The Financial Stability Act, Fed Policy, the Economy and the Jobs Agenda
Carlos M Pelaez

The Senate Banking Committee released the proposal for financial regulation in the form of a bill for Restoring American Financial Stability or Financial Stability Act (http://banking.senate.gov/public/ ). The most important aspects of this proposal are analyzed below: origins of the credit/dollar crisis, consumer protection, systemic risk oversight, Fed role in regulation/supervision and proprietary trading. The remainder of this post considers short-term economic indicators and Fed policy, which are more important to US welfare.
Origins of the Crisis. The intent of the Financial Act reveals the interpretation of the crisis: “to promote the financial stability of the United States by improving accountability and transparency in the financial system” (http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf ). The proposals emanating from government follow Official Prudential and Systemic Regulation (OPSR) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 30-4, Regulation of Banks and Finance, 217-24, International Financial Architecture, 101-60, Government Intervention in Globalization, 31-7, Globalization and the State, Vol. I, 30-43, Globalization and the State, Vol. II, 102-8). The assumed goal of OPSR is protecting depositors, investors, output and employment from failures in banking and financial markets. Financial crises are considered as the most important market failure, which is processed through “systemic risk.” The credit crisis allegedly originated in excessive risk taking by finance professionals who generated short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. The failure of Lehman Bros in September 2008 affected the ability of other financial companies such as American International Group (AIG) and Citigroup to finance their positions in the market. Systemic effects paralyzed counterparty credit in multiple segments of financial markets, causing illiquidity of large companies and the collapse of their stock prices that prevented the raising of new capital. The government was forced into bailing out failing companies by equity infusions through the Troubled Assets Relief Program (TARP), which eventually restored confidence in financial markets.
Professor Alan H. Meltzer, the author of the three-volume magnum opus A History of the Federal Reserve (http://www.amazon.com/s/ref=nb_sb_noss?url=search-alias%3Dstripbooks&field-keywords=%22Alan+H+Meltzer%22 ), stated in testimony to the House Financial Services Committee on Mar 17 that the official interpretation ignores “the government’s disastrous mortgage and housing policy. Without the policies followed by Fannie Mae, Freddie Mac and the destructive changes in government housing and mortgage policies, the crisis would not have happened” (http://www.house.gov/apps/list/hearing/financialsvcs_dem/meltzer.pdf ). OPSR is based on the Nirvana fallacy. This fallacy consists of identifying imperfections in actual markets while attributing to the government omniscience in observing imperfections in markets and omnipotence in always correcting them with textbook precision for an improvement in social welfare (cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 133-7, 201, Government Intervention in Globalization, 81, Regulation of Banks and Finance, 18, Financial Regulation after the Global Recession, 11). OPSR finds alleged imperfections in behavior of consumers, investors and financial markets and institutions that can be cured in all cases by errorless regulation. The New Institutional Economics (NIE) argues that both markets and regulation can fail (Oliver Williamson cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 137-43). Professor Meltzer provides an interpretation closer to reality: “The market is not perfect. It is run by humans, who make mistakes. They should pay for them. But the same humans run government where they make different, often more costly mistakes for which the public pays.” On Mar 19, the former Chairman of the Board of Governors of the Federal Reserve Alan Greenspan stated at the Brookings Institution: “Another factor contributing to the surge in demand was the heavy purchases of subprime securities by Fannie Mae and Freddie Mac, the major US Government Sponsored Enterprises (GSE). Pressed by the Department of Housing and Urban Development and the Congress to expand ‘affordable housing commitments,’ they chose to meet them by investing heavily in subprime securities. The firms accounted for an estimated 40 percent of all subprime mortgage securities (almost all adjustable rate), newly purchased and retained on investor’s balance sheets during 2003 and 2004” (http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf ). In the comments at Brookings on the Greenspan essay, Professor N. Gregory Mankiw concurs: “While neither Alan nor I would suggest that the current crisis is primarily the result of misguided housing policies, we both believe that these policies served to make a bad situation worse. We should be mindful of how imperfect the political process is” (http://gregmankiw.blogspot.com/2010/03/comments-on-alan-greenspans-crisis.html ).
