Financial Regulation – How Screwed Are We?
-Ed Dolan (Ed Dolan’s Econ Blog)
This past week brought a spate of articles on the woes of financial regulation. John Kay writes that the regulation we are getting “is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.” James Kwak thinks that crude capture at the level of Congress is exacerbated by intellectual capture at the level of regulatory staff. John Gapper sees a slightly different form of intellectual capture in which “any oversight that is biased towards preserving stability will often shy away from making life too difficult for banks.” Randal Wray sees outright fraud—a system in which top corporate managers run their institutions as weapons to loot shareholders and customers for their own benefit. Although some of these writers use more measured language than others, all of them seem to agree with Wray on one point: We’re screwed.
So, can financial regulation be fixed, or not? Each writer points out reasons why effective financial regulation may be impossible, and I would add one more. As I see it, one of the biggest problems is that too many regulations, even those that are not tainted by capture, are prohibitions of specific risky activities, such as ownership of hedge funds or proprietary trading. This approach has two kinds of unintended consequences.
One is that prohibiting specific kinds of risks increases the incentives for fraudulently hiding them from investors, shareholders, and regulators. The other stems from the fact that financial institutions have an infinite menu of risky activities to choose from. If regulations prohibit some of them without curbing their inherent appetite for risk, they just move on to the next activity on their menu. Unfortunately, that activity may have a risk-return profile that is inferior both from financial managers’ own point of view and from that of the public interest.
It is like a parent who tries to get an obese child to take some weight off by saying, “No more chocolate ice cream, no more Big Macs.” The child just switches to mint chip ice cream and pizza.
In an earlier post, I used this diagram to illustrate the point. Regulators and bankers have different preferences so they seek different optimal points along the risk-return frontier. Ideally, regulators would like to find a way to induce banks to slide down and to the left along the frontier to a less risky point. Instead, by outlawing the specific strategies banks have used in the past, all they do is to drive them inward, away from the frontier and toward some new set of still risky but less efficient strategies. Both sides end up worse off.
The implication is that only two kinds of regulations could ever do any real good. One would be those that curb the risk appetite directly, for example, by changing compensation practices, by exposing financial executives to personal legal risks, or by other reforms of corporate governance. The other would be to break up institutions into small enough units that their failure can be tolerated. Of course, crude capture might make that kind of reform exactly the hardest to achieve. If so, then we really are screwed.
What’s Up Doc?
-Edward Hugh (Don’t Shoot the Messenger)
According to Wikipedia, Kabuki is a classical Japanese dance-drama known for the stylization of its plot and for the elaborate make-up worn by the key performers. This definition seems to fit the drama in an interminable number of acts currently being acted out on the European stage by some of the continent’s leading central bank players.
It all started last Thursday when, as surely everyone but my blind and deaf uncle must know by now, Mario Draghi made what is widely thought to have been an important speech. We will do whatever it takes, as long as it is in the mandate, he is reported as saying. And since stopping anything which is life threatening to the Euro dead in its tracks forms part of the mandate under any conceivable interpretation, the ECB now have the widest possible brief within which to circumscribe their actions. The only limitation is that it should be enough, just enough, and no more. As Mario Draghi said, “believe me, it will be enough”.
But then on Friday dark clouds started to loom on the horizon, as the Bundesbank waded into the fray, making a statement which seems to have been intended to say “now just hold on a minute there!” As the Irish Independent put it in a headline “The Bundesbank Pushes Against ECB’s Draghi Attempt To Save The Eurozone.
Yikes! That sounds dangerous. Someone wants to save the Euro, and with it the entire planet, and someone else wants to stop him from doing so. Assuming we are not in James Bond territory here, how can that be?
Well, that’s why I say “seem”, since digging into the situation a bit, I found it very hard to identify an original source for the statements that were being attributed to that most venerable of German institutions. Certainly there was no trace of anything on the central bank website.
Well, as Ludwig Wittgenstein used to say, when you seem to hit bedrock, and even if the blade is a bit bent, don’t let your spade be turned. Just keep on digging. So I did.
What I found was a Reuters correspondent who claimed to have been told by a bank spokesman that “The Bundesbank regards central bank purchases of sovereign debt as monetary financing of governments, from which the ECB is prohibited by European law”.
