Bankers' Pay Revisited

Yet again the debate on bankers’ bonuses has taken an ugly turn, with ostensibly sober commentators getting caught into the populist flow…

…Which is really too bad, as op-eds like this are a missed opportunity to inform the public about the fundamental problems in the financial sector (of which compensation is a by-product) and build support for policies to address them.

It’s in this latter spirit that I’ll raise here three key questions on bankers’ pay and hopefully offer some food for (constructive) thought/policy:

1. Are bankers paid too much, at the expense of their firms' shareholders? In other words, do bankers grab a bigger share of their firms’ profit pool than they are warranted by the objective of maximizing shareholder value?

2. Since taxpayers are called, now and then, to foot the bill of keeping one or more banks alive, should executive pay be so regulated as to control risk-taking by individual employees?

3. Are bankers paid too much…. full stop?

I’ll start with (2), which is the easiest to answer in my view: So.. I don’t think so. Or, at least, not beyond what the Fed’s recent proposal tries to achieve, which is to get bonuses to reflect the risks of employee activities, and to use longer periods for measuring performance for bonus purposes. But beyond this, preventing the next financial failure rests predominantly on improvements in firm-wide (and industry-wide) monitoring and management of risks.

The challenges here are vast: From developing better tools to measure risks more accurately; to appropriately monitoring risks across different business units (e.g. to avoid “balance sheet arbitrage”-type activities like those of AIG); to designing appropriate counter-cyclical capital requirement ratios... There is also a case (which I discussed here) for making financial institutions pay an insurance fee against future failures in the sector (à la FDIC deposit insurance fee).

Provided we can address these challenges, regulating executive pay is almost redundant as a tool to protect the taxpayer.

Then comes the question of whether bankers are paid too much at the expense of shareholder returns—by which I mean both absolute and risk-adjusted returns. One way to go about answering this question is to look at the volatility-adjusted excess returns (the Sharpe ratio) of financial firms vs. the market's.

My focus here is on "the stress-tests 19 ex-GMAC" rather than the entire financial sector, which includes small regional banks with no "bailout" and no “bonus issue”. I look at the period from November 1999 onwards, when the Glass-Steagall Act was repealed, though the results broadly hold for longer periods.

Turns out the majority of these institutions have outperformed the S&P 500, both in absolute and volatility-adjusted terms. Indeed some have done exceedingly well, with Sharpe ratios of four (JP Morgan, BofA) to 15 (Goldmans) times higher than that of the S&P500.

One eyecatching underperformer is Citi, which, provocatively, went on giving out fat bonuses as late as end-2007. The likes of SunTrust, Regions and KeyCorp have also trailed the S&P500. As simplistic this exercise is, it does suggest that, in many cases, the size of bankers’ salary pools has not at all compromised financial firms’ ability to reward their shareholders competitively.

One caveat of course is that realized volatility is only a partial measure of ex ante risk: Arguably, the government’s financial rescue helped avert a much more disastrous outcome than shareholders experienced. In other words, the “true” risk adjusted return was much lower ex ante, esp. if one were to include tail risks.

I buy that.. Still, a financial sector collapse would have probably meant a disaster for the entire economy and every firm in it, from retailers to car-makers to pharmaceuticals, due to the ensuing credit crunch. So it's uncertain how such an outcome would have affected relative performance.

Importantly, the implications for the level of executive pay are unclear: It’s not the level per se that is important for managing risk, but the structure of pay incentives. Even more critical is the ability of financial firms (and their regulators) to monitor risk at the firm/industry-wide level, as I argued earlier.

So then we come to the question of whether bankers are paid “too much…full stop.” The knee-jerk response of many an inhabitant of Main Street (“YES!”) is driven by the large wage differentials between finance professionals and employees in many other industries. These differentials are an empirical fact, even for workers with similar skills and even after correcting for “compensating factors” (e.g. unfavorable working conditions).

Literature offers a number of explanations: Different incentive conditions between sectors leading to different levels of efficiency wages; “unobserved abilities” by employees in highly-paid sectors; weak coordination of wage bargaining across sectors, leading to disparities in the share of industry rents going to employees; and variation in the profits of different sectors (allowing profitable industries to pay their workers more).

