Paul Volcker on 'too big to fail'

LW: Central banks and governments have extended the "safety net" of deposit insurance and lender of last resort facilities "to support investment banks, mortgage providers and the world's largest insurance company". These non-banks receive massive taxpayer support, but most escape the tight regulation and supervision to which commercial banks are subject.

“Adam Smith more than 200 years ago advocated keeping banks small. Then an individual failure would not be so destructive for the economy. That approach does not really seem feasible in today's world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.

Instead, governments have long provided commercial banks with the public "safety net." The implied moral hazard has been balanced by close regulation and supervision. Improved capital requirements and leverage restrictions are now also under consideration in international forums as a key element of reform. ...

[As for other capital market institutions, few are] "too big" or "too interconnected" to fail. In fact, sizable numbers ... fail or voluntarily cease business in troubled times with no adverse consequences for the viability of markets.

What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed.”

Paul Volcker, "How to Reform Our Financial System", New York Times (31 January 2010).

http://www.nytimes.com/2010/01/31/opinion/31volcker.html


LW: Paul Volcker (1927-) chaired the Federal Reserve under Presidents Jimmy Carter and Ronald Reagan and is now chairman of President Obama's Economic Recovery Advisory Board. He is providing sensible advice, with international relevance. Government leaders and central bankers everywhere should take note.

DOW: I agree with Larry this is an important article by a very experienced central banker noted for his aversion to inflation and love of fly-fishing.

In this article, Volcker advances several ideas he has advocated for some time and which reflect elements in the proposed bank regulations announced by the Obama Administration last week.

Essentially, and in broad outline, Volcker distinguishes between the banking activities of deposit-taking institutions such as commercial banks on the one hand and those of investment banks, private equity funds, and hedge funds on the other. Under his proposal, commercial banks would be limited to traditional banking services such as accepting deposits, making loans to businesses and consumers, investing in corporate and government bonds, and generating fee-based income by renting safe-deposit boxes. They would be prohibited from engaging in risky activities such as trading stocks, bonds, currencies, commodities and derivatives. Only commercial banks would receive “lender of last resort” support from the Federal Reserve to protect depositors.

Investment banks have traditionally raised capital from investors and engaged in capital market activities such as issuing and selling securities, insuring bonds and providing advice and financial support for mergers and acquisitions. They also engage in the trading of derivatives, foreign currency, commodities and equities. At times, they “make a market” by buying and selling a financial product to earn income on each trade or deal in derivatives by creating complex financial products intended to generate a high return. Other activities include investment management for wealthy individuals and merchant banking were it invests its own capital in a client company. Investment banks frequently have global scope.

Until 1999, commercial banks were not allowed to engage in investment banking activities and investment banks were not allowed to accept demand deposits. In my view, removing the separation between these two kinds of banking activities has proven to be unwise and we should reinstitute it. If we do, commercial banking should be narrowly limited to those kinds of loans and investments which involve minimal risk.

Volcker and others say they want to limit the size of big finance and impose more and better regulation on the financial sector, including greater regulation at the international level. Yet he admits “keeping banks small … does not really seem feasible in today’s world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.” In this situation, investment banks clearly have to be tightly regulated but I for one am doubtful that more regulation by the public sector will make much of a difference. I simply do not believe better regulation by the public sector is possible. We always say we want better performance from government and we never get it. So why should I believe regulation of the banking system by government can really improve?

I would rather put very strong incentives in place to discourage bankers from growing too big in the first place and then, as they inevitably do, start making bad investments as a regular part of their everyday business. To be sure, let bankers make a good living and the banks be very profitable and let them be subject to government regulation. But let us change “the rules of the game” to encourage banks and their owners and investors to be prudent, very, very prudent. As a first step, as Volcker suggests, no bailouts for owners and investors in investment banks and similar kinds of financial institutions such as insurance companies. They are on their own. As a second step, remove limited liability protection from the owners of these banks and, more importantly, from the management of these banks. Let them pay personally when they make major mistakes. Both owners and management should be held liable in their personal capacity to creditors of these financial institutions. If we did this, the banks would not become too big because then the owners and managers would fear loss of control, with its risks to their wallets and their livelihoods.

