Scott Sumner  

What we are up against

I've Changed My Mind, Part 2... The (Metaphorical) Bet: Paul E...

The Great Recession led to a lot of "if only" comments. If only we could charge a negative interest rate on reserves, to discourage banks from hoarding excess reserves. If only we had had more regulation back during the housing boom, so that banks didn't make all those reckless sub-prime mortgages. If only we hadn't fed the real estate boom with a policy that held interest rates artificially low via taxpayer backstops of mortgage-backed bonds.

How serious were these regrets? Apparently not at all. One by one we've addressed all of these policy issues, and each time we've blinked. Let's start with negative interest on reserves. The Fed says it's reluctant to go this route because it could make the money market mutual funds insolvent. Almost everyone seems to agree that the MMMF industry needs to change its pricing policy, so that the funds don't collapse if the market value falls below $1. Unfortunately "everyone" doesn't have much political clout:

The Securities and Exchange Commission, poised to implement structural changes to money funds in coming months, is expected to broaden an exemption for mom-and-pop retail investors from requirements that certain money funds abandon their signature $1 share price and float in value like other mutual funds, these people said. Supporters of a floating share price argue it would train investors to accept slight fluctuations in the value of their shares and so not panic if they fall below the $1 price.

The revised approach would mark a victory for mutual-fund companies that have pressed the SEC to scale back provisions from a June proposal. It also would deal a blow to other regulators, including 12 regional Federal Reserve Bank presidents, who have argued for tougher rules requiring more funds, including those catering to retail investors, to float share prices. . . .

Such a move is likely to inflame proponents of tougher rules, including former SEC Chairman Mary Schapiro, who led a failed effort to make structural changes to the funds two years ago. Ms. Schapiro last summer criticized the SEC's approach as insufficient, saying meaningful change should "cover the entire sector" rather than just a narrow segment involving institutional investors. She declined to comment on the new approach until the SEC makes its changes final.

So the MMMF industry has more clout than the unemployed. Is anyone surprised?

With all the complaints back in 2008 about how "deregulation" had led to the housing/banking crisis, you might have expected at least a mild attempt to address the root cause of the excesses--public subsidies encouraging mortgage-backed bonds and subprime mortgages. In fact, Congress is about to pass a law that makes the subsidies explicit, and actually encourages subprime lending. Your tax dollars at work, creating another housing crisis:

A RARE area of agreement about the financial crisis of 2008 is that Fannie Mae and Freddie Mac were at the core of the meltdown and are in urgent need of reform. On March 16th the leading Republican and Democratic members of the key Senate Banking Committee belatedly released a plan for restructuring the two publicly traded mortgage giants.

The plan has received widespread attention in part because it appears to address the most evident problems of Fannie and Freddie and because it is deemed likely to be approved by Congress. Yet neither of these assumptions, on deeper examination, seems to be true.

To satisfy those who want low-priced mortgages on terms that private markets would never endorse, the plan makes explicit the government guarantee on debt which had been implicit for Fannie and Freddie. This would lower the interest rate on high-risk loans, while obscuring the cost of the subsidy. . . .

Opponents of Fannie and Freddie contend that the two played a key role in the crisis by encouraging the issuance of loans with tiny downpayments through a benign-sounding "affordable housing" mandate. Nothing much has changed. Under the new plan, downpayments of as little as 3.5% of the loan value would be permitted. Strewn through the proposed law are words such as "affordable", "equal access" and "underserved communities", which suggest that lending decisions will be based on political rather than credit criteria. "The result", says Edward Pinto of the American Enterprise Institute, a think-tank, "will be risky lending for those least able to cope."

Next time you hear politicians complain about "deregulation," just recall how they reacted to the 2008 crisis. There is zero desire in either party to regulate in a way that would inconvenience favored groups like MMMFs, small bankers, real estate salesmen, builders, and home buyers. Too many votes at stake. Instead, complaints about deregulation after a market fiasco are merely empty rhetoric designed to fool the public, earnest NPR listeners, and certain credulous bloggers and pundits. The real action takes place elsewhere, and much later, when no one is even paying attention. The GOP doesn't want deregulation and the Dems don't want regulation. Both want to use political power to advance the interest of their favored groups--often shared by both parties.

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COMMENTS (9 to date)

And if anyone isn't aware yet, all the detail one needs to support what Scott is concluding, is in Calomiris and Haber's Fragile By Design: The Political Origins of Banking Crises and Scarce Credit.

Bill Woolsey writes:

And in the final analysis, does the Fed listen to Congress, or to elite macroeconomist opinion?

Joe Cushing writes:

"The Great Recession led to a lot of "if only" comments. If only we could charge a negative interest rate on reserves, to discourage banks from hoarding excess reserves"

I see this as a way to boost government spending beyond its ability to borrow by pumping out new currency and not letting it flood the market causing huge amounts of inflation. The Fed has bought so many bonds as of late that if they didn't pay interest, inflation would be huge.

Joel Aaron Freeman writes:

I would be hesitant to assume the politicians are trying to placate special interests. Bad regulation can arise from rent-seeking behavior, but sometimes bad regulation also comes from simple ignorance.

All of us here believe that such an extreme market failure could only be caused by government-enforced incentives.

But if you're someone who believes that markets miraculously explode at irregular intervals because of unpredictable spikes in human greed, and thats the lens through which you view the world, then strengthening the relationship between the government and Fannie Mae would be logical.

Jeff writes:

The comment spam above is remarkably on point.

[*laugh* Yeah, but it still had to go. For those who didn't see it, it was a scam ad for loans for people in financial difficulty.--Econlib Ed.]

Greg G writes:


--"if you're someone who believes that markets miraculously explode at irregular intervals because of unpredictable spikes in human greed"

That sounds like a straw man version of Minsky's theory that stability itself is destabilizing to financial markets - which is just another way of saying that boom and bust cycles are natural.

I am not aware of any serious economist who thinks that sudden changes in human nature cause financial crises.

Minsky's point is that steady economic growth rewards risky finance. Then as those who have engaged in risky finance become a higher percentage of the recently successful, risky finance becomes more widely accepted and practiced and viewed as, not just safe, but wise. As risky finance becomes more widespread, fragility increases in the overall financial system.

The portion of human nature occupied by greed does not have to change for opinions to change radically about which financial risks are prudent.

"All of us here" don't believe the same thing apparently.

Scott Sumner writes:

Bill, Good question--I lean toward elite macroeconomist opinion.

Joe, It's not clear how IOR helps the Congress spend more, it is costly for the government.

Joel, I don't agree. If Congress truly believed that "more regulation" was the answer, they obviously would have banned subprime mortgages. But they instead decided to encourage them.

And they are not supporting Fannie and Freddie.

Greg, The Minsky theory you describe makes much more sense for a gold standard than for a fiat money regime.

LD Bottorff writes:

I am not normally a "follow-the-money" ranter, but I believe that the National Association of Realtors is one of the top political donors.

Brendan writes:

Scott's right. The whole reason behind the Great Recesson was perverse incentives brought on my housing subsides to encourage banks to invest in underserved communities -- you know the ones whom shoudn't even get loans since they can't get loans. And not to mention politicians pandering to populist sentiment as Haber backs up in Fragle by Design.

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