I’ve copied below a worthwhile article by Greg Ip from the Economist. It highlights some new (and some still unsolved) challenges that US policy makers face if there were to be another Lehman event. my take away from the article is that Dodd-Frank is fundamentally flawed because it leaves the larger too big to fail systemic risk problem unsolved while also creating new constraints on public bailouts in times of financial stress. One goal of Dodd-Frank is to “protect” tax payers from being on the hook for paying for future financial sector bailouts. However, the new rules that have been put in place to make it harder for policy makers to put tax payer funds “at risk” in future bailout programs may paradoxically put tax payers at greater risk if such constraints unwittingly lead to a systemic market crash!!!
On one hand this result is quite amazing, on the other hand it is totally predictable in the sense the Dodd-Frank treats symptoms of the global credit crisis (problems with: derivatives, mortgage originating, rating agencies, etc, etc. etc), but leaves the fundamental disease untreated (easy money).
What this article highlighst is that protecting tax payers in a system that operates with a central bank capable of blowing easy money bubbles is a very very tricky concept (read: impossible).
The irony of course in Dodd Frank is that by trying to protect tax payers up front from another round of massive public fund injections in to private markets, this very attempted “protection” may cost tax payers even more if emergency liquidity interventions are disallowed and the system ultimately crashes causing massive economic and financial market dislocation. If you are going to have an easy money system backed up by a central bank, then the only way to protect against systemic risk is by giving policy makers a blank check for bailouts. Tax payers are going to pay one way or the other.
There are no free lunches. We have been told by the PhD economists and politicians that we need a central bank to protect us from financial panics and business cycles. But it is a fact that only with the introduction of a central bank lender of last resort mechanism is “the market” at risk of systemic failure because individual firms and depositors are continuously bailed out and not allowed to fail, which builds up moral hazard risk until it gradually accumulates over time and turns into systemic risk.
This small little article I think exposes fundamental weaknesses in the legislation. Scary stuff.
Fighting financial crisis
Don’t look down
What if there were another Lehman?
Oct 15th 2011 | WASHINGTON, DC | from the print edition
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ASKED on October 11th how he might have handled the financial crisis of 2008 differently, Mitt Romney, the frontrunner for the Republican presidential nomination, refused to answer “a hypothetical”. He had good reason to prevaricate. The possibility of another crisis, given the euro zone’s woes, remains; the ability of the federal government to respond has changed drastically. The Dodd-Frank financial-reform law gives policymakers better tools to handle the failure of a firm like Lehman, but limits many of the other powers used to contain wider panic.
The Federal Deposit Insurance Corporation (FDIC) has long been able to place a failing bank in receivership and repay depositors while it finds a buyer or winds the bank down. This discourages a bank’s creditors from bolting, sparking a broader panic. But many of the companies at the centre of the 2008 crisis were not banks; the cast included investment banks (Bear Stearns and Lehman), an insurer (AIG) and money-market funds. That left two unappetising choices: bail-out, as with Bear and AIG, or bankruptcy, as with Lehman.
Dodd-Frank provides for this scenario. If a company’s failure poses systemic risk, the FDIC can place it in receivership and either sell it off to another company or place its viable bits in a bridge bank, which it can continue to operate, and the rest in a bad bank. The hope is that this will remove the incentive for creditors to run, precipitating a collapse and contagion.
Whether it will actually work is unclear, since it has never been tried. If it doesn’t, the rest of the official safety net is more threadbare than in 2008, when policymakers pulled out all the stops (see table). Dodd-Frank forbids specific support for a single company, as was done for Bear Stearns, AIG, Citigroup and Bank of America. The Treasury can no longer use its foreign-exchange account to backstop money-market funds—worrying, given the exposure of money-market funds to European banks. Before the FDIC can guarantee financial firms’ bonds, as it did in 2008, it now needs congressional approval.
The Federal Reserve can still lend to banks, and to foreign central banks via swap lines. But to invoke its power to lend to other companies in “unusual and exigent circumstances”, as it routinely did in 2008 and 2009, it must get the approval of the treasury secretary, and demand enough collateral to protect the taxpayer from loss. Recreating its backstops for money-market funds, commercial paper and asset-backed securities might require such stringent conditions that no one would participate.
