models and had flawed incentives; too many didn’t understand the role of regulation; and too many became “captured” by those they were supposed to be regulating.

... There are, of course, costs to regulations, but the costs of having an inadequate regulatory structure are enormous. We have not done nearly enough to prevent another crisis... King is right: banks that are too big to fail are too big to exist. If they continue to exist, they must exist in what is sometimes called a “utility” model, meaning that they are heavily regulated.

In particular, allowing such banks to continue engaging in proprietary trading distorts financial markets. Why should they be allowed to gamble, with taxpayers underwriting their losses? What are the “synergies”? Can they possibly outweigh the costs? Some large banks are now involved in a sufficiently large share of trading ... that they have, in effect, gained the same unfair advantage that any inside trader has.

This may generate higher profits for them, but at the expense of others. It is a skewed playing field – and one increasingly skewed against smaller players. Who wouldn’t prefer a credit default swap underwritten by the US or UK government; no wonder that too-big-to-fail institutions dominate this market.

The one thing nowadays that economists agree upon is that incentives matter. ... Given the lack of understanding of risk by investors, and deficiencies in corporate governance, bankers had an incentive not to design good incentive structures. It is vital to correct such flaws – at the level of the organization and of the individual manager.

That means breaking up too-important-to fail (or too-complex-to-fix) institutions. Where this is not possible, it means stringently restricting what they can do and imposing higher taxes and capital-adequacy requirements, thereby helping level the playing field. ...

Even if we fix bank incentive structures perfectly ... the banks will still represent a big risk. The bigger the bank, and the more risk-taking in which big banks are allowed to engage, the greater the threat to our economies and our societies. ... What is required is a multi-prong approach, including special taxes, increased capital requirements, tighter supervision, and limits on size and risk-taking activities.

Such an approach won’t prevent another crisis, but it would make one less likely – and less costly if it did occur.

I think limiting connectedness and limiting leverage ratios are both essential elements of reform. There will always be vulnerabilities, even in a system that has only small financial institutions, and we may not be able to identify the vulnerabilities in time. Shocks are going to happen. Limiting connectedness and leverage ratios for both big and small firms (along with regulation on what types of activities they can engage in, which addresses an aspect of connectedness) will reduce the magnitude of the damage to the financial system and the broader economy that those inevitable shocks are able to bring about.

Did Bank Executives Lose Enough to Learn their Lesson?

Will the losses that financial executives suffered as a result of the crisis provide the discipline necessary to prevent excessive risk taking in the future? Not according to this analysis:

Bankers had cashed in before the music stopped, by Lucian Bebchuk, Alma Cohen, and Holger Spamann, Commentary, Financial Times: According to the standard narrative, the meltdown of Bear Stearns and Lehman Brothers largely wiped out the wealth of their top executives. Many – in the media, academia and the financial sector – have used this account to dismiss the view that pay structures caused excessive risk-taking and that reforming such structures is important. That standard narrative, however, turns out to be incorrect.

It is true that the top executives at both banks suffered significant losses on shares they held when their companies collapsed. But our analysis ... shows the banks’ top five executives had cashed out such large amounts since the beginning of this decade that, even after the losses, their net pay-offs during this period were substantially positive. ...

Our analysis undermines the claims that executives’ losses on shares during the collapses establish that they did not have incentives to take excessive risks. ...[R]epeatedly cashing in large amounts of performance-based compensation based on short-term results did provide perverse incentives – incentives to improve short-term results even at the cost of an excessive rise in the risk of large losses at some (uncertain) point in the future.

To be sure, executives’ risk-taking might have been driven by a failure to recognise risks or by excessive optimism, and thus would have taken place even in the absence of these incentives. But given the structure of executive pay, the possibility that risk-taking was influenced by these incentives should be taken seriously.

The need to reform pay structures is not, as many have claimed, simply a politically convenient sideshow. ... To understand what has happened, and what lessons should be drawn, it is important to get the facts right. In contrast to what has been thus far largely assumed, the executives were richly rewarded for, not financially devastated by, their leadership of their banks during this decade.

It doesn't really matter whether executive compensation structures caused or contributed to the crisis or not. If the manner in which executives are paid creates perverse incentives and distorts decisions away from the best interests of shareholders, as it appears to do, then both the level and structure of the compensation should be fixed.

Deposits in Failed Banks as a Percent of GDP

Rolfe Winkler says suggestions that the current financial crisis was not as bad as the Great Depression are wrong and he offers this chart as evidence:

He adds:

If you add JP Morgan and Wells Fargo to the chart, it looks much worse. Goldman and Morgan Stanley don’t have deposits, but did have $2 trillion in liabilities between them as of August 31, ‘08

The Fed deserves more credit than it is getting for avoiding a much, much worse outcome for the economy. Yes, the Fed made mistakes, but are you really convinced that if Bernanke had been replaced by Larry Summers - and that was the likely outcome if he had been removed no matter how much you might wish it to be otherwise - things would have been better rather than worse? I'm not.

But I do want to add a few words about Bernanke's recent testimony before congress. I criticized Greenspan for taking a stand on fiscal policy in his testimony before congress, and I am not pleased that Bernanke waded into these waters. I think it's fine for the Fed chair to explain how budget deficits interact with monetary policy, how budget deficits affect the Fed's policy choices, what the Fed is likely to do if deficits persist (e.g., when markets return to normal, if deficits begin pressuring interest rates upward, will the Fed let interest rates rise or not?), matters that affect monetary policy in a fairly direct fashion. But to take stands on particular programs (e.g. Social Security and Medicare), to give advice on fiscal policy beyond its implications for monetary policy, to comment on matters outside of its purview unnecessarily politicizes the Fed. I have supported Bernanke's reappointment (if for no other reason than it's hard to imagine a viable candidate who would do better - be careful what you wish for), but this was disappointing.

Savings Gluts and Bubbles

Robin Wells says our current problems began with a global savings glut that was caused by "thrifty Germans, and state-owned enterprises in China – along with governments of other countries, of course, turning a blind eye to the escalating problems." And, she argues, if something isn't done to eliminate the glut, then asset bubbles and instability will continue, "exacerbating income inequality and favoring wealthy bankers and the Chinese elite":

Big savers got us into this mess, as well as big spenders, by Robin Wells, Commentary, Comment is Free: The world is trapped in a global savings glut. It is both the source of our economic woes and an obstacle to the task of pulling ourselves out of the ditch. Worse yet, the glut's continued existence will feed a succession of asset bubbles until we confront it, head on, and find ways to soak up the excess.

Yes, we can blame the City and Wall Street for turning the global savings glut into fissile material. But that's like saying, "hyenas do what hyenas do". Given extraordinarily lax regulation and a flood of money to play with, bankers were just acting according to their incentive schemes. They merely took advantage of the opportunities the glut presented. The real culprits are thrifty Germans, and state-owned enterprises in China – along with governments of other countries, of course, turning a blind eye to the escalating problems.

The flood of savings in the global economy arose from Germany and China's persistent trade surpluses over the last decade. A country with such a surplus sells more to its trading partners than it buys in return. Persistent deficit countries – the US, Britain, Iceland, and the eurozone excluding Germany, France and Italy – sell assets to the surplus countries to pay for their deficits. Thus persistent surplus countries accumulate the assets of persistent deficit countries: in the case of China, US treasury bills; in the case of Germany, Spanish eurobonds, sterling notes, and US sub-prime mortgages.

What makes this a global glut is that the world as a whole is saving more than can be profitably invested. The corollary is that, eventually, those funds will earn less than nothing. And through financial engineering, those losses are now distributed around the world.

Fed Watch: Bubbles and Policy

Tim Duy discusses the type of bubble-popping strategy the Fed ought to pursue:

Bubbles and Policy, by Tim Duy: The Wall Street Journal carried a front page article today detailing changing views at the Federal Reserve regarding the policy treatment of emerging bubbles of speculative activity. Much of the ground has been well tread. Is monetary policy or regulatory policy the best mechanism to address bubbles? I tend to favor the latter category, should we have a regulatory environment that is not essentially captured by those policymakers are supposed to regulate. Interest rate policy is a rather blunt weapon that kills indiscriminately. For instance, I am sympathetic with the view that interest rates were not necessarily too low during the build up of the housing bubble. Indeed, relatively low rates of investment (equipment and software) growth suggests that real rates were actually too high. But capital flowed to housing instead of more productive investment activities because that was the path of least resistance. Policymakers could have chosen to put some grit on that path by, for example, aggressively evaluating lending standards with regards to products such as "Liar's Loans," etc., but chose to follow a hands off approach.

What caught my attention in the article was this passage:

Yet the question of whether and how to tackle bubbles before they burst is becoming a growing concern amid fears of new bubbles developing in commodities markets and in emerging economies. Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did.

I think it is important to recognize what bubbles should be the focus of Federal Reserve concerns. After all, the Fed is charged with maintaining price stability and maximum sustainable employment in the United States. Why should the Fed be concerned with housing prices in Hong Kong or stock prices in Brazil and China? Don't those bubbles fall under the responsible of foreign central banks? It seems clear that in such cases, the extent of the Fed's concerns should be limited to the regulatory arena. Are US based banks lending into those bubbles, thereby setting the stage for negative feedback loops? If so, raise capital requirements on that lending, tighten underwriting standards, etc. Just don't derail the US recovery by raising rates to pop a bubble in Brazil.

I will admit that oil prices can be a bit more tricky. The gains in oil prices seem silly given ongoing evidence that the world is awash in oil. From the WSJ:

Café owner Ken Kennard sees the glut in the global oil market as a potential environmental threat to this sleepy seaside tourist hub.

Mr. Kennard is worried about a fleet of oil tankers -- almost 40 in all, each packing hundreds of thousands of barrels of crude and oil-derived products -- that have anchored several miles off the coast of southeast England in recent months.

The heavy traffic stems from a near-record excess oil supply, a byproduct of the recession, that is prompting producers to stash oil offshore until they can find customers. The excess supply hasn't stopped oil prices from surging almost 80% this year and padding the pockets of big oil producers like Royal Dutch Shell PLC and the Organization of Petroleum Exporting Countries.

To be sure, some of the rise in the price of oil is attributable to the decline in the Dollar, a natural consequence of low US interest rates and an important channel for the transmission of monetary policy. But it is not clear that higher oil prices necessarily yield additional core inflationary pressure given the current institutional arrangements between labor and management. The recent experience has been that individuals were not able to convert high inflation expectations in 2008 into higher wages. Instead, the opposite occurred as consumption sunk and unemployment skyrocketed. All of which means the Fed would need to think long and hard about leaning against the oil price increase if that entailed contractionary monetary policies; the costs are potentially high relative to the benefits. Here again, though, regulators need to be carefully evaluating the nature of lending into the oil space.

My views on this topic have shifted somewhat over the past two years. In early 2008, I was concerned that the Fed's rush to lower rates was contributing to destructive oil price bubble. But, in retrospect, nations that pegged to the Dollar and thus imported the Fed's easy policy were just as much, if not more, to blame, as those central banks failed to maintain policies appropriate for domestic conditions.

In short, the Fed does need to be aware of the full set of consequences of their policy stance. But bubbles abroad should not prevent the Fed from adopting the right policy stance for the US economy. Indeed, many of the bubbles discussed now clearly should not be the responsibility of the Fed.

James Galbraith on the Crisis

"Muddying the Waters on AIG"

John Berry defends the Fed and Treasury's assistance to AIG:

Muddying the waters on AIG, by John M. Berry, Commentary, Reuters: Neil Barofsky, inspector general of the Troubled Asset Relief Program, is making a name for himself with a misleading analysis of actions by the Federal Reserve and Treasury in combating the financial crisis.

A column in the New York Times called Barofsky “one of the few truth tellers in Washington”... Barofsky’s report, which is logically flawed, uses loaded language to create the impression that saving the economy wasn’t the Fed’s goal at all. No, it was all about helping the central bank’s friends on Wall Street.

“Questions have been raised as to whether the Federal Reserve intentionally structured the AIG counterparty payments to benefit AIG counterparties...,” the report says. ... The report duly notes that Fed officials deny a backdoor bailout was their objective. But the next sentence suggests the officials must be lying.

“Irrespective of their stated intent, however, there is no question that the effect of the Federal Reserve Bank of New York’s decisions — indeed the very design of the federal assistance to AIG — was that tens of billions of dollars of Government money was funneled inexorably and directly to AIG’s counterparties.” (Emphasis in the original.)

Well, AIG had sold the counterparties a great many credit default swap contracts covering collateralized debt obligations secured by mortgages. ...AIG owed the counterparties a whole pot full of money which it couldn’t pay.

If AIG was to be kept out of bankruptcy, of course the very design of the federal assistance had to include funneling tens of billions of dollars to the institutions to which it was owed. There was no other way to avoid a bankruptcy that would have affected not just big financial institutions but thousands of municipalities, individual savers and other investors. ...

The report does not offer an alternative way to avoid an AIG bankruptcy, and there wasn’t one. It does, however, suggest the Fed should have used its power as a banking regulator to force the AIG creditors to accept less than full payment of what they were owed.

The report acknowledges that the New York Fed tried to negotiate such a haircut... But the French banking regulator said it would be illegal for the two French institutions involved to take a haircut unless AIG was in formal bankruptcy, and the Fed said it had to treat all the banks the same way.

Nevertheless, Barofsky insists the Fed should have used its authority to force concessions. Unsaid, but implied: The Fed didn’t do that because its goal was to help its Wall Street friends.

Barofsky is getting great press and kudos on Capitol Hill by pandering to the public anger at Wall Street. Pity he’s not really a truth teller at all.

Paul Krugman: Taxing the Speculators

Is it time to impose a financial transactions tax?:

Taxing the Speculators, by Paul Krugman, Commentary, NY Times: Should we use taxes to deter financial speculation? Yes, say top British officials... Other European governments agree — and they’re right.

Unfortunately, United States officials — especially Timothy Geithner... — are dead set against the proposal. Let’s hope they reconsider: a financial transactions tax is an idea whose time has come.

The dispute began back in August, when Adair Turner, Britain’s top financial regulator, called for a tax on financial transactions as a way to discourage “socially useless” activities. Gordon Brown, the British prime minister, picked up on his proposal...