It would also cause them to think hard about every investment decisions they made. They would carefully evaluate each investment they made and spread the risks they took far and wide and in doing so add stability to the entire system.

I know I would sleep better if the owners and management of these banks were fully accountable for the performance of their banks, even if they wouldn’t rest as well as they do now.

A tip of the hat to Larry for the Tdj.

Saving and the sex ratio in China

“Much attention has been directed toward China’s high savings rate. Not only is the savings rate disproportionately high compared to virtually any other country, but it directly impacts China’s current account surplus and the U.S. consumer deficit. When national savings exceeds investment, the excess savings shows up in China’s current account surplus.
...
Given its far-reaching effects, both private sector analysts and policy makers have attempted to trace the causes of China’s high savings rate and to predict how long it will last. Some have attributed the savings primarily to Chinese corporations rather than households. Others point to a precautionary savings motive: because Chinese people are worried about costs of healthcare, education and old-age pensions and are unsure about how much these costs might change over time, they respond by saving more. Other explanations point to habit formation or financial development.

“But these explanations do not tell the whole story, and possibly are not the most important part of the story,” says Wei. Instead, Wei hypothesized that an important social phenomenon is the primary driver of the high savings rate: for the last few decades China has experienced a significant imbalance between the number of male and female children born to its citizens.

There are approximately 122 boys born for every 100 girls today, a ratio that translates into cutting about one in five Chinese men out of the marriage market when this generation of children grows up. Three factors conspire to produce the imbalance. First, Chinese parents often prefer sons. Second, it has become increasingly inexpensive for even a relatively poor farmer to afford the $12 Ultrasound B, the most common technology used for learning the gender of a fetus.

Third, and perhaps most importantly, China’s stringent family planning policy limits the number of children a couple can have. The policy allows most couples to have only one child. But in some regions, if a couple’s first child is a daughter, the state permits the couple to have another child. Families with one daughter that become pregnant with another daughter are more likely to terminate the second pregnancy in hopes of producing a son later on. (India, Korea, Vietnam and Singapore also have sex ratio imbalances that favor male children despite the absence of these stringent family planning policies. It might be that in these countries people voluntarily want to restrict the number of children they have, and still prefer sons and have access to inexpensive selective abortions. The sex ratio imbalance is high in these countries but not as extreme as in China.)

“The increased pressure on the marriage market in China might induce men and parents with sons to do things to make themselves more competitive,” Wei says. “Increasing savings is one logical way to do that, to the extent that wealth helps to increase a man’s competitive edge. Parents increase household savings mostly by cutting down their own consumption.”

Wei worked with Xiaobo Zhang of the International Food Policy Research Institute in Washington, D.C., to see if his hypothesis held up, comparing savings data across regions and in households with sons versus those with daughters. “We find not only that households with sons save more than households with daughters in all regions,” Wei says, “but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed sex ratio.””

“Why Do the Chinese Save So Much?”, post on Ideas that Work Blog, Columbia Business School (22 January 2010).

www4.gsb.columbia.edu/ideasatwork/feature/729422/Why+Do+the+Chinese+Save+So+Much%3F


Shang-Jin Wei is the N.T. Wang Professor of Chinese Business and Economy in the Finance and Economics Division at Columbia Business School and director of its Jerome A. Chazen Institute of International Business.


The most powerful forces now shaping the world are those related to demography and among the most significant of the changes taking place relate to fertility. Between 1970 and today, the world population experienced a major and unprecedented reduction in fertility levels, driven mostly by a reduction in fertility in developing countries. During this period, total fertility per woman fell from 4.5 children to 2.6 for the world as a whole, with 2.1 children as the replacement rate.

A number of factors are contributing to the decline in human fertility. Greater contraceptive use, abortion, and changing life styles have certainly affected the average fertility level. But in some countries, such as China, population controls and sex selection are also a important factor driving fertility down. China may be an extreme example of fertility decline, as its fertility has dropped sharply from an average of 5.7 children per woman in 1970 to an average of only 1.7 in 2007, far below the replacement level.

