Ah, something is forming up in Washington in counterpoint to the Goldman/Pimco axis ....
For the Whole Testimony see:
house.gov
Statement of Professor James K. Galbraith to the Subcommittee on Domestic Monetary Policy and Technology, Committee on Financial Services, U.S. House of Representatives, 2128 Rayburn House Office Building, July 9, 2009, 1:30 PM.
Chairman Watt, Ranking Member Paul, Chairman Frank and Ranking Member Bachus, as an
alumnus of this committee’s staff it is again a pleasure and a privilege to appear before you.
This hearing is directed at specific questions concerning the functions of the Federal Reserve
under the administration’s proposals for reform of financial regulation. Let me address those
points directly from the beginning:
“To what extent, if any, would the newly proposed role of systemic risk regulator be in
conflict... with the Fed’s traditional role as the independent authority on monetary policy?”
Would it be necessary to insulate the Fed’s traditional independence in executing monetary
policy from its new role as systemic risk regulator, and if so, how could that be
accomplished?
Professor James Galbraith:
I find this question difficult to understand. The Federal Reserve should not of course ever
conduct monetary policy in ways that undermine systemic stability and sustainability.
Unfortunately on occasion it has done so. The Fed’s failure to use the regulatory tools it has –
including margin requirements in the 1990s information technology boom and the bully pulpit
as well as its examination authority in the housing bubble of the past few years, are precisely
failures to take account of systemic risk in the work of monetary policy.
If the Federal Reserve is to have control of systemic risk regulation, then the goal of
institutional design should be to give that regulation priority, and to ensure that it is integrated
into, and not separated from, the execution of monetary policy. For the reasons given earlier in
this testimony, this is intrinsically very difficult goal to achieve. It would be better, therefore,
to vest the regulation of systemic risk in an agency that is focused on that objective.
What are public policy considerations for and against making the Fed the systemic risk
regulator, given its role as central banker and independent authority on monetary policy?
There is an argument in favor of consolidating systemic risk regulation into the Federal
Reserve’s existing role as lender of last resort. The lender of last resort function is there to
keep the financial system from collapsing in panic when systemic regulation fails. It may make
sense for the same agency to be charged with both establishing the fire code and dispatching the
fire trucks. But – to make my earlier point once again – it is clear that such an agency should
not be, in any way, under the influence of the arsonists. The Federal Reserve’s institutional
structure and political history raise doubts about its independence in this respect.
A principal public policy consideration is the actual track record of the agency in predicting and
averting systemic risk. By any standard, the record of the Federal Reserve in this area, from
Greenspan’s “New Paradigm” in advance of the 2000 technology crash to Bernanke’s
“predominant risk of inflation” in advance of the Great Crisis, is poor. (As I documented in a
review of Bob Woodward’s book on Greenspan in 20013, the Fed’s leadership was also poor in
slumps, always fearing inflation when none actually threatened, dragging its heels in providing
support for the economy when that would have been most useful, and anticipating recoveries
long before they occurred.) It does not seem reasonable to add an additional task to the
burdens of an agency that has difficulty, even in relatively ordinary times, in handling the
macroeconomic role of central banker and “independent authority on monetary policy.”
4 For months, Congressman Doggett has been pressing the Treasury department to
conduct an evaluation of the quality of the documentation behind the mortgage-backed
securities held by the banking system. Despite a promise in March to do so, Secretary Geithner
has not responded to Congressman Doggett’s request.
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The final question is whether the Fed “should relinquish any roles and why”?
The administration proposes to remove the role of consumer protection from the Federal
Reserve, and to give that function to a new Consumer Financial Product Commission. In line
with the view that important regulatory functions should go to entities that specialize in those
functions, I’m inclined to support this proposal. Everything depends, of course, on powers,
staffing, leadership and implementation.
More broadly, the administration’s proposal sets out to restore the shadow banking system and
all the various securities markets that have arisen in the past fifteen years or so, including credit
default swaps. The underlying presumption is that these markets serve public purpose, that they
can be restored, and that they should, in fact, be restored.
