What The Senate Must Do Now

This guest post was contributed by Charles S. Gardner, a former senior official at the International Monetary Fund.  He argues we must not overlook the importance of extending effective regulation to the nonbank sector.

As Congressional action on financial industry reform shifts to the Senate from the bill passed recently by the House, the urgent need now is to fill the gaps in the piecemeal House approach.  Regulators require an airtight scheme giving them clear responsibility plus tools to nip industry abuses early and drain the tendency to crisis out of world finance.  This rare opportunity also must be seized to restore the Federal Reserve’s control of the money supply, eroded by decades of expanding credit creation by nonbanks.

So far, Congress has ignored this macro dimension of the reform challenge. Understandably, the House Financial Services Committee focused mainly on the high-profile villains of the financial crisis enraging constituents from coast to coast: obscene pay practices, secret but deadly derivatives trading, the murky role of hedge funds, boundless leveraging of assets, and heedless loan packaging that left the originators both rich and risk free.

The House bill deals separately with the welter of technical issues in each of these problem areas.  It falls to the Senate now to take a step back and make sure that the pieces add up to more, not less, than the sum of their parts. Each piece may give regulators new and essential information for monitoring and controlling an industry practice, but will the new information fuse into the comprehensive picture needed for intelligent, forward-looking regulation?    

For example, requiring open trading of derivatives will help regulators identify potentially risky credit creation outside the regulated banking industry.  But will that be enough to assure preemptive action? The Fed or another agency should have explicit authority to oversee and regulate any nonbank entity engaging in leveraging assets and creating credit.  Since at least the 1960s, unregulated nonbank activity has been an increasing source of credit creation, ultimately equaling or surpassing the volume under regulation. 

If nonbanks like AIG, GMAC and GE—and long before that LTCM—can  threaten the stability of world capital markets, the time has come to regulate them in advance de jure not wait for a crisis that brings them under regulation de facto because they need a bailout.

Last fall’s financial catastrophe made the prudential case for direct regulation of nonbanks.  The macroeconomic case built less noticeably for decades, steadily eroding Federal Reserve power to manage the monetary system.  A turning point came during the chairmanship of Paul Volcker when traditional monetary aggregates became so meaningless they were no longer a useful focus of Fed policy and it switched to targeting inflation directly.  In place of a solid advance indicator of price movements to guide policy, the Fed had to fall back on its skills at prediction to manage credit and the price level. 

As the Fed now confronts the tough timing challenge of heading off inflation without killing the recovery, wouldn’t it be in a stronger position with a comprehensive picture of the money supply? Or could it have ignored the rapid buildup leading to the mortgage market bubble had its data been more complete?

The steady weakening of the Fed’s real power to deliver noninflationary growth was accompanied by a greater reliance on the personality of its chairman to sustain its credibility.   As long as the economy was performing reasonably well and periodic crises were not too severe, the chairman could promote the illusion of a Federal Reserve in reasonable control.  The illusion shattered in 2004 when the Fed belatedly tried to raise interest rates only to see longer rates fall instead.  Puzzlement prevailed at the time but the conundrum was really evidence of how weakened Fed leverage had become.

Since the financial meltdown, a disillusioned public is now blaming the Fed for a failure to exert power it did not really have: the nonbanking sector operated outside the reach of both its prudential and monetary policy regulation.  The sad result is a backlash in Congress threatening to reduce the Fed’s power when it should be restored and enhanced.  It may be quixotic now to suggest that useful monetary aggregates could be reconstructed; but if they could, it would help rebuild the Fed’s stature on the basis of technical competence, and reduce its reliance on a cult of personality.  In the end, Congress may hand the tasks of consumer protection and bank oversight (and hopefully nonbank oversight as well) to other agencies, leaving the Fed with its core monetary policy responsibility.  Even with this outcome, Congress should temper its anger at the Fed with wisdom to equip it for its responsibilities.

