Tuesday, October 27, 2009

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

6. We need more regulation

Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets, [including] tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily….

House Financial Services Committee Chairman Barney Frank … said any changes would [also] have to discourage “excessive risk taking.”

Treasury Secretary Timothy Geithner said there would have to be “more focused accountability” and a “much stronger set of oversight over all financial institutions that could pose risk of damage to the system. He said core parts of the financial markets, such as markets for derivatives and other complex products, must “have a basic framework of oversight around them.” [T]here would be stiffer capital requirements to deter companies from becoming overleveraged “so that a mess like this never happens again.”

“Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking …, and be held to high capital and liquidity standards,” Mr. Bernanke said.

Damian Paletta, Wall Street Journal, March 11, 2009.

All this is empty or disingenuous bombast for two reasons.

A. Financial regulation as pursued in the United States is, if honestly intended to protect the public, is impossible. Financial intermediation is a full-time, complicated, skillful, and costly task. Part-time amateurs removed from the scenes of action cannot assess expected returns or risk. They have neither the means nor the incentives to do so. Those who expect otherwise deny the principles of economics. Economic analysis rests on incentives and information, which itself depends on incentives as well as experience. Official and often artificial portfolio rules are accommodated while their intentions are thwarted by substitutions or innovations. Capital requirements, deposit insurance, and leverage restrictions induce riskier investments. Interest ceilings broke down because of evasions. Ed Kane (1981) has described the process as the regulatory dialectic of interactions between political and economic pressures in regulated markets. Avoidance leads to more regulation which leads to more …. Normally changing conditions further reduce the effectiveness of regulation. Many of the derivatives and other instruments that government agencies hope to regulate did not exist a few years ago, and will be succeeded by new and imperfectly understood instruments, partly to avoid regulation and partly in the normal course of events. The capitalistic system that has made us rich -- as well as secure compared with earlier times – requires the taking of risks in a free environment. Effective regulation would be self-defeating, but we need not fear because it is impossible.

B. Nor is it honestly attempted.

As a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.

George Stigler, “The theory of economic regulation,” Bell J. of Economics and Management Science, Spring 1971.

The history of regulation is better described as one of protection. The Federal Reserve was created by and for the big banks, primarily to support bank loan markets, guarantee cheap credit (the Greenspan put dates from 1913), and help fix prices and procedures (Wood 2009, pp. 105-110). The FDIC was created to forestall legislation favoring competition after the bank failures of the Great Depression (Golembe 1960). The Securities and Exchange Commission has discouraged small firms by increasing the cost of capital, it has cut the number of exchanges and retarded price and service competition in the financial services industry, nominally in support of “standards” but actually in opposition to competition. Whatever new regulations and regulators are decided by Congress, they will not threaten the profits of the politically powerful.

So what to do? The most essential change (one we can believe in) required of governments is to behave -- to stop supplying incentives for risky and inefficient behavior. The degeneration of loan qualities caused by the push for home ownership by government-sponsored enterprises, the easy money (negative real interest-rate) policies of the Federal Reserve, and the government’s too-big-to-fail commitment were the three main causes of the crisis.

If the urge to regulate is irresistible, it should be directed to results rather than rules. If we wish to reduce a bank’s chance of failure, we could (1) require more capital, less leverage, and/or fewer mobile-home loans; or (2) confiscate the assets of and/or imprison management if failure occurs. Can there be any question which would be more effective? Can there be any question which will be adopted?

It should be noted that the recent discovery of “systemic risk” is manufactured. The reason for the greater regulation of banks, which is as old as the republic, has always been the tendency of banks to fail in groups together with the perception that bank failures are worse for the economy than those of other firms.


Carter Golembe. “The deposit insurance legislation of 1933: an examination of its antecedents and purposes,” Political Science Quarterly, June 1960.

Edward Kane. “Good intentions and unintended evil: the case against selective credit allocation,” J. Money, Credit and Banking, Feb. 1977.

John Wood. A History of Macroeconomic Policy in the U.S. Routledge, 2009.


Tuesday, October 20, 2009

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

5. Confusion of insolvency and illiquidity

Although monetary easing likely offset some part of the economic effects of the financial turmoil, that offset has been incomplete, as widening credit spreads and more restrictive lending standards have contributed to tight overall financial conditions. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Consequently, the second component of the Federal Reserve's strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets.

Ben Bernanke, speech to the Greater Austin Chamber of Commerce, Dec. 1, 2008.

The Fed has made loans in various ways, Bernanke said, “to ensure that adequate liquidity is available, consistent with the central bank’s role as the liquidity provider of last resort.” This misrepresentation of insolvency for illiquidity has pulled the Fed into a policy that, in fact, violates traditional central banking. The two tasks of central banks have been the protection of the value of currency in the long-run and support of the payments system in the short run. The Fed has failed dismally in the first (after nearly equal price levels in 1789 and 1913, the purchasing power of the dollar has fallen 95% under the Fed) but it has been attentive to the latter. The central bank’s role as supporter of the payments system has been understood to include the responsibility to serve as lender of last resort.

A financial panic, or crisis, is a rush for cash, when “the rate of interest rises to a panic figure.” This normally comes at the end of an upward price movement, Irving Fisher (1922, p. 65) wrote, when those who have borrowed heavily are unable to renew their loans. They “must have currency to liquidate their obligations.” Runs on banks, even solvent banks, occur, and the central bank must come to their aid.

