July 2009 Archives
07/28/09 12:28 AM
Mortgage Modification Reconsidered
My misgivings concerning the government's competence in macroeconomic policy have been reinforced by a pair of recent articles: an article in the Economist on July 9 reporting on a study by three Federal Reserve Board economists, and an article in today's Washington Post by Renae Merle, on modifying mortgages. Calculated Risk, the superb finance/economics blog, which specializes in real estate issues, has also reported on the Fed study. And the Wall Street Journal, in an article yesterday, reported Administration dissatisfaction with the progress of its mortgage-relief program.
The accepted wisdom, which undergirds the Administration's program, is that modification is a superior method, from a mortgagee's as well as a mortgagor's perspective, to foreclosure for dealing with a mortgage default, but that securitization of mortgages, by severing the relationship between the originator of the mortgage loan and the borrower, impedes modification and so contributed to the drop in housing prices and increase in foreclosures, two of the symptoms of the housing crash. One of the Administration's responses to the economic crisis, accordingly, is a program that went into effect in March to encourage modification of mortgages that are in default. The Administration resports that 200,000 mortgages have been modified since March, which is actually a small number relative to foreclosures.
The articles in question, and the Fed study, challenge the accepted wisdom. The study, the conclusions of which are reinforced by discussion with bankers and borrowers reported in the Washington Post article, found in a very large sample of residential mortgages that only 3 percent of seriously delinquent borrowers received a modification of their mortgage "that reduced their monthly payments in the year after they got into trouble" (the quotation is from the Economist's summary of the study), and only 8 percent of those borrowers received any kind of modification.
The reason is that mortgagees generally prefer either foreclosure or what they call "self-cure" to modification. They reckon that most delinquent borrowers will either resume their mortgage payments without a modification ("self-cure") or default irrevocably sooner or later, so that little is to be gained by a modification. The modification will (if meaningful) not only reduce the monthly payments received by the mortgagee, but also entail negotiation costs and, by postponing foreclosure, lower the price that the mortgagee will receive, either because house prices are falling (as they are now, and as Calculated Risk expects them to continue to be for the next year) or because the financially stressed homeowner will not maintain the house adequately, and it will lose value between modification and eventual foreclosure.
Of course, there will be some cases in which modification is preferable from the mortgagee's standpoint, but probably few; we do not know how many--if any--of the 200,000 modifications since March owe anything to the government's program.
The Fed economists' study found, surprisingly, no significant difference in modifications dependent on whether the mortgage had been securitized. One reason may be that the incentives to modify are very weak even if the mortgage originator still owns the mortgage. There are reports that the servicers of mortgage-backed securities do not have the staff to handle all the modification requests they are receiving, and this is plausible since these securities often pool thousands of mortgages. On the other hand, the banks that service these mortgages have large staffs; they may be discouraging applications for modification simply because they don't think the costs of processing them are worthwhile, given how few modifications are in a mortgagee's best interests.
It's nice to have the study, and no doubt it took months to complete. But that does not excuse the government's failure to have realized that modification may not have been the magic bullet that its mortgage-relief plan thought it would be, and securitization of mortgages may not have been the culprit in the housing crisis that it was thought to be. All that would have been necessary to get to the same conclusion that the Fed economists reached would have been to talk to a few mortgage bankers. Once again we encounter the government's surprising ignorance of the economy that it is trying to regulate. It's not as if the federal government is new to the mortgage market. The banking industry is deeply invested in that market and pervasively regulated by the federal banking agencies. We are in the presence of another striking failure of federal financial intelligence, in both senses of the word "intelligence."
07/27/09 5:28 PM
Liberals Forgetting Keynes
In a striking turn in the unedifying history of business-cycle economics, John Maynard Keynes's masterpiece, The General Theory of Employment, Interest and Money (1936), was ignored by liberal and conservative macroeconomists alike until the collapse of the banking industry last September, and the ensuing economic depression, revealed that Keynes's book provided a better guide to our economic crisis than Milton Friedman's monetarism, Real Business Cycle theory, or even the New Keynesian Economics (which in fact bears little resemblance to Keynes's economic theory). Liberal economists like Paul Krugman quickly embraced Keynes.
But Krugman's passionate support for the Administration's health-care program suggests that he has not absorbed one of the central elements of Keynes's theory, which is the role of uncertainty in depressing investment spending and, both by depressing investment and by increasing passive savings, in depressing consumption spending as well. (I elaborate on the role of uncertainty in depressions in a forthcoming article in Challenge magazine, entitled "Uncertainty Aversion and Economic Depressions: Analysis and Implications"). When uncertainty in the sense of risk that cannot be calculated rises, it tends to make businessmen and consumers alike freeze--they hoard money rather than spend it, whether spending on investment in the case of businessmen or sending on consumption in the case of consumers. That is the prudent response to increased uncertainty, because by holding off on spending the businessman or the consumer buys time to gather information about his options, or simply wait for the situation to clarify itself, and also accumulates cash with which to deal with emergencies to which an uncertain economic environment can give rise. We see these tendencies at work today, in the huge excess reserves accumulated by the banks, the decline in new bank loans, the massive layoffs by employers uncertain about the demand for the goods and services they produce, the decline in business deals, and the sharp increase in the personal savings rate.
But by taking these precautionary actions (or inactions), businessmen and consumers are deepening the economic downturn and retarding recovery. The government's aim should be to reduce uncertainty and increase confidence in the future of the economy. Poorly designed as it was, the $787 billion stimulus package enacted in February was a justifiable anti-depression measure because, long before any of the appropriated money was spent, it boosted confidence in the government's determination to arrest the depression.
But even by today's standards, $787 billion is a lot of money. It added appreciably to a national debt already swollen by the Bush Administration's profligate spending and tax-cutting, by the bailout programs, and by the dive in federal tax revenues caused by the fall in incomes. The greater the national debt, the greater the worry about an aftershock to the depression when the time comes to pay back, in one way or another, the additional debt incurred to fight the depression.
I therefore thought it a mistake, as I have noted often in the blog, for the Administration to embark, without waiting for the recovery from the depression, on ambitious social programs that are likely to add substantially to the national debt. These programs, if enacted, will increase the likelihood of a severe aftershock.
The most ambitious of the programs is the plan to require, by a combination of mandates and subsidies, that the vast majority of the 45 million or so Americans who do not have health insurance at present obtain it.
Keynes warned President Roosevelt in an open letter of December 31, 1933, about trying to combine far-reaching reform with recovery from an economic depression. He wote that
even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place...And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once.
The passage that I have italicized deserves particular emphasis (though Keynes's warning that "it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once" is equally timely) because of the strange turn that the debate over health reform has taken in recent days.
Initially the concern was with the macroeconomic implications of adding some $100 billion a year to the federal deficit (an underestimate, in my view, because it ignores the increase in demand for medical services by tens of millions of persons who will have health insurance for the first time, which will reduce the marginal cost of medical services to them). The concern became so acute that focus shifted to measures for financing the program so that it would not add to the deficit. But when this happened, businesses and individuals alike began asking: what part of the cost of the new program will I bear? And this question injects a new and very major source of uncertainty into the economic environment. Small businessmen are worrying about the added cost to them if they are required to insure their employees, and individuals are wondering whether their cost of health insurance will rise. Most people do have health insurance and most of those who do are more or less satisfied with it; anyway better the devil you know than the devil you don't know.
