Macroeconomists are neither forecasters nor economic policy makers. They devise models. Economic policy makers are in charge of applying them.
In the NZZ, Hansueli Schöchli reports about further steps by UBS, the Swiss bank, to prepare for the next financial crisis. In the future, a legally independent service unit—UBS Business Solutions AG—provides other business units with critical internal services, including payments, trading systems as well as legal services. A “Master Service Agreement” specifies that the service unit remains operative even if other business units fail.
Die UBS vollzieht nun einen weiteren Schritt. Sie überträgt dieser Tage die konzerninternen Dienstleistungen für das Schweizer Geschäft in die rechtlich selbständige Dienstleistungseinheit UBS Business Solutions AG. Übertragen werden damit im Inland rund 8000 Mitarbeiter. Weltweit soll diese Service-Einheit bis Ende Jahr etwa 18 000 Beschäftigte umfassen. Zu den betroffenen internen Dienstleistungen zählen unter anderem Informatik, Zahlungsverkehr, Handelssysteme, Risikomanagement, Rechtsdienst, Personal und Marketing. Hauptzweck der Übung: Auch wenn Teile des Konzerns in den Konkurs schlittern, sollen kritische Dienstleistungen weiterhin sichergestellt sein. «Dies ist eine Lehre aus der Pleite von Lehman», sagt Markus Ronner, Chef Notfallplanung bei der UBS.
Ein globales «Master Service Agreement» regelt die Service-Lieferungen gegenüber gut 130 UBS-Gesellschaften. Nebst Preisen und Qualitätserfordernissen ist dabei auch geregelt, dass die Service-Einheit im Fall des Konkurses eines Konzernteils ihre Dienstleistungen gegen Bezahlung noch mindestens zwei Jahre lang weiterführen muss. Wenn interne Kunden zahlungsunfähig werden, muss die Service-Gesellschaft genügend Liquidität haben, um in einer Übergangszeit ihre Dienste aufrechterhalten zu können; die Rede ist von sechs Monaten als Referenzmarke.
In a CEPR discussion paper, Òscar Jordà, Björn Richter, Moritz Schularick, and Alan M. Taylor suggest that higher bank capital ratios help stabilize the financial system ex post but not ex ante, and that illiquidity breeds fragility.
Abstract of their paper:
Higher capital ratios are unlikely to prevent a financial crisis. This is empirically true both for the entire history of advanced economies between 1870 and 2013 and for the post-WW2 period, and holds both within and between countries. We reach this startling conclusion using newly collected data on the liability side of banks’ balance sheets in 17 countries. A solvency indicator, the capital ratio has no value as a crisis predictor; but we find that liquidity indicators such as the loan-to-deposit ratio and the share of non-deposit funding do signal financial fragility, although they add little predictive power relative to that of credit growth on the asset side of the balance sheet. However, higher capital buffers have social benefits in terms of macro-stability: recoveries from financial crisis recessions are much quicker with higher bank capital.
In the FT, Mehreen Khan reports about the resurgence of deposit flight.
On Bank Underground, Gene Kindberg-Hanlon criticizes the secular stagnation hypothesis:
Real interest rates have fallen by around 5 percentage points since the 1980s. Many economists attribute this to “secular” trends such as a structural slowdown in global growth, changing demographics and a fall in the relative price of capital goods which will hold equilibrium rates low for a decade or more (Eggertsson et al., Summers, Rachel and Smith, and IMF). In this blog post, I argue this explanation is wrong because it’s at odds with pre-1980s experience. The 1980s were the anomaly … The decline in real rates over the 1990s and early 2000s simply reflected a return to historical norms from an unusually high starting point. Further falls since 2008 are far more plausibly related to the financial crisis than secular trends.
On VoxEU, Adrian Jäggi, Martin Schlegel and Attilio Zanetti report that the safe-haven currencies Swiss franc and Japanese yen react strongly to non-domestic macro surprises, and did so especially during the financial crisis. For European macro surprises, only German data influence safe-haven currencies.
