Thoma vs. Mankiw on Opt-Out Financial Regulation

I score this one for Mark Thoma. Mark Thoma is... puzzled, I think is the word... by Greg Mankiw's claim that there is something intellectually wrong with Austan Goolsbee's endorsement of the idea that there should be "enhanced regulation of any financial institution that has access to the Fed's discount window.... Mr. Goolsbee said that an Obama presidency would ensure that investment banks are regulated as closely as commercial banks." Mankiw writes:

George Stigler rolls over in his grave: Remember when the University of Chicago used to be the intellectual center of the deregulation movement? No more.... This story seems to confirm the fears of Vince Reinhart [that the Fed's actions in Bear Stearns will be used to argue for more spending and more regulation...]

Mankiw is wrong here on a bunch of levels.

First, George Stigler is not rolling over in his grave. On matters of financial regulation, George Stigler showed great deference to Milton Friedman, and Milton was in favor of extremely tight regulation of any financial institution whose liabilities served as part of the economy's stock of liquid assets--as those of us who did the reading that Tom Sargent assigned and read Friedman's Program for Monetary Stability know: the restrictions that Friedman thinks should be imposed on what reserves banks must keep, what assets banks can hold, and what promises banks can make about the liquidity of their liabilities are absolutely draconian.

Second, Mankiw is mistaken in portraying the belief that additional regulation of not just commercial but investment banking as Obama's initiative. Here Obama is simply backing Ben Bernanke, who said last month:

Ben Bernanke, Liquidity Provision by the Federal Reserve, May 13, 2008: Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. Recall Bagehot's advice: "The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times" (p. 24).... In light of the recent experience, and following the recommendations of the President's Working Group on Financial Markets (2008), the Federal Reserve and other supervisors are reviewing their policies and guidance regarding liquidity risk management.... [F]uture liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing.... [I]f moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced...

Mankiw appears to be trying to portray this as Obama, and it's not: it's Bernanke and Geithner and Kohn and company.

Third, Mankiw does not grasp the reason that Ben Bernanke believes that the Fed needs additional regulatory tools. Mankiw asks:

George Stigler rolls over in his grave: Here's a question for Austan: Can an investment bank avoid such regulation if it promises never to use the discount window? Or is this insurance-regulation combo a mandate?

And here I want to turn the mike over to Mark Thoma, who starts out:

Economist's View: Is Austan Goolsbee Betraying the Chicago Tradition? If So, is That Bad?: [A]ccess to the Fed's lending facilities should come with regulatory restrictions. The question is whether banks should be allowed to move outside the regulatory umbrella if they voluntarily give up access to the discount window...

And then Mark puts his finger on it:

A bank would also have to promise that it would not become "too big to fail" for the commitment from the Fed to prohibit access to the discount window to be credible. If a bank does become too big to fail and if it runs into trouble and asks the Fed for help, then the Fed will be forced to bail them out... no matter what the prior agreement had been. Sending the economy into a tailspin and deep recession simply to honor a past promise to prohibit access to the window would not be the best policy at that point.... [B]anks [that] can grow large enough to threaten the overall economy... [require] a regulatory solution... either... regulate the size of banks... [and] intervene if a bank grows too large. Or... allow banks to grow large... because large banks have desirable efficiency properties, but [then] impose regulations to reduce the chances that they will need [help]... limit their ability to damage the overall economy...

The key which Mankiw does not recognize is that access to the discount window is not a favor that the central bank provides that is good for the bank in return for the bank's acquiescing in a regulatory power grab. Granting access to the discount window is a step the central bank takes in the interest of avoiding the mass unemployment that would be produced by bank failures that disrupted the payments and investment-finance system. The central bank is then required to take the next regulatory step to try to curb the moral hazard that its guarantee generates.

The last people to offer the financiers freedom from regulation in exchange for freedom from financial support in a crisis were Herbert Hoover and his Treasury Secretary Andrew Mellon, with Mellon's cry to let the Great Depression roll forward to its natural free-market conclusion. To quote Hoover:

[T]he “leave it alone liquidationists” headed by [my] Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”... http://delong.typepad.com/delong_economics_only/2007/02/why_oh_why_cant.html

That did not turn out so well. Ever since monetary policy has been made--and monetary theory made as well--in the shadow of the Great Contraction. That was why Stigler deferred to Friedman so completely on issues of financial regulation. And that was why Friedman was so anxious to make sure that no financial institution that provided a share of the economy's liquid, spendable assets had enough freedom from regulation to make large leveraged bets that would take it down in a crisis.

Comments

[kyle]

Investment Banking regulation? Do you think anyone's going to have strong feelings on this issue?!

Wow, what a topic. I'm not so sure that the $2 price for Bear Stearns didn't create an awfully big "moral hazard" in an of itself. I don't think the sale of Bear Stearns was a great career move for Schwartz, Cayne, and the other (responsible) Bear executives.

A the same time, I actually understand Mankiw's point. The regulation punishes the investment banks that acted wisely and are not in trouble. Goldman Sachs hedged properly, made safe investment risks, and avoided credit dislocations (as far as we know). So why should they face regulation because Bear messed up so badly?

