In an interview with The Independent, Jean Tirole discusses monopolies, regulation, the role of the state, the “Nobel syndrome,” and much more.
On his blog, John Cochrane happily reports about apparent agreement between Larry Summers and himself regarding the dangers of regulatory overkill and incompetence of government officials.
This is a watershed. Here is the kind of reach out for middle ground that could unlock our political and economic sclerosis. Larry is likely to be in government again sooner or later, and I hope he will push hard for this — and with more effect than the last hundred or so anti-red-tape and regulatory reform commissions.
The Economist reports that regulation catches up with peer-to-peer lending:
Meanwhile, a case working its way through the courts may subject P2P loans to state usury laws, from which banks with a national charter are exempt. That would prevent the P2P firms from lending to the riskiest borrowers in much of America. In addition, the Consumer Financial Protection Bureau, a federal agency, announced this month that it would begin accepting complaints about P2P consumer lending.
Rates of delinquency are rising as well.
On VoxEU, representatives of the German Council of Economic Experts outline the German crisis narrative. In disagreement with the ‘consensus view’ outlined in Baldwin et al. (2015) the German economists including Lars Feld, Christoph Schmidt, Isabel Schnabel and Volker Wieland do not want to
implicate the ‘intra-Eurozone capital flows that emerged in the decade before the crisis’ as the ‘real culprits’. … [Rather] it is the government failures and the failures in regulation and supervision leading to those excessive developments that should take centre-stage in the Crisis narrative.
Consequently, their assessment of the policy response to the crisis is positive:
While the alleged consensus summary concludes that ‘the whole situation was made much worse by poor crisis management’, our view is that the ‘loans for reforms’ rationale underlying the rescue approach was not only sensible, since it was the only way to successfully address the underlying causes of the Crisis. It also worked and substantially improved matters.
Sensibly, the writers favor the
objective of retaining the unity of liability and control in all relevant fields of economic policy.
They promote the ‘Maastricht 2.0’ framework proposed earlier by the German Council.
In a VoxEU post, Stefan Gerlach and Peter Kugler discuss the experience of Switzerland during the free banking era in the second half of the 19th century.
In a blog post, John Cochrane proposes step-by-step (politically unattractive) measures to increase growth:
- Smarter (growth-oriented) regulation, in particular
- Higher equity requirements and less short-term funding rather than complex financial regulation
- Deregulation of health care supply
- More cost-benefit analysis in environmental policy
- Broad-based consumption rather than investment taxes
- Clear separation of allocative and distributive fiscal policy
- Focus on distortions in social programs
- Deregulation of labor markets
- Rational immigration rules distinguishing between permits to entry, reside, or work and citizenship
- Less government intervention in the student loans market
- Less protection, more free trade
- More spending for the legal and criminal justice system
In a blog post, Gilles Saint-Paul describes how organized crime exploits the arbitrage opportunities that (bad) regulation creates.
He predicts that eliminating cash transactions by decree, along the lines of policy proposals currently en vogue, will lead organized crime to establish alternative, sound mediums of exchange that the general public might adopt.
Joachim Jahn and Manfred Schäfers report in the FAZ about pressure by the European Commission and the IMF to liberalize personal services in Germany. The IMF expects less regulation/protection of architects, tax advisors and the like to increase services growth. The tax advisors warn that liberalization would create conflicts of interest for the service providers.
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.
George Pennacchi discusses narrow banking in an article in the Annual Review of Financial Economics. He concludes as follows:
During the nineteenth century, US banks were more narrow than they are today, and the narrowest (e.g., those under the Louisiana Banking Act of 1842) appeared resistant to panics. Common modern-banking practices, such as maturity transformation and explicit loan commitments, arose only after the creation of the Federal Reserve and the FDIC.
… There appears to be little or no benefits available from traditional banks that could not be obtained in a carefully designed narrow bank financial system. Most importantly, a narrow-banking system could have huge advantages in containing moral hazard and reducing the overall risk and required regulation of the financial system.
In contrast, the reaction by US regulators to the recent financial crisis was to expand the government’s safety net by raising deposit insurance limits and by giving more financial firms access to insured deposits. Expanding, rather than narrowing, the activities that are funded with insured deposits is justified if one believes that regulation can contain moral hazard when firms have many, complex risk-taking opportunities. Unfortunately, this belief appears dubious if one recognizes that regulators face political and information constraints.
In my view, there is a need for research that considers the optimal design of a financial system when a government regulator is limited in its ability to assess risk. … Research needs to better identify those financial services where government support would produce a net social benefit. Services such as maturity transformation and liquidity insurance may not deserve costly government guarantees. Finally, should further research support the general concept of narrow banking, there are still open questions regarding the specific features of these banks. In particular, how narrow should be these banks’ assets and should their liabilities should be deposits or equity shares (at fixed or floating NAVs) are questions that need better answers.
That’s the title of the annual conference of the Journal of Financial Regulation to be held at the Georgetown University Law Center in June.
