Measuring The Fiscal Costs Of Not Fixing The Financial System

This post is a slightly edited version of remarks prepared for delivery at Unwinding Public Interventions in the Financial Sector: Preconditions and Practical Considerations, IMF High-Level Conference, Thursday, December 3, 2009, Washington D.C.  I participated in Session 2: Managing Fiscal Risks—Public Finance Aspects of Unwinding.

The Problem

1)      The underlying fiscal problems of the U.S. have significantly worsened as a direct result of how the financial crisis of 2008-09 was handled.

2)      The U.S. economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small or medium-sized financial institutions.  A large number of these institutions have failed so far this year, without causing major disruption to the economy.

3)      The U.S. does not yet have a similarly effective way to deal with the insolvency of large financial institutions.  The dire implications of this gap in our system have become much clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table.  In fact, our underlying banking system problems are likely to become much worse.

4)      The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks.  However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the U.S. and global economy.  The prospect of such disruption, they reason, would induce the government to provide various forms of bailout.  They also invest considerable time and energy into impressing this point onto government officials, in a wide range of interactions.

5)      Even more problematic is the underlying incentive to take excessive risk in the financial sector.  With downside limited by generous government guarantees of various kinds, the head of financial stability at the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.”  The implication is repeated bailout and fiscal stimulus-led recovery programs.

6)      The implementation of the Troubled Asset Relief Program (TARP) exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.”  This lowers their funding costs, enabling them to borrow more and to take more risk.  The consequences include a contingent fiscal liability – both for specific bank rescue measures and, on a larger scale, the fiscal stimulus needed to offset a potential future credit crisis.

7)      U.S. national debt will increase substantially as a result of direct bank bailouts and, more importantly, the discretionary fiscal stimulus needed to keep the economy from declining – as well as the standard deficit due to cyclical slowdown (a feature of the “automatic fiscal stabilizers”.)  Privately held net government debt will increase from around 40 percent of GDP to the 70-80 percent of GDP.

8)      If any country provides unlimited government support for its financial system, while not implementing orderly bankruptcy-type procedures for insolvent large institutions, and refusing to take on serious governance reform and downsizing for major troubled banks, it would be castigated by the United States and come under pressure from the IMF.  Yet this is the approach that the U.S. has implemented.

9)      At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand.  Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout.  That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term.   Again, this is the problem in the U.S. looking forward.

10)  The Obama administration argues that its regulatory reforms will rein in the financial sector in this regard.  Very few outside observers – other than at the largest banks – find this convincing.

Towards a Solution

1)      As legislation on restructuring the banking industry moves forward, attention on Capitol Hill is increasingly drawn to the issue of bank size. Should our biggest banks be made smaller?

2)      There is a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits.  This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”

3)      This cap was set at an arbitrary level — as part of the deal that relaxed most of the rules on interstate banking — and it worked well (until Bank of America received a waiver).

4)      Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy.  Of course, there are technical details to work out — including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would the benchmark around which all the specifics can be worked out.

5)      What is the right number: 1 percent, 2 percent, or 5 percent of G.D.P.? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.

6)      A hard cap at 4 percent of G.D.P. seems about right for a bank with the most conservative possible portfolio. This would mean no bank in our country would have no more than about $500 billion of liabilities, even with a relatively low risk portfolio.  On a risk-adjusted basis, most investment banks would face a cap around 2 percent of GDP.

7)      A large American corporation would still be able to do all its transactions using several banks. They would even be better off — competition would ensure that margins are low and the banks give the corporates a good deal. This would help end the situation where banks take an ever-increasing share of profits from our successful nonfinancial corporations (as seen in the rising share of bank value added in G.D.P. in recent decades).

8)      Indeed, the whole world would soon realize that our banks are more competitive and offer better pricing than others.

9)      If, as might occur, the Europeans subsidized their big banks with cheap finance and implicit subsidies, the U.S. should let our nonfinancial corporates benefit and understand that our banks may become ever smaller. We can let Europeans subsidize banking because we all get better deals through their taxpayer subsidies, and then our corporates will have more profits to bring back to America.

10)  Today our politicians and regulators lack credibility. They have bailed out too many banks and need to show they have truly regained the upper hand — by showing that they are installing such a hard size cap rule without exception.

11)  The litmus test is simple.  Does Goldman Sachs continue to grow, and continue to be regarded as almost as good a risk as the United States government (Goldman’s Credit Default Swap spread is currently around only 70 basis points above that of the United States), because it has demonstrated it is too big to fail? Or, will the government impose a cap on the size of such institutions and require Goldman Sachs to find sensible ways to break itself into pieces – becoming small enough so that it will not be bailed out again next time?