On his blog, Roger Farmer advertizes his new book, “Prosperity for All,” and argues that governments should stabilize asset prices:
Following the Great Stagflation of the 1970s, economists backtracked and revived the classical economic theory that had dominated academic economics for a hundred and fifty years, beginning with Adam Smith in 1776 and culminating in the business cycle theory described by Keynes’s contemporary Arthur Pigou in his 1927 book, Industrial Fluctuations. That backtrack was a big mistake. It is time to realize that much, but not all, of Keynesian economics is correct. …
In my book Prosperity for All: How to Prevent Financial Crises, … I do not conclude that more government spending is the right way to cure a depression. Instead, I argue for a new policy in which central banks and national treasuries systematically intervene in financial markets to prevent the swings in asset prices that have such debilitating effects on all of our lives.
The control of asset prices will seem like a bold step to some, but so too did the control of the interest rates by the Open Market Committee of the Federal Reserve System when it was first introduced in 1913. We do not have to accept hyperinflations of the kind that occurred in 1920s Germany. Nor should we be content with the 50% unemployment rates that plague young people in Greece today. By designing a new institution, based on the modern central bank, we can and must ensure Prosperity for All.
And in another post:
The New Keynesian agenda is the child of the neoclassical synthesis and, like the IS-LM model before it, New Keynesian economics inherits the mistakes of the bastard Keynesians. It misses two key Keynesian concepts: (1) there are multiple equilibrium unemployment rates and (2) beliefs are fundamental. My work brings these concepts back to center stage and integrates the Keynes of the General Theory with the microeconomics of general equilibrium theory in a new way.
In the NZZ,
In the FT, John Plender reviews Mervyn King’s “The End of Alchemy: Money, Banking and the Future of the Global Economy.” King diagnoses two problems underlying the crisis. First,
Interest rates today, he says, are too high to permit rapid growth of demand in the short run but too low to be consistent with a proper balance between spending and saving in the long run. The disequilibrium persists, as does a misallocation of capital to unproductive investments.
The second problem relates to the financial system and
the alchemy that runs through the financial system, whereby governments pretend that paper money can be turned into gold on demand and banks pretend that the short-term deposits used to finance long-term investments can be returned whenever depositors want their money back. …
King argues that Bagehot’s famous dictum on central bank crisis management — lend freely on good collateral at penalty rates — is out of date because bank balance sheets today are much larger and have fewer liquid assets than in the 19th century. Central banks are thus condemned in a crisis to take bad collateral in the shape of risky, illiquid assets on which they will lend only a proportion of the value, known as a haircut.
King suggests this lender of last resort role should be replaced by … a pawnbroker for all seasons. In effect, he offers an elegant refinement of the concept of “narrow banking”, which seeks to ensure that all deposits are covered by safe, liquid assets. In his system, banks would decide how much of their asset base to lodge in advance at the central bank to be available for use as collateral. For each asset, the central bank would calculate a haircut to decide how much to lend against it. Together with banks’ cash reserves at the central bank, this collateral would be required to exceed total deposits and short-term borrowings.
This central bankerly pawnbroking would facilitate the supply of liquidity, or emergency money, within a framework that eliminates the incentive for bank runs. It amounts to a form of insurance whereby the central bank can lend in a crisis on terms already agreed and paid for upfront …
The system would displace what King regards as a flawed risk-weighted capital regime ill-suited to addressing radical uncertainty. Today’s liquidity regulation would also become redundant. But banks would still need an equity buffer, with King seeing an equity base of 10 per cent of total assets as “a good start”, against the 3-5 per cent common today.
The current shortfall of fully liquid assets against deposits — the alchemical gap — could be eliminated progressively over 20 years, during which time the expectation would grow that banks would no longer be bailed out. The system would apply to all financial intermediaries …
Update: The Economist‘s reviewer writes:
… Lord King wants banks to buy “liquidity insurance”. In normal times banks would pledge collateral to the central bank, which would agree to lend a certain amount against it, if necessary. Banks would thus know in advance precisely how much help they could get in the event of a meltdown, making them behave responsibly when times were good.
In the NZZ (August 7, 2015), René Höltschi provides an excellent overview over the status of European Monetary Union (EMU).
- EMU combines centralized monetary policy authority with decentralized fiscal powers. This creates the risk that national governments try to free ride.