Why is this a good idea? The Turner-Brown proposal is a modern version of an idea originally floated in 1972 by the late James Tobin, the Nobel-winning Yale economist. Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies.

Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, “throw some sand in the well-greased wheels” of speculation.

Tobin’s idea went nowhere... But the Turner-Brown proposal, which would apply a “Tobin tax” to all financial transactions ... is very much in Tobin’s spirit. It would ... deter much of the churning that now takes place in our hyperactive financial markets.

This would be a bad thing if financial hyperactivity were productive. But after the debacle of the past two years, there’s broad agreement ... that a lot of what Wall Street and the City do is “socially useless.” And a transactions tax could generate substantial revenue, helping alleviate fears about government deficits. What’s not to like?

The main argument made by opponents of a financial transactions tax is that ... traders would find ways to avoid it. Some also argue that it wouldn’t do anything to deter the socially damaging behavior that caused our current crisis. But neither claim stands up to scrutiny.

On the claim that financial transactions can’t be taxed: modern trading is a highly centralized affair. ... This centralization keeps the cost of transactions low... It also, however, makes these transactions relatively easy to identify and tax.

What about the claim that a financial transactions tax doesn’t address the real problem? It’s true that a transactions tax wouldn’t have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.

But bad investments aren’t the whole story of the crisis. What turned those bad investments into catastrophe was the financial system’s excessive reliance on short-term money.

As Gary Gorton and Andrew Metrick ... have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions... Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”

And a financial transactions tax, by discouraging reliance on ultra-short-run financing, would have made such a run much less likely. So contrary to what the skeptics say, such a tax would have helped prevent the current crisis — and could help us avoid a future replay.

Would a Tobin tax solve all our problems? Of course not. But it could be part of the process of shrinking our bloated financial sector. On this, as on other issues, the Obama administration needs to free its mind from Wall Street’s thrall.

What’s Wrong With the Dodd Proposal to Restructure the Fed

At MoneyWatch:

What’s Wrong With the Dodd Proposal to Restructure the Fed, by Mark Thoma: A proposal from Senate Banking Committee Chairman Christopher Dodd changes the selection process for key positions within the Federal Reserve system. Unfortunately, this proposal makes the selection process worse, not better. If this proposal is passed into law, it would further concentrate power within the Federal reserve system and politicize the selection process, both of which are the opposite of the where reform should take the system. ...[...continue reading...]...

Paul Krugman: The Big Squander

The economy needs more help from the government, but it's unlikely to get it:

The Big Squander, by Paul Krugman, Commentary, NYTimes: Earlier this week, the inspector general for the Troubled Asset Relief Program ... released his report on the 2008 rescue of the American International Group... The gist of the report is that government officials made no serious attempt to extract concessions from bankers, even though these bankers received huge benefits from the rescue. And more than money was lost. ...

Throughout the financial crisis key officials — most notably Timothy Geithner... — have shied away from doing anything that might rattle Wall Street. And ... this play-it-safe approach has ended up undermining prospects for economic recovery. For the job of fixing the broken economy is far from done — yet finishing the job has become nearly impossible now that the public has lost faith in the government’s efforts, viewing them as little more than handouts to the people who got us into this mess.

About the A.I.G. affair:... why protect bankers from the consequences of their errors? Well, by the time A.I.G.’s hollowness became apparent, the world financial system was on the edge of collapse and officials judged — probably correctly — that letting A.I.G. go bankrupt would push the financial system over that edge. So A.I.G. was effectively nationalized; its promises became taxpayer liabilities.

But was there any way to limit those liabilities? After all, banks would have suffered huge losses if A.I.G. had been allowed to fail. So it seemed only fair for them to bear part of the cost of the bailout... Indeed, the government asked them to do just that. But they said no — and that was the end of the story. Taxpayers ... ended up honoring foolish promises made by other people ... at 100 cents on the dollar.

Could things have been different? ... Major financial firms are a small club, with a shared interest in sustaining the system; ever since the days of J.P. Morgan, it has been common in times of crisis to call on the big players to forgo short-term profits for the industry’s common good. Back in 1998, it was a consortium of private bankers — not the government — that put up the funds to rescue the hedge fund Long Term Capital Management.

Furthermore, big financial firms ... can pay a price if they act selfishly in times of crisis. Bear Stearns ... earned itself a lot of ill will by refusing to participate in that 1998 rescue, and it’s widely believed that this ill will played a major factor in the demise of Bear Stearns itself, 10 years later.

So officials could have called on bankers to offer a better deal,... and simultaneously threatened to name and shame those who balked. It was their choice not to do that...

And, as I said, these seemingly safe choices have now placed the economy in grave danger.

For the economy is still in deep trouble and needs much more government help. Unemployment is in double-digits; we desperately need more government spending on job creation. Banks are still weak, and credit is still tight; we desperately need more government aid to the financial sector. But try to talk to an ordinary voter about this, and the response you’re likely to get is: “No way. All they’ll do is hand out more money to Wall Street.”

So here’s the real tragedy of the botched bailout: Government officials, perhaps influenced by spending too much time with bankers, forgot that if you want to govern effectively you have retain the trust of the people. And by treating the financial industry — which got us into this mess in the first place — with kid gloves, they have squandered that trust.

The Fed “Refused to Use its Considerable Leverage”

A report on the NY Fed's role in the AIG bailout is less than flattering:

Audit Faults New York Fed in A.I.G. Bailout, by Mary Williams Walsh, NY Times: The Federal Reserve Bank of New York gave up much of its power in high-pressure negotiations with the American International Group’s trading partners last year, according to a government report made public on Monday.

Just two days before the New York Fed paid A.I.G.’s partners 100 cents on the dollar to tear up their contracts with the insurance giant, one bank volunteered to take a modest haircut — but it never got the chance. UBS, of Switzerland, alone offered to give a break to the New York Fed... It would have accepted 98 cents on the dollar.

But UBS’s good-faith gesture was quickly drowned out by Goldman Sachs and the top French bank regulator. They argued, with others, that it would be improper and perhaps even criminal to force A.I.G.’s trading partners to bear losses outside of bankruptcy court.

The banks and the regulator were confident that the New York Fed was not willing to push A.I.G. into bankruptcy... The New York Fed, led then by Timothy F. Geithner, who is now the Treasury secretary, therefore had little leverage in the negotiations...

The Fed “refused to use its considerable leverage,” Neil M. Barofsky, the special inspector general for the Troubled Asset Relief Program, wrote in a report to be officially released on Tuesday, examining the much-criticized decision to make A.I.G.’s trading partners whole when people and businesses were taking painful losses in the financial markets.

There have been suggestions that the Fed chose to negotiate weakly, Mr. Barofsky said, to give a “backdoor bailout” to A.I.G.’s banks. He said Mr. Geithner and the Fed’s lawyers had denied this, but added that “irrespective of their stated intent,” there was no doubt about the result: “Tens of billions of dollars of government money was funneled inexorably and directly to A.I.G.’s counterparties.” ...

Mr. Barofsky said the facts also undermined the Fed’s arguments that banking secrecy was an essential part of bank stability.

“The default position, whenever government funds are deployed in a crisis to support markets or institutions, should be that the public is entitled to know what is being done with government funds,” he said.

For the other side, see Economics of Contempt's Geithner Vindicated in TARP Watchdog Report.

"Sudden Financial Arrest"

Ricardo Caballero says that when there is a sudden failure of the financial system, governments should not let "fuzzy moral hazard reasoning" stop them from providing "massive" amounts of "credible public insurance and guarantees to financial transactions and balance sheets." He argues that "it is neither credible nor desirable to refuse to assist the private sector":

Sudden financial arrest, by Ricardo Caballero, Vox EU: “Sudden cardiac arrest (SCA) is a condition in which the heart suddenly and unexpectedly stops beating. When this happens, blood stops flowing to the brain and other vital organs…. SCA usually causes death if it’s not treated within minutes….”  – US National Institute of Health

There are striking and terrifying similarities between the sudden failure of a heart and that of a financial system. In the medical literature, the former is referred to as a sudden cardiac arrest (SCA). By analogy, I refer to its financial counterpart as a sudden financial arrest (SFA).

When an economy enters an episode of SFA, panic takes over, trust breaks down, and investors and creditors withdraw from their normal financial transactions. These reactions trigger a chain of events and perverse feedback-loops that quickly disintegrate the balance sheets of financial institutions, eventually dragging down even those institutions that followed a relatively healthy financial lifestyle prior to the crisis. In this article I draw on the parallels between SCA and SFA to characterize the latter and to argue that a pragmatic policy framework to address SFA requires a much larger component of systemic insurance than most policymakers and politicians currently support.

How to Prevent the Next Financial Crisis

At MoneyWatch:

How to Prevent the Next Financial Crisis, by Mark Thoma

Paul Krugman: World Out of Balance

Paul Krugman reiterates that China's currency policy must change:

World Out of Balance, by Paul Krugman, Commentary, NY Times: International travel by world leaders is mainly about making symbolic gestures. Nobody expects President Obama to come back from China with major new agreements, on economic policy or anything else.

But let’s hope that when the cameras aren’t rolling Mr. Obama and his hosts engage in some frank talk about currency policy. For the problem of international trade imbalances is about to get substantially worse. And there’s a potentially ugly confrontation looming unless China mends its ways. ...

Despite huge trade surpluses and the desire of many investors to buy into this fast-growing economy — forces that should have strengthened the renminbi, China’s currency — Chinese authorities have kept that currency persistently weak. They’ve done this mainly by trading renminbi for dollars, which they have accumulated in vast quantities.

And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.

What makes China’s currency policy especially problematic is the depressed state of the world economy. ... China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters.

But why do I say that this problem is about to get much worse? Because for the past year the true scale of the China problem has been masked by temporary factors. ...

That, at any rate, is the argument made in a new paper by Richard Baldwin and Daria Taglioni of the Graduate Institute, Geneva. As they note, trade imbalances, both China’s surplus and America’s deficit, have recently been much smaller than they were a few years ago. But, they argue, “these global imbalance improvements are mostly illusory — the transitory side effect of the greatest trade collapse the world has ever seen.”

Indeed, the 2008-9 plunge in world trade was one for the record books. What it mainly reflected was the fact that modern trade is dominated by sales of durable manufactured goods — and in the face of severe financial crisis and its attendant uncertainty, both consumers and corporations postponed purchases of anything that wasn’t needed immediately. How did this reduce the U.S. trade deficit? Imports of goods like automobiles collapsed; so did some U.S. exports; but because we came into the crisis importing much more than we exported, the net effect was a smaller trade gap.

But with the financial crisis abating, this process is going into reverse. Last week’s U.S. trade report showed a sharp increase in the trade deficit between August and September. And there will be many more reports along those lines.

So picture this: month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers. If I were the Chinese government, I’d be really worried about that prospect.

Unfortunately, the Chinese don’t seem to get it: rather than face up to the need to change their currency policy, they’ve taken to lecturing the United States, telling us to raise interest rates and curb fiscal deficits — that is, to make our unemployment problem even worse.

And I’m not sure the Obama administration gets it, either. The administration’s statements on Chinese currency policy seem pro forma, lacking any sense of urgency.

That needs to change. I don’t begrudge Mr. Obama the banquets and the photo ops; they’re part of his job. But behind the scenes he better be warning the Chinese that they’re playing a dangerous game.

"The World Needs a New Financial Architecture"

George Soros says we need a new world order.

After talking about the need for a new Bretton Woods conference to "establish new international rules, including treatment of financial institutions that are too big to fail and the role of capital controls," and the need for the IMF to "to reflect better the prevailing pecking order among states and to revise its methods of operation," he says:

World needs new financial architecture, by George Soros, Commentary, Project Syndicate: ...Reorganising the world order will need to extend beyond the financial system and involve the United Nations, especially membership of the Security Council. ...China and other developing countries ought to participate as equals. They are reluctant members of the Bretton Woods institutions, which are dominated by countries that are no longer dominant. ...

The system cannot survive in its present form, and the US has more to lose by not being in the forefront of reforming it. The US is still in a position to lead the world, but, without far-sighted leadership, its relative position is likely to continue to erode. It can no longer impose its will on others, as George W Bush’s administration sought to do, but it could lead a co-operative effort to involve both the developed and the developing world, thereby reestablishing American leadership in an acceptable form.

The alternative is frightening, because a declining superpower losing both political and economic dominance but still preserving military supremacy is a dangerous mix. We used to be reassured by the generalization that democratic countries seek peace. After the Bush presidency, that rule no longer holds, if it ever did.

In fact, democracy is in deep trouble in America. The financial crisis has inflicted hardship on a population that does not like to face harsh reality. President Barack Obama has deployed the “confidence multiplier” and claims to have contained the recession. But if there is a “double dip” recession, Americans will become susceptible to all kinds of fear mongering and populist demagogy.

If Obama fails, the next administration will be sorely tempted to create some diversion from troubles at home – at great peril to the world.

Obama has the right vision. He believes in international co-operation, rather than the might-is-right philosophy of the Bush-Cheney era. ...

What is lacking, however, is a general recognition that the system is broken and needs to be reinvented. ... Obama is preoccupied by many pressing problems,... reinventing the international financial system is unlikely to receive his full attention.

China’s leadership needs to be even more far-sighted than Obama is. China is replacing the American consumer as the motor of the world economy. Since it is a smaller motor, the world economy will grow slower, but China’s influence will rise very fast.

For the time being, the Chinese public is willing to subordinate its individual freedom to political stability and economic advancement. But that may not continue indefinitely – and the rest of the world will never subordinate its freedom to the prosperity of the Chinese state.

As China becomes a world leader, it must transform itself into a more open society that the rest of the world is willing to accept as a world leader. Military power relations being what they are, China has no alternative to peaceful, harmonious development. Indeed, the future of the world depends on it.

"Why Do Central Banks Have Assets?"

Nick Rowe says central banks hold assets for three reasons:

Why do central banks have assets?, by Nick Rowe: If you look at the balance sheet of a central bank, you will see it has liabilities (mostly currency) and assets (normally mostly government bonds/bills). Why do central banks have assets? Do they need them?

