Exiting the Great Depression: lessons for today

1. Exiting the Great Depression: lessons for today Kris Mitchener and Joseph Mason Discussion byMarcus Miller Warwick University

2. Discussant’s commentsWhat I liked M and M’s outline of fascinating features like • Extent of bank recapitalisation through RFC striking • Anti firesalesactivity of Deposit Liquidation Board Their flagging of key issues like • Tackling asymmetric information via certification, FDIC, etc. • Political problems of reversing crisis induced institutional support

3. What I missed • Didn’t get their 3 R’s! How about- • Rescuing the system, too little too late in 1930s • Regulating banks: in 1930s prudential regulation crucial complement to deposit insurance. • Reform the system: in 1930s this included Glass-Steagall, SEC, Chapter 11 Bankruptcy I will use these as headings for comments to follow

4. 1. Rescue (Image of the $1 trillion liquidity support by FRBNY)

5. ‘The Great Escape’ • What would have happened to the US economy if the Federal Reserve had not intervened by spending 7% of US GDP buying illiquid assets in 2008/9? • The FRBNY have modelled the effect of a liquidity crunch without such intervention; and then with the liquidity injection of $1 trillion • Results can be shown as:

6. Effect of a liquidity shock in US that lasts 10 quarters, Del Negro et al. (2009) Solid blue : no intervention. Dashed blue: $1 trillion liquidity injection. The Counterfactual 40 % fall of Investment Output falling initially by 25% Then down to 30% The capital stock falling by 1% a quarter until liquidity is restored

7. Help from Central Banks - since Aug ‘07

8. Plus support from Government =3/4 GDP! • United KingdomUnited States • Jan. 2007 Latest Jan.207 Latest • Government support £ trillions $ trillions • Guarantees of financial • institutions’ liabilities – 0.37 – 2.08 • Insurance of financial assets – 0.46 – 3.74 • Capital injections to banks and • special purpose vehicles – 0.06 – 0.70 • Increase in public sector support 1.26 – 10.44 (including CB assistance) • Percentage of GDP – 88% – 73%

9. 2. Regulation • Crisis has revealed profound problems of • asymmetric information • Financial externalities (fire sales, network effects) • Market concentrationThese lie outside the competitive paradigm of economics, so tackling them will require thinking outside the box

10. Competitive Market paradigm Challenges to the market paradigm Missing information; missing markets Strategic Power Externalities, e.g. systemic risk Market collapse

11. ‘Greenspan defends position on free market’Central Banking.com 6 Apr 2010 • Alan Greenspan, a former chairman of the Federal Reserve, has refuted claims that his comments on the recent failures in financial markets are in any way a repudiation of the laissez-faire view that markets can be trusted to police themselves. • "There is no alternative if you want to have economic growth, higher standards of living, in a democratic society, to have competitive markets," he said.

12. Externalities • Economists use the term ‘negative externality’ to refer to a side effect of economic activity that you don’t pay for. • One example is Global Warming: use of car has side effects on global carbon build-up - and some predicting Armageddon as a result. • Another example is atmospheric pollution. • We focus on ‘fire-sale’ and ‘network’ externalities.

13. Two Regulatory Responses: taxing externalities • Some advocate Pigovian taxation of externalities associated with HLIs ‘Highly Leveraged Institutions’* who generate externalities – e.g. by capital adequacy ratios and presumably liquidity ratios, Korinek (2009) and Haldane(2010) * inc banks, shadow banks and hedge funds who might get involved in ‘fire-sales’

14. Key Problem: Tail risk within financial systems is endogenous and often unobserved • it is hazardous to believe there is a magic number for regulatory ratios sufficient to insure against tail risk in all states of the world. Because tail risk is created not endowed, calibrating a capital ratio for all seasons is likely to be, quite literally, pointless – whatever today’s optimal regulatory point, risk incentives mean that tomorrow’s is sure to be different. • A.G. Haldane ‘The $100b question’

15. Prohibition • Andrew Haldane “The $100 b question”(2010) argues that: • Banks will always be able to move faster than the regulators , and avoid control by ‘regulatory arbitrage’. Look at the US shadow banking industry! • Hence the need for prohibition - to ban activities that threaten to generate negative externalities. • “Prohibition” may have a 1930s sound, and that’s right

16. US in 1930s: Glass-Steagall • Glass-Steagall : simple in objectives and execution. • Clear aim - shaped by an extreme tail event (the Great Depression) –was to avoid a repetition. • It sought to achieve this by acting directly on the structure of the financial system, quarantining commercial bank and brokering activities through red-line regulation. • Lasted over half a century without a significant systemic event in the US, until revoked in 1999 by Gramm-Leach-Bliley Act . And then….?

17. Average assets relative to GDP of US commercial banksSource: A.G. Haldane ‘The $100b question’

18. Concentration of the US banking systemSource: A.G. Haldane ‘The $100b question’

19. 3.Reform of structure • In a context of asymmetric information, HLI’s use the property rights of the capitalist system to generate profits which reflect transfers rather than value added. • Why not change property rights? E.g. • Volcker Rule to bring back Glass-Steagall • Investment banks to be partnerships again • Double liability for commercial bank shares?

20. Let me out of here!

21. Economic progress: two possibilities: What is not legally banned may be economically attractive (with moral issues left aside) • A: OK • B: PROBLEM Legally banned Morally unacceptable Is there not a risk that that well-heeled, politically savvy, financial institutions - with the best lawyers and least moral scruples - will stay ahead of legal and moral sanctions.

22. Postscript • ‘Wall Street titans still recklessly speculate with borrowed money. We cannot delay action any longer.’ (BarackObama) • Goldman charged with fraudFT Headline - 17 April 2010 • ‘US authorities yesterday accused Goldman Sachs of securities fraud that caused investor losses of more than $1bn (£649m).

23. Competition between Cultures? • In Western, market-based culture, the limitations on property rights depends explicitly on legal sanctions • But these are failing to internalise externalities • In some Eastern cultures, the rule of law is not paramount; and, in any case, there may be other sanctions , e.g. shame, capital punishment. • So they may be better able to internalise externalities! *DipakLalUnintended Consequences,