- Heterogeneity across Euro Zone member states renders centralized monetary policy difficult. Without national monetary policy instruments, prices and wages need to adjust more in the face of asynchronous business cycles.
- The stability and growth pact was meant to address the first issue. It failed, for political reasons. Markets didn’t impose sufficient discipline either; they anticipated bailouts.
- Hopes for reduced heterogeneity—as a consequence of EMU—have been shattered.
Reforms so far:
- During the crisis, member states established rescue funds and agreed on various crisis measures.
- They pursued a two-pronged strategy. On the one hand, they tried to build on the decentralized approach of the Maastricht treaty. On the other, they aimed at closer integration in the form of banking, fiscal and eventually, political union.
- Major responsibilities in the area of banking supervision and resolution have been transferred to the European Central Bank. Bail-in procedures have been agreed upon.
- No major changes occurred in the fiscal policy domain. The “Six-pack” and “Two-pack” measures to strengthen fiscal discipline, coordination and supervision have proved ineffective (e.g., no action against France).
Proposals and discussion:
- The recent “Five-presidents’ report” distinguishes between short-term (until 2017) and longer-term (until 2025) measures (see below). The report proposes to strengthen the existing framework before moving towards closer integration (Euro treasury, macroeconomic stabilization, fiscal and political union). France and Italy have voiced support.
- Fiscal union entails a common budget and potentially, a common unemployment insurance. Unity of liability and control would require that fiscal competences are centralized as well. In turn, this would require changes of the European treaties.
- A further strengthening of banking union, e.g. delegation of banking supervision to a newly created European authority (rather than the European Central Bank), also would require treaty changes.
- But throughout Europe, there is no desire to delegate powers to “Brussels.”
- Instead, skeptics like the Bundesbank or the German Council of Economic Experts advocate a bankruptcy procedure for Euro-zone governments: to strengthen discipline and encourage monitoring by financial markets any assistance by the European Stability Mechanism should be preceded by private creditor bail-ins (extensions of maturity, haircuts).
- Some observers also advocate exit from the Euro zone as an ultima ratio measure. But others argue that this very possibility would undermine the stability of the Euro area.
- Commissioned in October 2014 by the heads of state and government, the report has been published in June 2015 by presidents Jean-Claude Juncker (European commission), Donald Tusk (European council), Jeroen Dijsselbloem (Euro group), Mario Draghi (European Central Bank) and Martin Schulz (European parliament).
- In the short term, the report proposes: to improve elements of the previous “six-pack” and “two-pack” reforms, including streamlined coordination and supervision of national fiscal policies;
- a common backstop for national deposit insurance systems;
- a European fiscal council serving as watchdog; and
- independent national agencies to monitor competitiveness.
- For the longer term, the report proposes: completion of monetary union and fiscal union;
- macroeconomic stabilization, stopping short of permanent transfers or income equalization schemes; and
- a Euro zone treasury.
- Accountability as well as the role of national parliaments and the European parliament in coordinating fiscal policy is to be strengthened. The Euro zone is to be better represented vis-a-vis third parties. Intergovernmental arrangements (for example the European Stability Mechanism) that were created during the crisis are to become integral parts of the EU treaties.
In a Politico column, Yannis Palaiologos bitterly complains about the counter productive role that Paul Krugman, Joseph Stiglitz, Jeffrey Sachs and James Galbraith played in supporting members of the Greek government in the run up to the recent climax of the Greek crisis.
The Federal Reserve Bank of Richmond estimates that
60 percent of the liabilities of the financial system are subject to explicit or implicit protection from loss by the federal government. This protection may encourage risk taking, making financial crises and bailouts more likely.
In a Vox column, Ken Rogoff argues that the world economy experiences a “debt supercycle” rather than the onset of secular stagnation in the West.
Rogoff argues that macroeconomic developments since the financial crisis are in line with historical experience, as documented in his book “This Time is Different” (with Carmen Reinhart): A large fall in output followed by a sluggish recovery; deleveraging; protracted higher unemployment; and a strong rise of the government debt quota are typical after a boom and bust of house prices and credit.
