Make Failure Feasible and End “Too Big To Fail”

Today the Senate held a hearing on a bankruptcy reform proposal which would address the problem of too-big-to-fail head on. The reform applies to large financial firms and makes failure feasible under clear rules without systemic spillovers thereby greatly reducing the likelihood of government bailouts.  Much work has been devoted to this proposal, including at the Resolution Project directed by Ken Scott at Stanford’s Hoover Institution, where a third book on the topic is coming out with this suggestive cover (two of the co-editors, Tom Jackson and I, testified at the hearing: Tom’s testimony and my testimony).Making Failure Feasible_cover

And it is very encouraging that there are now two good reform bills, “The Taxpayer Protection and Responsible Resolution Act” in the Senate and “The Financial Institution Bankruptcy Act in the House,” which incorporate the idea.

While traditional bankruptcy has many benefits, including its basic reliance on the rule of law, it has shortcomings, perhaps the most important being that it is difficult both to resolve a failing institution and stop a run on it. To deal with the shortcoming, a new chapter is needed—it’s called Chapter 14 because there is no such chapter in the bankruptcy code now. Chapter 14 could be implemented over a weekend, and it would leave operating subsidiaries outside of bankruptcy entirely. It would do this by moving the original financial firm’s operations to a new bridge company that is not in bankruptcy.  This bridge company would be recapitalized by leaving behind long-term unsecured debt (capital structure debt).

The aim is to let a failing financial firm go through bankruptcy in a predictable, rules-based manner without spillovers while people continue to use its financial services, just as people flew on American Airlines planes, bought Kmart sundries and tried on Hartmax suits when those firms were in bankruptcy. To understand how a reformed bankruptcy code would resolve a large financial institution, Emily Kapur of Stanford has examined how it would have worked in the case of Lehman in the book Making Failure Feasible. Her summary of the analysis is attached to my testimony.

In my view Chapter 14 would work much better than Title II of Dodd-Frank where the FDIC would have to exercise considerable discretion, and the resulting uncertainty might lead nervous policy makers to resort to massive bailouts.

Chapter 14 would also facilitate resolution planning under the Dodd-Frank Act. The resolution plans submitted by the large financial firms have thus far been rejected by the Fed and FDIC as infeasible. With Chapter 14 the plans could be feasible.

In sum, reform of the bankruptcy law is essential for ending government bailouts. If accompanied by an increase in capital and capital structure debt, such a reform would go a long way toward ending too-big-too-fail.

Posted in Financial Crisis, Regulatory Policy

Does the Fed Have a Monetary Policy Strategy?

The subject of a monetary policy strategy for the Fed came up in Congressional hearings I testified at today and last week.  Today the hearing focussed on the bill to require the Fed to describe its strategy or rule for the systematic adjustment of its policy instruments. Last week the hearing was on “Fed Oversight: Lack of Transparency and Accountability,” at which members of Congress expressed concern over transparency regarding an alleged Fed leak about quantitative easing.

At both hearings I argued in favor of the Fed publicly describing a strategy or rule and explaining whenever it changed or deviated from the strategy.  In my view, research and experience over the years show that a rules-based strategy leads to better economic performance.

A rules-based strategy also leads to greater transparency and helps prevent leaks in contrast to a strategy-free policy, as the controversy over the alleged leak in October 2012 illustrates. Decisions about the timing, amount, path, or exit from quantitative easing are inherently discretionary, and inside information about each decision benefits those who can get it.  If there were a clear and publicly announced strategy for setting the policy instrument over time—as is possible in the case of a conventional instrument like the federal funds rate—then information about policy would be widely available.

Some argue, however, that the Fed already has a strategy, pointing to the Fed’s “Statement on Longer-Run Goals and Monetary Policy Strategy” posted on its web site.  If you read the statement you will find that it does set goals for inflation and employment; it says that the Fed “seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level” (goals respectively defined as an “inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption” and a “central tendency of 5.2 percent to 5.5 percent” for the unemployment rate).

