Paper of the Year

As bankers’ pay, at least for the fortunate ones at Goldman and JPMorgan, returns to pre-crisis heights, a paper by Thomas Philippon and Ariell Reshef is becoming everyone’s favorite citation. The paper, “Wages and Human Capital in the U.S. Financial Industry: 1909-2006,” got a first wave of attention from Paul Krugman, Martin Wolf, and Gillian Tett back in April (see Philippon’s web page for links). It’s also the subject of Justin Fox’s column in Time; see Fox’s blog for links to other discussions. (I also cited the paper in my ramblings provoked by Calvin Trillin.) The earlier references were mainly for Philippon and Reshef’s finding that pay in the financial sector correlated strongly and negatively with the degree of regulation — pay was higher in both the 1920 and in the post-1980 period, and lower under the stricter regulatory system created during the Great Depression. More recent references, including Fox’s column, have focused on the idea that people in finance are overpaid.

Since most articles have just focused on the headlines, I’m sure Philippon and Reshef are going to be misquoted all over the Internet. For example, at least two articles focus on a figure of “30% to 50% of financial-sector pay” in ways that are not quite correct. So I’ll try to lay out what they actually say.

Continue reading “Paper of the Year” →

Baseline Scenario, October 30, 2009

Yesterday morning I testified to a Joint Economic Committee of Congress hearing (update: that link may be fragile; here’s the JEC general page).  The session discussed the latest GDP numbers, the impact of the fiscal stimulus earlier this year, and whether we need further fiscal expansion of any kind.

I argued that a global recovery is underway and in the rest of the world will likely be stronger than the current official or private consensus forecast, but growth remains fragile in the United States because of problems in our financial sector.  While our situation today is quite different in key regards from that of Japan in the 1990s, the Japanese experience strongly suggests that fiscal stimulus is not an effective substitute for confronting financial sector problems head on (e.g., lack of capital, distorted incentives, skewed power structure). 

We are well into the adjustment process needed to bring us back to living within our means. Although such a process always involves an initial fall in real incomes, growth can resume quickly as the real exchange depreciates.  The idea that we necessarily are in a “new  normal” scenario with lower productivity growth seems far fetched, but continuing failure to deal effectively with the “too big to fail” banking syndrome delays and distorts our adjustment process – it also makes us horribly vulnerable to further collapses.

The fiscal stimulus enacted in early 2009 had a major positive impact, particularly as it was coordinated with other industrial countries – this prevented the global recession from being even deeper (disclosure: I testified to the need for a major fiscal stimulus in October 2008).  But a further broad stimulus at this time is not warranted and the first-time homebuyers tax credit should be phased out.  We should extend unemployment insurance and focus our future efforts on improving the skills of people with less education, e.g., through strengthening community colleges. 

Like all industrialized countries, we also need to look ahead to “fiscal consolidation” in order to stabilize our debt-GDP levels (and pay for the rising cost of Medicare).  The large contingent government liabilities implied by the existence – and potential collapse – of big banks are a major risk to medium-term outcomes.

My written testimony (with some small updates indicated) is below (pdf version).  This is now our revised Baseline Scenario. Continue reading “Baseline Scenario, October 30, 2009” →

Does Ben Bernanke Have The Facts Right On Banking?

Ben Bernanke, chairman of the Federal Reserve, has stayed carefully on the sidelines while a major argument has broken out among and around senior policymaking circles: Should our biggest banks be broken up, or can they be safely re-regulated into permanently good behavior? (See the recent competing answers from WSJ, FT, and the New Republic).

But the issues are too pressing and the stakes are too high for key economic policymakers to remain silent or not have an opinion.  On Cape Cod last Friday, Mr. Bernanke appeared to lean towards the banking industry status quo, arguing that regulation would allow us to keep the benefits of large complex financial institutions. Continue reading “Does Ben Bernanke Have The Facts Right On Banking?” →

Naming Systemically Dangerous Firms

This guest post was submitted by David Moss, professor at Harvard Business School, author of When All Else Fails: Government As The Ultimate Risk Manager, and founder of the Tobin Project.

 As currently drafted, the Financial Stability Improvement Act of 2009 (released by the House Financial Services Committee on 10/27/09) contains several important elements for reducing systemic risk.  It aims (1) to identify systemically dangerous financial firms, (2) to apply heightened regulation to these firms, (3) to establish a stabilization system to prevent or quell panic during periods of systemic distress, and (4) to create a resolution mechanism that would wind down complex financial firms when necessary.  These could represent very important steps forward.

Unfortunately, these reforms may ultimately be undermined by one very significant weakness – the explicit requirement in the bill that the identification of systemically dangerous financial firms by federal regulators remain entirely secret, and never be revealed to the public.  This is the bill’s Achilles heel.  Continue reading “Naming Systemically Dangerous Firms” →

How Big?

