Blame It On Basel

On November 20, 2011, in banking, Basel, executive compensation, moral hazard, by Jon Lewis

Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. Jeffrey Friedman and Wladimir Kraus. University of Pennsylvania Press, 2011, pp.212, $45.00 The majority of individuals involved in the Occupy Wall Street (OWS) movement tend to blame Wall Street bankers for the financial crisis and the ensuing recession and high unemployment rates. By contrast, [...]

Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. Jeffrey Friedman and Wladimir Kraus. University of Pennsylvania Press, 2011, pp.212, $45.00

The majority of individuals involved in the Occupy Wall Street (OWS) movement tend to blame Wall Street bankers for the financial crisis and the ensuing recession and high unemployment rates. By contrast, many in the Tea Party movement have appeared to focus their ire more on the federal government’s response to the crisis than on the root causes of the crisis itself.

Both movements, however, seem implicitly to agree that those economic and political actors most involved in the crisis and its aftermath were consciously motivated by either greed on the one side, or by a desire to grow government at the expense of liberty on the other. One would have to search very diligently to locate a protestor, either of the OWS or of Tea Party variety, who would say that the financial crisis was caused by ignorance, rather than by hubristic bankers or by the federal government’s willingness to bail out too big to fail financial institutions.

By contrast, in Engineering the Financial Crisis, Jeffrey Friedman (University of Texas, Austin and editor of Critical Review) and Wladimir Kraus (Université Paul Cézanne Aix-Marseille and associate editor of Critical Review) posit that, “the crisis was caused by ignorance on all sides.” While this specific line of argument is nuanced and certainly more philosophical than most analyses of the financial crisis, the authors do seem to suggest that there was no single deliberate, conscious decision, nor set of decisions by a capitalist or by an individual regulator that precipitated the financial crisis.

Indeed, a reader looking for either an excoriation of greedy bankers or a diatribe against close ties between Washington and Wall Street will surely be disappointed by the authors’ provocative academic monograph. Private label mortgage backed securities (PLMBS), however, do play a prominent role in the authors’ understanding of the crisis. The authors’ focus, however, is less on the securities themselves than on addressing why so many financial institutions purchased them.

In the book’s introduction, they emphasize that, in their opinion, there is no evidence that Fannie Mae and Freddie Mac’s lending practices, banks’ perception of their alleged too big to fail status, bank compensation practices, or “irrational exuberance” caused the financial crisis. A refrain in Friedman and Kraus’s work is that the too big to fail theory does not hold up under scrutiny. There is indeed considerable merit to their argument, particularly given the fact that they provide data to back up their claim. Readers will have to decide for themselves, however, whether the authors protest too much against the admittedly highly popularized too big to fail narrative. Often conventional wisdom is wrong; sometimes, it persists for a reason and does contain more than a kernel of truth.

If the traditional and oft-repeated narratives, in their view, do not satisfactorily explain what caused the latest crisis in global capitalism, then what does? The authors suggest that the crisis was not caused so much by capitalism, as by capitalism’s regulators. This goes to the heart of the authors’ essential argument that “the crisis was a regulatory failure in which the prime culprit was none of the usually targeted factors, but was, instead, the set of regulations governing banks’ capital levels known as the Basel rules.” Specifically, they single out the Recourse Rule, an American “regulation governing capital requirements for asset securitization and sale by U.S. banks,” which was finalized in 2001. In technical terms, the Recourse Rule amended Basel I to give AA- and AAA-rated PLMBS the same risk that the Basel Accord officially gave to agency bonds.

The Recourse Rule, the authors suggest, explains why so many banks loaded up on private label mortgage backed securities. Capital adequacy regulatory policy incentivized banks to buy PLMBS. “Without the favorable treatment of highly rated PLMBS by the Recourse Rule, U.S. commercial banks might have acquired only a third of the exposure to PLMBS that they did, in fact, acquire.” Regulatory policy also had a homogenizing effect on banks. As Friedman wrote succinctly in a thoughtful op-ed for the Wall Street Journal in 2009: “Regulations homogenize. The Basel rules imposed on the whole banking system a single idea about what makes for prudent banking. Even when regulations take the form of inducements rather than prohibitions, they skew the risk/reward calculations of all capitalists subject to them.” Capitalism promotes heterogeneity; regulation, homogeneity.

The interaction of the Recourse Rule with both mark-to-market accounting, and what the authors contend was the quasi-oligopolistic status of the three credit ratings agencies, created the perfect storm, culminating in the financial crisis of 2008. Their conclusions have implications beyond the scope of the recent financial crisis. “The disadvantage of modern democracy,” write Friedman and Kraus, “is that in attempting to solve social and economic problems, either the people or their agents—legislators or regulators—must adopt a single interpretation that, in legal form, homogenizes behavior throughout the entire system. If this single interpretation is erroneous, the entire system may be jeopardized. That, we believe, is the chief explanation of both the financial crisis and the Great Recession.” Bold words indeed.