Prudent businessmen and prudent individuals alike have thus been given an additional motive for hoarding cash rather than investing and consuming. No one knows how his financial situation will be affected by health reform, if it is is enacted. There is enormous and I think justified distrust of the government's ability to design and execute so ambitious a program as the Administration and the congressional leadership envisage.
One might think that this would give a born-again Keynesian macroeconomist like Paul Krugman pause. But not only does he say nothing about the effect of the debate over health reform on uncertainty and through it on the economic situation, even though he is pessimistic about the situation; he provides no analysis of the likely costs of health reform, and the incidence of those costs on particular groups in the society. He does nothing to allay the uncertainty that the debate over health reform has engendered.
07/26/09 4:16 PM
On Inflation
Federal Reserve chairman Bernanke testified last Tuesday (July 21) that there is no inflation danger even though the Fed is keeping short-term interest rates very low and the banks are awash with excess reserves (lendable cash), to the tune of some $800 billion, which if used for loans rather than left sitting in the banks' accounts in federal reserve banks would increase the amount of money in circulation by a considerable amount. Bernanke explained that if signs that unwanted inflation is looming appear, the Fed can head off the inflation in a variety of ways. One way, he emphasized, would be by paying interest on reserves at a rate that would increase the interest rates that banks would charge for loans and by doing so reduce the amount of money in circulation. Suppose the Fed paid 3 percent interest (at present it is paying .25 percent) on reserves; then a bank would have no incentive to lend at any lower rate. Indeed, it would insist on a significantly higher rate, since lending to the Fed (the banks' excess reserves are held in federal reserve banks, and so in effect are loans to the Fed, on which the Fed pays interest) is riskless. Another way to stop inflation would be for the Fed to sell securities to the banks (or to others) and retire the cash it received, thus reducing the amount of money in circulation. It could do other things as well.
But there are two clouds in this otherwise sunny scene. The first is that the device for reducing the amount of money in circulation with which Bernanke led in his testimony--paying interest on bank reserves on order to increase interest rates--has not been tried before by the Fed. It sounds as if it would work, but until it is true, no one can know.
Second and more serious, is a statement last Thursday by Richard Fisher, the president of the Federal Reserve Bank of Dallas and a member of the Federal Open Market Committee of the Fed, which controls (or tries to control) the money supply. After summarizing Bernanke's "exit strategies" from the current "easy money" Fed strategy, Fisher said that "We [that is, the Fed] know full well that monetary policy trickles in with a lag and that we will have to 'pull the trigger' of tightening policy well before it is politically convenient."
What I think he meant was the following. As the economy recovers, cash hoarding will decline, and cash in circulation will therefore increase. The ratio of cash to goods and services will therefore rise, quite possibly faster than output, and so inflation will increase. Even if the Fed can stop the rising inflation in its tracks (as Fisher is confident it can), it may by doing so slow or even stop the recovery--and at a time when the unemployment rate will probably still be very high.
For a time, as in 1979-1982, high interest rates, engineered by the Fed to stop inflation, may coexist with both high inflation and high unemployment--an immensely politically unpopular combination, which helped Reagan beat Carter in 1980. Partly because of Volcker's personality, partly because of Reagan's ideology, the Fed was allowed to crush inflation at the cost of a severe recession in the early years of Reagan's presidency.
If history repeats itself, I have no doubt that Mr. Fisher will vote to pull the trigger, because he is a famous inflation hawk. But will Bernanke, or his successor if he is not reappointed? And a majority of the Federal Open Market Committee? The Fed does not operate in a political vaccuum. It has no constitutional independence from the political process. It is unpopular in Congress, and Democrats are not as hawkish about inflation as Republicans are.
I think Fisher is overly optimistic about the Fed's willingness to "pull the trigger" regardless of "political inconvenience." At the other end of the political spectrum, liberal economists like Paul Krugman are I think overly optimistic about price stability. They argue that inflation is no danger, period. They argue that the economy has so much slack that it can absorb hundreds of billions in cash for years without any effect on price. But I suspect that what they actually believe is different, is that inflation, unless it gets out of hand (unless it exceeds 10 percent, say), is not such a big deal. (In fact, as I have pointed out in earlier blog entries, inflation during a depression is an economic plus because it reduces debt burdens and by doing so encourages consumers to spend. But I am talking now about the recovery phase of the business cycle.)
Inflation is a tax on cash balances and on fixed-interest loans. It is not an efficient tax, but few taxes actually imposed in our political system are efficient. It would be interesting to see a serious economic study of the social costs, and possible social benefits, of allowing inflation to rise above normal levels in the recovery phase from the current economic situation.
07/20/09 5:07 PM
Economists Take It on the Chin: II
I mentioned in my last blog entry three recent articles in the Economist magazine that criticize macroeconomists and finance theorists for their inadequate performance in regard to the current financial and economic crisis. The articles rely heavily on criticisms from within economics itself, notably from Joseph Stiglitz, Paul Krugman, and Bradford DeLong.
But here is what is notable about those criticisms: the economist critics do not themselves have a firm grasp on the crisis. You can tell this from their views on the stimulus. The "stimulus" is the $787 billion dollar program of deficit spending that Congress at the urging of the Obama Administration enacted in February. The stimulus is criticized by some conservative economists, such as Robert Barro, Eugene Fama, and John Cochrane, as incapable of increasing employment. Their argument is that because government expenditures must be paid for one way or another, a dollar of deficit spending subtracts a dollar from private investment, and so there is no net increase in output. The argument is unconvincing. If private demand falls, investment geared to production of goods and services for private consumption will fall. People's savings (other than cash savings) will be invested, but in assets such as Treasury securities and money-market accounts that do not generate productive activity, or much such activity. Even investments in equities and commercial bonds have only an indirect, and often long-delayed, effect on production. In contrast, if government hires private firms (road contractors, for example) to produce goods and services that they would not otherwise produce because private demand is insufficient, there is an immediate effect on output and therefore on employment--immediate, at least, when the private firms begin to hire and produce.
That word "immediate" brings me to the centrist criticism of the $787 billion stimulus, which is that it was poorly designed and is being lackadaisically executed. Too much of it has taken the form of tax and other benefits, much of which may be saved rather than spent--and even that needlessly feeble form of stimulus is on a slow track. Too little is going to the states, to enable them to avoid tax increases and layoffs necessitated by the sharp depression-induced reduction in tax revenues and the states' limited borrowing power (and they can't create money--"monetize the debt"--as the federal government can do). The public-works part of the stimulus package is not targeted on areas of the countries, and industries, with the greatest unemployment. Forms of stimulus, including increasing the investment-tax credit and replacing military equipment inventories depeleted by the Iraqi and Afghan wars, have been overlooked. And the Administration has failed to appoint an official who would act as the expediter of the program, cutting the red tape that is delaying execution.
