"Every Consensus Must End
The prevailing consensus on any economic policy is a fascinating beast. For years it can stay put, seemingly immovable, and even - in some cases - becoming enshrined in legislation or central bank statute. One day it begins to shake, ever so slightly; under the pressure of events, a wider range of serious opinion develops. And then, all of a sudden, the consensus breaks and you are running hard to keep up.
We saw this last year with regard to discretionary fiscal policy - fiscal stimulus - in the US. Eighteen months ago, very few mainstream economists or other policy analysts would have suggested that the US respond to the threat of recession with a large spending increase/tax cut. The consensus - based on long years of experience and research - was that discretionary fiscal policy generates as many problems as it solves. To argue against this consensus was to bang your head against a brick wall, while also being regarded as not completely serious.
At some point in November/December 2007, this consensus began to shake. The history may prove controversial but my perspective at the time and in retrospect is that Marty Feldstein was the first heavyweight economist to question the consensus (including in interactions on Capitol Hill), and he was followed closely by Larry Summers’ influential writings in the Financial Times. Within a month or so, the consensus broke. Not only did we get a fiscal stimulus in early 2008 for the US, but the IMF quickly adopted the same pro-stimulus line globally and the terms of the debate changed everywhere. This fed into a process out of which came at least a temporary new quasi-consensus: a large US fiscal stimulus is part of the sensible policy mix today.
The consensus on banking just broke cover. For some weeks it has been under intense pressure. At least since the fall, serious people have been informally floating various new ideas on how to deal with the technical problems surrounding toxic assets and presumed deficient bank capital. But since mid-January, the mainstream consensus - that we should protect existing large banks and keep them in business essentially “as is” - seems to have cracked.
Paul Romer and Willem Buiter favor an approach that emphasizes the creation of new banks. Roger Farmer wants to go in a completely different direction. These are just a few examples of the great (and completely constructive) new dispersion of ideas around banking - post links to your favorite new ideas in comments below.
Advocates for the previous consensus - and the status quo - seem to be located mostly in the financial sector itself (e.g., Lloyd Blankfein). The Administration’s view, as I discussed with Bill Moyers last week, is apparently still up for grabs. And I understand “what next” for banks will be a central theme for debate among staffers on Capitol Hill this week.
On the technical details, I could support any number of schemes. My main concern is limiting taxpayer downside and making sure the taxpayer gets as much upside participation as possible. We have a proposal on the table, but other ideas have merit and the US debate in this regard seems likely to be productive - in striking contrast with Europe, where denial is still the name of the game.
There is only one point on which I would insist. The banking lobby has become too powerful, in large part because big banks have balance sheets that are too big relative to the size of the economy. If a bank has total assets of over 10% of GDP, it is obviously too big to fail. Of course, the smart people who run these banks know this and act - politically and economically - accordingly.
We need a strong system of financial intermediation, and this must feature people willing to take risks with their own capital. In that context, there may be efficiency arguments in favor of relatively large deposit-taking/lending banks (although I’m far from convinced), but it is the political economy considerations that are overwhelming. When all is said and done, if we still have large banks with great political power, we will eventually find ourselves in even bigger trouble.
Written by Simon Johnson
February 16, 2009 at 9:30 am
http://blogs.ft.com/economistsforum/2009/01/putting-an-end-to-financial-crises/#more-315
“Apply the moral to banks and the regulatory prescription is clear. Don’t let banks take risky positions. Make banks stick to their two critical functions - mediating the payments system and connecting lenders to borrowers.
To safeguard the payment system, banks must hold 100 per cent reserves against their deposits either in cash or short-term US treasuries. With 100 per cent reserves, banks runs will be history.
This is not true of the current system, notwithstanding Federal Deposit Insurance Corp insurance. The FDIC’s potential liability exceeds $4 tn; its assets are less than $50 bn. A run on the banks would require massive money creation and engender greater economic panic.
To ensure their second function - the uninterrupted connection of suppliers of and demanders for funds - banks should be limited to a) packaging conforming mortgages and conforming business loans (commercial paper) within mutual funds and b) marketing these mutual funds to the public. The model here is Fidelity, not Lehman Brothers.
Yes, this proposed banking system is not your father’s Oldsmobile. But Jimmy Stewart is not your banker. Some overpaid chief executive thousands of miles away is deciding whether to foreclose your home and shutter your business. The clerk running your branch isn’t applying personal knowledge in deciding to lend you money or call your loan. He’s plugging your credit rating, collateral, and loan amounts in a computer and conveying the answer.
With the government ready to absorb losses, banks are talking outrageous risks knowing that Uncle Sam will cover them if things go south. Raising the trivially low capital requirements of banks, as Paul Volker’s Group of Thirty Commission just proposed, won’t change this behaviour.
What will change this behaviour is to not let it happen. Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 per cent-down and payments below 25 per cent of income.
The government, via the Federal Financial Authority, would use tax records to verify loan payment-to-income ratios. It would also spot check collateral. Once approved, the banks would bundle and sell “their” loans within mutual funds.
Again, traditional bank runs wouldn’t arise. And today’s bank runs, which entail lenders and equity investors avoiding risky banks, wouldn’t either. Why? Because banks would bear zero risk. Mutual fund owners would bear risk, but not the banks. And these lenders would know they were buying government-approved AAA-rated loans, not Bear Stearns‘ CDOs.
This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.
With limited purpose banking, financial crises would largely disappear. Banks would never fail, never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs - like gas stations.
The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.
Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 per cent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode.
What about investment banks, brokerage firms, hedge funds, and insurance companies? What’s their right financial order?
Again, regulate to purpose. Investment banks take companies public and assist in mergers and acquisitions. They shouldn’t be permitted to invest in their clients’ companies. Brokerage firms are here to help us buy and sell assets, not to gamble on spreads. Hedge funds are here to help limit risk exposure. They aren’t here to insure these risks themselves. Finally, insurance companies are here to diversify risk, not write insurance against aggregate shocks.
The FFA and “less is more” limited purpose banking won’t prevent asset markets from occasionally going nuts. But the functioning of financial markets will no longer be in question. Nor will con artists, parading as “financial engineers,” ever again be free to wreak havoc on the nation’s finances and its citizenry.
Christophe Chamley is a member of Boston University and the Paris School of Economics. Laurence J. Kotlikoff is professor of economics at Boston University”
And Taleb, via Arnold Kling:
“Taleb, like me, wants to get rid of risk-taking by banks, and leave non-insured institutions free to take whatever risks they want, as long as they are not creating risks for others. His solution is to nationalize banks.”
I’m hoping Narrow Banking could help us leave government out of this.
Finally, back to the banks. I’m arguing just the opposite point that you are. Most of these proposals come to more or less the same thing, that is wiping out the shareholders and seizing the banks. I care less about how we actually do it, than that we definitely call it nationalization, because it sends shudders down bankers and shareholders spines. They will daily pray to never hear it uttered about banks again. I agree you about the banking lobby, but, after all, that’s our system.Banks are simply one part of it. It’s amazing people aren’t aware of it.
It’s wonderful to hear people mention Fisher, my guide through all of this. Apparently, many people were unaware of him. However, Bernanke was, which makes me wonder why he went along with letting Lehman fail. By the actions taken during the rest of that week, it’s obvious that he understood that a Calling Run ( Debt-Deflation Spiral ) could result from this mess. I’m still puzzled by his decisions throughout this crisis. Again, he should have been one of the people most attuned the down side.
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