“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.”
–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 dot.com 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.