The left criticism of the stimulus--the criticism made by economists such as Stiglitz, Krugman, and DeLong--is that the stimulus is too small. They want a second stimulus. They have not named a number, but from their criticisms it seems that they would want $1 trillion or more. They may be right that the $787 stimulus is inadequate, but its inadequacy may be due less to its size than to its poor design and sluggish implementation. It will probably be spent over three years, for an average of $250 billion a year, and that is less than 2 percent of the Gross Domestic Product.
But without analysis and explanation that the left economists have not furnished, the idea of enacting another stimulus package of the same or larger size is irresponsible. With the national debt soaring, the question whether the nation can afford another $1 trillion or so of debt is acute. And what would the money be used for? And when would it come on line? And how would it be deformed as it wended its way through Congress en route to enactment? The states appear to be facing a budget shortfall of $100 billion, and there is an argument for a federal loan of that amount. But the other $900 billion? Could it be spent in the near term, or would it not be spent until 2011 and 2012, at which time it could have a strong inflationary effect?
I am not saying that there is no case for a further stimulus. But I haven't seen the case made. To make it effectively would require a knowledge of the economy that macroeconomists appear not to possess.
One begins to wonder whether the current crop of economists has made or will make an original contribution to fighting the economic crisis. It is not as if such weapons as easy money (the Federal Reserve's expansion of the money supply to drive down interest rates), bailouts of banks and other financial institutions, and deficit spending were inventions of modern economists. They were well known in times past (for financial crises are nothing new) to bankers and other businessmen and to economists such as Walter Bagehot (a nineteenth-century journalist rather than a professional economist), Irving Fisher, and John Maynard Keynes. Keynes in particular seems the best guide to digging our way out of our current economic crisis, even though he has been dead for 63 years and his great work The General Theory of Employment, Interest and Money (1936) has been neglected rather completely for the last 30 years or so.
07/19/09 8:03 PM
Economists Take it on the Chin
http://www.economist.com/opinion/displayStory.cfm?story_id=14031376&source=hptextfeature
http://www.economist.com/displaystory.cfm?story_id=14030288, and
http://www.economist.com/displaystory.cfm?story_id=14030296,
are well worth reading. Both the economists and government officials (often both) have received too small a share of the blame for the current economic troubles. This is a theme I sounded in my book and in several of my blog entries, but it has received little attention. The Obama Administration, with its ambitious public programs, does not want to accuse government of incompetence, and the economists who manage and advise the government's economic policies, many of whom were complicit in the failures of anticipation and response, do not wish to acknowledge their errors and those of their fellow economists. Furthermore, Congress and the public, and much of the media, do not understand macroeconomics or financial economics, and so they are drawn to a populist theory in which the economic crisis is attributed to the avarice and folly of financiers and the vulnerability of gullible consumers. The populist theory suits the Administration and the economics profession just fine, as it directs attention away from government failure and the failure of professional economists inside and outside the government.
Congress has just appointed a 10-member Financial Crisis Inquiry Commission, headed by a former treasurer of California named Phil Angelides, to investigate the origins of the financial crisis. The commission is bipartisan rather than nonpartisan; there are six Democrats and four Republicans, and most of them have strong partisan affiliations, as revealed by their campaign contributions. There is anxiety about how searching and professional the commission's inquiry will be. See, e.g., www.whatcausedthecrisis.com. I share that concern. None of the members, I believe, is a professional economist, and this will make the commisson's choice of a staff director critical. But if the economics profession does not understand the financial crisis, where is the commission going to find a competent staff director? It will be difficult, but there are a number of competent young economists who have not yet taken sides on the burning issues of macroeconomics and finance theory and could guide a neutral inquiry into the causes of the crisis.
My worry is that, because of the complexity of the economic issues and the difficulty of finding economists who are not committed to one side or the other of the methodological and ideological divides that permeate macroeconomics, the commission will devolve into an investigation of frauds and errors (and there were plenty of both, I am sure) of lenders and borrowers during the housing and credit bubbles. There may be some value in such an investigation, but it will not get to the root causes of the crisis or point the way toward economically sensible reforms. There are plenty of legal tools already for dealing with fraud, and errors (for example in assessing the risk of securitized debt) tend to be self-correcting. An investigation that does not delve into the failures of regulation (including the Federal Reserve's monetary policies and the SEC's regulation of broker/dealers) and of responses to the crisis will be severely truncated.
07/14/09 1:03 AM
Where Do We Go from Here? Part II
In this second part of a two-part entry, I discuss two far-reaching reforms that, it has been suggested, might help prevent a repetition of the financial crisis: regulating the compensation of top management of financial institutions that pose systemic risk; and tightening regulation of derivatives, including credit-default swaps.
The first proposal, in the form that I will consider, is the brainchild of Lucian Bebchuk, a very able lawyer and economist who teaches at Harvard Law School. Bebchuk is a leading critic of overcompensation of CEOs, but his proposal concerning the compensation of financial executives is distinct, and even (as I'll argue) inconsistent with his general position on overcompensation. He proposes that the top executives of financial institutions that pose systemic risk should be required to take most of their compensation in forms (such as common stock that the executive cannot sell for a specified number of years, or cash bonuses that can be "clawed back" at a later date should the profits out of which the bonuses were paid prove to be illusory) that assure that if such risk should materialize and the firms experience a deep loss in value, they will not profit from the risky activity that led to the disaster.
Bebchuk limits his proposal to top management. This may seem to overlook the fact that highly risky loans and other risky investments are made at the trading level rather than by top management. But Bebchuk is well aware of that, and reasons that if the losses at the trading level are made losses to the senior executives, the latter will take measures to rein in the risky behavior of their subordinates--and they are in a better position to design effective measures than the government is. Motivated to limit risks that may cause losses to themselves, the top executives may for example decide to shrink the firm, because control of subordinates is more difficult the larger a firm is, or to spin off the riskiest parts of the firm. Combining different organizational cultures--one of safe lending, for example, and the other of risky trading--in the same firm is problematic at best. The risky part of the firm is likely to generate greater profits and pay employees better, creating resentment among employees in the less-risky part of the firm, and, of particular concern in the present context, impelling them to take more risk in order to increase their relative earnings. A separation of the two parts into separate companies can solve the problem, and leave one part, at least, safe.
I remain skeptical about any proposal for regulating the compensation of executives of financial institutions, for reasons I have explained in earlier entries in this blog, but if any such proposal should be taken seriously and studied carefully, it is Bebchuk's. I must however note a tension between the proposal and Bebchuk's solution to the more general problem of compensation of CEOs and other top executives. Bebchuk fears correctly that boards of directors are not faithful agents of the shareholders and as a result fail to prevent top management from appropriating, in the form of excessive salary, bonuses, and other forms of compensation, corporate income that should really enure to the shareholders. He recommends measures for making boards, and through boards top corporate executives, more faithful agents of shareholders.
The problem from the standpoint of economic stability is that shareholders are likely to be less risk averse than top executives, because the former have a lesser stake in the continued survival of the corporation. By holding a diversified portfolio of common stocks, a shareholder can mitigate the risk to him of a collapse of the value of an inidividual stock. In contrast, a corporate executive is likely to have both a large financial and a large reputational stake in his firm. Measures that align the executive's interest with that of the shareholders may thus increase the danger of a corporate collapse, and such measures, if adopted, would therefore undercut Bebchuk's proposal for regulating the compensation of top financial executives.
