Category Archives: financial crisis

Let the US Fiduciary Rule Go Ahead

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The quantity of financial regulation is not quite as important as the quality.  One must get the details right.  The case of the US “fiduciary rule” strongly suggests that President Trump will not get the details right.

Could Dodd-Frank be improved?

Earlier this month, amid the flurry of tweets and other executive orders, the new occupant of the White House issued an executive order directing a comprehensive rethinking of the Dodd-Frank financial reform of 2010.

One can imagine various ways to improve the current legislation.   The most straightforward would be to restore many of the worthwhile features of the original plan that Republicans have undermined or negated over the last seven years.  (Most recently, the House this month voted to repeal a Dodd-Frank provision called “Publish What You Pay,” designed to discourage oil and mining companies from paying bribes abroad.  Score one for the natural resource curse.)

In theory, one might also attempt the difficult and delicate task of modifying, for example, the Volcker Rule, so as to improve the efficiency tradeoff between compliance costs for banks and other financial institutions, on the one hand, and the danger of instability in the system, on the other hand.  Some in the business community are acting as if they believe that Trump will get this tradeoff right.  I see no grounds whatsoever for thinking so.

In particular, the financial system has been strengthened substantially by such features of Dodd-Frank as higher capital requirements for banks, the establishment of the Consumer Financial Protection Bureau, the designation of Systemically Important Financial Institutions, tough stress tests on banks, and enhanced transparency for derivatives.  If these features were undermined or reversed, it would raise the odds of a damaging repeat of the 2007-08 financial crisis down the road.

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Who is right on US financial reform? Sanders, Clinton, or the Republicans?

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Eight years after the financial crisis broke out in the United States, there is as much confusion as ever regarding what reforms are appropriate in order to minimize the recurrence of such crises in the future.

There continue to be some good Hollywood movies concerning the crisis, including one nominated for multiple Oscars at the February 28 Academy Awards.  The Big Short has been justly praised for making such concepts as derivatives easy for anyone to understand.  As has been true since the first of the movies about the crisis, they are good at reflecting and crystalizing the audience’s anger.  But they are not as good at giving clues to those walking out of the theater as to the implications.  What policy changes would help?  Who are the politicians that support the desirable reforms?  Who opposes them?

If an American citizen is “mad as hell” at banks, should he or she respond by voting for the far left?  By voting for the far right?   (Or by refusing to vote at all?)   Each of these paths has been chosen by many voters.  But each is misguided.

There is a place in political campaigns for short slogans that fit on cars’ bumper stickers.  (“Wall Street regulates Congress.”)   And there is a place for ambitious goals.  (“Shrink the financial sector.”)  But the danger is that those who are attracted to inspirational rallying cries and sweeping proposals will lack the patience required to identify which is the right side to support in the numerous smaller battles over financial regulation that take place every year and that ultimately determine whether our financial system is becoming structurally safer or weaker.

Breaking up banks

Senator Bernie Sanders has proposed breaking up the banks into little pieces.  It is the centerpiece of his campaign for the Democratic presidential nomination.   The goal is to make sure that no bank is too big to fail without endangering the rest of the financial system.   That would require quite a sledge hammer.  The American banking system historically featured thousands of small banks.   But having thousands of small banks did not prevent runs on depositary institutions in the United States 1930s.

Continental Illinois was the original case of a bank that was deemed “too big to fail” in 1984, when it was bailed out by the Reagan Administration.   So banks would have to be broken into smaller pieces than that.  Merely turning the deregulatory clock back 30 years would not be enough to do it.

I am not sure whether or not, if one were designing a system from scratch, it would be useful to make sure that no bank was above a particular cap in size chosen so that any of them could later be allowed to fail with no further government involvement.   I do know that having a financial system dominated by just five large banks did not prevent Canada from sailing through the Global Financial Crisis of 2008-09 in better shape than almost any other country.

Attacking banks is emotionally satisfying, for understandable reasons.  But it won’t prevent financial crises.

Reforms proposed by Hillary Clinton

Hillary Clinton is correct in pointing out that the most worrisome problems lie elsewhere:  hedge funds, investment banks, and the other so-called non-banks or shadow banks.  These are financial institutions that are not commercial banks and that therefore have not been subject to the same regulatory oversight and the same restrictions on capital standards, leverage, and so on.  Recall that Lehman Brothers was not a commercial bank and AIG was an insurance company.

Secretary Clinton has done her homework and proposes specific measures to address specific problems with the non-banks.     Four examples:

  • She puts priority on closing the “carried interest” loophole that currently allows hedge fund managers to pay lower tax rates on their incomes than the rest of us pay.  This is a more practical step than most proposals to address the very high compensation levels in the financial sector that cause so much resentment.  It would help moderate inequality, reduce distortion, and raise some tax revenue to help reduce the budget deficit.
  • She proposes a small tax targeting certain high-frequency trading prone to abuse. (Sanders proposes a tax on all financial transactions.)
  • She also supports higher capital requirements on financial institutions, including non-banks, if necessary, beyond those increases already enacted.
  • She proposes a “risk fee” on big financial institutions that would rise as they get bigger.  This is reminiscent of a fee on the largest banks that the Obama Administration proposed in 2010, to discourage risky activity while at the same time helping recoup some revenue from bailouts.  It was going to be part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, but in the end three Republican senators demanded that it be dropped as their price for supporting it.

