Paulson's Plan Sounds Familiar
Alan Greenspan does not believe that he is responsible for the current financial crisis. Moreover, he doesn't think that regulators can prevent booms and busts. Isn't that like an NFL referee saying he can't prevent opposing teams from beating each other silly?
It is of course a convenient stance. Some charge that Mr. Greenspan's policies as Fed chairman led to today's housing meltdown. Mr. Greenspan deflects critics by saying, as he did in his recent op-ed in the Financial Times, that "regulators, to be effective, have to be forward-looking to anticipate the next financial malfunction. This has not proved feasible."
The Treasury secretary seems to disagree. His proposal to overhaul our financial regulations makes clear that, indeed, regulators do play an important role.
And, at the risk of alarming those who are frantic that the dollar will soon be supplanted by the North American currency union, or that we are slowly but surely losing our sovereignty, I suggest that Treasury Secretary Henry Paulson borrowed heavily from the Bank for International Settlements in coming up with his proposals. The BIS, the world's oldest international banking institution, hosts the Financial Stability Forum, which convenes leading monetary authorities to discuss, yes, financial stability. The BIS, in short, is the central bank for central bankers. Meetings of the BIS are regularly attended by Treasury staff; Fed chair Ben Bernanke is on the board of directors.
In his proposal, Mr. Paulson suggested that the Federal Reserve should act as an overall regulator, a "macroprudential" watchdog. The word "surprised and pleased" William White, the head of monetary and economic development at the bank. "Macroprudential" is a word they have used since the 1980s, he says. In numerous speeches, dating back to the early 1990s, and in a recent telephone conversation, Mr. White reaffirms his belief that financial regulators not only could, but should, attempt to temper the natural excesses that grow out of free capital markets.
"Financial markets get good news, they tend to pick up and run with it, which justifies more credit being allocated, and then to higher priced assets, which attract more collateral and so on. A lot of people want to start out saying that interfering in this process isn't practical. But we've seen a number of countries suffer enormous costs associated with boom and bust cycles. Finland lost 15% of GDP in one cycle; Japan lost 9%. Yes, there are costs and difficulties of putting in a system to regulate these cycles; but you also have to consider the costs of not doing it," Mr. White says.
Mr. White spoke last month before the Financial Markets Group and the Deutsche Bank Conference on Financial Crisis. His speech dealt with preventing future financial crises, and he addresses both "what is different" and "what is the same" about the current mess. Mr. White emphasizes the latter, since he feels we all know what is different this time around: newfangled financial instruments, globalization, and the enormous expansion of credit in the mortgage market. It is "what is the same" that interests Mr. White: The factors leading up to today's slump are essentially just like those that have precipitated most economic downturns. His conclusion sounds like the one reached by Mr. Paulson. What leads to these inevitable bubbles? Mr. White blames two human traits; the first is "a persistent tendency to extrapolate recorded returns and to discount risks inappropriately," and the second is "the inability to forecast outcomes arising from processes where all the variables are highly endogenous."
Mr. White goes on to explain that booms turn to busts "completely unexpectedly," usually precipitated by a trigger that is "usually far too inconsequential to explain the resulting mayhem." "The proposed macrofinancial stability framework would encourage both regulatory authorities and central banks to actively resist the natural pro-cyclicality of the financial system," he says.
What does that mean? First, he argues that the overseers should try to assess systemic risk. That is, they would monitor the extent to which institutions and people were exposed to similar possible shocks. They should also get regulators and central bankers working more closely together to decide what to do about systemic risks. Third, and possibly most controversial, is the proposal that monetary (and regulatory) policy would be used to "lean against 'booms' in the growth of credit and asset prices, particularly if accompanied by distorted spending patterns …"
Does this sound familiar? It should. It is the essence of Mr. Paulson's long-term plan.
Mr. White acknowledges many impediments to implementing such a program. For instance, it will be argued that the authorities may be unable to identify the appropriate moment to throw cold water on the roaring fire. Or that they do not have adequate tools. The biggest challenge, according to Mr. White, is to develop the "will to act." He says the real roadblock for regulators will be confronting the lobbying of those benefiting from the excesses. He is absolutely correct. Consider the howls that would have greeted any attempt to slow the housing cycle in 2006 — from builders, mortgage brokers, lenders, securitization folks, the CDO investors, ratings agencies, and even from home buyers.
In spite of these obstacles, Mr. White firmly advocates attempting to moderate the cycles that every few years disrupt economic growth, and peoples' lives. "In the end, if it can't be done, we can admit defeat and walk away," he says.
Mr. Paulson, it would seem, is ready to give it a try.
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