The Federal Reserve’s outlook on the economic recovery continues to get gloomier. In its statement released following the FOMC meeting today, the Federal Reserve acknowledged that “the pace of recovery in output and employment has slowed in recent months,” and “economic recovery is likely to be more modest in the near term than had been anticipated.” Not good news, especially when interest rates are already about as low as they can go. With today’s announcement that it is committed to keeping rates at rock-bottom levels ”for an extended period” going forward, the Fed also signaled that it is ready to go beyond rate setting to strengthen the economy.
After keeping the federal funds at historic lows for so long, with only disappointment to show for it, the Fed has decided that it’s no longer enough to lead the U.S. economy to water and wait for it to drink. So as part of its announcement today, the Fed signaled that it will once more resort to quantitative easing to pump money directly into the economy. Because there are risks to this strategy (see Krugman), the Fed couched this move in modest terms, explaining that it will be buying long-term Treasury notes to “keep constant” the level of assets on its balance sheet, which currently includes a large portfolio of mortgage securities it purchased to stabilize markets during the financial crisis.
The Fed will simply be rolling over its portfolio into Treasuries as the mortgage securities retire, which is actually not putting new money into the economy, as much as it is preventing the money supply from shrinking if the Fed’s portfolio were allowed to get smaller. But there are signals here for those who have been anticipating a new push for quantitative easing from the Fed.
The First Signal: The Fed is clearly ready to buy market securities to inject money into the economy as needed. This baby step toward quantitative easing is likely a preview of more dramatic asset purchases if the Fed sees real evidence of deflation or a double-dip recession. Be prepared for more.
The Second Signal: The Fed is not necessarily interested in using mortgage securities as an asset vehicle for expanding the money supply. Doing so would keep mortgage rates low, which would help prop up an ailing housing market. But mortgage rates are already the lowest on record, and that hasn’t helped sales much, so the Fed doesn’t need to waste time trying to lead another horse to water in housing markets.
The overall signal from today’s FOMC statement is not good news for the economy. The Fed is becoming less optimistic and less certain about the future. Bernanke and company are apparently convinced that stronger actions may still be needed for sustained stimulus. The fact that they are coming around to that view may do some good for restoring confidence in Fed policy. And the Fed needs all the help it can get these days, because it’s running out of useful monetary tools to boost the economy.
Hopefully the signals from today’s statement will be heard in Congress, where lawmakers still have a lot of steps they can take before the end of the year to bring better stimulus and more confidence to the economy.
The International Monetary Fund recently scolded the U.S. government for running large budget deficits. Leaving aside the absurdity of cutting deficits when unemployment is still extremely high, it’s clear that at some point – as joblessness declines toward 5 percent – deficit reduction will need to begin in earnest. But the real question is how to do that. There’s a risk that the Washington economic class – grounded as they are in 20th century neo-classical economics — will fail to balance the twin imperatives of fiscal discipline and public investment.
Indeed the common refrain that has become the new “group think” in DC is that “everything should be on the table” when it comes to addressing the debt. For example, the Bipartisan Policy Center’s Debt Reduction Task Force says, “everything should be on the table.” Even President Obama, who has at least rhetorically talked about the need for increases in public investment and fought to include public investment in the stimulus, now says that everything should be on the table. Other groups echo this intellectually easy, but intellectually simplistic, position. Pete Peterson’s Concord Coalition likewise calls for “applying budget discipline to all parts of the budget.” The New America Foundation’s Committee for a Responsible Budget supports a budget freeze on all discretionary spending. For these budget hawks, subsidies to farmers to produce crops that aren’t needed fall in the same category as funding for the National Science Foundation to advance science and technology critical to our nation’s future: they both cost money and both should be cut.
The Government’s Role
But there are some things that governments do – on the tax and spending sides – which drive productivity, spur innovation, improve health, clean up the environment and create other benefits that most certainly should not be on the table. The National Commission on Surface Transportation Financing (which I had the honor of chairing) recently highlighted a federal highway and transit funding gap of nearly $400 billion over the next five years. Increased federal support for highways and transit would lead to significantly greater societal benefits (reduced traffic congestion, higher productivity) than the costs in revenues. Yet some groups wave the budget red flag to oppose expanded infrastructure investment, even if increased user fees, such as the gas tax, pay it for. As ITIF has demonstrated, increasing the Research and Experimentation Tax Credit from 14 to 20 percent would return $9 billion more to the Treasury than it would cost. And as ITIF and the Breakthrough Institute have shown, solving climate change requires significant increases in federal support for clean energy innovation, but the benefits (saving the planet) are massive.
What’s behind this widespread unwillingness to prioritize investment? Budget hawks fear that sparing one item from the chopping block will only validate the demands of interest groups to exempt their pet programs. In addition, many adhere to a neo-classical economics perspective, which holds that government plays a negligible role in economic growth and should be neutral with regard to private sector activity. In the purest form of this thinking, everything is on the table, because nothing is more important than anything else. To paraphrase Michael Boskin, a neo-classical Bush I economist, a dollar of public investment on computer chips has the same societal value as a dollar spent on potato chips. But government should be anything but neutral. Science and infrastructure funding is more valuable than farm subsidies. Government support for research in computer chips is more valuable than support for potato chips.
For liberals, reducing spending on entitlements will not only harm working Americans, but will also reduce economic growth, since Keynesian doctrine holds that growth comes from increasing aggregate demand – meaning pump more money into the economy, period.
In contrast, an innovation economics approach to the budget distinguishes between spending on consumption and spending on investment. For innovation economics advocates, all spending (either on the tax or expenditure side) should be on the table, and all investment (on the tax and expenditure side) should be off the table.
Tax, Cut and Invest
The last time Washington paid attention to deficits was in the first Clinton term. At that time PPI Vice President Rob Shapiro wrote a series of reports with the title, “Cut and Invest.” The notion was that we should cut unnecessary spending and use a significant share of the savings to invest in the nation’s future, including education, infrastructure and research. That was the right message then and it is the right message now. Although today, such a report might be best titled, “Tax, Cut and Invest.” To solve the budget deficit in a way that enables the significant increases needed in investment, we need to raise some taxes, cut some spending and increase some investment.
The general outline should look like this: On the tax side, we should let the Bush tax cuts on the wealthy expire, including: dividend taxes, estate taxes (above a certain modest size) and top marginal rates. We should increase the gas tax by at least 15 cents a gallon (and index it to inflation) and at the same time institute a carbon tax. We should consider a border-adjustable business activity tax. We should eliminate the home mortgage interest deduction. (Home ownership has many societal benefits, but as we see from other nations without these large tax incentives, nations can get high levels of home ownership without wasteful subsidies.)
On the spending side, we need to deal with entitlements, including: progressive indexing of Social Security benefits and increasing the retirement age, continued health care reform — particularly focused on driving innovation to cut costs and cutting entitlements to farmers — farm subsidies. This should be a gradual process to spread the pain over time.
And most importantly, we should significantly expand investments. We need to expand investments in education and training, science and research, technology (including, but not limited to clean energy) and physical infrastructure. In order to ensure that companies in the U.S. are globally competitive and create jobs here at home, we need to expand corporate tax expenditures. For example, create a new corporate competitiveness tax credit that would include a much more generous credit for research and development, and a credit for business investments in workforce training and new capital equipment, especially software. Making these investments will cost money in the short run. But they will also generate returns to the economy and the government in the long term. In economic downturns, successful corporations don’t cut key investments because they know that these investments are vital to gaining market share and competitive advantage in the moderate term. Governments should think the same way.
