Don’t Just Do Something, Stand There

The Federal Reserve has taken its next step in trying to stop or at least slow the collapse of the world financial system:

NEW YORK – The Federal Reserve, working with central banks in Europe, Canada and Asia, pumped as much as $180 billion into money markets on Thursday to combat a seizing up of lending between banks that is intensifying global financial crisis.

The move was aimed at boosting waning confidence and getting banks around the world to open their ever-tightening purse strings. Asian markets closed lower, but the Fed action helped send European stocks higher after three days of losses.

Wall Street appeared headed for a higher opening, after dropping 450 points Wednesday when a Fed bailout of American International Group Inc., one of the world’s largest insurers, failed to settle the markets’ frayed nerves.

Worries that other financial companies could fail may cast a pall on the central banks’ step, which spread billions of dollars around the world in exchange for foreign currencies.

In a statement, the Fed said it had authorized the expansion of swap lines, or reciprocal currency arrangements, with the other central banks, including amounts up to $110 billion by the ECB and up to $27 million by the Swiss National Bank.

The Fed also said new swap facilities had been authorized with the Bank of Japan for as much as $60 billion; $40 billion for the Bank of England and $10 billion for the Bank of Canada.

All told, Fed action increased lines of cash to central banks by $180 billion to $247 billion.

Congressmen, like the rest of us, are wandering around, dazed, unsure of what to do about the situation that has been fomented over a period of decades by their action and inaction. The present mess is a bipartisan one. Gramm-Leach-Bliley, one of the last major acts of deregulation in the financial sector, was passed in 1999 with 90 senators voting for it and signed into law by then-President Bill Clinton. How much more bipartisan could it have been? Besides, it merely legitimized what had already been taking place for years, the consolidation of the financial services industry, effectively repealing the Glass-Steagall Act which prohibited commercial banks from owning stock.

Both of the presidential candidates are talking about increased regulation in the financial services industry. From Sen. Obama:

I certainly don’t fault Senator McCain for these problems, but I do fault the economic philosophy he subscribes to. It’s a philosophy we’ve had for the last eight years – one that says we should give more and more to those with the most and hope that prosperity trickles down to everyone else. It’s a philosophy that says even common-sense regulations are unnecessary and unwise, and one that says we should just stick our heads in the sand and ignore economic problems until they spiral into crises.

and from Sen. McCain:

It is essential for us to make sure that the U.S. remains the pre-eminent financial market of the world. This will be a highest priority of my Administration. In order to do this, major reform must be made in Washington and on Wall Street. We cannot tolerate a system that handicaps our markets and our banks and places at risk the savings of hard-working Americans and investors. The McCain-Palin Administration will replace the outdated and ineffective patchwork quilt of regulatory oversight in Washington and bring transparency and accountability to Wall Street. We will rebuild confidence in our markets and restore our leadership in the financial world.

Today’s editorial in the Washington Post points to the need for action:

The losses are far from over. Government must devise a more predictable and transparent way to help wind up the financial sector’s bad investments — along with new rules to help prevent a repeat performance in the future. That’s asking a lot. It’s asking even more to insist that it be done in the middle of a crisis and when Congress, a weakened president and two presidential candidates are fully engaged in election-year politics. But no economic issue is more urgent, and the winners in November will have to face it squarely.

What sort of regulations and reforms will be proposed? What is likely to be enacted into law? Would any of them have been likely to prevent the situation that’s unfolding?

Megan McArdle who’s not only a blogger but a financial reporter, examined a series of “retrospective regulations” and comes a cropper. She concludes:

But if you are looking to place regulatory blame, whatever changes you’d care to point to happened on Clinton’s watch, not Bush’s. You cannot have it both ways–hailing the Clinton genius at economic management (and implying that Obama will bring back those halcyon days), and then claiming that Bush should have trailed around undoing all his work. You most certainly cannot explicitly claim, as Obama did in his speech, that this crisis is the result of the Bush administration’s deregulation of the financial markets:

I think the problem here is that people are thinking completely within the box which, after all, is what you’d expect from scads of people who got where they are largely by giving the expected answer to every question, when what is really necessary is thinking outside the box. The regulatory framework we’ve had for the last 70 years was put in place to deal with a relatively small, closely-knit national banking industry that dealt in a lordly way mostly with each other. Today’s financial sector is a gargantuan, world-spanning globalized one, beyond the scope of federal government regulation, and chuck-full of consumer products.

