Consider the Boom in the Bust; Consider the Bust in the Boom

When you are in the bust phase of the credit cycle, there are no good solutions.  Do you try to reflate?  You can try to, and you will succeed (sort of), if the Fed Funds rate maintains a respectable positive value that does not kill savers.  But you might not succeed, because there is not enough interest margin available to capitalize today.  That is where we are today, and so the Fed moves on to QE, where any asset can be financed via the Fed’s fiat.

The best policy focuses on the booms, and seeks to limit excesses.  It seeks to deliver pain in the bust phase to those who made bad lending decisions.  Had the Fed allowed real pain to be delivered to the banks in the late 80s and early 90s, we wouldn’t be having our current problems.  The Fed lowered rates far lower than was needed, and kept them there until a crisis erupted, forcing change.

Had the Treasury and the Fed let Mexico fail in 1994, and let the stupid Americans who had put money into cetes lose money, we would have been better off now.  If losses are not delivered to those who deserve them imbalances build up.

The same applies to the 1997 Asian crisis, Russia/LTCM, the popping of the tech bubble, and the response of the Fed flooding the system with liquidity.  Too much, and too long — it set us up for the housing/financial bubble of which we are now in the aftermath.

So, when the latest crisis hit in 2008, I took up the lonely position of suggesting failure was the better solution.  If the government had to get involved, let it be a DIP lender.  If it had to meddle in the creation of credit, create a bunch of new mutual banks.

But as I mentioned in the first paragraph, when the big bust hits, and Fed funds drops to zero, all solutions are pretty useless.  At that level, normal monetary policy can no longer cause revaluations of asset prices (and liabilities), allowing the reflation of assets with low ROAs.  That is, until QE appears, leading to temporary inflation of assets through sucking in a decent chunk of the safest part of the intermediate fixed-income universe, forcing a temporary increase in risk taking.

I would argue that the best thing one can do in the bust, whether as an individual/policymaker is to ask what you would like the next boom to look like. Parallel examples (Individual/Policymaker)

  • What level of safety will you maintain? / are you willing to see the economy grow more slowly in the short-run, if it leads to better long-term growth?
  • How will you avoid getting caught up in euphoria? / how will you resist the political pressure from concentrated interests asking you to twist regulation/legislation their way?
  • Will you avoid too much debt, particularly short-term debt? / Will you fight to keep systemic leverage low, and keep the asset-liability mismatch at the banks low?

And more for policymakers:

  • Do you want the unaccountable (to the voters, and also Congress) Fed to have such influence?
  • Will you adopt policies that discourage steep yield curves?
  • Will you raise FDIC fees to economically fair levels, till you begin to see a few banks walk away?
  • Are you willing to invest in a regulatory structure that can and will say no to the banks?
  • Or, are you willing to break the banks up, end interstate banking, and let the states regulate the banks?  (Remember, state insurance regulators did relatively well through this crisis… AIG was mainly a derivatives failure.)
  • Are you willing to regulate derivatives as insurance contracts, with something similar to an insurable interest doctrine?
  • Do you really want to continue to farm out credit policy to the rating agencies?
  • Are you willing to create a better accounting system based on current net worth, rather than dated historical cost figures?

In the same mold, I would add that it is during the boom that you want to consider what you want the next bust to look like. For example, will you accept more frequent and sharper small busts in order to avoid a big bust?

You can limitedly control your own exposure to the next boom/bust; it depends how much you want to manage your time horizons, and limit your potential outcomes.  As for policymakers, I am less optimistic due to regulatory capture, and short-term opportunism.  Regardless, you are better off if you plan for the longer term; society as a whole would be better off if policymakers did the same.

1 Comment

  • matt says:

    State regulation of banks makes a ton of sense, as you note.

    First, they tend to use “dumb” regulation. At first glance, that doesn’t sound good until you look at the track record of discretionary regulators. As you note, they tend not to exercise their discretion. In some cases, out Federal regulators went out of their way to block any action on the national banks (I read several cases of assistant DAs in California trying to investigate mortgage fraud as far back as 2004 and 2005 only to be shut down by the office of thrift supervision on the grounds of Federal preemption. Then, the OTS never followed up on the complaints).

    Second, regulatory capture is much easier (and cheaper) when it is concentrated in one city. It’s not impossible, but it would be much harder to capture regulators in all States in which a bank operates.

    Third, diversification of regulation lowers the odds of having systemically poor regulation.

    (Note, the issues I see with my points 2 and 3 above are: (1.) that States tend toward convergence on uniform financial regulation because it is beyond legislators’ area of expertise and they tend to hire consultants from trade groups to advise on legislation and (2.) that banks will likely focus their lobbying attention on their respective largest markets and achieve the same regulatory capture–collectively–as they do in Washington.)