The debate over curbing companies seen as “too big to fail” is likely to be pivotal in whether the Senate will strive for an effectively airtight regulatory regime.   To date, this debate has played more to public anger at banks than to regulatory substance.  Sheer size, after all, has been less a cause of the crisis than industry practices that are too complex, too opaque, and too unregulated.   If sheer size is a factor in anticompetitive behavior, antitrust criteria should be used to deal with it, not some arbitrary concept of “too big.”

Until recently, the “too big to fail” argument was justified.   It is an argument the public can understand. Its bumper sticker appeal was useful when it looked as if Congress was foot dragging, and the risk was real that public anger could dull and undermine the drive for reform.  Clearly, public anger is not going away.  Congress is moving quickly to send a huge reform package for the President’s signature early next year. 

Now, however, the risk is that the “too big to fail” argument will be an impediment to enacting comprehensive regulation.   In its simplicity, it is, after all, an admission that fully effective financial industry reform may be unachievable.  Can’t the rich financial firms always hire smarter, quicker lawyers, capable of defeating the best technical drafting and oversight that underpaid government bureaucrats can field?  This defeatism quickly leads to the idea that any legislative result is good enough if it produces sufficient punishment now for the arrogant financial industry, even if it will be evaded in the longer term.

Neither the U. S. public nor the financial industry will benefit from this flawed result.  The largest damage, however, is likely to be to international efforts to make the globalized financial system safer and more efficient at capital distribution.  Here, the United States has a special responsibility to get domestic regulation right because it will be in the forefront in fighting international controls and insisting on regulation confined to the national level.  A high level of transparency will be needed in each major national system for this approach to work, and it will be up to the United State to provide the model.

By Charles S. Gardner

46 responses to “What The Senate Must Do Now

  1. Lavrenti Beria

    “What The Senate Must Do Now”

    Dissolve itself in the interests of public sanitation.

  2. We used to build locomotives, now we build scams.

  3. “Can’t the rich financial firms always hire smarter, quicker lawyers, capable of defeating the best technical drafting and oversight that underpaid government bureaucrats can field?”

    Regulation has a long and proven history of failure; and it fails when you need it the most. There is no reason to suppose that more of it will solve the problem, and more than likely will simply give us a false sense of security, while allowing financiers to fleece the taxpayer.

  4. I don’t believe it is a coincidence that “bankers” prefer regulation to the reintroduction of “Glass-Steagall” like legislation.

  5. “Since the financial meltdown, a disillusioned public is now blaming the Fed for a failure to exert power it did not really have: the nonbanking sector operated outside the reach of both its prudential and monetary policy regulation. The sad result is a backlash in Congress threatening to reduce the Fed’s power when it should be restored and enhanced.”

    In theory central bank independence is a worthy concept. In practice it must be won by prudent action. Providing the liquidity for one bubble after another can hardly be considered prudent.

  6. Personally, I think the distinction between “regulation,” and breaking up TBTF institutions is a little belabored. I don’t see why we can’t have hard caps on the size of financial institutions, regulation requiring derivatives be traded on free and open exchanges (or laws banning derivatives and most other forms of securitization altogether if that is warranted), executive compensation reform, an updated Glass-Steagall like firewall between commercial and investment banking, a new resolution mechanism for TBTF banks that end up failing anyway, a CFPA, and any number of other reforms that warrant support all at the same time. Progressives in this country have a long and bitter history of internecine conflict that has often been detrimental to their overarching goals. Before we attack people for having different priorities on which financial reform issue is most important I think it is important to step back and take a moment to seriously consider whether or not the person we are attacking is for the most part on our side.

    With that in mind, toward the bottom of this article there is a good rundown of which Senators are working on which parts of financial reform:

    http://www.washingtonpost.com/wp-dyn/content/article/2009/12/24/AR2009122402795.html?wprss=rss_politics/congress

    For those of you who feel financial sector reform is important please take a moment to contact the Senator you feel is working on the most important issue and tell him or her what can be done to make reform more effective.

  7. “requiring open trading of derivatives will help regulators identify potentially risky credit creation outside the regulated banking industry.” Oh, really?

    Is that before or after all the exemptions grandfathered in?

