The Fed and Reducing Government Deficits and Debt
Carlos M Pelaez
Macroeconomic policy during the credit/dollar crisis and the global recession has been characterized by monetary and fiscal stimulus (Pelaez and Pelaez, Regulation of Banks and Finance, 217-27, Financial Regulation after the Global Recession, 155-70). Confidence in financial markets collapsed after the Troubled Asset Relief Program (TARP) proposed in September 2008 to avoid economic catastrophe by purchasing toxic assets held by banks. TARP alarmism on devastating impact of write downs of assets on bank balance sheets caused exacerbated perceptions of default risk in counterparty transactions. Banks and investors ceased trusting themselves or other banks and investors. The volume of financing in sale and repurchase agreements (SRP) of asset-backed securities plummeted, resulting in fire sales and lower prices of those securities. The decline of security prices eroded capital of financed entities that were forced to sell positions, causing further declines of security prices across market segments. Confidence in financial transactions returned with higher risk appetite by investors around March 2009 that had no clear link to the monetary and fiscal stimulus. In fact, the same withdrawal plan of toxic securities was proposed in imitating the Swedish bank plan of 1992-3 under the different name of Financial Stability Plan (FSP) of February 2009, which again failed in implementation. Banks facing both the initial TARP in 2008 and the FSP in 2009 would rather hold the securities and assets than sell them at temporarily depressed prices that would bankrupt them (Financial Regulation after the Global Recession, 164-6 and 170-1). The recovery of prices of the derivatives portfolio of AIG illustrates the inconsistency of the toxic withdrawal plans. Panicking by the authorities with toxic securities caused the financial panic. The major part of toxic securities originated in the purchase or guarantee of $1.5 trillion nonprime mortgages by Fannie and Freddie. It is also difficult to find a clear link to the fiscal stimulus in the recovery of real economic activity after the second quarter of 2009. Definitive judgment awaits rigorous econometric analysis, which may never be fully conclusive. The policy issue at the moment is not the effectiveness of the monetary and fiscal stimulus but the potential threats to future economic activity in not implementing a timely and effective exit strategy of the combined monetary and fiscal stimulus. Both strategies are considered in turn. First, the exit strategy of the monetary stimulus requires an adjustment of the policy rate of the Fed of 0 to ¼ percent paid on uncollateralized loans among banks of deposits at the Fed (or fed funds) and a reduction of the portfolio of securities of the Fed in the value of $1.7 trillion. At some point, quite difficult in timing and dose, interest rates must increase again. Expectations of interest rate increases are influenced by the lowering of the fed funds rate by 525 basis points in 2000-2003 followed by an increase of 425 basis points in 2004-2005 and then by a decrease of 425 basis points in 2007-2008. Markets fear that the there may be another episode in the future of sharp increases in interest rates by the Fed. Monetary policy in the form of fixing fed funds rates is conducted by the Federal Open Market Committee (FOMC) of the Federal Reserve System (FRS) composed of the seven governors of the Board of Governors of the FRS, the president of the Federal Reserve Bank (FRB) of New York and four rotating presidents of the 12 regional FRBs of which one is chosen from each of four groups of FRBs organized by region (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 33-5, Financial Regulation after the Global Recession, 74-7, Regulation of Banks and Finance, 102-8). The FOMC and the FRS have been characterized by competent choices of prominent professionals for governors and presidents of the regional FRBs and elite staff in research, supervision and regulation. It is imprudent to replace this system during this difficult adjustment by a new risk agency, which would lack the technical excellence and independence of the FRS, being subject to political capture and influence as Fannie and Freddie. Debates on policies are constructive and occur within the FOMC but recession regulation dismantling the FRS poses a major risk to financial stability, economic activity and employment. The minutes of the FOMC meeting on November 3 document the ongoing work on the exit strategy of the monetary stimulus. An important analysis considered in that meeting is that the low fed funds rate of 0 to ¼ percent could lead to excessive risk taking but that possibility is not considered as important currently. A key likely cause of the credit/dollar crisis and global recession is that the 1 percent fed funds rate in 2003-2004 distorted risk/returns decisions, encouraging excessive risk/leverage, low liquidity and unsound credit (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The 0 to ¼ percent fed funds rate in 2008 caused the mirage of ever increasing commodity prices such as oil futures at $145/barrel, which is behind debacles similar to Dubai real estate. The necessary increase in interest rates will cause oscillation of exchange rates and emerging markets overvalued by the carry trade stimulated by low fed funds rates. These policy errors abound because the changing forecasts on the economy disguised as scenarios are commonly worst in predictive value than those of palm readers and astrologers. Economic policy has uncertain effects. The staff of the Fed is conducting research on the alternative policy tools to adjust interest rates and the portfolio of securities in the Fed balance sheet. There are four policies and alternative combinations in the tool kit of the Fed: (1) reverse sale and repurchase agreements (RSRP) in