Another demographic change underway in an increasing number of countries is a changing sex ratio at birth. Historically, about 103 to 105 boys were born per 100 girls in almost all countries. Because the mortality of boys is higher than that of girls, the sex ratio moved toward 100 boys per 100 girls over time, reaching parity in many countries in cohorts corresponding to marriageable ages of the 20s and 30s. However, sex selection has moved the world average from 105 boys born per 100 girls in 1970 to 107 in 2010. In the case of China, the change has been much greater, from 107 in the 1970s to 122 today. It is also high in other Asian countries, the Pacific and in South-East Europe.

All this has implications for the United States. The demographic imbalance between men and women is seen by Professor Wei as the primary driver of the high saving rate of China and other Asian countries and the cause of their huge export surpluses. These export surpluses, in turn, correspond to and finance the budget and trade deficits the United States and other countries have recorded in recent years. If the problem of global imbalances is to be addressed, China must import more and the U.S. import less and, what is effectively the same thing, China must save less and the U.S. must save more. But if the high Chinese saving rate is rooted in demographic factors rather than economic factors, the usual economic policy instruments such as changes to exchange rates, relative interest rates, and income and price levels are not going to be effective in bringing about the necessary balance of payments adjustments to restore a balanced world economy.

If Professor Wei is correct, it may very well be much more difficult to eliminate the U.S. balance of payments deficits than we now believe.

Thanks to Tyler Cowen of Marginal Revolution to the point to this article.

How a Mozart string quintet helps explain high health care costs

“Nearly everyone agrees that there is something sick about the American health care system, especially when it comes to the seemingly out-of-control rise in costs.

While Democrats and Republicans continue to fight over the remedy, there is one man who can claim to have rendered a specific diagnosis and — more than 40 years later — he wants lawmakers and President Obama to know that there probably is no cure.

What afflicts the American health care system (and those of other industrialized nations) is called Baumol’s cost disease. It is named for William J. Baumol, an economist at New York University, who turns 88 next month. And it explains why health care costs will almost certainly continue to rise faster than general inflation, and why Democrats might not want to set expectations too high when it comes to their health care bill.
…
Dr. Baumol and a colleague, William G. Bowen, described the cost disease in a 1966 book on the economics of the performing arts. Their point was that some sectors of the economy are burdened by an inexorable rise in labor costs because they tend not to benefit from increased efficiency. As an example, they used a Mozart string quintet composed in 1787: 223 years later, it still requires five musicians and the same amount of time to play.

Despite all sorts of technological advances, health care, like the performing arts, suffers from the cost disease. So do other public services like education, police work and garbage collection. While some industries enjoy sharp increases in productivity (cars can be built faster than ever, retail inventory can be managed better), endeavors like health care are as labor-intensive as ever.

And yet, wages in health care grow to match wage increases in the broader economy. (Imagine trying to pay today’s violinist the same as a counterpart in 1787.)

All of this happens invisibly, but the proof is in the budget ledgers of local, state and federal governments. Cost disease helps explain why low-income Americans can now afford flat-screen televisions that were out of reach a decade ago, but health insurance that was unaffordable in January 2000 remains unaffordable in January 2010.

At the same time, demand for health care never lets up. …

“We do now have robots performing surgery, but the robot is under constant supervision of the surgeon during the process,” Dr. Baumol said. “You haven’t saved labor. You have done other good things, but it isn’t a way of cheapening the process.”

Recent research, including a December 2008 study for Centraal Planbureau, the Netherlands Bureau for Economic Policy Analysis, has found that Baumol’s cost disease continues to be a major factor in rising health costs around the world.”

David M. Herszenhorn, “For Ailing Health System, a Diagnosis but No Cure”, The New York Times (17 January 2010).

http://prescriptions.blogs.nytimes.com/2010/01/17/an-economist-who-sees-no-way-to-slow-rising-costs/

David M. Herszenhorn is a reporter for the New York Times.