The wrong answer is that central banks need assets to "back" the value of the currency, and that paper currency would be worthless otherwise. The right answer is: since the government gets all the profits from a central bank anyway, there's no point in giving the government the assets; that owning assets lets the bank reverse course and reduce the money supply if it ever needs to; and it stops the accountants freaking out.

Let's deal with the wrong answer first. According to the "backing" theory of the value of money, the value of a central bank's currency is equal to and determined by the value of the central bank's assets backing the currency. (This is different from the fiscal theory of the price level, which says that the value of currency plus bonds is equal to and determined by the present value of primary fiscal surpluses.)

The backing theory sounds good. How can intrinsically worthless paper money have value? Because it is backed by valuable assets. It's just like shares in a mutual fund, which have value equal to and determined by the value of the assets in the fund.

Here are three arguments against the backing theory of money:

Paul Krugman: Obama Faces His Anzio

The failure to give the economy the fiscal stimulus it needs may be costly Democrats:

Obama Faces His Anzio, by Paul Krugman, Commentary, NY Times: Remember those Republican boasts that they would turn health care into President Obama’s Waterloo? Well, exit polls suggest that to the extent that health care was an issue in Tuesday’s elections, it worked in Democrats’ favor. But while health care won’t be Mr. Obama’s Waterloo, economic policy is starting to look like his Anzio.

True, the elections weren’t a referendum on Mr. Obama. Most voters focused on local issues... Yet there was a national element to the election. Voters ... are in a bad mood, largely because of the still-grim economic situation. And when voters are feeling bad, they turn on whomever currently holds office. ...

This bodes ill for the Democrats in the midterm elections next year ... because all indications are that ... unemployment will still be painfully high. And Republicans may well benefit, despite having become the party of no ideas.

Which brings me to the Anzio analogy.

The World War II battle of Anzio was a classic example of the perils of being too cautious. Allied forces landed far behind enemy lines, catching their opponents by surprise. Instead of following up on this advantage, however, the American commander hunkered down in his beachhead — and soon found himself penned in by German forces on the surrounding hills, suffering heavy casualties.

The parallel with current economic policy runs as follows: early this year, President Obama came into office with a strong mandate and proclaimed the need to take bold action on the economy. His actual actions, however, were cautious... They were enough to pull the economy back from the brink, but not enough to bring unemployment down.

Thus the stimulus bill fell far short of what many economists — including some in the administration itself — considered appropriate. ... Meanwhile, the administration balked at proposals to put large amounts of additional capital into banks, which would probably have required temporary nationalization of the weakest institutions. ...

Administration officials would presumably argue that they were constrained by political realities... But they never tested that assumption, and they also never gave any public indication that they were doing less than they wanted. The official line was that policy was just right, making it hard to explain now why more is needed.

And more is needed. Yes, the economy grew fairly fast in the third quarter — but not fast enough to make significant progress on jobs. And there’s little reason to expect things to look better going forward. The stimulus has already had its maximum effect on growth. ... Many economists predict that the economy’s growth, such as it is, will fade out over the course of next year.

The problem is that it’s not clear what Mr. Obama can do about this prospect. Conventional wisdom in Washington seems to have congealed around the view that budget deficits preclude any further fiscal stimulus — a view that’s all wrong on the economics, but that doesn’t seem to matter. Meanwhile, the Democratic base, so energized last year, has lost much of its passion, at least partly because the administration’s soft-touch approach to Wall Street has seemed to many like a betrayal of their ideals.

The president, then, having failed to exploit his early opportunities, is pinned down in his too-small beachhead.

If the Democrats lose badly in the midterms, the talking heads will say that Mr. Obama tried to do too much, this is a center-right nation, and so on. But the truth is that Mr. Obama put his agenda at risk by doing too little. The fateful decision, early this year, to go for economic half-measures may haunt Democrats for years to come.

Brad DeLong: Slouching Toward Sanity

Brad DeLong says government action during the crisis may have prevented another Great Depression:

Slouching Toward Sanity, by J. Bradford DeLong, Commentary, Project Syndicate: In America today ... the Republican congressional caucus is just saying no: no to short-term deficit spending to put people to work, no to supporting the banking system, and no to increased government oversight or ownership of financial entities. And the banks themselves are back to business-as-usual: anxious to block any financial-sector reform and trusting congressmen eager for campaign contributions to delay and disrupt the legislative process.

I do not claim that policy in recent years has been ideal. If I had been running things 13 months ago, the United States Treasury and Federal Reserve would have let Lehman and AIG fail – but I would have discounted their debt for cash at face value, provided that the debt also came with sufficient equity warrants. That would have preserved the functioning of the system while severely punishing the banking and shadow-banking systems’ equity holders...

If I had been running things 19 months ago, I would have nationalized Fannie Mae and Freddie Mac and ... shifted monetary and financial policy from targeting the Federal Funds rate to targeting the price of mortgages. Ever since 1825, the purpose of monetary policy in a crisis has been to support asset prices to prevent the financial markets from sending to the real economy the price signal that it is time for mass unemployment. Nationalizing Fannie and Freddie, and using them to peg the price of mortgages, would have been the cleanest and easiest way to accomplish that.

Nevertheless, policy over the past two and a half years has been good. A fundamental shock bigger than the one in 1929-1930 hit a financial system that was much more vulnerable to shocks than was the case back then. Despite this, unemployment will peak at around 10%, rather than at 24%, as it did ... during the Great Depression... Nor will we have a lost decade of economic stagnation, as Japan did in the 1990’s. ...

It is worth stepping back and asking: What would the world economy look like today if policymakers had acceded to the populist demand of no support to the bankers? What would the world economy look like today if Congressional Republican opposition to the Troubled Asset Relief Program program and additional deficit spending to stimulate recovery had won the day?

The only natural historical analogy is the Great Depression... That is the only time when (a) a financial crisis caused a widespread, lengthy, and prolonged reinforcing chain of bank failures, and (b) the government neither intervened nor passed the baton to a consortium of private banks to support the system as a whole.

It is now 19 months after Bear Stearns failed ... and industrial production stands 14% below its peak in 2007. By contrast, 19 months after the Bank of the United States ... failed on December 11, 1930 ... industrial production ... was 54% below its 1929 peak.

Opponents of recent economic policy rebel against the hypothesis that an absence of government intervention and support could produce an economic decline of that magnitude today. After all, modern economies are stable and stubborn things. Market systems are resilient... A 54% fall in industrial production between its 2007 peak and today is inconceivable – isn’t it? ...

The problem, though, is that all the theoretical reasons to think that depressions as deep as the Great Depression simply do not happen to market economies applied just as well to the 1930’s as they do to today.

But it did happen. And it could have happened again.

[Traveling: Preset to post automatically.]

"Stiglitz: U.S. Paying for Not Nationalizing Banks"

Barry Ritholtz:

Stiglitz: U.S. Paying for Not Nationalizing Banks, by Barry Ritholtz:

“We have this very strange situation today in America where we have given banks hundreds of billions of dollars and the president has to beg the banks to lend and they refuse. What we did was the wrong thing. It has weakened the economy and has increased our deficit, making it more difficult for the future.” -- Joseph Stiglitz

Any time Joseph Stiglitz calls out the government on their bad decision making, its worth reading:

“Nobel Prize-winning economist Joseph Stiglitz said the world’s biggest economy is suffering because of the U.S. government’s failure to nationalize banks during the financial crisis.

“If we had done the right thing, we would be able to have more influence over the banks,” Stiglitz told reporters at an economic conference in Shanghai Oct 31. “They would be lending and the economy would be stronger.”

Stiglitz has stuck with his view even after the U.S. economy returned to growth in the third quarter and as banks’ share prices climbed this year…

The U.S. government plans to alter the way that a similar rescue would be handled in the future. Draft legislation proposes that banks, hedge funds and other financial firms holding more than $10 billion in assets would pay to rescue companies whose collapse would shake the financial system.”

Why are we constantly governed by fools?

What I've said is that there is more than one route to get to the same destination, some of which are faster than others. Nationalization would have, I believe, led to a faster recovery. But even if that's not the case, even if the recovery would have gone at the same speed (I don't think it would have been slower), nationalization would have also allowed us to reach the same outcome with a different distribution of the bailout money, a distribution that would have been at least somewhat more acceptable to the public because it wouldn't have required giving so much of the bailout money to those who caused the problems.

Woodford on Financial Markets

Part of an interview of Michael Woodford:

Q&A: Economist Woodford on Fed and Rate Expectations, RTE: ...Given the importance of financial stability for the wider economy, do you think financial stability should play a greater or explicit role in the Federal Reserve’s policy strategy?

Woodford: No doubt, the Fed should give greater attention to financial stability than it did in the past. One should try and set up a framework to safeguard financial stability, and it may very well be that ... central banks should play a key role. But, ideally, one would be scrutinizing the risks developing and adjust capital requirements accordingly, rather than using monetary policy to respond to these risks. You’ve got to realize that pretending you can do everything with one tool means you won’t do any of them too well.

Should the Fed be more reactive — leaning against the wind -toward sharp moves in asset prices, such as house prices and equities? Should the Fed include a broader range of asset prices in its policy strategy?

Woodford: I’m not too sympathetic of that way of putting things. Using monetary policy to prevent certain moves in asset prices wouldn’t be a terribly effective tool. And to the extent that it would be effective, it’d involve important costs for the rest of the economy. It’d be particularly bad for the Fed to be saying “we have a view on where asset prices should be, and we’re going to get them there by using monetary policy.” Instead, the focus of the Fed’s investigation should be on what kind of risks financial institutions get themselves into — not on asset prices as such.

The Fed has downgraded the role of money and credit aggregates in its policy strategy. Given the more recent developments, do you think it’s now time to reconsider, or reverse the move?

Woodford: The issue that deserves more attention is monitoring risks to financial stability and identifying possible systemic risks. Unfortunately, traditional monetary and credit statistics aren’t that closely related to the things you really ought to be measuring. For example, lending by non-bank entities has played an important role in the recent real-estate euphoria. Given the emergence of new kinds of institutions and financing arrangements, you cannot simply revert to the old statistics people used to look at decades ago. There should be more research on understanding which measures are in fact the valuable indicators.

The last section is important. Many people have said that we cannot tell when a bubble is inflating (and thus when risks are increasing), but how hard have we actually tried? Have we seriously looked at data on, to name just one element of what I have in mind, leverage cycles? Do we know how leverage cycles relate to crises, that kind of knowledge that years of hard work by a variety of researchers brings about? Some people likely know the answer to this, or at least have some idea about this, but it's not data you'll find in standard sources such as FRED. As another example, what about measures and data on the degree of financial market connectedness? This can be measured in principle, but little effort has been devoted to doing so. Even traditional measures such as P/E ratios and Q-ratios haven't received the attention they deserve.

Until we dig in and try seriously to develop new empirical measurements that can monitor and identify risks, measures intended to inform us when risks are increasing to dangerous levels, we won't know if we can identify bubbles or not. I understand that financial theory says such predictions are impossible, and this has led people to shy away from such work, but that result relies upon assumptions that may not be true. The crisis has revealed the shaky foundation those models rest upon, so it's no  longer an excuse for not trying, or, as in the past, for dismissing work along these lines as unimportant and a waste of time.

"Reserve Accumulation and Easy Money Helped to Cause the Subprime Crisis"

Guillermo Calvo sketches an outline of a theoretical framework to explain the crisis. In this model, the demand for international reserves, low US interest rate policy and lax financial regulation leads to the creation of fragile financial instruments and the "large-scale creation of quasi-money subject to self-fulfilling-expectations runs":

Reserve accumulation and easy money helped to cause the subprime crisis: A conjecture in search of a theory, by Guillermo Calvo, Vox EU: A view that is gaining popularity as one of the fundamental explanations for the current crisis is that emerging markets’ voracious appetite for international reserves coupled with record-low US policy interest rates and lax financial regulation to produce a frantic “search for yield,” the creation of fragile financial instruments, and occasionally outright fraud. For example see Henry Paulson’s discussion quoted in Guta (2009).

This view – particularly, the “financial fragility” component – could help to answer a central question, namely, why minor fireworks in the subprime mortgage market ignited a fearsome powder keg and a local problem became global in a short span of time.

In this column, I will present a framework that provides some conceptual support for the view. The framework stresses fragilities associated with liquid financial instruments that have long been identified in the finance literature.¹ For the sake of concreteness, I will focus on the Fed and abstract from international aspects, unless strictly necessary.

"Bernanke: Smaller Banks Not Necessarily the Answer"

Ben Bernanke does not want to lose "the economic benefit of multi-function, international (financial) firms," so he is hesitant to break large banks into smaller sized institutions. I don't have much problem with the economics, if there are efficiencies that come with bank size we should exploit them, especially if breaking up banks into smaller entities does little to reduce systemic risk but instead simply fragments the problem into many more pieces (though I'd still like to know where the minimum efficient scale is, anything larger than that is unnecessary). Obtaining resolution authority for banks in the shadow system is also very important, so I don't disagree with the emphasis on this in Bernanke's remarks.

But there seems to be the view that if they have resolution authority, higher capital requirements, etc., that will make the probability of a major breakdown small enough so that the expected benefits of size outweigh the expected costs. While I agree that obtaining resolution authority and other regulatory change is extremely important, I wouldn't bet my house, or housing and asset markets more generally, that this will eliminate the chance of a major breakdown, or make the chance small enough to justify huge, powerful, market-dominating institutions.

I would like to see more effort to measure and regulate connectedness within the system (which can be very high even with banks broken into smaller pieces) since that would add another layer of protection, the degree of leverage should come under scrutiny as well, and I would also like to see more attention to the political risks (e.g. capture of legislators and hence regulation) posed by large financial firms:

Bernanke: Smaller Banks Not Necessarily the Answer for ‘Too Big to Fail’ Dilemma, by David Wessel, WSJ: Mervyn King, governor of the Bank of England, says the solution to banks that are “too big to fail” is to have smaller banks. But Ben Bernanke, chairman of the U.S. Federal Reserve, says he isn’t convinced that’s the best answer.