You hear a lot these days that banks need to be big to serve their clients. Charles Calomiris said this morning that we can’t run the global economy with “mom-and-pop banks.” Sure, I’m willing to concede that. But how that’s a silly debating tactic. More seriously, how big do they need to be?

Yves Smith, no friend of the mega-banks, says, “The elephant in the room is derivatives. The big players have massive OTC derivatives exposures. You need a really big balance sheet to provide OTC derivatives cost effectively.”

How big?

Continue reading “How Big?” →

Paging Jamie Dimon

Surprise, surprise — GMAC needs more money. As you may recall, GMAC was the one institution that got a C- on the stress tests this spring that were impossible to fail. I imagine the analysts at the Fed really wanted to give it an F, but they couldn’t. In any case, it seems that GMAC is too big to fail, because of its importance to the auto industry. Yves Smith says, “The reason for more dough to GMAC is so GM and Chrysler can continue to finance auto purchases, not as a result of greater than expected losses on its existing portfolio. So this is cash for clunkers under another brand name.”

Again, not surprisingly, the government is treating the 50% ownership threshold as some sort of magic line. From the Times article:

“With all three helpings of federal aid, it is possible that the government could wind up owning at least half of the company. But GMAC and Treasury officials are discussing ways to structure the investment in a way that could limit the government’s ownership interests. One possible option would be to also ask some of its private preferred stockholders to convert their investments into common stock.”

Continue reading “Paging Jamie Dimon” →

Homebuyer Tax Credit Update

Calculated Risk says there is a deal (bullet points are from his post):

  • Income eligibility for first-time home buyers stays at $75,000 for individuals, and $150,000 for couples.
  • For move-up buyers, income eligibility is $125,000 for individuals and $250,000 for couples.
  • There is a minimum 5 year residency requirement – in their current home – for move-up home buyers.
  • The tax credit is the lesser of $7,290 or 10% of the purchase price.
  • The credit runs from Dec. 1, 2009 to April 30, 2010, with an additional 60 day period to close escrow. (So end of April to sign contract, end of June to close escrow)
  • Expect bill to be signed by Friday, packaged with the unemployment benefit extension.

So my wife and I fit under the $250,000 couples limit. We’ve lived in our house for eight years. So now the government is willing to give me $7,000 to buy a new house? That would be a sale that wouldn’t have happened otherwise — but what good would it do the economy?

As I tried to explain previously, an $8,000 credit for first-time homebuyers will raise prices by less than $8,000 (leaving aside the effect of leverage for simplicity), because demand at any price point only goes up for first-time homebuyers, not all homebuyers. That means that the buyer gets a fair chunk of the subsidy. But vastly expanding eligibility like this (about 67% of households own houses, and probably about half of them have been in the same house for five years) increases the amount by which prices will go up, which lowers the buyer’s share of the subsidy and increases the seller’s share.

By James Kwak

More Too Big to Fail

Simon and Charles Calomiris were quoted on NPR this morning on the topic of the day — too big to fail.

I thought one of Calomiris’s examples was interesting. He cited Mexico, where banking was dominated by six families that wouldn’t lend to potential competitors. After the Mexican financial crisis and the entry of foreign banks, now it is easier for companies to raise money. It seems to me that story could be used by either side.

By James Kwak

Tax Credits, Screwdrivers, and Supply and Demand Curves

Our Washington Post online column today is another cry in the wilderness against the homebuyer tax credit.

There are many arguments against the tax credit. One argument we make is that the tax credit is a benefit for sellers of houses more than for buyers of houses. This is simplest to see if you imagine  a permanent credit available for all buyers: “Imagine the credit were expanded to all home buyers and made permanent. This would simply boost housing prices at the low end of the market by close to $8,000, since all buyers would be willing to pay $8,000 more. (Prices would rise by a little less than $8,000 because at higher prices, more people would be willing to sell.)”

It turns out Nemo had made a similar argument already.

Continue reading “Tax Credits, Screwdrivers, and Supply and Demand Curves” →

Bank Switching Costs

One of the Free Exchange bloggers (some people know who is who by name, but I don’t — if anyone wants to enlighten me, I’m listening) admits choosing his bank because it was big, and staying there because it is big. He also links to James Surowiecki, who asks in the “notes” to his latest column,

“[W]hy, given the broader backlash against the big banks and the less-than-inspiring performance they’ve turned in over the last couple of years, are people still sticking with them? What makes this even more curious is that the big banks, which have historically offered their customers worse deals than smaller banks, have not changed their ways: they pay less for deposits, charge more for loans, make billions from overdraft fees, and have jacked up credit-card rates.”

Continue reading “Bank Switching Costs” →

Are Big Banks Better?

