Are we having the right discussion about the financial crisis?

by Ricardo Hausmann, guest blogger

The discussion about avoiding a repetition of the current financial crisis has centered on the potential role of financial regulation. Hank Paulson announced on March 31 an organizational overhaul of the financial regulatory agencies. This seems more about process than substance, as argued by Paul Krugman. Many, inter alia Martin Wolf, argue that if the Fed’s safety net is extended beyond commercial banks to other market participants, prudential regulation should also be extended to avoid moral hazard. Those that argue in this direction may have a point. But it is hard to see how the kind of financial regulation that would be called for would have avoided the current crisis. At best it would reduce the risk of an even bigger future crisis caused by the impact of the precedent of the Bear Stearn rescue on future financial players. But the current crisis occurred in spite of the fact that current players could not have had the certainty of a rescue. And the crisis still took place. I believe that financial regulation is the wrong place to focus the policy discussion about the causes of the current crisis. It is macro policy, not financial policy that needs to be at center stage.

I propose we engage in the following counter-factual scenario. Let us suppose that more stringent financial regulations had been adopted in 2003 or some such date. Let us discuss two macroeconomic scenarios.

Consider first the case where the Fed would have set the same interest rates as we observe in the historical record. In this case, the new regulations would have lead to a smaller rate of credit expansion because the regulations would have meant that, for any interest rate set by the Fed, the market for credit would have been smaller. Presumably, there would have been less mortgage lending, fewer home equity loans and less junk mail offering zero percent loans on credit cards. Aggregate demand would have been lower and presumably so would have been the rate of growth, the level of employment, the inflation rate and the current account deficit.

Now, consider the alternative scenario in which the FOMC would have set interest rates following the way monetary policy is conducted, with the same inflation and employment targets. What would have been the consequences of this alternative and more plausible financial scenario?

Obviously, the Fed would have lowered interest rates until the amount of lending required by the inflation and employment targets had been achieved. The financial system would have been asked to find other ways to expand credit.

Maybe, that additional lending might have been safer than the form that lending actually took because risk would have been better priced. But I am not so sure that this would have been the case. With the even lower level of real interest rates, the incentives for financial engineers to invent new instruments that could be placed in large numbers would have been enormous and many more bright minds would have been hard at work at circumventing the new regulations than those that had crafted them.

My bottom line is that it is impossible to discuss the lessons of this crisis without talking about macro policy. I would put more of the blame on the way monetary policy is conducted. It is based on a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment, with blatant disregard to the current account, the exchange rate, asset prices, international finance, the rate of growth of credit or the balance sheets of households.

In the end, it is hard to believe that a macro policy that overshoots the sustainable growth rate by encouraging millions of citizens to over-borrow is going to be made safe through financial regulation.

Comments

[robertdfeinman]

This is an April fools joke right?

"Regulation" doesn't have to do with the specific policies of the Fed or other agencies in controlling macro behavior. It has to do with the correct policies to prevent fraudulent micro behavior. Or if not fraudulent, then extremely unwise.

When a Carlyle Capital leverages its capital 31 times one doesn't need to be a financial genius to see that this a highly risky behavior. In fact the 10% margin of 1929 taught the lesson that such high degrees of leverage were unwise which is why now stock purchases are usually at about 50% margin.

So what's wrong with putting similar limits on other financial firms? I don't buy the argument that the wealthy should be allowed to gamble since a) it's their money and b) being wealthy, they are "obviously" smarter.

The number of investors who thought they were engaged in low risk activities (such as municipalities and pension funds) shows that the risks were not fully explained. If this wasn't fraud it was something that had the same effect.

Similarly the conflict of interest in the ratings agencies led to assigning high quality levels to instruments that didn't warrant this. Undue optimism, fraud or ignorance. Whatever, they didn't fulfill their fiduciary responsibility.

To cap it all off we have the audit firms who also assisted in the scheme. Another example of an obvious conflict of interest.

To pretend that these abuses can't be fixed by proper regulation is unbelievable. At some point in the near future these same investment firms will be demanding new regulations since it will be the only way they can attract investors back.

It's like lead-laced toys or poisoned Heparin, once you have lost your credibility only the government can restore it.

[kris]

I agree with the above comment. Secondly, it is not at all clear that big banks like Bear Stearns did not have the certainity of a rescue. The bailout of LTCM by the Fed pretty much set the precedent that could make people believe that a bank the size of Bear Sterns would be bailed out. LTCM was also a very highly leveraged hedge fund that had practically no regulatory oversight, and the arguments for bailing out Bear Stearns were not very different in essence from those used in the case of LTCM. I think the belief that the lack of regulation of investment banks and hedge funds, and the corresponding weakening of depression era legislation (Glass-Steagall) is a major factor in creating the current crisis is correct.

[luci]

I like the point that interest rates would have probably just lowered to a new equilibrium, in a counter-factual scenario with this new regulatory environment.

