Bernanke

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Banking, Geithner, The Fed: Doomed to Repeat?

What a glorious day. I walked back up from the Strand bookstore and in so doing wandered past the citadels of more than one of our anti-social banking community. Spring may be the harbinger of warmer days, but I am now seriously wondering whether they will be better.

Why, you might ask, am I so downcast on such a beautiful day.

Banking is headed straight back to the crisis from which it just emerged. And in so doing is condemning us to a repeat of the economic crisis.

Ordinarily I would avoid being so certain about this prognosis, after all if there is one lesson we should all take from Keynes it is that economies are inherently uncertain. As I have explained before uncertainty and risk should not be confused, the one is intractable to analysis, the other is easily analyzed within the rubric of normal probability theory. So for me to assert that the banks are dooming us to a repeat is a contradiction of my own criticism of the banks themselves.

Enough of this philosophy, let me explain myself:

Allow me to present exhibit one.

The Fed. For some reason that eludes me right now, it appears that the fools in Congress are going to allow the Fed to continue as a major regulator of our large banks. This cannot be a decision based upon competency, since the Fed has amply displayed a remarkable lack of skill, foresight, and independence of mind when it comes to bank regulation. I would go further: if we were to compile a list of things not to do, the Fed would be a good place to start. Yet here we are, with the Fed getting its way, and the dolts who govern giving in to the inertia and fear mongering that supporters of the Fed have been relying upon. Let’s face it, the Fed is appalling at regulating. In any evidence-based decision process the events of the last few years would condemn the Fed to elimination from consideration. In a politically and crony driven process, nothing could be more natural than leaving the failed watchdog as the new watchdog. The sleepwalker is dead, long live the sleepwalker!

The fact of the matter is that the Fed is staffed to the rafters with wizard economists who want to leave a mark on macroeconomic policy. They run sophisticated models, they write brilliant papers, and they engage in learned to and fro with the biggest brains in academia. Great. And they leave the dirty work of regulation to the dullards down the hall. I sometimes get the feeling that the Fed has consigned its regulatory staff to some dusty basement room and told them not to say naughty things about all the important bankers who grace the upper floors, and attend hushed and vital monetary policy discussions. And it gets even worse when we think about the Fed’s abysmal record in its role as consumer protector. The word failure dignifies its record.

Anyone with ambition at the Fed does not get involved in regulation. While Bernanke may be correct in arguing that a good regulator needs to have an ear to the pulse of monetary policy, and that good policy makers need to deal directly with big bankers, he seems to fail to grasp the equality implied in that statement. Regulators and policy makers are equal partners in ensuring a smoothly operating banking system.

That’s why I want the two activities split apart. The Chairman of the Fed is a lifetime academic economist who is steeped in the follies of orthodox economics, and has absolutely no hands on grasp of the intricacies of day to day banking operations. A good regulator needs such a grasp. Besides, the staff of the Fed is indistinguishable intellectually from the bankers they are supposed to restrain from damaging the economy: they all attended the same schools, learned the same theories, and believe the same dogmas. This blurring of lines is called ‘regulatory capture’, and the Fed is the prime example of its toxic result.

So when I read that the Fed is retaining its central role in regulation, I naturally flinch. Obviously we learned nothing from the crisis.

On too exhibit two.

This one is a little obscure: the Icelandic bank controversy. You may have noticed that the good folks of Iceland went to the polls over the weekend to vote up or down on a referendum concerning the conditions for repayment of money lost by the governments of Britain and Holland. That money was lost because those governments felt obliged to underwrite the consumer deposits of an Icelandic bank with an extensive customer base abroad. When the bank failed the foreign governments stepped in to protect their domestic depositors – in the same manner that we would expect the FDIC to insure our deposits at American banks. The difference, of course, is that the failed bank fell under Icelandic jurisdiction and not UK or Dutch jurisdiction. So now those two governments want to be repaid for the cost of the bail-out and the Icelandic voters are balking. The issue boils down to this: why should Icelandic taxpayers cough up billions in order to cover the losses of a failed private bank? Especially when those losses are abroad.

Sound familiar?

The reason I raise this is simple: it illuminates the international nature of the banking system and the need, therefore, for international regulation.