In the Absence of Real Reform

1)      Real progress towards reducing the risks inherent in the U.S. financial system is unlikely.  As long as there are financial institutions that are Too Big To Fail, we face a potential fiscal cost.  We should recognize this in our government budget and balance sheet accounting.

2)      The overriding principle behind IMF fiscal assessments is the need to capture true total fiscal costs.  Best practice for the U.S. needs to reflect this approach.

3)      All subsidies and taxation – including the entire cost of supporting the continued existence of large banks – should be reflected transparently in the budget and subjected to the prioritization of the budgetary process.

4)      Our current accounting for guarantees and governments’ assumption of other contingent liabilities create the impression that government actions to support the banking system are costless. This is a dangerous illusion – as seen in the recent increase in US federal government deficit and debt.

5)      If we don’t recognize these costs explicitly, we run the risk of taking on ever more contingent liability.  If the financial system reaches the point where its failure cannot be offset by fiscal (and monetary) stimulus, then a Second Great Depression threatens.

6)      Next time, we cannot be certain that the available size of fiscal stimulus – either in the US or worldwide – will match the negative shock to demand caused by the credit crisis.  Either we will already have too much debt or we will be constrained by the consequences of taking on even more debt.  Or – just as in 1930 – the financial decelerator will simply be too large to be offset by any feasible fiscal measures.

By Simon Johnson

48 thoughts on “Measuring The Fiscal Costs Of Not Fixing The Financial System

  1. Some astute observations but regarding your last point i.e.
    “Next time, we cannot be certain that the available size of fiscal stimulus – either in the US or worldwide – will match the negative shock to demand caused by the credit crisis.”

    I would suggest that, in fact, we can be certain that there is no scope for another bailout of the current bailout. The longer the US continues with a zero interest rate policy and the longer the new asset bubbles are allowed to be pumped up the more chaotic will be the next crisis. Central bankers need a new mandate and methodology to protect the system from the illusory belief that wealth is created from asset inflation.

  2. I agree that a top priority of any reform needs to be a resolution mechanism for large, bankrupt financial firms.

    Beyond that, most of the debate of “too big to fail” is generating way more heat than light.

    Arbitrary caps on firm size are not the solution. The solution is the imposition of an updated Glass-Steagall that builds a firewall between the banking sector proper and the rest of the financial services industry. The “shadow banking system” needs to be brought inside the firewall, and no mew one must be allowed to emerge outside of it in the future. Banks inside the firewall must be strictly regulated on all fronts, and must not be allowed to finance speculation by firms outside of the firewall. What firms outside the firewall choose to speculate in is their business, so long as it’s being done with their owners’ capital and not borrowed money.

    “Over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money.”
    –Irving Fisher

    In addition to the above, credit derivatives need to be eliminated. The very notion that the default risk portion of an interest rate can be hived off and sold separately is an abomination. Lenders must take default risk into consideration when underwriting a loan and setting an interest rate, not simply purchasing “insurance” from some under-reserved third party and then ignoring the problem.

    I am not hopeful that we will get any meaningful reform, however.

  3. @RueTheDay:

    While I am generally, and morally/ideologically sympathetic to your notion of a re-introduction of a two tier system with those banks that enjoy deposit insurance being utility-like in the regulatory constants on the scope and risk of their operations, I fear that this view misses the point. If some large investment banks outside the wall of deposit insurance and regulatory constraint become (remain?) really large the government will be forced to bail them out because of all the negative effects the failure of such an institution would have on the larger economy. That is why there is a need for some sort of hard limit on size.

    Also, your other concern seems to be about leverage. Leverage is one way to use derivatives but it is not the only way, as any options trader can tell you. While concerns about leverage are quite legitimate — I think that leverage, institution size and the level of interconnection are what caused the crisis — it seems a bit disingenuous to argue for a two-tied system at the same time as for an absolute ban on some sorts of leverage. But, ultimately, if financial institution outside the regulatory firewall are really small enough to fail it should not matter what their leverage is.

  4. “10) Today our politicians and regulators lack credibility. They have bailed out too many banks and need to show they have truly regained the upper hand by showing that they are installing such a hard size cap rule without exception.”

    Polls show President Obama is perceived to be too closely aligned with the banks, according to NBC nightly news reporter Chuck Todd (December 4). The Administration continues efforts to put a positive spin on the failed policy of bank bailouts – President Obama says that since taxpayers rescued
    the banks, the banks need to lend more. Either by design or happenstance, the Obama mindset appears to accept the “trickle down” policy of bailouts.

    The Administration should admit their mistake, and reclaim the high moral ground by breaking up banks deemed too-big-to-fail.

  5. There’s nothing arbitrary about the proposed cap. On the contrary it’s calibrated to leave banks which can perform real functions without becoming systemically too significant. And although Simon doesn’t explicitly say so, presumably also to render it harder for banks to form lobbying oligopolies which would turn right around and chip away at all the other reforms you propose.

