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July 16, 2009

Economist's View - 5 new articles

"Congress Must not Touch the Federal Reserve"

Mark Gertler says the Fed's independence should not be compromised:

Congress must not touch the Federal Reserve, by Mark Gertler: The economy was experiencing the worst recession since the war. In Congress, members were beginning to wonder whether the Federal Reserve's intervention strategy was extracting too great a toll on the economy. Some started to suggest publicly that it may be time to rein in the central bank's independence.

Sound familiar? Though they bear a strong resemblance to ... today, the events I refer to in fact happened in the early 1980s, in the midst of what was then the most serious economic crisis since the Depression. The head of the institution under threat of losing its independence was none other than Paul Volcker.

Of course, Mr Volcker would go on to be recognised as one of the great central bankers of modern times. He would do so by standing firm against political pressures. By continuing on the course he set out, the economy recovered and a new era of price and output stability began. ... In the Volcker era, the political outcry occurred in the midst of the economic contraction that the Fed had engineered to tame inflation. The costs of the policy were plain to see, but the long-term benefits that would eventually emerge were difficult for many to imagine at the time.

The Fed's role has been different this time round. Rather than trying to slow the economy, it has been acting to contain the damage brought on by the most complex financial crisis of modern history. By the accounts of many, the Fed has acted masterfully under difficult circumstances. ...

Given that hard times remain, nonetheless, it is natural that Congress is questioning the Fed, just as it did in the early 1980s. ... Unfortunately, the Fed cannot demonstrate what would have happened to the economy if it had not intervened in the way it did. Many observers agree that the situation would be far worse than it is today. Yet discussions of reining in central bank powers proceed as if the financial system would have stabilised itself without any Fed intervention.

The Fed well understands the lesson from the Volcker era that it can be effective only when it resists political attempts to influence its decisions. One can only hope that sober voices in Congress who appreciate the importance of central bank independence will help keep Capitol Hill from taking any measures that do permanent damage to the Fed.

A more constructive route for Congress would be to proceed with regulatory reform that would prevent a repeat of the current situation. At the core of the crisis is an antiquated regulatory system that permitted large financial institutions to take excessive risks. By giving the Fed the ability to monitor risk-taking by these institutions, Congress would diminish greatly the likelihood the central bank would again need to intervene directly in private credit markets.

The Fed may not have been perfect in its response to this or previous crises, but that doesn't mean that a less independent Fed would have done better. Taking away Fed independence - including subjecting the Fed to audits by the GAO - would be a mistake. In addition, if we are going to strengthen regulatory authority so that we can better monitor and reduce systemic risk that threatens the financial system - and we should - that authority needs to be in the hands of an independent entity, and the Fed is the natural place for this. Finally, its role in regulating system-wide risk is complementary to many of its other activities. For example, its role as a systemic risk regulator would involve monitoring risk within large institutions. Should a bank get into trouble, that would be helpful in assessing whether the bank should be granted access to the discount window in its capacity as lender of last resort.

We need to maintain an independent Fed, to give the Fed the powers it needs to monitor and regulate the level of overall risk, and to give the Fed the authority it now lacks to put banks through an orderly bankruptcy process so it can avoid bailing out financial institutions that are in trouble and a threat to overall the financial system.

Update: See Willem Buiter for a longer, more detailed version of many of the same points, e.g.:

Probably the single most damaging failure of the US Treasury, the US Congress and the US financial regulators was there inability/unwillingness to create a special resolution regime (SRR) with structured early intervention and prompt corrective action for all systemically important financial institutions (those too big, too complex, to interconnected, too international or too politically connected to fail in the ordinary Chapter 11 or Chapter 7 way). ...

But however weak its past performance and credentials, they are rock-solid compared to those of the other candidate institutions. ...

