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July 26, 2009

Economist's View - 3 new articles

The Fed as Systemic Risk Regulator?

Alan Blinder favors making the Fed the systemic risk regulator for the U.S.:

An Early-Warning System, Run by the Fed, by Alan Blinder, Commentary, NY Times: ...[T]wo contradictory crosscurrents are swirling in Washington — one that would enhance the Fed's powers and one that would curtail them.

The Treasury's recent white paper on financial regulatory reform would have the Fed "supervise all firms that could pose a threat to financial stability," even if they are not banks, turning the Fed into what some people are calling the nation's "systemic-risk regulator." Doing so would expand the Fed's reach...

On the other hand, some members of Congress are grumbling that the Fed has already overreached, usurping Congressional authority. Others contend that it has performed so poorly as a regulator that it hardly deserves more power. Representative Ron Paul, the Texas Republican, has even introduced a bill that would have the Government Accountability Office audit the Fed's monetary policy — a truly terrible idea that could quickly undermine the Fed's independence. ...

The main task of a systemic-risk regulator is to serve as an early-warning-and-prevention system, on the prowl for looming risks that extend across traditional boundaries and are becoming large enough to have systemic consequences. Can this job be done perfectly? No. Is it worth trying? I think so. ...

Some people would end the systemic-risk regulator's role there, making it an investigative body and whistle-blower whose job is to alert other agencies to mounting hazards. But if systemic problems are uncovered, someone must take steps to remedy or ameliorate them.

Under one model, the regulator would be like the family doctor ... making a general diagnosis and then referring the patient to appropriate specialists for treatment: to the Securities and Exchange Commission for securities problems, to the banking agencies for safety and soundness issues... But if multiple agencies are involved, their actions would need coordination. Would a systemic-risk regulator ... find itself herding cats?

An alternative model would work more like a full-service H.M.O., where an internist refers patients to in-house specialists as necessary. To make that work, the systemic-risk regulator would need more power — not just to diagnose problems, but also to fix them. And it would need a huge range of in-house expertise.

Crucially, when truly systemic problems arise, a lender of last resort is almost certain to be part of the solution — and that means the central bank. So if there is to be a systemic-risk regulator in the United States, it should be the Fed.

Furthermore, unlike any other agency, the Fed would not be starting from scratch... The Fed already has the eyes and ears (though not enough of them) to do this job, and has the broad view (though, again, not broad enough) over the entire financial landscape. It must have such a view to handle monetary policy properly.

I am also deeply skeptical that a consortium or a committee would succeed at systemic-risk regulation. Creating a hydra-headed regulator, as some have proposed, invites delays, disagreements and turf wars — and dilutes accountability. So the Treasury plan sensibly puts the Fed in the driver's seat, with the others playing advisory roles.

Now to the final question. Critics who worry about the Fed accumulating too much power have a point. But the Treasury proposal already clips the Fed's wings by stripping away its authority over consumer protection, and further wing-clippings are possible. But when it comes to dealing with systemic risk, Treasury Secretary Timothy F. Geithner said last month, "I do not believe there is a plausible alternative." Neither do I.

Here's Alice Rivlin with a more space to write and hence a more nuanced view of the issues. This is from her testimony before the House Committee on Financial Services and the Senate Committee on Banking, Housing and Urban Affairs. I agree with most of what she says, but not point three where she argues that "it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed." One of her arguments is that we can't necessarily identify systemically risky institutions until problems actually develop, but I believe it is possible to do this. It may require that we develop some new measures of connectedness, size isn't the only determining factor, but it seems quite feasible and desirable to develop ways of characterizing risk from interconnectedness. And once the risk is identified, it needs to be controlled and I see the Fed as the best agency to do this for the reasons Blinder outlines (point three is the main focal point in the extracts below, but there's quite a bit more in the original, e.g. sections on the need for regulation to fix the perverse incentives in the mortgage and financial industries, and a discussion of controlling leverage):

Reducing Systemic Risk in the Financial Sector, by Alice M. Rivlin: July 21, 2009 — Mr. Chairman and members of the Committee:

I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. ...

It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic wellbeing and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and over-borrowing, excessive risk taking, and out-sized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world's economic wellbeing.