  8. Politics. TBTF means too much political influence on gov’t. Gov’t makes the laws, and without a functioning *fair* legal system the US is just a large banana republic.

  9. For years, I believed I was cynical and extremely distrustful of the government. I was wrong. I have reached new depths. There will be watered down efforts passed after long, long meaningless debates while maximum amounts of money are funneled to congressional members. This is not and, frankly, never has been about getting anything done. It’s about flim-flamming the public with smoke and mirrors. Presenting bills with hundreds upon hundreds of pages that no one reads or understands is the real focus. We may think we have a democracy but we don’t. The average American is far too interested in video games and the scores of one sporting event or another to bother paying the slightest attention to what is going on. It’s all magic!! Keep them diverted while the real show goes on.

  10. Thank you NKlein1553.

    There is a political imperative here for all incumbents. They must craft a new regulatory regimen that works. Every incumbent in Congress understands the immediate electoral need to put a new control regimen in place. The same imperative holds for the administration. Every politician inside the beltway was shaken to their political roots since Labor Day 2008. They all understand, some better than others, that a new crisis could erupt at any time . Thus, they must provide a frame work that conveys that they, as incumbents understand the national risks to the American State. They must craft something that works because a repeat of 2008-2009 on top of existing damage would topple not only the economy but the political system. Right now the bought dogs can no longer afford to be bought unless they are political fools. The elected politicals require a regimen in place before the election season to survive incumbency. That overrides being bought off. Of course, the stupid politicals might now see it that way. The big question is how many incumbents cannot smell survival time?

  11. What would happen if we don’t wait for government to do it’s job, but instead regulate ourselves?

    Pay off your debt, create a budget and stick to it.
    Don’t spend more than you earn. Search for smarter sales.
    Help out the unemployed family member or friend, cook meals for each other. A home cooked dinner doesn’t need to cost much more than $2-$2.50 per person. And family time is priceless.

  12. Nostalgianomics!

  13. Wake up. Fiat money has never ended well. End the Fed. People who make regulations are not smarter than markets.

  14. RESIGN; IMMEDIATELY!

  15. “laws banning derivatives and most other forms of securitization altogether if that is warranted”

    Hopefully not!

    There are thousands of valid and useful uses of derivatives: airlines buying call options on oil to protect themselves from the risk of increases in oil prices, import companies buying foreign currency forward for the date they will have to pay for something, so they know exactly how much it will cost in their home currency, companies using interest rate swaps to trade some of their variable rate interest for fixed rate interest. Even a farmer in the Hindu Kush harvesting his wheat but agreeing with a local trader to sell it in three months time at a fixed price is using a derivative.

    Banning securitized products is also, I think, un-needed. All it is is making an asset where before there was only a stream of payments. Creating a deed to a natural resource that allows someone to exploit it is not much different from creating a bond that allows someone to collect the payments from a bunch of mortgages. Basically you are turning income into capital, and this can be valuable (e.g. when a football club that can’t get a bank loan securitizes its ticket revenue).

    Neither derivatives or securitization are intrinsically harmful and both have important uses. The trick is to identify which practices or specific instances are too dangerous. Although that is much easier said than done.

  16. Mr.Gardner has got it right when he says we the U.S. need to be a model, It’s a very turbulent world economy. Also,regulating leverage isn’t rocket science. Also scams like sub prime don’t require a staff of Einsteins to monitor.

    If we fail to come up with better rules, we shouldn’t be telling the world how to run their economies, which is what we do on many levels.

  17. We need regulation of non-bank related, finance-related entities, no question. But, the regulation needs to have both positive and negative teeth. It must establish baselines for the regulators as well as those regulated, with substantial sticks, both civil and criminal, for all, and with substantial carrots for the regulators. I mean real rewards for bringing violators to justice. This must be hard nosed, and the language should not be either too tight, or too loose. Give them lots of rope and then hang them on it.

    It won’t be easy, and Congress is not allied with the interests of their taxpayer constituents, but rather with the money. It may well be that we get a new and more reform minded Congress after the 2010 elections, that is, if voters care enough, and there are enough candidates with real reform in mind to run for office. Lots of those now on the Hill will be in trouble, in both parties. Time for strong independents to get busy.