Although the authors mention that one of them will be interviewing some bankers as to whether the Recourse Rule did incentivize them to invest in PLMBS, the lack of bankers’ voices throughout the text is a notable weakness. That is not to say that those journalistic accounts of the crisis that detail the ‘who, what, and where,’ of the crisis are necessarily adequate explanations. Still, one would have preferred to see at least a few quotes from bankers, even if from unattributed sources who spoke in confidence, validating the authors’ thesis regarding the Recourse Rule. Furthermore, even if one fully accepts the authors’ arguments, this still leaves open the counterfactual question of whether the crisis would not have occurred but for the fact that the federal government promoted homeownership, cheap money was widely available due to extraordinary low interest rates, and the derivatives market was largely unregulated. While they do discuss these factors in the book’s first chapter, their analysis is far too brief.

The authors, at one point, appear to mistakenly conflate the concept of moral hazard with the principal-agent problem, both of which are particularly relevant to insurance regulation. Friedman and Kraus describe the theory that corporate compensation practices led to the crisis in terms of moral hazard. Of the “corporate-compensation thesis,” they write that, “bankers were put in a hazardous moral position, in which they might act contrary to the interests of their employers and society at large, by the incentives created by their performance bonuses.” Being put in a hazardous moral position is not moral hazard, properly understood. Indeed, corporate compensation is best understood as a principal-agent problem, wherein the interests of principals and their agents may diverge, thus leading bankers to engage in trades that are not in the long-term interest of their clients.

Finally, it should be noted that narratives of regulatory failures are far more compelling than regulatory successes; one does not ordinarily think of regulation when it actually works well, out of sight to most observers. It is when regulation fails (or is perceived to be failing), and particularly when it fails miserably, that elected officials and the general public become cognizant of the role of regulators and their regulations in attempting to manage complex, post-industrial societies.

In conclusion, despite some of the aforementioned criticisms, Engineering the Financial Crisis presents a compelling and novel argument as to what led to the near meltdown of both the financial sector and the real economy in 2008. The authors write clearly, present ample evidence to support their claims, and are extremely knowledgeable about financial regulation and political economy. While the book will not be accessible to the general reader, those readers with a specialization in economics, finance, or law will find it extremely valuable and worth consideration.

Jon Lewis (c) 2011

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Federal Government as Financial Institution

On November 8, 2011, in banking, credit, by Jon Lewis

Uncle Sam in Pinstripes: Evaluating U.S. Federal Credit Programs. Douglas J. Elliott. Brookings Institution Press, 2011, pp. 147, $19.95 Of all the demands of the Occupy Wall Street movement, none probably has more resonance to many underemployed young Americans than their call for student debt relief. Indeed, according to The Federal Reserve Bank of New [...]

Uncle Sam in Pinstripes: Evaluating U.S. Federal Credit Programs. Douglas J. Elliott. Brookings Institution Press, 2011, pp. 147, $19.95

Of all the demands of the Occupy Wall Street movement, none probably has more resonance to many underemployed young Americans than their call for student debt relief. Indeed, according to The Federal Reserve Bank of New York, outstanding student loans will soon exceed $1 trillion; for Americans, student loan debt has even managed to surpass credit card debt. Since it is doubtful that Congress will alter the U.S. Bankruptcy Code to allow for discharging government insured or guaranteed student loans through Chapter 7 bankruptcy, the upcoming generation will be indebted for many years to come. This will almost certainly have substantial effects on this generational cohort’s consumer spending habits, personal savings rate, and overall attitude toward government intervention in the economy.

In Uncle Sam in Pinstripes, Douglas J. Elliott (Brookings Institution) provides the reader with a comprehensive overview of the goals and history of federal credit programs, including those dealing with student loans. “The federal government,” writes Elliott at the beginning of this academic monograph, “is the biggest and most influential financial institution in the world, a fact often hidden by the widespread public conception that the American government largely stays out of business activities.”

The author notes that the federal government provides more credit, either directly or indirectly, than any of the country’s private banks. Indeed, as of 2010, federal loans outstanding exceed $8 trillion. This figure encompasses not only what he terms the four traditional loan and guarantee programs in housing, farming, education, and business, but also the additional credit that the federal government extended to respond to the recent financial crisis. While most federal credit is actually channeled through assistance to private lenders, this does not alter how large a role the federal government plays in the provision of credit.