So let’s stop talking about putting everything on the table and instead recognize that not only do investments need to be off the table, they need to get more from what’s on the table.
Rob Atkinson is president and founder of ITIF, a Washington-based think tank providing cutting-edge thinking on technology and economic policy issues.
First the giant stimulus package, then the ambitious revamping of America’s health care delivery system. Now Congress, under the patient prodding of President Obama, is lurching toward passage of another stupendously complex bill, this time centered on financial regulatory reform. Whether you like them or not, you have to admit that big things are getting done in Washington on Obama’s watch.
If Congress passes the Dodd-Frank bill, it will be another major notch in the belt of a president who could use a political victory about now. But what’s a non-master of the universe like me to make of this 2,000-page behemoth?
It may do considerable good, but we ought to be clear about one thing: It won’t prevent the next financial crisis. As long as there are fortunes to be made in financial markets, there will be excessive risk-taking and speculation, new bubbles and panics, and powerful incentives for chicanery and fraud. No regulatory scheme can fully protect the public against ingenious new forms of human greed and folly.
That, however, is not an argument for doing nothing. The government had to react to Wall Street’s near meltdown in the winter of 2008-2009. Its interventions, beginning under President Bush and continuing into Obama’s administration, doubtless averted a full-bore financial collapse. But they also triggered a fierce and abiding public backlash against bailouts.
The Dodd-Frank bill doesn’t get everything right, but on balance it’s a reasonable response to the crisis. It imposes new disciplines on bank behavior, increases transparency for complex financial transactions and institutions, and offers consumers new protections against the clever breed of predators who have degrees from elite universities and sport $3,000 suits.
Some liberals are chagrined that the bill doesn’t break up the big banks. Conservatives echo the Wall Street Journal’s charges that the bill is a regulatory nightmare that will make it more expensive for banks to supply capital to businesses. It’s tempting to say that Sen. Chris Dodd (D-CT) and Rep. Frank (D-MA) must therefore have found some kind of centrist sweet spot, but there is something to the left-right critiques.
Most important, for example, the bill doesn’t slay the “too-big-to-fail” dragon. It leaves financial power more concentrated than ever in the hands of five mega-banks: Goldman Sachs, J.P. Morgan, Citigroup, Morgan Stanley and Bank of America. True, Dodd-Frank does impose the “Volcker Rule,” forbidding banks covered by federal deposit insurance from making bets (called “proprietary trading”) with their own money. It increases capital reserve requirements to keep banks from taking excessive risks. It also sets up a council of financial guardians to anticipate systemic risks, and gives federal authorities power to seize and oversee the “orderly liquidation” of financial firms whose collapse could bring other institutions down as well.
But it’s hard to avoid the impression that the big banks will henceforth operate with a tacit government guarantee against systemic failure. This not only intensifies moral hazard – making it hard for administration officials to claim the bill would bar bailouts in the future – it also risks creating a privileged class of quasi-public banking utilities that will be able to borrow money more cheaply. That will raise the bar for new entrants and dampen competition in the banking sector.
Elsewhere, the picture looks more positive. Dodd-Frank would move much of the trade in financial derivatives onto exchanges and clearinghouses, though banks could still trade in over-the-counter derivatives to hedge their own risks. This seems like a sensible compromise that brings derivatives trading out of the shadows while retaining the ability of firms to hedge against interest rate and currency risks. In another boost for transparency, the bill would require private equity firms and hedge funds to register with regulators.
Dodd-Frank also puts in place what Obama last week called “the strongest consumer financial protections in history.” It creates a new Consumer Financial Protection Bureau housed with the Fed to police mortgage lending, credit and debit cards and other consumer loans – though not by auto dealers, who somehow won an exemption from oversight. This agency presumably will prevent abuses like the “no doc” and “liar” loans that helped to trigger the subprime lending frenzy, which was the spark that started the financial crisis.
The bill doesn’t deal at all with Fannie Mae and Freddie Mac. This is a huge omission, considering that these giant mortgage finance firms still hold a pile of dubious assets and are essentially in federal receivership.
For all its imperfections, Dodd-Frank seeks to protect consumers without creating undue regulatory obstacles to innovation in the financial sector, which traditionally has been a source of comparative economic advantage for the U.S. Pragmatic progressives ought to support it, while retaining a sense of humility about the ability of new regulatory bodies to prevent future abuses.
How to tell a good climate bill from a bad one? This series will guide you through the main issues that are likely to arise in the coming weeks as the Senate takes on climate change. In previous posts, we looked at the crucial and the merely important issues that factor in the climate debate. In this post we highlight issues that matter for climate policy, but will not necessarily make or break it. (To read the other posts in the series, click here.)
So far, we’ve established the absolutely critical aspects needed to make credible climate policy and identified the important features that would make that policy effective. Now we will focus on issues that aren’t quite on the same level, negotiable elements that could still have a meaningful role in determining the long-term viability and effectiveness of a domestic emissions mitigation program. These issues — specifically, price controls and the international implications of U.S. legislation — could become a big part of the political discussion.
Category III Issues: Negotiable Elements of Climate Policy
#1: Price controls: offsets and collars
An uncontrollably rising carbon price is a nightmare scenario for regulated firms and consumers, so industry groups have made a priority of getting robust price controls into climate legislation. Price controls generally take three different forms: banking and borrowing, offsets and price collars. Because banking and borrowing has such a strong effect on the emissions reduction path, we included them in our last post. Here we’ll focus on the two other strong cost containment mechanisms.
a) Offsets
If you’ve been paying attention to the debate over the past two years, you’ve likely heard something about offsets. They are one of the most controversial aspects of climate legislation. Environmentalists are suspicious of them and industry can’t live without them.
What exactly are offsets? As we mentioned in a previous post, carbon is a stock pollutant, meaning that we only care about its total accumulation in the atmosphere. If you keep adding carbon to the system, but remove an equal amount at the same time, it is just as good as no longer adding carbon at all. This is the underlying principle of offsets — firms that pay to remove greenhouse gases from the atmosphere (or keep them from entering in the first place) can receive the same credit they would get if they reduced their own emissions.
For example, with offsets in a cap-and-trade system, a utility that needs to reduce its carbon emissions by 20 million tons need not do so only through emissions cuts from its operations. It could reduce its own emissions by 15 million tons, then receive offset credits through financing a reforestation project and an agricultural methane reduction project that combined would lead to emissions reductions of five million tons, allowing the company to meet its target.
Here is a quick list of different kinds of offsets that might count under climate legislation:
Forestry: Forests absorb CO2 through natural respiration processes and store it in plant tissue and soil. When deforestation occurs, that stored carbon is released into the atmosphere, contributing to emissions. Deforestation and forest degradation count for around 15 percent of global CO2 emissions. Projects that reforest — increasing carbon sequestration — or reduce deforestation and forest degradation are growing increasingly popular in voluntary carbon markets and may facilitate significant savings. Some models have speculated that international forest offsets can account for 25 percent of emissions mitigation by 2020.