Approaches to Reducing Systemic Risk

The crisis was a financial "perfect storm" with multiple causes. Different explanations of why the system failed—each with some validity—point to at least three different approaches to reducing systemic risk in the future.

  • The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system... The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.
  • The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.
  • The system crashed because large inter-connected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms—or even break them up—and to expedited resolution authority for large financial firms... Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier One Financial Institutions. I believe it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.

The Case for a Macro System Stabilizer

One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, anti-regulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. ...

Systemically Important Institutions

The Obama Administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier One Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go.

It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the federal government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk-taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late.

Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks.

Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize 'Too Big to Fail' and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures.

Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the UK's FSA, but structured to be more effective than the FSA proved in the current crisis. In the US one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies.

I don't pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier One Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy.

Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macro economists—Paul Volcker, Alan Greenspan, Ben Bernanke—who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort—including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed's control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown—and the Fed has been more transparent about its objectives. Although respect for the Fed's monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives.

If the Fed were to take on the role of consolidated prudential regulator of Tier One Financial Holding Companies, it would need strong, committed leadership with regulatory skills—lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed's budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed's effectiveness and credibility in containing inflation.

In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system—again in coordination with the Council. I would not create a special regulator for Tier One Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank.

Thank you, Mr. Chairman and members of the Committee.

How Much of the Increase is Permanent?


Update: Brad DeLong answers:

I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.

Update: Since we're on the topic, Martin Feldstein thinks the saving rate will be higher in the future, but not high enough to avoid increases in the real interest rate:

US saving rate & the dollar's future, by Martin Feldstein, Commentary, Project Syndicate: ...The saving rate of American households has risen sharply since the beginning of the year, reaching 6.9 per cent of after-tax personal income in May, the highest rate since 1992. In today's economy, that is equivalent to annual savings of $750 billion.

While a 6.9 per cent saving rate is not high in comparison to that of many other countries, it is a dramatic shift from the household-saving rate... Dramatically lower share prices and a 35 per cent fall in home prices reduced household wealth by $14 trillion... Individuals now have to save more to prepare for retirement, and retirees have less wealth to spend. Looking ahead, the saving rate may rise even further, and will, in any case, remain high for many years.

The increase in the household saving rate reduces America's need for foreign funds to finance its business investment and residential construction. Taken by itself, today's $750 billion annual rate of household saving could replace that amount in capital inflows from the rest of the world. Since the peak annual rate of capital inflow was $803 billion (in 2006), the increased household saving has the potential to eliminate almost all of America's dependence on foreign capital. ...

Without a fall in the dollar and the resulting rise in net exports, a higher saving rate and reduced consumer spending could push the US economy into a deep recession. By contrast, the lower dollar makes reduced consumption consistent with full employment by shifting consumer spending from imports to domestic goods and services, and by supplementing this rise in domestic demand with increased exports.

But this direct link between higher household saving and a lower dollar will only be forged if higher household saving is not outweighed by a rise in ... government deficit. A large fiscal deficit increases the need for foreign funds to avoid crowding out private investment. Put differently, the value of the dollar reflects total national saving, not just savings in the household sector.

Unfortunately, the US fiscal deficit is projected to remain high for many years. ... If that high level of government borrowing occurs, it will absorb all of the available household savings even at the current elevated level. That would mean that the US would continue to need substantial inflows of foreign capital to fund business investment and housing construction. So the dollar would have to stay at its current level to continue to create the large trade deficit and resulting capital inflow.

It is, of course, possible — I would say likely — that China and other foreign lenders will not be willing to continue to provide the current volume of lending to the US. Their reduced demand for dollars will cause the dollar to decline and the trade deficit to shrink. That reduced trade deficit and the resulting decline in capital inflows will lead to higher real interest rates in the US. The higher interest rate will reduce the level of business investment and residential construction until they can be financed with the smaller volume of national saving plus the reduced capital inflows.

Although the higher level of household saving will limit the rise in US interest rates, it will not change the fact that the combination of large future fiscal deficits and foreign lenders' reduced willingness to buy US securities will lead to both a lower dollar and higher US interest rates.

Since the increase in the long-term fiscal deficit Feldstein is worried about is mostly due to the expectation of rapidly increasing health care costs, this points to the need for health care reform that can (compassionately) control escalating health care costs.