Here I’ll focus on the latter, because it is the most relevant for our “too much” discussion: If it is indeed large rents in the finance industry that drives bankers’ pay, could it be that financial institutions make too much profit?” Or, if you like, “Is there too little competition in the financial sector?”

Here is where things get tricky: Assessing the competitive environment in the financial sector is extremely difficult (see a nice discussion on this by Stijn Claessens here). Importantly, unlike many other industries, the “optimal” level of competition depends on balancing what are often competing objectives: The desire to improve access to financial services for a wide range of firms and households at low cost; foster product innovation; and ensure financial stability. The increasingly complex and evolving structure of financial institutions and the presence of scale economies and network issues complicate the task further.

This does not mean that policymakers should give up trying… on the contrary. In my view, a comprehensive assessment of the benefits and costs of the sector’s existing market structure, and the identification of measures to improve it (with both the stability and the access/efficiency objectives in mind) should be a top policy priority. Instead, what we’re getting these days are rash proposals to potentially limit banks’ size based on too-big-to-fail considerations, which completely miss the broader point of what is an “optimal” market structure.

Bottom line… Whatever the problems with bankers’ pay, they are the by-product of more fundamental problems in the financial sector as a whole: Inadequate risk-management and monitoring systems, unskilled (or complacent) and fragmented regulators and, possibly, a sub-optimal market structure.

So rather than going for the easy targets to appease a blood-thirsty audience, governments and journalists alike had better re-focus their efforts on policies that truly matter.

The Good, and the Quick ‘n Dirty

You look at the key housing indicators and you’re probably thinking the government’s homeowner support plan has got to be working… mortgage rates at record lows, house prices stabilizing, inventories coming down, new home sales (begrudgingly) crawling upward.

Yet, it all depends on how you define “success”… there is "temporary feel good" success… "clean up now, pay later" success… "everything/everyone but the kitchen sink" success… and success as in "targeted help to the neediest" and "permanent solutions to the root problems."

I fear that only a teeny portion of taxpayer money has gone towards this latter type of success. To see why, one has to judge whether the government’s measures are geared towards tackling the root problems in the housing sector; whether they are cheaper compared to alternatives; and whether they target the neediest.

By "root problems" I mean the excessive supply of homes for sale, demonstrated by the record housing inventories back in 2007/08; and the excessive mortgage debt taken on by people who could not afford it.

By “neediest” I mean households at high risk of foreclosure with too few resources to either relocate or trade down. In turn, by “high risk” I mean households with negative equity and a meaningful cashflow problem (e.g. due to the loss of employment or the sudden increase in their monthly mortgage payments).

The "and" is critical for identifying the neediest: According to research by the Boston Fed (here and here), negative equity alone is not sufficient to prompt walk-outs, as many have argued/feared (unless it’s at egregious levels and the homeowner does not expect to return to positive equity within a reasonable horizon). A cashflow problem is also necessary.

So now let’s take a look at the government measures:

First, you have the Fed’s purchases of mortgage backed securities (MBS) (Cost: To be determined). The purchases have boosted MBS prices, allowing MBS investors to make nice profits. Higher MBS prices have also meant record-low mortgage rates, encouraging purchases of new homes or the refinancing of existing mortgages.

The scorecard? Mixed at best. For starts, the program fails to target the neediest. Those refinancing or purchasing new homes are people who can afford to do so. OK, you might say, but doesn’t this help clean up the large housing inventories? Perhaps… but inventories can also be reduced by letting house prices fall sufficiently, instead of propping them up with artificially low mortgage rates.

Indeed, I’d say that letting prices fall would be preferable, given the fiscal cost of the likely losses on the Fed’s MBS portfolio; the complications for the conduct of monetary policy; and the empirical evidence that lower house prices alone do not prompt walk-outs by the buckets, unless there is a also cashflow problem.

OK OK, but surely the profits to MBS investors can’t have hurt, given the dire state of the financial industry last year? Yeap, profits are nice, but… MBS (and other asset) prices would equally respond to measures tackling the root problem: Excessive leverage in the household and financial sectors. Financial-sector leverage was partly addressed by the capital increases dictated by the stress tests. In contrast, VERY little has been done to reduce household leverage.

