It's true that the Fed is the agency with the brute force to make things happen in an emergency. But I'm not sure that's the relevant thing to think about. What we want is some kind of body that works to prevent emergencies. That requires credibility and influence, but it doesn't necessarily require a trillion dollar balance sheet.
I guess the model I have in mind here is the Congressional Budget Office. The CBO is unknown to most people, but despite its small size and low public profile it has a remarkable amount of power. This power comes from two sources. First, it has institutional credibility. I honestly don't know how it's managed to keep this credibility in the face of what must be enormous partisan pressure, but it has. It's widely considered an honest broker and its budget estimates are taken seriously by everyone.
Second, although the CBO itself doesn't have a huge staff or control of a huge budget, Congress has agreed to abide by its cost estimates for legislative programs. This means that CBO analysts have considerable indirect control over a lot of money. And in Washington, money equals power.
So my question is: could we create an agency like the CBO, but charged with monitoring systemic risk in the financial system? It would have to be nonpartisan and independent. It would need to have risk management baked into its DNA as its primary mission, rather than being #7 on a list of ten goals -- with everyone knowing that only the top three get any real attention anyway. Its director would need the kind of credibility that makes people listen when he warns that other agencies are allowing too much giddiness on Wall Street. And, finally, it would need the right mix of authority, either direct or indirect, that's enough to force people to take it seriously when its mere credibility isn't quite enough.
But here's the incoherent part: I'm not quite sure how you'd construct such an agency or what authority might be sufficient for it to do its job without getting it hopelessly at odds with other regulatory agencies. One way or another, though, I feel that giving this mission to the Fed is simply a waste of time. Right now, virtually every impulse -- both at the Fed and in the private sector -- works in the direction of either ignoring credit bubbles or actively cheering them on. If we're going to put a brake on this, we need to think about institutional priorities and balances of power, and figure out what it would take to get systemic risk established as a bureaucratic turf with a built-in constituency dedicated to protecting it over the long term.
My thoughts:
- In finance, the power to stop crises is often the power to prevent them. The FDIC stops a hell of a lot of bank runs from ever happening because people know their deposits are insured.
- More broadly, attempting to build systems that can't fail have generally . . . failed. Such systems tend to be brittle--a single failure is catastrophic. In general, we should seek ways to let systems fail gracefully. I.e. no matter how strongly you try to ensure that nuclear power plants can't overheat, you also build them so that if they do, there is no critical mass to create a bomb-like nuclear blast.
- A systemic risk regulator outside the Fed would spend a lot of time at war with the Fed. It would probably lose. And if it did not lose, the result might be ugly. A regulator that is only focused on preventing downside will be too conservative. Right now, that seems like a good thing. But inefficient capital allocation also has a high cost. Whether the systemic risk regulator won or lost, the battle would create great instability in financial markets at a time when we don't need more of it.
- A systemic risk regulator will probably have a harder time staying independent of Congress than the Fed, because the inflationary history of fiat currency puts a high cost on Congressional meddling. The systemic risk regulator will have no such insulation, making it less effective at its job.
there is no critical mass to create a bomb-like nuclear blast
Getting critical would be a bad thing, but far from a "bomb-like blast". There is a reason they build those implosion shells around the first-stage cores: energy released by the chain reaction scatters your critical mass very effectively.
Nitpicking, I know.
Actually, the first nuclear bombs didn't have such shells, and they still managed to blow up cities fairly effectively. That said, I should probably stop before this chain reaction of nitpicking the nitpicking also goes critical.
More broadly, attempting to build systems that can't fail have generally . . . failed. Such systems tend to be brittle--a single failure is catastrophic.
Exactly. This is why dams have spillways.
So my question is: could we create an agency like the CBO, but charged with monitoring systemic risk in the financial system? It would have to be nonpartisan and independent
Haha! Right, because that worked so well with FNMA and evaluating subprime risks.
They also dams have emergency plans, including evacuation for folks living below the spillway.
Right now, virtually every impulse -- both at the Fed and in the private sector -- works in the direction of either ignoring credit bubbles or actively cheering them on.
Meanwhile, politicians like Barney Frank weren't just cheering them on, but were insisting they weren't dangerous at all.
Putting the government in charge of evaluating risk is like saying "Well, Mom had a fender bender last week, so let's put the dog behind the wheel!"
But what if it's a really, really well intentioned dog?
Maybe we could use the internet as an intermediary in some way? My understanding is that online, no one knows you're a dog
Meanwhile, politicians like Barney Frank weren't just cheering them on, but were insisting they weren't dangerous at all.
You really need to get over your Barney Frank fetish. He's number 48 of the 50 reasons we are in this mess. For you to focus on him just shows how clueless you really are.
