Exiting the Great Depression: lessons for today Kris Mitchener and Joseph Mason Discussion by Marcus...
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Exiting the Great Depression: lessons for today
Kris Mitchener and Joseph Mason
Discussion byMarcus Miller
Warwick University
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Discussant’s commentsWhat I liked
M and M’s outline of fascinating features like• Extent of bank recapitalisation through RFC
striking • Anti firesales activity of Deposit Liquidation Board
Their flagging of key issues like• Tackling asymmetric information via certification,
FDIC, etc.• Political problems of reversing crisis induced
institutional support
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What I missed
• Didn’t get their 3 R’s! How about-• Rescuing the system, too little too late in 1930s
• Regulating banks: in 1930s prudential regulation crucial complement to deposit insurance.
• Reform the system: in 1930s this included Glass-Steagall, SEC, Chapter 11 BankruptcyI will use these as headings for comments to follow
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1. Rescue (Image of the $1 trillion liquidity support by FRBNY)
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‘The Great Escape’
• What would have happened to the US economy if the Federal Reserve had not intervened by spending 7% of US GDP buying illiquid assets in 2008/9?
• The FRBNY have modelled the effect of a liquidity crunch without such intervention; and then with the liquidity injection of $1 trillion
• Results can be shown as:
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Effect of a liquidity shock in US that lasts 10 quarters, Del Negro et al. (2009) Solid blue : no intervention. Dashed blue: $1 trillion liquidity injection.
The Counterfactual
40 % fall of Investment
Output falling initially by 25% Then down to 30%
The capital stock falling by 1% a quarter until liquidity is restored
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Help from Central Banks - since Aug ‘07
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Plus support from Government =3/4 GDP!
• United Kingdom United States • Jan. 2007 Latest Jan.207 Latest• Government support
£ trillions $ trillions• Guarantees of financial• institutions’ liabilities – 0.37 – 2.08
• Insurance of financial assets – 0.46 – 3.74 •
Capital injections to banks and• special purpose vehicles – 0.06 – 0.70 •
Increase in public sector support 1.26 – 10.44
(including CB assistance)
• Percentage of GDP – 88% – 73%
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2. Regulation
• Crisis has revealed profound problems of • asymmetric information • Financial externalities (fire sales, network
effects)• Market concentration
These lie outside the competitive paradigm of economics, so tackling them will require thinking outside the box
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Challenges to the market paradigm
CompetitiveMarket paradigm
Missing information; missing markets
Strategic PowerExternalities, e.g.
systemic risk
Market collapse
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‘Greenspan defends position on free market’Central Banking.com 6 Apr 2010
• Alan Greenspan, a former chairman of the Federal Reserve, has refuted claims that his comments on the recent failures in financial markets are in any way a repudiation of the laissez-faire view that markets can be trusted to police themselves.
• "There is no alternative if you want to have economic growth, higher standards of living, in a democratic society, to have competitive markets," he said.
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Externalities
• Economists use the term ‘negative externality’ to refer to a side effect of economic activity that you don’t pay for.
• One example is Global Warming: use of car has side effects on global carbon build-up - and some predicting Armageddon as a result.
• Another example is atmospheric pollution.
• We focus on ‘fire-sale’ and ‘network’ externalities.
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Two Regulatory Responses: taxing externalities
• Some advocate Pigovian taxation of externalities associated with HLIs ‘Highly Leveraged Institutions’* who generate externalities – e.g. by capital adequacy ratios and presumably liquidity ratios, Korinek (2009) and Haldane(2010)
* inc banks, shadow banks and hedge funds who might get involved in ‘fire-sales’
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Key Problem: Tail risk within financial systems is endogenous and often unobserved
• it is hazardous to believe there is a magic number for regulatory ratios sufficient to insure against tail risk in all states of the world. Because tail risk is created not endowed, calibrating a capital ratio for all seasons is likely to be, quite literally, pointless – whatever today’s optimal regulatory point, risk incentives mean that tomorrow’s is sure to be different.
• A.G. Haldane ‘The $100b question’
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Prohibition
• Andrew Haldane “The $100 b question”(2010) argues that:
• Banks will always be able to move faster than the regulators , and avoid control by ‘regulatory arbitrage’. Look at the US shadow banking industry!
• Hence the need for prohibition - to ban activities that threaten to generate negative externalities.
• “Prohibition” may have a 1930s sound, and that’s right
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US in 1930s: Glass-Steagall
• Glass-Steagall : simple in objectives and execution. • Clear aim - shaped by an extreme tail event (the
Great Depression) –was to avoid a repetition. • It sought to achieve this by acting directly on the
structure of the financial system, quarantining commercial bank and brokering activities through red-line regulation.
• Lasted over half a century without a significant systemic event in the US, until revoked in 1999 by Gramm-Leach-Bliley Act . And then….?
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Average assets relative to GDP of US commercial banks Source: A.G. Haldane ‘The $100b question’
0.014
a 0.012
as
Ban
k
GD
P
0.010
Com
mer
cial
Nom
inal
0.008
of
per
perc
enta
ge
0.006
Ass
ets
0.004
Ave
rage
0.002
0.000
34
1938
42 0
1954
8
19 62
6
1970
4
19 78 1982 86 0
94 8 02 6
5 5 6 7 9 9 0
9 9 9 9 9 0
1 1 1946 19 19 19
1 1 19
1 19
2 20
Y ear
A v e rag e A sse t S iz e o f C o m m erc ia l B an k s sc a led b y N o m in a l G D P
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Concentration of the US banking system Source: A.G. Haldane ‘The $100b question’
com
mer
cial 45 .00
40 .00
35 .00
tota
l
asse
ts)
of
30 .00
%
(as
25 .00
sect
or
bank
s
20 .00
bank
ing
US
3 15 .00
top
of
10 .00
asse
ts
5.00
Tot
al
0.00
1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
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3.Reform of structure
• In a context of asymmetric information, HLI’s use the property rights of the capitalist system to generate profits which reflect transfers rather than value added.
• Why not change property rights? E.g.• Volcker Rule to bring back Glass-Steagall• Investment banks to be partnerships again• Double liability for commercial bank shares?
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Let me out of here!
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What is not legally banned may be economically attractive (with moral issues left aside)
Legally banned
Is there not a risk that that well-heeled, politically savvy, financial institutions - with the best lawyers and least moral scruples - will stay ahead of legal and moral sanctions.
Morally unacceptable
•A: OK
•B: PROBLEM
Economic progress: two possibilities:
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Postscript
• ‘Wall Street titans still recklessly speculate with borrowed money. We cannot delay action any longer.’ (Barack Obama)
• Goldman charged with fraud FT Headline - 17 April 2010
• ‘US authorities yesterday accused Goldman Sachs of securities fraud that caused investor losses of more than $1bn (£649m).
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• In Western, market-based culture, the limitations on property rights depends explicitly on legal sanctions
• But these are failing to internalise externalities
• In some Eastern cultures, the rule of law is not paramount; and, in any case, there may be other sanctions , e.g. shame, capital punishment.
• So they may be better able to internalise externalities!
*Dipak Lal Unintended Consequences,
Competition between Cultures?