William Baumol (1922-) was for many years a professor at Princeton and New York universities. He made contributions in many areas but is best known for the theory of contestable markets, the Baumol-Tobin model of transactions demand for money, and Baumol’s cost disease. A major influence on Professor Baumol was Joseph Schumpeter, and he claims that the object of his lifetime work was to develop a place in economic theory for Schumpeter’s entrepreneur.

In his 1967 article, Professor Baumol used the Mozart String Quintet note that the productivity of Classical music performers has not increased in 200 years since it takes the same number of musicians today and the same amount of time to play the quintet as it did in 1787. The article Baumol published was entitled “Macroeconomics of Unbalanced Growth”, and it looked at the effects of automation on the U.S. economy.

At the time (and continuing today), the U.S. was undergoing a revolution of factory automation where the introduction of new technologies and processes was raising productivity in many lines of manufacturing production. Other sectors, however, such as education, health services, and government services, among many others, were more labor-intensive, and there was less scope to substitute new technology-embodying capital for labor. Consequently, these sectors did not experience much productivity growth. As a result, costs and prices (and total income and employment) tended to fall in those activities conducive to technological progress and generating productivity advance (such as manufacturing) while costs and prices remained relatively high in non-manufacturing sectors (especially services).

While many people who work in high-productivity growth sectors such as manufacturing lose their jobs to automation, those that remain are paid more and average incomes rise. The huge and growing output of manufactured goods resulting from the growth in productivity tends to saturate the market for these products and the income elasticity of manufactures falls with time.

In contrast, in the more service-oriented sectors productivity gains are difficult to realize. Workers in these sectors nonetheless experience rising wages because they have the option of working in other occupations, and will leave if they are not adequately compensated. Many of these workers are also highly educated and would be difficult to replace should they resign. This also tends to keep their wages high. Finally, the service sector also benefits from a high income elasticity of demand as people choose to spend their rising incomes on health care, education and other labor-intensive services where productivity gains are difficult to generate.

Health care costs are high and rising because they involve high labor skills and personal attention and cannot be easily reduced by spreading the costs over more people. Like a Mozart string quintet, a certain number of workers are involved and the time taken to treat a patient, like the time it takes to play the music, is fixed. (But, let me note, that while it costs the same to produce the music, with recorded music it is much cheaper to consume it than in 1787, as it can now be replayed at almost zero marginal cost. Unfortunately, this is not the case with health care.)

It is a mistake for Congress and the Administration to imply that public policy can do much to reduce health care costs or the general efficiency of the health care sector. It can’t.

Thanks to Greg Mankiw for the pointer to this article.

Simon Johnson on the financial crisis and Obama’s advisors

LW: MIT economist Simon Johnson explains that the policies embraced by key members of Obama's economic team are opposite those they supported during the Asian financial crisis of the 1990s. This charge applies in particular to Lawrence Summers, in charge of the White House National Economic Council, Treasury Secretary Timothy F. Geithner, and David A. Lipton, who is now at the National Economic Council and the National Security Council. All three were heavily involved in preparing a US response to the Asian financial crisis.

“In the 1990s, they were opposed to unconditional bailouts — providing money to troubled financial institutions with no strings attached. .... The Treasury philosophy was clear and tough: "a healthy financial system cannot be built on the expectation of bailouts," Mr. Summers said in his American Economic Association speech in 2000. ...

“In the 1990s, the United States — working closely with the I.M.F. — insisted that crisis countries fundamentally restructure their financial systems, which involved forcing out top bank executives. In the United States during 2009, we not only kept our largest and most troubled banks intact (while on life support) but allowed the biggest six financial conglomerates to become larger, both in absolute terms and relative to the economy. ....”

If true, this has a terrible implication. The structure of our financial system has not changed in any way that will reduce reckless risk-taking by banks that are large enough to cause significant damage when they threaten to fail.”
Simon Johnson, "Lessons Learned but Not Applied", Economix (31 December 2009).
http://economix.blogs.nytimes.com/2009/12/31/by-simon-johnson-lessons-lea/


DOW: Simon Johnson is currently the Ronald A. Kurtz Professor of Entrepreneurship at the Sloan School of Management at MIT. From March 2007 through the end of August 2008 he was Chief Economist of the International Monetary Fund. Recently Prospect Magazine named Simon Johnson as the "clear winner" out of 25 economists who have made notable contributions to "public conversation" during the current financial crisis. Also on the list were Martin Wolf of the Financial Times, Paul Krugman of the New York Times, and Columbia University economist Joseph Stiglitz.

