The Fed, Regulation, And The Next Recession

This op ed appeared in the New York Times yesterday (9/20/2009).

SPEAKING at the Brookings Institution last week, the chairman of the Federal Reserve, Ben Bernanke, remarked that the recession in the United States is “very likely over.” He’s surely right that a recovery is under way; in fact, the short-term bounce back may actually turn out to be faster than he thinks — rapid growth is not uncommon right after a severe financial crisis.

Mr. Bernanke commands great respect because of his impressive efforts to head off financial collapse, but his speech was deeply worrisome on the bigger questions: what caused the financial crisis, and how can we prevent another such calamity?

Mr. Bernanke still refuses to acknowledge the Fed’s role in creating financial boom-bust cycles, and therefore his diagnosis and solutions sound overly technocratic and somewhat hollow. He has called for requiring banks to hold more liquid assets and increase their equity cushions, and passing legislation that would permit the Fed to effectively close large financial institutions when they are failing. He also wants the Fed to be responsible for regulation of such large banks.

But none of this is enough. Why should we believe that the Federal Reserve could regulate banks and avert financial bubbles when that agency has repeatedly failed to do so over the past 30 years? The greatest failure of all time happened from 2002 to 2007, and for most of that time Mr. Bernanke was on the Fed’s board of governors. To make financial regulation workable again, the chairman needs to admit the institution’s recent failures and call for deeper reforms in the operation of the Fed to make financial regulation workable again. Otherwise, the United States and the rest of the world are being set up to face another — much larger — financial crisis.

As someone who came to government from academia rather than banking, Mr. Bernanke is not beholden to business, and that puts him in a good position to make the kind of basic changes to the culture of regulation that are most needed — in particular, changes that would stop so many regulators from moving back and forth into the finance industry. He is also a student of the history of the Fed and knows how, after 1934, his predecessor Marriner Eccles helped lead a redesign of the financial system that served America well for 50 years. So he should also realize that if he truly wishes to end our cycles of boom and bust, he needs to fight for a stronger regulatory system and against the powerful financial interests that encourage policy makers to avoid real reform.

In successive financial boom-busts over the past 30 years, the Fed undertook smaller versions of what Ben Bernanke did over the past 12 months. In the Latin American debt crisis of 1982, the savings-and-loan crisis of the late 1980s, the Asian financial crisis and the collapse of Long-Term Capital Management in 1998 and during the bursting of the dot-com bubble in 2001, you saw the same pattern: First, of course, the financial system grew rapidly, bank profits were large and a bubble emerged. At a certain point, we reached the market peak and stared down the mountain. Bankers frantically called the Fed, and it dutifully stepped in to prevent an economic collapse — by lowering interest rates and providing credit to “maintain liquidity.”

In his speech last week, Mr. Bernanke indicated that interest rates are now likely to stay low for a long time. That means that if you are running a major bank, you have good reason now to take on more “leverage” (debt). If collapse threatens again, bank executives know the Fed will support them. And lenders know that it is a far better risk to make loans to banks supported by the Fed than to firms that can go bankrupt, like automakers or high-technology companies.

All of this facilitates a short-term recovery, of course, and is the cornerstone of Mr. Bernanke’s strategy. But it also feeds a new financial frenzy — making it harder to sustain real growth, and also making it less likely that a broad cross section of society will benefit.

There is nothing wrong with having the Federal Reserve in place to deal with financial shocks. This was the original idea that emerged from the 1907 financial crisis, and from the subsequent National Monetary Commission reports — that the United States needed a central bank to manage downturns. At that time, Democrats were rightly suspicious that the commission, led by Senator Nelson Aldrich, Republican of Rhode Island, was looking for a way to give private banking interests influence over federal money.

When it was created in 1913, the Federal Reserve was meant to be a compromise — a way for private bankers to have a say in the operation of the national bank but also a way for the government to keep private bankers in check. And that is how it worked from 1935 to 1980, when the Fed and other agencies ensured that banks’ activities did not put the public purse at risk.

Both before 1935 and again after 1980, however, the Fed’s financial regulation was and has been weak. At the heart of this weakness are the large profits that can be earned by taking advantage of lax regulation in the financial sector. The phenomenal growth of the derivatives market over the past 30 years, for example, has made all our big banks far more interconnected, and hence systemically risky; if one bank falls the others fall with it. Yet our regulators, many of whom remain in office today, watched as this time bomb grew and then exploded with the collapse of the American International Group.

