May 28, 2008
Lessons from the North Atlantic Financial Crisis
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.
Abstract
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.
Dear Willem Buiter, You give a very large number of causes and I agree they have all contributed to the recent financial crisis. And yet it seems to me that in all the discussion of the financial crisis no-one has proposed eliminating the root cause – even though you include it in your list!
The Fed rate between 2000 and 2006 was successively used as a monetary control parameter. The rate was:-
reduced progressively by 5.5%, to 1.0%,
left constant for a short period, at 1.0%,
and increased progressively by 4.25%, from 1.0%.
These variations were about double the corresponding variations at other major central banks. The ‘resulting’ US house price variations on the Case-Shiller 20-city composite were:
a price increase of 105%, building up over six years,
followed by a drop in price of 12%, over 18 months.
Now the above Fed rate changes were reasonable interpretations of currently accepted macroeconomic theory for monetary controls, as required for maintaining desirable values of inflation and growth. The detail could be debated, but the general procedure surely fits the description of “reasonable interpretations”. It must therefore be reasonable to consider altering our monetary controls.
The purpose of my discussion below is to demonstrate that we can have a very good monetary control – more stable and more stimulating than at present – without using variations in the bank rate as a control parameter. Such a control would eliminate the root cause of the present variations in house prices and it would have prevented the crisis. I’m sorry the discussion below is rather long.
About 40 years ago the FT was good enough to publish as a letter my conclusions on the response rate and stability of a monetary control with feedback - on 26th February, 1969. The analysis predicted high stability. I recommended the arrangement accordingly. The growth rate, also, is high, as discussed below.
My first present interest in the control is in the method adopted for increasing the rate of spending.
For a very good performance a control must achieve an increase in the rate of spending very soon after the monitor has indicated the need for an increase. Of various ways of achieving that result, I currently favour gifts of new money - the “new” is essential - to a rota of people chosen to spend their gifts as an extra within one or two weeks. So if, for example, monitoring showed that there had been a slight build-up above optimum in the amount of goods for sale in the shops, and a slight rise above optimum in the availability of staff to perform services, then the control would provide gifts of new money to people according to the rota and that new money would be spent, as an extra, mostly within one or two weeks – without affecting the government’s budget or its borrowing requirement. The effect of the feedback would then be very rapid and the control would keep the economy very steady and very stable. Moreover, industry and commerce would find that, in total for the economy, all their output would be purchased however much they produce - provided average prices remain constant. So, for maximum profit, firms would strive to produce an increasing output, at constant prices, and growth would settle at a sustainable maximum. The demand for labour, also, would settle at the sustainable maximum, as would wages.
The current equivalent is variation of the bank rate. That can be seen from the above to be a poor match to the desired characteristics for the control, even before consideration of the undesirable side effects such as in disrupting the price of houses.
Consequently present circumstances require a switch to the above type of monetary control, in order to eliminate both, house price variations induced by the monetary control, and, the resulting interference with the financial credit system. Then, once the cause of the present problem has been removed, the investment banks could be subject as John Gapper suggests to a simple regulatory structure and improved incentives.
Posted by: Brian Stratford | May 28th, 2008 at 10:45 pm | Report this commentJean-Pierre Roth, Pres. of the Swiss National Bank, says he is surprised by the continuing high price of oil and the length of time that the price has remained high. He had expected that the oil price would have fallen, in line with the slowdown in the global economy. He also said it was a huge mistake (ein grosser Fehler) to have faith in the the self-regulation of the market, that self-regulation is not enough: legislators must intervene to make corrections.
The above reinforces the opinion that leverage and speculation are very probably a major cause of the high prices in the commodity markets.
There is no justification, moral, economic, commercial or political, for the over-sized rôle that leverage and speculation are playing in causing huge price increases in commodity and raw materials markets.
Posted by: J.J. | May 29th, 2008 at 7:58 am | Report this comment“I’m forever blowing bubbles, pretty bubbles in the air, They fly so high they touch the sky and when they pop I wonder why”
Oil is up there Cazaly because of the Bernanke Put debauching the currency. By pegging to the dollar, nations effectively become part of the USA but their inflation doesn’t register on the Fed’s dashboard.
If you question the relationship between statehood and currency then ask the Godfathers of the Euro about its true purpose.