The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of MBS by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the Federal Open Market Committee from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change.
OPSR fails to balance roles of regulation and innovation in promoting financial functions. The approach of functional structural finance (FSF) of Professors Robert Merton and Zvi Bodie warns against frustrating financial innovation because of the adverse impact on the efficiency of the economy and growth (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). Prudence instead of rush to taxation and regulation would be advisable to permit the adequate provision of banking and financial functions required for optimum allocation of resources that can move the economy to full employment. Financial stability has never been legislated or regulated but financial functions can be restricted by laws and regulation.
Consumer Financial Protection Bureau. The need for change here according to the Financial Stability Act is because “the economic crisis was driven by an across-the-board failure to protect consumers” (http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf ). The proposed solution is to politicize consumer credit by creating an agency inside the Fed “led by an independent director appointed by the President and confirmed by the Senate.” The result is likely to be higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation. Investors will withdraw funds from financial institutions engaged in consumer credit, reducing banks’ equity capital required for lending. The consumer will be harmed instead of protected. In testimony to the House on Mar 17, Professor Anil K. Kashyap advised: “I want to reiterate the Squam Lake Working Group’s recommendation to get the Fed out of the business of consumer protection” ((http://www.house.gov/apps/list/hearing/financialsvcs_dem/kashyap.pdf http://www.squamlakeworkinggroup.org/ ). The argument may be technically correct but the alternative politicized independent agency may even be worst in practice.
Financial Stability Oversight Council. The need for this new agency according to the Financial Stability Act is “identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.” Professor Meltzer provides criticism in his testimony of Mar 17: “Setting up an agency to prevent systemic risk without a precise, operational definition is just another way to pick the public’s purse. Systemic risk will forever remain in the eye of the viewer. Instead of shifting losses onto those that caused them, systemic risk regulation will continue to transfer cost to the taxpayers.” In criticism of appointing the Secretary of the Treasury as chairman of the systemic risk council Professor Meltzer reminds: “Treasury Secretaries are the officials who authorized all or most of the bailouts since bailouts began.” The Financial Stability Act has here also a proposal that withdraws authority from an independent, technical institution, the Federal Reserve System, to replace it with a politicized new agency that will never develop the professional expertise of the Fed. Professor Kashyap argues that: “No one thinks that it is possible, let alone responsible, to have a modern economy without a lender of last resort for financial firms. Likewise, a lender of last resort has to be able to provide liquidity on demand, and hence the central bank is the only credible lender of last resort.” The Swam Lake Working Group identifies the Fed as the location for the systemic regulator: “One regulatory organization in each country should be responsible for overseeing the health and stability of the overall financial system. We argue that the central bank should be charged with this important new responsibility” (http://www.squamlakeworkinggroup.org/ ).
Fed Role in Regulation/Supervision. Expert advice on the need of the supervisory information for monetary policy is equivocal. Professor Meltzer analyzes multiple institutional arrangements, such as the Financial Services Authority (FSA), concluding none has been effective in regulating systemic risk: “A main reason is that large permanent changes are difficult to foresee and even harder to act against in a timely way.” In compelling testimony to the House on Mar 17 Professor Kashyap concludes that “stripping the Fed of its role in bank supervision would be a step in the wrong direction” The Fed has relied on the information obtained in its supervisory functions to design and implement policy in a form of economies of scope (Ben Bernanke cited in Regulation of Banks and Finance, 100). Relocation of Fed supervision may weaken overall supervision, preventing the Fed from obtaining information for its policy decisions. There is here also the wasteful relocation of a function that has been performed technically by the Fed to a more politicized agency that has to start from scratch with higher costs to taxpayers and consumers of financial services. The case by Chairman Bernanke for maintaining the role of the Fed in regulation/supervision of banks is strong (http://www.federalreserve.gov/newsevents/speech/bernanke20100320a.htm ).