It is all well and good building great regulatory bulwarks domestically, but they have little value when confronted by large complex and internationally intertwined behemoth banks. Our problem is that the level of international cooperation is terrible and basically reduced to marginal quasi independent groups based in places like Basel, who take decades to talk about the major issues of the last crisis, and have not a clue about the issues of the next. Plus, naturally, in the aftermath of the kind of crisis we have just endured, and are, perhaps, still enduring, legislators get very parochial in their approach. Each country has politicians who are ambitious and want to make their reputations as ‘fixers’ of great problems, in America that means getting the legislation named after you, but this often prevents true coordination across national boundaries.

The Icelandic case is an example of the bureaucratic gridlock that can occur in such circumstances, and the populist fervor that can get in the way of a solution.

A different example is the ongoing liquidation of Lehman. It may surprise you to learn that there are armies of lawyers still haggling over the proper disposition of the assets of that defunct organization, even after all this time. Then again it probably won’t surprise you – lawyers always perpetuate the fee opportunities in such cases.

The point is that no amount of huffing and puffing, and no amount of good intentions can substitute for detailed inter-government cooperation. Since we are nowhere near such cooperation, we are doomed to experience many more episodes like this Icelandic case. Nationalism gets in the way of good regulation when the industry is global. Without global oversight, global banks will run rings around us. That’s what they do. We would be foolish not to recognize and correct that.

So far we are fools.

Lastly, exhibit three.

Today’s article in New Yorker defending Geithner. What a farce. I am not a visceral Geithner basher, I need evidence for me to get riled up about him. The problem is that there is plenty of evidence. He seems totally incapable of a human touch, and is prone to statements that strike me as the height of elitism. The New Yorker article has him saying that the Obama administration won the war against the economic crisis, but that it lost the people. By which he means that, somewhere along the way, the administration forgot to explain itself in words that would resonate with the public.

Well, Tim, that’s because you were doing the talking.

You come across as an arrogant dweeb.

Plus you flat out lie. Maybe I should retract that: you exaggerate wildly. The re-regulation that you point to as the most sweeping in 75 years is a watered down, banker biased, and overly detailed mess. It will not accomplish what, to me, is the big goal of such legislation: the hobbling of a rogue industry. These people are shut away from the rest of us and occupy a privileged, safe zone within the economy. They can play with fire, and crash, knowing full well that they will be picked up at our cost. Their homes won’t get foreclosed and their private wealth will not be at risk, so they can continue to concoct an alphabet soup of dense, self-serving, and ultimately dangerous products layered in legalese in order to pay themselves vast bonuses. The rest of us merely pay for their mistakes.

You, Tim, set this last stage of the game up. Your ‘stress-tests’ of the failing banks last year were designed to signal to the world two things: one, was the fact that the banks were adequately capitalized, and two, was the bigger fact that the US Treasury was backstopping them. They could not fail. They were too big.

So having allowed the taxpayers to taken hostage by the big banks, we all expected comeuppance. For the banks not for us. Instead what we got was watered down legislation and surrender after surrender to the lobbying might of the banks. We lost over 8 million jobs and countless homes, they got bigger bonuses and an ability to continue to play with our money.

How, exactly, we are supposed to have misinterpreted the administration’s capitulation to the banks I am not sure. The signals have been very clear and I think the public’s reaction completely justified: all the talk and most of the action appears to have been to help the banks. The stimulus was anemic by comparison, and squeezing a jobs bill out of Congress has been a painful embarrassment. The size of the jobs bill that finally emerged – months after the bankers were helped – is an affront to common decency. At $15 billion it is dwarfed by the cash that flowed into the greedy maw of Wall Street. Dwarfed. So how are we supposed to have missed the emphasis?

I think the problem lies within the issues I raised when I discussed the Fed earlier. Geithner and his minions at Treasury are all from the same school. They see their ability to fend off a new Depression as a singular triumph of their technical and bureaucratic skills. That none of what they did makes much sense to the average voter is that voter’s problem. The public should be grateful that there were great and accomplished scions of finance available to save the day. We need no worry our little heads about the details, we should just rest assured that the big people were protecting the other big people and that we little folk won’t get hurt much more.