Only the Fed can fulfill the macro-prudential regulator-supervisor role. That is because it has the short-term deep pockets. It is the source of the ultimate, unquestioned liquidity in the economy, through its monopoly of the issuance of base money. Without the short-term deep pockets, a macro-prudential regulator/supervisor cannot act as lender of last resort, market maker of last resort or provider of enhanced credit support. It would be ... toothless...

He also makes this point:

The problem with this solution of the macro-prudential regulator/supervisor problem is that it is incompatible with central bank operational independence as interpreted since 1989 or thereabouts. ... When the central bank plays a quasi-fiscal role, as the Fed has been doing on an unprecedented scale in the current crisis, the fullest possible degree of accountability to the Congress, the tax payer and the citizens is essential. The Fed has no mandate to engage in quasi-fiscal operations, even when it is for a good cause. ...

If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution. Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury.

You pick.

Okay. As much as possible, monetary policy should be kept out of the hands of politicians.

Why is the Recovery of Modern Labor Markets So Slow?

Arnold Kling is puzzled by current macroeconomic developments, particularly that banks are doing better than expected, and labor doing worse. I want focus on the second:

Relative to what a consensus forecast might have predicted last October, it appears that:

Two Puzzles of Current Macroeconomic Condition, Econlog: ...[E]mployment has fallen more than expected. ... Why is the severity of the recession so much greater in the labor market than in the goods market? ...

My answer ... is that we are superimposing a heterogeneous labor force on top of a trend of rapid productivity growth. In some sense, we are seeing an amplified version of what took place from 2001 through 2003. This was dubbed a "jobless recovery," but I called it a "productivity-cushioned recession." That is, growth in trend productivity of 2 to 3 percent per year is maintaining output higher than it would be if the trend were less than 2 percent. (Trend productivity growth is productivity growth measured over periods of five years or more, to iron out short-term fluctuations.)

The heterogeneous labor force means that it is very hard to reallocate labor from sectors that decline. Forty years ago, there were lots of industries that employed men with only a high school education. Today, there are fewer such industries, so that when the construction sector and the automobile sector shrink, the job losers have almost nowhere to go. These guys aren't going to turn into school teachers or nurses next month--or ever. It would be nice if the stimulus were actually creating construction jobs, but the reality is that the net increase in state construction projects is probably infinitesimal, as the states wind up juggling their budgets to keep Medicaid going. ...

There may be another factor as well. I think part of the problem - and the statistics support this interpretation - is that the economy is not creating jobs that pay as well as the jobs people are losing. Being unwilling to take a cut in pay, unemployed workers resist for awhile and keep looking, as long as they can anyway, and it isn't until they begin to exhaust the resources supporting the search and to accept the reality of a new job market that they finally lower their aspirations and take a cut in pay (or exit the labor force altogether). So it's not just that workers can't be retrained fast enough for the new, good jobs that are available, it's also that the availability of the jobs is not sufficient to reemploy workers at their previous rates of compensation.

But there is a factor that works against a long, drawn out search for a job that is a good fit with skills. If unemployment compensation is low, or does not last very long, then a worker may not be able to take the time needed to find a good employment match (though for workers with more personal assets to rely upon, i.e. higher paid workers generally, or another source of income such as an employed spouse that can help to tide them through, searches could still be relatively extended):

US Unemployment Benefits in International Context, by Mathew Yglesias: Gary Burtless has an interesting paper reviewing the social safety net measures in the American Recovery and Reinvestment Act. If you read the paper you'll see that even though these elements of ARRA have gotten less discussion than the state aid and infrastructure elements, boosts in safety net spending are actually the largest segment of ARRA spending. For blogging purposes, though, I really just wanted to reproduce this chart showing how relatively stingy unemployment benefits are in the United States:


In addition to being relatively stingy, unemployment insurance in many ways fails to protect people from the most salient economic risks. Older workers tend to earn more money than younger workers, in part because over the years they've acquired sector- and firm-specific skills that their younger colleagues lack. When they get laid off, however, these skills become devalued and even when recovery comes it's often difficult to get a new job that's as remunerative as the old one. This, in turn, encourages the political system to focus a lot of preservation of the status quo which winds up reducing long-run growth potential. Gene Sperling's idea of comprehensive wage insurance would help solve this issue and do a lot of good.