The last proposal in this two-part blog entry that I want to address is the proposal to regulate credit-default swaps by requiring that they be channeled through clearinghouses. Credit-default swaps are, in the first instance, private contracts to insure loans and other investments. The issuer might for example promise a creditor that if the value of the creditor's loan fell below its face value, the issuer would make up the difference. But credit-default swaps are also devices for speculation as distinct from insurance (not that insurance can't involve an element of speculation). So A might promise B that if C should default on its loan from D, A will pay B the amount of loss sustained by D. In other words, A and B might be gambling on the outcome of C's transaction with D, rather than insuring D against a loss caused by C's defaulting.
There is nothing wrong with either loan insurance or speculation. The problem with credit-default swaps is a lack of regulation, resulting in a lack of information about the value of the swaps and the liabilities of the issuers. Without such information, it is difficult to determine the creditworthiness of a borrower. This seems to have been a factor in the credit freeze that followed the collapse of Lehman Brothers and other major financial firms last September. LIBOR (London Interbank Offered Rate), a commonly used interest rate for unsecured loans between banks, soared because a bank asked to make such a loan couldn't gauge the solvency of the bank seeking it. A further complication is that credit-default swaps were not required to be backed by reserves, so that the ability of an issuer of such a swap to make good on its promise to pay if the insured-against event occurred was often unclear, though many buyers of such swaps did insist on collateral.
Stilll a further problem was that, since credit-default swaps were not limited to insurable interests, but could be used as purely speculative commodities, they invited and received securitization, and securitized packages of credit-default swaps were extremely difficult to value, adding to uncertainty about the solvency of the financial institutions that had invested in them.
These problems would be ameliorated if credit-default swaps were required to be traded through clearinghouses. When a clearinghouse is used for the trading of derivatives or other financial instruments, the clearinghouse guarantees payment and protects itself by requiring margin (collateral) calculated on a daily basis. Suppose that A pays $100 to B for a commitment by B to pay C's $10,000 debt to A if C defaults. The clearinghouse would require B to post a certain amount of collateral to provide assurance that it could make good on its promise should C default. If as time passed a default seemed more or less likely, as indicated by the prices at which that or similar credit-default swaps were trading, the clearinghouse could demand more, or require less, collateral. The financial industry and the financial regulators would understand the commitments of the issuers of the credit-default swaps and have reasonable assurance that the commitments could be honored if need be.
The clearinghouse solution is incomplete because even a fully regulated insurance market can collapse. Insurance is effective against independent risks, but not against correlated ones. If a plague carried off half the U.S. population, the entire life insurance industry would be broke. And it is because the risk of insolvency of financial firms created by the collapse of housing prices was a correlated risk that when it materialized, it brought down much of the financial industry.
A second limitation of the clearinghouse solution is that it presupposes uniform contracts, which can be traded without the traders' having to master complex contracts. But many credit-default swaps are custom-designed to fit particular circumstances. The more of these non-clearinghouse swaps there are (measured by value), the less the clearinghouse approach will succeed in making the commitments embodied in swaps perceptible to the markets and to the regulators.
But despite these drawbacks, as with Bebchuk's proposal the proposal of a clearinghouse for credit-detault swaps has sufficient promise, relative to the alternatives, to merit careful study.
07/12/09 8:39 PM
Where Do We Go from Here? Part I
In my June 24 and 29 blog entries, I made a few very modest suggestions for financial regulatory reform: a 9/11 Commission type of study of the causes of the financial crisis (and ensuing depression); a plan for rotating financial regulatory staff among the different financial regulatory agencies; the creation of a financial intelligence and contingency planning capability in the Federal Reserve; knitting the state banking and insurance regulators into a national "early warning" system of financial danger signs; financing financial regulatory agencies out of congressional appropriations rather than fees paid by the regulated firms. To this I now add another suggestion of modest reform: rather than create a Consumer Financial Protection Agency, just move the consumer protection divisions in the Federal Reserve and the other banking agencies to the Federal Trade Commission, consolidating them in a new Financial Regulation Division of the commission.
But the momentum for more-radical reform is powerful, and flat-out opposition unlikely to be effective regardless of its merit. So let me address in a constructive spirit what seem to me the far-reaching reform proposals that deserve serious consideration. These are: (1) gearing banks' capital requirements to the different phases of the business cycle; (2) making the Federal Reserve the systemic-risk regulator for the entire financial sector; (3) separating out commercial banking, mortgage banking, and money-market funds from other financial institutions, and making them safe; (4) regulating the compensation of top management of financial institutions that pose systemic risk; and (5) tightening regulation of derivatives, including credit-default swaps. I discuss the first three reforms in this first part of a two-part entry, and the other two reforms in Part II.
There are many high-risk industries, ranging from airlines to restaurants, but only one--the banking industry, broadly defined as it must be to include all other financial intermediaries--poses systemic risk in the sense that widespread failures of firms in the industry can turn a recession into a depression. Banking, as I keep emphasizing, is inherently risky. It involves the lending of borrowed capital; and creating a spread between the interest paid for the rental of the borrowed capital and the interest charged for lending that capital requires the bank to charge a higher interest rate than it pays, and to do that it must take a risk that the loan will not be repaid. In short, the bank's capital is at risk. One way to limit that risk is to place a low ceiling on the ratio of borrowed capital (debt) to owned capital (equity), the latter acting as a cushion against losses from defaults of loans made by the bank.
The tendency is for the ratio of debt to equity to rise in boom periods. The reason is that in a boom, values tend to be rising (house values for example), and this reduces defaults and so increases the market value of a bank's loan portfolio and other assets. (Defaults decline because in a rising market a borrower who has trouble paying off his loans can sell the house or other collateral for the loan at a profit and thus avoid defaulting, or refinance the loan because the collateral securing it has risen in value.) In addition, loan quality declines in a boom because there is greater demand for loans, for in a boom borrowers and lenders alike believe that rising values will prevent default even if the borrower is not creditworthy in the usual sense.
The problem is that the factors that drive up the market value of bank assets, and reduce loan quality, during a boom set the stage for catastrophe during a bust, at least a bust of the severity of the present one. A fall in the value of houses or other collateral precipitates defaults, aggravated by the declining loan quality during the bust; and with the market value of the banks' assets thus falling, their debt to equity ratio soars because debt is a fixed liability. (If at time t-boom a bank assets are worth $100, its debt is $90, and its equity therefore $10, at time t-bust its assets might be worth $90, its debt will still be $90, and its equity therefore will be $0.)
The solution is to require the bank to reduce its debt-equity ratio during booms. Banks will resist this solution because it will reduce their profits. Not that banks are indifferent to risk, but they are less sensitive to it than the regulatory authorities are (or should be) because to an individual bank the systemic component of risk is an "external" cost, as economists say. That is, it is a cost imposed on persons and firms with which the bank has no contractual relations (think of the millions of persons who have lost their jobs in this depression, without having been employed by or had any other contractual relation with any financial firm), rather than only felt by the firm that incurs it.
