A proposal to prevent wholesale financial failure

FT ^ | 01/29/09 | Lasse Pedersen and Nouriel Roubini

[marshmallow]

One of the major causes of this mess (but by no means the only one) was that the originator of the mortgage (that is, the risk) became separated from the eventual holders.

That problem must somehow be addressed.

[Lurker]

Because there is nothing wrong with the Fed.

Where exactly in the US Constitution is Congress given the authority to establish a Federal Reserve bank?

L

[marshmallow]

If the whole point of the exercise is that you want a functioning banking system *without* massive government capital being required to let it function, then the only way to get it, is to make the terms of return and risk for capital employed in finance *more* attractive, not less. You cannot fix a problem of no one wanting to risk a dime as a banker, by loading down bankers with brickbats and scorn and the heaviest requirements you can dream up.

In the world of economics, risk and return are diametrically opposed. Usually, lowering risk results in a lower return. And vice versa. Increased returns usually requires increased risk. Yet you seem to want to somehow rewrite the laws of economics by simultaneously decreasing risk and increasing returns for the banks.

Expand on this a little.

Tell us how that works, exactly?

Risk is real and it exists. Someone must assume it. If not the banks, then whom? You can't just wave it away.

One of the main reason for this crisis was that those who originated the risks (read "mortgages") became separated from it. The risk became someone else's problem.

[JasonC]

Sure, forcing banks to lend to deadbeats is stupid. On he graphic, you can find the same in practically any sector or commodity from time to time. It isn't the case that all sectors uniformly grow at the rate of inflation. That's just another way of saying "slowly loses its income share", since incomes always grow faster than inflation, long term.

Look at a chart of total US housing starts, unit count, sometime. A long one, back to the 50s if possible. It isn't one bubble. It is simply a cyclical industry - very. So is steel. So are lots of things.

The ruinous bit is always, always, the "its different this time" belief that the boom rise in a cyclical industry is a new long term uptrend that can be projected forever. The solution is also simple - never believe a trend for any cyclical industry that isn't a moving average long enough to take in a full bust, as well.

[JasonC]

You are just flat wrong - they do *not* control the whole money supply. Nearly all money is the debt of other banks, which they can influence indirectly through incentives and such, but do *not* control.

The Fed controls *M1* - the narrowest form of money, currency plus demand deposits like checking accounts. That is *all* that banks need to keep Federal Reserve balances (or vault cash) against. Because they need to keep reserves against M1, the Fed control M1 as being no more than a fixed multiple of the size of its own balance sheet. Even there, it sets a maximum, not an actual, value, and banks can and routinely do fall shy of it, particularly in slumps.

But all other forms of bank liabilities are *not* subject to this reserve requirement. When you add to a savings account at a bank, it doesn't need one dime of reserves against them. When you take out a CD, it doesn't need one dime of reserves against that CD. But those are effectively money - liquid, short term savings that can be turned into spendable form without loss on minimal time scales, sometimes a matter of days.

From March 2005 to March 2008, M1 didn't budge, but other banks - *not* the Fed, which was controlling M1 to *not move* - created $2 trillion in new broad money by running up their CD liabilities and similar - with *no* extra narrow, spendable forms of money to support any of it. They did this while the Fed was tightening, and in the face of very narrow spreads between their cost of raising this money and what they were investing it at.

This was objectively stupid and promptly blew up in their face. But it wasn't the Fed doing it. It was banks, private banks. You know, the supposedly infallible private sector of economic rationality and foresight, according to all the glossy libertarian brochures? The fact is, free men are fallible and they can and they do screw up royally at times. They did over the last 3 years.

The Fed can be faulted for being very slightly late - like 12 month late tops - to hit the brake after the boom took off. But it did hit the brake, and rid it for 2 years before banks got the message and pulled back. In the meantime they had issued $2 trillion of new loans that all came flying back at them as bad debts.

The Fed didn't make the borrowers deadbeats. The Fed didn't make the banks lend to deadbeats at non-existent spreads. Anyone following the Feds moves and reacting to them came through it fine. They banks killed themselves by *fighting* the Fed, and making epic inflationary bets when it was already on the brake.

Needless to say they were wrong and are currently holding their heads in their hands. And, natch, whining that it is all the Fed's fault!

[randita]

Thanks for your thoughtful posts. They are a nice alternative to the doom and gloom which is widespread.