"Ideas and Rules for the World in the Aftermath of the Storm"

This is a summary of the "causes and nature" of the financial crisis. I've added a few comments along the way:

Lessons for the future: Ideas and rules for the world in the aftermath of the storm, Part I, by Guido Tabellini, Vox EU: Almost two years after the beginning of the financial crisis that has overwhelmed the world economy, it may be time to draw some conclusions and outline the main lessons for the future. Is it really a turning point for market economies, a systemic crisis that will radically change the division of tasks between state and market? Or will everything be back to normal once a number of important technical problems concerning financial regulation are solved?

Market failure

Let us start with the market failure. There is no doubt that the crisis has revealed a serious failure in one of the most sophisticated markets in the world – modern finance. One of the crucial tasks of financial markets is allocating risk. They have failed stunningly. Risk has been underestimated, and many intermediaries took excessive risks. The reasons for this failure and the implications for economic policy, however, are less clear.

One possible explanation is that it was just due to poor judgement. Financial innovation has been so fast that even sophisticated operators were not always able to fully understand the degree of risk of the financial instruments that were constructed. The systemic implications of those instruments were even less clear. As a consequence, many investors overestimated global financial markets' capacities, overlooking the systemic risk and the illiquidity risk that proved crucial in this crisis. This mistake can partly be explained by the difficulty of correctly evaluating the probability of rare or infrequent events. If this were all, there would be no need to worry. This crisis will not be forgotten, and it will certainly leave a mark on risk management practices and organisation models of financial intermediaries.

There is also a less benevolent explanation for the failure of financial markets, however, that highlights a systematic distortion of individual incentives rather than a mistake. First of all, the "originate and distribute" model, which separates the concession of the loan from the financial investment decision, entails obvious moral hazard problems. Secondly, rating agencies, paid by those issuing the very assets being rated, experience an obvious conflict of interest. Third, managers' remuneration schemes encourage myopic behaviour and excessive risk taking – if the bonus depends on short-term performance indicators, each individual manager is induced to take risks that are large but rare. If this is true, it means that we cannot trust the ability of markets to learn. Distorted incentives must also be redressed, through new, stricter regulation, even at the cost of significantly slowing down financial innovation or giving up some of its beneficial effects.

It's worth pointing out that there are distinct market failures here because the best policy to overcome the market failure depends upon the type of market failure it addresses. I would have also highlighted the asymmetric information problem in these markets since the desire for reliable information on risks is what drives the need for the ratings agencies, and I would have also noted that the mal incentives extended beyond just the "originate and distribute" model, homeowners (with no recourse loans), real estate agents (who want to sell as many houses as they can for as much as they can to increase commissions), appraisers (who share some of the conflicts that ratings agencies have and also exist to solve an information problem), and so on. So it wasn't just banks and brokers responding to the bad incentives of the originate and distribute model, just about every link in the chain had bad incentives that distorted outcomes in ways that encouraged the build up of excessive risk.

Also, these two explanations are not mutually exclusive. The market failures can lead to excessive risk accumulation, and the extent of this risk could be misperceived. I think it was the interaction of the market failures and the misperception, not predominantly one or the other. If the market failures do not allow dangerous risk levels to accumulate, misperceiving it is not nearly so dangerous.

Regulatory failure

Mistakes in risk management cannot be only attributed to private operators. Supervisors have made major mistakes as well, allowing banks to accumulate off-balance-sheet liabilities and tolerating an excessive growth of leverage (i.e. the ratio of total assets to shareholders' equity) and indebtedness. This could be due to capture of supervisors by banks, arbitrage and international competition among supervising agencies, or implementation deficiencies. But more importantly, there has been a fundamental conceptual mistake –monitoring each financial institution solely on an individual basis, considering as the value at risk of the individual intermediary without taking systemic risk into any consideration. This is the same mistake that the individual intermediaries made.

