Greg Ip

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Economics focus

What if?

If Lehman had not failed, would the crisis have happened anyway?

Illustration by Jac Depczyk

[Greg Ip] IN AUGUST 2008 Kenneth Rogoff, a Harvard University economist, briefly rocked world stockmarkets when he warned a conference in Singapore: “We’re not just going to see midsized banks go under in the next few months, we’re going to see a whopper, we’re going to see a big one—one of the big investment banks or big banks.” A month later, in the early hours of September 15th, Lehman Brothers filed for bankruptcy. Read the rest of this entry »

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Barack Obama’s plan for regulatory reform is not bold enough

AFP

FINANCIAL regulation in America has two problems: there is both too much of it and too little. Multiple federal agencies oversee the financial system: five for banks alone, and one each for securities, derivatives and the government-sponsored mortgage agencies. They share these duties with at least 50 state banking regulators and other state and federal consumer-protection agencies. Yet all these regulators failed to anticipate and prevent the worst financial crisis since the Depression, because risk-taking flourished in the cracks between them. Toxic subprime mortgages were peddled by lenders with little federal oversight and shoved into off-balance-sheet vehicles. The greatest leverage accumulated in firms that avoided the capital requirements of banks.

On June 17th Barack Obama took aim at these weaknesses (see article). Read the rest of this entry »

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The simple rules by which central banks lived have crumbled. A messier, more political future awaits

Illustration by Derek Bacon

IN THE world that existed before the financial crisis, central bankers were triumphant. They had defeated inflation and tamed the business cycle. And they had developed a powerful intellectual consensus on how to do their job, summarised recently by David Blanchflower, a member of the Bank of England’s monetary policy committee, as “one tool, one target”. The tool was the short-term interest rate, the target was price stability.

This minimalist formula fitted the laissez-faire temper of the times. A growing array of financial markets could price risk and allocate credit efficiently. Central bankers had merely to calibrate their interest-rate tools and all other markets would automatically adjust. Central banks still cared about financial stability and full employment, but could argue these were best served by stabilising prices—without, if you please, interference from politicians.

The financial crisis has upended all that. Read the rest of this entry »

America’s treasury secretary is torn between politics and policy

AFP

ASKED after giving a speech on April 22nd whether he regretted taking his new job, Tim Geithner, Barack Obama’s treasury secretary, paused for what seemed an eternity. “I…uh…feel deeply privileged,” he replied. His audience erupted in laughter.

Mr Geithner’s first three months have been a baptism of fire. The markets soared last autumn (see chart) when the New York Fed chief’s name surfaced for the job. But within weeks of taking office in January, personal tax problems, a poorly received plan for fixing the financial system and a backlash against his bail-out of AIG, a big insurer, had some in Washington, DC, counting the months to his resignation.

Talk of resignation has died down as markets have recovered amid renewed hope about the economy. The outrage over AIG burned itself out. And Mr Geithner has scored some successes: he has proposed new federal powers to take over failing financial institutions and he led the way for the G20 to boost the International Monetary Fund’s credit by $500 billion to support cash-starved countries.

Even so, Mr Geithner has not yet silenced the sceptics. Read the rest of this entry »

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Apr 16th 2009
From The Economist print edition

Financial crises can drag on because efficient remedies are politically unpalatable

Illustration by Jac Depczyk

AS THEIR banking crisis approaches Japanese proportions, Americans can take comfort from the fact that their political culture is more capable of finding a solution. Or can they? Today’s anti-banker backlash bears a striking resemblance to the voter outrage that stymied efforts to fix Japan’s banking system in the 1990s. Indeed, an enduring lesson of financial crises is how political constraints interfere with economically efficient solutions.

For example, America’s Treasury and the Federal Reserve began examining options to use public money to buy up illiquid mortgage assets and to inject capital into financial institutions shortly after rescuing Bear Stearns, a failing investment bank, in March 2008. But it was another six months before they acted on those plans. “There was no way we could go to Congress without the American people understanding we faced a crisis,” says Henry Paulson, the treasury secretary at the time.

Sure enough, not until the failure of Lehman Brothers sparked a global panic in September did Mr Paulson and Ben Bernanke, the Fed chairman, ask Congress to authorise an outlay of $700 billion to support the system. Some say Mr Paulson should have tried harder to acquire the funds before the Lehman crisis. Perhaps, but it is doubtful he would have succeeded. “Even at the height of the crisis, [that] proved almost too hard to do,” he notes.

Phillip Swagel, an economist who will join Georgetown University this autumn, writes in a review* of his experience as an aide to Mr Paulson from December 2006 to January 2009 that market participants and academic economists often proposed solutions that glossed over real-world political and legal obstacles. Some academics argued bank creditors should be forced to swap their debt for equity, for example. But Mr Swagel notes that is not legally possible without a change in the bankruptcy code, a tortuous political process. Similarly, to reduce housing foreclosures the Treasury and Congress focused on reducing interest rates for struggling homeowners, even though this would be less effective than subsidising write-downs of mortgage principal. But politicians and voters would have seen that as an unacceptable bail-out of some undeserving homeowners.