    We do need to ban most derivatives and reinstate Glass-Steagal. But the linchpin is severely limiting size (along with restoring a rational and moral tax code). It’s the measure upon which all others depend.

  6. ” Next time, we cannot be certain that the available size of fiscal stimulus […] will match the negative shock to demand caused by the credit crisis”

    Any idea how soon “next time” could be, say at the 5% tail of the ‘soon’ end of the distribution?

  7. Synthetic CDOs made it possible for $300 million in defaults on $1.4 trillion bad mortgages to create a $14 trillion hit to the US govt (Fed and Treasury)balance sheet, and that is only so far. While Simon’s banking reforms are sensible, they will not help with the problem, which remains the $100 plus trillion in derivative bets not yet socialized by the government.

    Our entire economy is now hostage to these bets, which can only be validated by an inflation which will allow all underlying debtors to discharge their indebtedness. This means mortgages, credit card loans, auto loans, student loans, corporate loans, junk bonds, municipal bonds, and most of all, the Treasury debt, which has been tripled in the past year.

    How will the inflation be generated?

  8. Prof. Johnson —

    Two quick questions/comments.

    1) Do you count gross derivatives exposure as part of “gross liabilities”? I ask because (a) this is not the usual accounting definition and (b) some of these firms — notably JP Morgan — are counterparties to tens of trillions of dollars in derivatives trades. This is already hundreds of percent of GDP just for a single firm. To eliminate “too big to fail”, I think you have to include this number as part of your “bigness” definition… But even I am not sure 4% of GDP is a sensible cap.

    2) Speaking of GDP, you might want to add a few words explaining why it is the right measuring stick here. After all, liabilities are a “stock” while GDP is a “flow”, so it is not immediately obvious. (I think it is a reasonable metric, in the same way a P/E ratio is a reasonable metric, but it is worth stating explicitly, IMO.)

  9. @RueTheDay

    Glass-Stegall is crucial. I put it this way : Would you go to Las Vegas and deposit your savings at a casino for safe keeping? I wouldn’t. Citi, BoA, et al have become big casinos.

    @Simon Johnson

    IMHO caps are an important part of the reform. There are always strategies around these things. Example : splitting up large cash deposits over several banks to get past the $100,000 (now $250,000) maximum.

    For me, the advantage of caps is that it forces risk and pricing to be explicitly tagged. Right now, the “banks” can keep playing a shell game with the government (and taxpayer money). Caps make auditing and price discovery easier while reducing structural risk.

    (BTW: I have my own idea for ending the credit crisis called the Namke Debt Consolidation Idea. It is an idea for the current situation in the USA, England, Iceland, etc. I’ve been surprised that the IMF never suggests it. It’s my little contribution to the collective brainstorming.)

    all the best from

    Namke von Federlein

  10. “Next time, we cannot be certain that the available size of fiscal stimulus – either in the US or worldwide – will match the negative shock to demand caused by the credit crisis.”

    I am not yet certain we have overcome the negative shock this time. Otherwise I am pretty much 100% in agreement with caps, and would throw in a firewall for good measure.

  11. Dearest Simon Johnson,

    Would you not think of taxing certain capital flows?
    For example the capital inflows from countries refusing to compete “fairly”, like manipulating their currencies?

    If the Chinese refuse to appreciate and rather mass buy your Bonds, would you not have low interest rates anyways?

    Can your Central Bank really control interest rates regardless of the increasingly bigger outer world? I personally think the bigger the world the hardest it is.

    Even if we apply all your points, I would still a bit skeptic. You mention in 2 that the US have managed to successfully control small and mid size Financial Institutions, but I think that once you make them all small or mid size, you wont be able to control them as effectively: If they will remain interconnected as any financial sector, instead of 5 big dominoes falling we would have 500.

    I really hope you could tell me what you think,
    Thank you

  12. I assume in point #1 you’re talking about the credit default swaps and shadow banking and I couldn’t agree with you more Nemo. Any analysis done by Professor Johnson or others excluding this factor can be wadded up and thrown in the trash.

  13. I’m also wondering what is the point in sending young people to business school when we consider transactions carried off balance sheet a normal part of doing business. I guess when we have U.S Congressmen and U.S. Senators on the bank and finance committees rubbing winkies together with bank lobbyists this is what we can expect from now on.

  14. It doesn’t seem like, behind closed doors, many of the Obama administration officials were surprised (or should have been) by the failure of trickle down or out from the banks. They, presumably, had the best access through the Fed to just what the losses coming down the pike are and that the banks would want to hoard cash. As importantly, they created a catch-22 in that the hoarding of cash in the banks creates a worse economy and, of course, fewer credit worthy businesses, particulary small where most people work.

