He’s no FDRPosted: June 19, 2009
With the release of financial regulation reform and healthcare reform that has Wall Street breaking open the bubbly, I just want to join the chorus of highly skeptical economists. The tune of the last few days is hard to miss. Take this piece from the NY Time’s Dealbook as an example: Only a Hint of Roosevelt in Financial Overhaul. There’s also Paul Krugman’s Op-Ed Column today Out of the Shadows which is the typical on-the-one-hand-on-the-other hand economist behavior. (Could I just mention in passing that I like the OLD Paul better? The one that was an out spoken advocate for liberal economists? I’m not sure what happened at that White House Dinner, but I’m beginning to think we now have a Manchurian economist at Princeton. Oh, where is our Shrill One?) Oh, and you can still read my first impressions here. I’m going to start with Financial Reform but don’t leave me yet. Brad deLong takes on Christine Romer’s The Lessons of 1937 at The Economist and since he still hasn’t been invited to dinner at the White House, it’s classic Brad.
So what does Krugman think about the Alphabet Soup Agency reheat slugging its way through that perpetual Hall of Wall Street minions we know as our Congress? He believes that it throws some light on the shadow banking industry in that the Alphabet Soup gang at the FED get to see more balance sheets and books. There is also a stab at standardizing the process, but custom fitted Credit Default Swaps remain. The essential riskiness remains. Let’s examine the Krugman critique.
But what about the broader problem of financial excess?
President Obama’s speech outlining the financial plan described the underlying problem very well. Wall Street developed a “culture of irresponsibility,” the president said. Lenders didn’t hold on to their loans, but instead sold them off to be repackaged into securities, which in turn were sold to investors who didn’t understand what they were buying. “Meanwhile,” he said, “executive compensation — unmoored from long-term performance or even reality — rewarded recklessness rather than responsibility.”
Unfortunately, the plan as released doesn’t live up to the diagnosis.
Well, maybe the White House Pastry chef did not completely overwhelm the shrill one.
Tellingly, the administration’s executive summary of its proposals highlights “compensation practices” as a key cause of the crisis, but then fails to say anything about addressing those practices. The long-form version says more, but what it says — “Federal regulators should issue standards and guidelines to better align executive compensation practices of financial firms with long-term shareholder value” — is a description of what should happen, rather than a plan to make it happen.
Furthermore, the plan says very little of substance about reforming the rating agencies, whose willingness to give a seal of approval to dubious securities played an important role in creating the mess we’re in.
In short, Mr. Obama has a clear vision of what went wrong, but aside from regulating shadow banking — no small thing, to be sure — his plan basically punts on the question of how to keep it from happening all over again, pushing the hard decisions off to future regulators.
Andrew Ross Sorkin at the Dealbook is not a fan either.
Three-quarters of a century ago, Roosevelt earned the undying enmity of Wall Street when he used his enormous popularity to push through a series of radical regulatory reforms that completely changed the norms of the financial industry.
Wall Street hated the reforms, of course, but Roosevelt didn’t care. Wall Street and the financial industry had engaged in practices they shouldn’t have, and helped lead the country into the Great Depression. Those practices had to be stopped. To the president, that’s all that mattered.
By comparison, the Obama plan is little more than an attempt to stick some new regulatory fingers into a very leaky financial dam rather than rebuild the dam itself, the columnist says. Without question, the latter would be more difficult, more contentious and probably more expensive.
The article basically reviews the assessment of the plan by The New York Times’s Joe Nocera. It really couldn’t be more spot on even if it tried much harder. As you can read in my first thoughts and anything I wrote slightly earlier, I hate the idea of leaving ‘too big too fail, too big too restructure’ institutes unscathed but regulated. This issue still looms in the room like the Ghost of Financial Crises Future.
Yet the Obama plan accepts the notion of “too big to fail” — in the plan those institutions are labeled “Tier 1 Financial Holding Companies” — and proposes to regulate them more “robustly,” Mr. Nocera says. The idea of creating either market incentives or regulation that would effectively make banking safe and boring — and push risk-taking to institutions that are not too big to fail — isn’t even broached, he says.
