The Best Monetary Policy Is Strict Financial Regulation

On Wednesday, in her first speech on monetary policy, Janet Yellen, the new Chairwoman of the Federal Reserve, pointed out a discouraging paradox: In recent years, private-sector forecasters have been surprisingly accurate at forecasting changes in the unemployment rate, but they have been equally inaccurate when forecasting changes in the federal funds rate, the baseline interest rate controlled by the Fed.

Since interest rates supposedly have a strong effect on unemployment, how can forecasters be so right about unemployment if they’re so wrong about interest rates?

Three economists at the Bank of International Settlements — Morten L. Bech, Leonardo Gambacorta, and Enisse Kharroubi — have been studying this question, and coincidentally their results were published this week in the journal International Finance.

Bech and his colleagues amassed a dataset of interest rates and economic output for 24 industrialized countries from 1960 to today. Over that time period, these countries experienced 78 recessions, of which 34 were the result of financial crises like the one we experienced a few years ago. In each recession, the BIS economists measured how much the central bank lowered interest rates to stimulate recovery — and then how long it took for the economy to recover its lost output.

Unsurprisingly, they found that “normal” recessions — the ones without a financial crisis — were much less severe. On average, they resulted in an output loss of 1.9 percent, which it took the country 3.8 years to recover. Financial crises, on the other hand, resulted in an output loss of 8.2 percent, which it took 5.1 years to recover.

Monetary Policy in Different RecessionsWhat was perhaps more surprising was the fact that “accommodative” monetary policy — i.e. lowering interest rates — had no effect on the economy after a financial crisis. This wasn’t the case with normal recessions. Typically, the more the central bank lowered the interest rate, the faster the economy recovered its lost output. But not so with financial crises.

In times like these, interest rates simply don’t matter as much as they normally do.

That doesn’t sound like good news for Janet Yellen. What’s a central banker to do?

Fortunately, the BIS economists did find one thing that accelerated recovery from financial crises: private-sector deleveraging. After a normal recession, it doesn’t seem to matter whether households and firms pay down their debt, but after a financial crisis, it significantly speeds up economic growth.

As luck would have it, the Federal Reserve has a tool at its disposal that can reduce the economy’s reliance on debt. It’s called the “capital requirement,” and it refers to the difference between what a bank owns and what it owes.

When a recession strikes, asset prices fall, and since banks own a lot of assets, their value goes down. If they go down too much, they can fall below what the bank owes to its lenders and depositors, meaning it’s basically bankrupt. It doesn’t own enough to pay what it owes.

So the Fed sets a minimum capital requirement. The more capital a bank is required to have, the more it has to own relative to what it owes. It’s a buffer. The bigger the buffer, the more room asset prices have to fall before the bank becomes bankrupt.

Unfortunately, banks don’t like high capital requirements. They want to rely on debt. Why use your own cash when you can use somebody else’s cash? Lower capital requirements are cheaper — but they’re also more dangerous because it’s easier to go bankrupt when you owe so much relative to what you own.

Banks argue that high capital requirements restrain lending because they can’t borrow as much debt to fund their loans, but another paper published in the latest issue of International Finance debunks this myth. In it, the German economists Claudia M. Buch and Esteban Prieto study the behavior of German bank lending for the past 44 years, and they find that banks with higher capital actually issue more business loans.

This doesn’t come as a surprise to those of us who understand how banks actually operate. They don’t lend based on how much debt they can borrow. They lend based on how many loans they can sell. The more, the better. The only question is, will they fund the loans with cash or debt?

Janet Yellen may have her work cut out for her in this post-financial-crisis economy, but there is a way to stimulate the economy and prevent future crises. It all starts with financial regulation.


This op-ed was published in today’s South Florida Sun-Sentinel and Huffington Post.

Wall Street’s Rap Sheet Tells a Harrowing Story

There’s a serial killer on the loose.

This heartless criminal is slaughtering nations left and right.

For two decades, it’s been feasting on unsuspecting governments.

With each victim, its power grows.

And now, it’s at our front door.

The first reported crime occurred in 1982. That was the year when Mexico defaulted on its debt. For over two decades, Mexico and its Latin American neighbors had been borrowing money from American banks to finance their growing economies. The 1960s was a good time to be a finance minister south of the Rio Grande. Governments were flush with cash from the economic boom, largely financed by loans. When inflation drove U.S. interest rates into the double digits, Latin American governments found themselves with whopping interest payments. By the 1980s, they simply stopped paying the bills. Lenders fled, and a massive financial crisis swept through the region.