In Uncle Sam in Pinstripes, Elliott discusses the theories behind, and policy rationales for, federal credit programs (Chapter 2); a brief history and overview of the programs (Chapters 3 and 4, respectively); a discussion of the costs and benefits of the programs (Chapter 5); and an analysis of the recent emergency credit programs put into place in response to the financial crisis (Chapters 6 and 7). Although far too brief, the book’s third chapter, a history of federal credit programs, stands out as particularly relevant to aiding our understanding of how the federal government came to be the largest provider of credit. Elliott aptly recounts how, with the creation of the Federal Reserve System in 1913, the federal government became a major lender, but that the first real federal credit programs were designed to help farmers. The Great Depression, however, was the major turning point; before then, the federal government was not nearly the major provider of credit that it has since become.

Many federal credit programs that exist today such as the Federal Housing Administration, Fannie Mae, and the Export-Import Bank, have their roots in government’s response to the Great Depression. A comparison between the federal credit programs run by the United States and those run by other industrialized countries would have made this chapter stronger. While Elliott is correct that, between the Founding and the early twentieth-century, the federal government did not have a prominent role in supplying credit, it would have nevertheless been helpful to learn if the United Kingdom, France, and Germany maintain long-standing national credit programs and, if so, how they have fared.

As to the question are taxpayers getting their money’s worth, Elliott contends that, in all likelihood, they are not. Although his argument is nuanced, he concludes with dismay that, “the evidence suggests that credit programs, as they are run today, do not provide good value for money in the aggregate.” Elliott is, however, more than a mere critic of the status quo. In the work’s final chapter, he provides a set of ten overall thoughtful recommendations for improving the federal credit programs. Some, such as his proposal to utilize risk-based discount rates for federal budget purposes, should be relatively uncontroversial. Others, such as his proposal that the government incorporate more underwriting and risk-based prices, as well as his argument for the creation of a federal bank to administer all federal credit programs, are likely to be greeted with a bit more skepticism.

Elliott’s fifth recommendation, namely that the Fed “should run credit programs only under extremely unusual circumstances, outside of its normal interactions with financial institutions and its function as lender of last resort for regulated financial institutions” is undoubtedly correct. He rightly notes the Federal Reserve’s lack of experience in this area and the troubling political implications of having the country’s central bank running credit programs. Unlike those who would seek to abolish the Federal Reserve System, Elliott’s criticism is constructive, and should be taken into consideration by Congressional staffers and policymakers.

For those readers interested in learning about student loans, Elliott’s work provides a framework in which one can better understand both how, and why, the relevant federal programs were created. Although the author might have devoted an entire separate chapter with student loans as a case study, his discussion of this particular federal credit program is nevertheless quite informative. The federal government got into the student loan business in 1958 and expanded the program in the 1960s. Congress, through the Health Care and Education Reconciliation Act in 2010, got rid of guaranteed student loans, leaving only direct lending through the Department of Education. Elliott skillfully uses student loans to demonstrate why the federal government is the main source of credit in this area. Student loans are one area in which there are positive externalities, where the acquired education will not only benefit the debtor, but also society as a whole. In addition, as Elliott points out, private lenders will hardly ever make long-term uncollateralized loans to individuals who cannot demonstrate an ability to repay. This is why the federal government, now through direct lending only, is the primary source of credit to university students.

The federal government, whether Americans like it or not, is not only a financial institution, albeit a public one, but it is also an institution that is itself too big to fail. Although not the subject matter of Uncle Sam in Pinstripes, the indisputable fact that the United States is simultaneously a creditor to the private sector, and a debtor to China, raises serious questions about the long-term fiscal health of the American economy. For those individuals interested in learning about the federal government’s increasing role in providing credit to individuals and businesses, this recent work is an excellent place to start.

Jon Lewis (c) 2011

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China’s rise, America’s relative decline

On November 4, 2011, in economic theory, monetary policy, by Jon Lewis

Eclipse: Living in the Shadow of China’s Economic Dominance. Arvind Subramanian. Peterson Institute for International Economics Press, 2011, pp.216, $21.95 It is too soon to ascertain whether the latest attempt by Europe’s political elites to deal with Greece’s public debt, and to salvage the Euro in the process, will result in anything remotely resembling a [...]

Eclipse: Living in the Shadow of China’s Economic Dominance. Arvind Subramanian. Peterson Institute for International Economics Press, 2011, pp.216, $21.95

It is too soon to ascertain whether the latest attempt by Europe’s political elites to deal with Greece’s public debt, and to salvage the Euro in the process, will result in anything remotely resembling a success. Although some in Europe hoped that Beijing would rescue the Continent from its economic morass, Chinese President Hu Jintao has downplayed a Chinese leading role in bailing out Europe.

