Ten Minutes, Eleven Questions
I have been invited to speak for ten minutes on the financial crisis. As you will see below, I do not agree so much with President Bush (via Mankiw). Unlike the President, I see no benefit in putting credit default swaps on an organized exchange and I place no faith in the panacea of “transparency.” Transparency is to financial regulation what independence is to energy–something that sounds obviously good but on closer examination offers no guidance toward sensible economic policy.
The President channels Tyler Cowen when he says,
I’m a market-oriented guy, but not when I’m faced with the prospect of a global meltdown.
in my view “doing nothing” wasn’t really an option, again if only because of the preexisting FDIC commitment, not to mention the disaster associated with a plummeting money supply.
The primary need, in my view, was (and is) triage. Insolvent banks need to be shut down. Banks that might be solvent except for temporarily depressed asset prices need to be supervised very closely. Then healthy banks can go out and operate without fear of being dragged down (or competitively driven down) by the zombies.
Any policy that puts off doing the triage is a bad policy. Ergo, TARP was a bad policy, both in its original design and in its revised implementation.Eleven questions (my answers in parentheses)
1. To what extent were regulatory anomalies responsible for the shift from old-fashioned lending to securitized lending? (100 percent responsible. perverse capital requirements in particular)
2. What role did low down payments and speculation play in the housing bubble? (an essential role; in recent years, more than 15 percent of loans went for non-owner-occupied housing; )
3. Were executives responding to perverse incentives or lack of knowledge? (lack of knowledge; suits vs. geeks divide; Richard Syron did not think he was setting up Freddie Mac to fail, even though he was warned)
4. How should credit default swaps be regulated? (government policy should be “Buyer beware!” There is no natural seller for CDS. CDS exploit a regulatory anomaly. We need to align regulations with reality–if a diversified portfolio of low-rated bonds has a great risk-return profile, then capital regulations should say so. If not, then the regulations should not advantage low-rated bonds backed by CDS.)
5. What can be done to improve transparency? (This is a phony issue, sort of like energy independence. Specialized knowledge is the essence of financial intermediation. The problems that are attributed to lack of transparency are problems of regulatory anomalies.)
6. What can be done about systemic risk? (Every firm is a financial intermediary, and the demise of any firm can be labeled as systemic risk. You don’t create a firewall by saving firms. At best, you create a firewall by having a rapid, orderly process for closing them.)
7. What can we learn from international comparisons? (This is a really hard problem, but there are differences, e.g. Canada vs. Iceland)
8. Suppose we had stopped the housing bubble. Would some other bubble have emerged somewhere else? (I suspect that financial crises are inevitable. They might be smaller if people did not get complacent about the ability of government to prevent them.)
9. Who saw it coming? (In the aggregate, no one. Dean Baker and others saw the housing bubble, but as far as I know did not see the financial leverage on top of it–AIG. Ed Gramlich saw the risky subprime loans, but his solution was to have Freddie and Fannie do more in that market. Warren Buffett coined the phrase “derivatives are weapons of mass financial destruction,” but then he bought into Goldman Sachs and into the original Paulson plan to have the government try to revive the weapons market.)
10. Should government take from the ants to give to the grasshoppers? (try to keep people in houses they should not have bought in the first place with newly-subsidized mortgages and attempt to keep house prices high, while those who acted prudently and did not speculate or take on unaffordable houses get no positive reinforcement? bail out financial institutions using other people’s money? tax people who saved for their own retirement to help pay for the defined-benefit pension promises of auto companies, other private firms, state and local governments, Social Security, and Medicare?)
11. Is government failure avoidable? (Would pro-regulatory ideology and skill prevent crises? As intermediation becomes increasingly specialized, can centralized regulation overcome the discrepancy between dispersed knowledge and concentrated power? If Basel capital requirements were too crude and clumsy for the U.S., how can international co-ordination of regulation more broadly be anything but a disaster?)