Jeff Lacker gave what I think is an extremely important speech this past Friday on the crisis, the monetary policy response, and the role of economic theory during the crisis and in the aftermath. The speech is both enlightening and thought-provoking. Lacker has a unique perspective on the financial crisis. He has been President of the Richmond Fed for 10 years and, before assuming a management role at the Fed, worked on research problems in banking, financial contracts, and incentives. The Bank of America is in the Richmond Fed district, so Lacker would have had an inside track on what was going on in one of the largest financial institutions in the country, and thus in much of the rest of the financial system.
Some of the interesting points in Lacker's speech are the following:
1. Economists had plenty of tools and models available to apply to the problems of the financial crisis. But they may not have applied them very well. Lacker traces the roots of the crisis to August 2007, when interest rate spreads began to rise in the market for asset-backed commercial paper. This brought on a response from the Fed in the form of a change in discount window policy. Lacker questions whether that was the appropriate policy response, and uses this as an example of poor application of the available economic theory to the problem at hand. What Lacker mentions in his speech relates to a particular FOMC discussion, which can be found in the 2007 FOMC transcripts. In the transcripts, there is a very long discussion of the policy, and Bernanke defends it by citing chapter 6 in a book by Allen and Gale. My interpretation is that the policy decision had been made - the discount rate would be lowered - and Lacker was questioning the policy. Bernanke's response was to find a piece of academic work that supported the policy move, but that piece of work had questionable relevance to the problem at hand.
2. Too-big-to-fail is at the heart of the financial crisis. The U.S. financial system is fragile. Unless the features of financial disruption in 2008-09 were somehow only a symptom of some large underlying shock - a view which at this point seems a very long stretch - this seems clear. But where does that fragility come from? One view is that the fragility is inherent to financial systems. This view is framed in some versions of the Diamond-Dybvig model, in which the maturity mismatch and illiquidity inherent in banking imply that bank panics are possible. An alternative view is that the fragility is induced. It is well-known, for example, that deposit insurance induces risk-taking by banks that can be curbed through regulation - e.g. capital requirements. For small banks in the U.S., regulation is simple, because small banks are simple. Further, the failure of small bank is no big deal. In many cases, the FDIC can step in on a Friday, resolve the failed bank over the weekend, and have it open on Monday under new management.
Big banks and other financial institutions are another matter altogether. These large financial intermediaries are complicated and hard to regulate. Indeed, large financial institutions like Bear Stearns and Lehman Brothers could take on some of the characteristics of banks - e.g. maturity mismatch - while falling outside the regulatory umbrella that covers banks. As well, the failure and resolution of a large financial institution is a potential nightmare. The possibility of systemic disruption (which we saw in the financial crisis with the Lehman failure and the subsequent problems at AIG) from a large financial institution is what leads to the too-big-to-fail moral hazard problem. That is, a too-big-to-fail financial institution understands that it is too-big-to-fail, and therefore takes on too much risk, relative to what is socially optimal. This high level of risk could be reflected, for example, in a high-aggregate-risk asset portfolio, or in a maturity mismatch between assets an liabilities.
The too-big-to-fail problem is not only a long-run problem, but could manifest itself within a crisis period, as it may have in 2007-08. For example, it appears to have been well-known to regulators, and to Lehman Brothers itself, that Lehman was on shaky ground, perhaps a year or more before it failed. When Bear Stearns failed in March 2008, the Fed intervened in key ways, and helped engineer a sale to JP Morgan Chase. This could have created the expectation in other large financial institutions that their incipient failure would be met with the same type of intervention. Thus, it is possible that Lehman Brothers could have taken corrective action, including increasing capital and reducing dependence on short-term funding, to ward off failure, if it had correctly anticipated that a bailout would not occur.
Lehman Brothers filed for bankruptcy on September 15, 2008. One day later, the insurance company American International Group (AIG) received a large credit extension from the New York Fed. At that point, regulators had resolved six large failing financial firms in five different ways. Some positions in the capital structure were rescued in one firm's resolution but not rescued in another's. Each had been handled on an ad hoc basis, without comment on how similar cases might be handled in the future. Market conditions following Lehman and AIG cried out for a general policy statement providing guidance on future interventions.So this points to a policy failure. There was no explicit policy on how to deal with large financial insititutions, and those large institutions had to be confused about what would happen in the event of looming trouble. The most uncharitable view of Fed policy would be that, rather than saving the U.S. economy from the Great Depression, in the fall of 2008 Ben Bernanke was only cleaning up his own mess.
One might be tempted to think that too-big-to-fail is just an unsolvable commitment problem that we just have to live with. But, as Lacker points out
The thesis that financial market instability is inherent, rather than induced by poor policies, must also confront the fact that instances of instability are quite unevenly distributed across different countries and different regulatory regimes, as exemplified by the contrasting experiences of the United States and Canada. Over the past 180 years, the United States has experienced 14 major banking crises, compared with just two mild illiquidity episodes in Canada over the same period. If financial fragility were an inherent feature of financial markets, financial panics would be ubiquitous, but that's not what we see.So, somehow the Canadians managed to solve the too-big-to-fail problem. While I'm quite willing to entertain the possibility that Canadians are superior human beings whose financial acumen is beyond the comprehension of Americans, I think we should entertain the possibility that there are things going on in the Great White North that we can easily replicate.
3. Economic researchers need to think more carefully about their policy advice. There is no hint in Lacker's speech that pre-financial-crisis economic theory was somehow lacking. Obviously we have learned a lot from the financial crisis, and that episode raised questions and moved some researchers in different directions. But the economics that Lacker brings to bear in understanding the events of the financial crisis was well in place long ago. That economic theory included information economics, the theory of incentives and insurance, the theory of financial contacts, and banking theory. While some people want to tell us that the financial crisis demonstrated that economics is a failure, I think we can safely argue that any failure was in the inability of regulators and policymakers to apply what was on the shelf.
But we can do better, of course. Lacker is critical of the tendency for economists to produce "possibility theorems," i.e. models which tell us that such-and-such can happen under such-and-such conditions, without worrying too much about how to apply such knowledge in practice. In my experience, contact between policymakers and researchers can cure that problem easily. And that was exactly what the conference at Arizona State University (organized by Ed Prescott), where Lacker gave his speech, was all about.
4. Central bank crisis intervention is not primarily about the overnight nominal interest rate and Taylor rules. This was not one of Lacker's bullet points, but this idea is implicit in his speech. Lacker talked for an hour on monetary policy in the financial crisis without mentioning the overnight interest rate. During a financial crisis, a decision about whether the fed funds rate target should be 2% or 1.5% is second order relative to who is borrowing at the discount window, how much, and at what rate; what Fed officials are saying to what CEO of which large financial institution; or what assets the Fed is buying and putting on its balance sheet.