Such constraints make avoiding another panic all the more important. On October 11th regulators proposed that a financial firm meeting certain criteria, among them at least $50 billion in assets and $20 billion in liabilities, be classified a “systemically important financial institution” subject to special oversight by the Fed. If the authorities cannot catch big firms, they must try harder to stop them falling.
>>>>MY EDITORIAL COMMENTS: Greg Ip says: "If the authorities cannot catch big firms, they must try harder to stop them falling." GOOD LUCK WITH THAT!!!
A sound money policy is the only way to protect tax payers from being on the hook for financial market bailouts. This is because no matter how big an Individual firm, it can safely be allowed to fail in a sound money system. The public at large is not on the hook for bailouts in a sound money system. firms go bust but the system survives. the owners of a particular firm are at risk in a sound money system. The very idea of a central bank being used to protect the public from bank runs and systemic market risk is upside down logic.
It is only with a central bank that systemic risk can be injected into the larger financial market system. we never had a boom like the roaring twenties or a bust like the Great Depression (or for that matter a world war like WWI) until AFTER the Fed was established in 1913!!! World wars and epic economic booms require central bank financing!!! The inevitable result of historic easy money fueled growth and asset bubble booms are historic cyclical busts, like we saw with the Great Depression. The idea that the Fed caused the Great Depression by mistakes it made after the Great Crash of 1929 is pure and utter fantasy. The seeds of Great Depression were sown by the Fed in its easy money policy of the 1920s. (The Fed reduced the over night rate in the 1920s as a favor to Bank of England which wanted low rates in England to help spur economy following a painful post WWI recession. The BOE asked a favor to the Fed to keep rates low in the US so that England could also keep rates low and not risk having gold flow to higher rates in the US. The Fed rationalized its manipulation of the overnight rate to a rate lower than it otherwise would have been left to market because measured inflation remained low despite booming economy. My hypothesis is that the US was going through a productivity boom in the 1920s thanks to proliferation of electricity throughout the economy which injected “healthy deflation” into the economy. all things equal prices should have been falling in the US in the 1920s. this productivity shock provided cover to the Fed to suppress interest rates because “inflation” remained low. This is exactly what has occurred in China over the course of the last decade except that we’ve only seen the boom part of the cycle so far, a bust (likely shallower than Great depression, but maybe even longer) will follow the boom, like night follows day.
If individual firms and banks are allowed to go bust along the way and business cycles are allowed to play out “naturally” then you don’t get the mega bust cycles like we had with the Great Depression and like we are facing today. Micro busts and “natural” biz cycles are necessary for robust and sustainable markets. if policy makers try to suppress market volatility via central banking, the result is systemic risk building up over time leading to systemic bust.
Politicians and policy makers make a lot of promises to get elected. Whenever you hear a politician make a promise about what he can do to improve the economy, only believe him or her if the promise to improve the economy is based on an idea that entails REDUCING the footprint of government. so called economic reforms are only positive and durable when government reduces its footprint.
The use of the central government to solve social, economic or financial sector problems is a recipe for larger problems down the road. Having said that, I am not suggesting that there should be no government or that a small government is a simple recipe for utopia.
Let’s get rid of the idea of perfecting society or fixing what are natural (albeit unpleasant) features of markets.
Life is unfair. Markets will always behave unpredictably and sometimes harshly. A bankruptcy or business cycle is no more a market failure than an earth quake can be considered a failure of the earth’s lithosphere (crust) or a hurricane is a failure of the earth’s biosphere.
We humans have to live with natural disasters, we can't prevent them. If we could prevent earthquakes and hurricanes, we would upset the delicate balance of the earth system that allows for intelligent life. Sure we can develop early warning systems for earthquakes but we can prevent them without creating unintended consequences that fatally upset the balance of the earth system.
There is no practical way to establish a level playing field in competitive markets. Markets are imperfect. MArkets are by definition uneven. Humans are endowed with unequal gifts. Some people are born with a silver spoon; others are born into crushing poverty. That is life. Some people will go to college, others will go to technical school, others will work with their hands in manual labor.
Life isn’t perfect. markets aren’t perfect. society isn’t perfect. And not only that, but we should understand that we cannot fix market imperfections that are inherent to markets without setting in train a series of unintended consequences and negative feedback loops that causes more harm than good.