  18. then make them transparent. If there is nothing wrong with them, a little daylight shouldn’t be a problem.

  19. Make no mistake: someone reads the bills. The special interests that write them, for example, surely do…

  20. I’m actually quite sympathetic to what anonymous writes here, which is why I tried to “hedge,” my little statement about banning most forms of securitization by putting it in a parenthetical aside. In theory the kind of 1970’s style securitization anonymous describes can be quite advantageous to society. But in practice I think Redleg gets it right here. Over the past fifteen to twenty years or so it’s quite clear to me at least that the primary purpose of derivative trading has been to amplify short term profit by creating obscene amounts of leverage. Until recently few of the so-called experts really understood just how much risk these policies created. Anonymous is correct, judging tail-end risk is much easier said than done.

  21. I’m not aware of any modern examples of a nation deciding to go back on the gold standard or some other similar monetary scheme. So technically I don’t think your statement about fiat money never “ending well,” is accurate; fiat money has never really ended (at least in modern times). Going back through history one can see several examples of fiat money systems “ending,” but not necessarily with results that support a return to the gold standard. For example, the Currency Act of 1763 banning colonial scrip in the thirteen colonies was one of the major contributing factors to the American Revolutionary War. Many, but not all, of our founding fathers liked fiat money so much they were willing to start a revolution to preserve their control over the money supply (the notable exception being the ever big-business friendly Alexander Hamilton).

    On the other hand, I can think of several examples of monetary systems based on the gold standard “not ending well,” the Great Depression being the most obvious one. No offense intended, but your claim that “fiat money has never ended well,” is a bit nebulous. I think you’re going to have to do a little more to specify what you mean by “ending well,” if you want to have a meaningful discussion about the pros and cons of fiat money systems.

  22. “Now, however, the risk is that the “too big to fail” argument will be an impediment to enacting comprehensive regulation. In its simplicity, it is, after all, an admission that fully effective financial industry reform may be unachievable.”

    Reform of what kind? Is simplicity not a virtue in regulation? Size limits are part of robust organic systems. In the brain, neurons are connected to at most around 1,000 other neurons. That may seem like a lot, but there are billions of neurons. Each neuron in the brain is limited in size and connectivity. Brains work. They can still break down, but limits help make them successful. What do we call unrestrained growth in the body? Cancer.

    The regulations following the Great Depression may not have been perfect, but they gave us 50 years of stability, and probably would have given us more if they had not been dismantled. So now why not aim at 100 years? What regulations will provide 100 years of financial stability? Do we really think that complex microregulation will do the job? Back to the brain. Electrical interference between neurons is not good. (Think multiple sclerosis.) Was the answer to alter the intracellular workings of individual neurons? No, it was to wrap them in insulation (glial cells). Or consider curves on the highway. Today it might be possible to use on-board computers to adjust the speed of cars on curves for safety. But we already have a simple, effective solution: bank the curves.

    “Can’t the rich financial firms always hire smarter, quicker lawyers, capable of defeating the best technical drafting and oversight that underpaid government bureaucrats can field? This defeatism quickly leads to the idea that any legislative result is good enough if it produces sufficient punishment now for the arrogant financial industry, even if it will be evaded in the longer term.”

    Regulatory capture is a regular topic here, and is defeatist or triumphalist, depending upon one’s views. There is a general belief, based upon evidence, that it is inevitable. That is why the question, what kind of regulation, is important. For there is also a general belief, based upon even more evidence, that it is good to be a nation of laws. These two beliefs are in obvious conflict. If the law, despite its imperfections, is good, and regulation, which is part of the law, is ineffective, what is wrong with regulation? Simply passing another bill does not address that question.

  23. interesting article on the performance of gold versus oil in 2009 and factors affecting this relationship in 2010: http://www.goldalert.com/stories/Gold-Price-Versus-Oil-Will-Gold-Outperform-in-2010

  24. “The big question is how many incumbents cannot smell survival time?”

