Those who are responsible for the present mess are in charge of the clean-up.
These days Wall Street bankers sound like the lady who killed her husband and then asked for mercy because she was a widow. The New York Times even carried a story on the hardships they would suffer because some of them will face a salary cap of half-a-million dollars. Of course our own Vikram Pandit has done a Munnabhai by announcing that he will only take $1; but this may well be more than the net worth of the bank he runs.
The sad part is that their pleas are being heard by the regulators in the US who seem to be more interested in protecting managers and big investors rather than depositors, homeowners or workers. The fact is that the regulators are largely responsible for the massive financial crisis that has led to the worst recession since the Great Depression.
John Taylor, the man who devised and gave his name to the rule for setting policy interest rates, posed three questions in a recent NBER paper*: What caused the financial crisis? What prolonged it? Why did it worsen so dramatically more than a year after it began? He concludes that specific government actions and interventions should be first on the list of answers to all three.
The policy failure that caused the crisis is the low interest rate regime in 2001-2006 which is the major factor behind the housing boom and bust. The US Fed Fund rate fell from around 2 per cent to 1 per cent by mid-2004 while the Taylor rule required it to rise to 4 per cent. Between June 2004 and June 2006 a drastic correction was attempted and the Fed Fund rate was raised by 425 basis points. This burst the housing bubble. A counterfactual simulation shows that if the Taylor rule had been followed, the amplitude of the housing cycle would have been greatly reduced and we may even have avoided the worst of the sub-prime crisis.
The regulatory failures that led to the sub-prime crisis are to be found in the steps taken from traditional mortgage lending to investment grade collateralized debt obligations. The first step was the securitisation of illiquid mortgages into financial instruments that packaged the good and the bad risks together. Lax accounting standards allowed buyers of these instruments, like Lehman Brothers and others, to keep them off the balance sheet. The five big US investment banks had off-balance sheet liabilities of close to $18 trillion on a capital base of $200 billion. The emergence of exotic credit insurance products shifted these risks to insurance companies like AIG, which also could keep these contingent liabilities off their balance sheet. This insurance cover helped these instruments to get investment grade ratings from gullible rating agencies. These toxic assets spread through the global financial system as the two apex mortgage finance agencies in the US, Fannie Mae and Freddie Mac, which held or guaranteed 50 per cent of US mortgage debt, were a major conduit for the inflow of foreign funds into the US.
There are some in the US who blame what they describe as a savings glut in East Asia. Andrew Sheng, in his recent Delhi lecture, described this as a banker blaming his depositors for excess liquidity! Even if the East Asians had spent a larger proportion of their income, one doubts whether that would have deflected the US Fed from its disastrous interest rate policy.
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The financial crisis has been prolonged because the Fed sees it as a liquidity problem. But, Taylor argues, it was a crisis of confidence in the solvency of potential counterparties that jammed up the works. The blame for this rests with the lax accounting standards that allow liabilities to be hidden so that nobody is sure of who is solvent and who is not and everybody prefers to play safe. Additional liquidity cannot solve this problem. Only transparency and the sequestration of toxic assets can do that.
Taylor’s third question refers to the sharp deterioration which took place a year after the crisis in September 2008 when the Fed allowed Lehman to go under. There is now widespread agreement that this was a mistake. A crisis of confidence is not the time to worry about moral hazard. And soon enough the Fed and Treasury were forced to rescue AIG. Nobody knows now who is “too big to fail” and who is not. There are no clear criteria for whom to rescue, when and on what terms.
Some of these policy failures are a product of a change in regulatory culture that was ushered in by the Ayn Rand acolyte, Alan Greenspan. He believed that regulators should not try and correct asset price bubbles but only cope with the consequences when they burst. This is what led to the low interest regime after 2001 when the dot.com bubble burst.
Prudential regulation of banks shifted from rules about exposure to different classes of assets to capital adequacy, leaving banks to determine their risk exposure. There was also a certain laxness in the application of regulatory controls by the SEC. “Irrational exuberance” in stock markets fuelled by opaque hedge funds was allowed to continue, even when recognised as such. The recent Madoff scandal, when the SEC failed to respond to explicit warning signals, was a product of this “market knows best” philosophy.
The regulatory system for capital markets in the US was not run to protect retail savers and investors but to promote and protect financial engineering that raised short-term profits and bonuses at the cost of system stability. It led to the financial services industry appropriating 40 per cent of corporate profits. The Fed and US Treasury, who, along with the then SEC, are most culpable for the policy and regulatory failures that have led to the present mess are the ones who have been asked to design and run the rescue. Small wonder that so far all we have is a welfare system to rescue these financial wizards from their folly.
We in India have been protected by a cautious RBI from the worst of these excesses. But the secondary smoke from New York and Europe is going to choke our growth and force us to pay the price in the form of lost jobs, lost incomes and lost opportunities.
*John Taylor, The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, Working Paper 14631, NBER, January 2009