But despite the appearance of the words “monetary policy strategy” in the title, the statement does not contain any strategy for the instruments of monetary policy describing how they are to be adjusted to achieve the goals. As Michael Belongia and Peter Ireland put it “For all the talk about ‘transparency,’… the process—or rule—by which the FOMC intends to defend its two-percent inflation target remains unknown.”  At the least the Fed should report on a strategy or rule it uses as a basis for policy decisions. As is well known from Fed transcripts, the Fed uses policy rules and discusses deviations from such rules, so the Fed should report them as a matter of transparency.

Posted in Monetary Policy

A Deal and a Step to International Monetary Reform

I make the case in this Wall Street Journal piece and in more detail in Congressional testimony that there’s an opportunity for a deal between the Congress and the Administration on international monetary reform.  The case starts with perhaps the most obvious lesson from the Greek crisis: The IMF should not make loans to countries with unsustainable debt. Such loans bail out banks and often worsen the situation.

The IMF learned that lesson more than a decade ago and in 2003 adopted an “exceptional access framework” enshrining the rule of no lending to countries with unsustainable debt. There were few crises in emerging markets in the years following, and it seemed to work well.

But the rule was broken in 2010 when the Greek crisis came along.  Even though Greek debt was unsustainable, the IMF lent 30 billion euros anyway.  It wrote in an exemption to the rule for systemic risk, perhaps under pressure from private holders of Greek debt.

Following this 2010 decision, the Greek economy has deteriorated sharply and many private creditors were able to get out of Greek debt leaving the public sector holding the bag, as Benn Steil has dramatically shown.

Though the framework was broken in order to make the IMF loan to Greece, it remains broken as the exemption still applies.  So it is time to restore the framework and remove the exemption. There’s a lot of support for such a reform, but the US Treasury is resisting.

There is room for a deal here: Treasury wants Congress to raise the U.S. contribution to the IMF, but Congress is reluctant to do so with no framework limiting IMF lending. If Treasury agreed to restore the framework, then Congress could provide the support . This deal would be a first step in putting America in the lead again on international monetary reform.

Posted in Financial Crisis, International Economics

The Raisin Case: A Breeze not a Wind of Economic Freedom

The famous raisin case officially closed last week. As part of an old and ongoing government program to intervene in the raisin market to support the price, the government tried to take raisins away from a California raisin grower, Marvin Horne, and thus off the free market. When Horne and his family refused, the government assessed a huge fine and penalty. But Horne wouldn’t pay, and he went to court. His case eventually went to the Supreme Court. Last week the Court decided that “the Hornes should simply be relieved of the obligation to pay the fine and associated civil penalty they were assessed when they resisted the Government’s effort to take their raisins.”

It took ten years, but it is an important victory for the Hornes, and for my colleague Mike McConnell who represented the Hornes at the Supreme Court. And it is also a victory for economic freedom because it prevents the raisin program from intervening in the market in the way it has been for years (the program began with the Agricultural Marketing Agreement Act of 1937).  For these reasons the case has attracted a lot of attention (see Wall Street Journal opinion and news articles, and my blog pieces here with more references).  And it is kind of exciting that this is happening in this 800 anniversary year of Magna Carta which we celebrated at the Hoover Institution last week. Chief Justice John Roberts noted in the majority opinion that “The principle reflected in the [Takings] Clause goes back at least 800 years to Magna Carta, which specifically protected agricultural crops from uncompensated takings. Clause 28 of that charter forbade any ‘constable or other bailiff’ from taking ‘corn or other provisions from any one without immediately tendering money therefor, unless he can have postponement thereof by permission of the seller’….The colonists brought the principles of Magna Carta with them to the New World, including that charter’s protection against uncompensated takings of personal property.”