Mr. Bernanke ... said he would prefer “a more subtle approach without losing the economic benefit of multi-function, international (financial) firms.” ...

Mr. Bernanke suggested alternatives such as higher capital requirements against bank trading books, higher capital for “systemically important” institutions and a congressionally created process for coping with failing big financial firms in ways other than bankruptcy or bail out.

He also expressed interest in what have been dubbed “living wills” — plans that big banks would have to maintain for winding down their operations.

The goal, Mr. Bernanke said, is to reduce “the artificial incentives for size” — including the incentive to grow large so that government bailouts are anticipated — so that financial firms instead grow to a size that is economically valuable in a global economy populated by large multinational companies.

The Fed chairman did emphasize that supervisors should have the authority and willingness to tell the management of a large institution, where appropriate, that it cannot expand unless it improves its management and risk-management capabilities.

Both in answering the question and in his prepared text, Mr. Bernanke again beseeched Congress to act soon to give regulators “resolution authority” to cope with the imminent collapse of a big financial firm other than a bank, and to address other vulnerabilities in the regulatory regime exposed during the crisis.

Merriment and Diversion

Felix Salmon wonders what Hank Paulson was thinking. Me too:

The secret Paulson-Goldman meeting, by Felix Salmon: Andrew Ross Sorkin’s new book is out today, and breaks some pretty stunning news, dating from the end of June, 2008. At this point, we’re still months away from the now-famous but then-secret waiver, issued in mid-September, which allowed Hank Paulson to talk to Goldman Sachs; he’d promised not to do that when he moved from Goldman to Treasury.

But it turns out that Paulson just happened to be in Moscow at the same time that Goldman’s board of directors was having dinner there with Mikhail Gorbachev. (You know, as one does.) Take it away, Andrew:

When Paulson learned that Goldman’s board would be in Moscow at the same time as him, he had [Treasury chief of staff] Jim Wilkinson organize a meeting with them. Nothing formal, purely social — for old times’ sake.

For f#&%’s sake! Wilkinson thought. He and Treasury had had enough trouble trying to fend off all the Goldman Sachs conspiracy theories constantly being bandied about in Washington and on Wall Street. A private meeting with its board? In Moscow?

For the nearly two years that Paulson had been Treasury secretary he had not met privately with the board of any company, except for briefly dropping by a cocktail party that Larry Fink’s BlackRock was holding for its directors at the Emirates Palace Hotel in Abu Dhabi in June.

Anxious about the prospect of such a meeting, Wilkinson called to get approval from Treasury’s general counsel. Bob Hoyt, who wasn’t enamored of the “optics” of such a meeting, said that as long as it remained a “social event,” it wouldn’t run afoul of the ethics guidelines.

Still, Wilkinson had told [Goldman chief of staff John] Rogers, “Let’s keep this quiet,” as the two coordinated the details. They agreed that Goldman’s directors would join him in his hotel suite following their dinner with Gorbachev. Paulson would not record the “social event” on his official calendar…

“Come on in,” a buoyant Paulson said as he greeted everyone, shaking hands and giving bear hugs to some.

For the next hour, Paulson regaled his old friends with stories about his time in Treasury and his prognostications about the economy. They questioned him about the possibility of another bank blowing up, like Lehman, and he talked about the need for the government to have the power to wind down troubled firms, offering a preview of his upcoming speech.

How on earth did Paulson think this was OK? Goldman Sachs was a hugely powerful for-profit investment bank, and there he is, giving private chapter and verse on his opinions about the US and global economy, talking about internal Treasury matters, and previewing an upcoming (and surely market-moving) speech. All in secret, at a “social event” which somehow got kept off his official calendar. Oh, yes, and one other thing — the whole shebang took place in the Moscow Marriott Grand Hotel, in the context of Goldman directors joking about how all the Moscow hotels were surely bugged.

This is sleazy in the extreme, and will only serve to heighten suspicions that Paulson’s Treasury was rigging the game in favor of Goldman all along. ...

Paulson didn’t have this meeting out of fear or necessity... There was nothing in the way of extenuating circumstances which could possibly justify the secret rendezvous. This is definitely a situation where Wilkinson should have pushed back and said no way — but it’s hard to say no to Hank Paulson. Whose reputation has now taken yet another serious lurch downwards.

"How Paulson Gave Goldman the Lehman Heads-Up"

More from Felix Salmon:

How Paulson gave Goldman the Lehman heads-up, by Felix Salmon: The secret Paulson-Goldman meeting wasn’t the only time that Hank Paulson treated his buddies at Goldman Sachs especially well while at Treasury. In fact, it wasn’t the only time he did so before he got the now-famous waiver.

A bit further on in the Sorkin book, while Paulson is trying to work out what should be done with an imploding Lehman Brothers, we find this:

If all that weren’t enough to deal with, [Lehman president Bart] McDade had just had a baffling conversation with [CEO Dick] Fuld, who informed him that Paulson had called him directly to suggest that the firm open up its books to Goldman Sachs. The way Fuld described it, Goldman was effectively advising Treasury. Paulson was also demanding a thorough review of Lehman’s confidential numbers, courtesy of Goldman Sachs.

McDade, though never much of a Goldman conspiracy theorist, found Fuld’s report discomfiting, but moments later was on the phone with Harvey Schwartz, Goldman’s head of capital markets. “I’m following up at Hank’s request,” he began.

After another perplexing conversation, McDade walked down the hall and told Alex Kirk to immediately call Schwartz at Goldman, instructing him to set up a meeting and getting them to sign a confidentiality agreement.

“This is coming directly from Paulson,” he explained.

In many ways, this is worse than Paulson’s meeting with Goldman’s board: in this case, Paulson is forcing Lehman to open its books fully to a direct competitor, for no obvious reason. And in this case it’s not at all obvious that Paulson got a sign off from Treasury’s general counsel before doing so. ... If the Moscow meeting wasn’t enough to precipitate some kind of Congressional investigation of Paulson, this should be.

Update: There’s more, a few pages later:

As they were making yet another pass through the earnings call script, Kirk’s cell phone rang. It was Harvey Schwartz from Goldman Sachs, phoning about the confidentiality agreement that Kirk was preparing. Before Schwartz began to discuss that matter, however, he said that he had something important to tell Kirk: “For the avoidance of doubt, Goldman Sachs does not have a client. We are doing this as principal.”

For a moment Kirk paused, gradually processing what Schwartz had just said.

“Really?” he asked, trying to keep the shock out of his voice. Goldman is the buyer?

“Okay. I have to call you back,” Kirk said, nervously ending the conversation, and then almost shouted to Fuld and McDade, “Guys, they don’t have a client!”…

McDade, reasonably, was concerned about sharing information with a direct competitor: How much did they really want to divulge? At the same time, he felt they couldn’t take a stand against a plan that he believed had originated with Paulson…

McDade, turning back to his preparations for the fast-approaching call, made his position clear: “We were told by Hank Paulson to let them in the door. We’re going to let them in the door.”

There are questions here that need to be answered about the relationship between the Treasury, Paulson in particular, and Goldman Sachs, who was, we are told, "effectively advising Treasury."

"Fed Chief Cites Trade Imbalances’ Role in Crisis"

Ben Bernanke:

Fed Chief Cites Trade Imbalances’ Role in Crisis, by Edmund Andrews, NY Times: Ben S. Bernanke, the chairman of the Federal Reserve, said on Monday that global trade imbalances played a central role in the global economic crisis and warned that the both the United States and fast-growing Asian nations needed to do more to prevent them from recurring.

“We were smug,” Mr. Bernanke said of the United States, saying the American financial regulatory system was “inadequate” at managing the immense inflows of cheap money from China and other countries that had huge trade surpluses.

Though the Fed chairman acknowledged that trade imbalances have declined sharply as a result of the crisis, mainly because trade itself plunged, he warned that American foreign indebtedness will aggravate the imbalances once again unless the United States reduces its soaring federal budget deficit.

“The United States must increase its national saving rate,” he said. “The most effective way to accomplish this goal is by establishing a sustainable fiscal trajectory, anchored by a clear commitment to substantially reduce federal deficits over time.” ...

By the same token, he said, Asian countries needed to rely less on exports and more on their consumption at home for their economic growth. One way to increase Asian household consumption, he said, would be for countries like China to increase social insurance programs and reduced the uncertainty that currently hangs over many consumers. ...

With the Asian economy expanding at an annualized rate of 9 percent in the second quarter of this year, and China’s economy expanding at rates of more than 10 percent, Mr. Bernanke said, “Asia appears to be leading the global recovery.”

But the Fed chairman warned that the United States-led crisis was fueled in large part by huge inflows of cheap money to the United States from countries like China that were trying to recycle dollars from their huge trade surpluses.

The Fed chairman noted that global trade and financial imbalances have narrowed considerably since the crisis began... But he cautioned that the imbalances could widen out again as economic growth revives. While the United States has to tighten its belt by saving more and consuming less, China and other Asian countries need to increase their consumer spending in order to promote faster domestic economic growth.

Mr. Bernanke avoided what was in many ways the elephant in the room: the value of the United States dollar. The dollar has dropped sharply in recent weeks against the euro and the Japanese yen, which has helped increase American exports by making them cheaper in some foreign markets. But the dollar has not budged in more than a year against China’s renmimbi...

There were three important factors in the crisis, global imbalances (Bernanke's savings glut), low interest rate policy by the Fed, and the failure of markets and regulators to provide the checks and balances necessary to prevent the crisis from occurring. The global imbalances combined with the Fed's low interest rate policy led to the massive build up of global liquidity looking for a safe, high return home, and the market and regulatory failures allowed the extra liquidity and the false promise of high, safe returns to concentrate risk in the mortgage markets.

Bernanke focuses on two of these causes of the crisis, global imbalances and regulatory problems (market failures get less attention), but he does not focus on the Fed's role in the crisis at all. So let me say that I hope the Fed is more willing to consider popping bubbles as they inflate than it has been in the past. But that is not the main point I want to make.

The crisis, according to Bernanke, occurred when the excess global liquidity overwhelmed financial markets -- it was too much for either regulators and markets to handle. Think of a hurricane hitting a city that is so strong and powerful that it overwhelms levees and other flood/damage control mechanisms. That's essentially Bernanke's explanation, the shock was too big for the mechanisms we had in place to control the damage. One solution to the hurricane problem is to hope that such large shocks don't happen again and simply rebuild the same defenses as before, and another response is to recognize that such shocks will occur every so often and to build the stronger defensive measures needed to get ready.

Bernanke acknowledges that the defenses, i.e. the regulation of financial markets, need to be strengthened, but he seems to place a lot of emphasis on reducing the size of future shocks (reduce the budget deficit, have Asian countries consume more to reduce imbalances, etc.). I think that is fine, we should reduce the danger as much as we can, but we need to accept that global imbalances are possible, that a shock of this magnitude could and probably will happen again at some point in the future, and we need to make sure that markets don't fail like they did this time (i.e. we need to fix the bad incentives in these markets). But more importantly, we need to strengthen our regulatory defenses in anticipation of the next big shock. If it's fair to blame the government for not having levees, etc. ready for Katrina, if we insist that the defenses need to be strengthened going forward, then the same argument can be made in financial markets. Despite our best efforts to reduce the chances that a large shock will occur through deficit reduction and higher domestic saving rates, we should expect that global imbalances will rear their head again at some point, and the system cannot be overwhelmed again like it was this time.

For that reason, I'm a bit disappointed in Bernanke's willingness to point fingers at external causes and say other countries must change their consumption habits, or to blame budget deficits, at a time when financial regulation is coming onto the legislative agenda (though he didn't say anything about the exchange rate). Those are important problems and I don't mean to dismiss them, but right now financial regulation is being considered by congress, and it's essential that we get the regulations in place that can withstand the next big shock. Blaming external forces for the crisis will make it easier for opponents of regulation to blame China and other countries, and that gives legislators an excuse to give in to pressure (e.g. campaign contributions) from the financial industry to go soft on regulatory changes.

Update: Paul Krugman comments on Bernanke's remarks: America’s Chinese disease (not quite what you think).

Paul Krugman: The Banks Are Not Alright

The failure to pursue the best strategy for cleaning up the financial system, temporary nationalization and a large injection of capital, is slowing down the recovery, particularly for "the part of banking that really matters — lending, which fuels investment and job creation":

The Banks Are Not Alright, by Paul Krugman, Commentary, NY Times: ...[Many people] reacted with fury to the spectacle of Goldman Sachs making record profits and paying huge bonuses even as the rest of America, the victim of a slump made on Wall Street, continues to bleed jobs. ...

Ask the people at Goldman, and they’ll tell you that it’s nobody’s business but their own how much they earn. But as one critic recently put it: “There is no financial institution that exists today that is not the direct or indirect beneficiary of trillions of dollars of taxpayer support for the financial system.” Indeed: Goldman has made a lot of money..., but .... only ... thanks to policies that put vast amounts of public money at risk...

So who was this thundering bank critic? None other than Lawrence Summers... Administration officials are furious at the way the financial industry, just months after receiving a gigantic taxpayer bailout, is lobbying fiercely against serious reform. But you have to wonder what they expected to happen. They followed a softly, softly policy, providing aid with few strings, back when all of Wall Street was on the ropes; this left them with very little leverage over firms like Goldman that are now, once again, making a lot of money.

But there’s an even bigger problem: while the wheeler-dealer side of the financial industry,... trading operations, is highly profitable again, the part of banking that really matters — lending, which fuels investment and job creation — is not. Key banks remain financially weak, and their weakness is hurting the economy as a whole.

You may recall that earlier this year there was a big debate about how to get the banks lending again. Some analysts, myself included, argued that at least some major banks needed a large injection of capital from taxpayers, and that the only way to do this was to temporarily nationalize the most troubled banks. The debate faded out, however, after Citigroup and Bank of America, the banking system’s weakest links, announced surprise profits. All was well, we were told, now that the banks were profitable again.

But a funny thing happened on the way back to a sound banking system: last week both Citi and BofA announced losses in the third quarter. What happened?

Part of the answer is that those earlier profits were in part a figment of the accountants’ imaginations. More broadly,... economic distress, especially persistent high unemployment, is leading to big losses on mortgage loans and credit cards.

