Financial Market Oversight, Economic Recoveries, and Full Employment: Some Crucial Linkages

July 29th, 2014 at 2:59 pm

“The way to make a train go fast is to keep it from going slow.”

That bit of Zen was told to me by one of the nation’s foremost rail experts back when I worked on that issue.  He was explaining that part of developing a high-speed rail system entails straightening out existing curves in the track.  But to me, it’s become a metaphor for the importance of financial market oversight.

Let me explain.

Readers know that full employment is at the heart of my agenda.  My work shows that the absence of tight labor markets is implicated in wage and income stagnation, inequality, and the general lack of bargaining power by the majority in the workforce.  More recently, important research has found compelling linkages between the output gaps that characterize slack labor markets and structural damage to the economy’s potential growth rate.  Put it all together and we’re talking about large and substantive losses dragging down the living standards of workers both here and in other advanced economies that have been beset by such gaps for years now.

So if full employment is so important, why spend time on the tangled morass of financial market oversight?  Why plumb dark pools (private exchanges) and track the implementation of Dodd-Frank?

Because they are the equivalent of track straightening.  If we want to achieve full employment, we’re going to need expansions to last and recessions to be rare and shallow. “Minsky moments,” when key economic sectors freeze up in response to a period of financial recklessness (more technically, when risk pricing flips from underpriced to overpriced), must be avoided—and remember, such “moments” last for years.

That’s why those of us on team full employment must attend to the issue of financial oversight. When it comes to how…well, thankfully, there’s Mike Konczal.  He’s been following these issues with insight and clarity, most recently reviewing the status of Dodd-Frank at four years old.

Mike argues that the implementation of Dodd-Frank “…has seen significant advances on key issues of financial reform, with at least four major wins.”

Those are:

–Banks are required to lower their leverage ratios—to hold more capital against losses. The banks typically don’t like this, because leverage is how they multiply their gains when they trade their books (more on that below).  But many observers view this as the most important buffer against insolvency and bailout.  Mike reports that while “capital requirements aren’t as high as they could or should be,” they’re moving in the right direction.

–Some derivatives are now being traded over public exchanges, thus shining a bit more daylight on bets and hedges that reference contracts worth trillions, activities that were formerly outside the purview and sight of regulators.  And the launch has thus far been glitch-free.

–Re banks trading their own books, the Volcker Rule—the part of Dodd-Frank designed to restrict proprietary trades by federally insured banks—looks fairly tight.  By that I mean it is written to allow some exposure of bank capital in deals between customers (“market making”), while preventing reckless speculation with the potential for London-whale-sized losses.  Technically, traders must document the specific, identifiable risks involved in a “prop trade,” why they’re important (what’s the hedge?), how much of the bank’s capital is at stake, and bank risk managers must be aware of all the above. Yes, that’s more work for compliance officers and regulators but after what we’ve been through, it looks to me like codified common sense.

–Mike argues that contrary to much rhetoric, there’s been progress on TBTF (“too big to fail”) as well, with the articulation of how “last rights” and “death panels” would work for systemically connected, failed financial firms. I’d say that on this part we won’t know how it works until we try it, and no one should believe that federal bailouts are totally a thing of the past. But all of the above, from less leverage to Volcker to more transparent derivative trades, reduce the likelihood of the next costly bubble and bust.

That is, if we enforce the new rules.  The best switches will fail if regulators are asleep at them.  In that regard, one our most dangerous enemies in this space has been the diffused locus of financial market oversight. Dodd-Frank helps here as well, by creating both a council drawn from regulators across the agencies (the “FSOC”) responsible for monitoring systemic stability, and the CFPB to monitor consumer finances.

But that’s not enough. For the Dodd-Frank reforms to really work, the Federal Reserve must jump into financial market oversight with both feet. Their political independence gives them a huge edge here—how effective should we expect the CFTC or SEC to be under a Paul Ryan or Ted Cruz administration? That they’ve got the staff and the data to amply monitor market conditions is documented. History shows that they saw both the and housing bubbles, though in both cases Alan Greenspan assumed markets would self-regulate.

By now we know that the track doesn’t straighten by itself. Chair Yellen and company, along with their counterparts throughout the government, must recognize that absent close oversight, financial markets will unquestionably go off the rails again. To their credit, both Yellen and Vice-chair Stan Fischer appear to be taking this part of the job seriously. Most important, Chair Yellen has said, in so many words, that in the interest of macro-management, the Fed simply doesn’t have the luxury to ignore bubbles (sounds like a big “duh,” I know, but there it is…).

