deregulation eroded the Federal Reserve's power to stabilise the economy

From Free Exchange:

"Hamstrung Fed?

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Economist.com | WASHINGTON

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Monetary policy

KEVIN DRUM links to a piece by the Nation's William Greider on how deregulation eroded the Federal Reserve's power to stabilise the economy. Mr Greider writes:

When deregulation began nearly thirty years ago, some leading Fed governors, including [Paul] Volcker, were aware that it would weaken the Fed's hand, and they grumbled privately. The 1980 repeal of interest-rate limits meant the central bank would have to apply the brakes longer and harder to get any response from credit markets. "The only restraining influence you have left is interest rates," one influential governor complained to me, "restraint that works ultimately by bankrupting the customer."

....The central bank was undermined more gravely by further deregulation, which encouraged the migration of lending functions from traditional bank loans to market securities, like the bundled mortgage securities that are now rotten assets....In 1977 commercial banks held 56 percent of all financial assets. By 2007 the banking share had fallen to 24 percent.

The shrinkage meant the Fed was trying to control credit through a much smaller base of lending institutions. It failed utterly.

Not long ago, in the pages of the Wall Street Journal, Alan Greenspan wrote along similar lines. After suggesting that it was the global savings glut which depressed long-term mortgage rates that caused the housing bubble (and not the Fed) he said:

If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.

Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

The solution is improvements in regulatory practice, according to Mr Greenspan. But both Mr Greenspan and Mr Greider seem to be of the opinion that the Fed was powerless in this respect. Earlier this week, my colleague disagreed with this assessment:

There was, of course, an alternative between letting the bubble inflate and inviting recession. Had Mr Greenspan and his colleagues concluded housing prices were too high and there was value in taming them, they could have used regulatory tools instead of monetary policy. They could have insisted on a margin requirement for home purchases—no one could put down less than 20% unless they obtained mortgage insurance. (At the peak of the bubble, the widespread use of second liens made 100% loan-to-value mortgages without insurance commonplace.) This would have been politically difficult since it would have deprived lots of people the opportunity to own a home, in violation of America’s credo. It would have also contradicted Mr Greenspan’s own deregulatory impulses. He resisted raising margin requirements on stocks in the 1990s in part out of a conviction that only small investors would be affected; big sophisticated players would find a way around them.

Mr Greider recommends that the regulatory system be widened to include the shadow banking system, but the shadow banking system arose in order to skirt regulatory limits—to lever up more effectively. Mr Greenspan also wants us to put in place a regulatory system which, "will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy", but it's difficult to imagine what such a perfect system might look like. Financial players live to get around the rules and increase leverage. Given enough time, financial tools will develop to accomplish this goal.

Assuming we're comfortable with an independent and powerful Fed, I think the necessary changes are much more modest. The Federal Reserve has explicit policy goals—price stability, low unemployment. It's a safe bet that a president wouldn't nominate someone for the position of Fed chairman who believed the Fed shouldn't interfere in the economy to achieve those goals. And yet, multiple presidents had no problem nominating an Ayn Rand acolyte with a visceral distaste for regulatory interference to the chairmanship.

Regulations ought to be flexible; as Mr Greider rightly notes, the capital requirements necessary amid a boom are quite different from those necessary during a crisis. The Fed should be charged with limiting financial leverage and systemic risk, and should have some flexibility in achieving these goals (as it has flexibility in tweaking the economy's money supply). Then we won't have non-interventionists in an explicitly interventionist position, and Fed chairmen won't have the luxury of shrugging off dangerous imbalances as someone else's problem."

Me:

Don the libertarian Democrat wrote:

March 20, 2009 20:49

I know that this is going nowhere so far, but I like the idea of a guaranteed/narrow banking sector, as opposed to a self-insured/supervised/no government guarantees investment sector.

The Fed using rates to slow the whole economy or issuing warnings doesn't seem viable, and, you're correct, the rules of investment are made to be broken. I'm not advocating this, just describing reality. I just can't see the Fed slowing the economy on a theory, or regulators being one step ahead of investors. I think that time travel is more viable than both of those eventualities.

"Nationalizing the banks sounds more radical than it is"

William Greider on the Nation basically supports my position, but he thinks that it's more radical than it is. My position is nationalize, then privatize. It's going nowhere,but at least I can quote people, like Greider, who basically agree with me:

"The scale of this disaster explains why the Treasury secretary had to abandon his original plan to buy up failed mortgages and other bad assets from the banks. If government paid the true value for these nearly worthless assets, the banks would have to write down huge losses or, as Levy economists put it, "announce to the world that they are insolvent." On the other hand, if Paulson pumps the purchase price high enough to protect the banks from losses, $700 billion "will buy only a tiny fraction of the 'troubled' assets."