Update: Speaking of health care reform, Ezra Klein looks at the lessons to be learned from Clinton's attempt to reform health care:

The Ghosts of Clintoncare, by Ezra Klein, Commentary, Washington Post: Barack Obama's strategy to pass health-care reform seems based on a simple principle: Whatever Bill Clinton did, do the opposite. ... Few legislative failures have been as catastrophic as Clinton's on health-care reform. ... Yet there are aspects of Clinton's approach that could, and should, inform Obama's effort -- and not just as examples of what not to do. ... Clinton got the politics of reform wrong, but in important ways, he got the policy right. He just got it right too soon.

By the time Clinton and his team took office, the insurance market was changing. American consumers had traditionally relied on the most straightforward of insurance products: indemnity insurance. You went to the doctor or hospital of your choice, and that doctor or hospital sent your insurer the bill. Hopefully, your insurer paid it. That was that. The plans weren't confined to networks tangled in deductibles and co-pays. But they weren't holding down costs, either, and the system was becoming unaffordable. Managed care, a new system that ... envisioned a more central role for insurers ... was rapidly emerging... But this was a dangerous change. Insurers make money by denying claims. Money they spend on health care is money they lose...

So Clinton sought to cage managed care inside managed competition, which would regulate the behavior of insurers and force them to compete for patients. This would give consumers more power against their insurance companies, drive the bad actors from the market and generally protect against the excesses of managed care. Clinton's plan also included a handful of other safeguards, like out-of-pocket caps and an independent appeals process, designed to protect consumers from deficient insurance. ...

But if Clinton's team of enlightened wonks could glimpse managed care over the horizon, the public wasn't as farsighted. Bill and Hillary weren't seen as meeting and taming the managed-care revolution. The act of writing legislation that included managed care made it seem as if they were proposing it. And there was no political margin in that. Managed care, after all, means less choice. It means provider networks and insurance bureaucrats and complexity. It would have been a hard sell under any circumstances... The plan died a painful and public death...

But then a funny thing happened: Managed care came anyway ... HMOs and PPOs and HDHPs. We're all in networks now. We don't get our choice of doctor. There's no appeals process. No out-of-pocket caps. Nothing to stop insurers from rejecting ... coverage... And if we don't like our insurer? Tough. "We got managed care," says Chris Jennings,... one of Clinton's top health-care staffers. "But we didn't get the things that would protect us from managed care. We got the Wild West version of it."

In the modern health-care system,... the insurers who populate that market have grown all the stronger..., 94 percent of statewide insurance markets are highly concentrated. ... Clinton had promised us managed care within managed competition. Instead, the insurers took control of our care and managed to effectively end competition. Neat trick. ...

All of this has led to an interesting reversal in this year's health-care debate. In 1994, people feared that Clinton would restrict their choices. In 2009, people want Obama to bring their choices back. ... A ... poll last month showed that 62 percent of Americans support the choice of a public insurance option. ... But if the public option would drive private insurers out of business and reduce consumer choice, the numbers flip, with 58 percent opposing it. What people support, in other words, is not public or private insurance, but choice in insurance. That, along with protection from escalating costs, is the inviolable principle of health-care reform. ...

The lesson of Clintoncare was that even if the American people want reform, they do not necessarily want change. And so Obama's health-care strategy involves a delicate effort to ... reform the health-care system without substantially changing it... But this is not the early 1990s. The indemnity insurance that most Americans enjoyed then is virtually nonexistent today. The mergers and takeovers and consolidations in the insurance market have given people less choice and thus less power. Today, the cost issue is more acute, the president is more popular, the Democrats have more seats in Congress, and the Republicans are more fractured. Obama ... was right to dismiss those who would "dust off that old playbook."

But the ghosts still hover. Republicans are fixated on what worked for them in the last health-care battle, and Democrats are overly concerned with what contributed to their failure. Just as Clinton's plan was weighed down by the impression that it would change too much, history may leave Obama's effort vulnerable to the charge that it is changing too little.

The claim that reform will give people more rather than less choice will hard to sell. Politically, I think the focus has to be on how the increase in concentration and power within the insurance industry and the control that gives the industry over the delivery of health care limits choice in undesirable ways.

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