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!
Fascinating discussion. The efficient market hypothesis and rational market theory have taken a hit with the bubble/financial crisis and central bank talk of financial instability. Gone are the days when Greenspan spoke of self-correcting markets. I don’t have a firm grasp on these ideas but I wonder about the history and interplay of the central banks’ real rate, the finance system’s profitability and policies of deregulation and easing of standards (which leads to crisis).
I wonder if the push to deregulate was in part a reaction to declining profitability in the financial sector as well as a result of complacency as the Great Depression faded from memory. For instance the saving and loan crisis of the Reagan era.
Also imagine a different timeline, where the housing bubble didn’t blow, where Greenspan warned of it daily so people invested somewhere else not wanting to risk their money or the rating agencies rated toxic assets correctly? Where would it have gone? Would there have been more of a “savings glut” which would have pushed down rates and returns even more? In turn this makes me think of Piketty’s K21 and the discussion of capital and labor share. The critics of K21 say there’s a self-correcting mechanism there of supply and demand. Maybe asset bubbles short-circuit it in a way, I don’t know.
Housing failed. We didn’t have a free market in housing. At every step (mortgage interest deduction, FHA, Fannie & Freddy, HUD, HLBB). Housing received almost $14B in federal subsidies in 2000. Only in govt can one construct the antithesis to a free market and then blame the free market when things go south.
“not that the system of free private enterprise for profit has failed in this generation, but that it has not yet been tried.”–FDR
The problem with the FHA, and especially Fannie & Freddy, was guess which part of the private-public partnership? Do you think it was the government that pressed them to jump into the sub-prime market to increase profits and share price? Or was it the over compensated executives catering to the private side?
Also $14 billion is a drop in the mortgage bucket. Several private banks are paying that in fines for fraudulent activities related to the boom, without breaking a sweat.
You’ll be happy to hear the current plan favored by Obama and sell-out Democrats is to dismantle Fannie and Freddie so the already bloated financial sector can scrape more profits from everyone, with less oversight, and less interference from government trying to ensure fair play. Any sane person would be advocating major legislation to make banks smaller and keep a public option. The larger question for Freddie and Fannie is how their central involvement in the sale of mortgages as securities promotes speculation and leaves banks with no incentive to act responsibly. How can we keep the 30 year mortgage without government involvement? How do we stop banks from fraud when no one is personally prosecuted?
1. Non-Prosecution = failure of govt
2. Allowing quasi-private entities free rein to take on inordinate risk by backstopping it = failure of govt
3. Missing obvious consequences (Bubble!) of #2, even though Ron Paul warned the GSEs were doomed in 2002 = failure of (most of) govt. (Barney Franks cheers on the bubble, 2005: http://thomas.loc.gov/cgi-bin/query/R?r109:FLD001:H05182)
4. Future prediction: Not ending govt backstopping of risky loans (reverse morgtages, GSEs, student loans) when 2008 proved private-public partnership backstopping doesn’t work = failure of govt.
1. I guess we agree on #1, failure to prosecute banks for wrongdoing is a failure of government.
2. The backstopping did not give free rein to take inordinate risk. No one thought it was ok to fail and seek a bailout. The motivation came from partly privatizing the operation, having them compete with banks, and giving the executives of Fanny and Freddie financial incentive to make risky loans, same as the banks. Moreover…
WE BACKSTOP EVERYONE!
In case you didn’t notice, the U.S. economy is a quasi-private enterprise.
3. Fannie and Freddie weren’t able to recoup losses by ripping off the public like the private banks. However it was the private banks that brought down the economy and cost trillions of dollars, not Fannie and Freddie.
4. Future prediction, not removing incentives for risky speculation by private banks, not cutting bloated financial sector, not imposing adequate regulation, when it’s been proved private banking doesn’t work = failure of govt.
Backstopping student loans should end by making post secondary education free. Student loans fuel inflated tuition, million dollar college president salaries, excessive administrative costs and overbuilding, but cost the government nothing in the long run. You have to die to escape student loans. Let students declare bankruptcy again, and that might motivate the government to expose the waste and fraud in higher education.
The reason GSEs were able to take on risky debt, knowing a bailout was forthcoming:
Ditto private banks (pre-crash):
Hillary figures prominently on both lists………..
I don’t know that we will ever obtain the requisite foresight as a people or even on an institutional level. Our new YOLO culture certainly isn’t helping either haha. Clearly there is a role for ‘stronger’ centralized regulation and reinforced Basel Accords and such…
Too me, it seems like claiming “the stimulus was too small” just puts one behind the ramparts of unfalsiability. If the economy soars then we hear “see I told you stimulus works” , if it tanks (2014Q1 GDP, for example), the retort is “it just wasn’t large enough”.
Again, echoing Paul Krugman, we have a natural experiment(s) that took place in Europe. Several countries had no stimulus, many had moderate to none, the U.S. had a large (but too small as stated by Krugman in real time back in 2009), and guess which economies did better?
You must have missed our Q1 GDP.
The economy picked up right after the stimulus began. The economy slowed right after the stimulus ended. Yes, yes, post hoc ergo propter hoc and all that, but it’s hard to argue that the stimulus didn’t do at least most of what it was designed to to (not that I’m accusing you of making that argument).
Of the ~$750b in stimulus, about half was tax breaks, not direct spending. Couple that ~$400b in actual spending, the $2-3t lost in the recession and the timeline mentioned previously and I don’t think it’s a terrible stretch to claim the stimulus was too small.
But the stimulus was billed as a short term boost to get the economy moving on its own. Is infinite stimulus your suggestion?
Lack of ability to see downside risk is why we have regulations.
Part of the problem:
1. Economic/ financial failure
2. Impose regulations to prevent future repeat
3. Long period with no failures
4. Lack of failure = we don’t need regulation
5. Repeal regulation
6. Economic/ financial failure
The generation born after the Great Depression came to power and dismantled many of the safeguards. People like Alan Greenspan who was not even a teenager when WWII ended the depression became openly hostile to regulation and the need for regulatory policy. Greenspan tried to substitute monetary policy for regulatory policy and failed miserably. If monetary policy was too blunt to address a bubble, the bubble was ignored or denied. Regulatory policy, that could have selectively deflated the tech bubble or the housing bubble was not used, primarily because of ideological hostility to regulation.
People will look at regulation and think, “If only this regulation were removed, I could make a lot of money”. These people want a free lunch. Removing the regulation may allow them to get rich but it often comes at the expense of others. There are a lot of people, including a lot of economists that think like Greenspan. They do all manner of complicated workaround to avoid implementing simple regulations that would address the problem.
Friedman pushed the use of monetary policy further than it should go and abandoned good regulatory policy. The future of macroeconomics is not in fine tuning monetary policy, it is in developing better regulatory and fiscal policies.