Moving on to the measures by the Treasury:

First-time home buyer credit (Cost: $14 billion so far, per the CBO): Originally the scheme offered tax credits to new home buyers, but was recently expanded to also cover long-time homeowners and/or homebuyers with higher incomes! The scorecard? Thumbs down! Yet again, the measure does not target the neediest, fails to address the leverage problem and artificially props up house prices.

Support to Fannie and Freddie (Cost: $96bn of cash infusions and $43bn of subsidies in 2009 alone, per the CBO): The idea here is that Fannie and Freddie buy more mortgages from banks (thus allowing banks to extend more mortgages); and facilitate securitization and onward MBS sales to investors by providing guarantees that insulate MBS buyers from the risk of default.

The scorecard? Thumbs down… big time! The measure fails to benefit the neediest, fails to reduce household leverage and, on top of that, is aggravating the fiscal hemorrhage, since we have yet to see *a* plan for the institutional resolution of Fannie and Freddie.

The only program providing targeted help is the Home Affordable Modification Program (or HAMP). HAMP has allocated up to $75 billion to finance the modification of primary-residence mortgages owed by people in financial hardship. But progress has been painfully slow—the CBO estimates that only a tiny portion of HAMP resources have been spent this year. (The Treasury's latest progress report on HAMP shows 651,000 active trial and permanent modifications as of end-October 2009).

Part of the problem is that HAMP rests on the collaboration of mortgage servicers, which slows down the process, on top of limiting the amount of relief provided by the modification (e.g. due to “net present value rules” in the servicing agreement). The latter is crucial since, the lower the relief, the more likely a household will eventually fall back into arrears.

What I would have liked to see instead is true relief to low-income households with little home equity and a serious cashflow problem. If the hardship is due to employment loss, monthly grants would be offered to reduce a homeowner’s mortgage burden until s/he finds another job. If the cashflow problem is due to a jump in the monthly payment (e.g. due to an unaffordable ARM mortgage obtained through predatory lending), the relief should be permanent. But to avoid the risk of the homeowner pocketing the taxpayer money and then selling the home at a profit, help should take the form of monthly grants instead of one-off debt relief.

By my count, this relief would be targeted, tackle the leverage problem and would likely be swifter by avoiding the intermediation of mortgage servicers. It would be fiscally responsible by foregoing blank taxpayer checks to people with comfortable incomes. It’s also pretty obvious… which makes it all the more astounding why the government has chosen to bypass a good solution, opting instead for the quick ‘n dirty!

On Carry and Other Tales...

I’m amazed with the number of academics, journalists and “pundits” in my field who keep on talking about “the carry trade” as if it’s some sort of cult… “The end of carry as we know it”… “Carry-trade silence”… “Carry makes a comeback!”…

Since last week, the carry trade has also found a mother, a father and some heavyweight patrons (like the Fed) who, apparently, keep on feeding it to monstrous and potentially self-destructive proportions.

I want to use this post to respond to some of the points raised in these op-eds, notably with regard to the role of policy in feeding carry trades and, in turn, asset bubbles. But before I get there, let me deal with the cult notion first...

The carry trade is NOT a cult… “Carry trade” is another way of describing “risk-taking” in financial markets. Anyone who invests their money in anything riskier than a safe, cash-like asset (e.g. US Treasury bills or money market funds) is effectively a carry trader: They are short cash and long a risky asset such as a stock, a corporate bond, a foreign currency, etc.

Indeed, the term “carry” is a literal description of that risk-taking process: When you buy shares in Microsoft, for example, you decide to forego the safety of a US T-bill and instead “carry” the risks embedded in Microsoft’s stock: Risks related to the company’s management, its capital structure, the growth and/or regulatory outlook of the IT industry and so on. Similarly, investors in a foreign currency have to “carry” risks related to the foreign country’s external imbalances, inflation prospects, politics, etc.

Now, to be fair, what many refer to as “carry trades” in the press are leveraged investments. In the above examples, investors use their own capital to make the risky investment. But when they are leveraged, they borrow multiples of their capital short-term and invest the funds in higher-yielding products (e.g. asset-backed securities or currencies like the Brazilian real) to make the spread.

The principle is exactly the same as before—risk taking—only that the use of leverage helps multiply profits in good times (and totally destroy them in bad times!).

OK... now to 2009. Since March this year, most risky assets have seen stellar returns, be it global stocks, corporate bonds, emerging market assets, higher-yielding currencies, etc. How big a role has the “carry trade” played in driving this price action?