Ugh.

Tim’s problems are a microcosm of what’s wrong with Obama’s administration generally. There is no connection between the policy makers and the public. There is no common touch. There is plenty of haughty, well educated, self-congratulation, which comes across as disdain for Main Street.

Further, since Geithner and the others are drawn from the same circles as the bankers, they are incapable of the objectivity needed to make the changes in the regulatory regime to avoid a repeat of the crisis.

We still have banks way to large. We still cannot let them fail. We still have no international problem resolution ability. Our banks are still too complicated. They still indulge in anti-social financial structuring. They still have no discipline. worse, now they operate in a shrunken competitive pool. Their boards of directors are still supine. Only one of the CEO’s has been fired. They are already inventing new toxic products. They are obstructing consumer protection legislation. They are still the most powerful lobbying force in Washington – which considering the pharmaceutical industry is saying something. They still switch regulators to lessen our control. They still manipulate markets on the basis of inside information – Goldman’s ability to use customer information to make profits is legendary. And they still boss Geithner about.

To defend Geithner is to defend ineffectiveness. I refuse to do so.

So, as I was walking past the citadels of finance and saw the scurrying self-important folks running in and out of those buildings I was plunged into a worried reflection: we blew this opportunity to clean house. We blew it big time.

They are back to their old tricks.

Which means we are doomed to repeat.

Taxpayers of America: get your checkbooks ready! Goldman, Citi, JP Morgan, and the others will be needing your help in the not too distant future.

Thanks a lot Tim.

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Housing and Bernanke: Bleak House?

Hot after yesterday’s report on the ongoing weakness in home prices comes today’s shocking report on the sales of new homes. Just as was the case with the price data there is no way we can put a pleasant gloss on the sales news. It stinks.

Sales of new homes actually dropped in January to a record low level of 309,000. That’s a 11.2% decline, and the lowest level ever recorded in this data series which has been maintained since 1963. To put this in context: most of the pundits were looking for a slight increase.

So what the heck happened?

Nothing.

By which I mean that consumers see none of the recovery seeping through to them. At least not sufficiently to warrant taking on a major new expense. Wages are stuck in neutral and actually eroding slightly in inflation adjusted terms, so there is no impetus for households top upgrade their home. House prices are still weak which has two effects: one is to stop buyers from making a move in the hope that better deals will come along; the second is that people are suspicious that they could buy a new home and then find themselves holding an asset of declining value. Then there is the banking industry’s hibernation and current risk aversion – access to credit is limited to a much smaller pool of potential buyers because credit standards have been tightened so much.

Add all this together and we produce a potentially combustible brew. The populace is in a surly and introspective mood. They see nothing much being done to fix things – Washington’s gridlock is plastered all over the news. They see no improvement in the employment outlook. They see the hope for increased wages ebbing into the future. And they are acutely aware of their diminished asset values: especially the approximately 30% drop in home prices most parts of the country have experienced.

This is all culminates in the development of a fear driven siege mentality and a desire to hoard cash or pay down debts rather than indulge in discretionary spending. This is the Keynesian vision of the ‘paradox of thrift’ being writ large in our contemporary economy.

So the economy is crippled in some key areas.

An important point to recall is that during the grim employment years of the Bush administration, construction was a bright spot. With sales this low and with no prospect of much recovery in sight the outlook for construction will remain bleak. That kicks away the biggest source of jobs we have had over the past decade.

No wonder this recovery is jobless.

Just as the home sales report was released Bernanke was delivering his regularly scheduled update to Congress. His statement was less bullish than expected. To summarize: the recovery is in no way robust, and is yet to reach a self-sustaining level. This means that both fiscal and monetary policies have to remain stimulative. Any tightening now, or in the near future, would be disastrous.

That should pour cold water over the fiscal and monetary hawks who have been beating the drum for tightening. Within the Fed there is a growing faction advocating raising interest rates in order to stave off inflation. Apparently two of the votes at the last FOMC meetingwere cast in favor of a rate increase and the subsequent, and relatively benign uptick in the discount rate can be seen as a sop to that faction. The FOMC is the forum at which Fed policy is developed and voted upon, so there appears to be a growing division at that level about policy priorities. Which is more important: jobs or inflation fighting? The Fed’s official mission is to balance the two, and that balance is beginning to tip towards inflation fighting. In my view that’s a disaster.