I agree with the conceptual mistake noted here, but there was another one too. Everyone thought it was a good idea to get risk off of the traditional banking systems balance sheet. Somehow the notion was present that this would - through worldwide distribution of risks - reduce the chances of a meltdown to nearly zero, i.e. to reduce systemic risk. This, of course, turned out to be wrong since risk did, in fact, get concentrated in dangerous ways.

A crisis of these proportions cannot have stemmed exclusively from mistakes in risk management. The reason is that high-risk investments were relatively small compared to the overall dimension of global financial markets (Calomiris 2007). Many observers expected that the American real estate bubble would burst. But few imagined that that would overwhelm financial markets all over the world. If this has happened, it must be that the shocks hit important amplifying mechanisms. This amplification can largely be attributed to financial regulation. In other words, even more than a market failure, the crisis was triggered by a failure of regulation (see the eleventh ICMB-Geneva Report, summarised by Wyplosz 2009).

Not so much that regulation was too lenient, or that deregulation had gone too far – rather, the very founding principles of regulation have amplified the effects of a shock that in reality was not that large. Subprime mortgages, the financial products whose insolvency has originated the current crisis, amount to about one trillion dollars. It is a large number in absolute terms, but small with respect to the total of about 80 trillion dollars of financial assets of the world banking system. As a comparison, consider that the losses originally estimated in 1990 during the savings and loans crisis were about 600-800 millions of dollars, less than the total of subprime mortgages, but the total amount of financial assets was much smaller then. Yet, that crisis was quickly overcome without major upheavals. Why has it been so different this time?

There are two aspects of regulation that have amplified the effects of the initial shock: (i) the procyclicality of leverage, induced by constraints on banks' equity, and (ii) accounting principles that require assets to be evaluated according to their market value. In case of a loss on investments, which erodes the capital of financial intermediaries, capital adequacy constraints under the Basel accord require reduced leverage and thus force banks to sell assets to obtain liquidity. The problem is thus exacerbated: forced sales reduce the market price of assets, worsening the balance sheets of other investors and inducing further forced sales of assets, in a vicious circle. Exactly the opposite happens during a boom: capital gains on portfolio assets allow intermediaries to expand leverage, which means taking on more debt in order to acquire new assets, in such a way that the price of assets is pushed up and other intermediaries become indebted chasing increasingly high prices. In sum, banking regulation has created a mechanism that amplifies the effects of shocks and accentuates cyclic fluctuations in the indebtedness of financial intermediaries.

I am coming around on the need to regulate leverage, and it does appear to have important cyclical variations. As to the mark to model versus mark to market debate, I still don't like the bad incentives and the possibility for error that exists with the mark to model framework. But the general question of how to best value the assets on a balance sheet during a time like this is an area where I still have some uncertainty.

One of the main lessons to be drawn from this crisis is that we need to deeply reconsider financial regulation and ask ourselves what its ultimate objective is – correcting distorted incentives of agents, creating buffers that reduce procyclicality of leverage, or reducing risks, and, if so, which risks? A sound regulatory system should address two concerns:

  1. Correct distorted incentives of individual intermediaries or financial operators;
  2. Reduce negative externalities and systemic risk, bearing in mind that evaluating risk management practices within individual intermediaries is not sufficient.

Finally, inevitably, this will have to translate into rules that reduce the size of leverage in absolute terms and its procyclicality.

And just to amplify a point from above, since a variety of problems caused the crisis, no single solution can fix them all. It will take a variety of fixes to shore up the system going forward.

