In a 90-minute debate, I’m not sure it’s possible to cover every single issue of pressing national importance and to do so in coherent detail.  So the following is a complaint one could make about a number of issues that were missing from last Thursday’s VP debate, but it was a little eyebrow-raising that financial reform was absent from the conversation.

Sure, the collapse of Lehman is ancient history as far as the political news cycle is concerned, and regulatory details can sometimes come off as unbearably technical to the average viewer.  However, we are still living through the real-world economic consequences of a massive global financial crash; the ink on the 2010 Dodd-Frank Act is not yet dry (key regulations are still being finalized); and recent scandals should have reminded us that the soundness of the financial system cannot be taken for granted.

Hopefully, tonight’s presidential debate will feature a little more recognition of the catastrophic regulatory failure we’re still living with.  We’ll see.  At this year’s Minsky conference, Gillian Tett of the Financial Times joined a panel discussion (with Louis Uchitelle, Jeff Madrick, and Yalman Onaran) on the role of the press in the financial crisis and financial reform efforts (audio here).  Tett commented on the failure of the press to focus on what was really going in finance in the run up to the crisis, and one of the challenges she identified here was what she labelled the “complexity problem”:  the key activities in advance of the crisis, in derivatives for example, were poorly understood, and now, after the crisis, we have a regulatory response in Dodd-Frank that’s even more complex and opaque.

This issue of complexity isn’t just a challenge for the press.  It’s also a public policy problem.  Jan Kregel argues that the more recent JPMorgan and LIBOR scandals demonstrate that the financial conglomerates involved are “too big to manage” and too big to regulate effectively.  This isn’t a fact of nature.  This is the financial system we have built.  Whether we’re able to make informed public choices about the future of financial regulation is also bound up with the question of whether we will have a financial system whose operations can be readily supervised and understood. continue reading…

The idea of breaking up the big banks, while seemingly growing in popularity, leaves a lot of unanswered questions.  And one of the biggest questions is probably this:  what will be the structure of the smaller institutions that remain after such a break up?  If these smaller institutions are allowed to entangle themselves in the same complex activities as before, then we will still be a long way from stabilizing the financial system.

In this context (and with a recent IMF paper reconsidering the Depression-era “Chicago Plan”), Jan Kregel looks at one potential proposal for simplifying the financial structure; an alternative to Dodd-Frank’s partiality and complexity.  In his latest policy brief (“Minsky and the Narrow Banking Proposal: No Solution for Financial Reform“), Kregel looks at Hyman Minsky’s consideration of a narrow banking proposal in the mid-1990s (at the time, Minsky was looking at potential reforms for a post-Glass-Steagall financial system).  In this narrow banking proposal, commercial and investment banking functions would be separated into distinct subsidiaries of a bank holding company, with 100 percent reserves required for the deposit-taking subsidiary and a 100 percent ratio of capital to assets for the investment subsidiary.

Minsky eventually turned against the proposal, and Kregel likewise concludes that narrow banking is not the answer.  Among other reasons, Kregel notes that in such a narrow bank holding company system there would be no leverage, no liquidity creation, and no deposit-credit multiplier.  Banks would not be able to act as the “handmaiden to innovation and creative destruction,” as he puts it.  And for all that, the system would still be vulnerable to destabilization.  “[T]he real problem that must be solved,” Kregel writes, “lies in the way that regulation governs the provision of liquidity in the financial system.”

For those who worry that elevated federal deficits and quantitative easing (QE) by the Fed will lead to high inflation, a word about the macroeconomics of the 1970s. The topic came up in the news recently with the passing of economist and former presidential adviser Paul McCracken. In keeping with many orthodox accounts of the era, an obituary in the New York Times cast much of the blame for the stagflation [slow growth combined with high inflation] of the 1970s on “Keynesian” macro policies, in particular large budget deficits:

A wide-ranging thinker, Mr. McCracken was part of a postwar generation of economists who believed that government should play an active role in moderating business cycles, balancing inflation and unemployment, and helping the disadvantaged.

His nearly three years at the White House coincided with a turbulent era marked by rising deficits, rampant inflation, the imposition of wage and price controls, and the breakdown of the system of fixed exchange rates that had governed the world’s currencies since World War II.

As a result, by the early 1980s, Mr. McCracken, like other economists, questioned the Keynesian assumptions that had been dominant since the war. He concluded that high inflation had resulted from “a cumulative paralysis in our will” and called for greater fiscal discipline to limit the growth of government spending — a topic that continues to vex Washington….

Working for Nixon, Mr. McCracken was confronted with an inflation rate that had been rising since 1965, a byproduct of the deficits that the federal government had amassed during the Vietnam War…..

The article paints a picture in which McCracken stood in the middle ground between Keynesian “fine-tuners” of macro policy on the one hand and opponents of “activist” policies, such as Milton Friedman, on the other, who blamed inflation on excessive government spending and erratic growth in the money supply.