Agriculture: The agricultural sector accounts for six percent of U.S. emissions, but agricultural emissions will probably not be covered by a carbon price due to the complexity of measuring emissions from agricultural practices and the power of the farm lobby in Washington. The important gases from agriculture are methane emissions from large-scale cattle operations and manure management, and nitrous oxide emissions from fertilizer applications and soil management. Offset projects that capture renegade methane emissions or reduce nitrous oxide releases through better soil management will likely be the most widespread offsets available from the agriculture sector.
Renewable energy/energy efficiency: Projects that supplant dirty energy sources with cleaner sources or improve efficiency in energy production or end-use can also be eligible for offset credit. For example, a firm looking for cheap reductions could finance the development of a renewable energy project and receive credit for the emissions reduced when the renewable energy displaces conventional dirty energy. Additionally, projects that increase the efficiency of energy usage in buildings or facilities can count as offsets. These projects are a major component of the Clean Development Mechanism (CDM), which was established by the Kyoto Protocol. Using the CDM, developed countries can sponsor projects in developing countries and receive emissions reduction credit.
Waste management: The decay of garbage in the nation’s thousands of landfills represents the second largest source of U.S. methane emissions behind cattle operations. Methane flaring, a process that captures and burns these emissions, converting methane into CO2, is considered an offset, as CO2 has a lower global warming potential than methane. Combusting methane for energy generation may also generate offset credits.
Fugitive mine emissions: As with landfills, capturing fugitive methane emissions from coal mines presents an opportunity for offsets and may also have benefits in terms of miner safety.
While all of these offsets options are currently available in voluntary offset markets and allowed by regional cap-and-trade schemes like RGGI, they may not all be eligible for credit under federal regulation. Waxman-Markey does not count renewable energy, energy efficiency, waste management and coal emissions as offsets. Cantwell-Collins does not allow offsets in its trading system, but it does permit such projects to be paid for from its Clean Energy Reinvestment Trust.
Many offsets will be cheaper than actual emissions reductions, making them an important means of price control. This is especially true for international forest offsets — the EPA analysis of Waxman-Markey contended that allowance prices would be 96 percent higher without them. That said, Greenpeace and other environmental groups have firmly planted their flag in the anti-offset camp, and there are a number of issues that would need some serious policy attention in order to make forest offsets credible in the U.S. market.
There are four major requirements to making offsets a robust tool. First, they must be additional — that is, projects should only be considered offsets if the specific practice would not have happened anyway. Second, offsets should have permanence — projects are only useful if they are not quickly undone (an offset for planting a tree is of little value if it is rapidly cut down). Third, offsets should be verifiable — there must be some way to confirm that projects are doing what they claim (for forests, this can be very difficult). Finally, offset programs should address leakage — they should not simply shift emission-generating activities somewhere else. These are all valid concerns, and all four will have to be addressed for offsets to be a credible part of climate policy.
Potential hang-ups for offsets will likely involve politicians’ hesitations to send large sums of money overseas, the reliability and veracity of offset credits, the number of offsets allowed for use by regulated firms and the type of offsets available from domestic sources. Despite the misgivings of some policymakers and commentators, offsets will figure prominently in domestic legislation. Waxman-Markey included two billion tons worth of offsets annually, a significant proportion of overall U.S. emissions, the same amount as in the Kerry-Boxer bill introduced in the Senate last fall. Instead of spending time and energy railing against them, policy discussions should instead focus on setting up institutions to fix the problems listed above.
b) Price collars
More than anything else, firms want some certainty when it comes to climate regulations. Planning capital investments over the long-term will be significantly affected by carbon prices, and the more predictable the changes over time, the better firms can plan ahead. Moreover, sudden system shocks in the form of extreme drops or increases in prices can be very expensive and detract from the efficacy of cap-and-trade markets.
To protect the system and reduce price uncertainty, policy-makers are looking to use a price collar in the allowance market. A price collar is a way to define a general price path by restricting how much the price can rise or fall. Price collars work by establishing a price floor — under which the allowance price can never drop — and a price ceiling — above which the price will not rise. It is a simple mechanism in concept, and can provide a lot of certainty for regulated parties and market participants. The price floor and ceiling should be spaced far enough apart to accommodate market dynamics and rise at some rate to match the general rise in allowance prices.
When allowance prices hit the floor, they simply remain at that price until trading forces the price to rise again. Things get more complicated when they hit the ceiling, however. There are two options to bring down the price, depending on if you employ a hard collar or a soft collar. A hard collar releases additional allowances into the system until the price drops, regardless of how many it takes to do so. By contrast, a soft collar uses a strategic reserve of set-aside allowances to reduce the price below the ceiling. The difference between the two is a matter of emissions certainty. A soft collar maintains the overall emissions cap by taking some out of the system at the beginning, much like a rainy day fund, whereas a hard collar just dumps allowances into the market until the price changes. Firms may favor a hard collar because it provides more price certainty, but people concerned about overall emissions will prefer a soft collar.
#2: International aspects
If and when Congress does pass climate legislation, its impact will reach far beyond our borders. The international implications of domestic climate policy are extensive, and while they do not play a huge role in the political discourse, they have sway over some notable policy choices.
a) International negotiations
The Conference of Parties (COP) 15 in Copenhagen in December 2009 was advertised as a chance for the U.S. to reclaim its place at the world leader and innovator on environmental issues. The U.S. was able to do that only partially, and that was due largely to the extraordinary personal diplomacy of President Obama. U.S. negotiators had little to work with, bringing with them no official legislation to show other nations while trying to broker a deal that could pass Senate muster. Without a signed bill, the 2010 COP in Cancun this coming November will probably turn out similarly; nations will bicker and haggle and eventually end up not making any kind of serious commitment sans U.S. leadership. The EU does not have the sway to move a global climate deal forward, while other major emitters like China and India don’t have the incentive to act.
That’s not to say international negotiations will not have some influence on the shape of U.S. legislation. At Copenhagen, the U.S. committed to provide $30 billion from 2010 to 2012 to developing countries for mitigation, adaptation, technology transfer and other assistance. Additionally, the conference agreed to establish an annual $100 billion fund — of which the U.S. is expected to give roughly $20 billion — for developing countries for the same uses. Some of this funding will likely be partitioned from current programs, but it will certainly not be enough. Revenues from carbon markets established by climate legislation — as well as allowance allocations — will likely provide the most reliable source of international funds. The tradeoff is that every dollar spent on helping other nations adjust to climate change is one that can’t be used domestically. Though it won’t dominate the debate over any climate bill, the use of carbon revenues for international financing could end up having a real impact.
b) Competitiveness and leakage
Certain industries with intrinsically large carbon footprints, such as cement, steel and paper pulp, are particularly sensitive to carbon prices. These industries are concerned that paying for their sizable emissions will reduce their overall output, leading to job cuts and smaller profit margins. Moreover, they worry that a U.S. carbon price will lead to a shift in production to other countries that do not have similar regulatory burdens. When firms leave for other countries that don’t have a climate policy, it could lead to higher overall global emissions, a phenomenon known as leakage.