This reform of the capital structure of regulated banks could easily be implemented by the federal agencies that regulate banks, mainly the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision. There is thus no need to constitute the Federal Reserve the systemic-risk regulator, so far as systemic risks created by banks is concerned, at least if the Office of Thrift Supervision, which appears to have performed incompetently in the case of Countrywide and Washington Mutual, is either reformed or merged into the Federal Reserve. The concern rather is with nonbanks that might create systemic risk, as the investment banks and broker-dealers did in the current financial crisis--Bear Stearns, Lehman Brothers, Morgan Stanley, Goldman Sachs, and others. The first two have disappeared and most of the others have become bank holding companies, which has brought them under the regulatory supervision of the Fed. That leaves hedge funds, industrial loan companies (such as GE Capital, a financial company that is part of a nonfinancial company, General Electric), money-market funds, and perhaps forms of financial institution not yet invented. Hedge funds and money-market funds are under the actual or (in the case of hedge funds) potential regulatory control of the Securities and Exchange Commission, but perhaps rather than requiring the SEC to think about systemic risk the Fed should be given authority to determine that any financial institution poses systemic risk that requires additional regulation.
So consider hedge funds. Long-Term Capital Management, a large though not immense hedge fund the collapse of which in 1998 almost caused a global financial collapse, but which was bailed out by a consortium of Wall Street firms organized by the Federal Reserve, was highly leveraged by hedge-fund standards; its debt-equity ratio was 25 to 1. When the value of the securities in which its capital was invested suffered a sudden sharp decline, it had to start selling them in order to meet margin calls, and by dumping a large number of these securities in a short time it created a serious imbalance between supply and demand. That imbalance forced down the value of the securities, which compelled other owners of them to sell to meet their margin calls, thus jeopardizing the solvency of financial institutions other than just LTCM. This was an example of the interdependence of financial institutions, as a result of which a failure of one can set off a chain reaction that can endanger the solvency of many others and even of the entire global financial system. So there is an argument for empowering the Federal Reserve to identify such dangerous institutions and by limiting their leverage or by imposing other restrictions reduce the systemic risk that they pose. I have mentioned in previous blog entries the objections to this approach, which seem to me major; but worse approaches can easily be imagined.
A more radical approach, but one that has the virtue of clarity and definiteness that constituting the Federal Reserve as the financial system's systemic-risk regulator would not have, is to separate the banking system, defined as commercial banks and and money-market funds, from the rest of the financial sector, and, by the separation and by regulation of the type that the Fed, the Comptroller of the Currency, and the FDIC exercise over commercial banks, create a dike or protected zone against inundation from a collapse of other parts of the financial system.
The idea behind this suggestion is that commercial banks, though nowadays they supply less than a quarter of the total amount of credit in the United States, play a unique role in the overall credit system. The reasons are threefold. First, the banks provide essential financing for small- and medium-sized businesses (what is called "external finance")--businesses too small to meet their own financing needs out of retained earnings or by issuing commercial paper, or to be attractive to a lender that does not have an established relationship with the borrower, enabling the lender to evaluate creditworthiness. If a bank fails, though other lenders remain, borrowers from the bank may find it difficult to establish the kind of personal relationship with a new lender that would reassure the lender that the borrower was creditworthy.
Second, banks provide standby lines of credit that provide emergency funding when other sources of credit fails, as happened last September when the commercial paper market froze in the wake of the collapse of Lehman Brothers and the near insolvency of other broker-dealers that had been intermediaries in that market. Banks thus back up the riskier lenders.
Third, the banks are the normal conduit by which the Federal Reserve pumps cash into the financial system in order to increase the amount of lending, whether by lending money to banks directly or more commonly by buying Treasury securities from them (or lending to banks with the securities as collateral, by means of repossession agreements), thus increasing their lendable cash. It is easier for the Fed to recapitalize a bank than to recapitalize any other type of financial institution.
If commercial banks were forbidden to affiliate with other entities (such as an investment bank or a broker-dealer), and subjected to the type of "procyclical" regulation that I discussed at the outset of this entry ("procyclical" refers to the boom phase of the business cycle), the danger of a financial crisis engulfing the commercial banking sector would be substantially reduced. It would not be eliminated. Banking is inherently risky, as I have emphasized, and the risks frequently are correlated. If a nationwide housing bubble bursts and mortgages are a significant component of the asset portfolios of most banks, then most banks will experience an impairment of their capital, but the Fed should be able to prevent their collapse by pumping cash into them. In fact, the primary victims of the banking collapse last September were not commercial banks (though banks were victims, as I'll explain the second part of this two-part entry), let alone commercial banks unaffiliated with other types of financial institution, but were instead investment banks, broker-dealers, money-market funds, and the financial products division of a large insurance company (AIG).
Money-market funds are mutual funds, regulated by the SEC, that provide checkable accounts that usually pay higher interest than deposit accounts in commercial banks. They generate the interest that they pay their account holders by investing in commercial paper and other short-term securities. After a run on money-market funds began last fall following the collapse of Lehman Brothers, in whose commercial paper some of the funds were heavily invested, the federal government provided temporary insurance of the accounts. Money-market funds, like thrifts (mortgage banks), are so similar to commercial banks that all three types of financial institution should perhaps be regulated on the same principles, emphasizing safety and therefore separation from other types of financial institution. I am mindful, though. of the awkwardness of placing money-market funds under the systemic-risk-regulating authority of the Fed when those funds are regulated by the SEC rather than by a banking agency.
I do not mean to endorse the three forms of "radical" or far-reaching financial regulatory reform that I have described. I mean only to suggest that they have enough potential merit to warrant further consideration.
07/11/09 10:02 PM
The Role of the Law Schools in the Recovery from the Current Depression
The law schools were caught by surprise by the financial crisis of last September and the ensuing descent into what, realistically, must be regarded as the first depression (as distinct from merely a recession) since the Great Depression of the 1930s. (This is not--so far, at any rate, a repeat of the Great Depression--but it is a depression.) When I say they were "caught by surprise" I mean first of all that the training and research of academic lawyers have not been oriented toward macroeconomic issues or even issues of financial structure. There are many able professors of bankruptcy law, secured transactions law, and the legal regulation of securities (including futures contracts and other derivatives), but very few who study financial intermediation as a whole, and almost none who combine a deep knowledge of the financial system with an understanding of the economics of the business cycle, important as the financial system is to the cycle, as we now know.
To these limitations of knowledge must be added a career structure in academic law today that is inimical to research oriented to practical solutions to current problems. This limitation has two aspects. First, recruitment of academics from practice has declined, as academic law has become progressively "academified" and specialized. Increasingly, in imitation of more conventional academic disciplines, legal academics are expected to focus the research component of their work (and this inevitably influences the teaching component) on specialized research the results of which are publishable in academic journals read mainly by other academics in the author's specialized subfield. The preparatiion and publication of such research are time-consuming endeavors and therefore are ill adapted to responding constructively to rapidly evolving current issues, especially ones that cross disciplinary and subdisciplinary boundaries.