That’s more what Nobel Prize winner Joseph Stiglitz is doing in his observations about the financial crisis:

1. We need first to correct incentives for executives, reducing the scope for conflicts of interest and improving shareholder information about dilution in share value as a result of stock options. We should mitigate the incentives for excessive risk-taking and the short-term focus that has so long prevailed, for instance, by requiring bonuses to be paid on the basis of, say, five-year returns, rather than annual returns.

2. Secondly, we need to create a financial product safety commission, to make sure that products bought and sold by banks, pension funds, etc. are safe for “human consumption.” Consenting adults should be given great freedom to do whatever they want, but that does not mean they should gamble with other people’s money. Some may worry that this may stifle innovation. But that may be a good thing considering the kind of innovation we had — attempting to subvert accounting and regulations. What we need is more innovation addressing the needs of ordinary Americans, so they can stay in their homes when economic conditions change.

3. We need to create a financial systems stability commission to take an overview of the entire financial system, recognizing the interrelations among the various parts, and to prevent the excessive systemic leveraging that we have just experienced.

4. We need to impose other regulations to improve the safety and soundness of our financial system, such as “speed bumps” to limit borrowing. Historically, rapid expansion of lending has been responsible for a large fraction of crises and this crisis is no exception.

5. We need better consumer protection laws, including laws that prevent predatory lending.

6. We need better competition laws. The financial institutions have been able to prey on consumers through credit cards partly because of the absence of competition. But even more importantly, we should not be in situations where a firm is “too big to fail.” If it is that big, it should be broken up.

I think there’s a certain irony in proposing that the SEC operate somewhat more like the FDA while the FDA is getting criticism that it isn’t able to meet today’s challenges but no matter. I think that Dr. Stiglitz’s advice is probably closer to the mark but incredibly unlikely to be adopted for the reasons suggested above.

I’m not sure that we have the international structures in place to deal with today’s financial system and we may well be seeing willy-nilly a return to the old “boom and bust” of the old, unregulated one. I certainly don’t see the will to make the changes to return to an old, small, local financial system.

There may be quite a storm ahead without much to do but ride it out as best we can. Voltaire may have given us the best advice:

Pangloss, Candide, and Martin, as they were returning to the little farm, met with a good-looking old man, who was taking the air at his door, under an alcove formed of the boughs of orange trees. Pangloss, who was as inquisitive as he was disputative, asked him what was the name of the mufti who was lately strangled.

“I cannot tell,” answered the good old man; “I never knew the name of any mufti, or vizier breathing. I am entirely ignorant of the event you speak of; I presume that in general such as are concerned in public affairs sometimes come to a miserable end; and that they deserve it: but I never inquire what is doing at Constantinople; I am contented with sending thither the produce of my garden, which I cultivate with my own hands.”

After saying these words, he invited the strangers to come into his house. His two daughters and two sons presented them with divers sorts of sherbet of their own making; besides caymac, heightened with the peels of candied citrons, oranges, lemons, pineapples, pistachio nuts, and Mocha coffee unadulterated with the bad coffee of Batavia or the American islands. After which the two daughters of this good Mussulman perfumed the beards of Candide, Pangloss, and Martin.

“You must certainly have a vast estate,” said Candide to the Turk.

“I have no more than twenty acres of ground,” he replied, “the whole of which I cultivate myself with the help of my children; and our labor keeps off from us three great evils-idleness, vice, and want.”

Candide, as he was returning home, made profound reflections on the Turk’s discourse.