There are a couple of solutions to these problems. First, to help protect industries at home, climate policy can include rebates to industries — either in the form of cash or extra tradeable allowances — based on their output to help them adjust to the new reality of a price on carbon. Second (and more controversial), the federal government can establish border adjustments, slapping taxes on imports competing with vulnerable domestic industries. Essentially tariffs, such levies would put goods from countries without a climate policy on the same level as those from the U.S. Border adjustments can make for tricky politics, though. When the Waxman-Markey bill passed the House in 2009, President Obama openly criticized the inclusion of such measures. When the debate picked up in the Senate, however, 10 Midwestern senators stated they would not back any climate legislation that did not support manufacturing interests with some kind of border provision. Even if some compromise allows border adjustment to find its way into climate legislation, there’s a chance it would not be allowed under WTO agreements.
The Bottom Line
Last post, we reviewed important aspects of climate policy. In this post, we surveyed two areas that have value in generating good policy, but are negotiable in terms of their importance:
Is there a price collar? Are offsets allowed?
What is the effect of the proposal on international climate issues? How will it affect negotiations and commitments? How does it attempt to protect trade-vulnerable industries?
In our next and final post, we will focus on the issues that make little contribution to good climate policy — or might even be counterproductive.
James Kwak, coauthor of the new financial crisis book 13 Bankers, recently sought to explain his thesis “in 4 pictures.” And impressive pictures they are. But I’ve been particularly struck by one of them — this chart, from a paper by economists Thomas Philippon and Ariell Reshef, showing the close correspondence between deregulation trends on the one hand and the ratio of financial sector wages to private sector wages on the other. My reaction to the chart was essentially, Huh. Those trend lines look like the basic income inequality trend line.
But to my knowledge, no one has really made this point since the chart has circulated widely. Certainly no one has tried to illustrate it.
Maybe people just lack my whiz-bang PowerPoint and Excel skills, or maybe I’ve actually had an Original Thought. But take a look at the chart I created, which overlays a trend line showing the share of income received by the top one percent (the black line) on top of the Philippon-Reshef chart. The trend line comes from the widely cited work of economists Thomas Piketty and Emmanuel Saez, who used IRS data to look at the incomes of the very rich:
I’ve argued before that I think the Piketty-Saez top-share trend line overstates the recent rise in income inequality, but I don’t see much reason to doubt the basic U-shape of the trend since the Great Depression. For all of the consensus around the basic inequality trend, there’s surprisingly little agreement or understanding as to why it looks the way it does (a major theme of Paul Krugman’s Conscience of a Liberal). Could it really be as simple as the extent of financial regulation? Every analyst bone in my body says this is too easy, but…but….
Of course, saying it’s all financial regulation trends isn’t necessarily inconsistent with Krugman-esque arguments that it’s all about changes in cultural acceptance of inequality. Maybe financial regulation flows from public attitudes about inequality.
As the Senate turns to financial reform this week, the big question is whether any Republicans will join in, or whether the party will stick to its new political doctrine of Maximum Feasible Obstruction.
This doctrine is predicated on the idea that Barack Obama, elected with nearly 53 percent of the vote, is a dangerous radical bent on extinguishing American liberties and importing Euro-style social democracy. It’s an idea so crazy on its face that many progressives are convinced that racism must lurk behind it.
Maybe, but some conservatives also convinced themselves that Bill Clinton maintained a secret airport in Arkansas to import narcotics from Central America. The right’s feral attacks on Clinton led a sympathetic Toni Morrison to dub him in a figurative sense “America’s first black president.”
Whether or not race is a factor, Republicans have evidently calculated that there is no political cost in withholding cooperation from Obama, at least on domestic issues. That may have been true of health care, which lost public support as the debate wore on. But fixing Wall Street is another matter.
The Pew Center for Research reported yesterday that Americans overwhelmingly favor (by 61-31) reform of financial rules, even as they evince growing skepticism of government activism. It’s pretty clear the public takes a “never again” stance toward bailing out Wall Street bankers, speculators and bonus babies.
That’s why Mitch McConnell, the GOP Senate leader, latched onto the theme that the bill crafted by Sen. Chris Dodd (D-CT) would actually make future bailouts more likely. President Obama blasted that “cynical and deceptive assertion” over the weekend, and McConnell yesterday seemed to back down.
Still, Democrats need Republican votes to bring a bill to the floor. The Washington Postreports this morning that Democrats are targeting Sens. Olympia Snowe and Susan Collins of Maine and Bob Corker of Tennessee. Bucking his party’s sullenly oppositionist temper, Corker has worked constructively with Sen. Mark Warner (D-VA) to offer sensible improvements to the Dodd bill.
That bill is snagged on GOP opposition to a new regulatory body, to be independent but lodged in the Federal Reserve, that would protect consumers of credit cards, mortgages and other loans from deceptive or predatory practices. Dodd has signaled a willingness to compromise on another controversial provision, an industry-financed $50 billion fund to liquidate bankrupt firms. And the New York Times reports today financial sector lobbyists have lavished contributions on members of the Agriculture Committee, which is grappling with a key provision to regulate derivatives.
During the health care debate, Republicans did not appear to be moved by the plight of Americans with no medical insurance. But financial reform involves something Republicans traditionally care deeply about – money. Where are the sobersided conservatives of yesteryear, who understood that the safety and soundness of our financial system is fundamental to America’s economic health? Striking the right balance between regulation and innovation, security and risk, is an urgent national priority that ought to engage responsible leaders in both parties.
If Republicans aren’t willing to set aside reflexive partisanship long enough to stand up for American capitalism, we really are in a world of political hurt.
A little over a week ago, I praised Sen. Bob Corker (R-TN) for working with Sen. Mark Warner (D-VA) to come up with some bipartisan improvements to the financial regulatory reform package that Senate Banking Committee Chair Chris Dodd (D-CT) is looking to get through the Senate in time for Memorial Day. I may have spoken too soon. Corker said yesterday:
“I couldn’t support the bill in its current form,” Mr. Corker said in an interview with The Wall Street Journal. “I am absolutely not throwing in the towel. I have no plans to support the current legislation. I hope we’ll get back to the negotiating table.”
This is, of course, a familiar tactic. After a year of being actively courted by the administration and Democrats, congressional Republicans claimed they couldn’t support health care reform, but were willing to stall further by espousing an interest in negotiating. But despite Corker’s backing away from a bill that as recently a last week he said he thought was going to pass, it’s worth sticking to the principle of a bill with bipartisan ideas.
The big idea that Warner and Corker worked on was including an autonomous Consumer Financial Protection Agency (CFPA) as part of the Federal Reserve System. While sticking the CFPA in the Fed is an ungainly solution, it does have the benefit of giving the CFPA start-up funding through the Fed’s balance sheet. Additionally, creating a brand-new agency out of the parts of others does have the chance of echoing the struggles the Department of Homeland Security had getting off the ground, a fate a Fed-housed CFPA can avoid.
Senate Democrats shouldn’t bend over backwards and try to pass a flawed bill in the hopes of convincing Republicans to get on board. But neither should they give up on looking for broad-based support for meaningful reform.
Sen. Chris Dodd (D-CT), looking for a capstone to his 30-year career in the Senate, unveiled his vision for financial regulatory reform this week. The chairman of the Senate Banking Committee has long been dogged by claims that he’s in the pocket of the financial industry and hedge funds, but his plan is a robust effort to address the systemic issues that led to the 2008 financial crisis. While it’s far from perfect, the Dodd proposal is a good one that could be made even better with a few tweaks.