    I’m gonna go out on a limb here and say,”all of them”

  25. Fiat money is a lie anyway. You lie about how much each piece of paper works. Why not just create the money against nothing and stop paying interest to private banks for money creation? I’ve never quite “gotten” that part of the process. If you’re gonna make believe your paper is worth something, go all the way with it.

  26. Fiat money is now universal. Every state but Andorra and Monaco use central banking. Besides, substantially all of what constitutes money is banking and shadow system demand and time deposits. In a very practical sense money supply also includes state debt and corporate bearer bonds as used to be the case in the US before the 1970’s. The cessation of bearer debt created the need for Repo’s.

    What functions as money today is ultimately dependent on human promises to pay. Literally every asset behind a demand or time deposit is an account receivable asset of the bank or fund where money supply is stored.

    As of last week, the total outstanding Federal Reserve Notes were $1.082 trillion. Much of this total is permanently outside the US. Another reducer is the money in retailer imprest cash systems and in bank vaults.

    We are not China where almost no one has a personal demand deposit account. How much of your actual receipts and payouts are transacted literally in currency? Much of what is transacted in currency winds up being a demand deposit because the currency holder must buy Money Orders to pay major obligations. Thus currency is reduced to almost pocket change status for most people.

    Fiat systems are here to stay. If fiat systems reverted to circulating specie there would be population collapse. Credit would revert to levels not seen in centuries. It would , of necessity, be a crime to hoard specie. Specie reduced economic activity to simplistic bargaining. No highly technical society would be possible without a banking system.

    Ninety percent or better of what functions as “cash or equivalent” in the US is not currency depending on your definition of money supply. There would be far less currency if specie were substituted. There is probably less than $2,000 per capita currency actually circulating in the United States. That would include what is the mattress and not cirulating. Economies are literally a function of circulating money.

    Fixing the banking/finance system is literally a survival issue for most of the world. The US financial system is very sick and it’s collapse would collapse the bulk of the world systems. That seems self evident. What is not evident is what level of collapse would occur.

  27. In theory, you may be right. In practice, you get tax evasion, regulatory arbitrage, accounting fraud, leveraged gambling, phony profits exacted as obscene bonuses and gigantic losses ultimately socialized. Prostitution, pornography and epidenmic disease are not reasons to outlaw sex; nor is reproduction a reason to ignore the social consequences of promiscuous sex.

    Every defense of derivatives I have ever read says the same thing about the social value of unobjectionable plain vanilla transactions which are not the problem. Let’s hear the defense of synthetic CDOs and leveraged OTC products that nobody understands until they explode.

  28. One issue which I have been haranguing about recently is Clearinghouses vs. Registered exchanges for credit default swaps and other derivatives. I am hoping James Kwak will put his keen mind to this with his thoughts in at least 2 posts for early 2010.

    Derivatives dealers and finance industry lobbyists will try to convince people (Phil Gramm style rhetoric) that Clearinghouses are good enough, which they clearly are NOT. We need REGISTERED EXCHANGES for credit default swaps and derivatives so we can at least monitor the amount of this systemically threatening paper “out there”.

  29. Of course I have stated many times credit default swaps should be illegal. CDS should be 100% outlawed. But as long as guys like Rahm Emanuel are taking $320,000 from institutions like Freddie Mac to keep quiet and not rock the boat, I have to take what I can get.

  30. In my non-expert opinion from Main Street … a very competent opinion from Gardner.

  31. If anyone cares to research our buddy Rahm Emanuel’s short time of employment at Freddie Mac, please feel free to read this Chicago Tribune article. http://www.chicagotribune.com/news/politics/obama/chi-rahm-emanuel-profit-26-mar26,0,5682373.story

  32. JerryJ, I always find your comments worthy of attention among the many thoughtful posters on this blog. :)

  33. Well, thank you, Tippy. The feeling is mutual. :)

    And best wishes for the New Year. :)

  34. Ted K, you are definitely in competition for the Grand Heresiarch of the Shrill Award and shamelessly so. James Kwak already has already won this honour :) Take care.