    It really seems that they bet that the only way to save the Casino banks was to open up the Casinos once again and pray that they could gamble their way to fiscal solvency and that the economy, in the meantime, would stabilize just enough to make that wishful thinking work.

  15. Dropping dollars from helicopters? Certainly, at present, the banks are serving as more of a dam than river for dollars.

  16. I can’t tell you how happy I am to see a well known & highly respected economist finally, for the first time I’m aware of, say:

    “1) The underlying fiscal problems of the U.S. have significantly worsened as a direct result of how the financial crisis of 2008-09 was handled.”

    Using some higher mathematics, this equals ” Bernanke & Geithner are inept frauds.”

  17. There is a good reason that our government lacks credibility relating to banks and multifaceted financial firms: Its will to take any curative action has been bought. I mean bought. Millions have been, and more millions will be, spent to “encourage” “right thinking” among our legislators and in the Treasury and Fed. Until the President takes the lead and calls our Congressional leadership AND fires Tim Geithner, he will continue to suffer in polls AND continue to warrant the public’s thoroughgoing distrust. All we ever hear from any of Obama, Geithner, Bernanke, Frank, Dodd, and other blatherers is obfuscation, lies, red herrings, and endless platitudes regarding finding real solutions. The bottom line is that ONLY BY REFORMATION OF CAMPAIGN LAWS REGARDING POLITICAL CONTRIBUTIONS CAN THE SYSTEM BE REPAIRED AND THE GOVERNMENT BE RETURNED TO THE TAX PAYING CITIZENRY!!!!!!!!!!!!!!!!!!!!!

  18. Simon, nice post!! It just states the obvious, in causes, status and solutions. What is obvious to you and me is also obvious to our leaders. There will be no more bailouts, that is unless the leaders and wonks in Washington have a death wish. And, because they refuse to squelch the oligarchy, there will be no meaningful reforms. Period!!

    We need to move on as to how to remove the leaders we have and change the campaign laws so that the next elected set has not been bought like the current group. Until that happens, we won’t tame the financial system of the country, won’t reform health care, won’t cure our energy problem, won’t stop spending billions of dollars and thousands of lives on meaningless wars that can’t be won. I may sound cynical, but I’m really not. I’m just being realistic. I wish that there were a Bernie Sanders for every Behner and Bachman, but there’s not. The Prsident wanted change, but can’t begin to change things until the citizenry really has a TEA PARTy to end all tea parties and refuses to go away until the government is willing to do the right thing. We are already looking like a third world country where a very few control the greatest percentage of wealth and the majority are sinking further and further.

  19. Stop me if I’m stating the obvious here, but since the subtext of TBTF breakup is to reduce the political power of the financial sector, should this occur the job isn’t done, because there are other substantial entities that also distort the governance process. I’m thinking big pharma, large health care providers, energy conglomerates…the financial sector is the sickest of all and affects all, so merits the first efforts, but ultimately, shouldn’t TBTF logically lead to the dismantlement of all large-scale corporate activity as fundamentally destabilizing to good governance and efficient markets?

  20. “9) If, as might occur, the Europeans subsidized their big banks with cheap finance and implicit subsidies, the U.S. should let our nonfinancial corporates benefit and understand that our banks may become ever smaller. We can let Europeans subsidize banking because we all get better deals through their taxpayer subsidies, and then our corporates will have more profits to bring back to America.”

    This is essentially the same advice that a free-trade ideologue would give in the face of foreign subsidies to any industry: when someone subsidizes an industry, say thank you for the cheap goods.

    The assumption is that industries generate no positive externalities – in other words, that dependence on foreign banks (managed by foreign countries) is not at all risky, that debt in non-dollar currencies is not risky for the nation (Eastern Europe regrets that one), that a world in which global industries are increasingly concentrated in specific countries is not any more vulnerable to shocks, and finally that predatory pricing models in industrial org theory have no basis in reality…

    As a sheer matter of national security, the US will not let this happen. Nor should it.

  21. Quite the contrary, if we were to a adopt an official policy of price level targeting with 2% annual growth – meaning that the price level in 2017 should be 1.02^10 times the price in 2007 – then much of the problem would disappear.

    The deflationist mentality, including the refusal to adopt sufficient inflation to make up for lost ground, bears much blame for the intensification of the crisis far beyond the limits of what should have occurred.

    Even better than price level targeting would be NGDP level targeting, vis a vis a Sumnerian approach.

    The IDEAL situation back in September/October 08 would have been that the US adopt a much more ruthless stance toward banks with an expansionary monetary policy sufficient to compensate for the mass deleveraging that followed.