large scale and even with counterparties other than approved dealers; RSRPs are short-term collateralized loans consisting of the sale by the Fed of qualified securities in its portfolio with an agreement to repurchase the securities in the near term at the agreed price plus interest, resulting in withdrawal of bank reserves (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 34-5, 38-9, Financial Regulation after the Global Recession, 75-7, Regulation of Banks and Finance, 99-116); (2) a term deposit facility at the FRS available to depository institutions, reducing bank reserves during the term of the deposit and renewed when necessary; (3) linking the interest rate paid on reserve balances of banks held at the FRBs and the fed funds rate, directly raising interest rates; and (4) final sale of assets in the securities portfolio, withdrawing bank reserves. There is no magic in the tools for exiting: the withdrawal of bank reserves causes an increase in interest rates in all alternatives or possible combinations. The recovery of the economy will increase demand for bank loans with resulting withdrawal of all or part of the $1.1 trillion of bank deposits in the Fed balance sheet that largely financed the portfolio of $1.7 trillion of securities, causing an increase in interest rates. Second, the fiscal stimulus, decline in government revenue following contraction of economic activity, special programs and legislative agenda are causing significant increase in the public deficit and internal debt. The Cross Country Fiscal Monitor of the International Monetary Fund (IMF) for November 2009 analyzes the deficit and debt of G20 countries. The IMF is projecting that government debt in the advanced economies of the G20 will reach 118 percent of GDP in 2014 even after the end of temporary stimulus. The structural primary balance is defined as government revenue less government expenditures, excluding interest payments on the debt while adjusting for the cycle of the economy and onetime factors. Controlling government debt at 60 percent of GDP by 2030 requires an increase in the average structural balance of 8 percentage points of GDP relative to 2010. There would have to be an elimination of the current primary deficit of 3.5 percent of GDP and the creation of a primary surplus of 4 percent of GDP. Such adjustment has occurred in the past but requires firm policy and its execution. The Congressional Budget Office (CBO) baseline budget outlook projects the federal deficit to continue at more than 3 percent per year in all of the next ten years. If there is no effort of fiscal restraint, which is the assumption of that baseline outlook because the CBO does not know currently what the government will do, the debt may become explosive, forcing more costly adjustment in terms of declining growth. Major deviations from projections are common. Stabilizing the debt at levels after the credit crisis would raise interest rates in advanced G20 economies by 2 percentage points, according to the IMF. Economic policy should focus on an exit of monetary and fiscal stimulus with more prudent government expenditures. The failure of timely and effective adjustment may cause a future debt crisis with high costs in loss of production and employment. The lag of fiscal adjustment behind the monetary adjustment already discussed within the FOMC would result in much higher interest rates from continuing high federal deficit and debt issuance while monetary policy must increase short-term interest rates and also likely long-term rates by the sale of the Fed portfolio of $1.7 trillion securities. Fiscal restraint requires more delayed Congressional action and should begin to be considered immediately as the key national priority or interest rates will be higher than necessary for adjustment, restricting employment and growth. Taxing to spend will crowd out the private sector’s ability to produce and create jobs, frustrating fiscal restraint because actual government outlays are likely to exceed revenue by more than intended. (For a briefer version go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, November 29, 2009
Sunday, November 22, 2009
The Fed, the Carry Trade and the Misleading Bubble
The current carry trade consists of shorting the dollar against other currencies and simultaneously taking long positions in futures of commodities such as gold, other metals and oil or emerging stock markets. The term “carry” means that the position is financed or “carried” with a loan in the low yielding currency to profit from positions in higher yielding liquid assets. These are high risk uncovered positions that can cause losses if the dollar appreciates and/or if commodity prices and stock markets lose value (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). The carry trade at the turn of the millennium consisted of shorting the yen because of the near zero interest rates of Japan and simultaneously taking positions in high yielding currencies such as the Australian dollar and the New Zealand dollar. The Japanese yen (JPY) depreciated by 40 percent versus the US dollar (USD) in 1995-7, reaching an eight-year low of JPY147.26 per USD on August 11, 1998. In October 6-9, 1998, the JPY reversed the strong trend of depreciation and appreciated 15 percent versus the USD. The IMF observed a “cascade” of USD/JPY selling by institutional investors including hedge funds. There were no resulting shocks to the economy of Japan or the world economy but this episode has been used as illustration of instability caused by unwinding carry trades. The Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years. These policy impulses resemble traders who successfully shorted stocks reversing by going long in the same trading session to benefit from the undershooting during the 22 percent decline of the market on Black Monday, October 19, 1987. Central banks should not induce these swings