Bernanke Replies to the "Doom Loop" Theory

December 23, 2009 4:15 PM

Senator David Vitter (R-LA) submitted one of my questions to Federal Reserve Chairman Ben Bernanke, as part of his reconfirmation hearings, and received the following reply in writing (as already published in the Wall Street Journal online).

Q: Simon Johnson: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the United Kingdom and the United States) creates a "doom loop" in which there are repeated boom-bust-bailout cycles that tend to cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?

A. 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.

This answer misses the central issue. Haldane's argument (and our point) includes "time inconsistency"—i.e., you promise no bailouts today but, when faced by an awful crash, you provide a massive set of bailouts. There is nothing in Mr. Bernanke's statements, here or elsewhere, that addresses this concern.

His hope is that current proposed changes in regulation will make a crash less likely. This is a strange assertion, given current market conditions: e.g., the Credit Default Swap (CDS) spread for Bank of America (BoA) now hovers just 100 basis points above that of the US government, despite BoA having a very risky balance sheet. Creditors apparently believe they will not face losses—and the same is true for people lending to all our big banks. This is exactly the kind of thinking that produces reckless lending (and borrowing). Will Bernanke really disappoint them in our next crash?

Until markets price "small enough to fail" risk into our biggest banks, the time inconsistency problem is alive and well—and threatening.

The Fed's continuing refusal to confront this point directly—even as other major central banks shift their public positions (and more are moving in private)—is alarming and disconcerting. The Fed is falling far behind. This will have much broader consequences for its credibility and independence down the road.

Also posted on Simon Johnson's blog, Baseline Scenario. Following were previously posted:

Bankers at the White House: "It's Certainly Not for a Lack of Effort"

December 19, 2009

The fundamental divide in opinion regarding our financial system is: Are the people running "large integrated financial groups" hapless fools, buffeted by forces beyond their comprehension and control; or do they know exactly how to ensure they get the upside and the awful, sickening downside is borne by society—including through high unemployment?

Some light was shed on this issue by the meeting at the White House on December 14 or, more specifically, by who didn't turn up and why. Of the dozen bank CEOs invited, Vikram Pandit was supposedly busy trying to extricate Citi from Troubled Asset Relief Program (TARP) and asked Dick Parsons to attend instead—a wimpy, but smart, move as Parsons is close to the President.

However, three executives—Lloyd Blankfein, John Mack, and Dick Parsons himself—did not show up in person and had to join by conference call. Their excuse was bad weather (fog) in DC meant that they were unable to fly in; Mack was quoted as saying, regarding their absence, "It's certainly not for a lack of effort."

But really there are three possible interpretations:

  1. Pure bad luck. This happens to us all; even the best laid plans are for naught sometimes.
  2. Bad management by the executives and their logistic teams—who are ordinarily the best of the best.
  3. Willful defiance of the government, which—while not premeditated in this instance—means that the executives grabbed an opportunity to show disrespect and relative power.

We don't know all the facts of how these executives planned to travel or exactly their routes that morning—and I would be happy to be corrected on any details—but here's what we can readily construct from the public record. (We do know they didn't try to come down Sunday evening, because that would have worked.)

President Obama held a press briefing, after his meeting with the bankers, starting at 12:36 p.m. The meeting itself lasted a bit over an hour. As we all like to start meetings, particularly important meetings, on round numbers, it seems fair to assume that the appointment at the White House was for 11 a.m. Even VIPs need some time to clear security, so let's assume that the CEOs were asked to arrive by 10:30 a.m.

All three of the missing bankers were apparently coming from New York. There are many ways to make the flight, but US Airways is among the most reliable—flying from LaGuardia to National Airport, every hour on the hour from 6 a.m. The flight takes just over an hour, it's easier to get to LaGuardia from Manhattan before 7 a.m., and delays are common at LGA as air traffic builds up over the east coast. Any conservative banker, who really did not want to be the only person missing a meeting with the president, would aim for the 7 a.m. shuttle—putting him on the tarmac in DC at 8:10 a.m. with a comfortable time cushion (and an opportunity to have coffee with his chief lobbyist).

There was thick fog in DC on Monday morning, but this did not descend in a matter of seconds during rush hour—it was evident already by 5 a.m. Corporate jets could get through (Jamie Dimon came that way), but let's limit ourselves to public transportation—remember that the Acela train service is not generally slowed by fog and on Monday it ran almost on time.

