On Thursday 29 May and Friday May 30, the New York Fed and Columbia Business School are organising a conference, at the New York Fed, on The Role of Money Markets. On the second day of the conference, I will be presenting a paper titled Lessons from the North Atlantic Financial Crisis. It is a much-revised and expanded version of an earlier paper of mine, Lessons from the 2007 Financial Crisis, which was published by the Centre for Economic Policy Research as CEPR Policy Insight No. 18 on December 19, 2008.
The new paper focuses extensively on the performance of the three most affected central banks: the Fed, the ECB and the Bank of England. It evaluates their performance using three criteria: (1) macroeconomic stability; (2) effectiveness in dealing with the immediate financial crisis; and (3) the impact of the pursuit of macroeconomic stability and putting out immediate financial stability fires on the likelihood and severity of future financial crises. I conclude that although the Fed did a reasonable job dealing with the immediate financial crisis, it did significantly worse than the other two central banks as regards macroeconomic stability and the prevention or mitigation of future financial crises.
I identify two main causes for this underperformance by the Fed. As regards macroeconomic stability, there are flaws in its model of the transmission mechanism of monetary policy and other macroeconomic shocks. Two prominent errors are the overestimation of the effect of changes in house prices on consumer demand and the unfortunate focus on the will-o’-the-wisp of core inflation rather than on medium-term headline inflation. The Fed also either ignores the need for a major increase in the US saving-investment balance or believes that this can be achieved without passing through an extended spell of below-capacity growth of demand.
Second, the Fed, unlike the Bank of England and the ECB, has regulatory and supervisory responsbility for part of the US banking system. This has the advantage of giving it institution-specific information of a kind not available to the Bank of England or the ECB. The disadvantage is that the Fed’s position invites regulatory capture. I believe that during the Greenspan years there was what I call ‘cognitive regulatory capture’ of the Fed by Wall Street.
This regulatory capture has resulted in an excess sensitivity of the Fed to financial market and financial sector concerns and fears and in an overestimation of the strength of the link between financial market turmoil and financial sector deleveraging and capital losses on the one hand, and the stability and prosperity of the wider economy on the other hand. The paper gives five examples of recent behaviour by the Fed that are most readily rationalised with the assumption of regulatory capture. The abstract of the paper follows next. The latest version of the entire enchilada can be found here. Future revisions will also be found there.
The paper studies the causes of the current financial crisis and on the policy responses by central banks and regulators. It also considers proposals for the prevention or mitigation of future crises.
The crisis is the product of a ‘perfect storm’ bringing together a number of microeconomic and macroeconomic pathologies. Among the microeconomic systemic failures were: wanton securitisation, fundamental flaws in the rating agencies’ business model, the procyclical behaviour of leverage in much of the financial system and of the Basel capital adequacy requirements, privately rational but socially inefficient disintermediation, and competitive international de-regulation. Reduced incentives for collecting and disseminating information about counterparty risk were a pervasive feature of the new financial world of securitisation and off-balance sheet vehicles. So was lack of transparency about who owned what and about who owed what and to whom. In many ways, the crisis can be seen as a failure of the transactions-oriented model of financial capitalism favoured in the US and the UK. Proximate local drivers of the specific way in which these problems manifested themselves were regulatory and supervisory failure in the US home loan market.
Among the macroeconomic pathologies that contributed to the crisis were, first, excessive global liquidity creation by key central banks and, second, an ex-ante global saving glut, brought about by the entry of a number of high-saving countries (notably China) into the global economy and by the global redistribution of wealth and income towards commodity exporters that also had, at least in the short run, high propensities to save. Very low risk-free long-term real interest rates and unprecedently low credit risk spreads of all kinds together with the ‘great moderation’ – low and stable inflation and stable global GDP growth – prompted an increasingly frantic ‘search for yield’.
In the UK, failures of the Tripartite financial stability arrangement between the Treasury, the Bank of England and the FSA, weaknesses in the Bank of England’s liquidity management, regulatory failure of the FSA, an inadequate deposit insurance arrangement and deficient insolvency laws for the banking sector contributed to the financial disarray and the failure of a medium-sized home-loan bank, Northern Rock. In the US, the balkanised and incoherent structure of regulation of financial institutions and financial markets, even at the Federal level, meant that too many regulators are involved but none is ever in charge or responsible.
Despite this, since the excesses were confined mainly to the financial sector and, in the US and some European countries, the household sector, it should have been possible to limit the spillovers over from the crisis beyond the financial sector and the housing sector without macroeconomic heroics. Measures directly targeted at the liquidity crunch should have been sufficient. The macroeconomic response of the Fed to the crisis – 325 basis point worth of cuts between September 2007 and May 2008 and a 75 basis point cut in the discount window penalty – therefore seem excessive and create doubt about the Fed’s commitment to price stability.The liquidity-enhancing policies of the Fed, and its bailout of the investment bank Bear Stearns, were effective in dealing with the immediate crisis. They also were, quite unnecessarily, structured so as to maximise moral hazard by distorting private incentives in favour of excessively risky future borrowing and lending. The cuts in the discount rate penalty, the extraordinary arrangements for pricing the collateral offered to the Fed by the primary dealers through the TSLF and the PDCF, the proposals for bringing forward the payment of interest on bank reserves, the terms of the Bear Stearns bail out and the ‘Greenspan-Bernanke put’ rate cut on January 21/22 2008, 75 bps at an unscheduled meeting and out of normal hours, are most easily rationalised as excess sensitivity of the Fed to Wall Street concerns, reflecting (cognitive) regulatory capture of the Fed by Wall Street.
The macroeconomic stability records of the Bank of England and of the ECB have been superior to those of the Fed. After climbing a quite steep liquidity learning curve in the early months of the crisis, the Bank of England is now performing its lender of last resort and market maker of last resort roles more effectively. It would be desirable to have the information in the public domain that is required to determine whether the ECB (through the Eurosystem) is pricing illiquid collateral appropriately. There is reason for concern that the ECB may be accepting collateral in repos and at its discount window at inflated valuations, thus joining the Fed in boosting future moral hazard through the present encouragement of adverse selection.
The Fed, unlike the ECB and the Bank of England, is also a banking sector regulator and supervisor. This gives it an informational advantage. The downside to the Fed’s position is the risk of regulatory capture. I believe that what I call ‘cognitive regulatory capture’ of the Fed by Wall Street has occurred during the past two decades. The net result is that both as regards macroeconomic stability and as regards future financial stability, the Fed has performed worse during this crisis than the ECB and the Bank of England.
Future regulation will have to be base on size and leverage of institutions. It will have to be universal (applying to all leveraged institutions above a certain size), uniform, countercyclical and global.
Financial crises will always be with us.