of financial variables. The credit/dollar crisis carry trade consisted of shorting the dollar and simultaneously going long in oil futures that reached $145/barrel in September 2008. The alarmist proposal of TARP in the second half of September 2008 caused a crisis of confidence, analyzed by Cochrane and Zingales, which encouraged panic inflow into dollars, reversing the carry trade with the price of oil collapsing toward $40-$50 per barrel. The combination of the 0-0.25 percent fed funds rate with the recovery of confidence and risk appetite encouraged the current carry trade with devaluation of the dollar toward $1.50/euro and increase in gold futures prices by 64 percent to $1150/ounce. Governments threatened intervention in oil futures routing the carry trade to metals futures. The fluctuation of the dollar without piercing forcefully $1.50/euro reflects two related problems. First, traders are fully aware of the aggressiveness of the Fed in raising or lowering interest rates by hundreds of basis points. A minor change in perception of Fed policy could cause appreciation of the dollar, collapse of gold prices and major losses in the carry trade, explaining the hit and go behavior of dollar positions. Second, the Fed balance sheet in the last monthly report shows holdings of securities of $1690 billion, with the largest holdings of $775 billion of treasuries and $774 billion of agency-guaranteed mortgage-backed securities; the major item of liabilities is $1083 billion of deposits at the Fed by depository institutions or banks. The Fed financed the balance sheet initially with deposits of banks remunerated with interest payments and Supplementary Financing or loan by Treasury that has virtually disappeared, being replaced with issue of notes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). If the economy recovers more rapidly than in the current outlook of the Fed, banks will want to withdraw their deposits to earn higher interest from loan spreads than what the Fed pays in interest. The Fed would raise interest rates, increasing the marginal cost of lending of banks and thus the short-term interest rate. The Fed would also have to sell in the market about $1.7 trillion of securities, lowering their price which is the same as increasing their yields. The entire yield curve would shift upward, which means increases in both short and long-term interest rates. The dollar would appreciate unwinding the carry trade. The misleading use of the term “bubble” in the context of the carry trade and others implies that market participants are ignorant and follow trends recklessly while governments and analysts after the fact are rational and never err. The fact appears to be that traders have protected the funds entrusted to their management by taking defensive positions against the shocks of policy that threaten to reduce the wealth of their clients, which in this case is a zero interest rate. The problem of the credit/dollar crisis has not been positions by investors or unsound lending by banks but the aggressive, shifting, fast changes in central bank policy of hundreds of basis points and trillions of dollars. What is needed is not more regulation of banks and finance but rather recognition of the ambiguity of knowledge on central banking and less volatility in policy impulses. The aggressive change in interest rates in attempts by central banks to stay ahead of the lag in effect of policy by half a year or more caused the credit/dollar crisis and global recession by distorting risk/return decisions throughout the economy (Pelaez and Pelaez, International Financial Architecture, 18-28, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). Central bank balance sheets of trillions of dollars have created a tough adjustment trap complicated by a fiscal deficit of more than 10 percent of GDP with the federal debt approaching 100 percent of GDP. The adjustment to the monetary and fiscal stimulus can restrict growth and job creation. (For a briefer version go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
The current carry trade consists of shorting the dollar against other currencies and simultaneously taking long positions in futures of commodities such as gold, other metals and oil or emerging stock markets. The term “carry” means that the position is financed or “carried” with a loan in the low yielding currency to profit from positions in higher yielding liquid assets. These are high risk uncovered positions that can cause losses if the dollar appreciates and/or if commodity prices and stock markets lose value (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). The carry trade at the turn of the millennium consisted of shorting the yen because of the near zero interest rates of Japan and simultaneously taking positions in high yielding currencies such as the Australian dollar and the New Zealand dollar. The Japanese yen (JPY) depreciated by 40 percent versus the US dollar (USD) in 1995-7, reaching an eight-year low of JPY147.26 per USD on August 11, 1998. In October 6-9, 1998, the JPY reversed the strong trend of depreciation and appreciated 15 percent versus the USD. The IMF observed a “cascade” of USD/JPY selling by institutional investors including hedge funds. There were no resulting shocks to the economy of Japan or the world economy but this episode has been used as illustration of instability caused by unwinding carry trades. The Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years. These policy impulses resemble traders who successfully shorted stocks reversing by going long in the same trading session to benefit from the undershooting during the 22 percent decline of the market on Black Monday, October 19, 1987. Central banks should not induce these swings of financial variables. The credit/dollar crisis carry trade consisted of shorting the dollar and simultaneously going long in oil futures that reached $145/barrel in September 2008. The alarmist proposal of TARP in the second half of September 2008 caused a crisis of confidence, analyzed by Cochrane and Zingales, which encouraged panic inflow into dollars, reversing the carry trade with the price of oil collapsing toward $40-$50 per barrel. The combination of the 0-0.25 percent fed funds rate with the recovery of confidence and risk appetite encouraged the current carry trade with devaluation of the dollar toward $1.50/euro and increase in gold futures prices by 64 percent to $1150/ounce. Governments threatened intervention in oil futures routing the carry trade to metals futures. The fluctuation of the dollar without piercing forcefully $1.50/euro reflects two related problems. First, traders are fully aware of the aggressiveness of the Fed in raising or lowering interest rates by hundreds of basis points. A minor change in perception of Fed policy could cause appreciation of the dollar, collapse of gold prices and major losses in the carry trade, explaining the hit and go behavior of dollar positions. Second, the Fed balance sheet in the last monthly report shows holdings of securities of $1690 billion, with the largest holdings of $775 billion of treasuries and $774 billion of agency-guaranteed mortgage-backed securities; the major item of liabilities is $1083 billion of deposits at the Fed by depository institutions or banks. The Fed financed the balance sheet initially with deposits of banks remunerated with interest payments and Supplementary Financing or loan by Treasury that has virtually disappeared, being replaced with issue of notes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). If the economy recovers more rapidly than in the current outlook of the Fed, banks will want to withdraw their deposits to earn higher interest from loan spreads than what the Fed pays in interest. The Fed would raise interest rates, increasing the marginal cost of lending of banks and thus the short-term interest rate. The Fed would also have to sell in the market about $1.7 trillion of securities, lowering their price which is the same as increasing their yields. The entire yield curve would shift upward, which means increases in both short and long-term interest rates. The dollar would appreciate unwinding the carry trade. The misleading use of the term “bubble” in the context of the carry trade and others implies that market participants are ignorant and follow trends recklessly while governments and analysts after the fact are rational and never err. The fact appears to be that traders have protected the funds entrusted to their management by taking defensive positions against the shocks of policy that threaten to reduce the wealth of their clients, which in this case is a zero interest rate. The problem of the credit/dollar crisis has not been positions by investors or unsound lending by banks but the aggressive, shifting, fast changes in central bank policy of hundreds of basis points and trillions of dollars. What is needed is not more regulation of banks and finance but rather recognition of the ambiguity of knowledge on central banking and less volatility in policy impulses. The aggressive change in interest rates in attempts by central banks to stay ahead of the lag in effect of policy by half a year or more caused the credit/dollar crisis and global recession by distorting risk/return decisions throughout the economy (Pelaez and Pelaez, International Financial Architecture, 18-28, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). Central bank balance sheets of trillions of dollars have created a tough adjustment trap complicated by a fiscal deficit of more than 10 percent of GDP with the federal debt approaching 100 percent of GDP. The adjustment to the monetary and fiscal stimulus can restrict growth and job creation. (For a briefer version go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, November 15, 2009
The Federal Reserve System
Nobody owns the Federal Reserve System (FRS), which is an independent central bank that can take decisions without ratification by the President, Congress or anyone else. Members of the Board of Governors of the FRS are appointed to terms that extend over presidential and congressional terms. The FRS is subject to oversight and changes of statutes by Congress and must function within the general framework of government policy. The first major function of the FRS is monetary policy to ensure financial stability. According to 12 USC 225a, “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The role of “independence within government,” appointment of prominent members to the Board, the technical nature of monetary policy and decentralized appointment of the 12 presidents of the regional Federal Reserve Banks (FRB) resulted in an institution that is freer from political influence and characterized by elite staff. The FOMC reaches decisions on the basis of information obtained from the research and supervisory functions of the FRS and the state of the art on the conduct of monetary policy (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116, Financial Regulation after the Global Recession, 84-90). Errors have abounded in the decisions of the FOMC and central banks worldwide because of the ambiguous analysis of current and future economic conditions, which is a deficiency of a nonexperimental science such as economics. In addition, policy simulation models suffer from the Lucas Critique, by which expectations of economic agents may reverse policies, resulting in effects different than those intended. The errors and deficiencies in the credit/dollar crisis and global recession were by nearly all central banks in the world and not only by the FOMC because of insufficient knowledge of how the economy functions (Pelaez and Pelaez, The Global Recession Risk, 221-5, Financial Regulation after the Global Recession, 155-71, Regulation of Banks and