Since our top regulators are political appointees, it should be no surprise that, in the face of heavy lobbying by the financial sector, they often turn out to be regulatory doves. We’ve permitted our mid- and high-level regulators to revolve between jobs in finance and officialdom. To name just two examples, during the Clinton administration, Robert Rubin left Goldman Sachs to become secretary of the Treasury, then returned to the industry to take an oversight role at Citigroup, while Henry Paulson, the secretary of the Treasury during the last years of the George W. Bush administration, came straight to government from Goldman Sachs.

A high-level position at the Federal Reserve, the Treasury, the White House National Economic Council or at a Congressional committee overseeing banking can be a ticket to riches when public service is done. The result is that our main regulatory bodies, including the Fed, are deeply compromised. Rather than act as the tough overseers of the public purse that we need — and that we had before 1980 — they have become cheerleaders for the financial sector.

These cheerleaders, in turn, generate financial cycles by letting our financial system grow too fast, with far too little capital for the risks it takes. When the Federal Reserve inevitably bails banks out, it receives great applause (particularly from the financial sector). Yet with each cycle of failure and bailout, the financial system grows ever larger and more dangerous.

Not all of this, of course, is under Ben Bernanke’s control. Like Alan Greenspan before him, when he provides bailouts and facilitates recovery, Mr. Bernanke can say he is only doing his job. But the true and original responsibility of the Fed is much broader that that. The central bank is supposed to prevent crises that threaten to bankrupt the country.

In today’s nascent global recovery, we are already seeing bubble-like rises in the prices of real estate and assets, from Hong Kong and Singapore to Brazil. And many more emerging markets will likewise soon boom. The details of who makes which crazy loans to whom will no doubt be different from what they were from 2002 to 2007, but the basic structure of incentives in the system is unchanged. The same people are running the American banks, and the same regulators are regulating them, so you can easily get the same outcome here as we have just seen.

We should prohibit companies and senior managers in regulated financial industries from making donations to political campaigns. We should also restrict public employees involved in regulatory policy from working in those industries for five years after they leave office. And we should prohibit people who move to government from the finance sector from making policy decisions on bailout and regulatory-related matters for a minimum of five years.

Our regulators need to be smart people who understand finance, but they don’t need to be drawn from the upper echelons of the financial industry. There are many proven, dedicated professionals in our regulatory agencies today, and we should support the development of an even stronger cadre of career regulators. It should be up to the financial sector to make its practices clear and simple enough for these professionals to understand, and any that are too complex should not be approved.

Finally, we should significantly raise capital requirements for the financial sector — and the bigger the bank, the more capital you should need. (Of course, this would discourage banks from growing too large.) The Obama administration should at least triple the current requirements.

Our financial system provides valuable services to the public, but it also poses serious risks. If we can’t re-regulate more strongly to better protect public funds, the next crisis could be worse than the last one.

By Peter Boone and Simon Johnson

23 responses to “The Fed, Regulation, And The Next Recession

  1. In successive financial boom-busts over the past 30 years

    30 years ago Nixon slammed the gold window shut. I have become increasingly convinced that only a commodity-based currency is capable of limiting the depravations of Big Finance and it’s ally Big Government. The second I see any meaningful action on the financial crisis by the government is the second I consider reconsidering.

    And even if the government does make any token moves, I would be skeptical. It seems like regulatory capture by Wall Street after a brief time, once public attention is diverted elsewhere, would be the most likely outcome. The upside is too great, the current state of finance too arcane and the people too easily distracted for me to believe in another outcome. I mean, these guys have effectively captured the United States Senate. What possible theoretical organization can you imagine them not capturing?

    Me? A gold standard guy?

    I guess so.

    Cheers,
    Carson Gross

  2. Back to old routine for the Fed: Cheerleading, self-congrats and high-fives all around. Then Bernanke passes around his favorite flavor of kool-aid around the room. Then more cheerleading, self-congrats, and high-fives. Worked for Greenspan didn’t it??

    If I was President Obama, I would make copies of David Brooks’ Sept. 15 New York Times Op-Ed and make it required reading for Summers, Geithner, and Bernanke. With a little note jotted at the bottom of David Brooks’ column saying “See if you can learn something from this, eh guys?”

    Here is the link to David Brooks’ Column.
    http://www.nytimes.com/2009/09/15/opinion/15brooks.html?_r=1

  3. “As someone who came to government from academia rather than banking, Mr. Bernanke is not beholden to business …”

    An academician giving a pass to the academy when it is one of the very largest beneficiaries of lobbying activity and business charity? Come on, Simon, academia is right at the heart of the ruling establishment, every bit as much as the banks. I believe you’ve even said so in the past.