Economists have long studied how institutional constraints interfere with efficient economic choices, such as when special interests erect barriers to entry in product markets. Such constraints have received relatively little attention in the burgeoning literature on financial crises. Yet a closer examination shows that many of the same political obstacles crop up from one crisis to the next. Japan’s Ministry of Finance first sought private-sector solutions to its banking crisis so as not to arouse voter anger by using taxpayers’ money. When those solutions failed, the government proposed in 1995 spending a mere ¥685 billion ($7 billion) to take over the problem loans of seven jusen, or mortgage-finance companies. The backlash was intense. Opposition parties called for the finance minister’s resignation and staged a sit-in at parliament. In one poll, 87% of voters disapproved. The measure eventually passed, but the experience was so searing that it discouraged the government from tackling the banks’ much bigger bad loans until 1997.

In spite of these difficulties, some governments do negotiate the political shoals. South Korea is often praised for the speed and forcefulness with which it took over failing banks and bought up bad loans following its financial crisis in 1997-98. But the South Korean government was able to deflect public anger by arguing that it was being forced to take these steps by the IMF, which to this day most Koreans blame for the crisis.

Sweden took over two banks and issued a blanket guarantee of bank liabilities in the early 1990s even though the governing coalition did not have a majority in parliament. Bo Lundgren, the finance minister at the time, says Swedish voters would have rejected the bail-out had it been put to a referendum. But the government first ensured it had the support of the opposition party (from whom it had inherited the crisis) and then obtained authority from parliament for unlimited funds, so it did not have to return for more money later.

A blank cheque would greatly suit Barack Obama, who gave warning on April 14th that American banks may “require substantial additional resources”. Mr Obama has pencilled in another $750 billion of potential stabilisation funds in his 2010 budget but unlocking extra money will be extremely tricky. Despite commanding majorities in Congress and high personal-approval ratings, he must overcome solid opposition from voters jaded by revelations of bankers’ excess.

That may well mean violating certain economic principles. Economists generally prefer transparent to hidden subsidies. But Mr Swagel says that the Treasury came to realise that underpricing insurance for bank assets roused less political opposition than overpaying for assets precisely because the insurance is less transparent. The Treasury is also relying on the Fed to finance illiquid assets by printing money because that requires no congressional approval (even if it compromises the Fed’s independence).

The other temptation is to couple assistance for bankers with a hefty dose of punishment to sate the public’s hunger for justice. Sweden sued the boards of the two banks it nationalised. Several executives agreed to repay their “golden-handshake” severances to avoid prosecution. Mr Obama promised that if banks need more aid, “we will hold accountable those responsible.” The risk, of course, is that pandering to voters’ anger only inflames them further, and makes it even harder to put money into the banking system as need arises.

* “The Financial Crisis: An Inside View” by Phillip Swagel, presented at the Brookings Papers on Economic Activity conference, April 2009

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The hyperactive Fed finds its cherished independence is on the line

THE Federal Reserve has ventured ever further into the political realm, propping up failing companies, lending to industries other than banks and financing the federal budget through purchases of Treasury bonds. Now the politicians are threatening to respond in kind. Read the rest of this entry »

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EARLY in his tenure, Tim Geithner, the treasury secretary, promised that American policymakers would not make the same mistakes Japan did in tackling its financial crisis. But as politics threaten to upend his efforts, Mr Geithner should take a second to consider why Japan made its mistakes.

Japanese officials took too long to commit substantial public money to recapitalising their banks. But it was not because they were ignorant of the dangers or Andrew Mellon acolytes hell-bent on liquidating speculators. Like Mr Geithner, they feared being shot down by voters and politicians furious that taxpayers might bail out overpaid bankers. Read the rest of this entry »

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Should the Fed take up the cudgel as America’s regulator-in-chief?

BARACK OBAMA’S government is using the firestorm over American International Group to press a priority of its own: new authority to take over any big, troubled financial institution and a watchdog to look for risk in the entire financial system. But the controversy has also created a new obstacle for those plans. The most logical agency to fill those roles had been the Federal Reserve, but political support for that idea may have been hurt by its role in the bail-out of AIG.

That is the view of Barney Frank, the powerful chairman of the House Financial Services Committee, who suggested in an interview on Thursday March 19th that “The Fed has taken a bit of a hit over this AIG issue.” He argues that the “political case for the Fed as systemic risk regulator is going to have be rebuilt, re-examined. It has not changed my personal view of the Fed as the best possible [candidate] but it has substantially weakened their political position.” Read the rest of this entry »

Remarks by Greg Ip, Donald W. Reynolds Distinguished Visiting Professional

Washington & Lee University, Feb. 5, 2009

            When confronted with new challenges, we all look for analogies in our personal experience. To me this crisis feels in many ways like the financial equivalent of 9/11. Like most of you, I remember 9/11 quite clearly. It was Tuesday morning and our staff meeting in the Wall Street Journal’s Washington bureau was about to begin when the planes struck. After realizing what was happening, we got to work reporting the story. When I was done that evening, I went home on the subway. There were far fewer people than usual. And as I watched others ride the escalator up with me, I wondered, how many of us really know how much our lives are about to change?

            I recently had a very similar feeling. Read the rest of this entry »

Economics focus

The spectre of nationalisation

There are ways for governments to revitalise banks without taking them over

Illustration by Jac Depczyk

IT IS generally easier to remove a kidney from a dead donor than a live one. When regulators in Scandinavia and America in the early 1990s started extracting the bad assets from their crisis-hit banking systems, it helped that the banks they dealt with were bust or in the government’s hands. Today, policymakers are trying to excise toxic assets from banks that are still, at least officially, private and viable. That is a much trickier proposition. Read the rest of this entry »