Mistakes in managing the crisis

It is widely held that the current situation is mostly the result of economic policy mistakes (in regulation, in supervision and, according to some, monetary policy) made before the outbreak of the crisis. The corollary of this thesis is that it is sufficient to correct these mistakes in order to avoid the next crisis. But the truth is that many serious mistakes have been made during the management of the crisis and have significantly contributed to worsening the situation.

The unclear causes of the crisis have resulted in its management being improvised from step one without a clear path in mind. Bear Stearns was saved, Lehman Brothers failed, AIG was saved. Each decision was improvised, guided by neither pre-established criteria nor a sound and consistent strategy. The result is that, rather than boosting confidence, economic policy interventions have contributed to increasing confusion, panic, and fear.

I have made this point many times as well, and believe it created a lot of additional uncertainty. The handling of Lehman was a costly misstep.

Loss of confidence is always at the heart of any financial crisis. Expectations concerning the behaviour of authorities and other operators play a fundamental role in determining whether there will be contagion or whether the shock will be absorbed. But in order to influence expectations and restore confidence, policymakers must act according to procedures and criteria that are agreed upon and well understood, identifying the ultimate objectives and the policy tools to reach them. There has never been such clarity in this crisis, and that is an important lesson. To avoid repeating similar mistakes, it will be necessary to elaborate new and detailed procedures for managing complex phenomena such as the bankruptcy of large banks and more general policies aimed at preventing the worsening of systemic crises.

I agree, but how do we make these plans credible? We cannot bind future policymakers - they can do as they please - so how do credibly commit to these plans? When the next crisis hits and we have bankruptcy plans for a too big to fail institution, will we actually carry through or will we worry that it might not work out so well after all and step in as we did this time? Still, I think it's important that we try, and if the plans are good ones, we at least have a chance.

Given that large banks with systemic implications are typically multinational, these procedures will need to be coordinated at the international level. This is not easy, since, after all, only the state, and hence taxpayers, can cover systemic risk. Taxpayers must take on the burden of failing institutions' debts, at least temporarily. But which state, which taxpayers, when the institution is a large multinational bank?

Although difficult, this problem is not new. Financial crises in developing countries, which occurred almost yearly in the 1990s, have now become less frequent and less devastating thanks to the procedures of crisis management elaborated within the International Monetary Fund. It is now time to learn from those experiences, adapting them to the specific problems of large multinational banks.

Yes, we need an institution that can serve as a global and modern version of a lender of last resort.

In my next column, I will outline where we might go from here.

One final comment. I think there are dangers when political power becomes concentrated in too interconnected to fail financial institutions, and this potential contributor to the crisis deserves more emphasis.


Brunnermeier, Markus K, Andrew Crockett, Charles A Goodhart, Avinash Persaud, and Hyun Song Shin (2009). The Fundamental Principles of Financial Regulation. Centre for Economic Policy Research and International Center for Monetary and Banking Studies. Calomiris, Charles (2007). "Not (Yet) a 'Minsky Moment'", 23 November. Wyplosz, Charles (2009). "The ICMB-CEPR Geneva Report: 'The Future of Financial Regulation'", 27 January.

This article may be reproduced with appropriate attribution.

Enough Punishment for One Day

When you are teaching a course, imposing rigorous standards and giving lots of homework can be of great benefit to your students:

The rigors of the USC Masters in Real Estate Development Program, by Richard Green: A student of ours emails:

I just wanted you to know that this assignment got me out of a traffic ticket this morning. La Cienega was shutdown to due an accident and I was trapped. So, I made a u-turn which included driving over a curbed median. A motorcycle cop pulled me over and gave me a lecture about how this isn't Texas (I have texas plates) and "cowboy driving" is not acceptable....whatever that means. So I told him that I had to get to campus for the mid- term and I had a limited amount of time to complete the homework assignment. I pulled out assignment #3 to make my story credible and he took it with him when he went back to his motorcycle. When he came back he told me that it seemed like the assignment was going to be enough punishment and he let me go.

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