Posted by: gareth d | May 29th, 2008 at 2:53 pm | Report this commentI’d advance a few other possible explanations. All of them variations on this being a crisis of faith in the US economy’s ability to adapt in a world of high energy, high materials and extreme biomimicry in design. That is, the one we’re in.
The most “economic” of these explanations regards the US dollar’s lost status as a global reserve currency. When there is no clear single accepted standard of deferred payment, commodities with relatively inflexible demand and hard-to-expand supply may rise in price simply because they are known to have value in any regime. At times where there are many well recognized externalized harms from commodity (and especially oil and gas and most especially coal and bitumen) production, it may seem useful to lock in a supply of these to make up for later price hikes when the externalities are eventually accounted and paid for. For instance, when the EU and US actually pass a carbon cap-and-trade system enforced by a tariff at their borders against all imports, the price of oil will rise but less of it would then be realized by the speculators than right now. And of course the instability causes flights to gold and other precious metals, and to industrial and utility metals like copper, iron and so on that are required by the rising industrial economies.
(Note however that none of these prices are any where near their inflation-adjusted highs of the early 1980s when there were no clear substitutes for oil and US-USSR tensions were also very high)
We also see longstanding pegs to the dollar, such as that of the Saudis, crumble, reducing the US economy effectively in size. China is also under pressure to do something similar. In these circumstances, one would expect to see the former reserve currency (the US dollar) in the dumps due to uncertainty about the quality of its management and just how much it was pumped up in price by its priveleged global status as the standard of deferred payment, store of value, and to a lesser degree unit of account and medium of exchange. One would expect also in such circumstances to see very closely linked currencies relying on commodity exports to the US, such as the Canadian dollar, skyrocket since they are not subject to any of this uncertainty but produce these commodities. That’s exactly what’s occurred this past year. The Canadian dollar hovers around par and is today near $1.02.
Narrow technical analysis won’t explain much - note that the Europeans are changing the meaning of their numbers, for instance arguing about the status of energy generation in GDP and GNP etc., and what should be included in “inflation”. Old theories regarding inflation and investment seem to me very incoherent as so many changes are now occuring even in the pre-industrial economies scrambling to radically reduce energy and materials use. Consumers and producers are simply are not using a bill of materials or energy inputs that look like those they were using ten years ago. In some cases, like cement production, radically lower energy alternatives now exist. Scrap steel requires a much lower energy and ecological footprint to re-use than raw iron ire requires to locate, dig up and refine. Consumers are moving to vegan diets and “100-mile diets” and smaller cars and condos and smaller families in the developed world. In the developing world, energy and food prices skyrocketing force people to adopt totally new cooking and eating habits - and not always out of desperation. In Cuban cities for instance rooftop food gardens are practically mandatory - but they work - feeding the vegetable needs of most of the population. When underlying consumption patterns are changing this fast and this effectively to minimize energy and material and transport use, inflation may indicate quite a few things other than it used to. For one thing it may indicate a high demand for infrastructure like LED lights or garden roof sealing plastic, and eventually a lower demand for electricity or imported fruits. These are shifts in basic demand and aggregate numbers like consumer price indexes don’t do them justice. More fundamental analysis is required.
Accordingly, I believe that the US currency is “debased” by bad policy and the end of a period in which the US economy was seen as an uncontroversial and safe investment. To put tongue in cheek, as global demand for expensive weapons, gas-guzzling trucks, porn, lawyers, genetically damaged and pesticide-laden food, amazingly subsidized meat, faked-up military intelligence, bloated proprietary software, bogus bonds and celebrity sex tapes wanes, so too one would expect to see the US economy become much less relevant to the future world economy. These are, after all, its major exports.
Most of the rest has already left.
One need look no further than the fact that Cuba and India export medical expertise, Denmark exports windmills and UK architects are (thanks to regulations requiring zero-carbon housing by 2016) world experts in efficient home design, to wonder why their economies and their currencies are deemed to have better prospects than an economy run by Halliburton, Blackwater, Exxon with the worst fiber optic Internet access in the developed world.
A US dollar in other words may be a bet on the 20th century continuing. Which seems unlikely.
Posted by: Craig Hubley | May 29th, 2008 at 9:56 pm | Report this comment[…] Buiter posts an interesting essay (verging on polemic) regarding Lessons from the North Atlantic Financial Crisis: I conclude that although the Fed did a reasonable job dealing with the immediate financial crisis, […]
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