Simon Johnson: The Slipperiness of 'Macroprudential Regulation'

Back on April 1st, we produced an excerpt from Simon Johnson's excellent Atlantic essay "The Quiet Coup." We called our post "Line of the Year," with reference to Johnson's statement that "anything too big to fail is too big to exist."

Yesterday, at The Baseline Scenario, Johnson extended that line of thinking by wondering out loud whether the Fed--or any other "macroprudential regulator"--can "sniff" bubbles before they threaten the financial system.

"Asset bubbles may not be that hard to identify," [New York Fed President William C.] Dudley argues. Fine, but it would help to know exactly the Fed would do this ex ante-–not using the rear view mirror.

Of course, if the Fed can't get better at spotting bubbles, the implication is that no one can. Which means that "macroprudential regulator" is just a slogan-–a nice piece of what Lenin liked to call "agitprop."

And if macroprudentially regulating is an illusion, what does that imply? There will be bubbles and there will be busts. Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are-–or are perceived to be–-too big to fail"?

You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail.

We think Johnson's exactly right, not just in sensible-capitalist principle, but in practical terms as well. Government has a fighting chance to get antitrust-style stuff right. But identifying bubbles? And doing something about them at the right moments... neither too soon nor too late? We just don't see it.

Comments

[derryl:]

I don't think bubble formation should be that hard to identify and prevent. Bubbles form when too much quick easy credit is used to bid up the prices of existing assets. Buying stocks on 5% margin in 1929 comes to mind, or houses with $0 down in 2006. There are only a few kinds of assets whose markets are big enough to absorb damaging amounts of money. Real estate, stocks and commodities would be the big three. I think sovereign bonds, government debt, is a self-limiting market so I won't include it. Pretty soon Ben will have to bubble up the Treasuries market all by himself.

Stock prices are tracked constantly and, notwithstanding that we're now used to major volatility moving the markets up and down hundreds of points a day, major secular moves up on large volumes of trades without any systemically justifiable economic basis would seem to indicate a bubble forming.

If people are pumping their own money into this bubble then no problem, it's just money getting sucked from elsewhere in the economy (savings accounts, CDs, mutual and pension funds) into the bubble. When it deflates the money will have changed hands but there is no net monetary inflation. But if people are borrowing to invest then it's a credit-fueled bubble and when it deflates some people will have unpayable debts and other people, who sold high to the 'greater fools', will have inflationary quantities of money in their pockets.

To prevent this latter scenario regulators could do...what? Restoring Glass-Steagall would be a good place to start to prevent big banks from creating loans that their investment banks use to blow stock market bubbles.

Real estate bubbles could probably be prevented by returning to prudent banking that requires 20% down and sufficient stable income to pay principal and interest. That is 20% down out of your own savings, not 20% financed on a line of credit or other debt. So much for well-intentioned efforts to put poor people with marginal jobs into their own homes. If investors and homebuyers want to play bubble then their prudent bankers will ensure these buyers can afford to pay too much for real estate.

Commodities bubbles could be prevented by doing what has already begun: keeping speculators out of futures markets. Producers and users of commodities have a legitimate economic need to buy and sell future deliveries, but unless you are actually going to take delivery you can't play. If oil refiners pump up futures prices that is because they have legitimate fears of future supply constraints. If speculators pump up futures prices that is because they see a chance to suck some cash out of either sellers or buyers, most likely both. Either way they raise the cost structure for that commodity and you and me get to pay for it via higher goods prices. It's like a value added tax, except the speculators don't add any value.

I agree with Simon Johnson that macroprudential regulation would be 'slippery', if you were trying to identify and prevent bubbles in mid blow. But I think a return to the post-Depression bubble preventers I listed could stop bubbles before they start.

Jul 09 02:19 AM

[THofler:]

Excellent derryl!

We need sensible new (the old is new again?) regulation that that is rules based and designed to prevent excess risk and reduce cyclicality. Derryl's suggestions are a great start. The notion of creating a super risk supervisor with God-like powers exercised with God-like wisdom is dumb.

The idea of making every institution small enough to fail sounds nice & has the benefit of eliminating the bail-out tab for the taxpayer. Is it really a panacea though? Put another way; which was the better outcome, Bear Stearns or Lehman? I vote Bear by a mile in spite of the obvious moral hazard.

Not only did individual Lehman bond investors lose a great deal, but all of the capital markets outside of Treasuries were severely damaged. Was Lehman too big to fail? Just how small does a financial institution need to be? If the 19 jumbo TARP banks were spilt into 100 institutions and then 50% of those institutions fail, have we thereby prevented a market and economic crash? I think not. This is just a rearranging of the deck chairs.

Being a lender of last resort is a primary Fed function. It WILL create moral hazard and it IS better than the alternative, at least until we figure out how to dramatically reduce the inherent cyclicality of human markets.

Jul 11 12:15 AM