As a result, with a few notable exceptions, such as Lucian Bebchuk, Edward Morrison, and Steven Schwarcz, academic lawyers (and Bebchuk and Morrison have Ph.Ds in economics, as well as law degrees) have not made a contribution to the understanding and resolution of the current economic crisis, even though it bristles with legal questions. And I don't mean only or primarily legal questions that can be readily answered on the basis of orthodox legal materials; for those questions can be answered adequately by the large, sophisticated law firms engaged in a commercial or corporate practice. I mean rather legal issues that cannot be resolved intelligently without consideration of issues of policy--in the present instance issues of economic, including macroeconomic, policy. And not only legal issues, but issues of economic policy to which legal knowledge is relevant, even if the issue itself is, for example, legislative in character, rather than requiring the application of existing law.
I will list a few issues of both kinds (application of existing law, and whether to create new law), in no particular order:
1. Whether, given the economic emergency presented by the collapse of the global banking industry last September, Federal Reserve chairman Ben Bernanke is right in claiming that the Federal Reserve lacked legal authority to save Lehman Brothers, which was at or near the center of the crisis. (I have touched on this issue briefly in a previous blog entry.)
2. Whether a bankruptcy judge should be permitted to cram down the mortgage on a primary residence (that is, reduce the mortgage to the current market value of the mortgage property).
3. In a bankruptcy, should government bailout loans be given priority over claims of secured creditors?
4. Is there any constitutional limitation on the federal government's abrogating a private contract, for example a contractual obligation to pay bonuses to employee of AIG?
5. In cases in which the depression prevents a firm from honoring a contract, can it ever appeal to such doctrines of contract law as impossibility and frustration, or to such common contractual provisions as force majeure clauses and material adverise conditions clauses, to be excused from performance without incurring legal liability for nonperformance?
6. Should bankruptcy law be amended, with respect to the bankruptcy of financial institutions, to bring it closer to the "resolution" procedure by which the Federal Deposit Insurance Corporation winds up the affairs of banks that go broke. Were that done, would resolution still be a superior method of dealing with bankrupt financial institutions (not limited to banks)?
These are issues of law and policy that cannot be sensibly resolved without considering the impact of their resolution on the macroeconomy. Will a suggested resolution reduce or increase the likelihood of a future depression? Will it retard or promote recovery from the current depression? What other costs and benefits is it likely to produce? These are not questions that a lawyer can answer, but they are questions that a law professor steeped in macroeconomics and financial economics, or workiing with a macroeconomist or finance theorist, can contribute materially to answering. But to be able to make this contribution before the train leaves the station--before the workaday legal and poltiical systems grave an answer in stone--will require a change in the outlook, work habits, and even recruitment criteria of academic lawyers.
07/05/09 3:54 PM
Summer (and Fall) Reading
I would like to draw my readers' attention to four recent important contributions to the debate over our economic crisis.
The first, which unfortunately will not be published until the fall, is a book by Robert C. Pozen entitled Too Big to Save? How to Fix the US Financial System. A lawyer, a lecturer at the Harvard Business School, and the chairman of a large asset-management firm, Pozen is an immensely experienced and acute student of the financial system. His book is not only a detailed yet thoroughly lucid and accessible study of the financial crisis; it is also, and more important, the best critique I have seen of the government's responses to the crisis and its recent blueprint for financial regulatory reform. I hope that his analysis can somehow be conveyed to the Administration and Congress before the government makes irrevocable mistakes in its response to the crisis.
The second contribution is a special issue of the journal Critical Review (vol. 21, issues 2-3, 2009) entitled "Causes of the Crisis." (It is about to be published, and can be ordered at the following web site: http://www.criticalreview.com/crf/special_issue.html. It is a collection of essays dealing with the causes of our current economic crisis. The long introduction by the journal's editor, Jeffrey Friedman, entitled "A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure," is a particularly good summary of what can at this early stage in our understanding be said with some confidence about the causes of the mess. Without meaning to denigrate any of the other essays, all of which are useful, I found particularly welcome the acknowledgement by economists, including Daron Acemoglu and David Colander, of what Colander and his coauthors call the "systemic failure of the economics profession." This is a point that I stressed in my book but that has received insufficient recognition by the economics profession (naturally).
I do wish, however, to take exception to a tendency in Professor Acemoglu's essay to belittle the current global depression. He says that "despite the ferocious severity of the global crisis--and barring a complete global meltdown--the possible loss of GDP for most countries is in the range of just a couple of percentage points--and most of this might have been unavoidable anyway, given the overexpansion of the economy in prior years. In contrast, within a decade or two, we may see modest but cumulative economic growth that more than outweighs the current economic contraction."
There are, it seems to me, three errors in the passage that I have quoted. The first is the suggestion that the only cost of a depression is a temporary, and relatively minor, decline in GDP. This ignores the profound psychological effects of a depression, including the anxieties of those who lose their jobs or their homes or their retirement incomes or fear losing them (a series of costs that tenured professors tend to underestimate because they are largely immune from them). It ignores long-term economic effects--the aftershock danager that I keep emphasizing--as a result of the immense costs that governments are devoting to measures for halting the economic decline and speeding recovery.And it ignores political effects with economic consequences, such as increased size and intrusiveness of government.
The second error in the passage that I quoted is the suggestion that the fact that "most of [the loss of GDP] might have been unavoidable anyway, given the overexpansion of the economy in prior years," somehow mitigates the severity of the downturn. The idea may be that people were living high on the hog because of excessive borrowing and this is repayment time. But probably most of the people hurt are people who were not living high on the hog during the boom years; and even those who were may have lost more than they had gained during the boom.
The third error is the suggestion that when GDP returns to its pre-depression level, the cost of the depression will be wiped out. That ignores the fact that many and perhaps most of the beneficiaries of the higher GDP will not be the same people who lost in the bust. This is underscored by the phenomenon of "job destruction." Many jobs lost in a depression never come back; their occupants are not rehired and must therefore either leave the workforce altogether or find other types of job, which usually pay less. And few of the people whose jobs are destroyed will have been contributors to the economic collapse and therefore appropriately punished by a fall in their permanent income.
The third contribution is a soon to be published article by two law professors, Saule Omarova and Adam Feibelman, "Risks, Rules, and Institutions: A Process for Reforming Financial Regulation," 39 University of Memphis Law Review 881 (2009). The article discusses a number of proposals for financial regulatory reform, but its main significance is its careful attention to the process of effective regulatory reform. The authors properly emphasize the importance of careful, step-by-step program design, based on a solid body of knowledge. The Administration could with profit heed their suggestions.
Last, a website called www.ce-nif.org is well worth reading. It describes the project of the Committee to Establish a National Institute of Finance. The Institute would be responsible for gathering and analyzing data concerning systemic risk. The proposal is consistent with my belief that the essential need is better monitoring of systemic risk; the regulatory powers of the Federal Reserve, the SEC, and other regulators of financial institutions probably are adequate, though perhaps some relatively minor statutory changes would be desirable. The problem is not power but knowledge.
07/04/09 5:25 PM
The Proposed Consumer Financial Protection Agency Act of 2009
On June 24, in "Financial Regulatory Reform: III," I blogged on the proposal in Financial Regulatory Reform--the Administration's blueprint for revamping the regulation of the financial industry--that Congress create a Consumer Financial Protection Agency. A few days ago the Administration issued a 152-page draft of a proposed statute establishing such an agency, and the draft helps to clarify the Administration's thinking and in doing so it reinforces the doubts I expressed in my earlier blog entry. The length of the draft is deceptive; pages have only 23 lines, the print is large, and the margins are generous; more important, most of the draft is taken up with bureaucratic details, involving for example the transfer of staff from other agencies. I shall ignore those details (though they may be minefields) and focus on what seem the key provisions of the proposed statute.