Let’s see… One important driver has been the positive surprises in some parts of the real economy (remember those “green shoots”?) As a result, investors revised upwards their baseline forecasts on the economy. In statistical terms, their distribution of expected returns shifted to the right (i.e. a higher mean).

A second driver was the Herculean backstop measures by governments and central banks the world over, aimed at eliminating extreme downside risks. These basically cut off the left (negative) tail of investors’ expected-return distribution.

Neither of these can be said to have encouraged “carry trades” in the leveraged sense. But by shifting the distribution of expected payoffs from risky assets in a favorable way, both factors encouraged (some) investors get out of safe assets and take on risk.

Then you have the Fed’s (and other major central banks’) low-for-long interest rate policy. Is that contributing to “carry trades” and/or to asset price bubbles? There are at least three ways in which the low-for-long interest rates can impact asset prices:

First, the policy “condemns” investors to earning near-zero return on their cash assets for an extended period. This, together with a restored confidence, helps push investors out of zero-yielding cash towards riskier assets.

Asset flow data are supportive of such shifts, but it is important to understand that the low interest rate is only one of the drivers: Factors that changed the mean and the shape of the expected return distribution were arguably more important—recall that in the midst of the panic of 2008, investors were willing to sit on US Treasuries with negative (but certain) yield!

Second, the low interest rates are helping asset prices by boosting the profitability of banks. Think about it: Banks borrow short-term (e.g. depositors’ money or in money markets) and invest in long-term, higher-interest-rate assets like corporate or mortgage loans.

By fixing their borrowing rates at near zero, the Fed is helping banks make profits even in a difficult lending environment. In turn, this helps prevent the negative feedback loop we saw last year, when financial institutions fire-sold their risky investments to preserve their capital, driving down asset prices.

Third, the low-for-long rate can arguably encourage the fresh build up of leveraged carry trades: Investors could borrow short-term at low rates and invest in riskier assets like equities.

Maybe… but… Evidence of such leverage is lacking: Flow of funds data show that the liabilities of the US financial system on aggregate actually declined in Q2 2009--even as new capital was raised. True, we don’t have data yet for Q3, when asset prices kept shooting higher. But then, please, show me data that point to an ongoing “highly leveraged carry trade”! I’d love to see them, along with many in the markets who try to assess systemic risk on a real-time basis!

Even (even) if leverage were indeed occurring, the point that “traders are borrowing at negative 20% rates to invest on a highly leveraged basis on a mass of risky global assets” is grossly unfair: The “minus 20%” is the ex post cost of borrowing in dollars to invest in a basket of major foreign currencies, following the dollar’s depreciation since March.

But this ex-post analysis completely ignores the tremendous amount of uncertainty surrounding investors’ forecasts back then. No offence to my female cohorts in the industry, but it took gigantic balls to re-enter that market, especially when a LOT of asset managers were already deep underwater and capital preservation was the ultimate priority.

So to recap—low interest rates are just a small part of a broader set of policies and real-economy data that have helped boost asset prices since March. Importantly, based on available data, leverage has yet to manifest itself as the key driver of the price action.

Now, this doesn’t mean that systemic risk is not rising. In fact, IF that were so, the Fed should take notice. But is that so?

Some cite as evidence of systemic risk the high correlation between different risk assets recently (equities, commodities, EMs, etc). I’m not convinced: Since everything collapsed in tandem last year, the recovery in risk appetite should make everything recover in tandem. In other words, the high correlation is not necessarily a cause of alarm at this juncture.

Still.. high correlation means that, if there is a negative surprise, risk assets will all move down in tandem again. Which would be pretty bad! But here is the real crux of the debate: Have the prices of risky assets already moved “too much, too soon, too fast”? Are we already in bubble territory and, hence, at risk of a sharp correction as soon as “reality” strikes?

Well, it depends on your outlook of “reality” in the coming months/years, and on your framework for translating that outlook into a forecast for asset prices. It could indeed turn out that the world is in much worse shape than the average investor thinks (/hopes!)

But let’s get this straight: It is one thing to claim that current valuations reflect forecasts that are overly optimistic given the “true” state of the economy; and it’s another thing to say that the Fed’s low-for-long interest rates are feeding highly leveraged carry trades, which are in turn feeding asset bubbles.