Last week, Charles Calomiris wrote an op-ed in the Wall Street Journal arguing that big banks are better for various reasons. Simon wrote last week saying that Calomiris underestimated the political dimension, and that his proposed solution — a cross-border resolution mechanism for large institutions — is the policy equivalent of assuming a can opener.

I wanted to look at Calomiris’s specific claims. I think I’ve already dealt with the myth that banks “need to be large to operate on a global scale—and they need to do so because their clients are large and operate globally.” Calomiris also argues that there are economies of scope (it’s better to be big because you can play in multiple businesses). Here’s his evidence:

“True, some empirical studies in the field of finance have failed to find big gains from mergers. But those studies measured gains to banks only, and measured only the performance improvements of recently consolidated institutions against other institutions, many of which had improved their performance due to previous consolidation.

“Yet even unconsolidated banks have improved their performance under the pressure of increased competition following the removal of branching restrictions, which permitted the consolidation wave in banking. And when an entire industry is involved in a protracted consolidation wave, the best indicator of the gains from consolidation is the performance of the industry as a whole. One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.”

Continue reading “Are Big Banks Better?” →

Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors

This guest post was submitted by Peter Fox-Penner, a leading expert on regulation at The Brattle Group.  The views expressed here are those of the author alone.

Improving the regulation of the financial sector is a prime topic of conversation amongst financial economists, and appropriately so.  Most agree that massive failures of financial regulation were one, if not perhaps the largest, cause of the 2008 meltdown.     

When the conversation turns to the specifics of what needs to be regulated, how regulation should work, and what agencies should be involved, the range of views is tremendous.  There is agreement that some kind of prudent regulation is needed, as is investor and consumer protection, but that’s about it.  Fueled by billions of dollars of lobbying and purchased research, everyone has their own idea.  One super-regulator?  Council of regulators?  Control bankers compensation schemes?  Exchange-trade them?  The cacophony is deafening. 

As an industrial organization economist, I think this discussion would benefit greatly from a consensus on the role and goals of financial regulation.  Paul Joskow, a dean in the IO economics community, recently noted that:

Continue reading “Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors” →

Dan Tarullo Gets New Talking Points

On Wednesday, Dan Tarullo, a governor of the Federal Reserve and distinguished law school professor, dismissed breaking up big banks as “more a provocative idea than a proposal” and instead put almost all his eggs in the “creation by Congress of a special resolution procedure for systemically important financial firms”.  He stressed: “We are hopeful that Congress will, in its legislative response to the crisis, include a resolution mechanism and an extension of regulation to all systemically important financial institutions” (full speech).

This put him strikingly at odds with Mervyn King, governor of the Bank of England, who said Tuesday night, quite bluntly,

 “There are those who claim that such proposals [involving breaking up the largest banks] are impractical. It is hard to see why. Existing prudential regulation makes distinctions between different types of banking activities when determining capital requirements. What does seem impractical, however, are the current arrangements. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.” Continue reading “Dan Tarullo Gets New Talking Points” →

Financial Regulation on the Front Burner?

Nate Silver thinks that financial regulation will be the big political issue of the first half of next year. And for better or for worse, he thinks the central political issue — the “public option,” if you will — will be TBTF and breaking up banks.

I have been skeptical of this. I have been following the conventional wisdom that public anger has receded into confusion, health care has taken over the stage, and no one can get interested in financial regulation — it’s just too boring. Also, I thought the fact that financial regulation doesn’t break down along party lines hurts its popular appeal. In particular, it leaves liberal Democrats very confused (conservative Republicans have an easier time — oppose anything Obama wants).  But I suppose I could see breaking up banks — now that it’s come back from several months in the wilderness — becoming a rallying issue. And health insurance is intrinsically boring, too. In any case, Nate Silver knows politics a lot better than I do.

(Also, according to Silver, we are “Volckerists” and the other side are the “Summersists.” We could do worse.)

By James Kwak

Too Complicated to Work

Yves Smith has a long excerpt from testimony by Robert Johnson before the House Financial Services Committee on regulation of OTC derivatives. (Johnson’s testimony is not up at the committee site.) Johnson brings together the issues of too big to fail and derivatives regulation: “Absent a drastic simplification of derivative exposures and a transparent and comprehensive improvement in the monitoring of those positions when imbedded in large firms, complex derivatives render these behemoth institutions Too Difficult to Resolve (TDTR).”

In short, he argues that even if you give regulators the ability to “resolve” a Tier 1 financial institution in the event of a crisis, regulators will be afraid to pull the trigger as long as there is still this complicated web of non-standardized derivatives linking it to the rest of the financial system. In addition, this creates a bizarre incentive: if you think that you can escape being shut down by having an intimidatingly complex derivatives portfolio, then you will go out and create such a portfolio.

Continue reading “Too Complicated to Work” →