  4. This oped is certainly a restating of much that Dr. Johnson has already said on this site. There are many others in the economic world that are saying similar things. On the other side of the ideological fence there has also been talk of what the Fed should do, the exit strategy stuff. I do believe that even if major / monumental reforms were on Bernanke’s agenda he is smart not to roll them out right now, implementing any major changes will take time anyway, and early in a recovery period perhaps it’s best to let things run a little before “shocking” the system. However, there was a tiny little piece of legislation called Glass-Steagall, that greatly lessens the too big to fail problem. Why so much resistance to simply brining it back?

  5. Lavrenti Beria

    “Why so much resistance to simply brining it back?”

    Might it have to do with the fact that the maggots that “represent” you in Congress are owned by the folks that don’t want to see it brought back? You’ve just returned from a decade long trip to Antartica, perhaps?

  6. The end is closer than you think to real and deeper crisis.

  7. The essence of the problem is the idea we have been force-fed in the past year that government’s job is to prevent institutions from failing. Failure is at the heart of capitalism. Our government should have spent the past six months designing the structure to dismantle failed multinationals in a manner that is orderly to markets. Did anyone see that happen? I just want to make sure I haven’t missed something. Protecting failure leads to… anyone? More failure. It’s so simple it’s stupid. But as long as they are the recipients of the tax dollars going into “fixing” the system, our government is happy. The only question now is how thoroughly the US economy destroys itself and on what timescale. When I see a multinational allowed to fail, I will reconsider. I’m not holding my breath.

  8. As to Lehman (the one example we have of permitting a company to go under), those events are held up as the reason to prevent failure rather than the reason to learn to manage it. Lehman could have been a productive lesson. Instead, our puppet government loves to use it as the excuse to return to plundering-as-usual.

  9. Spiders come indoors in fall,
    Spin new webs, lay eggs, and wait,
    Its a boom-bust fate,
    Spiders live for summer’s haul
    Should we expect spiders to change at all?

    Militant Moderate

  10. That was more of a retorical question, I understand the political realities that are keeping this reform from happening. I just find it slightly amusing that we think we need a whole “new” system of regulations. The problem is not a lack of ideas for financial regulation, but the systematic dismantaling of the previously existing ideas. Bring back Glass-Steagall, 12-1 or less leverage ratios, and full documentation mortgages (the mortgage piece is now in place because of necessity but not by statute.)

    There was a great article I read somewhere a few years ago about sandbags. Basically the gist was that sandbags have been around for hundreds of years, yet for all our new technology there is no more cost effective, easily manipulated product to hold back flood waters than a sandbag. The sandbags of our financial regulatory system have been removed, no need to develop a laser-guided, internet enabled, intel inside flood prevention system – put back the sandbags.

  11. Lavrenti Beria

    mk,

    I’m afraid the question of the restoration of Glass-Steagall was decided when it was gutted several years ago. And in lead positions in today’s financial “leadership” are either the very people that gutted it or proteges of theirs.

    The whole question of reform is the great lie of the age. How does one reform the irremediable? Is one really to imagine a Congress and a President bought and paid for by the campaign contributions of special interest lobbies actually voting themselves out of such high-paying and comfortable jobs? You’d have a better chance of witnessing a Communist dictatorship vote itself out of existence. Short of massive public demonstrations and economy stopping strikes, you can kiss Glass-Steagall goodbye.

  12. Austrian Economists have been accurately predicting boom/bust cycles since the 1920’s and for the same reasoning noted in here; interest rates that are too low. And while I agree with the policy prescriptions noted in the article I wish the radical idea of “sound money” had been at least mentioned, even if the prevailing wisdom pooh-pooh’s the idea of a commodity based monetary system as an anachonism. Maybe so, but when the next crisis comes along, it could be so devastating that perhaps people will taken a second look and listen to the only economists who have been correctly predicting these boom/bust cycles….the Austrians.

  13. Brian, if your comment means that the “real and deeper crisis” is closer than you think, then totally agree with you. Can’t argue as an economist because I don’t have that skill set. But even as an ordinary businessman, the fundamentals look incredibly ugly. Frankly, I find this silence waiting for the next boot to drop very unsettling.

  14. I had forgotten that I quoted this from Gluskin Sheff’s daily newsletter on my own Blog and it seems relevant to post it here:

    From Breakfast with Dave Rosenberg.

    “Never before has the S&P 500 rallied 60% from a low in such a short time frame as six months. And never before have we seen the S&P 500 rally 60% over an interval in which there were 2.5 million job losses. What is normal is that we see more than two million jobs being created during a rally as large as this.