Unfortunately, however, the decision itself does not mean the end of the government program.  As Roberts stated in the majority opinion “A physical taking of raisins and a regulatory limit on production may have the same economic impact on a grower. The Constitution, however, is concerned with means as well as ends. The Government has broad powers, but the means it uses to achieve its ends must be “consist[ent] with the letter and spirit of the constitution.” McCulloch v. Maryland, 4 Wheat. 316, 421 (1819).”

In other words, according to Roberts, it is not inconsistent with the Constitution to regulate the amount of land that can be used in the production of raisins and thereby try to affect the price.  So, as legal scholar Richard Epstein (also a colleague) said at the conference on Magna Carta, regulatory limits are still permitted, and “we will have to wait and see” what other cases might be brought. Indeed, many interventions in agriculture involve regulatory limits or set asides of land rather than outright takings of crops.  So in this more fundamental way economic freedom can still be infringed upon, creating inefficiency and deadweight loss, as we show in Economics 1.

For many years in Economics 1, I have used the California raisin program to illustrate the impacts of government intervention, dressing up as a California raisin and dancing to Marvin Gayes’ “Heard It through the Grapevine” to show how crazy the policy is. Perhaps I should get into my California Raisin outfit again and try to turn this breeze into a wind, and really end the program.


Posted in Regulatory Policy, Teaching Economics

Growth Accounting for a Liberated Recovery

For several years I’ve argued that economic policy is holding the economy back and that a return to the principles of economic freedom would recreate a fast-growing recovery. It’s the subject of my book First Principles, of blogs and a recent Wall Street Journal column A Recovery Waiting to Be Liberated.

Because the economy has crawled along at such a slow pace for so long during this recovery, it has features of an economy at the bottom of a recession ready for a post-recession acceleration. The resulting gap of unrealized potential creates the possibility of rapid growth for at least 5 catch-up years, if there is a change in policies. And at this stage in the cycle, this means largely supply-side policies.

To see how this would add up, one can use basic growth accounting, noting simply that the growth rate of real GDP is the sum of two components: employment growth and labor productivity growth.

Reversing the decline in the labor force participation rate—it fell every year of the so-called recovery from 66.0% in 2008 to 62.9% in 2014—would cause a 5 percent increase in employment, or 1% annual growth for 5 years. Adding in about 1% for population growth from Census projections, gives employment growth of 2% per year. Some argue that the recent decline in labor force participation is simply due to the baby boom generation retiring, but the decline is larger for teenagers and young adults and has even increased for those of retirement age.

Reversing the recent productivity slump—it’s been growing at barely 1% recently—would bring productivity growth of 2.5% per year, the average over the past 20 years. Some argue that faster productivity growth is a thing of the past. But the IT revolution, which has been key driver of productivity growth during high investment periods, is not over as is clear from the innovative changes coming out of the high tech sector.

If we add these two components together—productivity growth of 2.5% and employment growth of 2%, we get real economic growth of 4.5%, at least for a number of catchup years, or more than double the average growth during the recovery. Economic policy–and again it’s mainly supply side policies now–should focus on these two components.

Posted in Slow Recovery

Stanford’s Economics 1 Course Open and Online

This summer Stanford will be offering an open online version of my on-campus course Principles of Economics.  People can find out more and register for the course, Economics 1, on Stanford’s free open on-line platform. The course starts on Monday (June 22). The  first week’s lecture and study materials are now posted.

The course is based on my lectures in the on-campus Stanford course. Each day after giving a 50-minute lecture, I recorded the same lecture divided into smaller segments for easier online viewing. Graphs, photos, and other illustrations appear as in the lecture. Moreover, we captioned and indexed the videos and added  study material, readings, reviews, quizzes, and discussion groups to the platform to make it a complete self-contained course.

