Well, I’ve been sort of off the grid for the past week (i.e., as far off as I’m comfortable, meaning I was rarely out of range of wifi; actually, a few hours ago I stood atop the continental divide, where thankfully, there is yet no wifi) but now return to life as I know it. Also, working on testimony before the JEC on Tuesday on evaluating the economic recovery at five (years old).
More to come on that once it’s public, but the theme is: we’ve actually made real progress over the recovery, especially in the job market in recent months. This progress is especially notable once you consider the depth of the recession that proceeded it. EG, one finding from the testimony: despite the fact that the 2001 recession was extremely mild and short compared to the “great recession,” private sector job growth in this recovery has far surpassed that of the previous expansion.
So, countercyclical policy worked to offset the worst damage of the downturn but it stopped (and even reversed) too soon thus failing to build on the early gains; the result is that the recovery has yet to fully reach most households.
One thing that caught my eye over the past week was this speech by Stanley Fischer, the new Fed vice-chair and former governor of the central bank of Israel, who spoke on the Fed’s role in financial stability. His talk struck me as the state-of-the-art thinking of a central banker who recognizes the essential need for adequate financial market oversight but is still struggling with calibration.
While he skirted an explicit view of what I consider one of the most important questions in this space—should the Fed try to spot and prevent the inflation of asset bubbles? (I certainly think so)—he provided a detailed and telling example of how the Bank the Israel intervened fairly aggressively to prevent the inflation of a housing bubble (hint, hint…).
I’d like to pull out one relatively small point that I’ve come to view as extremely important in diagnosing what’s going on in contemporary “macroprudential oversight” (Fedspeak for the role of regulators in keeping financial markets on the rails).
I was recently at a meeting with people from the retail side of the financial services industry on the topic of wealth building and retirement security from the perspective of under-banked populations. One of the points they made in the context of people’s tendency to under-save echoed an insight I’ve written about in the context of fighting climate change: the fact that people heavily discount the future in favor of the present.
Fischer referenced a close cousin of this problem in discussing the inability of banks to appropriately value portfolio risks (my bold): “This approach did not work, partly because the agreed regulatory minimum capital ratios were too low, but also because any set of risk weights involves judgments, and human nature would rarely result in choices that made for higher risk weights.”
What’s the connection? It’s this: a fundamental problem of today’s financial sector is that recent “innovations” interact perniciously with the basic human inability, or at least deep-seated unwillingness, to appropriately “risk-weight” the future.
It is already in our nature to overly discount future risks. Add in securitization, for example, where lenders can quickly offload risky loans, or introduce the spate of products that allow shoddy underwriting (alt-a, no doc loans, exploding ARMs, interest only, etc.) and you’re building a system that is custom made to tap our inherent tendency to heavily discount future risks.
While I appropriately dismiss the notion that solid macroeconomics must comport with micro fundamentals, I think differently about financial regulation. Here, understanding human nature is very important, and is at the heart of the best work in the area, like that of Hyman Minsky. Smart regulation (and smart climate policy) must recognize and work against our human tendency to overly discount future risk, an idea that has obvious implications for overseeing securitization, underwriting, derivatives, and TSLTF institutions (too-systemically-linked-to-fail).
Conversely, inadequate oversight assumes this problem away based on the Greenspanian assumption that financial markets self-correct and “irrational exuberance” cannot therefore persist. It can and it does, as the shampoo cycle–bubble, bust, repeat–has shown time and again, at great cost to the economy and most of the people in it.
A Selfie of Yours Truly Deep in Vacation Mode with Moose, Flag, and Strawberry Cone!