Finance, 217-33). A proposed financial stability agency or systemic risk council would not be able to attain the technical excellence of the FOMC and the traditional political independence of the FRS. Monetary policy could be captured for political purposes during cycles of presidential elections and midterm elections for Congress, causing future instability. Independence of the chief monetary authority is highly desirable if sound policy management is the main objective. The second function of the FRS is provided by the Federal Reserve Act 12 USC 248 (a-r) that empowers the FRS with supervisory and regulatory functions. The Federal Reserve has created over the years competent staff to implement these powers. The United States has four federal supervisors and regulators of financial institutions, FRS, OCC, FDIC and OTS, with multiple state bank supervisors and regulators (Pelaez and Pelaez, Financial Regulation after the Global Recession, 69-77). Each of these agencies has developed own staff and procedures. The elimination of the supervisory and regulatory powers of the agencies for concentration in a sole federal regulator may prove unfeasible and undesirable in the United States, which has thousands of financial institutions of different sizes that are focused on diverse segments of the financial markets. The logistics of consolidation of these agencies could create a chaotic and difficult transition period during high unemployment. The FOMC would lose key information on supervised banks. An ambitious agenda of single regulatory agency, centralized systemic risk council, reduction of size of banks, consumer protection agency and other proposals (Pelaez and Pelaez, Financial Regulation after the Global Recession, 171-5, Regulation of Banks and Finance, 229-36) conflicts with the immediate objective of promoting tranquil, growing financial markets required for recovering full employment. The regulatory shock could increase the premium of bank capital, reducing lending capacity. None of these proposals addresses the true causes of the credit/dollar crisis and global recession, which were errors of central banks in lowering policy rates to nearly zero in 2003-4 and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie. Congressional oversight failed in detecting policy errors and proposed regulation can cause more harm. The regulatory proposals can jeopardize the work of the FOMC and existing regulatory agencies, preventing the recovery of credit required for faster economic growth and employment creation. There are much higher returns in terms of employment creation in devising an exit strategy for the Fed balance sheet and the fiscal deficit than in proposing complex new controls.
Nobody owns the Federal Reserve System (FRS), which is an independent central bank that can take decisions without ratification by the President, Congress or anyone else. Members of the Board of Governors of the FRS are appointed to terms that extend over presidential and congressional terms. The FRS is subject to oversight and changes of statutes by Congress and must function within the general framework of government policy. The first major function of the FRS is monetary policy to ensure financial stability. According to 12 USC 225a, “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The role of “independence within government,” appointment of prominent members to the Board, the technical nature of monetary policy and decentralized appointment of the 12 presidents of the regional Federal Reserve Banks (FRB) resulted in an institution that is freer from political influence and characterized by elite staff. The FOMC reaches decisions on the basis of information obtained from the research and supervisory functions of the FRS and the state of the art on the conduct of monetary policy (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116, Financial Regulation after the Global Recession, 84-90). Errors have abounded in the decisions of the FOMC and central banks worldwide because of the ambiguous analysis of current and future economic conditions, which is a deficiency of a nonexperimental science such as economics. In addition, policy simulation models suffer from the Lucas Critique, by which expectations of economic agents may reverse policies, resulting in effects different than those intended. The errors and deficiencies in the credit/dollar crisis and global recession were by nearly all central banks in the world and not only by the FOMC because of insufficient knowledge of how the economy functions (Pelaez and Pelaez, The Global Recession Risk, 221-5, Financial Regulation after the Global Recession, 155-71, Regulation of Banks and Finance, 217-33). A proposed financial stability agency or systemic risk council would not be able to attain the technical excellence of the FOMC and the traditional political independence of the FRS. Monetary policy could be captured for political purposes during cycles of presidential elections and midterm elections for Congress, causing future instability. Independence of the chief monetary authority is highly desirable if sound policy management is the main objective. The second function of the FRS is provided by the Federal Reserve Act 12 USC 248 (a-r) that empowers the FRS with supervisory and regulatory functions. The Federal Reserve has created over the years competent staff to implement these powers. The United States has four federal supervisors and regulators of financial institutions, FRS, OCC, FDIC and OTS, with multiple state bank supervisors and regulators (Pelaez and Pelaez, Financial Regulation after the Global Recession, 69-77). Each of these agencies has developed own staff and procedures. The elimination of the supervisory and regulatory powers of the agencies for concentration in a sole federal regulator may prove unfeasible and undesirable in the United States, which has thousands of financial