The course covers all of economics at a basic level. It stresses the key idea that economics is about making purposeful choice with limited resources and about people interacting with other people as they make these choices. Most of those interactions occur in markets, and this course is mainly about markets, including the market for bikes on campus, or labor markets, or capital markets.  We will show why free competitive markets work well to improve people’s lives and how they have removed millions from people from poverty around the world, with many more, we hope, still to come.

People who participate in the open online course and take the short quizzes following each video will be awarded a Statement of Accomplishment, or a Statement of Accomplishment with Distinction.

The course also runs parallel with a for-credit Stanford Economics 1 course that also includes a midterm test, a final exam, problem sets, and homework, which are all graded and count toward a final grade and Stanford course credit. The for-credit course is offered online to matriculated Stanford students, incoming freshman, and visiting students in the Stanford Summer School.

As explained in this Wall Street Journal article, Stanford’s experience with Econ 1 online has been very good, and, of course, that’s the reason for offering this summer.

Posted in Teaching Economics

Too Low For Too Long Or Global Saving Glut? Both!

In an interesting new paper, “The U.S. Housing Price Bubble: Bernanke versus Taylor,” forthcoming in Journal of Economics and Business, Abrar Fitwi, Scott Hein, and Jeffrey Mercer examine two possible causes of the housing price boom that preceded the financial crisis. One, which I explored in a paper for the 2007 Jackson Hole conference, argues that the Fed’s unusually low interest rate during 2003-05 was a factor. The second, put forth by Ben Bernanke in a speech to counter that view given at the 2010 American Economic Association meetings, argues instead that a global saving gut led to a capital inflow driving down U.S. interest rates, including mortgage rates.

Fitwi, Hein, and Mercer step back from the debate as impartial referees—noting that there is “no unanimous agreement on either claim” and that it is important to know “more about the factors that led to one of the worst financial crises of modern time”—and proceed to test both hypotheses.

What do FHM find?  That both hypotheses are right! Expanding on a statistical regression analysis used by George Kahn they show that “Taylor rule deviations” are a statistically significant factor in the housing price acceleration, but they also add “capital inflows” from abroad to the regression and show that these are also significant. So they “find evidence consistent with both factors’ contributing significantly to the recent macro-housing price behavior in the U.S.”

The paper has a good literature review, and clearly exposits the methodology, clarifying, for example, that the objective of the original Taylor rule was “normative, to characterize how the Federal Reserve SHOULD adjust interest rates.” As the authors argue and empirically show in this case, it is possible that there were two factors behind the housing boom, and of course there could have been more than two: Peter Wallison points to the role of Fannie and Freddie and I have pointed to lax regulation.

Moreover, the various causes could be inter-related and this raises a question about the paper that suggests additional future research: Could the capital inflows examined by the authors have been caused, at least in part, by the low interest rates, as much as, or even more than, a global savings glut in ways that the regression might not pick up?

To see this consider the following chart which shows the US current account balance along with the capital inflow series.  The capital inflow series in the chart comes directly from BEA—called incurrence of liabilities—because the St. Louis Fed FRED data base has discontinued the series that the authors used. There is definitely a bulge in the capital inflow series during 2003-2006, the time of acceleration in the housing price boom, which corresponds to the statistical significance in the FHM regressions.

i and ca

But much of that bulge can’t be explained by the current account deficit (saving glut from abroad in Bernanke’s terminology) which is on a long downward trek during this period.  Claudio Borio and Piti Disyatat have made similar points. As an accounting matter, the capital inflow must also be related to capital outflows—acquisition of assets—as shown in the next chart by the blue line.

i and a

There is a bulge in capital outflows also about the time of the low federal funds interest rate and could reflect a “search for yield” outside the US.  The largely matching changes in capital inflows could reflect efforts of emerging market countries to prevent their exchange rate from appreciating by intervening in the exchange markets and buying dollar denominated debt, including mortgage backed securities.

In my view, we need more empirical work of the kind in the Fatwi, Hein, and Mercer paper to resolve these intricate causality issues.

Posted in International Economics, Monetary Policy