And here’s the thing: The continuing weakness of many banks is helping to perpetuate that economic distress. Banks remain reluctant to lend, and tight credit, especially for small businesses, stands in the way of the strong recovery we need.

So now what? Mr. Summers still insists that the administration did the right thing: more government provision of capital, he says, would not “have been an availing strategy for solving problems.” Whatever. In any case, as a political matter the moment for radical action on banks has clearly passed.

The main thing for the time being is probably to do as much as possible to support job growth. With luck, this will produce a virtuous circle in which an improving economy strengthens the banks, which then become more willing to lend.

Beyond that, we desperately need to pass effective financial reform. For if we don’t, bankers will soon be taking even bigger risks than they did in the run-up to this crisis. After all, the lesson from the last few months has been very clear: When bankers gamble with other people’s money, it’s heads they win, tails the rest of us lose.

"How Moody's Sold its Ratings -- and Sold Out Investors"

Robert Waldmann says "This McClatchy article by Kevin G Hall seems important to me." It does seem like there was "market failure in everything" when it comes to mortgage markets, from the incentives faced by the homeowner (non-recourse loans) and real estate agent ( maximize commission income) at the very first point of contact, through other points in the system such as appraisers, mortgage brokers, and bank managers.

Maybe fixing the incentive problems at each of these steps would have stopped the problem, or at least made it much less severe, but maybe not. In any case, it's clear that markets failed to self regulate at many key points, and that there are problems that need to be fixed covering the entire spectrum from the sale of higher priced, higher profit mortgage contracts to unwary homeowners when better options were available to the incentives bank managers had to maximize short-run profits and accumulate too much risk.

But the flow of toxic paper upward through the system should have had a gatekeeper of last resort, or at least a thorough checkpoint, and that was the ratings agencies. I don't think the failure of the ratings agencies, by itself, caused the financial crisis, but it was an important contributor and it's one of the things that needs to be fixed:

How Moody's sold its ratings -- and sold out investors, by Kevin G. Hall, McClatchy Newspapers: As the housing market collapsed in late 2007, Moody's Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.

A McClatchy investigation has found that Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.

Instead, Moody's promoted executives who headed its "structured finance" division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: "toxic assets."

As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren't fully aware of what went wrong at the bond rating agencies, and so they may fail to address misaligned incentives...

The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody's and its main competitors, Fitch Ratings and Standard & Poor's,... but the full extent of Moody's internal strife never has been publicly revealed.

Moody's ... disputes every allegation against it. "Moody's has rigorous standards in place to protect the integrity of ratings from commercial considerations," said Michael Adler, Moody's vice president for corporate communications... Insiders, however, say that wasn't true before the financial meltdown.

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings. ... Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by U.S. car loans, credit card debt, student loans and, especially, mortgages. ...

Nobody cared about due diligence so long as the money kept pouring in during the housing boom. ...

One Moody's executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market. Several former Moody's executives said he made subordinates fear they'd be fired if they didn't issue ratings that matched competitors' and helped preserve Moody's market share. ...

Clarkson rose to the top in August 2007, just as the subprime crisis was claiming its first victims. Soon afterward, a number of analysts and compliance officials who'd raised concerns about the soundness of the ratings process were purged and replaced with people from structured finance. ...

Another mid-level Moody's executive ... recalls being horrified by the purge. "It is just something unthinkable, putting business people in the compliance department. It's not acceptable. I was very upset, frustrated," the executive said. "I think they corrupted the compliance department." ...

Others who worked at Moody's at the time described a culture of willful ignorance in which executives knew how far lending standards had fallen and that they were giving top ratings to risky products.

"I could see it coming at the tail end of 2006, but it was too late. You knew it was just insane," said one former Moody's manager. "They certainly weren't going to do anything to mess with the revenue machine." ...[...more...]...

"Something is Wrong with Wall Street"

One element in the creation of  bubble is people's willingness to believe that this time is different. In the present case, this time was different because of financial innovation, better monetary policy, better technology to manage shocks (e.g. digital technology reducing supply bottlenecks), and so on leading to a (supposed) reduction in overall financial risk without a corresponding reduction in returns.

But this time wasn't different, it was in many ways a rerun of the dot.com bubble, and Shane Greenstein says people are finally starting to notice. In fact, according to the argument below, the effort to address problems on Wall Street has passed the "Russ Roberts test":

This just in, something is wrong with Wall Street, by Shane Greenstein [Note: original post replaced with an updated version at the author's request]:

Please forgive the irony in the title. But I just felt like expressing sarcasm because – Ha! — many professional economists have begun to notice something is wrong with Wall Street.

Better late than never, I guess.

This recent essay/podcast from Russell Roberts is a good indication that just about everyone has noticed that Wall Street has a tin ear for its public standing, which has sunk quite low due to self-serving behavior.

In case you have not noticed what Roberts has noticed, then let me remind you. Just recently the management at Goldman Sachs announced that the firm had a very profitable quarter, which, of course, resulted in very high pay for their executives.

That is where it gets interesting. Roberts points out (correctly, IMHO) that had the government not stepped in at AIG, etc., Goldman would have gone down with everyone else. Ergo, their executives should recognize that they have a connection to taxpayer money as much as any other firm, and they should, therefore, eschew blatantly selfish and observable behavior, such as paying themselves high salaries.

Russ Roberts is normally a free market economist, but in his essay he sounds like an old fashioned populist. When a firm does something to turn Russell Roberts into a populist then — perhaps — something is actually amiss with attitudes on Wall Street.

Alright, then, so what? Well, take this observation another step or two…

What Roberts did not say

Here is what Roberts did not say, so I will. Goldman displayed a tin ear by not making any gesture at the same time they announced their profitable earnings.

What do I mean by tin ear? Here is an example. They did not announce the hiring of many (otherwise) laid off workers — as sort of a political gesture to address the need to do something about the high unemployment rate around the country.

Here is another idea. Why stop with hiring a few more employees? How about making an unusually big (I mean VERY BIG) donation to a soup kitchen — once again, as a gesture to suffering of others in these hard time.

Hmmm, here is another idea. How about doing anything mildly publicly-spirited, like buying a new fire truck for the New York city Fire Department, because the whole city is having a bad budget year? Why the New York city Fire Department? Because nobody ever has anything bad to say about firefighters in most cities, and certainly not in New York City after their sacrifice during 9/11.

Heck, once you start thinking this way, it is quite easy to find a way to spend a half billion dollars in unexpectedly large profits. But if you have a tin ear for this sort of non-selfish gesture, then the thought might never have surfaced.

And now to the point of this rant…

For those of us who live in the land of high tech, these type of observations are nothing new. The self-serving and otherwise destructive behavior of some Wall Street managers is well known…

Look, I have been around the block enough to understand that sometimes financial managers have something useful to say to high tech firms. But there is also something wrong. For example, the short-termism of Wall Street managers is legendary among high tech managers who have a long term vision for their firm but are asked to deliver revenue tomorrow. The self-serving decision making of managers who give IPOs to friends is another well known behavior (and most young firms and VCs would love to eliminate it). Another common complaint concerns the unwillingness of IPO managers to change the system if it meant a loss of control. For example, remember this? Wall Street was unwilling to conduct any IPO as an auction until Google insisted — insisted! — that the old system would not apply to them.

Enough is enough. Even guys like Roberts can see that something is amiss.

Remember the dot com madness?

It is really nothing new. Really.

Back in the late 1990s — more than a decade ago — Wall Street cheered on one of the goofiest investment bubbles I have ever seen in my lifetime (and hopefully I ever will see). It was called the dot-com boom, and, frankly, it was nuts from any rational perspective.

Yes, there are lots of explanations for the boom. There was a social dimension: Plenty of observers tried to say it was nuts. They were drowned out by crazy evangelists who ignored basic finance and who argued that price earnings ratios could be way out of whack. And it sold copy: the business media loves of a sensational story, and that did not help.

But that is why adult supervision is required in high tech. The financial professionals and auditors of this country had a professional obligation to say sober things, to ask — perhaps, insist! — that revenues align with expenses, and advise investors when such alignment has little chance of appearing. And in the late 1990s, what did the professionals do? Well, it is complicated, but, suffice to say, few of them said no to the nuttiness.

Why not? Here is a good clue in an essay by Henry Blodget.

You may recall that Blodget was a wunderkindt cheer leader for dot coms. How did he get there? Basically, he made a bold call, got himself some attention, and kept making more bold calls. His bosses saw an opportunity and replaced someone else who had the good sense to point out that the promises had considerably risk. Blodgett instead went full steam ahead because — he fully admits it — he was hired to do just that.

I do not know this fellow, nor have we ever met. I have read some of his writing. As best I can tell, Blodgett actually has a pretty smart head on his shoulders. He writes well and has the capacity to make some intelligent and deep observations.

Anyway, Blodgett eventually got himself into trouble. While I understand how someone with those sort of smarts can delude themselves enough to tempt fate for a short while — he is human, after all — nonetheless, it is beyond my capacity as a psychologist to explain how someone can do it for a long time.  And he did. For several years. Until the dot com crashed, and a scandal broke, and he got banned.

There is a deeper question behind that run of several years. How did his bosses allow Blodgett to ply this trade for so long even though the wiser adults among them surely must have suspected/concluded/known that much of it was a financial charade?

The answer, of course is quite simple: they made so much money during that time. Blodgett’s bosses had no reason to change anything.

Many years later Blodgett wrote about his time in this essay. He finds many reasons for explaining his own behavior. Blodget says he did it because if he did not others would.  He did it because his bosses wanted him to do it. He did because everyone was making huge amounts of money from focusing on the short term benefits to their firm. All in all, he did it because it seemed like a good idea at the time.

In economics-speak, all those explanations add up to the following. Henry and his bosses simply ignored the consequences for the prudent investor or for the country as a whole — even though it had occurred to them that there was a chance that something might have gone wrong.

Let’s say this in general terms. Wall Street firms had no reason to internalize the issues with systemic risk — that is, they each ignored the downside to the entire system from all of them taking on too much risk, because each of them only contributed a small amount to it. Instead, each of them pursued their own selfish interests, and made out well in the short run, sacrificing system-wide long run stability.

Summing up

Those of us who live in high tech land noticed the odd behavior of Wall Street a while ago. Finally, it seems, the macroeconomics policy crowd has started to notice the same issues, and has started to argue that — perhaps — it is time to reign this in a bit. When a free market guy like Roberts notices, you know that the sensible people are finally thinking this one through.

Like I said, better late than never.

Now, on to the serious conversation: what to do about it….I am not sure what the right answers are, but limits on executive bonuses seems like a band-aid for a systemic issue. It is too much to ask a manager who makes several million dollars a year to stop gaming the system, but it might be reasonable to ask for better auditing, more transparency for investors, tighter capital requirements for firms taking risky actions, and a few others unpleasant measures that might help us all avoid these system-wide problems.

Oh yes… until then, the executives at Goldman might consider a public spirited gesture or two, such as — I dunno’ — donating a fraction of their recent profits to the New York Fire Department.

"Even guys like Roberts can see that something is amiss." So this time is different?

I want to believe that, I really do.

"The Chamber of Commerce Has It Backwards"

Simon Johnson:

The Chamber of Commerce Has It Backwards, by Simon Johnson: The US Chamber of Commerce is opposing the administration’s proposed Consumer Financial Protection Agency, on the grounds that it would hurt small business.  Their argument is that this agency will extend the dead hand of government into every small business.

For the Chamber of Commerce, government is the enemy of small business and should always and everywhere be fought to a standstill.  Chamber Senior Vice President (and former Fred Thompson campaign manager) Tom Collamore sees this as “advocacy on behalf of small businesses, job creators, and entrepreneurs”...

Somewhere, the Chamber’s senior leadership missed the plot.  What brought on the greatest financial crisis since the 1930s?  What has hurt, directly and indirectly, small business of all kinds to an unprecedented degree over the past 12 months?  What is killing small and medium-sized banks at a rate not seen in nearly 80 years?

It’s the behavior of the financial sector, particularly big banks and their close allies – by consistently mistreating consumers.  And the letter and spirit of the regulatory regime let them get away with it. ...

The state of knowledge regarding how to persuade people to buy stuff is impressive, the degree of potential manipulation for consumer preferences is simply stunning, and the “innovations” in this area are not slowing down.

The scope for taking advantage of consumers in subtle ways, or outright duping them, is probably higher for finance than for any other sector.  For fairly obvious reasons, people are more likely to misunderstand credit than, say, furniture. ...

Unscrupulous Finance has brought us down and will do it again.  Those most damaged now and in the future include small and medium-sized business owners who are trying to treat customers fairly.

The Chamber of Commerce ... small business membership should wake up to the current reality and press the Chamber hard to change its position before it is too late. ...  The Chamber of Commerce is arguing that unfettered finance is good for small business.  They are wrong.

Another case of mixing up the difference between "free markets" and markets that behave optimally:

Markets are Not Magic, by Mark Thoma: To listen to some commentators is to believe that markets are the solution to all of our problems. Health care not working? Bring in the private sector. Need to rebuild a war-torn country? Send in the private contractors. Emergency relief after earthquakes, hurricanes, and tornadoes? Wal-Mart with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats government every time. Or so we are told. But this is misplaced faith in markets. There is nothing special about markets per se - they can perform very badly in some circumstances. It is competitive markets that are magic, though even then we have to remember that markets have no concern whatsoever with equity, only efficiency, and sometimes equity can be an overriding concern.

In order to work their magical efficiency, markets need very special conditions to be present. There must be full information available to all participants. Product quality, locations and prices of alternative suppliers, every relevant piece of information must be known. Not quite sure if the wine is good or not? That's an information problem. Not sure if the used car has problems? Don't know where any gas stations are except the ones beside the freeway in a strange town? No way to monitor the quality of the building built in Iraq with U.S. aid? No way to be sure if consultants are worth the amount they are being paid? Information problems are common and they can cause substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single buyer or seller's decisions can affect the market price. For example, if a firm can affect the market price by threatening to limit supply, the market does not satisfy this condition. If, as some claim, CEOs are in such short supply that they can individually negotiate their compensation, then the market is not producing an efficient outcome. Whenever there are a small number of participants on either side of the market - suppliers or demanders - this is potentially problematic.