"The FDIC stops a hell of a lot of bank runs from ever happening because people know their deposits are insured."
This statement sounds pretty naive. People don't "know their deposits are insured" because in many cases, they aren't insured.
FDIC insurance only covers deposits up to $250,000. Now, you may not have $250,000 in the bank and so you think that's an endless pile of money, but it isn't.
In fact, many banks fail precisely because the FDIC isn't preventing runs on them by those depositors who do have balances in excess of $250,000 in the that bank.
Indybank failed because of a run on its deposits. The FDIC did not, and could not, prevent it.
Here's a list of banks that FDIC insurance hasn't prevented from failing so far in 2009.
http://www.fdic.gov/bank/individual/failed/banklist.html
Mom and Pop's paltry deposits aren't being hurt by bank failures, that much is true. Instead, their entire retirement accounts have been decimated by bank failures and systemic government corruption (in the SEC for example, which was protecting people like Bernie Madoff from being exposed).
Yeah, it's not perfect, but the claim wasn't that all bank runs are prevent, just many. The fact that not everyone is covered doesn't change the fact that most people are, and thus those people won't stampede the bank if it looks to be failing. Surely, that reduces the number of runs significantly.
I think Kevin's right on target with the CBO example. We don't need a regulatory agency per se. We need a respectable scorekeeper who could keep us updated on 1) the likelihood that bubbles may be forming and 2) whether our policies are exacerbating or alleviating the problem.
My idea: The PBR (Punchbowl Remover) would do the following:
1) Monthly announcement of the natural unemployment rate, whether we're above or below it and by how much
2) Monthly announcement about whether we're experiencing inflation, deflation or stable prices and to what extent
3) Monthly estimate (contrasting average monthly revenue YTD with federal spending) of whether our fiscal policy is expansionary or contractionary
4) Monthly estimate of whether our monetary policy is currently expansionary or contractionary
5) Would review, at the request of members of Congress, whether a program would have a stimulative effect
Somebody smarter than me would have to work out the mechanics of 4 and 5.
The last few bubbles haven't just been fueled by irrational exuberance; behind them there have been government policies to accelerate growth. This makes sense because it's very popular to be a president or congressperson during an expansionary period, and not at all popular during a contractionary period. As a result, we have a new boom-bust cycle, only the bust comes when the government runs out of cheap borrowing capacity instead of when businesses get stupid. Having a PBR that could say "We're going too fast!" but have no power to do anything about it is the best solution I see because instead of creating another regulatory agency to screw things up, what you'd have instead - as with CBO projections that throw cold water on stupid projects - is a way to give responsible politicians cover for not voting red ink as far as the eye can see and a big voice to spook cautious amateur investors out of the market when we get into the sort of territory where bubbles traditionally form.
Will the bigs stay big to enjoy the protection and cheap funds they'll have access to or get small so they escape the handcuffs?
My guess is the first step will be to get small until everybody has relaxed enough for the regulators to go to soft. Then bigness will be back.
The problem ( as I see it) is that we don't understand economics well enough to be able to design a system to control excess. Its not like a nuclear power plant where engineers can calculate the stresses that would occur under a given scenario and build a system strong enough to contain them.
Then there is the problem of greed. Plenty of people were aware of the bubble in residential real estate and many of them were at ground zero
in the industry but people were making money to include the same governments that were supposed to be regulating the industry. What regulator or official is going to have the power to get in front of a runaway locomotive that has everyone from the banks, the real estate industry and, finally, even homeowners riding on it.
Consider that it was entirely within the power of Fannie and Freddie to de-certify a state from participating in their mortgage guaranty program. They could have said no to California. That they were not going to be guaranteeing any mortgage that claimed a 1950's 2 bedroom
clapboard bungalow in the Oakland flatlands was a $500,000 house! Of course had they done so they might not have gone bust but the more likely outcome would have been Fannie and Freddie would have been put under new management.
This is the reason we've had TARP and we've bailed out the auto companies, isn't it? Softer landings than we might have otherwise had?
Fear of failure, according to Greenspan, was supposed to function as the control mechanism for reining in the financial industry. He did not fear fear-of-failure failing.
So that leaves us with fear of regulation. Or better, embracing regulation, and wisdom to see that good regulation (i.e., good government) are an integral part of healthy markets.
I'm not sure who should be the regulator in the case, though I think the Fed is the likely suspect. But it is a new and enhanced role for the fed.
I do have some concern of FDIC-style insurance for systemic risk of deposits greater than $250,000; it comes perilously close to insuring risk for pensions, etc., I think it would promote risk taking because the risk is insured. Right now, if you're wealthy enough to have that kind of cash laying around, you should be concerned with the stability of a bank holding it. I'd say instead of insurance, the better course might be more transparency in bank stability for depositors is required.