Liquidity is the proportion of an asset’s fundamental value that can be realized in cash quickly following the decision to sell. This is an individual concept, and differentiates assets in normal times. Market liquidity, on the other hand, refers to the general availability of cash. All assets except cash are illiquid during panics (Palgrave 1896; Wood and Wood 1985, pp. 163-66))

A traditional problem of the lender of last resort in maintaining the system’s liquidity has been to assist sound banks without bailing out the insolvent. The solution, Walter Bagehot advised in the classic Lombard Street (1873, pp. 187-88), has been to lend “freely and vigorously … at a very high rate of interest … on [the security of] good banking securities.”

None of this describes the Fed. The problem is clearly not one of liquidity, as the low interest rates on safe investments tell us. Even the safest securities, even Treasuries, are subject to panic interest rates during rushes for cash. This in seen in Frederic Mishkin’s (1991) account of seven financial crises from 1857 to 1907 (but not 1929 or 1987, when the Fed came to the aid of the money markets). Furthermore, despite the talk of the capital markets “freezing up” (simultaneously with a ”meltdown,” apparently) , bank credit was maintained and mortgages were available at traditionally low interest rates for good borrowers.

“For good borrowers” is key. The loan curtailments, except at high interest rates, of which some firms complained, and which, supported by the Fed, they called illiquidity, was due to the market’s assessment of their risk of insolvency. John Taylor and John Williams (2009) present data (see the figure) which indicate that the abrupt increase in the 3-month Libor rate relative to the overnight federal funds rate beginning August 2007 (after the failure of large banks heavily involved in mortgage-backed securities; it jumped again upon the failure of Lehman Brothers in September 2008) was due to risk rather than illiquidity. “As long as lenders who are not constrained by liquidity concerns exist, banks that seek to hoard liquidity can borrow from these lenders in the CD market…. Competition will lead to the equalization of borrowing rates across instruments for borrowers of the same credit quality. That CD rates have tracked Libor closely during the crisis …suggests that liquidity concerns at banks are not a significant factor separate from counterparty risk driving term lending rates.” Credit default swaps tell the same story, and regressions suggest that injections of Term Auction Swaps by the Fed have not affected what are clearly risk premia.

Recent Fed and Treasury actions have not been concerned with liquidity or the integrity of the payments system, which was not threatened, but rather with the salvage of particular managements (not firms, which would have continued with restructuring). Government purchases, and potential purchases, of bad assets have retarded the resolution of the crisis by preventing purchases of those assets by the many solvent firms who were able and might have been willing.


Walter Bagehot, Lombard Street. 1873. (new ed. edited by H. Withers. J. Murray, 1920).

Irving Fisher. The Purchasing Power of Money, 2d ed. Macmillan, 1922.

Frederic Mishkin. “Asymmetric information and financial crises: A historical perspective,” in R. Hubbard, Financial Markets and Financial Crises. University of Chicago Press, 1991.

Palgrave, R.H.I. Dictionary of Political Economy(1896),new ed., H. Higgs, ed. Macmillan, 1923.

John Taylor and John Williams. “A black swan in the money market,” American Economic J. of Macroeconomics, Jan. 2009.

John Wood and Norma Wood. Financial Markets. Harcourt Brace Jovanovich, 1985.


Tuesday, October 13, 2009

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

4. Excess reserves again

The unprecedented increase in excess reserves during past year is shown in the figure. They are due to the increase in the Federal Reserve credit. Concerns have been expressed for their inflationary potential when loan demand turns up, but Chairman Bernanke says not to fear. He has an exit strategy.

… at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize…. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy….

A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Ben Bernanke, Stamp Lecture, London School of Economics, Jan. 13, 2009.

Easier said than done. There is no reason to believe that the Fed will do any less damage than when it “shrunk” excess reserves in 1936-37. The monetary base grew 49% between May 1933 and May 1936, almost entirely due to inflows and the revaluation of gold. M2 rose 42% but half the increase in bank reserves was held as excess, which rose (in millions) from $319 to $2800, compared with the increase in requirements from $1806 to $2838. The rising ratio may be seen in the figure. The FOMC saw the large excess reserves as a threat to monetary stability that needed to be “mopped up.” It adopted the following resolution in October 1935:

It was the unanimous opinion of the Committee that the primary objective of the System at the present time is still to lend its efforts towards the furtherance of recovery…. But the Committee cannot fail to recognize that the rapid growth of bank deposits and bank reserves in the past year and a half is building up a credit base which may be very difficult to control if undue credit expansion should become evident.

The Banking Act of 1935 had given the Fed the power to raise reserve requirements up to twice the levels then existing, and that power was used to its full extent, in three steps, between August 1936 and May 1937. The resulting fall in excess reserves is shown in the figure. Although the Fed claimed that the excess reserves thus eliminated had been superfluous, it was soon revealed that banks thought otherwise. Having come through the great downturn of 1929-33, with massive runs and record failures, banks were cautious. Their cut-back in loans to restore their excess reserves contributed to the severe 1937-38 recession.

The figure indicates that the task is much greater today. As we learned (or should have), “excess” is a legal term that tells us nothing of desires. A policy of shrinking slowly, as Bernanke suggests, may not be an improvement. It may not be possible. If banks want these excess reserves, and they apparently do, they will restrict lending in anticipation of reserve losses. Things can seldom be done “on schedule” in the financial markets, which are characterized by arbitrage across time. We do not know what will happen. The problem is unnecessary and may come back to haunt us.

It is made more complex by the recent decision to pay interest on reserves, another example of the tendency of policymakers to enforce gratuitous changes in the environment that increase the uncertainty of their policies.



Milton Friedman and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton Univ. Press, 1963, pp. 520-32.

Clay J. Anderson. A Half-Century of Federal Reserve Policymaking, 1914-64. Federal Reserve Bank of Philadelphia, 1965, pp. 77-82.