But interest rates eventually came back down, and the lenders returned. Again banks like Goldman Sachs lent money to the Mexican government, and again investors panicked. In 1994, another financial crisis struck Mexico and — in a so-called “tequila effect” — spread to Brazil. This time, the American government stepped in. Treasury Secretary Robert Rubin, who used to be the Co-Chairman of Goldman Sachs, engineered a $20 billion bailout that saved his old firm’s ass.

Meanwhile, on the other side of the world, the “East Asian miracle” was lapping up the money that was spilling out of Latin America. Hong Kong, Singapore, South Korea, and Taiwan — the “Four Asian Tigers,” they were called — were industrializing faster than any country ever before, and Wall Street was more than happy to slake their thirst for investment funds with the cool liquid of debt. Until, of course, the bubble burst. In 1997, it became clear that investors had been too optimistic and asset prices had gone too high, especially in real estate. Lenders ran for the exits, and the local economies took a bloodbath.

When the “East Asian miracle” turned into the “East Asian crisis,” investors started to question all their foreign holdings, especially the loans they made to the Russian government. Just to be safe, they fled Russia too, leaving the Kremlin no choice but to default on much of its debt. The shockwave rippled all the way to Wall Street, where the mammoth hedge fund Long-Term Capital Management nearly crumbled from a bet gone bad. Their bankruptcy probably would have brought down the global economy, had the big American banks not stepped in and bailed them out.

These titans of Wall Street were hardly daunted by this near-death experience. First, they plowed their money into the American stock market and then, when that tanked at the turn of the century, into the American housing market. This too fell, and with it, the global economy.

But that was not all they bet their chips on. Led by Goldman Sachs yet again, the American banks spread their money across Europe — trading with hedge funds in Iceland, buying up mortgages in Spain, and yes, funding a widening budget deficit in Greece. When the bubbles burst, tax revenues plummeted, and governments started running out of money. Without central banks to buy their bonds, several countries ran the risk of defaulting on their debt. But the powers-that-be didn’t want that. They wanted the big banks to be repaid. So they took it out on the workers, slashing government spending and making the recession worse.

Only one culprit has been present at all of these crime scenes. It doesn’t take a detective to see that Wall Street has been duping naïve borrowers into excess debt time and time again, only to get away with it and strike again in a new location. In fact, after each conquest, the American banks found themselves bigger and more powerful, systematically demolishing the regulations that had prevented them from such predatory behavior since the 1930s.

In recent years, we have developed an unhealthy habit of blaming the borrower, but there are two parties in every financial contract — and the lender is almost always the more experienced, more sophisticated, and more powerful of the two.

For far too many years, we have allowed our banks to run roughshod over the world. And now, while our nation grinds through high unemployment and Europe suffers through worse, the Republicans have the inexplicable gall to nominate a Wall Street tycoon as their presidential candidate. To these thugs, I say: Leave us alone. Haunt us no more. Haven’t you done enough?


This op-ed was published in today’s South Florida Sun-Sentinel.

Making the World Safe for Finance

I promised you my take on Greece, and my take you shall have. Here’s my latest post on the Sun-Sentinel blog. It continues my work building up to a coherent framework (and hopefully a book) on international law. If you’re interested in learning more about tight coupling in financial markets, check out Richard Bookstaber’s A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation. If you’ve been following our “Best of the Week” series, you should be very familiar with the Hart/Zingales proposal; I’ve linked to it several times. Here’s the most recent reference. As always, before you do any of that, don’t forget to check out my post.

How Much Is the Obama Administration Asking You to Pay?

My latest blog post is up at the Sun-Sentinel. My dad gets credit for this idea. He was wondering the answer to this question, so I did a little digging through the research. It isn’t a very rich literature, but the few papers in it (especially the Fama one) are very strong.

The only thing I’d add to this post is to say that financial regulation should function like insurance. It costs money for firms to pay for insurance, and those costs may get passed along to you in the form of higher prices. But you’d probably prefer that than having the company go bankrupt because they get caught in a catastrophe without insurance coverage. Good financial regulation is supposed to prevent crises, but it’s only fair that the firms pay the taxpayers insurance premia in advance. We did, after all, just bail them out quite generously.

I was debating two different conclusions, so here’s an alternate ending:

This is good news for the Obama administration. Of course, it would be better news if that money came out of bankers’ salaries, but don’t worry: They’re working on that.

Don’t forget to read the original post.

Why Some Economists Still Aren’t Smiling

Jim Hamilton, truly one of the best macroeconomists of his generation, may not be smiling, but he’s getting closer. At all times, Hamilton keeps a cartoon face—smiling, frowning, or neutral—on his blog Econbrowser to represent his outlook for the economy. It’s like security threat levels for the business cycle. Yesterday, Hamilton replaced the longtime frowning face with a neutral one.   Continue reading “Why Some Economists Still Aren’t Smiling”