Proprietary Trading. There was not a single case of a bank that experienced problems because of proprietary trading, hedge funds or funds of private equity. Banks would become more vulnerable by restricting their diversification and diminishing their international competitiveness.
The week was rich in short-term indicators confirming the “nascent economic recovery” ((http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). Industrial production increased only 0.1 percent in Feb compared with 0.9 percent in Jan and capacity utilization was still depressed at 72.7 percent just barely up from 72.6 percent in Jan. The important change in the 12 months ending in Feb 2010 is an increase of 1.7 percent for the total index and 1.5 percent for manufacturing (http://www.federalreserve.gov/releases/g17/Current/default.htm ). Housing recovery may be slow and prolonged. In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In Feb 2010 housing starts were at an annual rate of 575 thousand (http://www.census.gov/const/newresconst_201002.pdf ). The producer price index (PPI) declined by 0.6 percent in Feb but increased by 4.6 percent relative to a year earlier. The core PPI increased by only 0.1 percent in Feb and by 0.9 percent relative to a year earlier (http://www.bls.gov/news.release/pdf/ppi.pdf ). There are no evident immediate threats of inflation. The consumer price index (CPI) did not change in Feb and was up by 2.2 percent relative to a year earlier with 0.1 percent increase in the core CPI and 1.3 percent in a year (http://www.bls.gov/news.release/pdf/cpi.pdf ). Initial jobless claims declined by 5000 to 457,000 in the week ending Mar 13 and the four-week moving average declined by 4250 to 471,250 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Recovery of the job creation impulse will coincide with initial jobless claims of around 350,000. The US current account deficit increased to $115.6 billion in the fourth quarter of 2009 from $102.3 billion in the prior quarter. For the entire year of 2009, the current account deficit of the US was $419.9 billion, much lower than $706.1 billion in 2008 and the lowest since 2001 (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm ). The current lower external imbalance of the US raises questions of whether it will increase in the expansion phase of the economy as it did before (Pelaez and Pelaez, The Global Recession Risk, Globalization and the State, Vol. II, 182-90). The currency tensions with China and the need to grow international trade in an improving but weak world economy raise the possibility of regulatory, trade and investment frictions (Pelaez and Pelaez, Government Intervention in Globalization).
The Federal Open Market Committee (FOMC) decided on Mar 16 to maintain the target range of the fed funds rate at 0 to ¼ percent, advising that economic conditions such as resource slack, restrained inflation trends and stability of inflation expectations warrant low fed funds rates for “an extended period” (http://www.federalreserve.gov/newsevents/press/monetary/20100316a.htm ). The yield curve continues to be J-shaped with percentage annual yields of: 0.16 3-months, 0.42 1-year, 1.02 2-years, 2.48 5-years, 3.70 10-years and 4.58 30-years (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). There are two threats of jumps and twists of this abnormal yield curve. First, the Fed holds a portfolio of $709 billion of Treasury notes and bonds, $1066 billion of mortgage-backed securities and $167 billion of federal agency securities for total of $1.9 trillion with excess reserve balances of $1115 billion and $75 billion in the Treasury supplementary financing account in the road to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). Second, budget deficits are proposed by the executive at $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP (http://cboblog.cbo.gov/?p=482 ). The budget proposal of the executive would increase the federal debt from $7.5 trillion at the end of 2009, or 54 percent of GDP, to $20.3 trillion at the end of 2020, or 90 percent of GDP. Sharp increases in long-term interest rates caused by unwinding the Fed portfolio of securities, financing budget deficits and refinancing maturing debt threaten the expansion path of the economy and recovery of full employment. Efforts resolving this immediate employment situation are far more opportune than regulatory exercises with delayed implementation. The agenda is jobs. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)