There are two kinds of market imperfections. One kind is systematic. These are “natural” imperfections that can’t be fixed by human intervention without creating some other worse problem. The other kind of market imperfection is caused by well intended government interventionist policy. It is very difficult to discern what has caused a market imperfection. What we do know, however, is that if we use government policy to try to fix it, we will only make it worse.
Just as the earth system can’t function sustainably without natural disasters, modern society can’t function without market imperfections like pollution and income inequality and business cycles.
There may be some "optimal" level of pollution, but less is a direction, not a level. There is no way for humans to decide what is the optimal level of pollution for the earth system as a whole. Is less pollution better? No way. Zero pollution means no life, no society, no cars, etc. Ok we'll never get to zero pollution, but should we always try to decrease pollution via public policy? No.
We should not because there is no way to calculate what is the optimal level of pollution or carbon dioxide emissions. The best way to ensure the "optimal" level of pollution is to create a system based on sound money. Central banking will always encourage growth booms that stress the earth system beyond its carrying capacity. That is why booms lead inevitably to busts. If we pump up the economy with easy money and we get too much carbon dioxide, the worst solution is to add more government regulations and taxes and interventions to the sytem to fix a problem that originated from well intended govt policy in the first place (i.e. central banking).
The biggest so called "market failures" occur when we identify a problem as a market failure and then assume we can fix it with public policy. Once we identify something as a market failure and introduce some macro policy to fix this so called failure, what we do is risk injecting systemic risk into the entire system. Market imperfections are signals to the market that something requires adjusting. If the imperfections are suppressed, then the risk builds and builds and builds until it eventually manifests anyway. when the bigger mess finally manifests, it is natural for we humans to blame the market rather than look in the mirror and blame ourselves for self creating the mess with well intended public policy.
There is no such thing as a market failure per se. There are features of markets that are unattractive, unfair, even painful, ugly and imperfect such as poverty, business cycles, market consolidation (e.g. big business), bankruptcy, pollution, industrial accidents, etc. However, if we try to use government policy to try to fix these features, we inevitably turn what are fundamental and unsolvable negative features into systemic problems for society. when we try to fix business cycles with central banking we create global warming problem, and Great Depressions and class conflict fueled income inequality.
It is basic human hubris to think that social order comes from the active imagination, planning and intervention of intelligent humans intervening via government to create order out of what otherwise would be chaos.
The fact is (based on teh latest break through findings in far from equilibrum science) that "Social order" is “spontaneous”!!!! Society, economies and markets are unplanned. They are all as natural and spontaneously formed via the same natural laws that have led to the ordering of the earth biosphere. no one planned the solar system or the earth or natural systems on earth like the amazon rain forest ecosystem or the earth's plate tectonic system; and no one planned or designed ant colonies or ocean ecosystems or the gulf stream or larger weather patterns. And no one planned the formation of villages or modern city states or countries or the modern economy. humans can inject islands of order into what we eventually see as the larger unplanned order of society. But micro orders planned by humans (companies, families, parks, towns, etc) are fundamentally different from macro orders that emerge unplanned as the result of the interchange between micro human planned orders. planned orders must be allowed to exchange freely with each other in order that a naturally and spontaneously forming macro unplanned orders that we call “the economy” or “the market” or society can emerge.
any macro order that is actively planned by humans will be lead to Malthusian constraints and it will crash under the weight of its own inherent contradictions.
Central banking is the public institution that promises the most and ends up creating the biggest problems for larger society including by exaggerating income inequality, sowing seeds of systemic market risk and Great Depression business cycles. Without central banks we would have pollution but not the systemic problem posed by global warming dynamics. Without central banks we would have business cycles but not Great Depressions. We would have income inequality but not the situation we have now where the rich get ever richer and the poor get poorer. Naturally ugly features of markets turn into systemic cancers when a central bank is introduced that facilitates the transformation of what are fundamental imperfect features into systemic cancers capable of causing global / social destruction.
If we try to solve global warming with more government, we are asking for even worse problems than those problems already caused by modern fiat money central banking systems. The underlying cause of global warming, systemic risk in markets, boom bust cycles and Great Depressions is easy money facilitated by central banks. Try to fix problems caused by central banking with new policy interventions and you’ll merely get temporary solutions causing an even bigger boom bust cycle down the road.