I personally see the Fed’s promise of low interest rates for an extended period (or the ECB’s term lending at low fixed rates) as a plea to investors to take on risk. The idea is to help assets reflate; support consumption through positive wealth effects; and help lending to the real economy through positive valuation effects on collateral.

Investors are slowly heeding, taking on more risk, some even levering up—but still in an environment of heightened uncertainty about the future. We’ll find out “the truth” about the future when it happens. And some will get the chance to say “I told you so!”. But given the scale of today’s uncertainty, nobody can credibly claim that investors (or “carry traders”) are taking on risk for free!

PS My apologies to those who have recently received some of my old posts, looks like Blogger has gone about recylcing old ideas, please ignore them if they recur, I seem to have no control over this!

What Triffin dilemma?!

Time and again you read these days many a commentator arguing that the recent global imbalances have been the inevitable corollary of the dollar’s role as a reserve currency.

It’s the Triffin dilemma, they say, after economist Robert Triffin, who, back in the 1960s, maintained that the country issuing the global reserve currency must be willing to run trade deficits, in order to supply the world with enough of its currency to meet the global demand for reserves. The “dilemma” arises from the fact that, the more dollars, say, are supplied to the world through US trade deficits, the more the value of the dollar is undermined, threatening its role as a reserve currency.

So, as it happens, I disagree both with Triffin (notwithstanding his Yale credentials)… as well as with the premise that it’s that very dilemma that has led to the global imbalances we still see today. Here is why…

First, probably a lesser point but, as a matter of principle, the supplier of the reserve currency (let’s call it United States) doesn’t have to run trade deficits. Countries wishing to accumulate FX reserves can do so by accumulating foreign liabilities. China’s central bank, for example, can buy the dollars entering China through foreign direct investment, and invest these in US Treasuries. Alternatively, countries can borrow dollars long-term from the official sector or even the private sector, and keep them invested in Treasuries in case there is a crisis.

Understandably, the latter (ie borrowing) option is anathema to most countries, due to the implicit or explicit conditions attached to these loans. Similarly, countries may need to hold more precautionary reserves than the foreign currency entering their market in the form of more stable, long-term liabilities such as FDI. So what’s the alternative?

It’s what some emerging markets have been doing in recent years: Namely, accumulating reserves partly through running trade surpluses. But is that sufficient to undermine the value of the US dollar? Not necessarily.

The presumption that it “should” rests on the concept of external debt sustainability—i.e. the fact that a country cannot accumulate liabilities for ever. Countries that do, usually end up with their currencies depreciated, which helps correct the external imbalances through valuation effects on their external balance sheet. But here are a few caveats for the case at hand:

First, if it’s precautionary reserves that we’re talking about, emerging markets reaching the desired/”optimal” level of reserves would stop accumulating further dollars (beyond an annual “maintenance” amount proportional to the capital and trade flows into the country).

Second, even if the stock of (precautionary) reserves is large, this doesn’t mean that there are “too many” dollars floating around. Countries demand reserves for insurance purposes—i.e. the stock of dollar reserves is not used to splurge in European luxury goods or Brazilian bikinis, which could lead to the dollar’s depreciation. Instead, dollar reserves are saved (e.g. invested in Treasuries) and are ready to be employed if there is a sudden stop in capital inflows.

Even (even) if the dollar depreciated somewhat, that wouldn’t matter anyway—again, if it’s precautionary reserves we’re talking about; and if the bulk of a country’s external obligations (e.g. imports or debt payments) are also denominated in dollars. In other words, even if the dollar were to depreciate, this should not undermine its role as a reserve currency.

So done with the Triffin dilemma?

Not yet... we still we need to answer the question… has the dollar's status as reserve currency encouraged the circulation of “too many” dollars around the world? And if yes, was that inevitable, as per Dr Triffin?

To see if there are “too many” dollars on would need to check whether (a) the foreign private sector is flushed with more dollars than it wants or needs; (b) the foreign official sector (i.e. governments) hold excess reserves (ie reserves that would eventually be spent on goods and services). So what has been the situation in recent years?

