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Monday, November 19, 2007

Paul Samuelson: Balancing Market Freedoms

Paul Samuelson (not to be confused with columnist Robert Samuelson) says recovery may not be "just around the corner," and we need to get ready for the worst case scenario. That means imposing financial market regulation and being ready to take take action immediately if there are any further signs of trouble. [On the continuation page, there are also comments from Yves Smith on a speech on financial market regulation by Minneapolis Fed president Gary Stern, and part of a Vox EU post by Stephen Cecchetti on how to regulate financial markets without stifling innovation]:

Balancing market freedoms, by Paul A. Samuelson, Commentary, IHT: All through the years of the Great Depression, Wall Street publicists and President Herbert Hoover would repeatedly declare: "Recovery is just around the corner." They were wrong. And history repeats itself.

Today, Federal Reserve Chairman Ben Bernanke admits that nobody, including him, is able to guess how near to bankruptcy the biggest banks in New York, London, Frankfort and Tokyo might be as a result of the real estate crisis.

As one of the economists who helped create today's newfangled securities, I must plead guilty: These new mechanisms both mask transparency and tempt to rash over-leveraging. ...

The situation is not hopeless.

New, rational regulations that discourage predatory lending and rash borrowing could help a lot. Also, as we learned during the Great Depression, the government's treasury and its central bank must be both the lenders of last resort and the spenders of last resort. Speculative markets will not stabilize themselves.

The best policy is actually the middle way: not too much freedom for market forces, and definitely not too little freedom. ...

Since we live ever in the short run, global leaders must make their best guesses about what to be doing in 2008. Here are my tentative suggestions:

Watch developments closely. If America's Christmas retail sales fail badly - as they could when high energy prices and high mortgage costs pinch consumers' pocket books - then be prepared to accelerate credit infusions by central banks on the three main continents.

Keep in mind threats of excessive inflation. But be aware that the skies will not fall if the price-level indices blip up from 1.9 to 2.6 percent per annum. What worsens the public's expectations about price instability are excessive spikes in the cost of living.

Finally, to reduce the burden of mass foreclosures of over-expensive mortgages, we should explore new quasi-public agencies, as we did with the Depression-era Reconstruction Finance Corp., that specialize in supplementing for-profit ordinary lenders. This suggests expanding in a controlled way the lending powers of quasi-public agencies such as Fannie May and Freddie Mac. Better that they should lose a bit when they help homeowners of modest means fend off foreclosures on their onerous mortgages.

Maybe such innovations will turn out not to be needed. But keeping in mind worst-case scenarios of the freezing-up of banks and other lending agencies, exploratory planning is worthwhile insurance.

What the world does not need now is tolerance for any persistent weakness in global Main Street growth. It is better when physicians worry too much about a patient's health than when they worry too little.

Maybe Samuelson should have a talk with Gary Stern. Here's a shortened version of a much longer post on Stern's speech from Yves Smith:

Fed's Gary Stern Makes Lame Arguments Against Increased Credit Market Regulation, by Yves Smith: Perhaps I am attributing too much importance to a single speech, but the Minneapolis Fed President Gary Stern's "Credit Market Developments: Lessons for Central Banking," reveals a lot of what is wrong about the way policymakers are thinking about our credit crisis. And if Stern's position is widely held within the Fed, we are in worse trouble that I imagined.

I'll first deal with what I consider to be the overarching problem, namely, ideological bias, and then deal with the particulars in his speech.

The MarketWatch summary of Stern's speech gave me cause for pause:

Federal regulators should be cautious in efforts to craft a regulatory response to the disastrous subprime mortgage meltdown, Minneapolis Fed President Gary Stern said Sunday.

Stern said he was not defending the status quo but simply urging caution.

Now, on the surface, this sounds reasonable, except that the Fed has yet to advance a single proposal as to what to do in response to the subprime crisis, save its interest rate cuts and suggesting that Fannie and Freddie purchase jumbo mortgages. But these moves are merely palliative; they don't address the underlying causes. So to urge caution without serving up proposals has the effect of forestalling action. ...

Policymakers will certainly find opportunities to improve current regulations and practices; the status quo will need to change in some areas. But, as we will see, and as foreshadowed previously, tradeoffs suggest that policymakers will want to be extraordinarily careful in addressing perceived inadequacies in the current environment.

Extraordinarily careful? Perceived inadequacies? You don't need to be expert in bureaucrat-speak to recognize that this is code for "don't touch that dial."...

Finally, from Stern's conclusion:

My comments this morning are not intended to defend the regulatory and financial status quo, although I can understand that some may interpret them in that way. Rather, they are meant to suggest that there is likely little, if any, “low hanging fruit” to harvest and that, specifically, reforms may well impose inefficiencies and other costs of their own.