I have a question for you. I have seen charts which indicate that the Fed is pumping money into bonds in order to keep the prices high and the yields low. This hurts the stock market and keeps people in bonds out of fear of the market.

But people who were depending on a “decent” rate of returns on equities (I don’t mean a killing, but certainly more than the .25-3% available now in the safe investments - that’s paltry) who have gotten out of equities and into safer investments, are really taking a hit on what they hoped their retirement funds might be.

Is it the Feds purpose to keep people fearful of the market in these low yield vehicles to prevent another bubble or is it just a byproduct of the Feds purpose of trying to keep interest low?

I would think it would greatly benefit the economy if people starting pumping money now in these very low interest accounts back into the economy via the stock market, but is the risk of interest rates going up too high?

I just don’t understand the connection.

[Woebama]

So the Federal Reserve hit the brakes a year late in your opinion but you don't hold them responsible for that delay in any way that alters your advocacy of the Fed as a good institution (I see a year late in reigning in a housing bubble as catastophic).

Greenspan states that he failed in his regulatory responsibilities and basically says that he didn't understand the incentives in place in the banking system - another huge failure. By placing the element of random judgment by a small group of central bankers at the center of the money supply, we get this outcome over and over again — misjudgment and economic chaos.

Look at the reality of a money supply pegged to nothing but the unconstrained choices of a handful of economists. It's a sort of Soviet system where any information not incorporated by the central bank or not understood and we have a potential disaster. Meanwhile on the regulatory side of this crises, the Fed, the SEC, the CFTC, the Treasury and Secret Service, the exchanges, Congress, Fannie May, Freddie Mac and a hodgepodge of other entities were all involved in regulatory issues of money and mortgages — but the mishmash left mortgage backed derivatives as a poorly regulated and understood time bomb ticking away in the banking system with no clear responsiblity on the regulatory side. It's a poor system and the Fed is at the center of it.

[Tolik]

I don’t know if you are right. There are so many examples in history when very wise people had opposite views. But I seek out your economics posts for my education. Please, don’t get frustrated too much when posters lose civility.

Just a note of appreciation. Thanks.

[JasonC]

The Fed is simply trying to keep interest rates low. Normally, all other credits are priced off of treasuries, so many basis points above the nearest treasury note or bond. Like, half a percent higher for strong credits in normal times, 1 to 1.5% for run of the mill industrial credits and mortgages, most of the time.

But that normal relationship doesn't just happen, it results from arbitrage trades by leveraged operatives. Who buy the slightly riskier loan or bond of someone other than the treasury for a modest mark-up over the treasury, because they expect loan losses to be small, as an overall average of many such loans. If the rates charged to other borrowers gets too high compared to treasuries, those people would sell treasuries and buy the corporates or mortgages etc, and make money on the spread between them being higher than any realized loan losses.

OK? That is how it *normally* works. And when those "gears" are connected and working properly, if the Fed pushes just *treasury* rates lower, all the other rates move, too. Maybe with a slight lag, maybe a little bit less, but basically the whole tiered credit structure moves up and down in line with treasury rates. So just moving the treasury rate moves all rates. But the Fed isn't doing the moving. Traders are.

Well, now they aren't. The traders who normally do that sort of thing *all went bankrupt* over the last 18 months. Those who survived did so by getting out of that game completely. The spread between corporates and treasuries hit all time highs as a result - worse than the 1933 bottom in the great depression, and not by a small amount either.

The "transmission" between the "pedal" the Fed is stepping on, and the axles, is about 3 exits back in the middle of the highway, having fallen out of the rusty bottom of the car.

It takes *capital* to run arbitrage risks. If that capital *disappears*, then until it is *replaced*, nothing is going to work as our institutions are set up to work and as their past practices expect. That is why it is vital to *recapitalize the banking system*, and not do it halfway while trying to punish those being helped.

If every bond trader on the planet who sees a corporate at 10% with the treasuries at 3% instantly buys the former and sells the latter at 5 times leverage, then rates stay in line with each other. If everyone parks in money markets instead waiting for an all clear to sound from a great voice out of the sky, then, well, they won't.

Corporate rates peaked at the November bottom in stocks. They have fallen a little since, but are still very, very high, especially relative to treasuries.