The presumption is not correct. The sub-prime and alt-a mortgages that caused the crisis could
never have been securitized had there not been a systematic failure of the credit rating agencies
to examine the documentation behind the loans, and a reliance instead on statistical models in
giving out ratings. Now the ratings agencies have lost credibility entirely. It is by no means
clear that these markets can now be restored, because trust in the underlying documentation
cannot be conjured out of thin air. It would be necessary to establish, credibly, that the
residential mortgage backed securities held by the banking system are not hopelessly
contaminated by misrepresentation, missing documentation, imperfect assignments of title, and
fraud. Yet the evidence that we have, so far, leads prudent observers in the opposite direction.4
Similarly, the market in over-the-counter credit default swaps is less than a decade old, having
been legalized only in 2000. These instruments are intrinsically dangerous; Warren Buffett’s
characterization as “weapons of financial mass destruction” is apt. Why tolerate their
existence? Humanity got along quite well for thousands of years without them.
Would the country be worse off with a smaller, simpler financial system, largely operating out
of institutions called banks and thrifts, themselves reorganized, downsized, broken up, more
competitive and less profitable than the financial sector has been in recent years? I can see no
reason to permit the continued existence, let alone to foster the market dominance, of financial
institutions so large as to be unmanageable by their own top leadership, let alone efficiently
regulated by public authority. Edward Liddy, CEO of AIG, has written that he realized quite
early on that the firm was “too complex, too unwieldy and too opaque” to manage as a going
concern. In general, “too big to fail” is a synonym for “too big to manage” and “too big to
regulate.” Such institutions exist, in part, to help with international tax evasion, to evade
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regulations, to project political power, to facilitate the kind of “financial innovation” that is the
essence of systemic risk.. They are intrinsically unsafe. An appropriate goal of public policy
would be to shrink them, permitting other institutions of more reasonable size, more
conservative practice and greater alignment with public purpose to grow into their market
space.
Unlike scientific knowledge, in this case the genie can be put back into the bottle. If a contract
is declared unenforceable, it generally will not be made. If institutions like hedge and private
equity funds are to be considered as posing systemic risks similar to banks, they can be
declared to be banks, and regulated as such. Money market mutual funds, which are now subject
to insurance, can be reconstituted and regulated as narrow banks, as I believe Chairman Volcker
has advocated. The problem of regulation will be simplified, if we recognize that the crisis
presents an opportunity to simplify, restructure and downsize the entire structure financial
system. Then some of the complex tasks envisioned for the regulatory agencies in the Obama
plan would become much easier. Having given the task of regulating systematically-dangerous
institutions to the FDIC, one medium-term goal of regulatory policy would be, in as many cases
as possible, to alter those institutions, so that after five years or so they can be declared nolonger-
dangerous, and removed from the T1-FHC list.
Moreover, there is precedent for reorganization of this kind. An exotic but very clear example
is the reorganization of airlines in China. In that country, as travelers from the old days may
recall, there used to be a single, national airline, which was an inefficient, obsolete and
dangerous state monopoly. The response of the government was not to privatize the monopoly,
but to break up the company, and to allow other parts of the government, at the provincial and
municipality level, to form their own competing airlines. The result was a riot of competition,
a huge increase in efficiency, and improvement in service quality as travelers in modern China
observe every day. There is nothing uniquely Chinese about this: as it happens the idea
originated in the early 1980s with an American physicist, John Archibald Wheeler, and was
relayed to the Chinese government by a Chinese physicist then working in the United States.
Competition generally improves efficiency, lowers profitability due to market power, and can
reduce the rent-seeking, lobby-driven politics associated with the relationship between industry
and government. If large banks and other large financial holding companies pose systemic
risks, then why not require them to shrink, to divest, and otherwise reduce the concentration of
power that presently exists in the financial sector? I do not argue that this would be, by itself,
sufficient to control all systemic risks. But it would help, over time, bring the scale of
financial activity into line with the capacity of supervisory authorities to regulate it, and the
result would be a somewhat safer system.
Thank you for your time and attention. |
