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Wednesday, May 06, 2009

Some Strings Attached

Timothy Geithner is changing the rules for financial firms that receive government assistance:

Geithner: If You Want to Cut the Strings, You Need to Cut All the Strings, by Mathew Yglesias: Here’s some good news from the Treasury Department. I’ve been complaining for a while that a number of financial institutions seem inclined to repay their TARP money, and then proclaim themselves free from government meddling, all the while taking advantage of a plethora of other emergency support programs that the government has put into place. Now Tim Geithner is saying, rightly, that a bank that wants to repay its TARP money also needs to cut itself off from the “guarantee of debt issuance offered by the Federal Deposit Insurance Corp.”

That’s the right thing to do. Now the next question becomes one of credibility. The official thinking is that the explicit FDIC guarantee lets banks borrow much more cheaply than they otherwise might. A truly healthy bank can repay its TARP money and cut itself off from the guarantee while paying little price, because a healthy bank won’t need an explicit guarantee to borrow pretty cheaply. But under the current circumstances, is the idea that the government would let a non-guaranteed bank fail and default on its loans really credible?

Consistency in policy is important. When policy is changed unpredictably, it creates uncertainty among firms and households, and that uncertainty can cause reduce or distort economic activity.

Both the Fed and the Treasury have had to alter policy mid course, more so for the Treasury, and that has brought justifiable criticism. It's as though policymakers didn't think the chess game through very many moves ahead, and as the game has unfolded they've been forced to alter their strategy in response. To some extent, policy has appeared ad hoc, developed on the fly as events present themselves to policymakers.

But let me offer some defense of this behavior, and even argue that it can be helpful in some cases.

First, I can't very well criticize policymakers for not putting policies into place fast enough and at the same time criticize them for not closing every possible loophole. If you are trying to put policies in place quickly, then you probably won't think of everything you might have discovered if you'd had the luxury of taking your time. I think policymakers can be rightly criticized for not having plans ready in advance. But given that no such plans existed, the polices that were rushed into place were going to have shortcomings that policymakers would have to deal with down the road.

Second, policymakers will never be able to think of everything, even with the luxury of as much time as they need. They may be able to think the chess game through several steps ahead, but they probably won't be able to think of every possible contingency or play by the opposition.

But what they can do is convey the spirit of the policy and make very clear the types of behaviors they are trying to prevent. And they should also make it clear that should firms that try to bypass the regulations with clever strategies exploiting loopholes in the legislation, those loopholes will be closed immediately in keeping with the spirit of the legislation. If firms know that these avenues will be closed, and if they see that firms that try to engage in this type of behavior are stopped from doing so by policymakers, and that it is therefore costly for them to even try, they won't be (as) tempted to use complicated strategies to bypass the spirit of the legislation.

Policy uncertainty is bad when the changes are ad hoc and cannot be anticipated, but not all mid course corrections to policy come under this heading. In the case just described, given that firms know the intent of the regulations they are under, the response of policymakers can be fully anticipated if they try to subvert the intent of the regulation (firms who are uncertain could ask policymakers if a particular behavior would be frowned upon).

Whether or not the actions described above come under this heading of simply closing off activities that violate the spirit of the rules can be debated, but I'd argue that the change in policy does fit into this framework and is therefore a justifiable correction.

    Posted by on Wednesday, May 6, 2009 at 12:58 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (9)


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