In order for markets to work their magic, the product must be homogeneous. That is, the product or input to production sold by all firms in the market must be perfectly substitutable so that as far as the buyer is concerned, one is as good as the other. If some buyers favor one brand over another, if CEOs are perceived to have different and unique talents, if government favors one contractor over another due to political contributions, this condition does not hold. In many cases the variety may be worth the inefficiency, not many of us would want just one style and color of shirt to be available in stores, but the inefficiency is there nonetheless.

In order for markets to work their magic there must be free entry and exit. Most people understand free entry, but free exit is sometimes less evident, so let me try to give an example. Starting a blog on Blogger or TypePad is easy. Entry is a snap and you can be up and running in no time at all. It's easy to join the competition and start supplying posts. But suppose that later you decide you want to switch to, say, TypePad from Blogger (or the other way around). That is not so easy. There is no way, at least no simple and convenient way, to export all of your old posts from Blogger and import them into TypePad, a significant barrier to exit if a large number of posts must be moved. Whenever barriers exist in markets that prevent free movement into and out of the marketplace or between firms within a market (on either side - there are sometimes barriers to purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can be no externalities, no public goods, no false market signals, no moral hazard, no principle agent problems, and, importantly, property rights must be well-defined (and I probably missed a few). In general, the incentives that the market provides must be consistent with perfect competition, or nearly so in practical applications. When the incentives present in the marketplace are inconsistent with a competitive outcome, there is no reason to expect the private sector to be efficient.

Markets don't work just because we get out of the way. When government contracts are moved to the private sector without ensuring the proper incentives are in place, there will be problems - waste, inefficiency, higher prices than needed, etc. There is nothing special about markets that guarantees that managers or owners of companies will have an incentive to use public funds in a way that maximizes the public rather than their own personal interests. It is only when market incentives direct choices to coincide with the public interest that the two sets of interests are aligned.

If there is no competition, or insufficient competition in the provision of government services by private sector firms, there is no reason to expect the market to deliver an efficient outcome, an outcome free of waste and inefficiency. Why would we think that giving a private sector firm a monopoly in the provision of a public service would yield an efficient outcome? If the projects are of sufficient scale, or require specialized knowledge so that only one or a few private sector firms are large enough or specialized enough to do the job, why would we expect an ideal outcome just because the private sector is involved? If cronyism limits the participants in the marketplace, why would we expect an outcome that maximizes the public interest?

There is nothing inherent in markets that guarantees a desirable outcome. A market can be a monopoly, a market can be perfectly competitive, a market can be lots of things. Markets with bad incentives produce bad outcomes, markets with good incentives do better.

I believe in markets as much as anyone. But the expression free markets is often misinterpreted to mean that unregulated markets are all that is required for markets to work their wonders and achieve efficient outcomes. But unregulated is not enough, there are many, many other conditions that must be present. Deregulation or privatization may even move the outcome further from the ideal competitive benchmark rather than closer to it, it depends upon the characteristics of the market in question.

For government goods and services, when incentives consistent with a competitive outcome are present, we should get government out of the way and privatize, and there are lots of circumstances where this will be appropriate. There is no reason at all for the government to produce its own pencils and pens, buying them from the private sector is more efficient so long as the bids are competitive.

When competitive conditions are not met but can be regulated, the regulations should be put in place and the private sector left to do its thing (e.g.  mandating that sellers disclose problems with a house to prevent asymmetric information or mandating that government funded projects be subject to competitive bidding and monitoring to ensure contract terms are met). There's no reason for government to do anything except ensure that the incentives to motivate competitive behavior are in place and enforced.

But rampant privatization based upon some misguided notion that markets are always best, privatization that does not proceed by first ensuring that market incentives are consistent with the public interest, doesn't do us any good. There are lots of free market advocates out there and I am with them so long as we understand that free does not mean the absence of government intervention, regulation, or oversight, even libertarians agree that governments must intervene to ensure basics like private property rights. Free means that the conditions for perfect competition are approximated as much as possible and sometimes that means the presence - rather than the absence - of government is required.

[Update: I should have added that perhaps the Chamber fully understands the difference between free markets and competitive markets, and simply wants to preserve the "freedom" to take advantage of customers.]

"How the Servant Became a Predator: Finance’s Five Fatal Flaws"

I am not as negative about banking and financial intermediation as William Black, I think intermediaries perform essential functions that, for example, pools risk across individuals, pools deposits over time (i.e. allows long-term loans with short-term deposits), pools small deposits to allow large loans, they help to overcome adverse selection and moral hazard problems by providing monitoring of loans and expertise on the ability of buyers to repay loans that individuals do not have. By providing pooling functions, solving asymmetric information problems, and so on, financial intermediaries allow productive activity to take place that wouldn't occur otherwise, and we are better off because of it.

So, for instance, on point one below that "The financial sector harms the real economy," I would state it differently. I would say that the net effect of the financial sector is unambiguously positive, without it there would be far fewer loans and a corresponding reduction in output and employment, but some parts of it have detracted from the overall good (significantly recently), and those parts do need to be fixed. But I cannot sign on to a general statement that the financial sector is harmful. Even given the large problems it has caused recently and in the past, we would not be better off if it didn't exist at all. I think this is implicit in the points made below, e.g. there is a call to return to the simple banking of the past, but we differ on the value of developments since that time. I don't see all complex financial products as bad or harmful, some provide essential functions. The trick is to weed out the bad parts, the bad incentives, etc., but save the good, and there are a lot of good parts to the system. I have been one of the stronger proponents of regulating the financial system and reining in the excesses, but it is possible to go too far:

How the Servant Became a Predator: Finance’s Five Fatal Flaws, by Bill Black: What exactly is the function of the financial sector in our society? Simply this: Its sole function is supplying capital efficiently to aid the real economy. The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

1. The financial sector harms the real economy.

Even when not in crisis, the financial sector harms the real economy. First, it is vastly too large. The finance sector is an intermediary — essentially a “middleman”. Like all middlemen, it should be as small as possible, while still being capable of accomplishing its mission. Otherwise it is inherently parasitical. Unfortunately, it is now vastly larger than necessary, dwarfing the real economy it is supposed to serve. Forty years ago, our real economy grew better with a financial sector that received one-twentieth as large a percentage of total profits (2%) than does the current financial sector (40%). The minimum measure of how much damage the bloated, grossly over-compensated finance sector causes to the real economy is this massive increase in the share of total national income wasted through the finance sector’s parasitism.

Second, the finance sector is worse than parasitic. In the title of his recent book, The Predator State, James Galbraith aptly names the problem. The financial sector functions as the sharp canines that the predator state uses to rend the nation. In addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy in order to reward already-rich financial elites harming the nation. The facts are alarming:

"Reviewing the Recession: Was Monetary Policy to Blame?"

David Altig says "it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate" due to a failure to base monetary policy rules on models that include a well developed credit channel:

Reviewing the recession: Was monetary policy to blame?, by David Altig: In a recent speech given at the University of South Alabama, Federal Reserve Bank of Atlanta President Dennis Lockhart added his voice to what is now the general consensus: "I agree with all who are declaring that a technical recovery is under way."

There is still much work to be done, of course, not least the continuing examination of just what led to the recession and how a repeat performance can be avoided. One theme of this examination appeared in last week's Financial Times:

"It is certainly true that the most recent bubble, its bursting and the Fed's actions in the aftermath have inspired existing critics and recruited new ones. The first charge is that interest rates under Alan Greenspan, [current Fed Chairman Ben] Bernanke's predecessor, were kept too low for too long, contributing to a bubble of easy credit."

Here is an exercise that that I find intriguing. Suppose we try to estimate, as closely as we can, the actual interest rate decisions of the Federal Open Market Committee (FOMC) over the period spanning the beginning of Greenspan's tenure to the present. It turns out that by using an approach based not only on measures of inflation and actual output relative to potential but also on the lagged fed funds rate, you can actually get pretty darn close to statistically describing what the FOMC did:

I'm going to resist the temptation to call this approach a "Taylor rule." The estimating "rule" used here does in fact include realizations of inflation and a measure of the output gap (that is, a measure of how different gross domestic product is from its potential). These are the essential ingredients of the Taylor rule, but not the source of the close fit evident in the chart above. Over the period covered by the chart, you could have done a pretty good job mimicking the actual federal funds rate outcomes in any given month using knowledge of the previous month's rate. (If you are interested in the details of the estimating rule, you can find them here.)

The interpretation of the tendency for today's federal funds rate to generally follow yesterday's rate—sometimes referred to as interest rate smoothing—is controversial. Glenn Rudebusch (from the Federal Reserve Bank of San Francisco) explains:

"Many interpret estimated monetary policy rules as suggesting that central banks conduct very sluggish partial adjustment of short-term policy interest rates. In contrast, others argue that this appearance of policy inertia is an illusion and simply reflects the spurious omission of important persistent influences on the actual setting of policy."

Rudebusch is decidedly in the second camp, but for our purposes here the exact interpretation may not be that important. Though I am glossing over some not insignificant caveats—such as the difference between final data and the information the FOMC had to react to in real time—the chart above suggests that whatever the underlying structure of policy decisions, after the fact the FOMC appears to have behaved in an extraordinarily consistent way over the period extending from the late 1980s. This observation, in turn, suggests to me that there was nothing all that unusual about monetary policy in 2003 once you account for the state of the economy.

Which leads me to my main point on the chart above: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with "proven" success as it set interest rates through the dawning of the new millennium.

There is, of course, the possibility that the pattern of the funds rate depicted in the chart above was incomplete all along in the sense that whatever variables are explicit and implicit in the estimated rule, they did not include information to which the FOMC should have responded. In calmer times, the story would go, not including potentially pertinent information was not much of a problem. Eventually the missing-data chickens could come home to roost. The prime omitted variable suspect would, of course, be some sort of asset prices.

Scratch any gathering of macroeconomists these days and out will bleed a steady stream directed at incorporating credit and financial market activity into thinking about the aggregate economy. The necessity of proceeding with that work was emphasized by no less an authority than Don Kohn, vice chairman of the Federal Reserve Board of Governors, speaking at just such a gathering of macroeconomists last week:

"It is fair to say, however, that the core macroeconomic modeling framework used at the Federal Reserve and other central banks around the world has included, at best, only a limited role for the balance sheets of households and firms, credit provision, and financial intermediation. The features suggested by the literature on the role of credit in the transmission of policy have not yet become prominent ingredients in models used at central banks or in much academic research."

I will admit that economists were not exactly ahead of the curve with this agenda, but prior to 2007 it was not at all clear that detailed descriptions of how funds moved from lenders to borrowers or how short-term interest rates are transmitted to longer-term interest rates and capital accumulation decisions were crucial to getting monetary policy right. Models without such detail tended to deliver policy decisions not far from the sort depicted above, and, as I noted, they seemed to be working quite well in terms of macroeconomic outcomes.

Thus far, one of the lessons from models in which financial intermediation is taken seriously is that interest rate spreads or stock prices or other asset prices do become part of the policy rate recipe. Your response might well be something along the lines of "duh." You are entitled to that opinion, and I won't push back too hard. But it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate caused by the failure to make whatever adjustments might have been indicated by the inclusion of pertinent financial variables in implicit rate-setting rules of thumb. Furthermore, early versions of research I have seen that combines capital regulation policy and interest rate policy suggest that the macroeconomic consequences of getting the former wrong may be much greater than the consequences of getting the latter wrong. To me, that conclusion has the ring of truth.

I have advocated targeting a price index that includes asset prices as part of the policy rule, but I share the view that this likely would not have been enough by itself to stop the crisis from occurring. Targeting a broader price index might have tempered the downturn some, or even quite a bit -- it sounds like I am more optimistic than David along about how well this might work -- but changes in regulation must be an essential component of reform if we are going to prevent problems from reoccurring in the future.

However, I think that not having models with detailed descriptions of the credit transmission mechanism was costly. The New Keynesian model that is used to inform monetary policy decisions relies upon wage and price rigidities to explain how changes in monetary policy and/or financial market conditions are transmitted to the broader economy. Thus, the price/wage rigidity transmission channels must serve as a proxy for the effects that work through credit (or other) channels, and it is not evident to me that they are adequate proxies for this task (e.g. what would a government spending multiplier look like within a model that had a richer set of connections between financial markets and the real economy?). Whether or not having such models would have prevented the crisis is an open question, and I won't push back too hard against David's view of this, but not having such models once this crisis hit did, I think, make it more difficult for us to evaluate the appropriate policy response. Not having the models we needed led to uncertainty from policymakers that showed up in the seemingly, if not actual ad hoc and trial and error nature of many of the policy responses.

The Bank Lending Channel

Many economists, Ben Bernanke foremost among them, have argued that monetary policy has effects that are independent of the traditional interest rate channel (where an increase in the money supply lowers the real interest rate and induces more investment and consumption spending). The alternative models include a "credit channel" for monetary policy, which is often further divided into financial accelerator models and bank lending channel models.

One class of models within the bank lending channel branch relies upon a difference in the availability of credit for large and small firms. If smaller businesses have fewer sources of credit than large firms (who can issue bonds, stocks, commercial paper, etc.), then a credit shock induced by policy or some other factor will have an asymmetric negative effect on the activity of large and small firms. Since smaller firms have trouble getting credit from non-bank sources, a disruption in bank credit can cause them to contract their activities much more than large firms. (If all firms have perfect substitutes for bank credit, e.g. borrowing from foreigners on the same terms, then monetary policy cannot affect real output through the bank lending channel. The point of this research is that some firms do not have close substitutes for bank credit, and therefore monetary policy can have real effects.) According to this, there's some evidence that these effects are operable:

Credit Tightens for Small Businesses, NY Times: Many small and midsize American businesses are still struggling to secure bank loans, impeding their expansion plans and constraining overall economic growth...

Bankers worry about the extent of losses on credit card businesses as high unemployment sends cardholders into trouble. They are also reckoning with anticipated failures in commercial real estate. Until the scope of these losses is known, many lenders are inclined to hang on to their dollars rather than risk them on loans to businesses in a weak economy...

