Today’s policy consensus on how to prevent future Great Recessions (or worse) is manifestly wrong. If the policy design is not reworked, the Federal Reserve and U.S. Treasury will confront future crises deprived of many of the tools that in 2009 pulled the economy back from depression. The cost of that episode of extreme instability, estimated at many trillions of dollars, combines with the likelihood of future financial-market disruptions motivates this three-part look at the current stabilization-policy consensus.
The first post sets the stage by describing the three pillars of the policy consensus that quickly emerged in the aftermath of the 2008-09 financial crisis. The second will summarize relevant macro analysis, drawing from the GEM Project’s modeling of extreme instability. The third takes a closer look at some of the most egregious mistakes made so far in pursuit of the current policy.
Policy objectives. The professed objective of the post-crisis reworking of U.S. stabilization and regulatory frameworks is to prevent future Great Recessions. Public support for the overall effort is largely rooted in the first pillar of the new consensus: Taxpayer funds will never again be used to inject capital into big banks. Eliminating such bailouts is the central rationale for, and most broadly cheered accomplishment of, the centerpiece Dodd-Frank legislation, enacted in 2010. Sheila Bair (2013), while head of the FDIC, was one of the architects of that hurriedly cobbled-together law: “We worked hard to make sure taxpayer bailouts [to big banks] are completely prohibited.”
Closer analysis than Bair’s turns her case upside down. It is easily shown next week that, rather than protecting taxpayers, the prohibition of government capital injections into the banking system, in circumstances like 2008-09, exposes taxpayers and everybody else to many trillions of dollars in losses.
The second pillar of consensus is that size matters. Policymakers quickly concluded that the existence of the largest banks is inherently damaging to economic stability. In response, a multi-pronged program of sharply increasing capital requirements on the biggest banks has been implemented and continues to be expanded today. We know that even outsized capital cannot prevent the sort of bank runs experienced in the Great Recession. Warren Buffett, in his 2010 testimony before the Financial Crisis Inquiry Commission, was on-target: “No capital requirements protect you against a real run. I mean, if virtually all of your liabilities are payable that day, you can’t run a financial institution and be prepared for that. And that’s why we’ve got the Fed and the FDIC.” Thoughtful regulators accept Buffet’s assessment. They admit, usually quietly, that the purpose of ever-higher, ever-costlier size-related capital is instead to force the biggest institutions to break themselves up.
The third pillar is the Congressional desire to remedy what many members believe to have been an overreach for power during the Great Recession, especially by Ben Bernanke. Pursuit of this rein-in-the-Fed objective, receiving little attention outside Washington, is variously motivated. Foremost is the conviction that many of the powers used by the Fed to tame the 2008-09 instability were usurped from, and rightfully belong to, Congress. They want the power back, despite the fact Congress cannot effectively use it. There is also a belief that spontaneous market adjustments are sufficient to prevent the huge costs of extreme instability. Related, some in Congress assert that, given the Great Recession did not in fact morph into a 1930s-class depression, the extraordinary Fed intervention into the private economy was unnecessary. Finally, a kind of cronyism conspiracy theory fuels the whispered belief that the real object of the Fed’s actions was to help their big-banker friends. In order to make sense out of the three pillars of today’s consensus, we need to understand the economics of the 2008-09 extreme instability.
Looking ahead. Next week’s post will look at the macroeconomics of the Great Recession. The analysis will be informed by the characteristic decomposability of episodes of instability, including the 2008-09 debacle, into an originating macro shock and its propagation by weakening nominal demand. It follows that there are two broad, not mutually exclusive, strategies available to policymakers: (i) prevent future financial crises via effective regulation and (ii) prevent propagation of financial disruptions that do occur by effectively intervening in total spending.
In the reform program cobbled together after the Great Recession, policymakers have chosen to concentrate on the regulatory strategy and to largely limit their attention to the existing federally regulated banking system. The consensus policy is to doomed to fail. Financial risk easily migrates to and becomes concentrated in the shadow banking system, which continues to prove difficult to regulate. The large, rapidly growing nonbank system exists to avoid regulation and, in pursuit of that goal, cultivates nimbleness. It is much easier to impose higher capital, product restrictions, and size penalties on large federally regulated banks, even if those institutions were less implicated in past, and will be less implicated in future, macro shocks than their shadow-system counterparts. Despite Dodd-Frank and the host of other new regulations, financial crises rooted in various forms of excessive risk-taking will continue to occur. It is a huge mistake to put all our stabilization-policy eggs in that first-strategy basket.
In order to effectively contain welfare losses from future financial crises, policymaking must pay much more attention to the second strategy, i.e., prevention of crisis propagation by contracting total spending. The next two essays argue that the Federal Reserve should carefully identify the tools made available by its balance sheet that are useful in preventing collapsing demand. The Fed should then make a concerted public effort to convince Congress of the necessity of a powerful demand-stabilization toolkit. In a related task, global investors and lenders should be convinced of the power of the expanded toolkit and the resolve of the Fed leadership to use it to contain the propagation of any future financial crisis or other macro shocks. Such persuasion, seeking credibility for the Fed’s trend full-employment objective, would be the natural bookend to the earlier successful effort of central banks to convince global market participants of their commitment to low trend price inflation.
Blog Type: Policy/Topical Saint Joseph, Michigan