A robust Consumer Financial Protection Agency (CFPA) is vital. Concerns over creating a whole new bureaucracy have to be balanced against developing a consumer watchdog agency that has teeth to rein in subprime mortgages, hidden banking fees and the like. I got to hear Sen. Mark Warner (D-VA) talk about this with Sen. Bob Corker (R-TN) at a panel sponsored by the National Journal, where they described striking that balance by housing the CFPA in the Fed. The new autonomous agency would get Fed funding for its activities but would not fall under its oversight. That responsibility would fall on a CFPA director appointed by the president and confirmed by the Senate. This should give it enough independence from the financial institutions that fund the Fed to make the agency a real force for protecting consumers.
However, as described in the bill, the CFPA would exempt some lenders from oversight. An improvement would be to follow President Obama’s lead and create a CFPA that covers retail activities from all financial entities, including small banks, auto loan and mortgage originators (like Countrywide or GMAC), and payday lenders. The Department of Defense got military personnel protected from such lenders four years ago, finding that such loans “undermine military readiness, harm the morale of troops and their families, and add to the cost of fielding an all-volunteer fighting force.”
The Dodd bill includes the so-called Volcker rule, limiting the scope of bank activity, which I’ve argued before won’t make a real difference in prop trading, as banks can mask it behind market-making and client trading. However, the excess leverage tax in the Volcker rule — if properly beefed up — will discourage firms from becoming Too Big Too Fail (TBTF). And where the bill as envisioned doesn’t seem to rein in behemoths like Citi or Bank of America, increasing the capital requirements on overly large firms is a relatively easy fix, if the political pressure from bank lobbyists can be overcome.
The bill looks to wind down TBTF through a special financial panel of bankruptcy court, which would allow systemic risk overseers — envisioned in the bill as comprised of representatives from Treasury, the Fed and the CFPA — to take vulnerable firms into receivership and liquidation in times of crisis. The FDIC would manage a $50 billion fund that banks would pay into to provide liquidity in these situations. As envisioned, the treasury secretary petitions the court, the financial firm in question responds, and the court has 24 hours to decide. But a decision can be appealed to a Court of Appeal and then the Supreme Court, a process that could take up to 30 days. In a financial era in which multibillion dollar institutions like Merrill Lynch and Lehman Brothers can evaporate over the course of a weekend, giving management 30 days in which to stonewall means that an orderly wind-down as the new rule envisions is unlikely.
We’re waiting to see what will come from Sens. Jack Reed (D-RI) and Judd Gregg (R-NH) on derivatives, but the existing language encourages increased transparency and centralized clearing for standardized derivatives (the maligned CDS’s and the like) and increases margin requirements for non-standard derivatives. All trades being reported will help regulators understand the evolution of the financial system better.
The inclusion of a non-binding shareholder vote on executive pay will give shareholders a greater role in compensation. While it won’t solve the “heads I win, tails you lose” problem of Wall Street’s bonus structure, it will give outsiders more say on pay and hopefully check the worst excesses.
Like the CFPA and the chairman of the Fed, the proposed legislation would also make the New York Fed presidency a White House appointment. That role, which was vital at the height of the 2008 crisis when now-Treasury Secretary Tim Geithner held it, and was central in previous crises, like the LTCM meltdown of 1998, has long been seen as beholden to Wall Street. A presidential appointment would increase its independence form investment banks.
As presented, the Dodd bill has its flaws — in addition to the ones mentioned above, others have argued that political realities have compromised the force of the bill, and because it hasn’t addressed leverage, the seeds of an asset-bubble-driven crisis like the most recent one are still there. It’s true, as Sen. Dodd said when he announced the bill: “This legislation will not stop the next crisis from coming. No legislation can…” But this bill — with improvements — can give regulators the tools they need to address future crises in a more proactive manner.
Paul Volcker, vanquisher of inflation in the early ’80s as chairman of the Federal Reserve System and now the chairman of President Obama’s Economic Recovery Advisory Board, said, “[T]he most important financial innovation that I have seen the past 20 years is the automatic teller machine.” While he qualified the comment as a “wiseacre remark,” he stood by it, going on to say, “Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.”
Our friend Bob Litan has a new report out from the Brookings Institution on the benefits from financial innovation over the past thirty years. The report is worth reading in full, but a quick summary of his findings is found in a chart at the beginning of the paper (condensed into one image by Kevin Drum):
Given attitudes like Volcker’s, it might be surprising to see so many “+”s, connoting relative benefits, relative to “-“s, connoting developments that did not improve that part of the economy. (“0” indicates the innovation was a wash.) But that is the reality of innovative financial instruments — they are, by and large, designed to be beneficial, but unmonitored can cause more harm than good. Innovations like credit scoring, collateralized debt obligations (CDOs), and inflation-protected Treasury bonds (TIPS) — all were developed since Volcker was Fed chair. But the benefits from these innovations (increased access to credit, which allows for consumption smoothing) can also lead to abuses of the system (crushing credit card debt, NINA mortgages, balloon payment mortgages) and asset bubbles. These abuses can be swept under the rug if the underlying assets in a CDO are not transparent, and that CDO is sold to an unsuspecting client by an investment bank trading desk.
The status quo is unsustainable, but attempts to ban some of these activities are problematic as well. Proclamations like the Volcker rule — limiting the scope of bank activity — are either too tightly defined to be effective or are so broad they throw out the above benefits with the bathwater. What would be better is to provide transparency in these activities — through clearing credit default swaps (CDS) and other derivatives on exchanges, providing credit terms in an easily understood manner upfront, and eliminating hidden fees — so that all involved know what they are getting into.
Litan also points out one key fact at the end of his paper: we’re not done with financial innovation. He argues that despite the headlines, not all innovation is bad, and there is more to come. He cites the work of Robert Schiller, the Yale professor who has pioneered work in housing price markets — designed to give homeowners protection they currently don’t have against a fall in the value of their home — and counter-cyclical tax policy, as an obvious source of financial innovation that is for the good.
But Litan concludes by noting that the market — not government — will continue to drive innovation, but “policymakers must be better prepared in the future than they were before the financial crisis to step in — first with disclosure standards and possibly later with more prescriptive rules” to prevent crises like the most recent one from happening again. The one area where he sees a more active government role is in consumer finance, an area in which a robust Consumer Financial Protection Agency will be key.
The news yesterday that the U.S. Federal Reserve raised the discount rate 25 basis points (to 0.75 percent from 0.50 percent) is being interpreted as an indication of a fundamental change in how the Fed views our economic crisis. The hike in the discount rate could signal the beginning of the end of our economic crisis.
The discount rate is not to be confused with the more prominent Fed funds rate. The Fed funds rate is the rate at which banks lend money to each other in overnight loans for regulatory and liquidity requirements. The discount rate is the rate at which the Fed lends money to private retail banks — traditionally at a percent above the Fed funds rate — in short-term loans aimed at easing liquidity constraints. But in recent decades borrowing from the so-called discount window had been seen by large banks as the financial equivalent of pulling over to ask for directions — you can do it, but it’s seen as a sign of weakness. The aftermath of 9/11 was the last time the discount window had seen serious activity prior to the 2008 economic crisis.