According to Rogoff, policy makers should have implemented more heterodox policies including debt write-downs; bank restructurings coupled with recapitalisations; and temporarily higher inflation targets. Rogoff supports the (in his view, orthodox) fiscal policy responses that were adopted but criticizes that many countries tightened prematurely.
Rogoff acknowledges that secular forces shape the macroeconomy, in particular population ageing; the stabilization of the female labor force participation rate; the growth slowdown in Asia; and the slowdown or acceleration (?) of technological progress. But
[t]he debt supercycle model matches up with a couple of hundred years of experience of similar financial crises. The secular stagnation view does not capture the heart attack the global economy experienced; slow-moving demographics do not explain sharp housing price bubbles and collapses.
Rogoff doesn’t accept low interest rates as an argument in favor of the secular stagnation view. Rather than reflecting demand deficiencies, low interest rates (if measured correctly—Rogoff expects a utility based interest rate measure to be higher) could reflect regulation (favoring low-risk borrowers and “knocking out other potential borrowers who might have competed up rates”) and to some extent central bank policies.
Rogoff argues that the global stock market boom poses a problem for the secular stagnation view. He proposes changed perceptions about the likelihood and cost of extreme events (Barro, Weitzman) as factors to explain both low real interest rates and the stock market boom (after an initial asset price collapse during the crisis).
Regarding policy prescriptions to expand public investment in light of the low interest rates, Rogoff notes that
it is highly superficial and dangerous to argue that debt is basically free. To the extent that low interest rates result from fear of tail risks a la Barro-Weitzman, one has to assume that the government is not itself exposed to the kinds of risks the market is worried about, especially if overall economy-wide debt and pension obligations are near or at historic highs already. [Moreover] one has to worry whether higher government debt will perpetuate the political economy of policies that are helping the government finance debt, but making it more difficult for small businesses and the middle class to obtain credit.
Rogoff considers rising inequality to be problematic (and a possible factor for higher savings rates):
Tax policy should be used to address these secular trends, perhaps starting with higher taxes on urban land, which seems to lie at the root of inequality in wealth trends
He concludes that the case for a debt supercycle is stronger than for secular stagnation:
[T]he US appears to be near the tail end of its leverage cycle, Europe is still deleveraging, while China may be nearing the downside of a leverage cycle.
Narrow banking proposals are fashionable. Here is a selective list of contributions to the debate:
- Cantillon (1755) and Mises (1912) argue that money creation leads to distortions.
- The 100% reserve proposal by Irving Fisher and his colleagues in the 1930s is reviewed by William Allen in the article “Irving Fisher and the 100 Percent Reserve Proposal” (Journal of Law and Economics, 1993). The article covers precursors to the 1930s debate; the March 1933 memorandum by University of Chicago economists; the March 1939 “Program for Monetary Reform;” and Friedman’s “Program for Monetary Stability.” See also Wikipedia on the “Chicago Plan”.
- In 1990, Tyler Cowen and Randal Kroszner wrote an article entitled “Mutual Fund Banking: A Market Approach” in the Cato Journal.
- In the early 2000s, Joseph Huber and James Robertson proposed a “plain money” reform (website with links to various documents). Grass root movements pushing for monetary reform in several countries reference their work.
- On May 14, 2009, Laurence Kotlikoff and John Goodman proposed a system of “Limited Purpose Banking” in New Republic, and in 2010 Kotlikoff published the book “Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking.” According to the proposal, “all financial corporations engaged in financial intermediation, including all banks and insurance companies, would function exclusively as middlemen who sell safe as well as risky collections of securities (mutual funds) to the public. They would never, themselves, own financial assets. Thus, they would never be in a position to fail because of ill-advised financial bets.” On July 17, 2010, Tyler Cowen criticised the proposal in a blog post; Kotlikoff responded on August, 3 and Cowen responded in turn on August, 4.
- In August 2012, Jaromir Benes and Michael Kumhof published an IMF Working Paper entitled “The Chicago Plan Revisited” (revised paper, slides [pages 18–29 display the balance sheet changes]). Benes and Kumhof write in the abstract: “We study [Irving Fisher’s (1936)] claims [about the advantages of the Chicago Plan] by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent …” Benes and Kumhof also argue that the plan eliminates the zero-lower-bound problem (see my post on other proposals to eliminate the zero-lower-bound problem).