institutions of different sizes that are focused on diverse segments of the financial markets. The logistics of consolidation of these agencies could create a chaotic and difficult transition period during high unemployment. The FOMC would lose key information on supervised banks. An ambitious agenda of single regulatory agency, centralized systemic risk council, reduction of size of banks, consumer protection agency and other proposals (Pelaez and Pelaez, Financial Regulation after the Global Recession, 171-5, Regulation of Banks and Finance, 229-36) conflicts with the immediate objective of promoting tranquil, growing financial markets required for recovering full employment. The regulatory shock could increase the premium of bank capital, reducing lending capacity. None of these proposals addresses the true causes of the credit/dollar crisis and global recession, which were errors of central banks in lowering policy rates to nearly zero in 2003-4 and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie. Congressional oversight failed in detecting policy errors and proposed regulation can cause more harm. The regulatory proposals can jeopardize the work of the FOMC and existing regulatory agencies, preventing the recovery of credit required for faster economic growth and employment creation. There are much higher returns in terms of employment creation in devising an exit strategy for the Fed balance sheet and the fiscal deficit than in proposing complex new controls.
Sunday, November 8, 2009
How Big a Bank
Carlos Manuel Peláez's Latest Blog Posts
How Big a Bank
5:56 PM PST, November 8, 2009
Agendas of financial regulation in parliaments, international official institutions and monetary authorities include limits on the size of banks or how big a bank should be. These proposals imply that regulators would decide the total value of assets held by banks. Assets would have to be weighted by risk, which is the best practice applied in the Basel capital accords. Regulators would decide not only the total value of assets but also the structure or percentage share of assets by risk class and credit rating such as how much in consumer credit, real estate lending, securities holding, corporate lending and so on. If the regulators decide on the total value of assets and their risk, they effectively micro manage bank decisions on risk and return. Managers would only implement regulatory criteria with little decision power on how best to reward shareholder capital. Regulators would mandate maximum assets and their risk distribution by leverage, credit and liquidity regulation. There are two concerns on the regulation of how big a bank should be. First, there is the issue of best practice in bank management and its consequences for financing prosperity. Banking is characterized by declining costs because of bulky fixed investments required for initiation of lines of business (Pelaez and Pelaez, Regulation of Banks and Finance, 82-9, Financial Regulation after the Global Recession, 63-9). There has been a new industrial/technological revolution in the past three decades centered on information technology (IT). Banking is highly intensive in the creation, processing, transmission and decision use of information. The first transaction of a $100 million IT facility costs $100 million but the hundred millionth costs only one dollar. Competitive banking requires a large volume of transactions to reach the minimum cost of operations. At the time of the call report for the implementation of Basel II in 2006, 11 banking organizations had total assets of $4.6 trillion, equivalent to 44 percent of total US banking assets of $10.5 trillion, and about $978 billion in foreign assets, equivalent to 96 percent of US foreign banking assets of $1 trillion (Pelaez and Pelaez, Globalization and the State: Vol. II, 147). Concentration likely increased during the credit/dollar crisis and its reversal by regulation could cause another confidence shock. The regulation of how big a bank should be would disrupt investment in the best practice of using technology and delivery of products at lowest cost by US banking organizations. It would also undermine the competitiveness of US banks in international business, violating the essential principle of the Basel capital accords of maintaining fair competitive international banking. Second, the regulation of how big a bank should be is based on an inadequate interpretation of the credit crisis/global recession. The panic of confidence in financial markets is commonly attributed to the failure of Lehman Bros. in September 2008. Cochrane and Zingales have shown that the crisis of confidence originated in the proposal of the Troubled Asset Relief Program (TARP) of $700 billion two weeks after the failure of Lehman Bros. TARP was proposed in negative terms of: withdraw "toxic" assets from bank balance sheets of banks or there would be an economic catastrophe similar to the Great Depression. Counterparty risk perception rose sharply because of fear of banking panics, paralyzing sale and repurchase transactions and causing illiquidity of multiple market segments. The "toxin" was introduced by zero interest rates in 2003-4 that induced high leverage and risk, low liquidity and imprudent credit together with the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie on the good faith and credit of the US. Regulatory micro management of the volume and structure of risk of banks and financial markets will weaken banks, reducing the volume of credit required for steering the world economy from currently low levels of activity. It will also restructure markets with arbitrary concession of monopolistic power to less efficient banks, creating vulnerabilities to new crises. There is need for less intrusive regulation that induces a sustainable path of prosperity, using effectively the staff, expertise and resources of existing regulatory agencies.