Bankers acknowledge that loans are harder to secure than in years past, but they say this attests to the weakness of many borrowers rather than a reluctance to lend.

“Banks want to lend money,” said Raymond P. Davis, chief executive of Umpqua Bank, a regional lender based in Portland, Ore. “The problem is the effect that the recession is still having on us. Some of these businesses are still trying to come out of it. For them to go to a bank, if they are showing weak performance, it is harder to borrow.”

As the financial crisis has largely eased in recent months, big companies have found credit increasingly abundant, with bond issues sharply higher.

But for ... many smaller companies,... borrowing remains tough. ...

Recall this graph posted here not too long ago (discussed further at the source):

It may be hard to see at first glance, but the graph shows the "disproportionate effect the recession has had on very small businesses." In 2001, only 9% of the job losses came from small businesses, while in the current recession - where credit problems are a much larger factor - small business accounts for 45% of lost jobs. Part of the discussion of the graph notes this comment from William Dudley, the president of the Federal Reserve Bank of New York:

In a speech yesterday,... he said:

"For small business borrowers, there are three problems. First, the fundamentals of their businesses have often deteriorated because of the length and severity of the recession—making many less creditworthy. Second, some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards. Third, small businesses have few alternative sources of funds. They are too small to borrow in the capital markets and the Small Business Administration programs are not large enough to accommodate more than a small fraction of the demand from this sector."

It will take more careful analysis to make the case that the bank lending channel has been important in this recession, but it is suggestive.

"Global Imbalances and the Financial Crisis: Products of Common Causes"

Maurice Obstfeld and Kenneth Rogoff attempt to sort out the role that global imbalances played in the financial crisis. This is the introduction to their paper:

Global Imbalances and the Financial Crisis: Products of Common Causes, by Maurice Obstfeld and Kenneth Rogoff, October 2009 (Conference Draft): In my view … it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. --Ben S. Bernanke¹

Introduction Until the outbreak of financial crisis in August 2007, the mid-2000s was a period of strong economic performance throughout the world. Economic growth was generally robust; inflation generally low; international trade and especially financial flows expanded; and the emerging and developing world experienced widespread progress and a notable absence of crises.

This apparently favorable equilibrium was underpinned, however, by three trends that appeared increasingly unsustainable as time went by. First, real estate values were rising at a high rate in many countries, including the world’s largest economy, the United States. Second, a number of countries were simultaneously running high and rising current account deficits, including the world’s largest economy, the United States. Third, leverage had built up to extraordinary levels in many sectors across the globe, notably among consumers in the United States and Europe and financial entities in many countries. Indeed, we ourselves began pointing to the potential risks of the “global imbalances” in a series of papers beginning in 2001.² As we will argue, the global imbalances did not cause the leverage and housing bubbles, but they were a critically important codeterminant.

In addition to being the world’s largest economy, the United States had the world’s highest rate of private homeownership and the world’s deepest, most dynamic financial markets. And those markets, having been progressively deregulated since the 1970s, were confronted by a particularly fragmented and ineffective system of government prudential oversight. This mix of ingredients, as we now know, was deadly.

Controversy remains about the precise connection between global imbalances and the global financial meltdown. Some commentators argue that external imbalances had little or nothing to do with the crisis, which instead was the result of financial regulatory failures and policy errors, mainly on the part of the U.S. Others put forward various mechanisms through which global imbalances are claimed to have played a prime role in causing the financial collapse. Former U.S. Treasury Secretary Henry Paulson argued, for example, that the high savings of China, oil exporters, and other surplus countries depressed global real interest rates, leading investors to scramble for yield and underprice risk.³

We too believe that the global imbalances and the financial crisis are intimately connected, but we take a more nuanced stance on the nature of the connections. In our view, both of these phenomena have their origins primarily in economic policies followed in a number of countries in the 2000s (including the United States) and in distortions that influenced the transmission of these policies through financial markets. The United States’ ability to finance macroeconomic imbalances through easy foreign borrowing allowed it to postpone tough policy choices (something that was of course true in many other deficit countries as well). Not only was the U.S. able to borrow in dollars at nominal interest rates kept low by a loose monetary policy. Also, until around the autumn of 2008, exchange-rate and other asset-price movements kept U.S. net foreign liabilities growing at a rate far below the cumulative U.S. current account deficit. On the lending side, China’s ability to sterilize the immense reserve purchases it placed in U.S. markets allowed it to maintain an undervalued currency and postpone rebalancing its own economy. Had seemingly easy postponement options not been available, the subsequent crisis might well have been mitigated, if not contained.⁴

We certainly do not agree with the many commentators and scholars who argued that the global imbalances were an essentially benign phenomenon, a natural and inevitable corollary of backward financial development in emerging markets. These commentators, including Cooper (2007) and Dooley, Folkerts-Landau, and Garber (2005), as well as Caballero, Farhi, and Gourinchas (2008) and Mendoza, Quadrini, and Rios-Rull (2007), advanced frameworks in which the global imbalances were essentially a “win-win” phenomenon, with developing countries’ residents (including governments) enjoying safety and liquidity for their savings, while rich countries (especially the dollarissuing United States) benefited from easier borrowing terms. The fundamental flaw in these analyses, of course, was the assumption that advanced-country capital markets, especially those of the United States, were fundamentally perfect, and so able to take on ever-increasing leverage risklessly. In our 2001 paper we ourselves underscored this point, identifying the rapid evolution of financial markets as posing new, untested hazards that might be triggered by a rapid change in the underlying equilibrium.⁵

Bini Smaghi’s (2008) assessment thus seems exactly right to us:

[E]xternal imbalances are often a reflection, and even a prediction, of internal imbalances. [E]conomic policies … should not ignore external imbalances and just assume that they will sort themselves out.⁶

In this paper we describe our view of how the global imbalances of the 2000s both reflected and magnified the ultimate causal factors behind the recent financial crisis. At the end, we identify policy lessons learned. In effect, the global imbalances posed stress tests for weaknesses in the United States, British, and other advanced-country financial and political systems – tests that those countries did not pass. ...

See also: Why are we in a recession? The Financial Crisis is the Symptom not the Disease! [open link]. The paper argues that the huge increase in the labor supply available to developed countries is the primary force behind our current troubles. Here are parts of the introduction and conclusion:

The impact of globalization is a sharp increase in the developed world’s labor supply. Labor in developing countries – countries with vast pool of grossly underemployed people – can now compete with labor in the developed world without having to relocate in ways not possible earlier. ... [W]e argue that this huge and rapid increase in developed world’s labor supply, triggered by geo-political events and technological innovations, is the major underlying force that is affecting world events today.² The inability of existing financial and legal institutions in the US and abroad to cope with the events set off by this force is the reason for the current great recession: The inability of emerging economies to absorb savings through domestic investment and consumption caused by inadequate national financial markets and difficulties in enforcing financial contracts through the legal system; the currency controls motivated by immediate national objectives; the inability of the US economy to adjust to the perverse incentives caused by huge moneys inflow leading to a break down of checks and balances at various financial institutions, set the stage for the great recession. The financial crisis was the first symptom. ...

10 The Way Forward The common wisdom is that cheap money and lax supervision of financial institutions led to this financial crisis, and solving that crisis will take us out of the recession. In our view, the financial crisis is just the symptom. The fundamental cause of the crisis is the huge labor supply shock the world has experienced, not the glut in liquidity in money supply.

Recovery will only occur when structural imbalances in global capital flows are corrected, in part through higher saving in developed nations and in part through greater capital flows into developing nations. ...

It may be tempting for those in power to close the door to outsourcing of manufacturing and other activities. While that may provide some immediate relief, it will accentuate other problems...

When millions of World War II soldiers returned home that increased the US labor force of about 60 million workers by almost 25% within a very short period of time. At that time the Department of labor, which certainly had no cause to accentuate the negative, predicted that 12 to 15 million workers would be unemployed.²⁸ That did not happen! We managed that problem well leading to prosperity instead of doom, thanks in no small part to the GI Bill and other governmental fiscal intervention. We can manage this one as well. For that to happen, the first step is to recognize the problem for what it is. A solution may well require actions similar in scope to the GI Bill and require a national debate.

While there is plenty of blame to go around for mistakes, the macro forces triggered by the labor shock is like a tidal wave that needed to wash ashore no matter what. History might have taken an entirely different path with better risk management controls in place in the US but then again, financial innovation might just have found a different way of getting highly leveraged deals done off-shore or through creative accounting.²⁹ The root cause of the excess liquidity in the global financial system must be addressed, otherwise we are just squeezing the proverbial balloon only to see it bulge out somewhere else. However, this does not negate the need for the development of improved risk management in the broadest sense in order to ensure financial stability and prosperity going forward.

China and India will continue to need to bring tens of millions of rural laborers into the productive workforce in the coming decades and the world economy must find a sustainable way of dealing with this influx. Clearly China’s export led growth strategy of the past cannot continue indefinitely and domestic consumption must be allowed to grow as a share of GDP. At the same time, Western economies must adjust to a new equilibrium in which commodities are scarcer and households will face stiffer competition for jobs.

"Skewed Rewards for Bankers"

Joseph Stiglitz remembers another Nobel:

Skewed rewards for bankers, Joseph Stiglitz, Project Syndicate:  -- The recent death of Norman Borlaug provides an opportune moment to reflect on basic values and on our economic system. Borlaug received the Nobel Peace Prize for his work in bringing about the "green revolution," which saved hundreds of millions from hunger and changed the global economic landscape. ...

"So Much Happening in Washington and So Little To Show for It"

Robert Reich is not pleased with the proposals from congress for health care reform, financial regulation, environmental legislation, and job creation, all of which come up far short of what is needed, and he says lobbyists are to blame:

So Much Happening in Washington and So Little To Show for It, So Far, by Robert Reich: The Senate Finance Committee is set to vote Tuesday on a healthcare bill that just got a seal of approval from the Congressional Budget Office and is very likely to garner the vote of Republican Senator Olympia Snowe -- a twofer that gives the bill preeminence over four other healthcare bills that have emerged from House and Senate committees... Unlike those bills, though, the Senate Finance bill won't it have a public insurance option to compete with private insurers. Nor does it allow Medicare to use its bargaining power to negotiate lower drug prices, or adequately subsidize millions of middle-class families who will be required to buy health insurance that will be hard for them to afford. In short, it's a great deal for private insurers and Big Pharma but not such a great deal for middle-class Americans.

Meanwhile, the House Banking Committee is quietly circulating a draft set of reforms of financial markets... Barney Frank, who heads the Committee, is a thoughtful progressive. But the draft has gaping loopholes that will let most financial firms escape -- such as one that exempts corporations that deal in financial derivatives from any requirements for capital, business conduct, record-keeping, and reporting if they use derivatives for the purpose of "risk management," which is the very thing they all claim they're doing. Neither the draft bill, nor the Committee, nor anyone on the Hill having anything to do with financial regulation, is ... resurrecting the Glass-Steagall Act that once separated commercial from investment banking, and applying antitrust laws to the remaining five biggest Wall Street banks so none is "too big to fail."

At the same time, environmental legislation is now slinking its way through Congress..., but the bills are, frankly, far short of what's needed. ...

And what's happening on the job's front? Nothing except a blip of interest in tax credits to small businesses that create new jobs. That's not a bad move (I suggested it myself), but it's rather like bailing out the ocean with a teacup. If that's all there is, we're headed toward two years of double-digit unemployment. No one on the Hill or in the Administration is yet willing to say openly and clearly that the stimulus plan must be larger, and continued through 2010 and 2011.

My friends in the Administration and on the Hill repeatedly tell me "don't make the perfect the enemy of the better," or words to that effect. Politics is the art of the possible, blah blah blah. True. But in each of these areas -- healthcare, financial regulation, environment, and jobs -- the "better" is really not that much better. Forget perfect; anything that offered real reform would suffice for now. But in every case, what should be the centerpieces of reform are being left out.

Why? Congress is overwhelmed with corporate and Wall Street lobbyists (far too many of whom are former Democratic office holders). The White House is trying best it can to push ... in the right direction but there's too much going on, too many arenas where private interests are framing the debate and stifling major reform, and too many friends of friends and relations of relations who are making tons of money working for the other side. The public doesn't know what's going on because the national media would rather report on the sexual escapades of famous people... And progressives -- that is, progressive organizations in our nation's capital -- have been remarkably and consistently outgunned, outmaneuvered, or just plain ineffectual. This is largely due to the fact that they're sitting in Washington rather than organizing and mobilizing the rest of the country.

And I haven't even brought up Afghanistan.

"Clash of Autonomy and Interdependence"

Something quick between classes - Jean-Paul Fitoussi says "Don't hold your breath" waiting for those who have found success within the free exchange system to acknowledge it was the result of more than their own meritorious achievement:

Clash of autonomy and interdependence, by Jean-Paul Fitoussi, Commentary, Project Syndicate: The bailout of the financial system was a bizarre moment in economic history, for it benefited those who benefited most from the markets’ “irrational exuberance” — the bosses of financial firms.

Before the crisis hit, however, redistribution of wealth (and the tax and social security payments that make it possible) was considered the biggest obstacle to economic efficiency. Indeed, the values of solidarity had given way to those of individual “merit”, judged by the size of one’s paycheck.

The paradox is that a part of this evolution may be attributable to two positive factors: the slow work of democracy, which liberates individuals but at the same time leaves them more isolated; and the development of a welfare system that shares risks and makes individuals more autonomous.

With this isolation and autonomy, people increasingly tend to believe, for better or for worse, that they alone are responsible for their own fate.

Here lies the conundrum. An individual is free and autonomous only because of the collective decisions taken after democratic debate, notably those decisions that guarantee each person access to public goods such as education, healthcare, etc.

Some sense of social solidarity may remain, but it is so abstract that those for whom the wheel of fortune has spun so favorably feel little debt. They believe that they owe their status purely to merit, not to the collective efforts — state-funded schools, universities, etc. — that enabled them to realize their potential. ...

The central place where this self-(over)evaluation meets the fewest obstacles is the financial market. ... Of course, when the crisis hit, financial institutions were the first to argue that autonomy was unrealistic, and that we are all interdependent. After all, why else should taxpayers agree to rescue them?