The objectives of the proposed statute are stated broadly, and to a degree inconsistently, as well as (of course) redundantly. The principal objectives are that "consumers [of financial products] have, understand, and can use the information they need to make responsible decisions," and "are protected from abuse, unfairness, deception, and discrimination," but also that "markets for consumer financial prodducts or services operate fairly and efficiently with ample room for sustainable growth and innovation" and that "traditionally underserved consumers and communities have access to financial services." The inconsistency lies in the fact that the more consumers are protected (largely from themselves) from being abused, deceived, and so forth in the purchase of financial products, the more those products will cost and so the less rapidly the market will grow and underserved consumers--a disproportionate number of whom are poor credit risks--will have access to it. The clearest example is a separate provision of the proposed statute that authorizes the agency to forbid arbitration clauses in consumer finance contracts. These arbitration clauses are inserted by the credit-card companies or other lenders, and so presumably--since consumer finance is a competitive industry--the clauses reduce the lenders' costs and therefore interest rates.
Oddly, although high credit-card interest rates are a focus of complaints about consumer credit, the proposed statute forbids the agency to establish a "usury limit," that is, to limit interest rates, unless explicitly authorized by law to do so.
The proposed statute confers the broadest possible authority on the new agency to require reports from providers of consumer financial products and to conduct surveys, for example of the consumers themselves, to determine the risks to consumers and consumers' understanding of those risks. Given the number of sellers of financial services to consumers, not to mention the number of consumers, the potential costs of the reporting and monitoring function, both to those providers and to the agency, are likely to be very high.
The statute authorizes the agency to prevent, both by rulemaking and in administrative enforcement actions, "unfair, deceptive, or abusive acts[s] or practice[s]." To declare a practice "unfair," the agency must determine that it "causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers and such substantial injury is not outweighed by countervailing benefits to consumers or to competition." This vague standard confers enormous discretion on the agency; and there is no attempt to define "abusive" ("deceptive" is reasonably self-evident).
Of particular significance, the agency may prescribe rules to ensure "effective disclosure or communication to consumers of the costs, benefits, and risks associated with" any consumer financial product; risks and costs must be communicated in a manner "designed to promote a consumer's awareness and understanding of the risks and costs, as well as to use the information to make financial decisions." The agency is to "consider available evidence about consumer awareness, understanding of, and responses to disclosures or communications about the risks, costs, and benefits of" consumer products.
In an earlier era, all this could probably have been dismissed as hot air. Ever since the late 1930s, the Federal Trade Commission has had the authority to prevent "unfair or deceptive acts or practices," but in practice this has usually meant nothing more than preventing false labeling and advertising. What is new in the proposed CFPA statute though not mentioned in it is "behavioral economics," which is the application of cognitive psychology to economic phenomena. The literature of behavioral economics, which appears to be influential with the Administration, emphasizes cognitive deficiencies that make it difficult for even people of normal intelligence and good education to act in their best interest even when fully informed. One can easily imagine the insights of behavioral economics being used by the new agency to go far beyond typical consumer protection measures, which involve forbidding false information, and often also requiring true information, to be provided to consumers.
That this is likely to happen is suggested by the grant of authority to the new agency to create "standard" consumer financial products, which means products designed by the agency itself. These products (a mortgage for example) are not only to be "transparent to consumers" and "facilitate[] comparison with and assessment of the benefits and costs of alternative consumer financial products or services," but they are also to "contain[] the features or terms defined by the Agency for the product or service." If this language is taken literally, it means that the CFPA could draft a mortgage loan contract that provided for a 30-year nonrecourse 100 percent (that is, zero equity) fixed-rate mortgage loan, or for that matter a 25-year fixed-rate 80 percent loan. The mortgage banker or other seller of the mortgage would be required to offer the prospective mortgagor the agency-created mortgage at or before offering its own alternative financial product. One concern the "standard" creates is that the seller's own financial product, if it departed substantially from the standard product, might be deemed abusive or unfair.
The agency is also authorized by the statute "to prescribe rules establishing duties regarding compensation practices" of all the firms that it regulates, although it is not to "prescribe a limit on the total dollar amount of compensation paid to any person."
The statute transfers consumer financial protection powers and staff of the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Trade Commission to the new agency, but allows state consumer protection laws to apply, even if they provide greater protection than the Consumer Financial Protection Agency Act, as long as they are not in conflict with requirements imposed by the proposed act or the rules that the CFPA adopts. But the proposed statute does not apply to financial products regulated by the Securities and Exchange Commission or the Commodity Futures Trading Commission.
The objections to the proposed statute are obvious and, it seems to me, compelling. The statute is intended to prevent a repetition of the current financial crisis, yet has been drafted and proposed in advance of evidence that deception or cognitive deficiencies played an important causal role in the crisis. Even if the sort of deficiencies identified in the literature of behavioral economics did play a significant role, there is no reason to think that differently drafted mortgage forms, payday loan forms, credit-card solicitations, etc., would influence consumer behavior. When interest rates are low and credit therefore abundant, Americans borrow. If the new agency's "standard" financial products result in lower interest rates, Americans will borrow more, setting the stage for a future financial crisis, while if the products result in higher interest rates, they will delay the recovery from the present crisis.
The latter--higher interest rates--are the likelier consequence, because the thrust of the proposed statute is to pile more rights on consumers, which will raise the costs of the finance companies. This may or may not reduce the amount of consumer indebtedness (which would be a good effect, since overindebtedness is one of the circumstances that has contributed to the economic crisis). The amount of debt that consumers take on will be less, but the burden may be greater because debt will be more costly.
As pointed out by Robert C. Pozen in an important book, Too Big to Save? How to Fix the US Financial System (to be published in the fall by John Wiley & Sons, Inc.), the new agency will complicate, by dividing, the regulation of banking between the banking agencies and the CFPA. This would not be a problem if the new agency were just concerned with protecting consumers against deception (although if that were all it were concerned with there would be no need to create it). But its immense discretionary authority over the marketing of consumer financial products ranging from mortgages to credit cards could if exercised aggressively have significant effects on the economics of the finance industry--effects that could increase systemic risk and could thus bring it into conflict with the Federal Reserve and the other banking regulators.
At a time when the entire credit system is fragile, the very proposal of such a statute (coming hard on the heels not only of a raft of other proposals for the regulation of the finance industry but also of a hastily enacted statute regulating credit-card credit--the Credit Card Accountability, Responsibility and Disclosure Act of 2009, which may substantially increase the costs of credit-card issuers) is likely to retard the economy's recovery from its present sickness, if only by further unsettling the economic environment of the finance industry. The statute if enacted would as I have said increase the costs of providers of consumer credit, and the prospect that it will be enacted in some form close to that proposed will cause the credit industry to mobilize its resources to oppose enactment, when the industry should be devoting all its time and energy to self-repair.
