Squam Lake or Swamp?
By Arnold Kling
What happens when you bring leading academic experts in economics and finance together to come up with ideas to prevent future financial crises? You get The Squam Lake report, enthusiastically greeted by Ben Bernanke.
I am not impressed. The report finds the time (an entire chapter, in fact) to address the “need” to regulate how people save for retirement without offering a word of criticism of the policy of promoting home ownership with lenient, subsidized mortgage credit. To me, that indicates how much the report reflects the “insider” point of view and how little consideration it gives to flaws in the political process or the potential for fallibility of regulators.
The authors have the audacity to suggest that a systemic risk regulator would have been able to forestall the problems with Fannie Mae and Freddie Mac. The political reality was that Freddie and Fannie were an unstoppable freight train of powerful lobbying, right up to the point where they were insolvent.
The report is based on two central principles. The first principle is that regulation was too heavily focused on individual institutions, rather than on systemic risk. I think that is way, way, overstated. First of all, the Fed and the IMF were always looking for systemic risks. In this case, they just did not see them. They saw the opposite–a financial system in which innovations had succeeded in reducing risk.
The second principle (p.137)
is that regulators must create conditions that minimize the likelihood of bailouts of financial firms by forcing them to internalize the costs of failure…Many of our recommendations are intended to create a robust financial system in which any troubled financial company is allowed to fail.
If you want to prevent bailouts, the issue is not so much the behavior of bankers as it is the behavior of government officials. For government officials, there is a huge time consistency problem. In the abstract, they will promise never to bail anyone out. In reality, in an actual crisis, they have an overwhelming incentive to break that promise.
In the abstract, it makes sense to vow never to pay ransom to kidnappers. In reality, when someone is kidnapped, you are likely to break that vow. Government officials face that same time consistency problem with bailouts.
The report recommends the contingent capital approach and the “living will” approach to make it easier to resolve troubled banks. However, in the real world, the willingness of government officials to use these mechanisms is likely to be lacking. As Sam Peltzman pointed out at the talk he gave last week, after the S&L Crisis, the government also enacted measures to provide enhanced resolution authority for troubled banks. But when it came to Citigroup and Bank of America, the will was lacking to apply that authority. That is likely to hold in the future as well.
A “living will” suggests that we would, in a crisis, break up too-big-to-fail banks. So the government officials who today are unwilling to break up TBTFs will, in the midst of a crisis, find the courage to do so? Count me skeptical, to say the least.
The authors display considerable faith in technocratic control. Their systemic risk regulator will have God-like powers to assemble and process information. On p. 34-35, they write,
a new information infrastructure is needed for regulators to understand trends and emerging risks in the financial industry. This will require a broad set of financial institutions to report standardized measures of position values and risk exposures. Such information is valueless unless it can be analyzed, and this is a natural function of the systemic regulator.
As I have said before, the Insiders view the financial crisis as a Keynesian moment, requiring more central management from technocrats. Instead, I think it is a Hayekian moment, illustrating the inability of central planners to process increasingly dispersed information. Of the fifteen authors of the report, four are from the University of Chicago, including John Cochrane and Raghu Rajan. But the way I see it, these folks are closer to Keynes than to Hayek.