But I think it's even more complicated than that: the Fed can only go so low, so there is probably a non-linear relationship, as rates approach zero. (So they couldn't actually go as low as necessary to reach equilibrium).

Also, the Fed works the low end of the yield curve, while mortgages are affected much further out. Towards the long-term end, a significant part of the demand for bonds is not "price sensitive," I think, as central banks are using Treasuries to store USD reserves and manage their exchange rates.

China buys Treasuries even though the price is high, keeping rates extra low. Seems to me this adds to the lack of control the Fed has over credit markets, and (I think) would support the assertion that the Fed oughta keep a more Macro view in mind when making policy.

[Declan Trott]

In what way has the "sustainable growth rate" of the US economy been overshot in this decade? Certainly the labour market has not been particularly tight. I suppose a Japan-like stagnation would prevent any bubbles forming - is this the logical outcome of focusing on "the current account, the exchange rate, asset prices" etc?

[thorstein veblen]

who is this guy?

moral hazard arguments are made merely to fool the feeble-minded, ricardo; you shan't be so silly. The rational for the Fed's regulatory role is not to clamp down on runaway moral hazard, it's to ensure that the financial system is sound. Cutting down on poor lending practices is good in-and-of itself, and because it helps alleviate risk to the system as a whole. if the Fed set out to flog any bankers who went belly up, it might eliminate moral hazard, but it would do nothing to protect our financial system. Certainly, one could also say that, for all bank panics before FDR created the Fed, bankers could not guarantee that they would be bailed out, and in fact weren't. They failed. There was no moral hazard, and yet the system was very unstable. Since the Fed was created, there is much, much more moral hazard, and much, much more stability. These are hardly difficult or debatable things I'm writing, ricardo, but they flatly contradict your reasoning. Perhaps you can modify your argument.

[Brad Setser]

Should we also consider a counterfactual where many Asian economies (and others) did not intervene as heavily to keep their currencies from appreciating? Based on the work of the Warnocks, I suspect in that world US long-term interest rates would have been higher (for any fed policy path), as such intervention led to an increase in reserves and increased purchases of US bonds. A weaker dollar would also have encouraged more investment in the tradables sector, and less in the housing sector -- so the composition of US output would differ.

I tend to agree both with Dr. Wolf and Dr. Hausmann -- regulation should have been tighter and interest rates should have been higher (Even if that meant less growth), but I would also argue that policy choices outside the US mattered.

[reason]

I think Brad Setser has it right. The correct assignment of instruments to targets is exchange rate to employment, not short term interest rates to employment. The problem lies in international capital markets. Lower domestic interest rates may have brought forward US dollar devaluation. There is also in macro a tendency to ignore differences in quality (composition) and concentrate only on quantity (totals). Composition matters.

[Luis Enrique]

I think you need to decouple your bottom line (which I think is an excellent and overlooked point) from the idea that, loosely, 'regulation can't fix this'. Or just change it to regulation alone won't be enough, rather then giving the impression that you think there's no need for a regulatory response.

Your bottom line is quite compatible with the idea that certain regulatory fixes are urgently needed, and seeming to suggest otherwise has diverted readers from your main idea.

[Per Kurowski]

Of course it takes two to tango! Regulations and macro.

Since Ricardo is admonishing correctly the macro guys let me hit, again and again, at the regulators.

We all know, for a fact, that had it not been for the credit rating agencies giving prime wings to the securities collateralized with real junky sub-prime mortgages, at least this explosive matter would not have gone anywhere.

Therefore in order to avoid repeating history, and next time following these modern pipers of Hamelin over an even more dangerous precipice… the regulators must now decouple the markets from the credit rating agencies.

There are many useful roles that the credit rating agencies can fulfill but forcing the markets to use them invalidates the whole reason for them, since they thereby, on their own, become a prime risk element… or is the next step a rating agencies for credit rating agencies?

[robertdfeinman]

I want to say something about "moral hazard". It is based upon a false analogy. People learn from their mistakes, institutions don't. The people who engaged in risky behavior in 1929 are not the same people who did so in 1999. The people who did so in 2006-7 will not be the same people who will try to do so a decade hence.

You cannot teach firms a lesson because the individuals who make up the firm change as do those who are in the markets.

So "punishing" those who engaged in such behavior can't work. The way lessons are learned for firms is by putting in to force new laws and regulations. That is the way society transfers lessons from one generation to the next.

The present failures are a direct result of the program to remove this institutional experience by repealing laws and deliberately refusing to enforce existing regulations. It's not "moral hazard" that needs to be considered, it is why the markets were allowed to escape from the lessons of history.

[Justin Rietz]

When the Fed sets interest rates below what the market would determine, it creates excess demand for loans (one could say “in excess” of the market clearing level). The Economist in several articles has pointed out that over 50% of subprime applicants submitted fraudulent applications, no doubt as a result of wanting to take advantage of the remarkably low interest rates. With higher rates, loan demand and the concurrent fraud would have been less.