[christofay]

Goldmine Sacks, the exception? Has it handed over any junk bonds discounted, sure, but discounted to market prices, to the Bernanke open like an all night store Fed?

[Matt]

I have to go with Mankiw.

The fed's major customer is the federal legislature, and that entity is often working at odds with large investment banks. You cannot tie large investment houses to the federal government as long as bozos like Bush/McCain/Reagan potentially control it. Doing so just makes the fall larger and harder.

The federal legislature is going to want stop loss reserves from others while keeping first access to the discount window. They simply make the monopoly that much worse.

[CN]

Kyle, if "Goldman Sachs hedged properly, made safe investment risks, and avoided credit dislocations", would they not then BE in accordance with any prudent regulations that might have been legislated? I would argue that they would.

[Rob]

The point is if Goldman Sachs makes a bad decision, they will have to be bailed out. They now know they will be bailed out. Its amazing how worried conservatives are about moral hazard in health insurance where non monetary costs are still very high whereas moral hazard among firms that fully price out risk are supposed to minor considerations.

[fred]

Why take Greg Mankiw seriously on anything that has any political implications?

If Obama argued that regulating Ponzi schemes would be a good thing, Mankiw would find something virtuous in them. Likewise, if McCain decided to abandon supply side ideas, Mankiw would decide to that the time was right to reintroduce the comment about supply siders being "cranks and charlatans" to his textbook. Of course, Manikw would declare that such a choice had nothing at all to do with politics.

Not that Mankiw has supported torture, but what makes anyone think he is more honest than John Yoo? Actually, I suspect that Yoo doesn't have a position on torture -- he was just content (like Mankiw) to sell his so-called expertise to further the aims and practices of the Bush/Cheney administration.

[Peter K.]

"The point is if Goldman Sachs makes a bad decision, they will have to be bailed out."

Right. If they're "too big to fail" they should be regulated. What is Mankiw's argument against that? Or does he have one?

The issue is the type and quality of regulation.

[ogmb]

"Goldman Sachs hedged properly, made safe investment risks, and avoided credit dislocations (as far as we know). So why should they face regulation because Bear messed up so badly?"

Should we sane and sober drivers face regulation because drunk and reckless drivers screw up so badly?

[piotr]

"As a numerate person, but illiterate in economics" I have hard time grasping what is going on.

What is regulation and intervention supposed to prevent, and how? Clearly, investors around the globe go to cleaners, stuck with piles of bonds that somehow do not shine as well as their yesterday's AAA glory. Estimated losses of Japanese banks were increased by 41% (don't you love this two-digit precision?). Swiss, French, Germans -- all writhe in pain, the Chinese and petro-funds suffer in silence. And this is as it should be, and Fed will not do a thing about it.

A gigantic pile of bad debt is perhaps, beside losses to investors who should know better, a serious mis-allocation of national resources, so somehow it would be better if bonds were priced with a certain modicum of rationality. Restricting on the behavior of the chief intermediaries trading those bonds could perhaps have that effect, but how? The issue seems rather arcane to me.

A naive but straightforward approach would be to require risk taking for private evaluators of bonds. Some minimum escrow to be paid in case of performing below the evaluation (1% of the face value?). Small but unlimited liability (secured against all assets of actual persons doing the evaluation or backing them) as it was done by Lloyds of London?

I recall a TV interview with a "name" from Lloyds who suffered severe setbacks, loosing "everything down to my cufflinks".

-- "Sir, I can't help but notice that you do have [diamond-studded] cufflinks"

-- "Borrowed for the occasion."

[Greg A.]

CN - Goldman may or may not be in compliance with government regulations. It depends on the regulation.

Suppose the new banking regulations require investment banks to maintain a certain capital/asset ration (like conventional banks). That capital asset ratio might force Goldman to reserve (hypothetically) 10% of its assets for leverage.

Today, Goldman might hold 5% of its assets as reserves (again this is hypothetical - I have no idea what their leverage preferences are). In this hypothetical situation, regulation could destroy 50% of Goldman's revenue generating capacity.

[Robert Waldmann]

I think the question to ask Mankiw is "do you think the discount window fell out of the sky ?" (crashhhhhhhing dying metaphor). It's there for a reason. If you have the discount window, then you must have prudential regulation or moral hazard which implies reduced expected welfare and a large expected transfer to bankers.

Or another question, if he thinks prudential regulation should not be extended to investment banks, why doesn't he think it should be removed from depositary institutions ? Obviously a case can be made (and was hence current regulations) but it is not "Chicago economists are either opposed to all regulation or are apostates."

[David in NY]

OT -- does anyone else think that the term "moral hazard" is absolutely the worst verbal formulation ever invented for a signficant concept? It's surely in the running. Makes my head spin every time I hear it, and the concept itself is not difficult. It just that the words don't describe it in any adequate way.

Isn't there a better term? Why, oh why, can't we have a better corps of economists?