But now these same institutions are deciding that they want to go their own way again. ... Dismissing the risks that taxpayers incurred, financial institutions used the bailout to restore profitability and are now reverting to their old habits...

No one should be surprised about this. ... The bailout of banks led to a wave of mergers. If they were already too big to fail, what should we now say when banks are even bigger? Their market power has increased, yet they know they incur no risk, owing to the aggravated systemic impact of their potential bankruptcy. Moreover... Working in so uncompetitive a market is a real stroke of luck. I do not know many businessmen who would not take advantage of this; to be honest, I do not know any.

The free-market doctrine, which has become almost a religion, reinforced this belief: markets are efficient, and if they pay me so much..., it is because my own efficiency warrants it. I also participate indirectly and abstractly in forging the common good, by creating value through my work, and I am rewarded for it.

But suddenly the system collapses, the creation of value turns into destruction and parallel universes collide ... with autonomy becoming (for the brief moment of the bailout at least) interdependence. ...

Eyes are opened... The crisis reminds us what each person owes to others, highlighting an ethical truth that we were quick to forget: the rich benefit more than the poor from their cooperation with other members of society.

Two conclusions can be drawn from all this.

The first is that we all owe at least some of our success to others, given the public goods that society provides. This calls for more modesty and restraint in determining the highest salaries, not for moral reasons but for the sustainability of the system.

The second conclusion is that the most privileged classes, which have benefited the most from the solidarity of others, notably the poor, can no longer deny the latter’s contributions. But don’t hold your breath waiting for them to agree.

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop

Has Federal Reserve policy been able to break the "adverse feedback loop"?:

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop by Danielle DiMartino Booth and Jessica J. Renier, Economic Letter, Vol. 4, No. 7, September 2009, Federal Reserve Bank of Dallas: An adverse feedback loop takes hold when a weakening financial system and a slowing economy feed off each other. A crisis or shock curtails lending, hobbling the real economy; the more production and employment falter, the more lending contracts, causing further harm to the economy. The result is a downward spiral of business and financial activity.

The Federal Open Market Committee (FOMC) warned of the danger in late January 2008, when few analysts recognized that a recession had begun the previous month. It noted “the especially worrisome possibility of an adverse feedback loop; that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions.”[1]

The financial crisis validated the FOMC’s concern, igniting what has become the worst post-World War II economic downturn in terms of length and, by some measures, depth and breadth. Housing market troubles began in 2006 and deepened well into 2009. As the economy sank into recession, an October 2008 Fed survey found that two-thirds of banks had tightened standards for the highest-quality residential mortgages and over three-quarters had reined in business lending. The credit contraction sent spending down and unemployment up, exacerbating threats to the financial sector and dimming prospects for stability in housing.

Arresting the adverse feedback loop could prove to be the seminal challenge of early 21st century monetary policymaking. Since sounding the alarm in January 2008, the Fed has taken a series of actions—many unprecedented—to prevent additional damage to financial markets and restore lending activity. These policies have had some success in loosening the grip of the adverse feedback loop and may have finally positioned the economy for growth. Still, doubts linger. The risk remains that the actions may prove insufficient to put the economy on a clear path to rising employment and stable prices.

"Why the Lehman Failure Did Change Everything"

There's a lot of revisionism going on over the consequences of the Lehman's collapse. The standard view is that allowing Lehman to fail was a mistake, and hence government intervention could have lessened the severity of the crisis. Government intervention wouldn't have avoided problems altogether, but the problems wouldn't have been as bad as what we experienced. 

However, a few people are now pushing the idea that the failure of Lehman wasn't a primary contributor to the problems that financial markets and the economy experienced. According to the revisionist view, government intervention would not have made any difference, the problems would have been just as bad either way. The notion that government intervention would not have helped is, of course, the main point that this group wishes to emphasize. However, the revisionist view does not hold up to closer examination:

Why the Lehman failure did change everything, by Richard Robb, Economists' Forum: For anyone who was engaged in the financial markets during the week of September 15, 2008, Lehman changed everything. It was obvious. So what could be more tempting to finance professors than to overturn this conventional wisdom? Descartes described the man of letters who takes more pride in his speculations “the more they are removed from common sense,” and so showing that the Lehman collapse was inconsequential has spawned a minor literature.

The latest contribution by John Cochrane and Luigi Zingales, like others before them, rests partly on misunderstanding of the data. The authors deduce that Lehman wasn’t the main cause of last autumn’s turmoil by inspecting the daily movements in the spread between Overnight Interest Rate Swaps and three-month Libor, which they define as “the rate at which banks can borrow unsecured for three months.”

But a better definition of Libor under the circumstances was “the rate at which banks said they can borrow”. Libor is the result of a survey, not a measure of actual transactions. In the week of September 15 last year, big banks refused to settle foreign exchange with each other. They were not lending interbank for three month terms, so Libor during that week tells us little.

We could say the same thing for OIS. Volume was light to nonexistent in the week of September 15 last year. What we do know is that three-month T-bills traded at 0.04 per cent on September 17, down from 1.47 per cent on Friday September 12. These are real data that ought to impress the professors that the market was breaking down as fast as it knows how.

John Taylor, the father of the Lehman-was-no-big-deal thesis, wrote in a Wall Street Journal op-ed last year that spreads between T-bills and Libor “remained in that range [of the previous year] through the rest of the week” after Lehman’s demise. In fact, in the year prior to Lehman’s collapse, the peak spread was 2.05 per cent; on September 17, 2009 it reached 3.00 per cent. (Of course, any conclusions based on Libor that week are equally unreliable.)

The other principal mistake of the Lehman deniers is their assumption that the incident unfolded entirely on September 15, 2008 and any effect had to be observable by that morning. But during the final two weeks of September, the market still had to absorb the news that the Securities and Exchange Commission had no plan for an orderly transfer of client assets in the US, while Lehman Brothers International Europe would be handed over to an administration process designed for liquidating grocery stores. ...

There is plenty of room to debate the larger counterfactual: if the government had never bailed out Bear Stearns and other too-big-to-fail firms that followed, would Lehman have mattered? If the government had never bailed out anyone at all, would we be better off? But given the bailouts that preceded the Lehman failure, the Lehman failure did in fact change everything. Sometimes things that are obvious turn out to be true.

W/P = MP?

Bankers are, apparently, being rewarded generously for their fine performance in recent years:

In 2008, salaries of the top 10 banks reached $75 billion (up from $31 billion in 1999), while cash dividends to shareholders were only $17.5 billion. Management took 4.3 times more than shareholders at a time when shareholders were injecting capital and government was guaranteeing deposits.

If people were really compensated according to the value they create, wouldn't bank managers would owe us money?

"An Inside Look at How Goldman Sachs Lobbies the Senate"

I am not as negative toward naked short-selling as Matt Taibbi (feel free to convince me I'm wrong), but his insights into the lobbying effort against financial reform are useful, and I share his concerns about the distortions (e.g. regulatory capture) this brings to the reform process:

An Inside Look at How Goldman Sachs Lobbies the Senate, by Matt Taibbi: ...Later on this week I have a story coming out in Rolling Stone that looks at the history of the Bear Stearns and Lehman Brothers collapses. The story ends up being more about naked short-selling and the role it played in those incidents than I had originally planned..., but it turns out that there’s no way to talk about Bear and Lehman without going into the weeds of naked short-selling...

It’s the conspicuousness ... that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn’t a better example of “regulatory capture” ... than this issue.

In that vein, starting tomorrow, the SEC is holding a public “round table” on the naked short-selling issue. What’s interesting about this round table is that virtually none of the invited speakers represent shareholders or companies that might be targets of naked short-selling, or indeed any activists of any kind in favor of tougher rules against the practice. Instead, all of the invitees are either banks, financial firms, or companies that sell stuff to the first two groups.

In particular, there are very few panelists — in fact only one, from what I understand — who are in favor of a simple reform called “pre-borrowing.” Pre-borrowing is what it sounds like; it forces short-sellers to actually possess shares before they sell them.

It’s been proven to work, as last summer the SEC, concerned about predatory naked short-selling of big companies in the wake of the Bear Stearns wipeout, instituted a temporary pre-borrow requirement...

The lack of pre-borrow voices invited to this panel is analogous to the Max Baucus health care round table last spring, when no single-payer advocates were invited. So who will get to speak? Two guys from Goldman Sachs, plus reps from Citigroup, Citadel (a hedge fund that has done the occasional short sale, to put it gently), Credit Suisse, NYSE Euronext, and so on.

In advance of this panel and in advance of proposed changes to the financial regulatory system, these players have been stepping up their lobbying efforts... Goldman Sachs in particular has been making its presence felt.

Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss’s office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.

Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman’s fact sheet.

Now, the mere fact that two different congressional aides were so disgusted by Goldman’s performance that they both called me on the same day — and I don’t have a relationship with either of these people — tells you how nauseated they were.

I would later hear that Senate aides between themselves had discussed Goldman’s lobbying efforts and concluded that it was one of the most shameless performances they’d ever seen from any group of lobbyists, and that the “fact sheet” ... was, to quote one person familiar with the situation, “disgraceful” and “hilarious.” ...

"Crunch Time: The Fight to Fix the Financial System"

Simon Johnson and James Qwak wonder how much political capital the administration is willing to use to meaningfully reform the financial system:

It's Crunch Time: The Fight to Fix the Financial System Comes Down to This, by Simon Johnson and James Kwak, Commentary, Washington Post: The next couple of months will be crucial in determining the shape of the financial system for decades to come. And so far, the signs are not encouraging.

The Obama administration is trying to refocus our attention on regulation, beginning with the president's speech in New York two weeks ago. ... Barney Frank, chairman of the House Financial Services Committee, says that he still plans to pass a regulatory reform bill before the end of the year.

But in a clear indication of trouble ahead, Frank signaled his intention last week to scale back the proposed Consumer Financial Protection Agency, one of the pillars of the administration's reform proposals. ...

We have criticized the administration's reform proposals, in particular for not going far enough to address the problem of financial institutions that are "too big to fail." But we support much of what was in the original package... The question now is how hard Obama and Geithner will fight for it.

Financial regulation, like health care reform, has entered the phase where speeches and proposals matter less than arm-twisting and horse-trading on Capitol Hill. With health care, President Obama attempted to go over the heads of Congress, directly to the American people. With financial regulation, that is no longer an option, given the extent to which it has faded from public consciousness. Instead, the administration is playing on the home turf of the banking industry and its lobbyists. ... Is Obama up for this fight? ...

Elections have consequences, people used to say. This election brought in a popular Democratic president with reasonably large majorities in both houses of Congress. The financial crisis exposed the worst side of the financial services industry to the bright light of day. If we cannot get meaningful financial regulatory reform this year, we can't blame it all on the banking lobby.

The initial bill needs to be as strong as possible, and I agree that the administration needs to do what it can to prevent the bill from being scaled back. However, the initial legislation won't be as strong as I'd like even if the administration does prevail. But I hope we aren't thinking that we'll take one stab at financial reform and then we'll be done with it. Like climate change and health care, it will require a series of bills to achieve effective reform.

Stiglitz Interview

James Surowiecki interviews Joseph Stiglitz about "the mishandling of the financial crisis, the relationship between government and markets, and the future of capitalism around the world."

When You Believe in Things That You Don't Understand...

Robert Shiller defends financial innovation:

In defense of financial innovation, by Robert Shiller, Commentary, Financial Times: Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity. ... They do have a point. Unnecessary complexity can be a problem ... if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. ...

But any effort to deal with these problems has to recognize that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

The advance of civilization has brought immense new complexity to the devices we use every day. ... People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.

Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.

Why have financial products remained mostly so simple? I believe the problem is trust. ... People are ... worried about hazards of financial products or the integrity of those who offer them. ... When people invest for their children’s education or their retirement, they ... may not be able to rebound from mistaken purchases of faulty financial devices...

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. ... They must ... be open to ... complex ideas ... that have the potential to improve public welfare.

Unfortunately, the crisis has sharply reduced trust in our financial system..., people do not trust some good innovations that could protect them better. ... I have proposed ... “continuous workout mortgages”...[to] protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future. ...

Another innovation that is underused is retirement annuities... There are ... annuities that protect people against outliving their wealth,... that protect against inflation,... that protect against having problems in old age... and generational annuities that exploit the possibilities of intergenerational risk sharing. But most people do not make use of any of these.

Ideally, all of these protections for retirement income should be rolled into a unified product. Such products are not generally available yet. Certainly, people might be mistrustful of committing their life savings to such a complex new product at first even if it were available. So, such products are not offered and people often do nothing to protect themselves against most of these risks.

Behind the creation of any such new retail products there needs to be an increasingly complex financial infrastructure... It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. ... Regulatory agencies need to be given a stronger mission of encouraging innovation. ...

Something has to assure people that these product are safe before they will purchase them. We might have expected the market to regulate risk not so long ago, and trusted it to do so, but that seems like a bad bet now. An "interface with consumers that is simple enough to make [the products] comprehensible" could build trust if people could believe that the person doing the simplifying had considered and understood every possible risk that is attached to the product, but did anybody really comprehend the big picture in our most recent crisis? If there were such people, there weren't very many of them, not enough to inspire confidence and trust more generally.

Another method of building confidence is ratings agencies, but they won't be trusted again any time soon. Regulators that make the public confident that nothing can go wrong would help too, but building that kind of trust in regulators after what just happened is a tall order. Private insurance of some sort is an option, but absent some sort of government guarantee, can private insurance companies be trusted with your life savings if there is a severe financial meltdown? People have even lost faith in government's ability to insure people against medical and financial calamity in old age, so when it comes to providing financial insurance, government is not the solid, trusted institution it was not so long ago.

As you tick down the list of ways trust might be restored, you find one failure after another in terms of providing reliable information on the risks of particular financial products or strategies, and no matter what regulators or anyone else tries to do to rebuild the trust in financial institutions and products that has been lost, recent track records make it likely that this will be a long, drawn out process. Given that forgetting about such risks over time seems to be an ingredient in the development of bubbles, I'll let you decide whether that's good or bad.