Arnold Kling  

Stanley Fischer on Moral Hazard

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He says,

in a variety of financial crises, I have arrived at the following guide to conduct: if you find yourself on the verge of imposing massive costs on an economy - that is on the people of a country or countries - by precipitating a crisis in order to prevent moral hazard, it is too late. You should not take the action that imposes those costs. Rather in thinking through how a system will operate in a crisis, you need to take into account the likelihood of facing such choices, and you need to do everything you can in designing the system to keep that likelihood very small.

This still does not settle what I see as the big issue, which is whether you think in terms of a system that is hard to break or easy to fix. I think that "hard to break" is an illusory goal. Wanting a system that is easy to fix leads me to prefer financial systems where debt finance is relatively more expensive and where banks are smaller. I would like to see more equity finance, and I would like to avoid having a situation where a bank is so big that its failure becomes unthinkable.

Thanks to Justin Lahart for the pointer. Fischer's entire talk is interesting.

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COMMENTS (4 to date)
Various writes:

I think in an optimal world, hard to break and easy to fix should both be objectives. For example, commercial aircraft are designed to be both hard to break and easy to fix. But in a democratic society, I agree with you that easy to fix is probably at least slightly more feasible than hard to break. It all comes down to what is politically more palatable to the special interests you are dealing with.

On that subject, trying to make financial institutions smaller may be challenging. A potentially elegant solution is to tie federal deposit insurance to enterprise value. You increase fdic and spic insurance in a graduated level as enterprise value goes up. A BofA or Citi could still exist, but it would be expensive for them to do so. You would need some rigorous method of calculating enterprise value so it can't be gamed, or at least not be gamed excessively. You probably also want to include off-balance sheet items and insurance/derivative/hedging instruments in the calculation somehow, although they may not be included in an enterprise value calculation. For example, you could use a notion of enterprise value, plus a margin type requirement for some types of derivatives.

Kenny writes:

As someone that maintains a complex, ambiguous system (of software), I appreciate 'easy to fix' as a far more useful attribute than 'hard to break'. 'Hard to break' is free with enough time; 'easy to fix' gets you there (even when 'there' keeps changing).

But I interpreted Fischer as saying that you should not impose massive costs on an economy (i.e. people) to prevent moral hazard – it's already too late if you have to impose massive costs. The necessity of the huge costs imply that the moral hazard has already happened and Fischer believes, as I, that you should write-down your (beliefs about your) assets immediately, take the full hit of the accumulated mistakes and compounded stupidity all-at-once, and then move on (to the new 'there').

Rimfax writes:

I think that Fischer overestimates his and/or policymakers' ability to judge when they are "on the verge of imposing massive costs". Has he ever seen a "too big too fail" bank actually fail in a modern economy? Where does he get the confidence that he knows how that will unfold or that it will impose massive costs in even the medium term?

This sounds like a formula for the bureaucrat with the big red button to push it whenever there is any pressure to do so. Doing nothing, even if it might be the better course of action, has no branch in his decision tree.

Jeff Hallman writes:

Gary Gorton has pointed out that what needs explaining is not the recent financial crisis, but rather the "Great Moderation" of 1940 - 2007 wherein the U.S., at least, did not experience much in the way of financial crises. If you look at history and across countries, you find that recurrent financial crises are the norm, not the exception.

Not so long ago, the combination of limited entry, deposit insurance and deposit rate ceilings meant that a banking charter was a very valuable franchise. This led banks to internalize risk management because they wanted to preserve and increase the value of the franchise. When we eliminated the deposit rate ceilings and opened up the lending industry to new and different entrants, we also turned valuable banking franchises into options, options whose value was maximized by levering up and taking huge risks. If the risks paid off, the banks made tons of money. If not, the FDIC would be left holding the bag.

Credit booms and busts have always been with us and probably always will be. What we can and should do is (i) reduce the sizes of the booms and subsequent busts, and (ii) insulate, as far as possible, the rest of the economy from the credit market swings.

Milton Friedman made the case a half-century ago that funding private credit via deposits is a bad idea. Entities whose liabilities serve as a medium of exchange should be limited to investing in only the safest short-term instruments, like 30-day Tbills and/or reserve deposits at the Federal Reserve that pay interest. In fact, Friedman long favored 100 percent required reserves for depository institutions. In such a regime, panic in the credit markets does not affect the money supply and its effects on money demand can be offset by open market operations.

The 100 percent reserves system also eliminates the need for deposit insurance, since the assets of depository institutions would always be highly liquid and extremely safe.

We should also seriously consider eliminating laws that favor debt financing over equity funding. Eliminating the corporate income tax and taxing all forms of income (including capital gains, dividends and earned interest) at the same rates would help a lot here.

Finally, we've got to get rid of "too big to fail". Too big to fail is also too big to be well-managed. As Arnold has often pointed out, the top management at Fannie and Freddie seem not to have known how much risk their firms were taking on, and the lobbying power that big firms have invites all kinds of mischief.

Sadly, it's unlikely that we'll do any of this, and so we'll have more financial crises in the near future.

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