The call for papers includes the following paragraphs which provide a nice overview:
Attempts by national regulators to give their regulatory standards extra-territorial effect beyond their own borders have become increasingly popular in fields as diverse as banking, securities and derivatives regulation. The attractiveness of extra-territorial regulation for policy-makers is obvious: in a world still reeling from the 2008 financial crisis, regulators can export policy preferences unilaterally while preventing some of the most malicious forms of regulatory arbitrage that can undermine their effectiveness.
But extraterritoriality can also generate a range of legal and even economic tradeoffs. At a most basic level, when practiced haphazardly it risks clashing with principles of public international law and the comity of nations, in particular when such regulation is enforced with public authority. Furthermore, extra-territorial rules can increase, as opposed to decrease the potential for conflicting or duplicative regulatory policies as other regulators respond in kind. This can lead to increased compliance costs for market participants that reduce liquidity and subject market participants to operational and legal risks that themselves can potentially introduce new forms of systemic risk.
The conference Extra-Territoriality and Financial Regulation, the annual conference of the new Journal of Financial Regulation, will seek to enhance our understanding of these and other important problems. More specifically, the conference will seek to explore topics including, but not limited to:
· the policy motivations for writing extra-territorial rules and the conditions for selecting this approach – this would include considerations from political economy, political science, and state organization theory;
· the advantages and the limits of extra-territorial financial regulation, with particular regard to the different current policy initiatives and their impact on both financial innovation and prudential oversight;
· the relationship between extra-territorial rules and the growing consensus on international standards and global soft law, in particular through international bodies such as the G20, the FSB, the Basel Committee, and others;
· regulatory responses in other jurisdictions, including the likelihood of retaliation or counteracting measures;
· responses by regulated market participants, in particular theoretical or empirical accounts of reactions by the financial industry to the adoption of extra-territorial standards;
· legal considerations for enforcing extra-territorial standards, possibly including problems from all of public international law, conflict of laws, and democratic accountability.
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 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
The Economist reports about plans to have Fannie Mae and Freddie Mac accept mortgages for intermediation and insurance even if these mortgages only satisfy weaker lending standards than those currently required by the two government sponsored entities. (Fannie Mae and Freddie Mac buy eligible mortgages, repackage and guarantee them and sell them on to investors.) The plans to accept laxer lending standards appear to be motivated by the aim to improve the affordability of home ownership for risky borrowers. The same aim is widely credited to have contributed towards sowing the seeds of the recent financial crisis.
- A 100% money regime reduces the risk of credit bubbles, but requires more and better fine-tuning by the central bank.
- Central banks can already implement higher reserve requirements. If the fact that they don’t reflects policy failure, then the 100% money proposal risks handing more power to one source of the problem.
- A 100% money regime increases financial stability, at least temporarily, but it forces banks to find new sources of funding and lowers the interest rate for depositors, which is fine.
- If lender of last resort support by the central bank occurs at too low interest rates then seignorage revenues are privatised and costs socialised under the current regime. Moving to a 100% money regime would help but so would simple Pigouvian taxation.
- How can a 100% money regime be enforced if market participants end up coordinating to use other securities than deposits as means of payment?
- More stable deposits in a 100% money regime do not imply a more stable banking system unless other regulation is imposed that completely prevents “maturity transformation.”
- Aggregate liquidity cannot be created out of nothing, with or without deposit insurance.
- Societies have to take a stand on whether they want to guarantee broader monetary aggregates than base money. If so, the cost of the guarantee should be privatised. Problems arise if societies pretend not to provide such guarantees but central banks nevertheless feel obliged to step in ex post and market participants are aware of that fact ex ante; bad, self-fulfilling equilibria are the consequence.
- Commitment on the part of policy makers is key; it requires independent central bankers and regulators.
The Economist reviews the history of finance and financial regulation, arguing that
institutions that enhance people’s economic lives, such as central banks, deposit insurance and stock exchanges, are not the products of careful design in calm times, but are cobbled together at the bottom of financial cliffs. Often what starts out as a post-crisis sticking plaster becomes a permanent feature of the system. … The response to a crisis follows a familiar pattern. It starts with blame. New parts of the financial system are vilified: a new type of bank, investor or asset is identified as the culprit and is then banned or regulated out of existence. It ends by entrenching public backing for private markets: other parts of finance deemed essential are given more state support.
The Economist identifies five major events that shaped modern finance:
- Hamilton’s bank bailout in 1792.
- The creation of joint-stock banks in England after the “emerging markets” crisis of 1825.
- The railroad crash of 1857, global panic and the Bank of England’s stricter requirements for discount houses to hold cash.
- Financial fraud and low cash holdings, the 1907 panic, the National Monetary Commission’s demand for a lender of last resort and the 1913 Federal Reserve Act establishing the (third) central bank in the US.
- Recession and financial meltdown in 1929, the bank holiday of 1933, publicly funded bank recapitalization, Glass-Steagall and the FDIC.