    Instead, Fed minutes (even as late as October 29) reveal an infatuation with historical headline inflation, including the complete dismissal of the TIPS spread (a tool they created partly to help measure inflation expectations) due to fluctuations in the liquidity premia.

    Click to access fomcminutes20081029.pdf

    The Fed’s focus on inflation, and willingness to invent any number of reasons to explain the mass deleveraging OTHER than a demand shock (e.g. the “credit blob”) is precisely what turned somethin akin to the S&L crisis into a full fledged global catastrophe.

    It was precisely the excessive obsession with inflation that caused the Fed to attempt to deal with the problem through massive credit channel intervention (“recapitalizing banks”) rather than classical tools (expanding the money supply).

    In other words, the Fed used the excuse of inflation-fear to justify a massive and unprecedented subsidy of over-sized banks.

    And, in retrospect, the American people see that the Fed cares more about preserving the banks than preserving jobs (or preventing a massive deficit-expanding recession). And, basically, they are correct.

  22. You’re the first and only person I’ve heard or read say the Federal Reserve was obsessed with inflation fear during the economic crisis which hit the fan in ’08. Better lay off the booze when posting.

  23. Put me firmly in the cynic group. I agree with all of the observations, but believe the U.S. system is already beyond the point of no return, the other shoe has just not dropped yet. It will be a very unpleasant experience, but in my view a necessary step. Economists have neen trying to figure out how to fix a systemically broken system-impossible. Economists have also been trying to figure out how to regulate a non-transparent un-regulatable structure-impossible.

    Specifically, Simon’s “In the Absence of Reform” point 5)”…If the financial system reaches the point where its failure cannot be offset by fiscal (and monetary) stimulus, then a Second Great Depression threatens.” In my view, we’re already there. Because, for such stimulus programs to work, they must be sent through an existing infrastructure of economic activity generators. IE businesses (in addition to governments) that can employ people, make things, provide benefits, and pay taxes. I believe Simon, like many economists make a faulty assumption that there is a surplus of pent up demand to put stimulus to work-businesses operating at less than full capacity-that can quickly ramp back up to pre-fall 2008 levels if provided stimulus.

    This is not the case. Many, many businesses are dead, not just operating at limited capacity. Shut down. Plant, machinery, and equipment sold off. Buildings sold or foreclosed on. People permanently laid off. Forever gone. These businesses are not simply sitting around waiting patiently for the government to get its act together and stimulate them. They no longer exist. Nor, does the entrepreneurial appetite to “give it another go” abound.

    The washing machine factories no longer exist at all. There is nothing to stimulate. And, there is significant lead time and investment required to re-create the economic activity generating business infrastructure that could accept and perform with stimulus.

    The last U.S. state I lived in was in the Midwest, and the unemployment rate was well below the national average (7%)-it was one of the over performing states. But plants of nationally known companies that had operated for generations are forever closed, broken up, sold, dead. Multi-generational family businesses that expanded into new buildings as recently as 2008 have been shuttered, broken up, sold, dead. Small businesses disappeared, and commercial vacancies exploded. It would literally take decades to replace the business infrastructure that existed but 2 years ago.

    The failures of the TBTF reaction have killed the U.S. infrastructure. There is nothing to stimulate.

  24. “We need to move on as to how to remove the leaders we have and change the campaign laws so that the next elected set has not been bought like the current group. Until that happens, we won’t tame the financial system of the country, won’t reform health care, won’t cure our energy problem, won’t stop spending billions of dollars and thousands of lives on meaningless wars that can’t be won.”

    There will be no removing of leaders or changing of the campaign laws. We are too far gone for that. Kiss your vote goodbye, it has absolutely no meaning. Your democracy has been stolen from you and you will not recover it through parliamentary means. Only massive demonstrations and economy paralysing strikes offer any hope of change. The problem is not unlike the one faced by the Polish people in the 1980s and the solution likely will be found in methods similar to those employed there. Don’t expect the ruling clique to give up its power and the personal wealth that it has created for them without a struggle.

  25. Could someone explain me why there should be inflation in the economy? Isn’t deflation in normal times a sign of increasing productivity?

  26. The next wave of economic stimulus will focus on internal security- snooping, spying, private security, private weapons, a militia. Also, work camps, team sports, propaganda mills (education), gambling palaces. There is enormous growth potential in the Army, FBI, CIA. Ultimately, money will be free to everyone; they will give it away at the post office. It is the ration books that will be important, the reason everyone will carry a gun. Don’t worry about the banks; worry about locating meat and cheese!

  27. Watching this video on Andrew Sullivan’s site made me wonder if Tim Geithner ever sent this same type voice message to Lloyd Blankfein or Richard Parsons. Romantic background music for lovers.

  28. “The Obama administration argues that its regulatory reforms will rein in the financial sector in this regard.”