The right way to play it is to step in where the capital is missing, and buy corporate bonds. Not stocks, still way too early and dangerous for those. (OK, some are so cheap fine, but buy amounts like the interest on your bonds, not like the capital. Slowly average into them).

The choice isn't between treasuries and stocks. The winning trade is between them - the senior securities of private companies, taking some credit risk.

[JasonC]

There is no perfection in this life, and a year late but all the moves in the right direction is pretty close to the best performance by any banker ever, public or private. There were manias, panics and crashes long before we had a Fed and there would be if we didn't. You might as well condemn the US military because it hasn't abolished military conflict.

[Woebama]

Asset bubbles in the financial markets tend to domino and create a boom and then a bust. The handling of the money supply is inevitably bound up in the panic (either by being too tight and precipitating the crises or by being too loose and precipitating the bubble). The more complex the system and the more personal judgment by a small group of individuals the more likely major misteps. We have an incredibly complex system with an incredibly small number of individuals handling the Fed. By defending the current circumstances as “pretty close to the best performance by any banker ever, public or private” you make my point stronger — the central bankers don’t do a very good job. Chaos, recession, government debt, unemployment, eviction, foreclosure, business and personal bankruptcy, loss of income, etc., and it is the “pretty close to the best performance by any banker ever, public or private.” We need a system with more constraints on the creation and contraction of the money supply (which would make the “Fed” or it’s successor more predictable — which in turn would make decision making by other actors in the system more rational and in line with reality (since they would know what the actual reality is as opposed to guessing at what the Fed will do)).

[Jim Noble]

There are many mature and developed societies which, since 1865, have had to deal with the end of their money system.

The large money center banks, it would appear, are going down. The dollar may be going the way of Confederate money or the Reichsmark.

Nevertheless, the apocalyptic nature of the commentary about this is grossly overstated - or, it would be if we had a proper government.

But the money crisis reveals something much larger - a systematic political crisis, arising from our failure over at least 30 and perhaps as many as 50 years to put virtuous men in office and to honor and reward public and private virtue (and, no, I don't mean politicians' girlfriends, which are an historical constant).

The Soetero-Obama "administration" is a result of the political crisis, not the cause - and the political crisis now threatens to morph into a full-blown regime crisis, with unpredictable consequences.

If the virtue of the People were sound, we could jail or execute the thieves, close the borders (yes, I mean to COSCO), cancel the debt, flush the currency, recapitalize the productive sector, and be up and running in six months.

However, the People, the sovereign, have been drugged by easy credit, easy and consequence-free sex, and protection from the demands of maturity for years. They may be too far gone to recover.

From that state, survival itself is in peril.

[Jim Noble]

Problem, we do not have adult leadership, but a bunch of Commies committed to destruction of all but their power.

See my #32 above.

[Jim Noble]

Our government as a whole gets my vote for the whole mess.

Yes, of course, but they got there by us voting. See my #32.

[JasonC]

I understand your position entirely, and I think it is in error. Do not confuse this with being uninformed about it or not knowing every argument ever made for it, cold.

You think that instability in the objective exchange value of money is always caused by factors effecting its supply. Thus your statement "We need a system with more constraints on the creation and contraction of the money supply", believing that this alone would ensure full financial stability, eliminating all effects due to fluctuations in the objective exchange value of money.

But this is a flat error. *Two* factors determine the objective exchange value of *any* commodity, including money. Only *one* of them is the *supply* of that commodity. The other is the *demand* for that commodity. And the demand for money is *not* a constant. Fluctuations in the objective exchange value of money would occur, and did occur, whether the supply of money is fixed, or grows at a constant slow rate, or grows slowly, or meanders.

The primary fallacy of the entire position is the illusion that the demand for money is a constant. It simply isn't.

As a matter of pure microeconomics, instability due to fluctuations in the objective exchange value of money can only be damped if supply *responds* to changes in demand. A constant money supply is an inelastic supply, and in every commodity in existence, inelasticity of supply means *more* volatile fluctuations in price or exchange value, not less.

It is possible for monetary policy to do active harm by *driving* the ocillations in demand for money, if the supply of money is *contracted* whenever demand for it rises sharply. Although it was not truly appreciated at the time, this was the case under the gold exchange standard with an open economy in international trade. Thus, the US money supply was dropped 30% at a time when demand for money was soaring, in the great depression.