The Dodd-Frank reforms

The Dodd-Frank law was a big step in the direction of needed financial reform.  It included such desirable features as increasing transparency for derivatives, requiring financial institutions to hold more capital, imposing further regulation on those designated “systemically important,” and adopting Elizabeth Warren’s idea of establishing the CFPB, the Consumer Financial Protection Bureau.

It goes without saying that Dodd-Frank did not do everything we need to do.  But the law  would have moved us a lot further in the right direction if many in Congress  had not spent the last six years chipping away at it.  Those who worked to undermine the financial regulatory reform legislation – mostly Republicans – appear to have paid no political price for it, since most of these issues are below the radar for most voters.

Here are a few examples of how Dodd-Frank has been undermined:

  • I mentioned the abandonment of the fee to discourage risk-taking by large banks and of an earlier proposed global bank levy.
  • Auto-dealers, amazingly, lobbied successfully to get themselves exempted from regulation by the CFPB, allowing the resumption of some abusive lending practices that resemble the sub-prime mortgages which played such a big role in the 2008 financial crisis.  There are 17,838 auto dealers.  I guess highly concentrated industries are not the only ones that can buy their way to special-interest carve-outs.
  • The Dodd-Frank law was supposed to require banks and other mortgage originators to retain at least 5% of the housing loans they made, rather than repackaging every last mortgage and reselling it to others.  The reason is that the originators need to have “skin in the game” in order to have an incentive to take care that the borrowers would reasonably be able to repay the loans.  Under heavy pressure from Congress, that requirement was gutted in 2014.   (This one is not especially the fault of the Republicans.  Virtually every American politician in both parties still acts as though the goal should be to get as many people into as much housing debt as possible, even if many will not be able to repay the loans and even after such practices caused the worst financial crisis and recession since the 1930s. Other countries manage to do this better.)
  • The Congress has refused to give regulatory authorities such as the SEC (Securities and Exchange Commission) and CFTC (Commodities Futures Trading Commission) budgets commensurate with their expanded regulatory responsibilities, in a deliberate effort to hamper enforcement.  Many Republicans appear still to believe that these agencies represent excessively aggressive regulation.  This is remarkable in light of the financial crisis.  Remember that Bernie Madoff — who is himself now the subject of new Hollywood portrayals — was able to run his Ponzi scheme right up until 2008 despite repeated tip-offs to the SEC, because it systematically refrained from pursuing investment management cases during this period.

Who can get the job done?

Sanders has indicated that if he were president, nobody with past experience on Wall Street would be allowed to serve in his administration.  A blanket rule like this would be a mistake.  Judging people by such superficial criteria as whether they have ever worked for Goldman Sachs, for example, would have deprived us of the services of Gary Gensler.  As CFTC chairman from 2009-2014 Gensler worked tirelessly to implement Dodd-Frank.  To the consternation of many former Wall Street colleagues, he aggressively pursued regulation of derivatives and, for example, prosecution of a case against five financial institutions who had colluded to manipulate the LIBOR interest rate (London Interbank Offered Rate]. Yet Sanders tried to block his appointment in 2009.

Financial issues are complicated.  Getting the details of regulation right is hard.  (The examples mentioned here are just the tip of the iceberg.)  We need leaders and officials who have the wisdom, experience, patience, and perseverance to figure out the right measures, push for their enactment and then implement them.  If such people are not the ones who receive political support for their efforts, we should not be surprised if the financial sector again escapes effective regulation and crises recur in the future.

[I have given my subjective evaluation of various specific legislative proposals – some in Dodd-Frank, some proposed by Bernie, some proposed by Hillary– on a 1-slide diagram.  A shorter version of this column was published at Project Syndicate.  Comments can be posted there or at the Econbrowser post.]

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Only Tsipras Can “Go to China”

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Alexis Tsipras, the Greek prime minister, has the chance to play a role for his country analogous to the roles played by Korean President Kim Dae Jung in 1997 and Brazilian President Luiz Inácio Lula da Silva in 2002.  Both of those presidential candidates had been long-time men of the left, with strong ties to labor, and were believed to place little priority on fiscal responsibility or free markets.  Both were elected at a time of economic crisis in their respective countries. Both confronted financial and international constraints in office that had not been especially salient in their minds when they were opposition politicians.  Both were able soon to make the mental and political adjustment to the realities faced by debtor economies.  This flexibility helped both to lead their countries more effectively.

The two new presidents launched needed reforms.  Some of these were “conservative” reforms (or “neo-liberal”) that might not have been possible under more mainstream or conservative politicians.