    There can be no regulatory reform of international banks without international agreement. Obtaining international agreement is a slippery slope in the best of times, and is subject to a changing political climate. For example, in the UK – the Conservative Party is predicted to win the next general election; the latest polls give them a double digit lead over the governing Labour Party. Should they win, they propose changes that would effectively dismantle the current UK regulatory system that was created in 1997.

    The US taxpayer should not have to depend on solutions which have built-in seeds of their own destruction.

  29. No worries. Focus on the end-run. Assuming that we have a “digital skunkworks,” we probably already have the ability to download our brains and live without all these conflicting needs, or at least we’re way ahead of the predicted singularity 20-30 years out. I just hope we’ll be able to simulate the taste of fatty tuna well.

    All the cool kids are thinking about it:

  30. What if a foreign power had control of your banking resources. I’ll take it a step further. What if a foreign power had control absolute control of your banking system for the last 300 years. Also what if your country and it’s leadership all just shook in their boots at the possibility of even exposing what’s REALLY going on. Oh you can international bank it to death.

    Please give me a break. People love being debt slaves. I guess it leads to much kinkiness. Thats all I can figure out. So don’t complain. Until people decide they really want to work for a living. Saving little by little Instead of borrowing huge amounts and paying back the borrowed, with 77 times the money, labor and energy not to mention free labor. Paying it back

    Why complain? No one actually wants to admit the stupid little game and who’s really calling the shots. So you know what. Why should I care. Drown it in technical terms that confuse. Jump in with the liars so you’ll all get confused. That just confuses everyone else to. Until someone comes out and gives the unvarnished truth it’s a waste of time

  31. I suggest you read more broadly then – beyond the Neo-Con hard-money fanatic Hayekian sites. Only a few very perceptive economists recognized the Fed’s excessively contractionary policies through October 2008…

    But the view has grown in credence, particularly since the TIPS yield (arguably, the best measure of _real_ interest rates we have) spiked to ~4% briefly during summer/fall 08, even as the Fed obsessed with headline inflation (the oil bubble/dollar run, vis a vis the Fed minutes from May 08 – as late as October 29 2008).

    Scott Sumner, a die-hard libertarian monetarist, has been loudly trying to get the world to look at the abundant evidence of the Fed’s hawkish behavior, and the global consequences (which, to be blunt, have caused incredible harm to the world’s poor).

    And, by the way, Baseline Scenario was one of the ONLY blogs to recognize the Fed’s weak monetary medicine in 2008 (even as the Fed conspired with Paulson to implement TARP to recapitalize banks).

    Also, I do not engage in drunk posting.

  32. Inflation and deflation both incur menu costs – that is, inefficiencies in coordination of economic activities due to irregularly changing prices. Neither is good.

    Long term, the justification for 2% inflation is that when the economy experiences a demand shock, the monetary authority can stimulate demand by expanding money (e.g. they are not at the zero bound).

    In the short term – regardless of whether you believe the menu costs argument more than the zero bound argument – the reason for _staying_ at 2% inflation is because many contracts have been set with that explicit expectation built in (which has been the official policy of central banks for at least 2 decades). Any sudden change from that trajectory creates a massive transfer of wealth (partly due to leverage, partly due to long term debt).

    A sufficiently large move off the trajectory creates such a big wealth transfer that it can cause massive disruption in the economy… banks going bankrupt, people losing houses and jobs, massive unemployment…

    …dogs and cats living together, mass hysteria!

  33. If the Federal Reserve was “obsessed” with inflation, they probably would have used the easiest tool available—the Discount Window or RAISED the federal funds rate. I don’t suppose any of your vast reading has told you the most recent time they raised that rate. Or that in your vast reading you have noticed how many times the Federal Reserve has lowered the rates versus the times they have raised them in the last, say 7 years.

    It is entertaining to see you dig your heels in deeper to this fascinating opinion though….

  34. “5) Even more problematic is the underlying incentive to take excessive risk n the financial sector.”

    New BIS study finds low interest rates cause an increase in risk-taking by banks.

    “Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk. Using a comprehensive dataset of listed
    banks, this paper finds that low interest rates over an extended period cause an increase in banks’ risk-taking.”

  35. As much as I agree with Professor Johnson’s analysis, I believe there are two important points missing; transparency and oversight.

    The FDIC requires transparency or else banks can lose their federal insurance backstop. There is no “off balance sheet” transactions or holdings. When larger non-bank entities use legal accounting methods to hide and distort the amount of risk they are taking on, regulation as described above is impossible.

    Somehow, over the course of the year, the role of the oversight agencies (Moody’s, Fitch, and Standard and Poor’s) in facilitating the sub-prime collapse has been completely forgotten. I’ve not heard of any proposal for how to guarantee their independence yet provide an income model that attracts the best and brightest. In the world of big finance, they are still lagging indicators (downgrading after announcing bankruptcy not before).