- On April 16, 2014, John Cochrane advertised his paper “Toward a Run-Free Financial System” in a blog post. Key points in the paper are: The recent financial crisis involved a systemic run. Accordingly, one should eliminate run-prone securities rather than guaranteeing them and regulating bank assets. Banks should have to back demand deposits, fixed-value money-market funds or overnight debt by short-term treasuries; they would have to finance risky investments from equity or long-term debt. Fully equity-financed banks (that are difficult to resolve) could still be held by downstream institutions that issue debt (and are easy to resolve). Leverage should be regulated by means of Pigouvian taxes rather than quotas and ratios. Modern technology and large public debt stocks render narrow banking feasible: Treasury-backed or floating-value money-market fund shares can be used for payments; risky assets are highly liquid and can easily be sold and bought for transaction purposes.
- On June 3, 2014, the Swiss group “Monetäre Modernisierung” started to collect signatures with the aim to force a national referendum on changes to the Swiss constitution. In the tradition of Joseph Huber’s work, the group aims at abolishing all money except for base money. See my post on the initiative.
- On June 5, 2014, the Economist’s Free Exchange blog covered the narrow banking idea, somewhat sceptically. John Cochrane argued that the post suffered from misconceptions.
- On July 27, 2014, John Cochrane discussed Sheila Bair’s opposition against letting the broader public hold reserves. On August 21 and September 22, 2014, he approvingly discussed (here and here) the Fed’s balance sheet policy from a financial stability perspective. He published another related post on September 17. On November 21, 2014, he interpreted minutes of an FMOC meeting as suggestive evidence of plans to establish segregated cash accounts. These deposit accounts would be backed by central bank reserves. They would be safe and run proof, and the link to (interest paying) reserves would facilitate a rate rise by the Fed.
- In August 2014, Ralph Musgrave published a paper that defends the full reserve banking model against various criticisms.
- In December 2014, Romain Baeriswyl published a paper that discusses narrow banking proposals in light of Cantillon (1755), Mises (1912) and Fisher (1936).
I have discussed pros and cons of narrow banking against the background of the Swiss “Vollgeldinitiative.” The issue of segregated cash accounts connects the narrow banking debate to the debate on government provided electronic money that I discuss in another post.
This post has been updated and extended after the initial publication.
In the tenth chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” John Cochrane argues that at its core, the financial crisis was a run and thus, policy responses should focus on mitigating the risk of runs (blog posts by Cochrane on the same topic can be found here and here). Some excerpts:
… demand deposits, fixed-value money-market funds, or overnight debt … [should be] backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. …
Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund … Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, and providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt.
If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in an hour …
Rather than outlawing short-term debt, Cochrane suggests to levy corrective taxes on run-prone liabilities. Moreover:
… technology allows us to overcome the long-standing objections to narrow banking. Most deeply, “liquidity” no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities.
… electronic transactions can easily be made with Treasury-backed or floating-value money-market fund shares, in which the vast majority of transactions are simply netted by the intermediary. … On the supply end, $18 trillion of government debt is enough to back any conceivable remaining need for fixed-value default-free assets.
Cochrane rejects the claim that the need for money-like assets can only be met by banks that “transform” maturity or liquidity. He argues that current regulation reflects a history of piecemeal responses that triggered the need for additional measures; and he points out that the shadow banking system creates run risks because a “broker-dealer may have used your securities as collateral for borrowing” to fund proprietary trading.
Cochrane debunks crisis lingo and clarifies links between aggregate variables:
The only way to consume less and invest less is to pile up government debt. So a “flight to quality” and a “decline in aggregate demand” are the same thing.
He questions the need for fixed value securities other than short-term government debt as means of payment or savings vehicle; offers a short history of financial regulation; and deplores regulatory discretion.
In the seventh chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Peter Fisher argues that the Fed’s mandate should be reviewed:
- The Fed did not address leverage early enough. In the future, monetary policy should weigh financial stability objectives more strongly—at the cost of employment and inflation objectives.
- Moral hazard should be addressed before, not during the crisis.