Abstracting here from the post-crisis period, and the Fed’s massive dollar-supply operation, (a) does not seem to have been the case in recent years. Looking at the US international investment position, the net amount of dollars in private foreign hands (i.e. the US net liabilities to the foreign private sector) had actually been declining in US GDP terms since 2002 (and more so in global GDP terms, which is more relevant).

What have ballooned instead are America’s net liabilities to the foreign official sector. And provided that some of these reserves are “excess”, yes, there are “too many” dollars floating around.

But surely that’s not the result of a Triffin dilemma and the dollar’s role as reserve currency. That’s the outcome of another (well-known) dilemma altogether: The growth-model dilemma of some emerging markets (and their fixation with exports).

I shouldn't let the US completely off the hook here... Countries do not accumulate any types of foreign assets as reserves. Instead, they prefer assets that are safe, with deep and liquid markets. And the US for decades has offered the perfect product for FX reserves, namely US Treasuries (unlike the eurozone, where debt markets are liquid but fragmented due to the different creditworthiness of each eurozone member).

In this sense, the return of the US fiscal deficits post-2002 (and associated rise in the supply of Treasuries) facilitated reserve accumulation. And so did the (not-so-implicit) guarantee on the GSEs, which offered a tremendous pool of spready products with the kind of government backing that FX reserve managers love. But still, that should not divert attention from the fact that these assets were accumulated as a result of policy intent.

So where do we go from here? Well, first of all, China’s ongoing accumulation of Treasuries is only delaying the inevitable down the line. Second, its slow asset shifting from dollar to non-dollar assets (e.g. using its dollars to acquire companies in the resource sector in Africa, etc) is not really a sustainable solution: At some point, you begin to irritate the recipients of these flows, as their currencies appreciate vs. the dollar (and the renminbi for that matter), hurting exports and encouraging voices of protectionism.

Ultimately, part of the solution rests on what has become the consensus call by Western policymakers and academics alike: A conscious decision by China to replace its fake Prada bags for the real deal!

The State of Monetary

Back in August 2008, Olivier Blanchard, an undisputed “czar” of macroeconomics, professor at MIT and currently Director of Research at the IMF, was asked to write a paper on the future of macro for the first volume of a new journal, the Annual Review of Economics.

“The state of macro is good”, he concluded--in a phrase that has since become a favorite source of laughter (or sarcasm) for many a theorist and practitioner in the field, given what happened only a month later (/1):

The near-death of the global economy, the discrediting of macroeconomists for failing to see it coming, and the eruption of internecine debates among them, so partisan in nature that made a mockery out of economics as a social “science.” The state of macro was… in disarray!

So a year later, Donald Kohn, vice-chairman at the Federal Reserve Board, knew better. At a speech last Friday for the launch of the third volume of the Handbook of Monetary Economics, Kohn humbly avoided any definitive statements on “the state of monetary”.

Rather, he talked about the strands of monetary theory that helped guide the Fed’s efforts to rescue the global economy; and the gaps in the literature that need to be addressed to make monetary policy more effective.

The state of monetary may be in flux, he might have concluded… but hail to our theorists who, over the years, have built a valuable body of literature to guide our decisions, even when the worst of stuff hits the fan.

Hard to disagree... But here is where I see the problem: Not with monetary theory itself, which, for all its limitations, is the best we have… but with the theory’s execution.

Basically, despite its success in resurrecting the financial system, the Fed made a number of fundamental misjudgments during (and even before) the crisis that had little to do with the failings of theory to capture *the* truth.

Instead, they were the result of institutional constraints, naïve neglect, or a sclerotic adherence to theoretical models, the limitations of which were spectacularly ignored.

Let me begin.

The first blunder was the failure to accept early on that the crisis was one of insolvency rather than illiquidity. OK, maybe, there is a blurry line between the two concepts, which can become even blurrier when a liquidity crisis transforms itself, like a self-fulfilling prophecy, into an insolvency crisis. Maybe the authorities’ understanding of systemic risks was compromised by the explosion of securitization and its ostensibly efficient distribution of risk across a wide gamut of investors. Maybe I have the benefit of hindsight here.. Maybe.. but…

…The policy debate never really went in that direction, until it was too late.. The Fed effectively turned a blind eye to sources of insolvency in the system, going about with its ample liquidity provision, thus postponing an inevitable crisis to a later date. And that movie went on even after the failure of an institution as big as Bear Stearns.