The lesson of history is clear: a premature tightening will plunge us back into recession, and possibly even further into depression.

A superficial reading of the economic situation reveals that GDP grew at about a 4% rate over the last six months. But that is entirely specious. The underlying, self-sustained portion of that growth was much, much, slower – maybe in the 1.5% to 2.o% range. That is way too slow to justify either a rate hike or a budget squeeze.

So we need to keep the policy foot firmly on the gas in the hope that consumers perk up later in the year. If the hawks win the debate … then read up on the Japanese experience of the 1990’s and their ‘lost decade’. It may be more pleasant than our outlook.

Bleak house indeed.

Addendum:

Paul Krugman points to Martin Wolf’s comments in today’s Financial Times. The point they both make is that this recovery is getting more, not less, precarious. We need either a big increase in consumer spending, or a surge in investment. Either would boost final demand and get the private sector moving at a sustainable pace. Without either it is very difficult to construct a positive path through the next few quarters. No matter how you spin the outlook there is a gaping hole in the economy that needs filling. The filler has to come from somewhere. Right now it is the government trying to plug the gap. But such support can only last for so long: sometime the private sector – businesses and consumers – have to take up the slack.

Meanwhile, we need more stimulus.

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Bernanke Confirmation

I have left Bernanke’s confirmation for a second term at the Fed uncommented upon for the simple reason that I have little to add. But for the record: on balance I opposed his re-appointment.

On the negative side:

  • He has shown little indication that he intends to adjust the Fed’s activities in light of the experiences from the crisis.
  • He was culpable in the run up to the crisis because he maintained the low interest rate and easy money regime of his predecessor.
  • He seems incapable of advocating of implementing thorough bank reforms.
  • He is insensitive to the need for a consumer protection agency in finance.
  • He is too wedded to orthodox economic principles.

On the positive side:

  • He reacted well and forcefully once the crisis began.
  • He implemented a highly unorthodox ‘quantitive easing’ program once it became apparent that orthodox policies were having no effect.
  • He is a known quantity to the markets.
  • He is one of our leading experts of crises such as the one we just went through.

In my opinion the negatives above outweigh the positives and therefore he should not have been re-appointed.

The 70 – 30 vote in the Senate was a historically narrow margin in favor of re-appointment, so evidently opposition ran strongly against him. Those who voted to support him have, by extension, voted in favor of the entire set of actions the Fed undertook and is currently undertaking in support of the economy. This does not augur well for reform. The discussions and questioning that accompanied the confirmation hearing simply stand as testimony to the shallow and politicized nature of the Senate’s procedures. Bernanke should he been raked over the coals, and asked, in far more detail, to reveal what actually went on during crises negotiations and policy meetings. Instead the Fed remains an opaque and mysterious body beholden to the banks it supposedly regulates. Even its geographical organization is riven through with anachronism: we have two Fed districts in the farm belt, but none in the southeast where much of the crisis brewed. California remains horribly under represented, as does the South. A more modern structure may have meant more or better information flowing in about local housing conditions.

I am getting tired of coming across instances of systemic or structural problems in American governance. The entire edifice is overly rigid and extraordinarily unresponsive in times of crisis. This is partly due to the fact the constitution was deliberately framed to act against change – in particular to prevent democracy from breaking the peace and quiet of the status quo; and partly due to an unwillingness to recognize or correct deficiencies. Americans are seemingly indifferent to the system of government that affects so much of their lives. The wild over-influence of the farming states both in the senate and in the Federal Reserve Board acts as an anchor preventing change. It is undemocratic and unfair.

And it helps lead to the legislative gridlock that now is crippling the Senate, and therefore the country as a whole.

Bernanke’s confirmation hearing should have acted as a lightening rod for thorough debate about recent monetary policy and prospective financial system reform. Instead it became yet another gentlemen’s club discussion and a processional affirmation of a ‘good old boy’. That 30 senators mustered the energy to vote ‘no’ in such sclerotic circumstances surely implies that discomfort and anger must be pent up in that musty, old fashioned, and anti-democratic hall. If this is the best they can do to vent those feelings it is no wonder nothing gets done there.

