The Fed Makes a Bid (And Other Thoughts)

July 7, 2009 12:15 PM

Policymakers like to make particular kinds of statements at a "low attention" moment, e.g., right before a holiday weekend. This gets items onto the public record but ensures they do not get too much attention. And if you are asked about these substantive issues down the road, you can always say, "we told you this already, so it's not now news"—usually this keeps things off the front page.

Released on July 3rd (a federal holiday), and buried inside the Washington Post on Saturday (p.A12): An important speech (from June 26th) by the New York Fed's controversial President, William C. Dudley.

If the Fed is to become the system or any kind of "macroprudential" regulator, what would it do with that responsibility? This is a hot topic for Capitol Hill in coming weeks as various committees take on this topic in whole or part.

Dudley says that the Fed can pop or prevent asset bubbles from developing. This would represent a major change in the nature of American (and G7) central banking. It's a huge statement—throwing the Greenspan years out of the door, without ceremony.

It's also an attractive idea. But how will the Fed actually implement? Senior Fed officials in 2007 and 2008 were quite clear that there is no technology that would allow them to "sniff" bubbles accurately—and this was in the face of a housing bubble that, in retrospect, Dudley says was obvious.

Dudley is quiet on whether or not, for example, we have an emergent bubble in emerging markets today. Is there also an effective bubble in US Treasuries, as John Campbell has argued persuasively?

"Asset bubbles may not be that hard to identify," Dudley argues. Fine, but it would help to know exactly how the Fed would do this ex ante—not using the rear view mirror.

Of course, if the Fed can't get better at spotting bubbles, the implication is that no one can. Which means that "macroprudential regulator" is just a slogan—a nice piece of what Lenin liked to call "agitprop".

And if macroprudentially regulating is an illusion, what does that imply? There will be bubbles and there will be busts. Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are—or are perceived to be—"too big to fail"?

You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail.

The following were previously posted by Simon Johnson

The Jones Doctrine: Economic Development For Afghanistan (July 5)

The administration is signaling a new strategy for Afghanistan: "economic development and governance". On the front page of the Washington Post, President Obama's national security adviser, James L. Jones, told Bob Woodward:

"The piece of the strategy that has to work in the next year is economic development. If that is not done right, there are not enough troops in the world to succeed."

This is an appealing statement. But does it make any sense?

Providing people with the means to earn a decent standard of living is a good thing in itself, and better future prospects can encourage them not to fight. Economic stress often—but not always—encourages violence.

Still, there are three problems with the Jones Doctrine, as applied to modern Afghanistan.

  1. Economic development generally requires a high level of physical security. You only make investments if you are reasonably confident that you will live to see the benefits of those investments. If setting up a store or planting more acreage raises your profile in the community and makes you more of a target, why not keep your head down? The Taliban knows this and acts accordingly. Economic development is something that follows—hopefully - from more physical security, rather than providing an alternative.
  2. The U.S. can provide more resources to targeted communities, e.g., roads and other physical infrastructure, improved health, and more teachers. But none of this necessarily adds up to sustained increases in incomes. This may not be a problem, if we are willing to keep ploughing money in essentially without limit. But what is the budget for this activity and how much support does it have on Capitol Hill?
  3. If you can achieve security and provide infrastructure, what exactly will the rural citizens of Afghanistan invest in? If it's opium poppy production, doesn't that create a whole other set of issues? If you try to prevent people from cultivating poppy, what exactly are their alternatives—and how much money can they make? If you try to eradicate poppy production, doesn't that undermine the physical security goal? And if the poppy trade gains the upper hand, doesn't that support illegality and mafia-type activity in both Afghanistan and its neighbors? How does that impact the Jones' Doctrine's sensible emphasis on improving governance?

All of these questions surely have answers, but none of these answers seem easy or should be assumed to have political support. If you really want to switch emphasis in Afghanistan, there needs to be a much more engaged and detailed conversation—led by the White House and very much involving Congress.

As it currently stands, the Jones Doctrine appears more as a slogan for an intra-military discussion about troop levels (68,000 vs. 100,000). Or perhaps it is just an exhortation to keep civilian casualties down—a sensible goal, but not by itself offering a way out of the quagmire.

How to Buy Friends and Alienate People (July 3)

The banking industry is exceeding all expectations. The biggest players are raking in profits and planning much higher compensation so far this year, on the back of increased market share (wouldn't you like two of your major competitors to go out of business?). And banks in general are managing to project widely a completely negative attitude towards all attempts to protect consumers.

This is a dangerous combination for the industry, yet it is not being handled well. Just look at the current strategy of the American Bankers' Association.

Edward L. Yingling is justifiably proud of his organization's position as one of the country's most powerful lobbies.

