The Squam Lake Report (Princeton University Press) is a set of recommendations by 15 leading economists on reforming the financial system. Considering the magnitude of the recent financial crisis, it is surprising how little change the book proposes.

Certainly, the first step in devising a set of recommendations for reform is to understand what went wrong, something the authors set out to do in their first chapter. They list a number of factors that may have contributed to the crisis but take no stand on their relative importance. They believe that their recommendations will help make the system more stable, although not crisis-proof, even if they don’t completely understand the origins of the current crisis. While a few of the recommendations are intended for guiding the financial system towards stability, most are only useful for when a financial crisis has already erupted.

Perhaps the best recommendation is for a systemic regulator with an explicit mandate of maintaining financial stability. As financial institutions are increasingly involved in activities outside their traditional domain, having a systemic regulator makes sense. But the report recommends that the central bank be that regulator—which is logical, since the Fed’s discount window gives it a good view of financial institution balance sheets. The problem, at least in case of the U.S., is that the Federal Reserve had the authority to regulate key aspects of the financial system when the last meltdown occurred, but chose not to exercise that authority. For instance, the Fed had had the power to regulate all mortgage lenders since 1994.

The question now is whether the culture of deregulation that has prevailed at the Fed for at least the past 25 years will allow it to transform itself into a good regulator. The FDIC has a better track record of being tough on the financial sector, and may well be better suited for the job.

The report is also big on transparency. For instance, it proposes that large financial institutions, including hedge funds, “report information about asset positions and risks to regulators each quarter.” Having better-informed regulators is certainly important but only goes so far. The magnitude of fraud during the last crisis demonstrates the difficulty of relying on information reported by the institutions themselves and underscores the importance of active regulation (The Repo 105 transactions used by Lehman, Citibank and Bank of America were merely the tip of the iceberg in the accounting gimmicks used by these institutions to mask their true positions.) The authors don’t seem to recognize the role of fraud in the financial sector and offer no recommendation on how to deal with it.

A whole chapter of the Squam Lake Report is devoted to regulating retirement savings, which is timely and appropriate considering that pension funds have been among the biggest losers in the current crisis. The crux of the Squam Lake proposal is to require investment products offered in defined contribution plans to have a standardized disclosure of costs and risks, to increase deductions from workers’ pay and to restrict default investment alternatives to low-fee, diversified products. These are sensible ideas but won’t insulate retirement savings from a crisis, because in a crisis asset classes (except for Treasuries) tend to crash in unison. At such times, diversification doesn’t help.

Furthermore, diversification (already required by federal pension law) was a major contributor to the bubble economy of the past decade as pension funds hunted for financial products uncorrelated with stocks. Overall, I don’t see merit in their pension reform proposal. The best solution would be to eliminate tax advantages for pension plans and instead boost Social Security to ensure that anyone who works long enough to qualify will receive a comfortable retirement. See Nersisyan and Wray (2009) for more on the trouble with the pensions.

The report also calls for higher capital requirements for major institutions, another reasonable idea that wouldn’t have helped much last time around, when the market for asset-backed securities froze and their prices collapsed. Under such circumstances, only impractically high capital requirements would have made any difference. Besides, an institution can face liquidity issues even if it’s highly capitalized. Bear Stearns, before its collapse, had enough capital but couldn’t finance its asset positions for want of willing lenders.

The report also recommends that financial institutions issue long-term debt instruments that convert into equity under specified conditions. This would automatically recapitalize banks if they got into trouble. But again, higher capital levels cannot prevent a crisis. Besides, one of the proposed conversion triggers is the declaration by the systemic regulator that the financial system is in a crisis. But a crisis is not always so easy to spot. When Bear Stearns failed, some people said the problem wouldn’t spread. Later, the consensus was that it wouldn’t go beyond subprime mortgages. If the regulator proclaims at soe point that there is a risk of a systemic crisis, this itself might freeze the markets and make institutions unwilling to lend to each other. Giving the disease a name, in other words, might well kill the patient.