    In fact, what is normal is for the market to rally 20% from the trough to the time the recession ends. By the time we are up 60%, the economy is typically well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended. In other words, we are witnessing a market event that is outside the distribution curve.

    While some pundits will boil it down to abundant liquidity, a term they can seldom adequately defined. If it’s a case of an endless stream of cheap money, we are reminded of Japan where rates were microscopic for years and the Nikkei certainly did enjoy no fewer than four 50% rallies and over 420,000 rally points in a market that is still more than 70% lower today than it was two decades ago. Liquidity and technicals can certainly touch off whippy tradable rallies, but they don’t take you all the way to a sustainable bull market. Only positive economic and balance sheet fundamentals can do that.”

    My post with link details to the above is http://learningfromdogs.com/2009/09/19/stockmarkets/

  15. Consider that the two most popular scenarios are the LEAST likely to occur:

    1) a V-shaped “recovery” (equity markets, corporate profits, production, trade). Employment gets left out of this picture, because no one thinks it’s going to quickly bounce back, and anyway less employment equals more productivity (i.e., greater profit margins).

    2) a brief “bounce” followed by a deeper “leg down” toward a repeat of the Great Depression.

    Given that deleveraging has been steady and still made little headway on consumer/business debt ratio to GDP, that the banks as a whole are still formally insolvent, that the government is printing and borrowing at rates only comparable to Japan 1989-2000, and that the Fed and Treasury will do “whatever it takes” (God help us!) to “restore” the pre-2008 status quo ante, I believe we may have a generation of stumbling around in various forms of recession, recovery, deflation, inflation, etc etc, more like Japan than any other historical model (though with a giant trade deficit), before we will know how many boots will drop and where they will drop.

  16. Hear hear. I’m sure a gracious benefactor has already started to whisper sweetly in Bernanke’s ear about where he’ll be going to work after he gives the banks a hummer and a handjob during his tenure at the Federal Piggy Bank. Why else would there be absolutely no rumblings of bringing back real regulation with teeth, and no talk of eliminating his bright future in running the US with the rest of the banksters.

    Whole system stinks to high hell, and I doubt I’ll see it fixed in my lifetime.

  17. Richard Hoogesteger

    I agree with your analysis. The most important work for economists today during this time of relative calm is to continue presenting a clear alternative to current policies with a detailed explanation of the ideas behind the alternative policies. There is likely to be a frantic search for new solutions if the crisis returns. The battle of ideas can take many years.

  18. Why delay gratification when you can spend now and pay later? Low interest rates are the candy. The Fed loves it, politicians love it, consumers love it, and banks love it.

    But just like real life, a diet of candy and you end up fat, unhealthy, and dead before your time.

  19. ReturnFreeRisk

    Prof,
    This needs to be said. Thank You.

  20. I love the article, however, as a cynic when it comes to things oligarchic, I believe that you are, unfortunately, spitting into the wind. I really believe that Bernanke is sincere, concerned, and really interested in reform. And, there are, for sure, certain steps that he can take to unilaterally effect outcomes in the financial sector (oligarchy), but without meaningful Congressional action, and without a clear purpose at Treasury, the problem will continue to be subject to regulatory/fiscal arbitrage, and won’t really be solved. Because Bernanke’s prime role is to see to the health of the banks, and because Congress’s prime role is to meaningfully provide legislative direction to regulation, the bottom line is likely to continue to be highly leveraged and risky.

    Recovery, of a sort (at least for the financial industry, and certain other segments of the economy) is underway, but will not be broad based, and will not reach down into the middle class and lower for many months, if not years, and, quite frankly, maybe never, because the oligarchy will continue to place the burden for its excessive greed on those who can’t compete for legislative attention, meaning the non-rich. Such a shame, considering that all could be better off in the long run if the non-rich were given the opportunity to live well and peacefully in at least a comfortable way.

    The way things are, the next bubble is already under construction, and the next bust is going to happen very rapidly this time unless many of those “inside the beltway” suddenly find their way to sanity.

  21. Can anyone tell me:
    Is it true that our current measurements for unemployment are not the same as those in effect in the 1930’s?
    If the same metrics applied what would be the current unemployment situation, better or worse than currently reported?
    If there was a change made when and why?

  22. Can anyone tell me:
    Are the metrics for unemployment the same now as in the 1930’s?
    If the 1930’s measurements were used, would our current unemployment rate of 9.7% be the same, more or less?
    If the measurements were changed, why and when?

  23. Sorry for the duplicate post.