Similarly, it is possible for monetary to do active harm by driving oscillations in the demand for money, if the supply of money is *increased* sharply at a time when the demand for money is non-existent and falling, as in a rapid inflation. If a monetary authority increases money supply while an existing inflation is ongoing (as it will if e.g. it has a fixed real revenue target from new money issuance, and receives less real value from past issuance amounts as demand for money falls), then it can send money supply soaring while demand for it is evaporating, as happens in hyperinflations e.g. in Zimbabwe recently, or Brazil in the 1970s and 80s, or Germany in the early 1920s.

But, if the monetary authority reacts to changes in demand for money in the opposite sense, increasing supply when demand for money rises and reducing supply when demand for money falls, then it *damps* oscillations in the exchange value of money. Which would be *even more extreme* in the absence of that damping. From *demand* changes alone.

The demand for money, far from being a constant, is highly variable and cyclic. It falls in booms as men try to get out of money into other assets rising in price, and it rises in smashes as men scramble to get out of those assets and into money. They cannot in the aggregate succeed, even approximately, if the quantity of money in existence does not change. A million sell orders won't reduce the stock in existence by one share. A million sell orders for everything else are a million buy orders for money. It is the other side of every sell order.

Various actors will speak of any given course of money supply as being "too tight" or "too loose", but mean very different things by those characterizations. Someone who has bet on a rapid inflation by going short money on an epic scale, to hold hard or long dated assets, will think anything "too tight" that doesn't allow the prices of his favorite bubble assets to go on increasing or even accelerating, while letting him repay all his short dollar positions (loans, leverage, etc) with confetti.

"Too tight" in that sense is too tight relative to the bubble speculator's commitments. And the only thing loose enough to satisfy him, for very long, would be a hyperinflation. It is simply possible for men to take positions that are fundamentally incompatible with money continuing to hold any objective exchange value to speak of, at all.

In the past real estate bubble, very large numbers of people took on financial commitments that they could only have a prayer of meeting if the general price level and their wages, doubled, on a time scale of 3-5 years, and house prices continued to increase at double digit rates indefinitely. Anything loose enough for them, would mean dollars not holding any value to speak of for everyone else. A smash is *inevitable* once that happens. Their plans are *incompatible* with those of the men on the other side of their own trades, or with reality.

I understand that you think that any course of money supply that results in speculators speculating too recklessly, has been proven by that very fact to have been too loose. But men are free and folly is as old as Adam. There isn't a course of money supply that is incompatible with destabilizing speculation.

There is no substitute for sensible action by participants at *all* levels in economic action. End consumers must manage their own finances responsibly, or they are quite capable of ruining themselves, and involving everyone else in their mess. Producers must manage their activities efficiently, and they are quite capable of investing in the wrong activities, wasting capital, destroying it in the process, sucking up resources to no purpose. Financiers must manage their activities well, lending to sound operations and not to unsound ones, channeling capital to places with high returns, but also avoiding overdriving mere cycles by averaging and smoothing their expectations. And the monetary authorities have to measure demand for money accurately and respond to changes in it. The government needs to manage its finances responsibly, and not try to use the monetary system as a revenue source, nor try to enrich itself at the expense of the populace or economically vital sectors of it.

If anyone screws up any one of those things, they can crash the system for everyone. Doing so does set off restoring forces, but they take time to operate and their operation is intensely painful for all concerned.

The economic problem is a fundamentally difficult one, not a theorem of marginal calculus. The coordination of everyone's actions to a single trajectory for the overall economy is not a given, it proceeds by trial and error. Expecting perfection of it is unrealistic and conservatives are realists. Expecting booms and busts that have afflicted commerce since its dawn to just stop tomorrow because you don't like them, is utopian, and conservatives despise utopianism.

What we want from the monetary system is (1) an effective medium of exchange (2) some flexibility in response to demand and (3) some longer term price stability. Asking for an infinite amount of (3) doesn't give you (2) for free - on the contrary. We cannot rely on the monetary system to *also* solve the entire economic problem for us. That is *our* business, as consumers, producers, and investors.

[Darkwolf377]

I wish I could come up with something clever, but that’s a great post. Thanks for sharing it. Lots to think about in a few short paragraphs.

[Woebama]

The Fed has failed under your criteria:

http://mwhodges.home.att.net/cpi-1800.gif

[Texas Fossil]

I have no argument with your analysis.

Agree totally.

[Jim Noble]

Thanks, bro. Stay safe.