The issue Professor Johnson has focused on in this post is the one of “Moral Hazard”. Moral hazard is the tendency of a person or institution that is imperfectly monitored to engage in dishonest or risky behavior. (“Moral hazard” is another one of those lousy economic terms that makes no sense but is used by everyone anyway.) In the case of financial institutions, moral hazard is the tendency for financial bailouts by governments and central banks to encourage risky lending in the future, if the bankers come to believe they will be bailed out and not suffer personal loss if things go wrong.

Moral hazard has been a concern expressed about the Administration policy since it first took office. The objection is both that Wall Street has not simply been “saved” from its own stupidities but that the very people that made disastrous decisions have benefited from the very mistakes they made. This, it is argued, will only encourage them to be even more reckless in the future and, anyway, they should be fired and not benefit from their mistakes.

Nor has the issue of moral hazard been limited to the banks, as the Administration also bailed out auto companies, investors in housing, states and localities, and pension funds, among others. The fear on the part of the critics is both the unfairness of shifting the costs of all these bailouts to the taxpayer and the precedent it sets for the future.

As Simon Johnson notes, the problem of moral hazard is well understood by President Obama’s economic advisors. When addressing the question of bailouts at the international level in 2000 Larry Summers had this to say about the problem of moral hazard in his speech to the AEA:

“… as in the case of an efficient and incentive-compatible deposit-insurance and safety-net scheme, possible moral-hazard distortions induced by automatic guarantees need to be avoided to ensure that the scheme does not lead to systemic losses and distortions. Thus, it is certain that a healthy financial system cannot be built on the expectation of bailouts.”

American Economic Review, Vol. 90, No. 2 (May 2000).

But bailouts are exactly what the Obama Administration’s policy has been. Wall Street is back in business earning huge profits and its executives are back in their offices receiving the huge bonuses. Car companies are living off the public dole and their executives are still receiving high salaries. Fannie and Freddie are still in business, still paying exorbitant salaries to their management, and still near financial collapse. Yet the rest of the economy remains in the doldrums and employment is still sinking.

It’s hard to understand why bailouts were bad policy during the Asian financial crisis in the 1990s and yet bailouts are wise economic policy for the U.S today.

Thanks to Larry Willmore for the Tdj.Presumably this time, the Summers-Geithner-Lipton group will argue that the only way to restore confidence was through the kind of unconditional and implicit bailout guarantees they opposed in the 1990s.

The downside of fixed exchange rates

LW: Martin Wolf has drafted another superb Wednesday column. He begins with these words:

“What would have happened during the financial crisis if the euro had not existed? The short answer is that there would have been currency crises among its members. The currencies of Greece, Ireland, Italy, Portugal and Spain would surely have fallen sharply against the old D-Mark. That is the outcome the creators of the eurozone wished to avoid. They have been successful. But, if the exchange rate cannot adjust, something else must instead. That "something else" is the economies of peripheral eurozone member countries. They are locked into competitive disinflation against Germany, the world's foremost exporter of very high-quality manufactures. I wish them luck.”

Martin Wolf, "The eurozone's next decade will be tough", Financial Times (6 January 2010).

http://www.ft.com/cms/s/0/19da1d26-fa2f-11de-beed-00144feab49a.html

The remainder of the column is just as informative, just as well-written, and should be read in its entirety. Martin ends on a sober note:

“When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.”

I've said this before, and will say it again: Martin Wolf's column alone is worth the price of an online subscription to the Financial Times. Non-subscribers, I understand, are allowed to download three articles each week. If you are a non-subscriber, do reserve one of your free weekly downloads for Martin Wolf. Martin rarely disappoints.


DOW: Let me begin by saying I endorse what Larry says above about the wisdom of Martin Wolf and double endorse his recommendation to download Martin’s weekly column.