- “Since the end of the financial crisis, the Fed is making the mistake of conceiving of its mandate over too short—and too narrow—a horizon. This permits the Fed to avoid articulating the difficult intertemporal trade-offs that it is making.”
- The Fed’s mandate is not crystal clear and has been interpreted differently over the years. In light of the new experiences, it should be clarified or adjusted.
In chapter six of “Across the Great Divide: New Perspectives on the Financial Crisis,” Michael Bordo argues that the Fed misinterpreted the experience of the Great Depression when acting during the financial crisis. Insolvency rather than illiquidity fears were central to the great recession.
In the third chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” John Taylor argues that monetary policy, regulatory policy, and an ad hoc bailout policy caused the financial crisis:
- Monetary policy was too loose before the crisis.
- “[R]egulators permitted violations from existing safety and soundness rules.”
- An “on-again, off-again bailout policy … created more instability.”
The policy responses during the crisis saw more—counter productive—temporary and discretionary measures. Taylor argues that the Reinhart-Rogoff “weak recovery is normal” and the Summers “secular stagnation” views are inconsistent with the data.
In the first chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Sheila Bair and Ricardo Delfin argue that regulatory responses to past crises sow the seeds of the next ones:
- The “Greenspan put” fostered risk-taking and overconfidence.
- Low interest rates and the search for yield led to a lowering of lending standards and stronger demand for mortgages; a rise in housing wealth accompanied falling household incomes. The Fed’s strong policy response to the Great Recession may create new risks.
- The 1980s savings and loans crisis led to stronger reliance on the originate to distribute model and securitisation of mortgages. Market participants lost sight of the risks. Regulatory incentives led banks to take the securitised loans back on their balance sheets and additional sources of maturity mismatch arose from strong reliance on short-term funding.
- The “self-correcting markets myth” led Congress to deregulate financial services. The Gramm-Leach-Bliley Act fostered competition and consolidation; the Commodity Futures Modernization Act loosened oversight over the OTC derivatives market. Financial regulators also relaxed restrictions; Basel II replaced standardised regulator-set capital charges with internal models of banks.The Dodd-Frank Act reversed this trend, allowing for more discretion and micro-management.
- The pre-crisis incentives led to large, “too-big-to-fail” institutions and bred moral hazard. Dodd-Frank improve things, by establishing consolidated oversight, living will requirements, enhanced prudential standards and enabling the FDIC to resolve systemic entities that cannot be resolved safely in bankruptcy. Clearing houses may require more regulation.
A Hoover Press book edited by Martin Baily and John Taylor collects articles about the financial crisis. The contributions in “Across the Great Divide: New Perspectives on the Financial Crisis” include (with links to PDF files):
- Introduction, Martin Neil Baily and John B. Taylor
- Chapter 1: How Efforts to Avoid Past Mistakes Created New Ones: Some Lessons from the Causes and Consequences of the Recent Financial Crisis, Sheila C. Bair and Ricardo R. Delfin
- Chapter 2: Low Equilibrium, Real Rates, Financial Crisis, and Secular Stagnation, Lawrence H. Summers
- Chapter 3: Causes of the Financial Crisis and the Slow Recovery: A Ten-Year Perspective, John B. Taylor
- Chapter 4: Rethinking Macro: Reassessing Micro-foundations, Kevin M. Warsh
- Chapter 5: The Federal Reserve Policy, Before, During, and After the Fall, Alan S. Blinder
- Chapter 6: The Federal Reserve’s Role: Actions Before, During, and After the 2008 Panic in the Historical Context of the Great Contraction, Michael D. Bordo
- Chapter 7: Mistakes Made and Lesson (Being) Learned: Implications for the Fed’s Mandate, Peter R. Fisher
- Chapter 8: A Slow Recovery with Low Inflation, Allan H. Meltzer
- Chapter 9: How Is the System Safer? What More Is Needed?, Martin Neil Baily and Douglas J. Elliot
- Chapter 10: Toward a Run-free Financial System, John H. Cochrane
- Chapter 11: Financial Market Infrastructure: Too Important to Fail, Darrell Duffie
- Chapter 12: “Too Big to Fail” from an Economic Perspective, Steve Strongin
- Chapter 13: Framing the TBTF Problem: The Path to a Solution, Randall D. Guynn
- Chapter 14: Designing a Better Bankruptcy Resolution, Kenneth E. Scott
- Chapter 15: Single Point of Entry and the Bankruptcy Alternative, David A. Skeel Jr.
