Systemic Risk Is Unmanageable

Often when we talk about the Fed, we talk about a dual mandate — low inflation, and low labor unemployment. But as I suggested at RealMoney many times, there is a hidden third mandate: protect the integrity of the banking system.

Often, a tightening cycle would end with a bang, with some credit starved entity (Residential Housing, Nasdaq, LTCM, Lesser-developed Asia, Mexico, etc.) dying. The Federal Reserve would then spring into action and say, “We must fight the threat of unemployment.”

Would they? No, they would invoke protecting the financial system, which protects the banks. After all, monetary policy does not work when banks are compromised, as they are today. No wonder there is credit easing.

So when I hear the Fed proposed to be the systemic risk regulator, I have two thoughts:

1. You did a bad job with monetary policy and bank supervision, but you are nice guys, because you do for the US government all of the things the Treasury department can’t constitutionally do. Now let’s see if you can do better with controlling systemic risk, even though we haven’t granted you control over all the levers necessary to do so.
2. Maybe this will make them better with monetary policy; it makes the triple mandate explicit.

My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times. The temptation that Greenspan succumbed to was to throw liquidity at problems too early, which avoided liquidation of marginal debts, and the debt levels built up.

If the Fed has to minimize systemic risk in the economy, maybe it becomes less willing to loosen policy profligately. I would hope it would work that way.

That said, given the lack of success for the Fed on its goals, I suspect that if it were given the task of reining in systemic risk, it would fall prey to political pressure, and fail at that as well.

I go back to my earlier proposal — the Fed would have to keep the US economy under a limit of private debts being less than 2x GDP. But can you imagine the Fed tightening during a boom to avoid systemic risk, or raising margin requirements? I can’t, so even though ideally the Fed would be the right player to manage systemic risk, in practice, systemic risk is unmanageable, because there are too many interests that benefit from boom times.

That’s why I don’t expect much from the proposals to manage systemic risk, regardless of who gets the power to do so.

Comments

[Living4Divi...:]

Great article, David. Like all your others.

Jun 22 09:44 AM

[Tom Armistead:]

This gets back to Bernanke's observation that the current regime of bank regulation is Procyclical. The best time to reverse that would be during a time of prosperity, to reduce the supply of money and reduce debt, to increase capital requirments for banks when times are good.

Or capital requirements could be eased during bad times, essentially glossing over solvency issues for banks. The compromise reached is for government to create capital and apply it to bank balance sheets whether they feel they need it or not.

Politically the solutions are extremely unpopular, especially reigning in the banks at the top of the cycle.

Jun 22 09:54 AM

[conceptwizard:]

The Chairman of the Fed, Ben Bernanke, would have us believe along with other, so-called experts, that monetary easing will come in time to head off hyperinflation. Unfortunately that cannot happen. The minute money and credit is withdrawn from the system it will collapse. The underlying deflationary drag is too great and that drag will take years to diminish. How can our Fed Chairman and our Treasury Secretary think for a moment that they’ll just be able to turn the tap off when their current orgy of spending ends? Politicians unfortunately see this, as only they would, as an opportunity to purchase votes by making sure the spending continues. It will be interesting to watch over the next several years, as many nations scramble in the bond markets to raise money to keep their economies going. There is no telling at this point how high interest rates are going to go.

Our President tells us of trillion dollar plus deficits are far as the eye can see. Those deficits assume 3% growth rates in GDP, which is not going to happen and the end of the Bush tax cuts. Deficits will be much larger than the Congressional Budget Office estimates, if due to nothing more than exploding entitlement expenditures. This plan involves the perpetual rolling of $5 trillion in Treasury paper much of which is held by foreigners plus the new debt incurred, plus the interest on the existing debt. Do you really believe foreigners are going to fund such deficits indefinitely?

Jun 22 10:02 AM

[Steve in Gr...:]

Thanks, Mr. Merkel, for another interesting note. I agree with much of what you wrote, except the headline.

You said: "...My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times..."

Yes. I don't think this can be disputed. The dot.com crash and the current crash are both the direct result of inept Fed manipulation of the money supply. Combine the Fed's willingness to debase the currency with the Treasury socializing the downside risk to the big banks and you have a massively unstable system.