“This good old man,” said he to Pangloss and Martin, “appears to me to have chosen for himself a lot much preferable to that of the six Kings with whom we had the honor to sup.”

“Human grandeur,” said Pangloss, “is very dangerous, if we believe the testimonies of almost all philosophers; for we find Eglon, King of Moab, was assassinated by Aod; Absalom was hanged by the hair of his head, and run through with three darts; King Nadab, son of Jeroboam, was slain by Baaza; King Ela by Zimri; Okosias by Jehu; Athaliah by Jehoiada; the Kings Jehooiakim, Jeconiah, and Zedekiah, were led into captivity: I need not tell you what was the fate of Croesus, Astyages, Darius, Dionysius of Syracuse, Pyrrhus, Perseus, Hannibal, Jugurtha, Ariovistus, Caesar, Pompey, Nero, Otho, Vitellius, Domitian, Richard II of England, Edward II, Henry VI, Richard Ill, Mary Stuart, Charles I, the three Henrys of France, and the Emperor Henry IV.”

“Neither need you tell me,” said Candide, “that we must take care of our garden.”

“You are in the right,” said Pangloss; “for when man was put into the garden of Eden, it was with an intent to dress it; and this proves that man was not born to be idle.”

“Work then without disputing,” said Martin; “it is the only way to render life supportable.”

18 comments… add one
  • Dave;

    Good post.
    But look, your title implies the real answer, here.
    The best thing we can do is make sure the government stays out of the home loan industry altogether. The problem is not free markets or the investment world. The problem is government. In this case, specifically, the FDR creation of Fannie Mae, and it’s recent mismanagement of it.

    As I’ve pointed out else where… Let’s not delude ourselves into thinking that F&F are anything but governmental creations, run by political appointees, who turned around and raped the place so badly it crashed. If all the banks in the world were to coordinate their efforts, in trying to create this large an issue, absent governmental involvement in the home loan industry, it could not happen. The key here is government, and the abuse of power thereof.

  • PD Shaw Link

    Most, if not all, the regulatory fixes being thrown around sound like they would tighten the flow of capital, when that’s the opposite of the immediate problem. McCain’s commission may be the best idea for dealing with the causes.

    As to the immediate problem, there was a financial advisor on CNBC this morning arguing that the government has to take over faltering financial institutions preemptively; don’t wait until a company like AIG loses all of its going-concern value. I hope there is some rational balance between laissez faire and socialism.

  • McCain’s commission may be the best idea for dealing with the causes.

    I said as much on OTB Radio last night.

    These blue ribbon commissions have advantages and disadvantages. One advantage is that because they’re usually composed of retired politicians, judges, and so on they’re not as embroiled in the political tit-for-tat. Another is that, unlike a Senate committee, they have a beginning, a middle, and an end.

    The disadvantages are that because they’re not usually composed of pols in the thick of things their results have no inside salesmen. That’s why so little actually results from them. Another disadvantage is, as I suggested in the post, that they’re almost always ways of re-packaging the conventional wisdom.

  • PD Shaw Link

    I didn’t catch OTB, so you may have addressed this, but you might divide the issues into two categories: Wall Street reform and housing policy reform. I think a commission can do a good job of proposing reforms against the distant and arcane financial industry. But on the issues pertaining to home ownership and the policies that encourage extensive borrowing on homes, a commission is going to run into severe problems, but so would politicians.

  • Interesting comments by Stiglitz. I agree in part.

    1. The incentives on Wall Street and elsewhere are whacked. Changing that around would be good.

    2. The part about being fit for human consumption, disagree.

    What if somebody wants to take that kind of risk? I think such a comission should simply state the level of risk and that’s that. Let people decide if they want to take that risk.

    3. Leverage.

    Same thing as above. If a firm is relying more and more on leverage in its investments then let investors know that. Publish both in hard copy and on the intertubes. If a firm suddenly sees its investors bailing like rats from a sinking ship they’ll reconsider.