His testimony to Congress on the potential new Consumer Financial Protection Agency plainly shows where his group stands. The most revealing quote, highlighted in the ABA's own press release, reads:

"It is now widely understood that the current economic situation originated primarily in the largely unregulated non-bank sector," he said. "Banks watched as mortgage brokers and others made loans to consumers that a good banker just would not make and they now face the prospect of another burdensome layer of regulation aimed primarily at their less-regulated or unregulated competitors. It is simply unfair to inflict another burden on these banks that had nothing to do with the problems that were created."

The premise here is false. If major banks had really not been involved in the mortgage fiasco, we would not have had to roughly double our national debt-to-GDP in order to save the US and world economy.

Within the banking community, and presumably within the ABA's membership, there is serious tension. The small banks feel—overall with some justification—that the essence of the recent problem was not about them. But they can't bring themselves to suggest publicly that the economic and political power of the largest banks should be curtailed.

Small banks have always had clout in the American political system, particularly when they work through the Senate. But we have not always had our current kind of crisis. The executives of these banks lived comfortably in the 1950s and 1960s; their kind of banking was boring, stable, and nicely remunerated.

It is the changing nature and power of the largest financial institutions—banks of various kinds—that has damaged our system since the 1980s; the rise in financial services compensation is part symptom and part pathogen. Big banks present the major risk going forward—to both the economy in general and to smaller banks in particular.

Most banks are "small enough to fail" (seven closed yesterday). It is absolutely not in their interest to have some banks that are perceived to be "too big to fail" and to ever re-run any version of the last two years.

The ABA should be discussing and addressing this issue. Instead, it is making all banks unpopular by opposing sensible legislation aimed at protecting consumers—look at the public relations context provided, for example, by Citi's recent move on credit cards.

The ABA's leadership needs to quickly rethink its approach.

This is Their Reform Strategy for Big Banks? (July 2)

Anil Kashyap is one of our leading researchers on banks. His book with Takeo Hoshi on the evolution of the Japanese corporate finance is a must read on the twists and turns that built a great economy and then laid it low. And he has many other papers and relevant recent commentary.

Professor Kashyap has a sharp perspective the administration's financial sector reform thinking, in part because he has long worked alongside key people now at the National Economic Council (the NEC, by the way, has disappointingly little transparency; even Treasury is more open).

So we should take him seriously, writing Tuesday in the Financial Times, on the importance of the proposed new "funeral plans" for banks.

Kashyap's point is that if banks are forced to explain, in convincing detail, how they can be wound down, this will effectively limit the complexity and scale of their operations. (See "Rapid Resolution Plans" on p.25 of the regulatory reform proposals; p.26 in the online NYT version)

The notion is intriguing, if such rules are actually enforced. Essentially, banks would be required to specify the extent and nature of costs for any bailout they may require.

A key part of any plan would be the people involved. Are there critical individuals who would need to be kept on to wind down positions (as was claimed to be the case with AIG FP)? Would they therefore require large retention bonuses? How large exactly?

You can see how such resolution planning might go wrong—particularly if banks were only forced to consider whatever they now regard as "normal" risks. Remember the head of quantitative equity strategies who said, in early August 2007, "Events that models only predicted would happen once in 10,000 years happened every day for three days."

A checklist approach is definitely not going to work (been there, done that, for countries). You need something that can be simulated or, even better, played out in a war game. Bring in some difficult outsiders and try to break the bank in the messiest way possible (in a game), then follow the consequences and costs.

These banks are so large and intertwined with so many others, it's hard to fathom how a "funeral plan" would be reassuring—unless it means that they become smaller and less complex.

And this brings up the real weakness of this approach to reform—the political economy. How do regulators of any kind press for meaningful plans regarding closing down, say, Citigroup or JP Morgan Chase? The CEOs of those firms have direct access to the Secretary of the Treasury and on Pennsylvania Avenue they are regarded as gurus and bastions of the economy. They'll say, "Look, if you let this person force us to simplify our business, there will be less credit growth and a big recession." Which recent Treasury Secretary would be able, at that moment, to face them down—particularly as these bankers can, if pushed, go to the big boss?

On top of this, keep in mind there is no cross-border resolution authority currently on the table in the US regulatory reform proposals or at the G20 level. The Europeans say they are inching in this direction; I'll believe that when I see it. In our next boom-bust iteration, big banks may well be regarded as having "too many cross-border liabilities to fail," so there'll be another quasi-bailout with potentially huge fiscal costs.

And then someone will promise a new regulatory reform plan.

More From

Simon Johnson Senior Research Staff

More on This Topic

RealTime Economic Issues Watch

Simon Potter (PIIE)

April 22, 2020
RealTime Economic Issues Watch
April 9, 2020