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Exiting the Great Depression: lessons for today

Kris Mitchener and Joseph Mason

Discussion byMarcus Miller

Warwick University

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Discussant’s commentsWhat I liked

M and M’s outline of fascinating features like• Extent of bank recapitalisation through RFC

striking • Anti firesales activity of Deposit Liquidation Board

Their flagging of key issues like• Tackling asymmetric information via certification,

FDIC, etc.• Political problems of reversing crisis induced

institutional support

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What I missed

• Didn’t get their 3 R’s! How about-• Rescuing the system, too little too late in 1930s

• Regulating banks: in 1930s prudential regulation crucial complement to deposit insurance.

• Reform the system: in 1930s this included Glass-Steagall, SEC, Chapter 11 BankruptcyI will use these as headings for comments to follow

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1. Rescue (Image of the $1 trillion liquidity support by FRBNY)

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‘The Great Escape’

• What would have happened to the US economy if the Federal Reserve had not intervened by spending 7% of US GDP buying illiquid assets in 2008/9?

• The FRBNY have modelled the effect of a liquidity crunch without such intervention; and then with the liquidity injection of $1 trillion

• Results can be shown as:

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Effect of a liquidity shock in US that lasts 10 quarters, Del Negro et al. (2009) Solid blue : no intervention. Dashed blue: $1 trillion liquidity injection.

The Counterfactual

40 % fall of Investment

Output falling initially by 25% Then down to 30%

The capital stock falling by 1% a quarter until liquidity is restored

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Help from Central Banks - since Aug ‘07

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Plus support from Government =3/4 GDP!

• United Kingdom United States • Jan. 2007 Latest Jan.207 Latest• Government support

£ trillions $ trillions• Guarantees of financial• institutions’ liabilities – 0.37 – 2.08

• Insurance of financial assets – 0.46 – 3.74 •

Capital injections to banks and• special purpose vehicles – 0.06 – 0.70 •

Increase in public sector support 1.26 – 10.44

(including CB assistance)

• Percentage of GDP – 88% – 73%

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2. Regulation

• Crisis has revealed profound problems of • asymmetric information • Financial externalities (fire sales, network

effects)• Market concentration

These lie outside the competitive paradigm of economics, so tackling them will require thinking outside the box

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Challenges to the market paradigm

CompetitiveMarket paradigm

Missing information; missing markets

Strategic PowerExternalities, e.g.

systemic risk

Market collapse

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‘Greenspan defends position on free market’Central Banking.com 6 Apr 2010

• Alan Greenspan, a former chairman of the Federal Reserve, has refuted claims that his comments on the recent failures in financial markets are in any way a repudiation of the laissez-faire view that markets can be trusted to police themselves.

• "There is no alternative if you want to have economic growth, higher standards of living, in a democratic society, to have competitive markets," he said.

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Externalities

• Economists use the term ‘negative externality’ to refer to a side effect of economic activity that you don’t pay for.

• One example is Global Warming: use of car has side effects on global carbon build-up - and some predicting Armageddon as a result.

• Another example is atmospheric pollution.

• We focus on ‘fire-sale’ and ‘network’ externalities.

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Two Regulatory Responses: taxing externalities

• Some advocate Pigovian taxation of externalities associated with HLIs ‘Highly Leveraged Institutions’* who generate externalities – e.g. by capital adequacy ratios and presumably liquidity ratios, Korinek (2009) and Haldane(2010)

* inc banks, shadow banks and hedge funds who might get involved in ‘fire-sales’

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Key Problem: Tail risk within financial systems is endogenous and often unobserved

• it is hazardous to believe there is a magic number for regulatory ratios sufficient to insure against tail risk in all states of the world. Because tail risk is created not endowed, calibrating a capital ratio for all seasons is likely to be, quite literally, pointless – whatever today’s optimal regulatory point, risk incentives mean that tomorrow’s is sure to be different.

• A.G. Haldane ‘The $100b question’

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Prohibition

• Andrew Haldane “The $100 b question”(2010) argues that:

• Banks will always be able to move faster than the regulators , and avoid control by ‘regulatory arbitrage’. Look at the US shadow banking industry!

• Hence the need for prohibition - to ban activities that threaten to generate negative externalities.

• “Prohibition” may have a 1930s sound, and that’s right

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US in 1930s: Glass-Steagall

• Glass-Steagall : simple in objectives and execution. • Clear aim - shaped by an extreme tail event (the

Great Depression) –was to avoid a repetition. • It sought to achieve this by acting directly on the

structure of the financial system, quarantining commercial bank and brokering activities through red-line regulation.

• Lasted over half a century without a significant systemic event in the US, until revoked in 1999 by Gramm-Leach-Bliley Act . And then….?

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Average assets relative to GDP of US commercial banks Source: A.G. Haldane ‘The $100b question’

0.014

a 0.012

as

Ban

k

GD

P

0.010

Com

mer

cial

Nom

inal

0.008

of

per

perc

enta

ge

0.006

Ass

ets

0.004

Ave

rage

0.002

0.000

34

1938

42 0

1954

8

19 62

6

1970

4

19 78 1982 86 0

94 8 02 6

5 5 6 7 9 9 0

9 9 9 9 9 0

1 1 1946 19 19 19

1 1 19

1 19

2 20

Y ear

A v e rag e A sse t S iz e o f C o m m erc ia l B an k s sc a led b y N o m in a l G D P

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Concentration of the US banking system Source: A.G. Haldane ‘The $100b question’

com

mer

cial 45 .00

40 .00

35 .00

tota

l

asse

ts)

of

30 .00

%

(as

25 .00

sect

or

bank

s

20 .00

bank

ing

US

3 15 .00

top

of

10 .00

asse

ts

5.00

Tot

al

0.00

1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007

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3.Reform of structure

• In a context of asymmetric information, HLI’s use the property rights of the capitalist system to generate profits which reflect transfers rather than value added.

• Why not change property rights? E.g.• Volcker Rule to bring back Glass-Steagall• Investment banks to be partnerships again• Double liability for commercial bank shares?

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Let me out of here!

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What is not legally banned may be economically attractive (with moral issues left aside)

Legally banned

Is there not a risk that that well-heeled, politically savvy, financial institutions - with the best lawyers and least moral scruples - will stay ahead of legal and moral sanctions.

Morally unacceptable

•A: OK

•B: PROBLEM

Economic progress: two possibilities:

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Postscript

• ‘Wall Street titans still recklessly speculate with borrowed money. We cannot delay action any longer.’ (Barack Obama)

• Goldman charged with fraud FT Headline - 17 April 2010

• ‘US authorities yesterday accused Goldman Sachs of securities fraud that caused investor losses of more than $1bn (£649m).

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• In Western, market-based culture, the limitations on property rights depends explicitly on legal sanctions

• But these are failing to internalise externalities

• In some Eastern cultures, the rule of law is not paramount; and, in any case, there may be other sanctions , e.g. shame, capital punishment.

• So they may be better able to internalise externalities!

*Dipak Lal Unintended Consequences,

Competition between Cultures?