EconoMonitor

Peterson Institute for International Economics

Archive for August, 2009

  • Benefits of More Trade Between South Asian Rivals

    Mohsin S. Khan argues that India and Pakistan have much to gain from putting aside their hostilities and increasing economic cooperation and trade. Recorded July 13, 2009. © Peterson Institute for International Economics. Steve Weisman: This is Steve Weisman at the Peterson Institute for International Economics. Mohsin Khan, senior fellow at the Institute is here […]

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  • American Multinationals and American Economic Interests: New Dimensions to an Old Debate

    The 2008 election rekindled debate about whether US multinationals shift technology across borders and relocate production in ways that might harm workers and communities at home. President Obama now pledges to end tax breaks for corporations that ship jobs overseas. The preoccupation about the behavior of American multinationals takes three forms: (1) that US-based multinational […]

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  • Trade and the Global Economic Crisis: “If It’s Not Part of the Solution, It’s Part of the Problem”

    Remarks presented at the APEC symposium, “Addressing the Economic Crisis, Preparing for Recovery,” Singapore July 17, 2009 This year marks the 20th anniversary of the Asia Pacific Economic Cooperation (APEC) forum. Over the past two decades, the 12 founding members have broadened the scope of regional economic cooperation, contributed importantly to the conclusion of multilateral […]

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  • A Step Forward on Financial Regulation

    Morris Goldstein, assessing the merits and defects of the US Treasury Department’s financial regulatory proposals, finds the balance on the positive side. Recorded July 7, 2009. © Peterson Institute for International Economics. Steve Weisman: This is Steve Weisman at the Peterson Institute for International Economics. Morris Goldstein, senior fellow at the Institute, has written extensively […]

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  • Escalating Tensions with North Korea

    Marcus Noland cautions that more political, economic, and military pressure on North Korea could push the regime in Pyongyang toward more provocative behavior. Recorded July 9, 2009. © Peterson Institute for International Economics. Steve Weisman: This is Steve Weisman at the Peterson Institute for International Economics. Our guest on Peterson Perspectives is Marc Noland, senior […]

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  • Systemic Risk: Are Some Institutions Too Big to Fail and If So, What Should We Do about It?

    Testimony before the US House Committee on Financial Services hearing, “Systemic Risk: Are Some Institutions Too Big to Fail and If So, What Should We Do About It?” July 21, 2009  

    Main Points

    1. The US economic system has evolved relatively effective ways of handling the insolvency of nonfinancial firms (through bankruptcy) and small or medium-sized financial institutions with retail deposits (through an FDIC-run intervention process).1 These kinds of corporate failures inflict limited costs on the real economy, and even a string of problems in such firms does not generally jeopardize the entire financial system.
    2. We do not yet have a similarly effective way to deal with the insolvency of large financial institutions (e.g., any bank with assets over $500 billion, which is roughly 3 percent of GDP). When one of these firms gets into trouble, the authorities face an unpalatable choice of “bailout or collapse.” If the problems spread to more than one firm, the balance of responsible, official thinking shifts toward: “bailout at any cost.”
    3. The collapse of a single large bank, insurance company, or other financial intermediary can have serious negative consequences for the US economy. Even worse, it can trigger further bank failures both within the United States and in other countries, and failures elsewhere in the world can quickly create further problems that impact our financial system and those of our major trading partners.
    4. As a result, we currently face a high degree of systemic risk, both within the United States and across the global financial system. This risk is high in historical terms for the United States, higher than experienced in most countries previously, and probably unprecedented in its global dimensions.
    5. Short-term measures taken by the US government since the fall of 2008 (and particularly under the Obama administration) have helped stabilized financial markets, primarily by providing unprecedented levels of direct and indirect support to large banks. But these same measures have not removed the longer-run causes of systemic instability. In fact, as a result of supporting leading institutions on terms that are generous to top bank executives—few have been fired or faced other adverse consequences—systemic risk has likely been exacerbated.
    6. Some of our largest financial firms have actually become bigger relative to the system and stronger politically as a result of the crisis. Executives of the surviving large firms have every reason to believe they are “too big to fail.” They have no incentive to help bring system risk down to acceptable levels.
    7. Specifically, the surviving large US financial firms and their foreign competitors have a strong incentive to resume “pay-for-performance” incentive systems; they compete by attracting “talent,” and if any one firm brings its compensation under control, it will lose skilled employees. But these firms, and their regulators, have also demonstrated they cannot prevent such incentives from becoming “pay-for-disguised-risk-taking” on a massive scale.
    8. The potential for unacceptable systemic risk remains deeply engrained in the culture and organizational structure of Big Finance. Over the past 30 years, this sector has benefited from a process of “cultural capture,” through which regulators, politicians, and independent analysts became convinced this sector had great and stabilizing technical expertise. This belief system is increasingly disputed, but still remains substantially in place: Big banks are, amazingly, still presumed by officials to have the expertise necessary to manage their own risks, to prevent systematic failure, and to guide public policy.
    9. There are four potential ways to reduce systematic risk going forward:
    1. Changing our regulations so as to reduce ex ante risk-taking, e.g., by more effectively controlling the extent of leverage in the financial system or by more tightly regulating derivatives transactions;
    2. Changing the allocation of regulatory authority within the financial system, so that the relative powers of the Federal Reserve, Treasury, FDIC, and various other regulators are adjusted;
    3. Making it easier for the authorities to close down failing large financial companies using a revised “resolution authority”;
    4. Changing the size structure of the financial system, so that there are no financial institutions that are too big to fail.