- Chapter 16: We Need Chapter 14—And We Need Title II, Michael S. Helfer
- Remarks on Key Issues Facing Financial Institutions, Paul Saltzman
- Concluding Remarks, George P. Shultz
- Summary of the Commentary, Simon Hilpert
In Prospect Magazine, Ken Rogoff reviews Martin Wolf’s account of the financial and European debt crises as well as his policy conclusions. Along the way, he offers his own views. Some excerpts:
Wolf rightly believes that one needs to look at the entire global economic system to understand what happened.
… he essentially concludes that there will be no long-run financial stability without kicking banks out of the money creation business, leaving it as a government monopoly, much as leading “Chicago Plan” economists first suggested in the 1930s.
Although Wolf makes a coherent case for considering this radical reform [the Chicago plan], he is rather circumspect on just how bad things will be if we don’t do it. For one thing, he seems to agree with Chicago economist Robert Lucas (whom he otherwise sharply critiques) that if the US financial firm Lehman Brothers had not been allowed to fail, the financial crisis would have been far less acute.
But if one really believes this, then why take all the risks of radical change? Anyone advocating a radical fix, as Wolf does, needs to convert the many politicians, financiers, regulators and even academics who conclude that the real lesson of the crisis should be to never let big banks fail. (This is certainly not my position.)
… By mulling whether the crisis could have been mitigated simply through better tactics during the weekend of 13th-14th September 2008, Wolf undermines his own case for radical reform. To be clear, I think that a major financial collapse would have been very difficult to avoid regardless of how Lehman was handled. Thus Wolf is fundamentally right: radical change is needed. Turning to the eurozone, … He is right that Germany bears its share of responsibility. But he emphasises the potential role of German fiscal stimulus far too much, and correspondingly underestimates the importance of regulatory failures, the rigidity of the 2 per cent inflation target and, above all, northern recalcitrance to restructure and write down southern debts.
… The first problem with Wolf’s simple arithmetic is that Europe is not a closed economy, and indeed Germany depends vastly more on exports to China and the US than exports to the periphery.
… If the capital flows to the eurozone periphery had been mainly in the form of direct foreign investment or equity (instead of short-term debt), they would have been far less problematic. … Germany’s biggest mistakes, by far, were in financial regulation that produced instability.
In truth, the southern Mediterranean countries in Europe are a place where there really is secular stagnation … But secular stagnation in the periphery would have been happening with or without the financial crisis … what could Germany have done? … First, it should have acted earlier to take a euro break-up off the table. Second, it should have found a way to restructure periphery debts at lower interest rates and with more time to repay. Third, it should have moved earlier to endorse a looser monetary policy at the European Central Bank (ECB). Fourth, and more for itself, it should have expanded infrastructure investment at home and abroad.
… rather than pouring fiscal stimulus into a German economy that has for some time arguably been overheated, it would have been far better to give periphery countries more help. … The point that periphery countries suffer from debt overhang should be an obvious one by now …
Wolf finds convincing the comparison between Spain and the UK made by the Belgian economist Paul De Grauwe, who argues that Spain would have been in much less trouble if it had had its own currency. True, but misleading. The claim overlooks the fact that, in many ways, Spain has still not completed the transition from being an emerging market to being an advanced economy. … But governance and institutional development can take many generations to unfold. My overwhelming presumption is that these countries would still have had problems containing their debts. … It is ludicrous to think the periphery has a mere liquidity problem. That is why the debts needed to be written down, or more likely stretched out at lower interest rates, which amounts to the same thing.
… So Germany could have done more to alleviate the crisis in the periphery. But the best way was not to increase spending in Germany, but to help increase spending in the periphery. Even the IMF has finally reached this epiphany, arguing that it should have insisted on “bailing in” private creditors in Europe; that is, making lenders take losses. Instead, too much of its lending effectively just helped to pay off private creditors, and did not provide meaningful budget relief.