Although a whole chapter of the book is devoted credit default swaps (CDS), there is no recommendation that would make CDS safer for the financial system. The authors oppose limiting CDS trades to entities that hold the underlying security on the basis that this will make derivative markets less liquid, raising costs. They propose merely to encourage financial institutions to clear CDS and other derivative contracts through clearinghouses as well as to trade them in exchanges (rather than making such arrangements mandatory).

Again, the response seems wholly inadequate to the scale of the hazard. Derivatives create counterparty risk out of thin air and vastly magnified the recent crisis. Without CDS the subprime mortgage industry couldn’t have grown to the proportions it did. Getting rid of CDS would make it hard for financial institutions to hide risks from regulators, and make investors more cautious when investing in asset-backed securities.

Despite their deliberations, the Squam Lake economists overlook some important aspects of the financial structure that ought to be reformed. Securitization and off-balance sheet activities that were largely to blame for the current debacle are not even mentioned. It wasn’t until securitization that the shadow banking sector exploded. Securitization creates major incentive problems by separating risk from responsibility. Off-balance sheet activities allow financial institutions to avoid capital requirements and use more leverage. And while the authors seem to recognize the costs associated with having too-big-to-fail institutions that are systematically dangerous, they have no prescriptions for what needs to be done about them.

The authors are acutely conscious that regulation often has unintended consequences, yet as they implicitly recognize (by proposing regulations), this doesn’t mean there shouldn’t be rules. What should these rules look like? continue reading…

Nervous financial markets and waves of fiscal austerity spreading across Europe raise an important question: when does a country’s budget deficit become a problem?

The easy answer, of course, is that a deficit is too large when it can no longer be financed. But by that time it’s too late, so it’s important to ask if there is a good way to tell before things get that bad.

Carmen Reinhart and Kenneth Rogoff, in a recent paper called Growth in a Time of Debt, found that when government debt reaches 90 percent of GDP, economic growth is seriously retarded.

But rules of thumb are by their nature imperfect, and it’s difficult to apply the 90 percent formula across the board. The U.S., for example, is not Greece—it’s closer to being the anti-Greece, in fact. Greece is a tiny, uncompetitive country that does not control its own currency. The business climate there is terrible. America is a vast, competitive, adaptable nation that not only controls its own monetary policy, but is blessed with the world’s reserve currency. The climate for business is favorable, abetted by large reserves of cultural and intellectual capital.

So we shouldn’t conclude that just because the Europeans are suddenly cutting public spending, we ought to as well. Since deflation looks more threatening than inflation, it seems sensible, for now at least, for America to borrow and spend. Washington’s cost of money is close to zero, and the multiplier effect (for which this blog is named) means that pumping funds into the economy is likely to pay growth dividends, especially if the money is directed at those likeliest to spend it.

Countries almost always run deficits and, despite the ardent wishes of fiscal conservatives, they probably always will. The problem, when debt accumulates, is that it can make you vulnerable to investors who may become impatient or even irrational. If these are the people who have the money you need to finance your deficit not in your own currency, you may find yourself in the position of several Eurozone countries now, who are forced to embrace austerity at the worst possible time. Perhaps the lesson is not to run up large deficits in good times, as Greece, Portugal, Spain and Ireland, so that in bad times you can get credit when you need it.

David Cameron, the new PM, warns that the nation’s fiscal hole is even deeper than it seemed, and that savage spending cuts will be required. An important union leader calls Cameron’s speech “a chilling attack on the public sector, public sector workers, the poor, the sick and the vulnerable.”

The full (and sobering) story is here.

Michael Scherer at Time has a fascinating story on three women in Washington–Sheila Bair, Elizabeth Warren and Mary Schapiro–who have risen from the ashes of the financial meltdown. If nothing else, the crisis has at least helped put some women in charge of Wall Street.