The solutions seem obvious. 1) Reduce the power of the Fed; limit its mandate to slow growth in the money supply and remove all reference to full employment. 2) Reduce the power of the Treasury; prevent it from bailing out banks and limit it to an FDIC-like role of shutting down bankrupt banks and reimbursing depositors.

Systemic risk is manageable, but the key is to know that the government is the source of the risk and have the political will to reform the system by limiting government power.

Jun 22 10:51 AM

[kingaj12:]

The bottom-line question appears to be what to do during the inflationary build-up that preceeds (or triggers) a deflationary crisis. According to Minsky, the financial sector inevitably transitions from conservative lending (when liquidity is plentiful), to speculative activity (when liquidity is scarce and and risk-taking is well-rewarded), and finally to outright Ponzi schemes like subprime securitization.

We need to make all this financial scheming pay in advance for the liquidity that these schemes depend on. The reserve banking system has in effect sold a "put" option on the equity of the financial sector: a systemic bank rescue restores the balance sheets of the financial system so it can be viewed as the payout of a put option on bank equity. The marginal change to the cost of hedging this put option can be attributed to changes in bank positions, and some percentage of this change can be charged back to the banks in the form of a systemic risk haircut, or some such device.

Even if one got the calculation wrong (a reasonable assumption!) systemic risk haircuts would supply a counter-cyclical pressure on leveraged financial risk-taking. Moreover such attributions can be scaled based on a reasonable view of the fundamentals. Financial institutions taking large leveraged positions in crowded markets are making use of a social good (liquidity). Liquidity is not free. If they paid for it up front then maybe, just maybe, their behavior would change.

Jun 22 11:08 AM

[Dave Wrixon:]

Well the Fed being privately owned by a banking cartel means that there is conflict of interest right from the off. Failure is a no-brainer!

Jun 22 12:27 PM

[Moon Kil Woong:]

Controlling rates is a power best left to no one. And by the way, I agree 100% that the Fed's primary job is to help the banking institutions that own it make money and not go bankrupt. It doesn't take a genius to figure that one out. Go figure.

Their second task is to make sure the public is healthy enough they can keep on milking them of their assets.

Jun 22 12:34 PM

[greg weitzner:]

I think this all validates Milton Friedman's belief that there should be no Federal Reserve but a computer that increases the monetary base every so often. In my opinion the Federal Reserve sought Goldilocks economy too often and the economy was too stable. This made leverage appealing and made it seem safe since assets appreciated so consistently with low levels of inflation. The Federal Reserve should let the economy gyrate more and step in in only real crises which will occur much less often then they do now.

Jun 22 03:23 PM

[Alex Filonov:]

Actually, Fed was created as a lender of the last resort, so so called "hidden" mandate is number 1 in reality.

Jun 22 06:26 PM

[Fighting Yoda:]

America’s business model last couple of decades has been ‘bubbles– the sure road to short term prosperity.’ Fed has been actively playing its part under the tutelage of Greenspan and now BB. All this suits Wall Street very much – they have plenty of gullible investors to prey on. Last 2 decades we had more and bigger bubbles, and the economic recoveries shallower. But the same guys continue on the jobs, what else you would expect.

Jun 22 09:07 PM

[Living4Divi...:]

David - Reading thru the others comments, I have come to conclude Systemic risk is reduceable, ONLY if we are willing to pay a high enough price.

Jun 22 10:55 PM

[morph366:]

Whoever is chosen to be the ultimate guarantor of the financial system the question can just as easily be asked - who guarantees the ultimate guarantor?
If Treasury auctions were to start failing this would appear much less theoretical than it might at first glance.

Jun 23 09:13 AM

[Jimbo:]

A commenter to another article on SA this morning used the expression:"bankster-g... I like it. It seems to me that the big money center banks have too much influence in Washington, irrespective of political party.The repeal of Glass-Steagall helped this disaster to occur. We need a revolution, bloodless I hope, to wrest control of the nation from these bankster-gangsters. They are using ordinary citizens material substance to recover from their own folly. Witness the money flowing into AIG to make Goldman-Sachs(aka "government -Sachs") whole.

Jun 23 12:48 PM

[perceptions...:]

Often when we talk about the Fed, we talk about a dual mandate — low inflation, and low labor unemployment. But as I suggested at RealMoney many times, there is a hidden third mandate: protect the integrity of the banking system."

Actually, I would say that the FED and others, use unemployment as one of their "tools" to manage their real mandates!

Jun 23 10:49 PM