The Fed met the current crisis in part by making the discount window more available to banks. The terms of loans through the discount window went from being overnight to ultimately 90 days. The discount rate was cut from being 100 basis points (one percent) above the Fed funds rate to 50 basis points. And in a move that underscored the gravity of the October 2008 liquidity crisis, Goldman Sachs and Morgan Stanley turned themselves into bank holding companies — a technical change in their operating structure that required much more oversight — in part to be able to access the discount window in case they faced a liquidity crunch.
This opening of the discount window was part of a larger project by the Fed — which involved pumping liquidity into the economy by buying up almost two trillion dollars in assets — to prevent the crisis of fall 2008 from leading to a global depression. But now that the worst seems to be over from a monetary perspective, the Fed is beginning to step away from the crash position it assumed almost two years ago.
Newly reappointed Fed Chairman Ben Bernanke laid out a plan for unwinding the Fed’s position in the economy last week, testifying to Congress that “when the times comes,” the Fed will move to sell that two trillion in assets (in an orderly fashion) to a stronger market. This would give the Fed more room to manage the economy to bring us out of recession. The raising of the discount rate would be the first step in that process.
The phrase “when the time comes,” however, makes all the difference in the world, and many wiser people than I are expecting the Fed to go easy on its plan to shrink it’s balance sheet and raise rates. With unemployment hovering at 10 percent, this recession isn’t over for a lot of Americans. And, despite last quarter’s strong headline number, there is no obvious driver of GDP growth (like exports) on the horizon, so it may not be over for the rest of us, either. So it may be too soon to call the recession over and begin raising rates. The fear is that this may not be the beginning of the end, but the end of the beginning.
The White House yesterday announced new restrictions on banking activity, designed to address the issues that caused the crisis 15 months ago. Wall Street reacted by letting stocks fall 200 points, which initially would make you think the announcement must be right. The White House’s plan has two main parts: a limit on the scope of banking activity and a limit on the size of banks. One part makes sense, but as presented, the other should be re-thought.
Limit on Size – The good part is the limitation on the size of banks. This will include a tighter cap on the control of deposits. Currently no bank can control more than 10 percent of the nations deposits — but Bank of America got the Bush administration to waive that in 2007 to buy LaSalle. The administration’s proposal would have this cap include non-insured assets and other deposits. While this is a good first step, its effectiveness will be spelled out in the details. Bank of America is the only bank that exceeds the current cap, and almost 25 institutions could be considered “Too Big To Fail.”
Limit on Scope – At first blush, this seems to be a ban on banks taking FDIC-insured deposits – or having received TARP money – from engaging in proprietary trading. Prop trading is a major part of Wall Street activity, in which investment banks trade with “their own money.” That is, they engage in trading on their own behalf, not on the behalf of customers. The administration is right that a lot of this trading on prop desks is speculation. However, prop trading is also how investment banks and market makers engage in risk management and hedge positions. Banning prop trading by banks would severely curtail their market-making ability, and dry up liquidity on Wall Street faster than a sponge in the sun. Better than limiting the type of activity trading desks engage in would be to limit the amount of leverage they can use in that speculation.
The administration has said it is going to work with Congressional leaders in the coming weeks to spell this out in details. We’ll see if Congress is able to improve on these suggestions.
Following a week of trial balloons about a tax on banks and bankers, President Obama today unveiled a “financial crisis responsibility fee,” to be levied against 50 of our nation’s largest banks. While the tax will not be able to seriously address the deficits that the government faces – it’s expected to raise only $90 billion over 10 years – any tax on the financial system can affect the course of our economy. The details of the proposed tax have yet to be outlined. Compared to the alternatives, this tax is a good start – but it doesn’t go far enough.
In the discussion of taxing banks and bankers, a couple of possibilities have been floated, some of which can reap short-term political points, others of which have the potential to promote progressive policies:
Bonus tax – One of the easiest – and politically most satisfying – would be a tax on excess bonuses. The British exercised this option on London bankers this past year. Bonuses in the City above a certain amount were taxed at a 50 percent rate. Banks responded by threatening to move offshore and – when that threat rang hollow – doubled the bonus pool they paid out to bankers. The end result was that the bankers whose decisions led in part to the crisis were financially unharmed, the British government raised a relative pittance in taxes, shareholders in City banks took a hit (as the bonus pools were increased at their expense), and the underlying fault lines in the British banking system remain unaddressed.
Transaction tax – The worst of the options would be a tax on transactions. As discussed before, this would merely pour sand in our financial system, breaking it and slowing economic recovery.
Excess profits tax – A more appealing option would be a tax on excess profits. A defining aspect of the financial bubble of the last decade was the fact that financial profits were 40 percent of overall corporate profits – more than double the slice financials made up of profits in the 1980s. A tax on these excess profits would rein that in. But while this could be useful, as Simon Johnson points out, it would be fairly easy to game, and end up being ineffective.
Tax on assets – A tax on bank assets above a certain amount addresses not just political sentiment that banks have made it through the crisis unscathed, but also the fact that banks are too big to fail. Encouraging banks to “right-size” themselves would make our economy safer from the systemic risk imposed by banks like Citigroup or Bank of America – which are debilitated but whose failure would be economically catastrophic.
Excess leverage tax – Taxing the leverage that financial institutions use to increase returns would allow us to avoid situations like that faced a year and a half ago when Lehman Brothers – leveraged over 30:1 – collapsed over the course of a weekend. It would make banks “safer” but would leave them still too big. In the event a bank were to fail, it would still be a systemic threat to our economy. This would be a more targeted version than an assets tax, but it would be harder to implement — definitions of leverage differ – and if not properly defined would leave hedge funds, insurance companies and other “non-bank financial institutions” untouched, leading to a crisis like that perpetuated by Long-Term Capital Management in 1998 or AIG last fall.
The taxes unveiled today are a very tentative step down the path towards an effective tax on assets. But the administration’s proposal is too broad – affected institutions could be as small as $50 billion — and too light to be effective.
If the Obama administration were strictly looking to tax the problem of an outsized and dangerous financial industry out of existence, a combination of the last two taxes — properly implemented to cover the whole financial sector when looking at leverage and focused on banks that are bigger than, say, $300 billion when looking at assets — would be the most effective. But hastily implemented, they could have unintended consequences, crippling our economy while merely pushing the problem offshore. Coordination with the EU and other G-20 countries will be vital to help with the de-leveraging of our economy.
As we head into the new year, one of the biggest questions facing the economy is: “Whither the interest rate?” This number is set by the Federal Open Market Committee and its targeting of the fed funds rate – or the rate at which banks lend funds to each other – is currently effectively zero (technically in a range from zero to 0.25 percent). It’s been there for just over a year, and is likely going to stay there for the better part of 2010 (if I could tell you when, I wouldn’t be here – I’d be lighting cigars with hundred-dollar bills some place much warmer).
Despite its provenance as a dry economic term, the interest rate is interesting. It’s a fundamental piece of how our economy works. It determines everything, from how likely you are to get a loan or a mortgage (ceteris paribus – as the economists like to say – the lower the rate, the more lending that is done), to how likely we’re going to have inflation (high interest rates head off inflation, ceteris paribus), to how much a dollar is worth (a higher interest rate relative to overseas rates means it’ll be worth more, cete- you get the idea), to how fast the economy will grow (higher interest rates mean slower growth). It is usually the most powerful tool in any central banker’s toolbox, and certainly the one that’s most often used.