With the recent financial turmoil in Greece, the press has turned its attention away from the bailouts of Citigroup, AIG, Fannie Mae, Freddie Mac, and other major U.S. financial corporations. Less than a month ago, though, Gretchen Morgenson noted in the New York Times that a Treasury Department estimate of the costs of the main financial bailouts probably understated their total costs to the economy. Around the same time, federal officials and others pointed to the government’s investment in Citigroup as a relatively successful venture that could make a profit—perhaps $11 billion plus $8 billion in interest and fees. (The company’s stock has fallen somewhat since then.)

Bailouts are of course intended to benefit the economy as a whole, and it is certainly hoped that such benefits will greatly exceed the return to the government on its investment. A large part of the return went to investors who have increased their wealth by owning the shares of Citigroup since it was saved by the government. The market capitalization of Citigroup is now very roughly $90 billion, after subtracting the U.S. government’s stake of about $32 billion. (The latter figure may overstate the size of the government’s share, because it may include stock that has been sold by the government this year.)

Predictions of a good return on the Citigroup bailout are good news. But since the bailout appears not to have been a zero-sum game (a win-win situation was possible), the lion’s share of the benefits to the company as of now (15 months after the government’s last investment) did not go to the government. In fact, a $90 billion windfall of sorts went to shareholders, even as the government incurred large costs for other bailouts. continue reading…

The Washington Post reports that, testifying before a panel investigating the financial crisis, Henry Paulson “cautioned against overreaching on financial overhaul legislation now before Congress that he said could stifle innovation in the markets.” Well, we certainly wouldn’t want to do that! After all, financial innovation has been great for the economy right? Maybe not, but as Yves Smith notes, it has certainly been good for the finance sector and for financial innovators, as both empirical and theoretical studies argue. This suggests to me that Paulson, former head of Goldman Sachs, may not be thinking of the good of the society as a whole when he worries about the impact of financial regulation.

That being said, I don’t think any financial regulation coming out of Congress is likely to have much bite. Indeed, the Federal Reserve may have already had the regulatory power to avert the crisis but failed to exercise it, according to Bill Black (this post lays out his argument with links to video of his testimony on Lehman Brothers). This should come as no surprise, since the regional Federal Reserve boards are elected by bankers. Tom Ferguson points out that Obama was the candidate of finance, getting more of his early donations from them than any other candidate. If finance owns Congress (as Dick Durbin memorably said), the Federal Reserve and the White House, where is effective financial regulation realistically going to come from? continue reading…

(This is the testimony of Levy Institute Senior Scholar James K. Galbraith before the Senate Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010.)

Chairman Specter, Ranking Member Graham,  Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession.  Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including “rational expectations,” “market discipline,” and the “efficient markets hypothesis” led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on,  and that widespread fraud therefore could  not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft-pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble.  They continue to do so now.  At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word “naughtiness.”  This was on the day that the SEC charged Goldman Sachs with fraud. continue reading…

There is nothing lovable about Goldman Sachs, and its recent grilling by the ominously named Senate Permanent Subcommittee on Investigations understandably drew a lot of attention.

We should not, however, obscure the reality. Goldman Sachs is a bank, and except for questions about the Abacus deal, in which it’s accused of disclosure failings, Goldman was doing what modern banks do. In collateralized debt obligations and credit default swaps, it wasn’t the biggest player.

So question for Congress isn’t whether Goldman did the right thing. The real question is, why on earth were banks allowed to do the things that Goldman was doing?

The late Hyman Minsky had something to say about this. In a paper from 1993, he was clear-eyed about the role of institutions like Goldman:

Essentially these operators have superior knowledge about their customers who need financing. . . and their customers who have a need for outlets in which money can be placed. They turn this private knowledge of the conditions under which funds are desired and the conditions under which funds are available to their own advantage, even as they perform the social function of selecting the investments that the economy makes.

Each of these financial intermediaries, Minsky well knew, “has an agenda of its own: they are not charitable institutions.” But they play a crucial role in the most sensitive aspect of capitalism, which is lending. And lending, Minsky said, is capitalism’s Achilles heel, a kind of fatal flaw whereby growth breeds instability. continue reading…