Thomas Jefferson was right: we don’t need the Senate. It is a quaint anachronism that should be abolished.

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Obama and The Banks: Part 2

Well Obama came out swinging. Not quite hard enough for my taste – I remain a hard liner when it comes to the banks – but at least there was a hint of anger and a suggestion of a willingness to fight. That is a pleasant change from the insipid and muddled approach we had to suffer through on health care. The immediate downward plunge in bank stock prices was an accurate reaction from the markets. It could be, I stress that word ‘could’, that the days of bank rent seeking are over.

Let’s hope anyway.

The really good news, and I must admit it was both a great boost and surprise, was that Paul Volcker seems suddenly to have gone from forgotten periphery figure to central actor. Almost overnight the so-called ‘Volcker Rule’ has become a major component of the administration’s attempt to re-regulate the banking industry. Since I have always had a soft spot for Paul Volcker, I have to voice my pleasure at this turn of events.

The basic themes of the new proposal are to place limits on bank size and to separate investment banking from commercial banking in the manner of the old, and much lamented, Glass-Steagall Act. The banks took decades of lobbying to get rid of Glass-Steagall and only one decade to abuse their new powers sufficiently to warrant its return. If that isn’t a lesson for economists I don’t know what is.

For those of you whose eyes glaze over whenever bank reform is mentioned please pay attention: in my opinion – and I am by no means alone – getting the banking system back onto a sound footing is the most important single structural domestic issue facing America today. Balancing the Federal budget is a distant second. Fixing health care is part of the budget balancing process and so is subsumed in that second priority. You will notice that I was careful to say ‘structural’ issue because I view getting the employment situation as a cyclical or short term issue. The difference, of course, is that structural issues are those that need permanent or long term attention.

The banking system is broken. It is being exploited by ruthless individuals at the big banks to pad their own wealth. It has veered into unsafe territory because those individuals are willing to take vast risks with other people’s money safe in the knowledge that if they screw up they will be bailed out by the taxpayers. This sounds too simple to be true, but it is the essence of our problem. The big banks have gone on an orgy of risk taking that they scarcely understood and failed to manage. Traditional banking skills like relationship building and tending were thrown overboard and new skills introduced: ‘deal making’ became the norm. So perverse did the banking culture become that deal making was seen as a new form of relationship building. Goldman Sachs exploited its relationships to broker deals and saw itself as the epitome of a relationship bank.

But relationships in banking are not asymmetrical in the way Goldman sees them: they are mutual. Both sides should benefit. I read and hear far too many complaints from Goldman customers that the information they hand over on the course of one deal is then exploited relentlessly by Goldman for its own profit in unconnected deals. It might not be against the law, but it is corrosive to long term mutual benefits if the bank can endlessly take information and use it for its own book without compensating the customer in some way.

As I mentioned yesterday one reason I advocate breaking up the banks – rather than simply restricting their size – is to induce competition. The relationship exploitation I just referred to is one form of anti-social behavior that extra competition would control or eliminate. Right now Goldman and the others can run roughshod over their own customers because those customers have little choice about where to go to get their banking needs met.

I have said it hear repeatedly: the benefits of capitalism – which are abundant – are only ever delivered in real terms when competition exists. The heart of capitalism is competition, not profit making. The allure of profits generates competition. Competition drives innovation. Innovation drives cost cutting and lower prices. The end result is that customers end up paying less for better products. they are wealthier as a result. Along the way capitalists can make short term profits but not long term profits. The only way, in theory, that a capitalist can make long term profits is to innovate endlessly.

Defenders of banking argue that we have seen enormous innovation from the big banks. That is a shallow and failed argument. Innovation is not the creation of even more obscure legalese and fine print. Nor is it the creation of products that only exist to pad out bonus pools. The banking system is supposed to allocate capital effectively through the economy, and to provide a low cost and sound payment system so we can save and get cash reliably when we need to. As Volcker has said, the last big innovation in banking was the ATM machine. The plethora of murky and dubious securitized ‘products’ don’t count: they are simply variations on an old theme.

