Baseline Scenerio

The Baseline Scenario
Why You Should Read the Text, Not Just the Tables
Posted: 20 May 2009 02:27 PM PDT
Keith Hennessey, the last head of the National Economic Council before Larry Summers, has a blog post out (hat tip Alex Tabarrok) reviewing yesterday’s announcement by the Obama administration on their proposed new CAFE (Corporate Average Fuel Economy) standards. It links to a very informative report that I’m still digesting. (I was planning a post on the economics of CAFE for today, but now I need to read part of that report.)
Update: I found a mistake in the way Hennessey used a table and I posted about it here. Hennessey graciously acknowledged the mistake, fixed it on his post, and left a comment here. So I decided to delete my criticism. I really should have sent him an email first, and I feel bad about that.
By James Kwak

Consumer Protection When All Else Fails (Written Testimony)
Posted: 20 May 2009 03:00 AM PDT
I took three points away from yesterday’s hearing in the House of Representatives.
We need layers of protection against financial excess. Think about the financial system as a nuclear power plant, in which you need independent, redundant back-up systems - so if one “super-regulator” fails we don’t incur another 20-40 percentage points in government debt through direct and indirect bailouts. A consumer financial products protection agency should definitely be part of the package. Update: The Washington Post reports that such an agency is now in the works; this is a big win for Elizabeth Warren, Brad Miller and others (add appropriate names below).
Congress will work on this. The intensity of feeling with regard to the need to re-regulate is striking, and there is much that resonates across the political spectrum.
In the end, much of banking is likely to become boring again. Special interests are convinced that they can fend off the regulatory challenge, but I find this increasingly unlikely. Enough people have seen through what they did, how they did it, and what they keep on doing. No doubt the outcomes will be messy and less than optimal, but at this point “less than optimal” is much preferable to “systemic meltdown”.
There is still much to argue about and, no doubt, there will be setbacks. We’ll get a better or a worse system, depending on how the debate goes. And if the external scrutiny slips away, so will point #3 above. But this was still by far the most encouraging hearing I’ve so far attended.
The main points from my written testimony to the subcommittee are below.
1) The U.S. economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small or medium-sized financial institutions. It does not yet have a similarly effective way to deal with the insolvency of large financial institutions. The dire implications of this gap in our system have become much clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table. In fact, our underlying banking system problems are likely to become much worse.
2) The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks. However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the U.S. and global economy. The prospect of such disruption, they reason, would induce the government to provide various forms of bailout. They also invest considerable time and energy into impressing this point onto government officials, in a wide range of interactions.
3) As an example of the ensuing bailouts, in its latest iteration the current administration has (a) run stress tests in which the stress scenario was not severe, (b) determined that banks are solvent, but some should raise small amounts of capital, (c) at the same time continued to provide large amounts of government subsidy through FDIC-guarantees on bank debt, large credit lines from the Federal Reserve, and cheap capital from the Troubled Assets Relief Program.
4) The government strategy today is forbearance, as in the early 1980s, in which you wait for the economy to recover by itself and hope that this brings the banks back to financial health. This is risky because: it may not work (depending on the defaults seen in “toxic” assets); it may lead the banks to engage in undesirable short-term behavior (with either too much or too little credit, depending on how exactly their incentives are distorted); and it rewards banks for previous irresponsible actions (and therefore encourages more of the same in the future).
5) As a consequence of both this general failure to deal with big bank insolvency and the specific problems induced by current government policy, big bank executives have an incentive to reduce the probability that their bank fails for idiosyncratic reasons but they are much less concerned about their bank failing in a manner that is synchronized with other banks. These bank executives have a strong incentive to copy the actions and policies of other big banks.
6) By not changing incentives for powerful bank insiders, we are lining ourselves up for another big “moral hazard trade” – think of this as a bailout by the Federal Reserve of everyone, but especially banks. Current and future bank executives will take risk again – but next time it will be risk with the public’s money. A housing bubble led to the current difficulties but the meta-bubble is a rise in financial services as a share of the economy, which has been underway since the 1980s. In the latest manifestation of the ensuing shift in economic and political power towards the financial sector, an unsustainable “Fed bubble” is potentially underway. This may lead to outcomes that are considerably worse than what we have seen so far.
7) Everyone agrees that insolvent banks are a bad thing. Since September 2008, we have learned about the additional difficulties that follow when no one knows if banks are insolvent are not. There are many manifestations of this problem, including: illiquid markets for toxic assets; accounting tricks, like the FASB rule change and the preferred-for-common stock conversion; and stress tests that turn out to be not very stressful, with outcomes that are apparently negotiable and mostly about public relations.
8) There is a striking contrast between how we deal with small/medium-sized banks (using an FDIC intervention) and large banks – only the latter can obtain never ending bailouts. The solution would be some kind of regulator able to take over any financial institution, but also better ways of measuring asset value, capitalization, etc. In line with that general approach, Thomas Hoenig has a strong proposal for our current situation, which is to use negotiated conservatorship, as was done with Continental Illinois. However, even his approach needs to be supplemented with quickly breaking up and selling off troubled banks; this is a daunting administrative task, but better than the alternatives.
9) The critical weakness in our system is that bank executives get to keep their jobs and their money. All key insiders should be fired when their banks become insolvent (as part of the government intervention and support process), irrespective of the reason for that insolvency. They should also be subject to large fines, equal to or in excess of the value of their total compensation while leading the bank that failed. As things currently stand, powerful insiders have learnt that they can gamble heavily and never lose personally or professionally.
10) Our national debt will increase substantially as a result of direct bank bailouts and, more importantly, the discretionary fiscal stimulus needed to keep the economy from declining – as well as the standard deficit due to cyclical slowdown (a feature of the “automatic fiscal stabilizers”). This will constrain our future actions as a nation. For example, it may limit our options in terms of health care reform, with severe adverse social, economic, and budgetary implications.
11) The costs to consumers from our broad and deep banking crisis come in many forms. For example, in a period of financial confusion, it is easier to raise fees on consumers – they will have a harder time switching to other credit companies and many of them need the credit in order to survive. Supporting consumption is a key part of our economic recovery, but we are letting credit card issuers hit consumers hard; this is evidence of prior uncompetitive behavior (i.e., limiting entry, in order to raise prices later).
The remainder of my testimony summarized the argument from “The Quiet Coup“, as published in The Atlantic.
By Simon Johnson