  35. Derivatives ought to be banned, or reduced, controlled, etc. for NON COMMERCIAL operators. (Airlines and farmers ARE commercial operators.)

    When NOT used as insurance, derivatives are a parallel universe, they suck world capital away from socially and economically useful activities. Not just capital, actually, but MOST capital. Details galore on my site.

    Patrice Ayme
    http://patriceayme.wordpress.com/

  36. Perfectly said!

  37. This is my clarion call to Mr. Johnson, Mr. Kwok et al.
    It is time to step up!
    Time to stop taking seriously these ridiculous arguments like how to regulate for “too big-to-fail”.
    Time to loudly, publicly, and consistently advocate for the return of Glass-Steagal.
    Time to loudly, publicly and consistently advocate for the indefinite extension of unemployment benefits!
    It’s time to take a stand.
    Time to act more like Robert Skidelsky and less like Paul Krugman.
    Time to bury the Anglo-American model of capitalism once and for all.
    Time to develop a social-democratic movement in America!
    A new New Deal!

    You know what to do!

    Carthago delenda est!

  38. Well, just like Mr. Kwak, I will take that as a compliment. A couple times I have posted here after having alcoholic beverages and probably went over the line. But I stand proudly behind 99.8% of my posts. And I dare say I won’t regret them as the years go on.

    By the way, on a completely unrelated side note. I saw a quote today on Angry Bear blog, and I want to steal that quote verbatim to illustrate a point to all those giving Bernanke hell on monetary policy in recent weeks. Frankly, many people have totally missed the boat on when and where the Fed made it’s mistakes. Most of the mistakes were made BEFORE the crisis. And most of the mistakes were with lack of regulatory enforcement, NOT with monetary policy. And if there were mistakes with monetary policy, it was credit was TOO EASY for many years before the crisis. So most of the Federal Reserve’s blunders were due to lack of regulatory enforcement.

    And in closing, I would like to say to “StatsGuy” and others with his same line of thinking on Fed monetary policy, this quote (swiped from Angry Bear blog on an unrelated topic) sums it up perfectly in relation to Bernanke and Federal Reserve monetary policy:

    “If you truly believe that peeing in the gas tank is going to improve your mileage, sooner or later you’re going to end up broken down on the side of the road.”

  39. “..wouldn’t it be in a stronger position with a comprehensive picture of the money supply? Or could it have ignored the rapid buildup leading to the mortgage market bubble had its data been more complete?”

    “Congress should temper its anger at the Fed with wisdom to equip it for its responsibilities.

    “The Fed or another agency should have explicit authority to oversee and regulate any non bank entity
    engaging in leveraging assets and creating credit.”

    “Since the financial meltdown, a disillusioned public is now blaming the Fed for a failure to exert power it did not really have: the non banking sector operated outside the reach of both its prudential and monetary policy regulation.”

    The common theme running through these comments is that if only Congress had allowed the Fed to gather additional information ,and gave the Fed more power , they could have have met their responsibility to ensure the stability of the financial system and thereby avoid the financial crisis.

    First, if a CEO of a private company surprised the corporate board with the news that the company was about to suffer a financial disaster, due primarily to events beyond his control, the CEO would be summarily dismissed.

    Second, the Fed recognized that derivatives dispersed risk throughout the non banking sector making the financial system more difficult to control, but that gaining additional information from the non banking sector would not likely be useful, and might make the financial system more risky.

    From Fed Vice-Chair Kohn Speech ,May 16 2007:

    The growth of derivative “products with substantial embedded leverage has made it more difficult to assess the degree of leverage of individual institutions or of the financial system as a whole.”  The dispersion of risks beyond the banking sector “requires us to live with less control and less knowledge than we had when banks were dominant   ”  The  uncertainty of where risks are lodged has increased.  “Gathering additional information about the risk profiles of currently less regulated institutions is unlikely to yield insights that can be acted upon and may create a false sense of comfort among market participants, which could make the system substantially more risky. “

    http://www.federalreserve.gov/newsevents/speech/kohn20070516a.htm

    Third, by law the Fed is charged with the responsibility for promoting economic growth and financial stability. The Fed has long recognized that financial stability is a precondition for economic growth. Leading up to the current financial crisis, the Fed failed in its primary area of expertise – macro analysis; it failed to identify, monitor, and recommend solutions for the macro and system wide imbalances arising in the financial system. To the contrary, Bernanke ,in congressional testimony and public statements ,downplayed the significance of problems related to derivatives, the housing bubble, and capital adequacy of the banking system. The idea – that the Fed cannot do its job unless Congress tells them how to do it – is absurd.

    In the micro prudential area, the Fed failed to use its regulatory power. In the face of rising home prices and risky mortgage underwriting, the Fed failed to act. The Fed chose not to use its rule-making authority over mortgages to arrest risky lending and underwriting practices. Although numerous statutes such as TILA, HOEPA, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act, and the Home Mortgage Disclosure Act gave the Fed the authority to act, nothing was done.

  40. Ted K,

    As someone who is more or less is of the same mind as StatsGuy when it comes to monetary policy let me try to take a shot at responding to the Angry Bear quote you posted above. But before I do that let me first say happy holidays. I wish you and your family all the best in the New Year.

    First, let’s try to establish some facts everyone can agree on. Between roughly Labor Day, 2008 and late March/early April, 2009 GDP growth in the United States collapsed, declining at an annualized rate of somewhere between 6-9% depending on when you measured it. In response to this collapse the Fed reduced the federal funds rate to around 0% in a largely failed attempt to prop up aggregate demand. So far nothing I’ve said should be controversial. These are facts. Now comes the hard part, interpreting the facts.

    One of Scott Sumner’s most interesting talking points is that there really isn’t much agreement among economists about what constitutes “tight,” as opposed to “easy,” money. For example, during the interwar period in Weimar Germany nominal interest rates remained quite high, but still Germany experienced a bout of severe, even hyper-inflation. Can we then call monetary policy during the Weimar Republic “tight?” Obviously not. Since “I know it when I see it,” isn’t really a good basis to analyze monetary policy decisions economists tend to rely on measurements that try to capture fluctuations in the “real interest rate.” Probably the best such metric is the yield on Treasury Inflation Indexed Securities (TIPS).

    Since the real interest rate = the nominal interest rate – inflation, real interest rates remained high throughout late 2008 and early 2009 (0% nominal interest rate – [-6% inflation] = +6% real interest rate). This is Scott Sumner’s point, and while it was quite controversial at first, over the past several months it has largely moved into the mainstream of macro-economic/monetary policy analysis. The success of Sumner’s rather counter-intuitive view that monetary policy at the height of last year’s financial panic was too tight rests on this graph:

    http://research.stlouisfed.org/fred2/series/DFII5?cid=115

    Looking at this graph we can see that real interest rates on five year TIPS rose from 0.57% in mid-July 2008 to 4.24% in late November 2008. If real interest rates are the appropriate indicator of the stance of monetary policy, then this four month period was one of the most sudden and aggressive examples of monetary policy tightening in all of recorded history. If you’re going to argue money was too easy at the height of the financial panic you’re going to have to come up with a plausible interpretation for the spike in interest rates depicted in the graph above. The inability of most economists to do this is what has caused Sumner’s star to rise so rapidly. And when you think about it, Sumner’s point really does make sense. A 0% return on the money you have tucked away in your savings account not may seem like a lot, but compared to losing 15% in the stock market it seems positively bullish. As Melville pointed out almost two-hundred years ago: “there is no quality in this world that is not what it is merely by contrast. Nothing exists in itself. If you flatter yourself that you are all over comfortable, and have been so a long time, then you cannot be said to be comfortable anymore.” In short, a 0% nominal interest rate in a deflationary environment is not easy money.