In regards to “greedy” financial institutions which should have known better, they didn’t have much choice if they didn’t want to lose market share. If one bank takes advantage of the low interest rates, others must follow or lose customers. However, lower rates on loans also force banks to offer lower rates of return to their depositers (via CDs, money market accounts, etc.). Hence, there is more incentive for people to spend their money than save given the low rates of return on low risk investments. This causes two issues. First, banks need to focus on their volume of loans in order to make up for the decreased interest rate spread. Second, and more importantly, we now have a mismatch - less savings but more loans. This also drive pressures to commit fraud as bankers and mortgage brokers scramble to maintain profits (not that this justifies fraudulent actions). Lastly, because of the low interest rate perpetuated by the Fed, interest rates did not adjust upwards as they would under a free market which would have curtailed borrowing.

There is another important factor at play here: FDIC insurance. With no risk differential between saving with a conservative bank versus a bank offering a slightly higher rate but heavily leveraged in the subprime market, riskier banks are able to garner a higher percent of investors’ savings. Without FDIC insurance, more investors would keep their money with conservative banks who were not so active in the subprime market. This would reduce the percent of funds invested with high-risk banks and create an incentive for banks to reduce their risk profile.

Finally, we also have the risk inherent in fractional reserve banking at play. Under such a system, banks are inherently bankrupt - if all of a bank's depositors requested their money at the same time, the bank wouldn't be able to hand it over (a traditional bank run that we are currently seeing with hedge funds). Given the many ways that banks can currently sidestep reserve requirements (such as sweeps), there is a huge incentive to take on leverage. A 100% reserve system would remove this incentive. While this would slow growth in the short run, it would also even out the ups and downs in our economy that result from huge credit expansions and contractions. In the long run, this would in all likelihood increase the economy's strength.

Of course, where there was fraud, people should be punished. We don't need new regulations, regulatory agencies, etc., to do this. Laws against fraud are already on the books. A few bankers and mortgage brokers in orange jump suits behind chained linked fences and razor wire would do more to deter future fraud than any regulations. Moreover, it may overcome the institutional memory problem pointed out above - institutional "myths" tend to be perpetuated over time.

[jose carlos]

macro vs regulation is a false dilemma

[Marcos Siqueira]

When else will you reform financial regulation if not during a time of crisis? Politically, the time to focus on that issue is now. Whenever you are trying to transfer responsibilities between competing agencies and take on lobbies head-to-head you better have mustered enough political momentum for your reform. Paulson is right to focus on regulation now that everyone is inclined to do something.

I don’t disagree that at least part of the discussion should be focused on macro. One question that seems particularly interesting to me is the extent to which monetary policy should be used as a tool to control bubbles. That is an issue that deserves more discussion, but which does not require so much political support (at least for now).

[Bruce Wilder]

I thought the previous comments were quite good.

Prof. Hausmann's peroration was a better argument than his argument: "I would put more of the blame on the way monetary policy is conducted. It is based on a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment, with blatant disregard to the current account, the exchange rate, asset prices, international finance, the rate of growth of credit or the balance sheets of households." He should make that sentence his thesis.

The Taylor Rule mentality reflects a narrowing of analytical focus, which, while useful for theorists, has been nearly fatal for policymakers.

We completely de-contextualize the variables, and lose all perspective. We talk about whether short-term interest rates are "high" or "low", when, really, what is relevant is the slope of the yield curve and its implication for intermediated lending.

That small step in the framework of thinking -- from thinking of short-term rates as high or low, to thinking about the slope of the yield curve and its implications for financial intermediation -- should not be too far for economists to go.

Too many economists insisted that the yield curve is just a leading indicator of doubtful reliability, not a key mechanism with near certain effect.

Low short-term rates steepened the yield curve, encouraging an expansion of intermediated lending in an environment in which the exchange rate and the international flow of funds had made investment in the production of tradeable goods domestically unprofitable.

There was enormous pressure to find an outlet for intermediated lending, but that pressure was channelled into a lot of fraudulent and predatory lending. This calls for an "AND" not a "BUT".

We should question why the normal barriers -- both the government's regulatory oversight and the normal private barriers of ethical and prudent business practice -- did not constrain and limit the flow into fraudulent and predatory lending to finance unproductive investment in housing not worth its cost of development and construction.

AND we should ask why there were not alternative channels for productive investment. Prof. Hausmann does us a disservice when he cavalierly asserts a growth path bound, without inviting further examination. If observers and policymakers are to pull their heads out of the Taylor Rule sand, then it must be to look around the landscape. I dare say, denial of the housing bubble while it was building, recommending ARM when interest rates were at historical lows, refraining from regulatory intervention when it was clearly called for, and precious talk of a global savings glut, were all indications that key policymakers had their heads firmly in the sand or other dark places.