  36. If you want confirmation of Bernanke’s ineptness, you only need to watch this compliation of his incompetent (or was he just lying?) assessments:

  37. From my perspective (someone outside of DC and any Ivory Towers), this current post of Simon’s is excellent — at least in the observations and expressed sentiments.

    I’d have to give more thought to all the pieces of the proposed solution, but they are a good starting place.

    ~ ~ ~

    The goal of a Capitalistic Economy should be to create the best and most useful goods and services for the best price – i.e. to create value.

    While the profit-motive often impels the business person, and pushes some to strive towards monopoly, monopoly (duopoly, triopoly, etc.) undermine the competition needed to create value.

    Thus, a primary economic role of government MUST be to ENSURE COMPETITION in the marketplace (exclusive of functions, such as education, deemed essential for public policy reasons, which then become highly regulated, if not outrightly run by the government). This is just as true for banks as it is for coffee shops.

  38. I do not particularly care for pithy snark that lacks substance. Please put some thought into your posts. I suggest, at the very least, you read the Fed minutes:

    There are numerous references to headline inflation, dismissals of low core inflation, reliance on “survey based measures of inflation expectations” and deliberate dismissal of the implied real interest rate based on TIPS.

    For example, from August: “Although downside risks
    to growth remained, they appeared to have diminished
    somewhat, and the upside risks to inflation and inflation expectations increased.”

    This was right before the largest deflation in the post-war era. Given this, I’m not entirely sure what you are arguing.

    In your comment about the discount window, you are also failing to distinguish between the real interest rate and the nominal rate (one of the things that Milton Friedman – bless his soul – got right in his analysis of the Great Depression; OK, credit to Anna Schwartz too).

    With regard to the Fed’s long term easing (in combination with stable low inflation rates – the so-called Great Moderation), one has to question exactly how this represented a failure of the Fed’s narrow mandate since inflation-in-excess-of-2% did not occur during that period and employment remained high?

    I have argued elsewhere that this was not so much a failure of monetary policy per se, but a failure of trade and financial regulatory policy, and policies of excess consumption. In particular, the expanding international dollar reserves allowed the Fed to print money which was absorbed by foreign countries (in some cases, into their dollarized domestic economies). The chronically overvalued dollar obliterated the trade balance; in essence, we were exporting dollars (i.e. pledges to repay in goods/services in the future).

    Now that dollar flows are reversing due to accumulatd US debt and fears of partial monetization – the dollar is losing its sole reserve currency status – the Fed is doubly constrained. Necessary devaluation will cause inflation due to commodity push inflation (particularly as the world moves forward with the decoupling that was over-anticipated). US structural consumption and trade deficits will encourage this, with the US floating debt to support the overvalued dollar and consumption. Unemployment will be high, and low growth will create further debt due to tax revenue losses (which James Kwak and others have discussed in detail). It is a deadly trap, and there are two sides viciously arguing about the way out: the deflationistas, and the inflationistas.

    The deflationistas want to stabilize the dollar to keep imports cheap, and try to get the world to start buying up dollars again. Consider this the Reagan approach (check the debt and fiscal deficit levels in the 80s). The goal is to keep the strong-dollar-party going a little longer. (Heh, good luck… There’s no national bank buying that line of argument.) This may work for a while, but the end result is almost certainly very high debt and low employment/growth, with a net result of heavy inflation/default later down the road.

    The inflationistas are arguing for dollar depreciation, and a shift to living within our means – which means trade balance, debt reduction, lower consumption, and working harder (higher employment).

    I also suggest you read Scott Sumner’s entire discussion of nominal NGDP leveltargeting, as well as Woodford’s neo-Keynesian perspective. Two completely different perspectives (Chicago vs. Keynes), yet the same conclusion.

    I look forward to your thoughtful, well reasoned, and non-pithy reply.

  39. StatsGuy,
    So, you’re not going to answer my question of when the last time the Federal Reserve raised rates was??? Or answer the question how many times the Federal Reserve has raised rates versus lowered rates the last 7 years??? OK, how about the last 5 years??? It’s an easy gauge of the Fed board’s fear (or YOUR words “excessive obsession”) of inflation, since the Fed usually raises rates when they foresee a threat of inflation.

    As for putting thought into posts, I don’t think referencing Fed minutes from October 2008 which raise the topic of inflation as a basis for saying the Federal Reserve is “obsessed” with inflation, shows thought. I would say it shows ZERO thought on your part. I have news for you: Inflation is a topic at EVERY Federal Reserve (FOMC) meeting.

    And since you were too obtuse to figure out what I was arguing in my other post, I am arguing your statement that the Federal Reserve has been “excessively obsessed” with inflation during this recent recession which started in ’08.