The view represented by the Times article is far from the only reasonable account of the causes of the stagflation of the 1970s, in particular the episodes during which the US experienced double-digit inflation (see figure below, in which year-over-year CPI inflation is shown in blue). continue reading…

Randall Wray joined Suzi Weissman for radio KPFK’s Beneath the Surface to discuss monetary policy, financial fraud, and a number of other issues.  The interview kicked off with Wray explaining his skepticism of the effectiveness of monetary policy, and in particular of quantitative easing, under current conditions, touching also on the question of why this long-term bias in favor of monetary over fiscal policy has developed.  The interview turned to LIBOR and the long string of recent financial scandals and outright fraud, with Wray tying it all to a broader (and growing) financialization of the economy.  Elaborating on the dominance of the FIRE sector in our economy, he discussed the increasingly fuzzy boundaries between, say, finance and industry.

Listen to the interview here.

In his recent commentary on the LIBOR scandal, Jan Kregel elaborates on a distinction that is crucial to understanding this story.  The scandal centers around revelations that financial institutions had been manipulating their LIBOR rate submissions to the British Bankers’ Association (BBA).  Questions have subsequently been raised as to whether regulators were aware of and condoned, or actively encouraged, these manipulations.  But as Kregel explains, there were two very different types of manipulation that were going on, and the distinction between the two is acutely relevant to evaluating attempts to pin a major share of the blame for this scandal on regulators and central bank officials.  (LIBOR is a proprietary index put out by the BBA that is supposed to represent an average of the rate at which banks are able to borrow from each other short term.  It is composed of rate submissions from banks selected for a panel who are asked to give the rate at which they have borrowed or could hypothetically borrow.  The highest and lowest 25 percent of the submissions are thrown out.  LIBOR sets the benchmark for things like mortgages, student loans, credit cards, etc.  See Kregel’s piece for a more detailed explanation.)

Prior to the most recent financial crisis, LIBOR was rigged by banks in an attempt to benefit their trading positions (the banks had made bets whose payoffs depended in part on what was happening to LIBOR).  The investigative reports from the Financial Services Authority in the UK and the Commodity Futures Trading Commission and Department of Justice in the US point to evidence of such manipulation as far back as 2005.

But during the heart of the financial crisis there was a different type of misreporting going on, this time driven by the collapse of interbank lending.  While regulators appeared to have been aware of the latter misreporting, the evidence does not suggest they were aware of the former, more nakedly venal, pre-crisis manipulation.  A lot of the controversy on this question stems from a confused reading of the 2012 testimonies of Paul Tucker (currently deputy governor of the Bank of England) and Robert Diamond, the former head of Barclays Capital, before a House of Commons committee.  The testimonies are being read as providing the smoking gun evidence that the Bank of England was aware of the scandal from the beginning and failed to stop it—but this interpretation only works, as Kregel demonstrates, if you confuse or fuse together the two varieties of LIBOR manipulation.  And there are good reasons to keep them separate in our analyses. continue reading…

There’s a sad truth about the fate of financial regulation: It’s almost certain to be outmoded by the time it’s introduced. This was as true of Glass-Steagall in 1933 as it is of Dodd-Frank today.

This month we begin the third year since the Dodd-Frank Wall Street reform act passed, with the struggle over its shape ongoing. It’s a still-unmolded toddler, and already on the fast track to fossilization. Does the most ambitious finance legislation in decades carry the DNA to successfully cope with the next crisis? In a word, no.

The take-away from this challenge doesn’t have to be cynicism, inaction, or laissez-faire tirades. To be ready for the next shock rather than the last one, though, we need to reset our thinking.

Dodd-Frank is based on the idea that financial markets are normally stable, with the exception of the occasional alarming “event.” The New Deal’s Glass-Steagall Act and the Clinton-era Gramm-Leach-Bliley “Modernization” shared those assumptions. All of these efforts were conceived as system-wide overhauls. In reality, though, they were designed only to remedy random, ad hoc crises; shocks like the 2008 meltdown, sometimes called “Minsky Moments.”

Ironically, the late economist Hyman Minsky actually believed that these “moments” were anything but. At the Levy Institute, we share his view that instability is central to the genome of modern finance.

In other words, it’s normal for the boat to keep rocking. The increasingly risky practices that fuel danger and instability are still being rewarded, and the absence of penalties for losses continues. The shocks will keep coming.

And each new threat to stability is destined to be different than the last. Dodd-Frank aims to identify the most vulnerable institutions and practices. That approach is too brittle to contain the disastrous effects of risks that are always morphing. Even constructive aspects of the Act could have perverse consequences, unless the rules are subject to sophisticated re-examination as the finance world develops. continue reading…

From the announcement of a new joint research project by Mariana Mazzucato and the Levy Institute’s Randall Wray (“Financing Innovation: an Application of a Keynes-Schumpeter-Minsky Synthesis”):

The purpose of this project is to integrate two research paradigms that have strong policy relevance in understanding the degree to which financial markets can be reformed in order to nurture value creation and ‘capital development’, rather than value extraction, and destruction.  The first one might be called the Keynes-Minsky vision that puts effective demand front and center of economic analysis, and the second is the Schumpeter-Minsky vision that places innovation at the center of competition theory, rather than relegated to the periphery of imperfect competition. The project will bring the two visions together to provide rigorous analysis of competition in the financial sphere and how it interacts with competition in the industrial sphere. The new framework will help us better understand the difference between creative destruction and destructive creation, and its applicability to new periods of economic growth such as that which will hopefully result from the green technology revolution.

