This post looks at Anat Admati’s chapter in Progress and Confusion, the 2016 volume that reports on the IMF’s most recent biannual conference on the state of macroeconomic policy in the aftermath of the Great Recession. Admati is the George G.C. Parker Professor of Finance and Economics at the Graduate School of Business, Stanford University. If taken seriously as a guide to stabilization policy, her chapter, “Rethinking Financial Regulation: How Confusion Has Prevented Progress”, is fundamentally flawed. Given space constraints, what follows focuses on the 2008-09 extreme instability that occurred in the United States. In that context, generalized-exchange macro theory is used to examine four of her most important points captured in quotes from the chapter.
First quote. “The failure of the financial regulation can, and did, cause significant harm to the economy.” (p.61) This is her foundational point, for which she provides little support. Her chapter provides no compelling mechanism that links the residential-mortgage crisis, absent its propagation by contracting nominal demand, to the six million involuntarily lost job loss and the trillions of dollars of lost production, income, and wealth. Once the criticality of demand propagation is recognized, the causality from financial regulation to significant economic harm is no longer obvious.
The GEM Project argues that the collapse in nominal demand that was organizing itself in the second half of 2008 had a necessary condition. Investors/lenders must have become uncertain about the credibility of stabilization-authorities’ trend real-side (full-employment) objective, which the Project denotes by Ƈ. Such credibility is intuitively determined by the perceived power of authorities’ toolkits to halt and reverse contractions in total spending as well as the authorities’ will to aggressively use their available tools in crisis. It follows that effective macro policy reform must enhance the power and will of stabilization authorities to intervene in total spending, while also making that determination and capacity well known to investors/lenders globally.
Second quote. “In taking deposits and issuing short-term debt, banking institutions naturally engage in borrowing. Borrowing creates leverage, which magnifies risk and increases the likelihood of distress, insolvency, and default.” (p.62) Admati’s focus on short-term liabilities crowds out important differences in classes of insolvency. Critically ignored is the policy-relevant distinction between broad mark-to-market insolvency rooted in collapsing total spending and asset prices and idiosyncratic insolvency rooted in excessive risk-taking. Call the former macro insolvency and the latter micro insolvency. The former, not the latter, sets off damaging asset fire sales that contribute to collapsing asset markets. The former, not the latter, must be understood as an integral part of stabilization authorities’ efforts to halt and reverse contracting demand. Once total spending is reversed and Ƈ credibility is restored, asset prices recover quickly and widespread bank mark-to-market insolvency melts away. Does anybody not remember that is what happed in 2009? Industry-funded insurance is the efficient, effective solution for idiosyncratic bank insolvency; effective aggregate-demand management is the solution industry-wide bank insolvency in episodes of extreme instability.
Third quote. “Concerns with systemic risk have created the expectation of supports from central banks and government. Implicit guarantees have translated to outsized and distortive subsidies to banking institutions and the entire financial sector.” (p.63) Again, Admati’s analysis is damaged by failing to make the crucial distinction between macro and micro bank insolvency. In the GEM Project’s modeling of extreme instability that is inherently associated with macro insolvency, a central task of effective policymakers is to convince investors/lenders that financial institutions and markets will be supported in circumstances of collapsing demand. The robust capacity and will to provide such support is a necessary condition for Ƈ credibility, which itself can prevent the broad propagation of financial shocks and prevent Great Recessions or depressions. Preventing macro insolvency does not generate meaningful moral hazard. The widely held notion that it does is little more than an artifact of mainstream coherent market-centric general-equilibrium thinking.
Fourth quote. “All the contagion mechanisms that create systemic risk, including direct contractual dominos, inferences from weakness of one institution about the strength of others, a credit crunch owing to lenders’ distress, and the intensity of asset sales in deleveraging, would be alleviated if institutions were more resilient to shocks and able to absorb more losses without becoming distressed.” (p.65) Admati’s understanding of contagion is at best sketchy. It is certainly inferior to Hal Scott’s (2016, p.xv): “Connectedness occurs when financial institutions are directly over exposed to one another and the failure of one institution would therefore directly bankrupt other institutions, resulting in a chain reaction of failures. Contagion is a different phenomenon. It is an indiscriminate run by short-term creditors of financial institutions that can render otherwise solvent institutions insolvent due to the fire sale of assets that are necessary to fund withdrawals and the resulting decline in asset prices triggered by such sales.” The central engine of contagion, which Scott does not closely specify, is investors/lenders who become broadly uncertain about the credibility of stabilization-authorities’ trend real-side (full-employment) objective. Policymakers, seeking to prevent Great Recessions, must focus on correcting that uncertainty whenever and whenever it crops up. Macroprudential initiatives are reduced, at best, to operating at the margins of truly effective policy.
Conclusion. Why isn’t all this featured in a book that purports to assess the state of macroeconomics with respect to preventing future Great Recessions? The answer is that the volume’s authors, almost every one of them, are mainstream theorists who are badly restricted by consensus market-centric DSGE theory. They haven’t figured out how to microfound meaningful wage rigidity and, in order to remain micro-coherent, construct models that avoid the causality from contracting nominal demand to involuntary job loss and lost production, income, and wealth. Their badly compromised analysis does not come close to adequately explaining the 2008-09 extreme instability. Progress and Confusion editors recognize the need for another conference in 2017. Maybe they can stretch a little, think about breaking out of the mainstream box, and provide some useful guidance to policymakers.
Blog Type: Policy/Topical Saint Joseph, Michigan