So the question becomes: At what point did the CEOs realize that there was a fog issue, and was there still time to come by train? The Acela leaves Penn Station every hour on the hour, with the 7 a.m. train getting to DC at 9:49 a.m. and the 8 a.m. arriving at 10:49 a.m.

We can rule out explanation one (bad luck). These are experienced people who travel all the time, with first class support staff, and they are supposed to be the best in the timely information business. These executives don't generally wander around airports trying to puzzle out flight information displays.

Is explanation two plausible (bad management)? It is possible that at least one bank team wasn't paying close attention and sent their boss to the airport for the 7 a.m. shuttle (although what are the odds that this would happen for three of our biggest and most dangerous banks?) An experienced traveler, who has checked in online, might aim to arrive at the airport at 6:30 a.m. to discover the delays already in progress.

So then the question becomes: Can you get from LaGuardia to Penn station in 90 minutes early on a Monday morning? My experience is: Yes (if any New Yorkers know differently or if anyone saw John Mack pushing desperately through the crowds at Penn Station just before 8 a.m. Monday, please send that information in).

The implication is inescapable. These three bank executives did not plan on missing the meeting but, once they learned of the fog delay, they did not rush to the train station—which is what any other business traveler with a pressing commitment would have done.

These three executives—who were, in some sense, the primary audience for the president's remarks—did not really want to attend. They do not see the need to show deference or even respect. They won big from the crisis and that is now behind them. As they move on (and up), there is nothing—in their view—that the executive branch can do to hold them back.

Even so, it wasn't polite to behave in this fashion; showing disrespect to the president of the United States is always objectionable. But there is a pattern of behavior here reflecting a deeper culture on Wall Street. This arrogance will eventually prove their undoing—no self-respecting White House can let this kind of repeated insult pass unaddressed.

Don't Worry About Greece

December 16

The latest round of fretting in global debt markets is focused on Greece. This is misplaced.

To be sure, there will be a great deal of shouting before the matter is formally resolved, but the Abu Dhabi-Dubai affair shows you just where Greece is heading.

The global funding environment (thanks to Mr. Bernanke, Time's Person of the Year) will remain easy for the foreseeable future. This makes it very easy and appealing for a deep pocketed friend and ally (Abu Dhabi, the eurozone) to provide a financial lifeline as appropriate (a loan, continued access to the "repo window" at the European Central Bank [ECB]).

Of course, there will be some conditions—and in this regard the Europeans have a big advantage: the Germans.

Everyone knows the German authorities are tough and hate bailouts (aside: except for their own undercapitalized banks). And the Germans can punish the Greeks with hostile bluster that the bond markets will take seriously—further pushing up Greek bond yields and credit default swap (CDS) spreads.

But, in reality, there are many voices at the ECB table and most of them are inclined to give Greece a deal—put in place a plausible "medium-term framework" and we'll let your banks roll over their borrowing at the ECB, even if Greek government debt (i.e., their collateral) is downgraded below the supposedly minimum level.

So Greece has a carrot and a stick—and refinancing its debt is so cheap in today's Bernanke-world, they will not miss the opportunity.

Greece has become a quasi-sovereign in the sense that it issues debt, not in its own currency, but it still has control over its own cash flow. And most budget math is based on perceptions of plausible baselines that are—in case you didn't already know—more about political perceptions (in this case, within the ECB governing council and perhaps Ecofin) than likely economic futures.

The important development is the role of the European Central Bank. It is becoming a de facto International Monetary Fund (IMF), but just for the eurozone (or is that the European Union?). It will lend a troubled country money, but only if the government does some of the hard fiscal work. The IMF may have a role to play in budget advice and assessment for Greece, but it may also be squeezed out of a meaningful policy role.

This is good in the sense that there is no stigma attached to having your banks borrow from the ECB. When random bad shocks hit, it's good to have a safety net that countries are willing to use.

But this is also less good in the sense that as the global economy moves back toward boom times, putting more bailout mechanisms in place and removing even further the downside risks for creditors is—in the broadest possible terms—asking for trouble. Why worry about whether borrowers can repay if there is a deep-pocketed sovereign (run by a cousin, neighbor, or committed friend) who will, when push comes to shove, protect all creditors?