Nevertheless, the recent statement by the head of the European Financial Stability Facility that the European bailout fund might one day issue bonds denominated in yuan is yet another indication that many observers increasingly perceive China as the world’s economic power broker. Furthermore, some Chinese officials have reportedly floated the idea of European borrowing in renminbi to lower China’s foreign exchange risks and to bolster China’s monetary policy internationally. This suggests that there are strategic-minded policymakers in Beijing who see the European debt crisis as an opportunity to advance national goals and is particularly interesting in light of China’s recent investments in non-dollar assets.

In Eclipse, Arvind Subramanian (Peterson Institute for International Economics and the Center for Global Development) contends that China is well on its way to being the world’s dominant economic power, and advocates for multilateralism as the best means of protection against China in the unlikely event that Beijing would decide to use its future economic dominance for less than benign means. This timely academic monograph begins with a chilling scenario set in 2021: a recently inaugurated Republican president heads to the office of the International Monetary Fund’s Chinese managing director to secure IMF financing. China is able to utilize its economic muscle within the IMF to make the removal of the U.S. Navy from the Western Pacific as a precondition for funding; the terms of the IMF agreement itself would force the United States to engage in tax increases, entitlement reform, and a substantial reduction in defense spending.

While Subramanian doesn’t necessarily believe that the situation will come to pass in this exact manner, he indicates that he does not believe it to be out of the realm of possibility either. Indeed, in the book’s postscript he writes as follows: “To clarify, the 2021 scenario described in the introduction is still very low probability one. But stranger things have happened, as the recent global financial crisis showed.”

That said, Subramanian does challenge the notion of American exceptionalism and, more significantly, the idea that if only the United States got its fiscal house in order, it could withstand China’s challenge to American economic dominance. Subramanian is skeptical of this line of argument; he is not convinced that Washington can successfully arrest China’s emergence as the dominant economic power. Readers will have to decide for themselves whether the author gives far too little credit to the quintessential American ability to overcome seemingly insurmountable obstacles, even if the cards are stacked against the United States.

What sets the author’s work apart from an already significant corpus of scholarly literature on China’s economic rise and America’s decline is his skillful utilization of quantitative methods. Subramanian creates an index of economic dominance in which resources, trade, and external financial strength are the three determinants. He employs that index both to compare several prominent economic powers past, present, and future. The results are sobering and should garner attention from both American policymakers and investors. Subramanian projects, for instance, that by 2030 China will likely become the dominant world economic power, eclipsing the United States much like the upstart former colony eclipsed the United Kingdom. Subramanian boldly contends that, not only is there a transition in economic dominance and reserve currency status, “but that the shift away from the United States toward China is more imminent, more broad-based, and greater in magnitude than is currently anticipated or contemplated.” He projects, for instance, that in 2030 China will account for close to 20 percent of world GDP and 15 percent of world trade. There is no particular reason for the reader to doubt these projections. That said, we are increasingly living in an uncertain world in which it is becoming increasingly difficult to predict what will happen next week, let alone twenty years from now.

In terms of currency dominance, Subramanian is less certain of impending Chinese supremacy. He contends that the three determinants for economic dominance – resources, trade, and external finances – also account for the status of a country’s reserve currency. “Together,” he writes, “they explain nearly 70 percent of the variation in reserve currency holdings.” That said, whether the renminbi will achieve reserve currency status is yet to be determined. Subramanian suggests that a transition to Chinese currency dominance “is far from inexorable. It will be conditional on China undertaking far-reaching reforms of its financial sector and exchange rate policies.” Subramanian is spot on when he writes that China is demonstrating its desire to elevate the renminbi’s status, “not least because internationalization of the renminbi offers China’s policymakers a possible exit from the current mercantilist strategy.” This is particularly salient in light of the European debt crisis and in Beijing’s all but certain role in helping to resolve it, at least in some fashion.

It should be noted that the author, subsequent to the publication of Eclipse, penned an op-ed for the New York Times in which he argues that China should play a considerable role in bailing out Europe. Whether increased Chinese influence in Europe, even if through multilateralism, is in the American national interest, however, is debatable. This is particularly true given the significant cultural and political ties between the United States and the European Union’s member states.

While Eclipse is clearly written and mostly avoids academic jargon, much of the material will be inaccessible to a general readership. Those with an academic background in economics or public policy, on the other hand, would find much to appreciate in Subramanian’s nuanced work. It behooves those who seek to take the Chinese challenge to American dominance seriously to give the author’s views ample and due consideration, particularly given the author’s acknowledgment that “[p]rojections of Chinese economic and currency dominance are of course conditional.” In conclusion, one need not agree with all of the author’s views to acknowledge that Eclipse is a serious book and that the author’s arguments should be taken seriously.

Jon Lewis (c) 2011

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