A more moderate approach would be to transfer the consumer financial product regulatory staffs of the Federal Reserve, the Comptroller of the Currency, and the FDIC to the Federal Trade Commission, and to further enlarge the resulting combined staff, thus both consolidating and strengthening the enforcement of the existing federal laws (which are numerous, such as, besides the new credit card law, the Truth in Lending Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, and the Real Estate Settlement Procedures Act, for the protection of the financial consumer. That might accomplish most of what the proposed Consumer Financial Protection Agency Act is intended to accomplish, and at far lower social cost.
The proposed statute is one more example of an emerging regulatory philosophy that, in understandable but not excusable reaction against the recent history of lax, ineffectual financial regulation, can be summed up as too much, too soon, too costly.
07/02/09 4:30 PM
Taking Stock: Economy and Government on July 2, 2009
It is 18 month since the official onset of the current depression (as I continue to regard it), and almost six months since the inauguration of President Obama. It is a good time to take stock--to take the pulse of the economy, but also of the new Administration's efforts to speed economic recovery.
A few statistics will help set the stage for analysis. On January 20, inauguration day, the Dow Jones Industrial Average was 8300; it closed that day at 7900. Today, July 2, five months and two weeks later, the DJIA closed at 8300. There have been ups and downs in between these notes, but what is so striking is that the Dow has not risen significantly even though the panic that gripped the nation between September and March has dissipated. Evidently the problems of the economy go deeper than panic, just as the financial crisis of last September was a crisis not of liquidity, borne of panic, but of solvency, reflecting tremendous losses of personal and corporate wealth.
The unemployment rate was 7.2 percent on January 20; it is 9.5 percent today. The underemployment rate has risen from 14.8 percent to 16.8 percent. An interesting statistic, emphasized by Paul Krugman, is the decline in the aggregate number of hours worked per week. In January, it was almost 3 percent higher than it had been in 2002; it is now 1 percent lower.
Most other economic indicators also reveal a deterioration in the economy, although the rate of decline has slowed, as of course had to happen at some point. The media tend to focus on month to month percentage changes in the indicators, but a more illuminating comparison is with the same month in the last pre-depression year, which was 2007. If some indicator, like employment or housing starts, was 100 in May 2007, 70 in May 2009, and 80 in June 2009, the May-June change is strongly positive at plus 14 percent; but the indicator is still 20 percent below its pre-depression level. Similarly, the DJIA has risen by about 5 percent since the close on January 20, but is 42 percent below its 2007 peak of 14,200. The unemployment rate was 5.7 percent last June (before a mild recession became a depression), the underemployment rate was 10.3 percent, and the aggregate number of hours worked per week was 107.
The Gross Domestic Product (the market value of all goods and services produced in the economy) is unchanged since the end of 2007; since the inflation rate in 2008 was 3.8 percent, and average annual real growth in the economy is about 3 percent, the economy is operating at almost 7 percent below trend. On the one hand, this exaggerates the real decline in potential economic output, because unemployment and underemployment shift some resources from market to nonmarket output; for example, people eat at home more, substituting home production of meals, which is not included in estimates of GDP, for the purchase of restaurant meals, which is. On the other hand, and of vastly greater significance from the standpoint of utility (welfare, happiness, preference satisfaction), a severe economic downturn produces great anxiety on the part of all who lose their jobs, suffer a loss of income, or fear such losses.
Another statistic of significance is the increase in the personal savings rate: from 4.6 percent to 6.9 percent since January of this year--but in 2007 it was less than 1 percent. The significance of these increases lies in the fact that money saved is diverted from money spent to buy goods and services, and the decrease in spending results in reduced production and therefore employment, and reduced employment leads to a further reduction in spending. Low personal savings rates in the early 2000s, coupled with the housing and stock market booms, meant that people's savings were heavily concentrated in housing and stock. When the market value of those assets plummeted, people found themselves with inadequate assets relative to debt, and curtailed spending. The ensuing recession became a depression when the financial crisis of last September froze credit, resulting in further reductions in spending. The banks were saved, but credit remains extremely tight.
There are some indications of incipient recovery, including upticks in manufacturing and sales of durable products and housing starts. But as long as unemployment (and underemployment) is rising and housing prices (a major store of value) and personal consumption expenditures are depressed, the economic prospects are uncertain. There have been too many false dawns and overoptimistic predictions, including by government officials. An example is the emphasis on unemployment as a "lagging indicator" of depressed economic conditions. It is true that unemployment often continues increasing after an economic recovery begins. The standard explanation is that firms prefer not to incur the cost of hiring or rehiring workers until they are sure that demand for goods and services is increasing. An alternative explanation is tacit collusion: firms may hesitate to expand output as demand rises, hoping their competitors will follow suit, since the more slowly supply rises in response to rising demand, the faster prices and profits will increase. But it is only after a depression is over that one can recognize an increase in unemployment as a lagging indicator. It would have been ridiculous to observe the steep decline in employment in 1930 and be reassured that, since unemployment is a lagging indicator, the depression was over. It had just begun.
Every sign of incipient recovery, moreover, causes long-term interest rates to rise, which in turn retards the housing recovery because mortgage interest rates, an important part of the cost of buying a house, are long term. Because the government has committed enormous sums of money to fighting the depression ($2.6 trillion, with another $7.6 trillion planned, or in guaranties), against a background of chronic budget deficits and ambitious long-range spending programs by the Obama Administration, there is concern that an economic recovery will touch off serious inflation, which might result in a tightening of credit by the Federal Reserve that might kill the recovery. Every bit of bad news, of course, reduces concern about inflation, by pushing off the prospect of it into the more distant future. There is still some fear of deflation, since the Consumer Price Index has been essentially flat for the last year, as sellers cut prices ferociously to retain customers. Because the purchasing power of the dollar has not declined, people who incurred debt in the last few years, thinking that inflation would make it easy to repay, are experiencing disappointment, and in many cases bankruptcy.
We should consider how the new Administration has done in fighting the depression. Continuing the policies of the Bush Administration, it seems to have stabilized the banking industry and limited the decline in credit availability. The enactment of the $787 stimulus program (Keynesian deficit spending) in February was an important confidence-building measure, as I explained in my book, though the program itself was poorly designed and has had as yet virtually no impact (other than the psychologivcal--but that is very important) on the economy. The government-managed bankruptcy of General Motors and Chrysler have kept those firms alive, albeit at great cost, and the cost includes not only the $60 billion or so of direct or indirect government subsidy but also an implicit commitment to further support, at least of General Motors, and an acute danger of increased government interference in private business.
Other depression-fighting programs by the Administration, notably the $75 billion mortgage relief program and the program of subsidizing the purchase of securitized debt from banks, have fizzled.
The high-handed treatment of secured creditors in the Chrysler bankruptcy, the firing of the CEO of General Motors by the government, the overambitious program of financial regulatory reform recently announced by the Treasury Department, and the financially reckless medical program being pushed in Congress by the Administration are retarding economic activity by unsettling the economic environment in which business has to operate. Active investment--the expansion of productive capacity--is a risky activity at best, and when government makes it more risky by its fiscal and regulatory policies, the amount of active investment is likely to fall.
Richard A. Posner
