Scott Sumner  

Two new picks for the Fed?

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The NYT reports that President Trump is about to nominate two people for the Board of Governors:

The Trump administration has selected candidates for at least two of the three open positions on the Federal Reserve's Board of Governors, according to people with direct knowledge of the decision.

The expected nominees include Randal K. Quarles, a Treasury Department official in the George W. Bush administration, and Marvin Goodfriend, a former Fed official who is now a professor of economics at Carnegie Mellon University.


Here is a WSJ piece written by Randal K. Quarles and Lawrence Goodman:

Focusing on bank size is politically appealing but diverts attention from the major source of systemic risk in the financial sector: a shortage of stable deposits. Banks are but one part of an interconnected financial sector providing over $40 trillion of credit to the economy, but that credit is supported by only about $11 trillion of bank deposits.

The gap must be closed largely with professionally managed, "wholesale" funding, such as short-term repurchase agreements. Wholesale funders are quick to pull their support by not rolling over short-term credit if they perceive those funds are at risk. This leads to periodic runs on financial institutions and the resulting demand for government intervention to prevent the failure of those institutions. . . .

Mr. Kashkari's alternative proposal, promoted by academics including most vocally Stanford economist Anat Admati, is to ramp up bank capital to such a degree that the possibility of failure would be remote to nonexistent. But the consequence of a dramatic increase in bank capital is an increase in the cost of bank credit, meaning higher interest rates across the board. Those who favor much higher bank capital argue this would not happen, because investors would accept lower returns if the banks they put their money in were safer.

In the real world of capital markets, however, there are not enough natural investors in bank equity seeking utility-like returns. Institutions capitalized largely with debt would encounter similar constraints.

Given these structural facts, the job of the regulatory system is clear. First, facilitate the reallocation of capital during the inevitable periodic crises through orderly liquidation of failing or failed banks. Second, adopt a monetary policy rule, such as the Taylor rule, that would normalize interest rates and reduce the incentive for big banks and even smaller institutions to take dangerous risks.


This completely misses the point. The problem with our banking system is not that wholesale funding that is susceptible to bank runs---the Fed can provide almost unlimited liquidity in an emergency---the problem is excessive risk taking with FDIC-insured deposits. Quarles doesn't seem to recognize the role of moral hazard in making the banking system less stable.

Even worse, he suggests that monetary policymakers should worry about excessive risk-taking when deciding where to set interest rates. If interest rates had been set according to the Taylor Rule during the recovery from the Great Recession, we'd still be in recession. Indeed the ECB made a similar mistake in 2011, raising rates during a weak recovery, and thus precipitating a double dip recession.

This part of the NYT story also raises some concerns:

At the Fed, Mr. Quarles would take the place of Daniel Tarullo, who led the Fed's push to tighten financial regulation after the 2008 crisis, though he was never formally nominated to serve as the vice chairman for supervision.

Mr. Quarles is regarded as significantly more sympathetic than Mr. Tarullo to the industry's concerns that regulation is overly restrictive, limiting economic growth.


Deregulation of banking would be a great idea, once we've solve the moral hazard problem. Unfortunately the American banking system doesn't want to solve the moral hazard problem, because that would be "costly". Yes, but wasn't the 2008 financial crisis also sort of costly?

The good news is the pick of Marvin Goodfriend, who is a superb monetary economist and well qualified to serve on the board. Don't pay attention to discussion of "doves" and "hawks", which are pretty meaningless terms in a world of 2% inflation targets. Rather there are economists who take seriously the Fed's responsibility to provide nominal stability, and those who do not. Goodfriend is most certainly in the former group.

PS. I'd expect Miles Kimball to be pleased about Goodfriend, who is (AFAIK) the first economist to propose negative IOR.

PPS. The NYT also has this interesting tidbit:

Mr. Quarles, 59, is a managing director at the Cynosure Group, a private equity firm based in Salt Lake City. His wife's great-uncle is Marriner Eccles, the Fed's chairman from 1934 to 1948 and the namesake of the Fed's marble headquarters on the National Mall in Washington, where Mr. Quarles would have an office.
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HT: Tyler Cowen


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COMMENTS (6 to date)
Kurt Schuler writes:

Lehman Brothers, AIG, and money market mutual funds were not commercial banks, hence they had no FDIC guarantee, yet they too suffered the equivalent of runs. The Lehman Brothers run triggered the global financial crisis. The problems of AIG and the money market mutual funds were sufficiently worrying that the U.S. federal government intervened to prevent them from spreading. So yes, the greater mobility of wholesale funding is a concern.

AlanG writes:

I agree with what Kurt Schuler writes above. FDIC insured deposits are really a drop in the bucket compared to all of what the major banks hold. Probably 90% of all Americans don't have enough money to breach the current FDIC deposit limit and the "moral hazard" for big banks is really not with the small depositor in the same way as it was back in 1930.

Maybe it's time to rethink this and wall off FDIC insured deposits either by bank size or corporate entity (e.g., have a separate division within Chase/Wells/Citibank that handles only FDIC deposits) where those funds can more easily be protected.

I worry less about the FDIC problem than I do about the investment activities of the large banks which are usually opaque (and yes I do have equity holdings in one major bank). I'm not sure that any regulatory regime will work very well these days given the heterogeneity of the financial system in the US and elsewhere.

Scott Sumner writes:

Kurt, Investors thought (wrongly) that the government viewed Lehman as too big to fail. The government did view AIG and MMMFs as too big to fail. So even in those cases we had a serious moral hazard problem. But yes, it was not all FDIC.

The GSEs were also a big problem, again due to moral hazard.

Scott Sumner writes:

Alan, As long as taxpayers are not on the hook, the big banks can take all the risks they want. It's not my problem.

The problem is moral hazard. End FDIC and TBTF, and the banking system can be completely deregulated.

Randomize writes:

AIG is a strange case in that it provided huge amounts of insurance to the FDIC-insured banks. Had AIG gone under, how many FDIC-insured banks and their accounts would have followed it? The treasury is smart enough to do the math and realize that bailing out AIG was cheaper than bailing out all those personal checking accounts.

Kurt Schuler writes:

Okay, Scott, you have changed the focus of your position from the FDIC to too big to fail. But I do not see evidence that AIG or especially the money market mutual funds were expected to need government support. In fact, the money market mutual funds were not regulated like banks because supposedly they were pure equity investments. It also seems contradictory to criticize too big to fail on one hand while saying on the other that the Fed can provide almost unlimited liquidity in an emergency. Almost unlimited liquidity is what makes too big to fail possible.

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