“The mechanism of bond purchases is problematic”, the spokesman apparently added, “because it sets the wrong incentives.” On the other hand the possibility of the EFSF bailout buying government bonds was reportedly viewed as “less problematic”.
But then I moved on to Dow Jones News Wires, where I got the weird feeling their journalist had had exactly the same conversation with just the very same Bundesbank spokesman. “Germany’s central bank remains opposed to further government bond purchases by the European Central Bank, but isn’t against using the euro-zone’s temporary rescue fund doing so to drive down soaring sovereign borrowing costs”, the writer claimed to have been told by a Bundesbank spokesman. Odd, I thought that two separate journalists had rung up the bank independently only to have had the exact same conversation.
In order to try and clarify matters – remember markets next week have to decide what the next chapter in the Euro Debt Crisis is going to be, so it isn’t simply pedantic to want to get this one right – I did what every well trained economist does in cases of an emergency – I went back to the original story that caught my eye in the Financial Times, where to my horror I found there was no mention of any presumed conversation with any bank spokesman whatsoever. The FT simply informed the world majestically that “The Bundesbank says…..” which was followed by a wording not that different to the ones to be found in Reuters and Dow Jones Newswires. Then I went to the Daily Telegraph, and found they followed the FT in simply asserting that the Bundesbank says blah blah blah. But where, I am asking myself, do they say it?
Why does this matter? Well, maybe this IS being pedantic, but I don’t think we should start accepting that the Bundesbank (or anyone else) thinks “something or other” simply because the FT says they do, much as I love the paper and its charming corps of staff. Even if we are told “an anonymous source from the Bundesbank who under no circumstances wanted to be identified publically” said x, this can help us evaluate the significance of x. If we are told nothing, then frankly I for one don’t know where to start.
Thankfully, Bloomberg finally came to my rescue. They owned up to what had actually happened:
“A spokesman for the Frankfurt-based central bank said in a statement read over the phone earlier today that there haven’t been any changes in its position on bond purchases”.
So there we have it, a case of sex (or rather policymaking) over the phone. What journalists were presenting us with was an official pre-prepared Bundesbank statement, which was read out to any journalist who was sufficiently interested to ring them up. So this is something the German central bank wanted to go out. It was a way of influencing the situation by applying the law of least effort.
Having understood that (which was the hard part) I have then spent the rest of the weekend wondering what it might mean. But to find out what my conclusions were you’ll need to read the full blog post.
Spanish Unemployment: Mondays in the Sun
-Emre Deliveli (The Kapalı Çarşı: Emre Deliveli’s blog on the Turkish economy)
As loyal readers know, I usually summarize my weekly Hürriyet Daily News columns here, but this week’s topic, the low women’s labor force participation rate in Turkey, may not appeal to EconoMonitor’s usual crowd. You are more than welcome to read the column, or the fresh-out-of-the-oven policy note and research reports by Istanbul think-tank BETAM, on which it is based, but I will focus here on the more Economonitor-friendly topic of Spanish unemployment.
As you can see in the Bloomberg article on the data release, the emphasis was on the fact that this was the highest unemployment rate ever in democratic Spain. However, I am more interested in the relationship between growth and employment: See, the average quarterly contraction in GDP over the past year has been 0.1 percent, whereas employment has decreased by 0.9 percent, on average, over the same period.
This is where I get confused: This seems like the sensitivity of employment to output has actually decreased after the recent labor market reforms, which were, by the way, rather applauded in the IMF’s most recent assessment of the Spanish economy.
Of course, four quarters is hardly an appropriate time period to judge elasticity. On the other hand, the Bloomberg article mentions that fashion retailer Adolfo Dominguez SA and cement-maker Cementos Portland SA have been able to shed off their workforce after the new laws kicked in. A friend who is a hedge fund manager was recently in Spain and talked to the CEO of one of the largest banks, who said they had been able to lay off many workers after the approval of the new law.
I take all this to mean that firms have only recently started to make use of the new labor laws. Given that Spain is undergoing austerity and many experts, including Roubini Global Economics, are expecting the country to stay in recession this year and the next, I don’t think the unemployment rate has maxed yet…