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Article Excerpt
We remain in an economic crisis and financial crisis, one that Gary Gorton has named "The Panic of 2007" (Gorton 2008). The thesis of this article is that monetary policy has played a pivotal role. Under Alan Greenspan and now Ben Bernanke, the Fed has conducted monetary policy so as to foster moral hazard among investors, notably in housing (O'Driscoll 2008a). More generally, the crisis is the product of a "perfect storm" of misguided policy. Policies to encourage affordable housing fostered the growth of subprime lending and complex financial products to finance that lending. Regardless of the desirability of the social goal, the financial superstructure depended on housing prices never falling. Housing prices do fall sometimes, and did so decisively beginning in 2007 (Gorton 2008: 50).
It is largely a myth that unregulated financial capitalism failed and new regulation is needed. Aside from health care, financial services is the most heavily regulated industry in the economy. No part of it completely escaped regulation and most parts were heavily regulated, typically with multiple government agencies overseeing the activities of financial services firms.
The last legislative deregulation occurred in 1999 during the Clinton administration. The most significant change it wrought was to permit commercial and investment banks to combine into universal banks. (In reality, the statute legalized and regularized activities already in place.) All such entities (e.g., Citigroup and JPMorgan Chase) have survived the debacle. Stand-alone investment banks, the legacy of Glass-Steagall, have fared much worse. Of the five major investment banks operating at the beginning of 2008, Merrill Lynch merged with a commercial bank, Bank of America; the Fed financed and arranged for the shotgun marriage of Bear Stearns with JPMorgan Chase; Lehman failed; and Goldman Sachs and Morgan Stanley each sought protection by transforming themselves into bank holding companies. Born in one crisis, Glass-Steagall's 75-year-old separation of commercial and investment banking was undone by another.
In 2004, by unanimous vote among the commissioners, the SEC changed the net capital rules designed to protect brokerage accounts at investment firms. The SEC wanted to apply international standards for commercial banks to investment banks. There is still controversy over whether the commissioners intended to improve regulatory oversight, or ease capital standards. Investment banks certainly leveraged up after the change, as did commercial banks under the Basel capital standards. The attempt to establish risk-based capital standards has been a failure, as many (including the present author) predicted they would be when proposed. It is unclear whether a failed attempt at regulation should be termed deregulation. In any case, the SEC commissioners acted within their authority under existing law.
Regulation of financial services certainly failed, but not for lack of quantity (Dorn 2008). Former congressman John LaFalce described the performance of financial services regulators as competition in laxity. Those advocating enhanced regulation in response to the current crisis must explain why the system will work better in the future.
Financial services regulation pretty much functioned as Public Choice would have predicted: agencies were largely captured by the industries they regulate. Buiter (2008: 102) defines capture and provides citations on the literature: "Capture occurs when bureaucrats, regulators, judges or politicians instead of serving the public interest as they are mandated to do, end up acting systematically to favor specific vested interests--often the very interests they were supposed to control or restrain in the public interest." To suppose it could be otherwise would be to adopt "a romantic and illusory" theory of politics (Buchanan 1999: 46). It is unclear how adding more regulation would change that outcome.
The now-global financial crisis broke in the popular press in early 2007 when HSBC Holdings and New Century Financial disclosed increased loan loss provisions. The subprime crisis grew through 2007 and by year-end, more than 100 mortgage companies had suspended operations, sought buyers, or failed (as did New Century).
Problems spread among all classes of mortgages, and spilled over into other credit markets. The credit problems cascaded down onto bank balance sheets as problem assets. Gorton (2008) presents a comprehensive account of why problems in the subprime market caused a financial panic. In order to economically provide subprime mortgages, the financial system evolved a complex set of "interlinked securities, special purpose vehicles, and derivatives" related to subprime mortgages. The value of the securities was unusually sensitive to the value of the homes underlying the mortgages. Once the prices of these homes stopped rising and began falling, the effects rippled through the chain of securities and were magnified by lack of information about where the risk resided in that chain.
Consider a partial list of the fallout on financial institutions:
* Bear Stearns was forced to merge with JPMorgan Chase.
* Lehman Brothers failed.
* AIG was taken over by the Fed.
* Fannie Mae and Freddie Mac were put into conservatorship.
* WAMU was taken over by JPMorgan Chase.
* Wachovia was taken over by Wells Fargo (after a struggle with Citigroup).
* PNC took over National City.
In addition, the deposit insurance net was greatly expanded, limited insurance of money market funds was instituted, and government guarantees were extended to non-depository creditors and even, in at least one case, to preferred shareholders. The U.S. crisis spread overseas, in sometimes a more virulent form.
Before we can propose solutions, we must assess the institutions, policies, and incentives that produced the crisis. The seeds of the crisis were planted well before 2007 and the crisis is one in a series, not by any means sui generis. To anticipate this article's main conclusion, the crisis is the product of implementing monetary policy in textbook fashion. How did this happen?
Monetary Theory and Policy
Much of the macroeconomic theory developed over the last 30 years excludes the possibility of the very problems confronting policymakers today (Temin 2008; Buiter 2008: 30n8). An earlier set of monetary theorists focused on these very problems. And their work influenced contemporary theorists.
The monetary theory underlying modern monetary policy evolved out of two main traditions, which for a long time were intellectually at odds with one another: monetarism and Keynesianism. The founder of monetarism is, of course, Milton Friedman. In numerous works, he presented and defended his version of the quantity theory of money. He also advocated a policy of controlling the rate of growth of the money supply to avoid or dampen economic fluctuations (Friedman 1956, 1960).
His 20th century intellectual progenitor was Irving Fisher (1913). (1) He presented an early version of the modern quantity theory. Fisher (1920) also proposed stabilizing an index of prices as...
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