    Basically I think providing more information and letting people make decisions for themselves is the solution. Telling people what they can and can’t do isn’t the answer. In fact, I say the same thing about the FDA. If I have a disease that is going to kill me with certainty and an experimental drug might cure me, or prolong my life and its side effects are unknown and could be fatal…thanks for the concern but I’d like to make the decision whether or not to use the drug. Leaving it up to some faceless/nameless bureaucrat in D.C. is not my preferred way of doing things.

    And there is another problem with Stiglitz’ world view. The very people making up these commissions are people…people just like the ones he is seeking to protect from making bad decisions. So, if we follow Stigiltz’ advice and when the next financial crisis hits can we string him up and beat on him with sticks? If he agrees to that and I can be the first one to smack him upside the head, I’ll go for his ideas.

  • I agree with your last point wholeheartedly, Steve. Fordist technocrats look at any situation and think they would handle it better. Maybe. Maybe not.

    I think the basic root problem at the heart of this whole debacle is that there simply was no vocabulary for evaluating the risks in some of the instruments that were being created. Their creators couldn’t say how risky they were. Their sellers couldn’t say how risky they were. Their buyers couldn’t say how risky they were. And I think it’s at least possible that it was impossible to determine how risky they were.

    That’s where I think the good sense in making fundamental financial regulatory structure is. The cats who are creating these exotic instruments need to be able to prove just how risky they are.

  • Steve Plunk Link

    I get Steve V’s point about letting people take risk if they are fully informed but with so much money being managed by mutual fund managers how can the average 401K/pension investor get that knowledge and exert any control over their money? The layers of insulation between the actual investors and the management decisions seem to be at an all time high.

    Would limits on leveraged trading harm the system? It seems that sort of leveraged buying serves the few without benefiting the system in general.

    When short selling was curtailed today the market responded immediately and shot up 400 points. Do short sellers have the ability to irrationally panic the market in their quest for profits? Does short selling serve a large enough purpose to not regulate more heavily?

    The risky investment may indeed make money for some but are they necessary for the market to work? If they serve no purpose other than provide the money for a Hamptons getaway are they worth the risk to overall market stability?

    Once again I’ll harp about the culpability yet irresponsibility of the Boards of Directors. Where are these people when it comes to consequences for crappy business decisions and the hiring of CEOs who lead the companies to ruin.

    Great post and worthwhile discussion.

  • That’s where I think the good sense in making fundamental financial regulatory structure is. The cats who are creating these exotic instruments need to be able to prove just how risky they are.

    Sort of. If left up to them they might try to spin risky instruments as less risky instruments. This is where, I think, the government can possibly fill a role. Take a look at these instruments and judge how risky they are, then tell everyone. Maybe come up with some sort of risk index so that the people who don’t have either the training or the time to delve into the risk analysis can still make a sound decision. We have indexes for inflation and other things, why not risk of financial instruments?

    Once again I’ll harp about the culpability yet irresponsibility of the Boards of Directors. Where are these people when it comes to consequences for crappy business decisions and the hiring of CEOs who lead the companies to ruin.

    I agree. Many of these people will likely get off without even the slap on the wrist. Being this stupid needs to hurt.

  • I see the uptick as a temporary reaction at best if the banning of shorting is at all a part of that process. This particularly given what we’re seeing in the remainder of the world. London, it seems have had an up day like they’ve never had in heir history. I can’t imagine a connection to short selling in the states, to that sizeable event, frankly.

    There is, however, something I’ve not yet defined that rubs me the wrong way about such regulations in a ‘free’ market.

  • In a similar vein, the apostle Paul, Silas, and Timothy wrote to the church in Thessalonica, instructing them to “Make it your ambition to lead a quiet life, to mind your own business and to work with your hands…”.

    I do have a few complaints about Stiglitz, however: the market is to determine the safety of consumption. In this case, that process broke (tranche, rate, repeat) but that was largely due to sketchy and illegal practices by the FMs. Secondly, again to point the finger at the government, we don’t need “speed bumps” to lending. We need the government to not use federal muscle to preempt the speed bumps that the free market already had in place.

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