  41. *Breaking my comment up into two parts

    For more on the deflationary measures the Fed has taken over the course of the financial panic see this post over at Econbrowser:

    http://www.econbrowser.com/archives/2008/10/the_federal_res.html

    What James Hamilton is saying here is that much of the money the Fed has injected into the economy hasn’t really made it into the real economy yet, and probably never will. It’s mostly just accounting tricks to re-capitalize the banks in the hope they will eventually start to lend out money. Brad DeLong appropriately calls what the Fed has been doing “credit easing,” as opposed to quantitative easing. Basically it’s the drop money out of helicopters metaphor, but instead of landing in a public space where it would presumably help the economy, it’s falling in bankers’ backyards. What’s worse is the Fed is actually paying big banks interest to sit on these loans:

    http://www.federalreserve.gov/newsevents/press/monetary/20081022a.htm

    Moreover, the Fed has also pretty strongly indicated that it will suck all this money out of the economy by either raising interest rates, selling bonds, or calling in its loans at even the slightest hint of inflationary pressure. So in conclusion, I don’t think you can accurately say an expansionary monetary policy has been implemented. I think StatsGuy’s point isn’t so much that monetary policy is necessarily superior to fiscal policy (which I suspect is what you would prefer. Somehow I don’t picture you as a liquidationist/recalculation theory kind of guy), only that monetary policy hasn’t really been tried. Personally, I tend to agree with Marc Thoma that it is best to try and take the middle ground by using both monetary and fiscal policy tools. I don’t think StatsGuy disagrees with this. The world is a complex place. It’s best to keep your mind open and be willing to change your views in response to changing conditions.

  42. Mark Thoma has a great new post about the choice between monetary and fiscal policy over at CBS Money Watch. Certainly better than anything I’ve written here:

    http://moneywatch.bnet.com/economic-news/blog/maximum-utility/will-economists-ever-learn/366/

  43. I enjoyed the article, and consider it to be well conceived and appropriate, but it is spitting into the gale.

    Take the non-transparent derivatives non-market. The great advantage to transparency (and the reason why it is so steadfastly opposed by those in that market) is that it would actually successfully price those now toxic assets, thereby essentially making accounting for their value a non-accounting influenced fact. No longer could those who hold them make claims at values which fly in the face of reality, because reality will be the market place. Of course those in the derivitives markets could always scam us with bogus trades under some unspoken treaty, but that wouldn’t really hold up. If derivitive markets became transparent and regulated, it might actually, substantially limit the numbers generated to hedge gambling, thereby crippling the Vegas mentality on Wall Street.

    All this having been said is exactly the reason why this market will not be effectively transparent or regulated. The TBTF’s and their conspiratorial hedge funds and non-financial partners won’t let it happen, and they have already paid for the results.

  44. Charles S. Gardner

    Thanks, Bayard, for your comment. I too fear that industry pressure will make full-scale regulation of nonbank financial activity too much of a hot potato for the Senate. The Treasury Department’s initial regulatory reforms proposed this (www.financialstability.gov/docs/regs/FinalReport_web.pdf) and it got a strong endorsement from the IMF staff in the Selected Issues section of its July 13 report on the U.S. economy (www.imf.org). The issue is still on the agenda of the Group of 20 in its efforts to coordiante international reform efforts (www.g20.org); it publishes a handy check list of reform agenda items at each of its meetings, but this item is notable short of accomplishments, compared with most other goals. As in the House bill, the emphasis has shifted to exit strategies for failed firms and away from a regulatory scheme that would make failures less likely.

    You can hardly exaggerate the importance of the link between the Federal Reserve’s macro management and its responsibility for financial stability. The recent Warwick Commission Report (www2.warwick.ac.uk) argues that without cross company and industry knowledge of who owes what to whom and when, central bankers are limited in their ability to lean against booms or busts. Garry Schinasi of the IMF staff emphasizes the importance of the macro- and micro- connections in his paper “More than one step to Financial Stability” (garry.schinasi@bruegel.org).

  45. george wilson

    My father rightly kept telling me as I was growing up, “If Roosevelt did nothing else, he showed us what a bunch of damn fools bankers are.”

    He would approve of Charlie’s lucid and instructive piece on what the Senate should do now. Congrats to him. George Wilson