But Kim and Lula were also able to implement other reforms consistent with their lifetime commitment to reducing income inequality.  South Korea under Kim began to rein in the chaebols, the country’s huge family-owned conglomerates. Brazil under Lula expanded Bolsa Familia, a system of direct cash payments to households that is credited with lifting millions out of poverty.

Mr. Tsipras and his Syriza party, by contrast, spent their first six months in office still mentally blinkered against financial and international realities.  A career as a political party apparatchik is probably not the best training for being able to see things from the perspective of other points on the political spectrum, other segments of the economy, or other countries.  This is true of a career in any political party in any country but especially one on the far left or far right.

The Greek Prime Minister seemed to think that calling the July 5 referendum on whether to accept terms that had been demanded previously by Germany and the other creditor countries would strengthen his bargaining position.  If he were reading from a normal script, he would logically have been asking the Greek people to vote “yes” on the referendum.   But he was asking them to vote “no”, of course, which they did in surprisingly large numbers.   As a result – and contrary to his apparent expectations — the only people’s whose bargaining position was strengthened by this referendum were those Germans who felt the time had come to let Greece drop out of the euro.

The Greek leadership discovered that its euro partners, predictably, are not prepared to offer easier terms than they had been in June, and in fact are asking for more extensive concessions as the price of a third bailout.  Only then, a week after the referendum, did Mr. Tsipras finally begin to face up to reality.

The only possible silver lining to this sorry history is that some of his supporters at home may – paradoxically – now be willing to swallow the bitter medicine that they had opposed in the referendum.  One should not underestimate the opposition that reforms will continue to face among Greeks, in light of the economic hardship already suffered.  But like Kim dae Jung and Lula, he may be able to bring political support of some on the left who figure, “If my leader now says these unpalatable measures are necessary, then it must be true”.  As they say, Only Nixon can go to China.

None of this is to say that the financial and international realities are necessarily always reasonable.  Sometimes global financial markets indulge in unreasonable booms in their eagerness to lend, followed by abrupt reversals.  That describes the large capital inflows into Greece and other European periphery countries in the first ten years after the euro’s 1999 birth.  It also describes the sudden stop in lending to Korea and other emerging market countries in the late 1990s.

Foreign creditor governments can be unreasonable as well.   The misperceptions and errors on the part of leaders in Germany and other creditor countries have been as bad as the misperceptions and errors on the part of the less-experienced Greek leaders.   For example the belief that fiscal austerity raises income rather than lowering it, even in the short run, was a mistaken perception.  The refusal to write down the debt especially in 2010, when most of it was still in the hands of private creditors, was a mistaken policy.  These mistakes explain why the Greek debt/GDP ratio is so much higher today than in 2010 — much higher than was forecast.

A stubborn clinging to wrong propositions on each side has reinforced the stubbornness on the other side.  The Germans would have done better to understand and admit explicitly that fiscal austerity is contractionary in the short run.  The Greeks would have done better to understand and admit explicitly that the preeminence of democracy does not mean that one country’s people can democratically vote for other countries to give them money.

In terms of game theory, the fact that the Greeks and Germans have different economic interests is not enough to explain the very poor outcome of negotiations to date.  The difference in perceptions has been central.  “Getting to yes” in a bargaining situation requires not just that the negotiators have a clear idea of their own top priorities, but also a good idea of what is the top priority of the other side.   We may now be facing a “bad bargain” in which each side is called upon to give up its top priorities.  On one side, Greece shouldn’t expect the ECB and the IMF to be willing explicitly to write down the debt they hold.  On the other side, the creditors shouldn’t expect Greece to run a substantial primary budget surplus.  A “good bargain” would have the creditors stretch out lending terms even further so that Greece doesn’t have to pay over the next few  years and would have the Greeks committing to structural reforms that would raise growth.

One hopes that the awful experience of the recent past has led both sides to clearer perceptions of economic realities and of  top priorities.   Such evolution is necessary if the two sides are to arrive at a good bargain rather than either a bad bargain or a failure of cooperation altogether. The non-cooperative equilibrium is that Greek banks fail and Greece effectively drops out of the euro. This may be even worse than a bad bargain, although I am not sure.

Admittedly, both Kim and Lula had their flaws.  Moreover, Korea and Brazil had some advantages that Greece lacks, beyond Syriza’s delay in adapting to realities.  They had their own currencies. They were able to boost exports in the years following their currency crises.

But a recurrent theme of the Greek crisis ever since it erupted in late 2009 is that both the Greeks and the Euro creditor countries have been reluctant to realize that lessons from previous emerging market crises might apply to their situation.  After all, they said, Greece was not a developing country but rather a member of the euro.   (This is the reason, for example, why Frankfurt and Brussels at first did not want Greece to go to the IMF and did not want to write down the Greek debt.)  But the emerging market crises do have useful lessons for Europe.  If Tsipras were able to shift gears in the way that Kim dae Jung did in Korea and Lula did in Brazil, he would better serve his country.

[An earlier version appeared in Project Syndicatecomments are welcome there.]



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