  40. “…since the Fed usually raises rates when they foresee a threat of inflation.”

    The Fed can also choose not to lower rates, and/or to lower them less than required, due to inflation fears. If you consider the magnitude of the projected capacity underutilization in summer/fall 08, monetary policy was very tight. Going into early 2009, various estimates of Taylor Rate projections called for effective rates of between 0% and -6%, depending on which model was used.

    The fact that most of the pithy financial press complains that monetary policy was loose demonstrates a clear lack of understanding of the difference between Real and Nominal interest rates. The unfortunate thing is that the Fed _also_ suffered from money illusion during that time period.

    The Real/Nominal rate issue was the core insight of the Friedman/Schwartz analysis of the Great Depression. Again, the financial press of that era wrung their hands over the “loose” monetary policy which would inevitably lead to inflation.

    Yet, Deflation persisted for 4 years, until Roosevelt deliberately devalued the dollar and raised price levels – the rapidity of the recovery in 1933 was unbelievable. Yet, in 1937, they returned to their old ways, and the second phase of the Great Depression began.

    As to the Fed minutes, one can almost forgive them in June 09 (almost). I can’t bring myself to forgive them in August 09 (by then, the evidence was getting stronger). But October 29, 2008? With T-bill rates dropping to unbelievably low historical levels, the bond market projecting deflation, and the sky falling… US consumers were hunkering down, businesses were engaging in mass layoffs, banks were hoarding reserves… Yet the Fed still considered the threat of inflation too high to engage in further easing.

    Read the Hamilton piece on Econbrowser. He discusses in detail how the Fed very carefully sterilized their money injections for the first 3 months of the crisis.

  41. StatsGuy: ¨If you consider the magnitude of the projected capacity underutilization in summer/fall 08, monetary policy was very tight. Going into early 2009, various estimates of Taylor Rate projections called for effective rates of between 0% and -6%, depending on which model was used.¨

    Please note that Mr Taylor in an interview expressed his dismay about negative effective rates: his formula was abused.

    One of the errors is the capacity underutilization. Typically, one extrapolates GDP from before the recession, minus GDP we have now, and calls that ´cap. underutilization´. This leads to huge errors!!

    ´Thanks to´ the almost ZIRP of the FED, and the ´innovation´ MBS (lenders not doing due diligence as the problem of a borrower not being able to service the mortgage had been innovated away from the lenders, with rating agencies as co-conspirators) a lot of people used their house(s) as ATM´s and spent those HELOC´s away, thereby pumping GDP. We should correct GDP in this decade. If we do, then we find that there has hardly been GDP growth. Hence, the capacity underutilzation today is less dramatic than being published in many — not corrected — graphs.

  42. Carol –

    I read that interview, and it was quite good. That was why I cited numbers varying between 0% and -6%, with Taylor himself arguing for the 0% number. Even at the 0% number, that’s just barely where we are today – and it took the Fed several months to get there. That also presumes that Taylor’s original rule, which was backwards looking and highly empirical, is correct. Those with the negative numbers generally argue for using forecasts rather than current numbers, among other modifications.

    Your point about capacity underutilization and GDP measurement is well taken. The CBO currently puts the output gap at ~6%… But, on the other hand, unemployment is very real and quite measurable; 10% is the conservative estimate.

  43. in conjuction with Bernanke’s job application the following is relevant, in particular

    Three Strikes on Ben Bernanke: AIG, Goldman Sachs & BAC/TARP
    December 7, 2009

    The FRBNY not only used but abused the Fed’s power’s under Section 13(3) of the Federal Reserve Act. In AIG, the FRBNY under Tim Geithner invoked the “unusual and exigent” clause again and again, but there is a serious legal question whether the then-FRBNY President and the FRBNY’s board had the right to commit trillions without any due diligence process or deliberate, prior approval of the Fed Board in
    Washington, as required by law. The financial commitments to GS and other dealers regarding AIG were made always on a weekend with Geithner “negotiating” alone in New York, while Chairman Bernanke, Vice Chairman Donald Kohn and the rest of the BOG were sitting in DC without any real financial understanding of the substance of the transactions or the relationships between the people involved in the

  44. I am going the same direction in my thinking lately. We are back at square one: campaign finance. As a country, we talked about this a few years back and fundamentally got nowhere. Now that we have effectively merged New York and DC, the problem has grown infinitely large. I will no longer vote for a major party candidate at this point. I will vote, but my vote will be a write-in. The system is broken. Fundamentally broken systems can no longer be fixed. They require replacement. If we can pull this off without violence, this truly is the strongest society in the world. If violence erupts, it would be hard to argue we were “surprised”. The transfer of wealth has been going on for at least thirty years.

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