Brad Plumer reports that a Texas-based bank and a pair of conservative advocacy groups have filed suit against the Consumer Financial Protection Bureau, claiming that the agency is unconstitutional (the agency was created by the Dodd-Frank Act and was a longtime cause of senatorial candidate Elizabeth Warren, who had a hand in setting it up).

Normally, this is the sort of story that wouldn’t merit a pause.  But given the fact that we’re now patiently waiting for the Supreme Court to rule on the constitutionality of the Affordable Care Act (“Obamacare”), with many expecting that the Court will strike down some portion of the law—a scenario very few people took seriously when the law passed—anyone interested in financial regulatory reform should probably start paying attention to this lawsuit.  (Plumer has posted a copy of the suit, which also targets FSOC, the Financial Stability Oversight Council.)

Despite the numerous flaws in the regulatory approach taken by Dodd-Frank, many of which have been highlighted by Levy Institute scholars (see, for instance, here, here, and here), Randall Wray and Yeva Nersisyan argued (in a paper written when the law was being put together) that the idea of the CFPB was “the best part of the proposal put forward by Washington.”

According to a CFPB spokesperson cited by Plumer, “this lawsuit appears to dredge up old arguments that have already been discredited.”  Stand ready for those old arguments to be given new life.  And be on the lookout for some shiny new arguments, likely of the slippery slope variety; preferably involving a cruciferous vegetable.

After the news broke of his firm’s (now $3 billion) loss on a hedge gone awry, Jamie Dimon quipped: “just because we’re stupid doesn’t mean everybody else was.”  Stupidity, however, is beside the point.

Jan Kregel has pointed out how a lot of the discussion surrounding this episode is designed to give the impression that this was just a matter of personal folly and bad judgment.  Get rid of a few people, tweak a model, and everything should be fine.  But there’s far more to this story, says Kregel in a new policy note.  First, the fact that management appeared not to recognize what was going on in a unit that reported directly to them suggests that JPMorgan was too big to manage.  And if it’s too big to manage, it’s too big for regulators to supervise effectively.

But simply making banks smaller won’t solve the problem either, according to Kregel—not if they’re allowed to engage in the same kinds of trades on the same kinds of assets.  Here he captures the “heads they win, tails we lose” dynamic of the post-Gramm-Leach-Bliley banking world:

[S]ince the passage of the Gramm-Leach-Bliley Act in 1999, the major activity of banks is to profit from changes in the prices of the assets held in its trading portfolio—and for JPMorgan Chase, in its hedging of its global portfolio. This activity generates little new investment and virtually no employment. If the bank guesses right, it makes capital gains for its shareholders; if it guesses wrong, and other banks have made the same guesses, the government and the general public are called upon to bear the losses. The problem is not simply that the banks are too large; it is that they generate shareholder returns by betting on changes in asset prices in their portfolios rather than by betting on investments in real productive activities that create income and employment for the economy as a whole.

The last line here is fundamental.  Dodd-Frank approaches the regulatory challenge by trying to make banks’ trading activities less risky.  But risk alone is not the issue for Kregel. The problem isn’t simply speculation or riskiness per se, but that “they are engaging,” he says, “in the wrong kinds of investments and the wrong kinds of risks.”  What Dodd-Frank fails to do is to reorient the banking system from speculating on price changes in exotic assets toward speculating on the real economy: on the ability of entrepreneurs to identify and pursue business opportunities that generate employment and real output.

Read it here.

Whether or not you already know what a “repo” is, Public Citizen’s new report on repurchase agreements, which played a part in the recent financial crisis (as well as the collapse of MF Global), is well worth reading.  Here’s their introduction:

In the run-up to the 2008 financial crisis, banks depended increasingly on an unreliable method of funding their activities, called “repurchase agreements,” or repos. Repos may look like relatively safe borrowing agreements, but they can quickly create widespread instability in the financial system. The dangers of repos stem from a legal fiction: despite being the functional equivalent of secured loans, repo agreements are legally defined as sales. Dressing up repo loans as sales can lead to sloppy lending practices, followed by sudden decisions by lenders to end their risky lending agreements and market panics. Repos also permit financial institutions to cover up shortcomings on their balance sheets. The problems in the repo market were exposed as the 2008 financial crisis unfolded, yet the risks posed by repos remain largely unaddressed. Without reform, the financial system will remain susceptible to the sudden and severe shocks that repos can cause.

Micah Hauptman and Taylor Lincoln have also written a blog post that runs down some of the basics.

In their report, Public Citizen uses data from the Financial Stability Oversight Council (FSOC) that displays how heavily repos are (still) being used among the top six bank holding companies. This figure shows the percentage of the liabilities held by the biggest banks that are deemed “less stable” by FSOC.  As you can see, repos (in green) represent the largest chunk:

Source: Financial Stability Oversight Council Annual Report (2011)

The Public Citizen report also includes a brief history of the regulatory changes that enabled repos to play a role in the financial crisis. continue reading…