Again, Nocera has a thing against customized derivatives which are left in the mix. This, again, is another area that I felt was a complete sell out to the boys in blue suits.
Or take derivatives. The Obama plan calls for plain vanilla derivatives to be traded on an exchange. But standard, plain vanilla derivatives are not what caused so much trouble for the world’s financial system, Mr. Nocera says. Rather it was the so-called bespoke derivatives — customized, one-of-a-kind products that generated enormous profits for institutions like A.I.G. that created them, and, in the end, generated enormous damage to the financial system, he writes. For these derivatives, the Treasury Department merely wants to set up a clearinghouse so that their price and trading activity can be more readily seen, Mr. Nocera says. But, he notes, it doesn’t attempt to diminish the use of these bespoke derivatives.
So, in other, is this really an FDR moment news, Dr. Christine Romer (for sure a great economist) wrote an article arguing that we should not repeat the mistakes of 1937. Those would be the mistakes that have driven fresh water economists to the conclusion that none of the Keynesian-like fiscal stimulus got us out of The Great Depression. Those actions worked but other actions put the country into a second dip. Basically, the fresh water argument denies how policy emphasis shifted to the deficit so they instituted tax increases and also how the Fed exercised some tight monetary policy without any real grasp of what it was doing and caused another downturn.
The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.
However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.
UC Berkley’s Dr. Brad deLong says you saw the lessons but are you really applying them?. Both articles are wonky but readable and I would really recommend you try to make your way through them. You’ll learn a lot about the Great Depression. He thinks the Obama administration is trying to fly the victory banner way to soon and risks making things a lot worse. His arguments are just laden with things you really should know about early attempts at macroeconomics. I’m only putting his bottom line out but please read the entire thing.
[t]he 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy following an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment. Financial crises, in particular, tend to leave scars that make financial institutions, households and firms behave differently [than in normal times]. If the government withdraws support too early, a return to economic decline or even panic could follow…
The blunt fact is that the economic recoveries that have been rapid and seen fast growth in employment are those that ended when a Federal Reserve following strongly restrictionary policies to fight inflation eased off and significantly lowered interest rates. No such lowering of interest rates is possible this time–interest rates are already as low as they can possibly go at the short end. So I can see no reason to anticipate a rapid recovery and employment when the cliff-diving stops. And I do not understand why the Obama administration is following policies that presume such a rapid recovery–a V rather than an L for the shape of the recession–is not just possible but probable.
I would also recommend checking out his analysis at The Week where he argues that we are still living the Wall Street Fairy Tale. As I said, I’m sending up pleas to the Greater Ethos that Brad doesn’t get invited to White House dinners because since the semester ended, Brad’s on fire. You have to just love the headline, but the arguments are even better.
The story we tell ourselves about what happened to the financial markets last fall is vitally important. It will determine what form financial market regulation takes in the next few decades, and how vulnerable we will be to the next disruption. At this moment, a relatively calm one, a fictional version of last fall’s events is gaining traction.
He provides a short, succinct version of the facts and an even nice description of the spin. The spin is extremely important to unmask as that reform build winds its way through the Halls of Wall Street minions.
The fact that the rescue of the banking system took the form of nationalization of AIG, and the honoring of its paper, rather than equity investments by the government in the banks, and the discounting of AIG paper, has encouraged a bout of revisionism in which most of Wall Street and at least a third of Congress now embrace a fairy tale. They tell themselves—and us—a story of a banking system that was fundamentally sound, that merely needed a little temporary liquidity to tide itself over a panic. But the true story is one of an overleveraged banking system that was insolvent save for a $300 billion gift from American taxpayers.
If I haven’t turned you into an amateur economist yet, these links will surely give you that nudge. Check them out because our taxpayer dollars depend on a populace armed with the facts.