Anyone worried about austerity in the periphery should have been first and foremost focused on writing down debt. The idea that arguing for such policies, and that worrying about the effects of debt overhang on growth, amounted to favouring “austerity” is simply ludicrous.
… Austerity in the periphery eurozone is an entirely different animal to that seen in the US and UK. The eurozone periphery suffered a classic sudden stop in private lending, and although the “troika” of the IMF, European Commission and the ECB did step in to help, they were too limited in their willingness to write down debt. Facing a sudden withdrawal of financing, periphery countries had to reduce expenditures.
For the US and UK, the decision to expand and then gradually reduce deficits gave policymakers considerable discretion over the exit strategy. For these countries, one can meaningfully speak about the trade-off between stability and stimulus….
Another key pillar in recovering from a financial crisis should be to boost infrastructure investment. Virtually every economist of every stripe agrees with this recommendation. … Administration officials privately expressed concern that infrastructure projects would take too long to get off the ground, and by the time they did, the spending would no longer be needed. My book with Carmen Reinhart, This Time Is Different, suggested that the recession was likely to be around for a long time, and that infrastructure spending would be extremely helpful.
… In fact, the ostensible argument over debt has nothing to do with progressive and conservative differences. It is about the size of government.
… The financial crisis does create an additional and very important argument in favour of fiscal stimulus, and Wolf is absolutely correct to highlight it. When an economy is at the zero bound on interest rates, and the central bank is unable or unwilling to stimulate inflation, fiscal policy is more effective in raising output. … However, the empirical size of the “fiscal multiplier” (how much output rises relative to increased government spending) is widely debated, and the evidence is very thin. … The fact the UK and US both achieved solid growth in the face of fiscal cuts would seem to contradict the view that multipliers are always and everywhere very large.
… Wolf, in line with Krugman, appears to believe that even wasteful government spending would raise welfare, a claim that is at best debatable.
… As for the resulting debt burden not being an issue, it is far from obvious that governments were wrong to worry about the fiscal burden, as debt more than doubled within a very short time. The ability to issue large amounts of debt in response to crises is a valuable option for governments. But if a country’s debt starts to reach a situation that is perceived as risky, the option might not be as available when needed most.
… Wolf now argues that of course we all knew there would eventually be a vigorous recovery in the UK. I can only say this was not obvious from reading either the Financial Times or the New York Times. Again, this is a matter of calibration, and the awful forecasts of those who focused excessively on fiscal policy and nothing else, underscores how difficult real-world policymaking can be.
… it is clear the crisis had multiple causes. The most obvious is the financiers themselves—especially the irrationally exuberant Anglo-Saxon sort, who claimed to have found a way to banish risk when in fact they had simply lost track of it. Central bankers and other regulators also bear blame, for it was they who tolerated this folly. The macroeconomic backdrop was important, too. The “Great Moderation”—years of low inflation and stable growth—fostered complacency and risk-taking. A “savings glut” in Asia pushed down global interest rates. Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities. All these factors came together to foster a surge of debt in what seemed to have become a less risky world.
The Economist reports about an EFTA court decision concerning Iceland’s decision to discriminate among depositors after the collapse of Icesave, an online bank. The bank had collected deposits in the UK and the Netherlands, using a European “passport” which relied on the notion that the Icelandic deposit insurance scheme would back those deposits. After the collapse, the insurance turned out to be insufficient; while Icelandic savers received their money back, British and Dutch depositors did not. But eventually, their respective governments bailed them out—and now went to court.
… the court found that Iceland was obliged only to make sure that it had a deposit-insurance scheme. The state was not required to pay out if the scheme had no money because of a banking crisis. Oddly, the court also found that Iceland had not breached an obligation not to discriminate between domestic and foreign depositors, even though it made only the domestic ones whole.
The new edition features an interview with Douglas Gale on “Financial Crises and Liquidity Regulation.” PDF.
- Policy makers confuse debt and financial crises with a currency crisis.
- Different crises call for different policy responses. Many of those lie in the national policy domain, not the supra national one.
- Shifting too much policy responsibility, too quickly to the European level sows the seeds of new problems.