In addition to its central role in the economy, the interest rate is interesting for two other reasons these days.
First, there is the discussion of where the interest rate should be for recovery. There’s a good rule of thumb to determine what the ideal interest rate is: the Taylor rule. Very briefly put, the Taylor rule takes the inflation rate and the unemployment rate and uses them to compute what the ideal interest rate should be (check out the San Francisco Fed for more info). According to some Fed research last spring, the Taylor rule says that interest rates should be at -5 percent (that’s negative five percent – as unemployment is 1.5 percent higher now, the Taylor rule would say the rate now should be even lower).
The problem with negative interest rates is that while they’re technically feasible, they really discourage lending (would you give me a dollar today if I promised you ninety cents next Tuesday?). More realistically, negative real interest rates are possible if you encourage inflation. But inflation eats away at economic growth – ask Zimbabwe – and the “inflation tax” of high inflation falls disproportionately on the poor.
But inflation hawks have been arguing for the Fed to raise rates for a couple of months – to two percent. These hawks tend to be strongly laisse faire conservatives, One of the voices saying we should ignore the Taylor rule is – as Brad DeLong points out – the man who invented it himself, Stanford University’s (and Bush Treasury appointee) John Taylor.
Secondly, as the old saying goes: when the only tool you have is a hammer, every problem begins to look like a nail. Interest rates, while powerful, cannot solve every economic problem. The Taylor rule tells us we shouldn’t raise the interest rate, we can’t lower the interest rate, and no one is happy where the economy is now. At a time when the interest rate is at zero, and should be negative, alternatives need to be explored. As Clive Crook says in his latest column:
Interest rates that take into account asset prices as well as general inflation are part of this, of course. But when it comes to financial regulation, the key thing is rules that recognise the credit cycle, and change as it proceeds. Most important, as argued by Charles Goodhart in these pages, capital and liquidity requirements should be time-varying and strongly anti-cyclical. In good times, when lending is expanding quickly and financial institutions’ concerns about capital and liquidity are at their least, the requirements should tighten. Under current rules, they do the opposite.
Crook is right that unusually low capital ratios (and their counterparts – high leverage ratios) were a catalyst of last year’s crisis. Now that we need to get the economy going again, banks need to lend. One way to do so would be to lower capital ratios (if it wouldn’t bring the solvency of some large banks into question). As part of a regulatory reform package, policymakers should pursue a counter-cyclical capital requirements policy.
They should also expand who has to follow capital requirements. As currently defined, only depository institutions and not investment banks – such as Lehman Brothers and Merrill Lynch were, and Goldman Sachs and Morgan Stanley used to be – are required to follow the Fed’s Board of Governor’s capital requirements. Getting other financial institutions to respond to capital requirements will make that a much more powerful tool.
Word going around Washington this week is that Sens. John McCain (R-AZ) and Maria Cantwell (D-WA) are pushing to reinstate Glass-Steagall:
McCain and Cantwell, a Washington Democrat, join other lawmakers in Congress proposing to reinstate the 1933 law, repealed a decade ago by the Gramm-Leach-Bliley Act that led to a rise in conglomerates including Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. active in retail banking, insurance and proprietary trading. Legislation to reinstate the ban was introduced today in the House.
While this move is a well-meaning attempt to rein in the financial sector, it doesn’t address the issues that caused last fall’s crisis.
Glass-Steagall was aimed at separating “boring” retail banking (the Bailey Building and Loan Association, for example) from “risky” investment bankers (Gordon Gekko). It was eventually repealed, as U.S. banks felt it put them at a disadvantage in the global marketplace against European “universal” banks, such as Deutsche Bank, Credit Suisse, and HSBC.
At the time there was concern that repealing Glass-Steagall would create banks that were systematically dangerous. In hindsight, that concern would seem to be born out — but it isn’t. After all, the three major bank collapses that precipitated the crisis were Bear Stearns, Merrill Lynch, and Lehman Brothers. All three were obviously Too Big Too Fail, but all three would have been unaffected by a reinstatement of Glass-Steagall — none of them is a retail bank (this is why you never saw Merrill or Lehman ATMs).
Rather than focusing on micromanaging bank structure, and stifling entrepreneurship in the financial sector, the Senators would be better served by evaluating different options to limit the size of Too Big Too Fail banks. A smarter idea would be to extend the retail bank deposits cap idea to total bank assets. Currently, no bank can have more than 10 percent of total national retail deposits (Bank of America got a waiver for the 2007 purchase of Chicagoland’s LaSalle bank and now has 12.2 percent of national deposits). Peter Boone and Simon Johnson suggest applying this simple principle to total bank liabilities. They recommend a limit of 2 percent of GDP, which is in line with the $300 billion that Felix Salmon has been recommending since March. Importantly, it’s also in line with the de facto $100 billion threshold that bank regulators are using now.
This way the government isn’t running banks and bankers can pursue the capitalist impulse that drives our economy. But with a cap on liabilities, the decisions of bankers cannot threaten our economy like they have in the past.
It’s a sign of the times when “our bridges and roads are falling apart” gets cited as an issue more pressing than college football’s annoying Bowl Championship Series (BCS) on ESPN.
And, while the president hasn’t fulfilled his promise to set up an eight-team playoff yet, he’s taken the issue of infrastructure head-on. The administration’s focus on infrastructure investment is good for both long-term growth and generating jobs through the quick start-up of “shovel ready” projects.
However, one-time disbursements like those outlined in the Recovery Act or the president’s announcement earlier this week fall short of fixing more fundamental issues.
Ellison is a co-sponsor on Rep. Rosa DeLauro’s (D-CT) National Infrastructure Development Bank Act, a good start on developing sustainable infrastructure funding the country so desperately needs.
DeLauro and and Ellison’s bill builds on the work of a bipartisan commission chaired by former Sen. Warren Rudman (R-NH) and titan of finance Felix Rohatyn. The bill envisions $5 billion a year from the federal government to capitalize the bank and a government debt guarantee of up to $50 billion.
But even Ellison and DeLauro’s idea can be improved upon. As outlined in Jessica Milano’s PPI policy memo, “Building our 21st Century Infrastructure,” an American Infrastructure Bank (AIB) seeded with a one-time investment at the federal level — a potential use for the TARP funds the president announced this week — and stakeholder buy-ins from the states would be a more effective way to fund a bank dedicated to financing infrastructure programs.
An infrastructure bank would offer a way to leverage much larger private sector investments from a strapped public budget. The bank would raise inexpensive funding for infrastructure projects by issuing debt on the capital markets backed by the U.S. government’s credit rating. By backing these bonds with the revenue or assets of the projects they are financing, taxpayers would not be left to pick up the bill. These projects would be determined according to strict criteria that promote economic development while being fiscally and environmentally sound.
After the President’s remarks on Tuesday, Gov. Ed Rendell of Pennsylvania — an infrastructure bank supporter — said the president had “essentially” endorsed the idea of an AIB. But while the president sounded open to the idea this week, he hasn’t gotten behind the legislation needed to get it done. President Obama endorsed an infrastructure bank back when he was candidate Obama. But, much like his promise of reforming the BCS, this threatens to become another campaign promise that falls by the wayside. Now’s the moment for the president to come off the sidelines and lead a sustained drive down the field.