Baloney. Here is some low hanging fruit and readers can no doubt come up with more items:

All residential mortgage brokers will be subject to Federal reporting and oversight (presumably at least along the lines of the requirements for brokers employed by regulated banks, although those may need to be toughened too).

Requiring the prospectus for any rated security to be filed with the SEC (right now, even regulators cannot get copies of collateralized debt obligation documents unless someone is kind enough to pass it to them because they are made available only to "qualified investors" and the Fed is not a "qualified investor"!. I am not certain CDOs will survive this downturn, but if they do, they will have to go to more standardized structures, and this move would facilitate that.

Standardized disclosure of mortgage terms, particularly payments and fees. Definitions, method of calculation (and inclusion of taxes and insurance), terminology, placement in the mortgage documents (and any preliminary selling documents) will be consistent.

Finally, here is Stephen Cecchetti with recommendation on how to regulate financial markets without forestalling innovation:

Preparing for the next financial crisis, by Stephen Cecchetti, Vox EU: There is a natural tendency for financial regulators and supervisors to fight the last battle, looking for systemic weaknesses revealed by the most recent crisis. It happened after the 1987 stock market crash, during the Asian crisis, and again following the LTCM collapse. And it seems almost certain to happen again this time. So, while it is surely important to examine the specific problems involving banking system off-balance-sheet activities, the quality of collateral used to back commercial paper, and the manner in which ratings are used, I believe that we need to look further.

While market forces seem likely to cleanup much of the current mess, punishing the people who had inadequate oversight and risk controls in place, government officials who create the regulatory environment in which these problems occurred still have work to do. My proposal is that existing international committees like the Financial Stability Forum examine the design and trading of securities, especially derivate instruments, working to increase standardised and encouraging the movement of trading to organised exchanges.

In looking at the financial landscape, we can see that securities fall into three broad categories: (1) exchange traded; (2) standardised, but over-the-counter traded; and (3) customised. In the first case, the securities are standardised, transparent, and traded through a clearinghouse system. The first two properties mean make it more likely that you will know what you own and that you will know the best way to try to sell it.  The existence of the clearinghouse helps to improve the stability of the entire financial system.  Let me explain why.

A critical part of any financial arrangement is the assurance that the two parties to it meet their obligations.  In organised exchanges, there is something called a “clearinghouse” that insures that both sides of the contract will perform as promised.  Instead of making a bilateral arrangement, both the buyers and sellers of a security make a contract with the clearinghouse.   

Beyond reducing counterparty risk, the clearinghouse has other critical functions.  The most important are maintenance of margin requirements and the “marking to market” of the gains and losses.  In order to reduce the risk that it faces, the clearinghouse requires parties to contracts to maintain deposits whose size depends on the details of the contracts. And at the end of every day, the clearinghouse posts gains and losses on each contract to the parties that are involved – positions are marked to market. ...

It is important to realise that because they reduce risk in the system as a whole, clearinghouses are good for everyone. They are what economists refer to as “public goods”. But the fact that everyone obtains the benefits regardless of whether they pay the costs, means that they are difficult to set up.  Private markets will not supply public goods, so governments have to get involved. ...

How can we encourage the movement of mature securities onto exchanges?  The answer is through a combination of information and regulation.  On the information side, it is important that less-sophisticated investors realise the importance of sticking with exchange-traded products.  The treasurer who manages the short-term cash balances for a small-town government should not be willing to purchase commercial paper, or any security, that is not exchange traded.

As for regulation, over the years we reached broad agreement on which financial institutions are critical to the operation our economic system and proceeded to impose substantial restrictions on the assets that they can hold.  These come as a combination of outright prohibitions and differential treatment in capital regulation.  For example, commercial banks in the United States are not allowed to hold equity, and they are discouraged from holding corporate bonds.  It is not difficult to imagine changes in regulation and supervision that would encourage migration of a variety of bonds, commercial paper, and derivatives onto organised exchanges.

In conclusion, as we think about the right response to the current and future crisis, there are two things to keep in mind.  First, we do not want to stifle innovation.  In the same way that we all want newer and better drugs, we all want newer and better securities. Second, the innovators will always find and exploit the weakest point in the system.  So, just as drugs are tested outside the general population, we need to test financial innovations in places where they are least likely to do damage to the parts of financial system we deem critical.   But then, once we know that something is safe, it should be standardised and pushed onto an organised exchange where it will be traded through a clearinghouse.

    Posted by on Monday, November 19, 2007 at 10:17 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (28)


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