Let me add that many economists -- I was one of them -- were never a supporter of the euro precisely because we did not think Europe as a whole was sufficiently integrated to allow a single currency to operate across such a varied economic landscape with such diverse policy objectives and different institutional structures. But I was sympathetic to the need to reduce the transactions costs associated with currency conversions and fluctuating exchange values, and I hoped that the introduction of a single currency would sufficiently discipline economic policy and improve economic performance so as to limit any problems caused by the introduction of a rigid and unchangeable unit to effect transactions and carry out investments over such a wide area. Opening up Europe as a whole to flows of people and capital was also a good idea that could help a continent overcome a terrible history of nationalistic turmoil.

Our fear was the euro would shift the internal balance of payments adjustment process among these countries entirely to changes in the level of income (and hence employment), as fixed exchange rates inevitably do, rather than allowing changes in relative prices to absorb some of the adjustment effects, as more flexible exchange rates tend to do. Wider swings in growth and more persistent external imbalances would result if a fixed exchange rate were imposed and the unemployment rate would be higher. If this happened, the economic situation in some of these countries would worsen over the long-run, not improve, at least relative to the other countries. This is what appears to have happened some of the peripheral countries.

The peripheral countries now have a difficult decision to make. By accepting the euro they have turned the conduct of their monetary policy over to the European Central Bank. It is no longer available to them as a domestic policy instrument. Moreover, now their fiscal policy must be directed at their external concerns rather than their internal problems. For these countries, fiscal policy is no longer a domestic policy instrument. The fixed exchange rate of the euro has become the sole concern and focus of economic policy in these countries. They will either have to discipline their internal policies to the demands of their external monetary relationships or they will have to abandon the euro.

As Martin Wolf mentions in his article, the late Charles Kindleberger of MIT argued that an open economy required a hegemon to bring stability to the external environment within which countries conduct their external economic relations. In the case of the eurozone it is Germany. But because of the nature of its own structural relationships Germany is not capable (or even willing) of carrying out this role. Consequently, the peripheral countries of the eurozone are left to fend on their own not only without support from other countries but with the constraints imposed by others tightening on them. Their immediate outlook is bleak and their adjustment process to deal with their problems is becoming increasing difficult.

In the same way for the same reasons as Kindleberger set forth the world economy requires a hegemon to provide it the stability and lend it the time required to adjust domestic productive structures and trading patterns to the incessant changes brought about by technological change and rising incomes. This hegemon is the United States, whose currency is the main international currency and whose economy is the main absorber and provider of goods and services at the international level. The U.S. attempted to avoid the role as hegemon at the end of the Second World War, or at least minimize it, through the establishment of a set of international monetary institutions -- the Bretton Woods System -- to which it transferred many of the operations necessary for the efficient functioning of the world economy. By doing so, it hoped to release itself from the constraints entailed in managing the world economy.

But the United States quickly learned that, in the end, there must be a spender and borrower of last resort in a crisis, and the IMF and other international agencies it created were not up to the task. Moreover, it quickly learned, to its sad regret, that that a fixed exchange rate system at the world level required domestic policy discipline on the part on the global hegemon and its failure to live within its means and conduct its domestic policy with the goal of international stability in mind would bring down the entire system. The world (and, equally, the Americans) has lived with the consequences of the inability of the United States to conduct its economic policies in a manner worthy of its responsibilities since the late 1960s and early 1970s. Nowhere is this clearer than in the sharp deterioration in long-term world and U.S. economic performance since that time and an increasingly chaotic international economy.

The upside of fixed exchange rate systems is that they provide the stability required for rapid economic advance and spreading global prosperity. The downside of fixed exchange rate systems is that they require discipline on the part of governments in the conduct of their monetary and fiscal policies, especially on the part of the hegemon, and a willingness to adjust to changes taking place outside their domestic economies.
As Martin points out, we are about to find out whether the peripheral members of the eurozone can summon the discipline necessary to deal with their deteriorating economic circumstances. One wonders whether the United States, which is far more important to the world economy and encompasses far more people than the smaller countries of the eurozone, can do the same.

Thanks to Larry Willmore for the Tdj.