The Rep. Barney Frank (D-MA)-authored Wall Street Reform and Consumer Protection Act passed the House Financial Services Committee last Wednesday, and could come to a floor vote in the House as soon as this week. Through legislative jujitsu on Frank’s part, the bill will have a lead on Sen. Chris Dodd’s (D-CT) efforts in the Senate.
The day after the committee passed the legislation, I saw Rep. Ed Perlmutter (D-CO) talk about it at an event hosted by the National Journal and got to exchange a few words with him on the subject. He was positive about the bill and its chances in the House (it will likely pass easily), and gave positive marks to the administration’s handling of the crisis in its first year in office.
But while Perlmutter said he felt the House has done its part to address regulatory reforms, I thought some of the accomplishments he touted leave unanswered fundamental questions raised by the financial crisis.
He spoke about the legislation’s planned Financial Stability Council, that would provide a forum for regulators like the Fed to address systemic risk. But the Financial Stability Council, instead of facilitating coordination among regulators, won’t live up to expectations — much like what happened with the Director of National Intelligence (DNI) that was supposed to facilitate information-sharing in the intelligence sector, but has had limited effectiveness in getting different agencies to talk to each other. The weak mandate of a Financial Stability Council would lead to regulator shopping by financial institutions, a temptation that can lead to problems similar to those seen in the case of under-regulated AIG. Moreover, the resolution authority that the council would have is useful only after the fact — it would not preemptively deal with the Too Big To Fail problem we still face.
Fixing Mark-to-Market Requirements
More generally, however, Perlmutter mentioned two ideas the House is considering that could actually contain the seeds of our next crisis.
One idea is extending the Financial Accounting Standards Board’s (FASB) loosening of mark-to-market requirements for financial institutions to value their securities. Perlmutter wants to suspend mark-to-market and make permanent the FASB’s contentious April decision to ease mark-to-market rules.
The rule would let the Financial Stability Council order FASB to suspend mark-to-market in cases where there is no market in a security or securities are being sold in a “fire sale” or distressed environment. More worrisome, however, is that banks get to declare whether the market in the securities they are holding is distressed or not. Banks can drive a truckload of bad investment decisions through this loophole without having to disclose them on their bottom line or affecting capital requirements. Under this new rule, banks will have no incentive to conduct diligent analysis of the securities they hold — anything that turns out to be worthless (like bonds backed by subprime loans) can just be called “distressed.” This would decrease transparency and not restore confidence to the system.
But mark-to-market does have the bad consequence of increasing volatility in bank balance sheets. During crises like last year’s, banks can even perversely see mark-to-market improve their bottom line the closer they get to bankruptcy.
A better idea than the one Perlmutter mentioned has been put forward by PPI contributor Robert Pozen in his new book, Too Big To Save. Pozen suggests delinking banking capital regulations from accounting mark-to-market rules by effectively recognizing all securities as being “held for sale” (an accounting distinction) for regulatory purposes. This would allow us to continue to keep the transparency in assets that mark-to-market allows, while avoiding the bottom line volatility that banks would like to avoid.
What to Do About Sarbanes-Oxley
The second idea is exempting firms from some Sarbanes-Oxley (SOX) reporting requirements. Passed in the wake of Enron, SOX was designed to hold companies and their executives accountable for their auditing, and eliminate some glaring conflicts of interest in financial auditing.
SOX does two good things. It makes a publicly held company have legitimate auditors, and ensures that those same auditors aren’t also advising the company on how to prepare the books for auditing (thereby basically handing over the answer key before a test). SOX also made sure that companies had proper controls that minimized the risk of errors in financial statements and of people either using company money inappropriately (as Enron did in off-balance-sheet shell companies) and of people embezzling money. Exempting firms from this would eventually lead to the same bad behavior happening again.
That said, SOX isn’t without flaws. Many in the auditing industry perceive it as very manpower intensive and, as a result, a significant burden to publicly listed companies, especially smaller ones (with income under $100 million). The SEC has responded by annually exempting small companies from some reporting requirements, but the exemption is not going to be extended past next year.
The solution to this problem is to streamline SOX to make it less burdensome to companies, not gutting it and letting new Enrons bubble up. Instead of providing an internal control report with each annual filing to the SEC — which can require up to three percent of a small company’s income — the SEC and Congress should encourage accounting oversight boards to spell out further guidelines and best practices to adopt. This streamlined SOX could even be extended to non-public financial institutions, as a key part of what allowed Bernie Madoff to steal people’s money for so long was having a small one-man upstate auditor keep tabs on his multi-billion dollar Ponzi scheme.
The Federal Reserve’s outlook on the economic recovery continues to get gloomier. In its statement released following the FOMC meeting today, the Federal Reserve acknowledged that “the pace of recovery in output and employment has slowed in recent months,” and “economic recovery is likely to be more modest in the near term than had been anticipated.” Not good news, especially when interest rates are already about as low as they can go. With today’s announcement that it is committed to keeping rates at rock-bottom levels ”for an extended period” going forward, the Fed also signaled that it is ready to go beyond rate setting to strengthen the economy.
The International Monetary Fund recently scolded the U.S. government for running large budget deficits. Leaving aside the absurdity of cutting deficits when unemployment is still extremely high, it’s clear that at some point – as joblessness declines toward 5 percent – deficit reduction will need to begin in earnest. But the real question is how to do that. There’s a risk that the Washington economic class – grounded as they are in 20th century 
First the giant stimulus package, then the ambitious revamping of America’s health care delivery system. Now Congress, under the patient prodding of President Obama, is lurching toward passage of another stupendously complex bill, this time centered on financial regulatory reform. Whether you like them or not, you have to admit that big things are getting done in Washington on Obama’s watch.
So far, we’ve established the absolutely 
As the Senate turns to financial reform this week, the big question is whether any Republicans will join in, or whether the party will stick to its new political doctrine of Maximum Feasible Obstruction.
A little over a week ago, 
Sen. Chris Dodd (D-CT), looking for a capstone to his 30-year career in the Senate, unveiled his vision for financial regulatory reform this week. The chairman of the Senate Banking Committee has long been dogged by claims that he’s in the pocket of the financial industry and hedge funds, but his plan is a robust effort to address the systemic issues that led to the 2008 financial crisis. While it’s far from perfect, the Dodd proposal is a good one that could be made even better with a few tweaks.
The news yesterday that the U.S. Federal Reserve 
The White House yesterday 
Following a week of trial balloons about a 
As we head into the new year, one of the biggest questions facing the economy is: “Whither the interest rate?” This number is set by the Federal Open Market Committee and its targeting of the fed funds rate – or the rate at which banks lend funds to each other – is currently effectively zero (technically in a range from zero to 0.25 percent). It’s been there for just over a year, and is likely going to stay there for the better part of 2010 (if I could tell you when, I wouldn’t be here – I’d be lighting cigars with hundred-dollar bills some place much warmer).
Word going around Washington this week is that Sens. John McCain (R-AZ) and Maria Cantwell (D-WA) are pushing to 
It’s a sign of the times when “our bridges and roads are falling apart” gets cited as an issue 