    All of these approaches have some appeal and it makes sense to proceed on a broad front, because it is hard to know what will gain more traction in practice. The growing complexity of global financial markets means that even sophisticated financial-sector executives do not necessarily understand the full nature of the risks they are taking on. There is no ideal, or even proven, regulatory structure that will work inside the US political system. Relative to the alternatives, strengthening the FDIC makes sense. For certain levels of potential bailout (e.g., as with CIT Group recently), the FDIC has an effective veto power over providing some forms of government support. This has proved a helpful check on the discretion of the Federal Reserve and the Treasury recently, but it would be a mistake to assume this will be the case indefinitely. While an extended resolution authority could be helpful, it is not a panacea. As markets evolve, new forms of interconnections evolve, and we have learned that not even managers of the best-run banks understand how that affects the transmission of shocks. Furthermore, as banks become more global, an effective resolution authority would need to span all major countries in comprehensive detail. We are many years away from such an arrangement. The stakes are very high: The country’s fiscal position has been significantly worsened by the current crisis, and our debt/GDP ratio is on track to roughly double. As a result, it makes sense to also consider measures that will reduce the size of the largest financial institutions. The recent experience of CIT Group suggests that a total asset size under $100 billion may provide a rough threshold, at least on an interim basis, below which the government can allow bankruptcy and/or renegotiation with private creditors to proceed. Market-based pressure for size reduction can come through a variety of measures, including higher payments to the FDIC (or equivalent government insurance agency) from institutions that pose greater systematic risk, higher capital requirements for bigger firms, and differential caps on compensation based on the cost of implied government assistance in the event of a failure—think of this as prepayment for failure. Breaking up our largest banks is entirely plausible in economic terms. This action would affect less than a dozen entities, could be spread out over a number of years, and would likely increase (rather than reduce) the availability of low-cost financial intermediation services. The political battle to set in place such antisize measures would be epic. But as in previous financial reform episodes in the United States (e.g., under Teddy Roosevelt at the start of the 20th century or under FDR during the 1930s), over a 3–5 year period even the most powerful financial interests can be brought under control. If we are able to make our largest financial firms smaller, there will still be potential concerns about connected failures or domino effects. Much tougher implementation of “safety and soundness” regulation is the only way to deal with this. In that context, stronger consumer protection, through a new agency focused on the safety of financial products, would definitely help (as well as being a good thing for its own sake).

    The remainder of this testimony provides further background regarding how systemic risk developed to its current high levels in the United States and suggests why we need new limits on financial institutions whose management regards them as too big to fail.

    Background

    The depth and suddenness of the US economic and financial crisis today are strikingly and shockingly reminiscent of experiences we have seen recently only in emerging markets: Korea in 1997, Malaysia in 1998, and even Russia and Argentina, repeatedly.

    The common factor in those emerging-market crises was a moment when global investors suddenly became afraid that the country in question wouldn’t be able to pay off its debts and stopped lending money overnight. In each case, the fear became self-fulfilling, as banks unable to roll over their debt did, in fact, become unable to pay off all their creditors.

    This is precisely what drove Lehman Brothers into bankruptcy on September 15, and the result was that, overnight, all sources of funding to the US financial sector dried up. From that point on, the functioning of the banking sector has depended on the Federal Reserve to provide or guarantee the necessary funding. And, just like in emerging-markets crises, the weakness in the banking system has quickly rippled out into the real economy, causing a severe economic contraction and hardship for millions of people.

    This testimony examines how the United States became more like an emerging market, the politics of a financial sector with banks that are now “too big to fail,” and what this implies for policy, particularly the pressing need to apply existing antitrust laws to big finance.

    How Could This Happen?

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  • China’s Undervalued Currency

    Nicholas R. Lardy, coauthor of a new book with Morris Goldstein, says China’s exchange rate practices have improved but could benefit from more reform. Recorded July 21, 2009. © Peterson Institute for International Economics. Steve Weisman: This is Steve Weisman at the Peterson Institute for International Economics. Nicholas R. Lardy, our guest today, is the […]

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  • Pacific Asia and the Asia Pacific: The Choices for APEC

    The Asia Pacific Economic Cooperation (APEC) forum comprises 21 developed and developing economies that surround the Pacific Rim. The organization was created in 1989 and holds annual Leaders’ Meetings that bring together its heads of government. In this policy brief, I assess the record of the APEC over the 20 years of its existence and […]

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  • Latvia Defies the American Conventional Wisdom

    For nearly a year, prominent American economists, such as Paul Krugman, Nouriel Roubini, and Kenneth Rogoff, have maintained that Latvia is just another Argentina (as Krugman has put it) and that it was only a matter of when, not whether, Latvia would be forced to devalue its currency. Well, despite these warnings, devaluation seems less […]

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