But, back to Obama.

The proposals have the right thrust. Capping bank size at 10% of the nation’s deposit base is a good start. There are a host of details yet to work out, and I imagine that the armies of lawyers Wall Street employ are already devising sinister schemes to dodge any new rules. Similarly putting a stop to ‘proprietary’ trading will be enormously difficult in practical terms since identifying such trading and separating it from trading undertaken on behalf of a customer is sometimes very difficult. [Proprietary trading is that done by a bank for its own profit rather than being done to satisfy a client need]. Besides, there is little evidence that proprietary trading contributed excessively to the banking melt down. The really big errors were made in securitization and the failure to understand elementary risks of things like sub-prime mortgages and commercial real estate loans. A final objection to a ban on proprietary trading is that banks use such positions to hedge their risks: do regulators really want to expose banks to excessive risk?

So the details will determine the success of the proposals. My approach as you know is much more blunt for exactly the reason that banks are very good at cheating and getting around rules. I know. I helped devise such schemes. Since I believe that creative bankers, lawyers, and accountants will always find ways to cheat – the financial incentive is too powerful for them not to try – then we need to accept that fact and act accordingly. We need to assume cheating and therefore insulate ourselves against the result.

The only way to do that is to limit our exposure to the banks.

To do this we need to force banks to play with their own money and not ours. One way to do this is to increase capital requirements way beyond where they are now. Entering the last crisis most of our banks met or exceeded current capital requirements so we know that such rules are not a solution by themselves. They do, however, limit the taxpayer involvement in a crisis. So start there.

Next we need to limit our insurance exposure. Some bank activities should be made clearly uninsured. Proprietary trading is a good example. We can do this by hiving off that form of banking into uninsured private banks – like the old time investment banks – and thus restricting our insurance to commercial or main street banks. We can limit the size of banks so that each bank failure does less damage. And we can raise the fees we charge banks for the insurance, so as to price properly for the privilege of using our insurance backstop. Naturally banks will raise prices to customers for any increase in insurance costs, but that will have the positive effect of dampening demand for bank services and slowing the industry down, which is not a bad thing at all.

The Obama proposals, based as they are on the Volcker recommendations, aim along these lines. As such they are a major step forward.

Are they enough? No. But they are a much better set of ides than the pablum being put forward by the Treasury Department or the Federal Reserve Board.

Which brings me to the politics of the proposals.

It is quite apparent that a shift in power within Obama’s advisory circles led to yesterday’s announcements. The ludicrous capitulation of the Democrats in Massachusetts obviously contributed to the hasty timing, but the infighting over bank reform had been going on much longer. Obama had originally asked for reform proposals on his desk by year end 2009. That didn’t happen and so he switched to plan ‘B’. I have already said that the winner of the switch is undeniably Volcker, and to a lesser degree Goolsbee at the NEC, the big losers are Geithner and Bernanke. Geithner because he fumbled getting a reform package organized last year, and Bernanke because he represents so much of the status quo.

Indeed the first victim of Obama’s shift in focus could well be Bernanke whose confirmation is now in the balance. As the Democrats try to reframe the political debate in reaction to the loss on Massachusetts and obvious and vulnerable target will be the banking industry and all those who apologize for its anti-social antics. Bernanke is front and foremost in that line. His recent defense of the Fed was all about limited action and new obscure rules to empower the Fed. A quiescent Congress might well have gone along with him. A chastened and newly populist Congress might not.

Geithner too is in trouble. He has openly opposed the Volcker style fix for banking, and has argued for incremental and more bureaucratic approaches. While he stood on the podium yesterday as the president made his statement, he was unusually pushed to the back behind the towering figure of Volcker.

So a shift for the better has taken place. There is an opportunity to get banking back in a box where it cannot do the damage it did. I was pleasantly surprised by the content of Obama’s announcement. I was particularly pleased by the evident influence Volcker has had. Now comes the tricky bit: getting the details worked out. But this time at least we are working from a strong position. The odds are much better that we will get something meaningful.

That’s change progress we can believe in.

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