Carlos Manuel Peláez's Latest Blog Posts
How Big a Bank
5:56 PM PST, November 8, 2009
Agendas of financial regulation in parliaments, international official institutions and monetary authorities include limits on the size of banks or how big a bank should be. These proposals imply that regulators would decide the total value of assets held by banks. Assets would have to be weighted by risk, which is the best practice applied in the Basel capital accords. Regulators would decide not only the total value of assets but also the structure or percentage share of assets by risk class and credit rating such as how much in consumer credit, real estate lending, securities holding, corporate lending and so on. If the regulators decide on the total value of assets and their risk, they effectively micro manage bank decisions on risk and return. Managers would only implement regulatory criteria with little decision power on how best to reward shareholder capital. Regulators would mandate maximum assets and their risk distribution by leverage, credit and liquidity regulation. There are two concerns on the regulation of how big a bank should be. First, there is the issue of best practice in bank management and its consequences for financing prosperity. Banking is characterized by declining costs because of bulky fixed investments required for initiation of lines of business (Pelaez and Pelaez, Regulation of Banks and Finance, 82-9, Financial Regulation after the Global Recession, 63-9). There has been a new industrial/technological revolution in the past three decades centered on information technology (IT). Banking is highly intensive in the creation, processing, transmission and decision use of information. The first transaction of a $100 million IT facility costs $100 million but the hundred millionth costs only one dollar. Competitive banking requires a large volume of transactions to reach the minimum cost of operations. At the time of the call report for the implementation of Basel II in 2006, 11 banking organizations had total assets of $4.6 trillion, equivalent to 44 percent of total US banking assets of $10.5 trillion, and about $978 billion in foreign assets, equivalent to 96 percent of US foreign banking assets of $1 trillion (Pelaez and Pelaez, Globalization and the State: Vol. II, 147). Concentration likely increased during the credit/dollar crisis and its reversal by regulation could cause another confidence shock. The regulation of how big a bank should be would disrupt investment in the best practice of using technology and delivery of products at lowest cost by US banking organizations. It would also undermine the competitiveness of US banks in international business, violating the essential principle of the Basel capital accords of maintaining fair competitive international banking. Second, the regulation of how big a bank should be is based on an inadequate interpretation of the credit crisis/global recession. The panic of confidence in financial markets is commonly attributed to the failure of Lehman Bros. in September 2008. Cochrane and Zingales have shown that the crisis of confidence originated in the proposal of the Troubled Asset Relief Program (TARP) of $700 billion two weeks after the failure of Lehman Bros. TARP was proposed in negative terms of: withdraw "toxic" assets from bank balance sheets of banks or there would be an economic catastrophe similar to the Great Depression. Counterparty risk perception rose sharply because of fear of banking panics, paralyzing sale and repurchase transactions and causing illiquidity of multiple market segments. The "toxin" was introduced by zero interest rates in 2003-4 that induced high leverage and risk, low liquidity and imprudent credit together with the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie on the good faith and credit of the US. Regulatory micro management of the volume and structure of risk of banks and financial markets will weaken banks, reducing the volume of credit required for steering the world economy from currently low levels of activity. It will also restructure markets with arbitrary concession of monopolistic power to less efficient banks, creating vulnerabilities to new crises. There is need for less intrusive regulation that induces a sustainable path of prosperity, using effectively the staff, expertise and resources of existing regulatory agencies.