True, the Fed did not have regulatory authority over many of the financial institutions that almost went under in the Fall of 2008. True, the issue of insolvency should be addressed by the fiscal authority (aka US Treasury), not the Fed. But why was the issue ever ignored by either institution? Why did it take a ginormous crisis and one full year later for banks to be forced to raise capital?

In this sense, Kohn’s reference to Bagehot’s writings as the Fed’s guide in fighting the Panic of 2008 is all but ironic. Rather than “lend[ing] early and freely to solvent institutions, against good collateral and at high rates”, the Fed lent freely to a number of insolvent institutions at low rates and lenient collateral in what really was a bailout of gigantic proportions. (Mind you, the bailout still goes on, in the form of ultra low rates for an extended period, which is allowing financial institutions to beef up their earnings through a steeper yield curve.)

Effective? Yes, (alas!). But let’s not kid ourselves, this was not exactly the most dexterous application of monetary theory to practice!

Then you have the whole quantitative easing (QE) saga and the Fed’s back-and-forths with Treasury purchases. Not only was theory inconclusive about the effectiveness of Treasury purchases in lowering private long-term borrowing rates; not only did the measure ignore the fact that, when extreme demand for liquidity is *the* problem, Treasuries and cash are near-perfect substitutes, making QE useless...

...The Fed just failed to explain why purchasing Treasuries was a good idea in its own right, rather than an act of despair in its rush to “employ all available tools to promote economic recovery.” And in the process, it also underestimated the impact the “monetization” of government debt would have on the American psyche, which undermined, at least temporarily, the long-fought battle of anchoring inflation expectations.

Then you have the whole infatuation with inflation targeting—as in, product-price inflation targeting, as opposed to a monetary policy framework that embeds asset prices in it. Now that’s my favorite baby, and I’m glad to see that things seem to be moving on that front (even if at a glacial speed!). But..

..I cant help noting that I’m still amazed with the headlong adherence of some policymakers to the prescriptions of the available literature (like, “do nothing until it’s time to clean”). Might have to do with the fact that the Chairman is himself is the author of a seminal paper in that literature…Might have to do with the fact that the "clean-up approach" is all we have. Still, there is no excuse, given that the assumptions supporting those prescriptions are very simplistic.

Asset bubbles exogenous to monetary policy? Hello? If that were the case, why would the Fed ever assume it can revert the “negative bubble” (as in, utter collapse in asset prices) once it happened, with its extraordinary rate cuts and other policy actions?

Asset prices affecting demand only though tiny wealth effects on consumption? You’re kidding me! What about the whole lending spree in the form of home equity loans? Or the broader credit boom, facilitated by a steadily rising collateral, that led to the build-up of large systemic risks as well as external imbalances?

The Fed has no comparative advantage vs. the markets in determining the “fair value” of asset prices?! But does it need to? If risk management is (as it should be) a necessary component of policy, the containment of large asset price swings, upward or downward, may be a worthy objective in its own right.

Anyway, don’t get me started…!

Final point: The crisis brought into the fore the absolute necessity of a transparent and disciplined relationship between the Fed, the Treasury and the other regulatory bodies governing the financial sector.

As I argued above, insolvency problems should be dealt by the Treasury (if at all)—yet the Fed found itself engaged in bailout operations, while the Treasury (and Congress) were still dragging their feet! Clarification of the roles of the two institutions, and the commitment by the Treasury’ to take over ownership of the toxic assets on the Fed’s balance sheet only came in March this year.

At least it came, you might say! But in the future, a clearer definition of each institution’s mandate would help avert concerns about the Fed’s political and financial independence. Similarly, clarity about which regulator has the ultimate say on the financial sector will allow a swifter enforcement of corrective actions—to the extent that looming problems are diagnosed early on.

More generally, even the finest economic models won't "deliver" unless the institutions are in place and ready to assume swiftly their due respective roles.

I’ll close with this note--and I know I'm no Blanchard, nor Ben Bernanke for that matter!

The state of monetary (theory) is not bad; and it’s set to become much better. But while academics are looking to find the magic serum, practitioners can make huge progress by re-shaping the landscape for the theory’s effective implementation.


/1 Blanchard’s paper is actually much more nuanced about the achievements of macroeconomic theory, and more humble about its limitations, than suggested by his ill-fated punch line.