Consensus Stabilization Policy Is Wrong, Part III

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This is the final post in the series critiquing the current policy consensus on preventing future Great Recessions. It reviews some of the egregious mistakes resulting from the three-pillar approach.

First pillar. The Dodd-Frank prohibition of injections of public funds into financial institutions is simply wrongheaded. Taxpayer losses from 2008-09 TARP lending to the largest banks is no more than a frequently repeated lie. (Recall last week.) Here is what policymakers need to understand. If mark-to-market bank insolvency results from collapsing total demand and asset prices, it is part of the general problem confronting stabilization authorities and must be dealt with accordingly.

Last week’s feedback dynamics demonstrates how prohibiting capital transfers to financial institutions can expose taxpayers to, not protect them from, huge losses. During the next episode of collapsing aggregate demand, the Dodd-Frank ban on temporary capital injections will be repudiated. The malfeasance in doing otherwise would be too obvious. The crucial question is whether the repudiation, now requiring legislative action, would come in time to effectively contribute to stabilization authorities’ effort to reverse free-falling nominal demand and prevent the immense costs of depression. History suggests great skepticism about placing a massive bet on Congress acting with foresight and speed in real-time macro emergencies.

Second pillar. The second pillar of the stabilization consensus, i.e. breaking up the largest U.S. banks, has been pursued in the on-going multi-pronged campaign of ever-higher capital requirements on targeted institutions. The effort seeks to transform scale, typically a source of productivity-enhancing synergy, into a cost-prohibitive burden. The most overt action here is the Federal Reserve’s announced intention to impose substantial (albeit unspecified) capital surcharges on the largest banks. The new capital requirements pile onto the U.S. implementation of Basel III capital requirements (while the rest of the world ignores the agreement), imposition of substantial size-sensitive belt-and-suspender leverage ratios, and tighter definitions of capital that can be used to meet government requirements. Most ominously, U.S. regulators broadly hint at evermore required capital with no indication of how much is enough beyond background chatter endorsing whatever it takes to force the largest banks to substantially shrink.

The campaign of increasing capital requirements until big banks break up is being pursued absent any demonstration of how their size causes instability or any careful assessment of the damage to economic efficiency and growth, international competitiveness, the capacity to manage future episodes of extreme instability, the international political power inherent in the globally powerful U.S. banking system, and fundamental property rights. There is no apparent concern that a large number of huge foreign banks, deeply interconnected with the global financial system, will continue to exist. Moreover, the consensus capitalization-against-risk effort is fatally flawed by largely ignoring increased capital requirements for the risk-seeking shadow banking system. The quietly acknowledged reason for the omission is that shadow-system institutions are much more difficult to regulate than large banks. Regulators admit, also quietly, that the next financial crisis will most likely originate in nonbank institutions/markets or outside the United States.

Third pillar. The third pillar, returning demand-intervention powers that Congress believes have been improperly usurped by stabilization agencies (especially the Fed), has been variously pursued. In 2008-09, the Fed quickly and aggressively interpreted Section 13(3) of the Federal Reserve Act to lend massively to the shadow-banking system, where market failure causing the greatest damage to total spending was concentrated. The rationale for that public-policy response, especially the need for speed and scale, is ignored in today’s consensus.

A closer look at the money-market-mutual-fund (MMMF) crisis usefully illustrates the need for speed and scale in circumstances of brewing acute instability. Asset markets quickly and generally tanked after the bankruptcy filing by Lehman Brothers on Monday, September 15, 2008. On Tuesday, the Reserve Primary Fund, a respected $67 billion money-market mutual fund was being hit by a tsunami of withdrawal requests and had to “break the buck”, surprising those hit by a capital loss. The Fed staff estimated that withdrawals, if unchecked, would by Friday result in the collapse of the entire $3.8 trillion MMMF industry, with the forced sale of assets into already free-falling markets generating huge depositor losses. The best bet was that, by the next week, the gathering collapse of spending by investors/lenders/households would become irreversible by stabilization authorities. The immense welfare loss of depression was imminent.

Instead, three days after Reserve broke the buck, the Fed announced the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) that lent to cooperating big banks so that they could purchase securities being sold by money-market mutual funds, which were then pledged to the central bank. The Fed became the buyer of last resort for the multi-trillion-dollar nonbank MMMF industry. Some $24 billion was lent the first day of AMLF operations, $217 billion for the run of the program. It became clear that the industry was not going to fail, avoiding dire consequences for total spending. The crucial lesson here is the need, in circumstances of a brewing demand collapse, for speed and size in effective stabilization policies. I can attest that Bernanke’s mantra during those dark days was: No program is too big; no program too quick.

Today, the central bank’s power to lend to nonbanks under 13(3) requires consent of the Treasury Secretary; the central bank’s lending to nonbanks must be organized as a broad program, prohibiting targeting of a single institution (e.g. AIG); and nonbank institutions must put up significantly increased collateral. Each of those changes, as well as other restrictions still being considered, hinders the ability of the Fed to intervene quickly and in size to halt and reverse a nonstationary contraction in total spending. Today, the U.S. central bank’s power to act as a lender of last resort is weaker than the European Central Bank, the Bank of England, or the Bank of Japan.

There is more. In 2008-09, the Treasury extended temporary guarantees to the MMMFs, while the FDIC expanded the scope and level of deposit insurance which was particularly supportive of smaller banks. Prior Congressional approval is now required for the Treasury or FDIC to expand guarantees, destroying their ability to act quickly in a crisis of collapsing demand.

Parting word. This essay is not alone in its indictment of the existing stabilization-policy consensus. Space limitations restrict mention to one additional critic. Hal Scott is probably today’s preeminent economist in the specialized field of financial regulation in the circumstances of extreme instability. His assessment of the current public-policy consensus is succinct: “The losses and the impact on our economy and country in September 2008 would have been much worse but for the response of our government to halting the contagion [spreading panic among investors] that broke loose following the bankruptcy of Lehman Brothers. However, since then the Congress has dramatically weakened the Federal Reserve, FDIC, and Treasury’s ability to respond to contagion, leaving our financial system sharply exposed to another contagion.”

Blog Type: Policy/Topical San Miguel de Allende, Mexico


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