Monday, November 2, 2009
Regulation and the Cost and Availability of Credit
4:14 AM PST, November 2, 2009
An influential view explains the transmission of the business cycle by the effects of a primary shock on balance sheets, income and liquidity of households, companies, financial institutions and the government. Internal financing of families is provided by savings, assets and liquid deposits while external financing consists of credit unsecured or collateralized with assets such as home equity. Internal financing of companies consists of retained earnings and liquid assets while external financing consists of unsecured or collateralized bank loans and issue of debt securities and equity. A primary shock in the form of lack of confidence could reduce the value of assets that households and business could pledge to lenders in raising external financing. The weakening of balance sheets of debtor households and companies would raise the credit default probabilities of loan portfolios of financial institutions, resulting in further contraction of external financing as lenders become more selective in providing credit. Declines in wealth and income of households, business and financial institutions lower the revenue of government, which may raise taxes. Consider the credit/dollar crisis and global recession. Central banks caused the credit crisis by lowering interest rates to nearly zero, inducing households, companies and financial institutions to take high leverage and risk and low liquidity, while Fannie Mae and Freddie Mac purchased or guaranteed $1.6 trillion of nonprime mortgages. The official, misleading version of the cause of the resulting credit/dollar crisis and global recession by the G20 was an alleged "era of irresponsibility" by financial institutions instead of actual regulatory errors in the form of zero interest rates and purchase or guarantee of nonprime mortgages by Fannie and Freddie. Intrusive proposals of financial regulation are creating adverse expectations that restrict the conditions and increase the interest rates of external financing to households and companies. Reduced external finance at higher cost restricts expenditure and production, which would move the economy out of recession. The effect is the same as that of the new credit card law, CARD, which caused reduction in credit limits and increase in fees for everybody. The cost of bank capital is significantly increased by proposals of full powers to government agencies controlling executive compensation, consumer credit, systemic risk, volume and structure of assets, cyclical capital, bankruptcy insurance fees and general management decisions. Imperfect knowledge on the functioning of regulation prevents success in fostering stability. Financial institutions would not be effectively managed by regulators with excessive work burdens, without superior business acumen and subject to political/corporate influence. The increase in costs of capital of financial institutions will restrict external financing to families and private companies, preventing recovery of full employment output. Regulation should induce balanced risks but without frustrating innovation promoting growth and effective bank management.
http://www.amazon.com/-/e/B001HCUT10
4:14 AM PST, November 2, 2009
An influential view explains the transmission of the business cycle by the effects of a primary shock on balance sheets, income and liquidity of households, companies, financial institutions and the government. Internal financing of families is provided by savings, assets and liquid deposits while external financing consists of credit unsecured or collateralized with assets such as home equity. Internal financing of companies consists of retained earnings and liquid assets while external financing consists of unsecured or collateralized bank loans and issue of debt securities and equity. A primary shock in the form of lack of confidence could reduce the value of assets that households and business could pledge to lenders in raising external financing. The weakening of balance sheets of debtor households and companies would raise the credit default probabilities of loan portfolios of financial institutions, resulting in further contraction of external financing as lenders become more selective in providing credit. Declines in wealth and income of households, business and financial institutions lower the revenue of government, which may raise taxes. Consider the credit/dollar crisis and global recession. Central banks caused the credit crisis by lowering interest rates to nearly zero, inducing households, companies and financial institutions to take high leverage and risk and low liquidity, while Fannie Mae and Freddie Mac purchased or guaranteed $1.6 trillion of nonprime mortgages. The official, misleading version of the cause of the resulting credit/dollar crisis and global recession by the G20 was an alleged "era of irresponsibility" by financial institutions instead of actual regulatory errors in the form of zero interest rates and purchase or guarantee of nonprime mortgages by Fannie and Freddie. Intrusive proposals of financial regulation are creating adverse expectations that restrict the conditions and increase the interest rates of external financing to households and companies. Reduced external finance at higher cost restricts expenditure and production, which would move the economy out of recession. The effect is the same as that of the new credit card law, CARD, which caused reduction in credit limits and increase in fees for everybody. The cost of bank capital is significantly increased by proposals of full powers to government agencies controlling executive compensation, consumer credit, systemic risk, volume and structure of assets, cyclical capital, bankruptcy insurance fees and general management decisions. Imperfect knowledge on the functioning of regulation prevents success in fostering stability. Financial institutions would not be effectively managed by regulators with excessive work burdens, without superior business acumen and subject to political/corporate influence. The increase in costs of capital of financial institutions will restrict external financing to families and private companies, preventing recovery of full employment output. Regulation should induce balanced risks but without frustrating innovation promoting growth and effective bank management.
http://www.amazon.com/-/e/B001HCUT10
Subscribe to:
Posts (Atom)