Too often, economic silos lead us to work on micro, not macro; labor markets, not financial markets; fiscal, not monetary. But dude…it’s all connected! The path to full employment runs through financial market oversight, and Dodd-Frank is shaping up to be an important ally.

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9 comments in reply to "Financial Market Oversight, Economic Recoveries, and Full Employment: Some Crucial Linkages"

  1. Robert Buttons says:

    External financial regulation has never worked. Despite our pretense of knowledge, we are no better at regulating markets than we were when “markets failed” (that is to say, market regulation failed) in 2009, 2000-2002, 2008 or the various and sundry other “crashes” (S&L comes to mind). One would have thought the pretension would have dissolved five short years after Sverges Riksbank Prize winning economist Robert Lucas hilariously proclaimed in 2003: “[The] central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”

    If anything Dodd-Frank has made TBTF worse. Liquidationism is the internal market regulator and markets cannot and will not work correctly when implicit or explicit bailouts remove the fear of failure.

    • smith says:

      Most people would view the downturns of 2000 and 2007 as a direct result of removing important oversight and regulatory functions that heretofore had constrained financial markets. The fact that the Great Recession was the greatest since the Great Depression and coincided with the weakest regulatory climate seems to prove market regulation works. The S&L crisis, the tech stock dive, the housing bubble flourished in the absence of adequate regulation that previously did exist and was purposefully removed to increase profits.

      Dodd-Frank is totally inadequate to tackle the issue of TBTF, the unwinding scenarios are a joke. Breaking up the banks should be the first order of business of the Warren administration. Banks have no fear of failure, not because of available of bailouts, but because the profits are larger the closer to the edge, like Icarus.

  2. Robert Salzberg says:

    Financial market oversight is a necessary but not sufficient solution. Financial markets have been exerting monopoly power to extract 3-4% of GDP over and above previous norms. Computerization should have reduced finance’s share of GDP not increased it.

    The solution is obvious. A financial transactions tax.

    We have also been underfunding our infrastructure by about 1% of GDP for decades. Happily, a FTT could yield close to 1% of GDP that could become a new dedicated tax for infrastructure.

    Tax Wall Street to rebuild every street. (And bridge, levy, port, water system, airport, electrical grid…)

    • Robert Buttons says:

      Whack-a-mole.Tax transactions off Wall St, they move to London. (inversions anyone?) Tax money moving to London and it goes underground. Regulate banks to stop the underground movement and you end up with e-currency. Clamp down on e-currency and all your commerce moves to a locale with economic freedom. The solution is for the fed to stop lavishing interest free money on Wall St.

      • smith says:

        Pursue the lowest common denominator tax rates and we’ll become the Cayman Islands, Mitt Romney would love that. It’s not whack-a-mole when you can virtually stop inversion dead in it’s tracks. There is also the idea of capital controls making companies pay for the privilege of living and working in America.

        It’s wrong for the fed to lavish interest free money on Wall Street without taxing it. Increase corporate tax rates, and close loopholes.

        Piketty advocates international cooperation to stop the bidding wars, but I’m quite sure unilateral actions can make it illegal or too expensive to move operations overseas, whether physically moving offices or in name only.

        • Robert Buttons says:

          Are you seriously advocating the fed giving out free money, so it can be taken by taxation??? Why not just cut out the middle man and let the fed deliver cash directly to the treasury?

          • Smith says:

            The Fed is using the highly inefficient and largely ineffective method of aiding recovery by keeping interest rates about as low as they can go. In a recession that wasn’t caused by a housing bubble and prolonged by debt overhang, that would spark recovery. Instead it mostly allows banks to make a killing because the low nominal rates mask the true rate providing a more than adequate return. I’m actually just assuming this is the case behind boosted profits, 2014 so far just a bit behind the “record-setting 2013” Could be just the normal financial sector shenanigans.
            However, the middleman, in this case the banks, still play an important role, when they’re not hedging, self-dealing, bamboozling, and speculating, they manage occasionally to do some banking. Thus they can’t be cut out, but the can be cut down, and the excess trimmed.
            The Treasury should step in and coerce the middleman to aid distressed homeowners.