The uncertainty and complexity of the plan made it unworkable.

"Obama can begin by declaring a "bank holiday" like FDR's in 1933--an opportunity to put the hard facts on the table and assume temporary control of the entire financial system. Nationalizing the banks sounds more radical than it is, since banking law already empowers regulators to impose extraordinary controls and close supervision over troubled institutions. Facing facts will be painful, but it's better than continuing a costly charade. Paulson's approach, endorsed by many Democrats, was designed to preserve oversized Wall Street titans. In fact, Paulson and the Federal Reserve are making things worse by creating new members of the privileged club of "too big to fail." Public money is being used to finance bank takeovers that will become new behemoths. "

This is correct. The tax subsidies for mergers was intended to facilitate a market solution, with tax concessions, of course, by having banks merge, thereby saving the government from intervening. However, you do have to count the tax incentives. This isn't a good idea, but one can understand why mergers are better than dissolution.

"A genuine solution means closing down the hopeless institutions and creating a more democratic system based on small to medium-sized banks, financial intermediaries that are less imperious and closer to the real economy of producers and consumers. The Levy institute suggests that some banks are "too big to save." If the president-elect seeks an opinion quite different from his circle of orthodox advisers, he could start with the institute's tartly incisive analysis "Time to Bail Out: Alternatives to the Bush-Paulson Plan," by Dimitri Papadimitriou and Randall Wray. Their perspective is Keynesian, not market worship. They argue (as The Nation and others have) that the bailout is proceeding backward. Instead of saving Wall Street first, government should devote its heavy firepower to reviving jobs, incomes and business enterprises. The banks will not get well or begin normal lending until there is overall economic recovery."

I agree with the emphasis on more and smaller banks, but the Keynesian part I don't get. Presumably, businesses need to borrow, as do individuals, so taking care that loans are available is not a trivial problem. The other emphasis seems like a stimulus, which is a way to deal with any downturn, but that isn't peculiar to this problem, while the banking crisis is. Maybe I'll try and find this paper.

"The financial system, meanwhile, can be managed much as it was during the Depression, with regulators weeding out doomed banks and closing them, putting troubled banks under conservatorship and supervising healthy ones closely to prevent excesses. "If we are going to leave insolvent institutions open, it is critically important to replace or at least control management," the Levy paper explains. "Business as usual would be a disaster."

This I agree with.

"Under these conditions, the government can grant forbearance and prescribe business plans for a slower recovery of bank balance sheets. Instead of buying ruined assets from banks, the government can allow them to sit, possibly for several years, until the economy revives and mortgages or other debt paper regains value. This would amount to an "imposed purgatory" for major banks, keeping them from growing too fast with unsound ventures. Taxpayers will not get off the hook either; government will need to spend hundreds of billions to bail out bankrupt pension funds and pay off insured deposits at failed banks. "

I'm okay with that, except that I would make them private again as soon as possible. The government running banks in the long run I don't approve of, although the idea offered of a small one to seed competition doesn't bother me as much.

"Economic stimulus requires preservative measures to stop the bleeding, like a moratorium on home foreclosures and federal lending to the auto industry, as well as force-feeding innovation. Like the financial sector, the reform imperatives must accompany any aid for troubled industries. Do not subsidize more bad behavior by corporate titans or assist companies shipping US jobs and production overseas. In Detroit's case, Washington better get it in writing--an enforceable contract to recover our money if the auto industry doesn't deliver."

So, he says:

1) Moratorium on home foreclosures ( Don't agree. We need to get through this. I would support aggressive negotiations to refinance loans that most borrowers could afford, but that's complicated as hell in some cases, although not impossible. That's a PR spin from the servicers and lenders to get a better deal from the government )
2) Auto bailout I'm for, with very onerous terms
3) I don't see the point of subsidizing foreign jobs, so I'm not sure what he means. Does he mean that the money can only be used in the U.S.?
4) He's correct about the getting in writing

"President-elect Obama, of course, cannot act directly on any of these matters before January 20. But the Democratic Congress can, since the Treasury cannot spend any of the next $350 billion in the bailout fund without Congressional approval. Congress's first task is to cut off Paulson's water. Representative Dennis Kucinich, as usual, is out front demanding that Congress reject Paulson's request in advance. You can see why Wall Street hates these propositions. No more free money from Washington. No more "masters of the universe." You can also see why the people might be delighted. "

Let's not get carried away, we've got some heavy lifting to go,but, at this point, a good deal on anything would be delightful, if unanticipated.