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Monday, May 11, 2009

"Financial Policy: Looking Forward"

Susan Woodward and Robert Hall have advice for policymakers:

Financial policy: Looking forward, by Woodward and Hall: Washington is turning its attention to the future, having put out most of the financial fires. The crisis seems to be over, but questions remain about how to manage under-capitalized banks and, especially, how to design a financial system for the future that is more robust to adverse shocks. With fiscal stimulus in place and no likelihood of more, financial policy by the Fed and the Treasury is the only active possibility for further action to offset the recession.

The current state of the economy The stock market thinks that the economy is turning around, and the financial press greeted last Friday’s payroll report with a positive spin, for once. But the news is not good. ...

Apart from the successful effort to prevent the collapse of the financial system, the primary financial action to offset the recession has been the Fed’s  adoption of an interest-rate target for interbank lending of essentially zero. Rates on short-term safe assets–Treasury obligations and private instruments enjoying explicit or implicit government guarantees–are close to zero. But, sadly, rates actually paid by most private decision makers are almost as high, or in some cases higher, than before the recession began. ...

The notion that monetary policy has been highly expansionary–promoted by those looking only at safe government (Treasury) interest rates and at the volume of bank reserves–is plainly incorrect. Rather, higher interest rates are discouraging spending and production.

Monetary expansion The Fed is attacking high interest rates by purchasing private debt. Higher demand for any class of debt will drive down the interest rate for that class. One of the important lessons of the past year has been that various interest rates do not all move together in times of severe financial stress (or at other times either). Thus, the Fed has not run out of options after it drives the Fed funds rate to zero. Unfortunately, the Fed is not able to expand its holdings of private securities efficiently. The efficient borrower is the Treasury, which floats short-term debt at very low rates in the world credit market. ... By contrast, the Fed borrows only from American banks. The Fed currently pays twice as high an interest rate on its borrowings as does the Treasury for its shortest-term borrowings... Earlier in the crisis, the Treasury did borrow and place the funds at the Fed’s disposal, providing the efficient approach to Fed expansion, but the Treasury has withdrawn most of those funds. It’s time for the Treasury to resume its past practice on a much larger scale and for the Fed to cut reserves back to more normal levels. The political obstacle to this move is the ceiling on the national debt, which fails to count reserves as part of the debt, so the government can circumvent the ceiling by creating reserves instead of issuing Treasury securities, at a somewhat higher cost.

Current policy for weak financial institutions Economists are increasingly puzzled by the government’s treatment of banks and other financial institutions that are teetering near insolvency. The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. The government’s actions for Chrysler and General Motors follow the doctrine. ...

By contrast, the government’s current policy for all large financial institutions is to dribble taxpayers’ funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. ... The government has forgotten the doctrine of immediate full recapitalization in the case of financial institutions, despite the clear lessons of international experience. The Scandinavian countries aggressively reorganized and recapitalized banks after the crisis of the early 1990s and quickly restored full employment and growth; the Japanese followed the policy of supporting marginal banks for what became the “lost decade.”

The celebrated stress tests, just completed, illustrate the current policy perfectly. The test asks if it is likely that a bank can sustain its current status through the end of 2010. “Sustain” means earn enough ... to cover losses that would occur under a pessimistic macro forecast. ... If the bank can just squeak through the next 20 months..., then it passes the test. ...  The stress test is the right way to figure out the minimum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong policy. ...

Unfavorable developments since the design of the stress test raise questions about its interpretation as the most pessimistic reasonable forecast. ...

The bottom line is that Congress and the taxpayers are intolerant of continued expenditures for bailouts that generate large capital gains for debtholders, that the bailout policy maintains shaky financial institutions while a better policy would deliver fully capitalized, reliable ones, and that Congress should enact legislation promptly that would make these reorganizations possible. 

Reform for the longer run

...The idea that banks should have large amounts of fully subordinated debt is hardly new. The only novelty in this line of thought is methods for protecting banks and similar institutions from breakdowns in high-speed financial transactions. And this novelty arises because our financial institutions have new moving parts they did not have even 25 years ago, and because it has been such a long time since our largest banks were so close to insolvent.  The regulatory structure has not kept up....

[There's quite a bit more, including graphs, in the full version.]

    Posted by on Monday, May 11, 2009 at 12:39 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (2)


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