Sunday, March 25, 2012

Committee to Save the World and its successors instead destroying Western capitalism

Bloomberg published a long article on the Committee to Save the World, its successors and the negative impact they have had on Western capitalism.

Before looking at the article, it is useful to remind oneself that the way the successors got to be successors was by actively supporting and not arguing against the efforts of the Committee to Save the World.
In 1999, Alan GreenspanRobert Rubin and Lawrence Summers were celebrated as “The Committee to Save the World” on the cover of Time magazine. Today, their successors are still picking up the pieces. 
The three were hailed as the brightest economic minds of their generation, whose free-market solutions quelled the Asian financial crisis while generating economic growth of almost 5 percent in the U.S. 
Yet their model of unfettered capitalism eventually invited disaster. 
The trio’s deregulatory approach encouraged banks to take risks that later threatened the U.S. financial system....
Actually, the trio's deregulatory approach allowed what Ferdinand Pecora, who led the Senate committee that investigated Wall Street after the 1929 Crash, called "legal chicanery and pitch darkness" to re-emerge as "Wall Street's stoutest allies."
“The ’90s were a time of triumphalism in Washington economic circles and in the American economics profession in general. Certainly Greenspan and Rubin and Summers didn’t help to combat that.”...
In fact, they championed the idea that market discipline was superior to regulatory discipline and therefore that the regulatory infrastructure set up in the 1930s should be eliminated.

The only problem with this idea is that market discipline is only superior to regulatory discipline when there is ultra transparency.  Ultra transparency is the necessary condition for market discipline.

Without ultra transparency, market participants do not have all the useful, relevant information they need in an appropriate, timely manner.  As a result, they cannot properly assess risk and enforce the appropriate level of market discipline.
The “committee’s” successors, including Treasury Secretary Timothy F. Geithner and Federal Reserve Chairman Ben S. Bernanke, are trying to rein in the risk that was allowed to build under their predecessors as they write rules under the Dodd-Frank Act of 2010, the most sweeping overhaul of the financial system since the 1930s. 
“If these protections had been in place, then we would not have faced the risk of this severe a crisis with this much basic damage,” Geithner, 50, said at a Feb. 2 news conference to discuss the law. The U.S. had “allowed a very large amount of risk to build up outside the formal banking system without the safeguards we put in place after the Great Depression.”...
The primary safeguard that was put in place in the 1930s was ultra transparency.

Had the SEC insisted that structured finance securities provide disclosure on an observable event basis for the underlying collateral, market participants would have been able to assess the risk of these securities and far less would have been sold.

Had the SEC insisted that banks provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, far fewer derivative securities would have been sold as market participants would have seen the risk of these securities and exerted market discipline on the banks.
Greenspan, Rubin and Summers also advocated repeal in 1999 of Glass-Steagall, the Depression-era law separating deposit- taking institutions from investment banking. The blurring of lines accelerated the growth of risky activities that often took place in the so-called shadow-banking system, outside the reach of bank supervisors.... 
Greenspan, in an interview, said blaming the crisis on lack of derivatives regulation and the repeal of Glass-Steagall amounts to a “rewriting of history.”...
This is one of the few times your humble blogger agrees with Mr. Greenspan.

A major cause of this crisis was the failure by regulators to ensure that ultra transparency existed throughout the financial system.  Instead, under the inspired leadership of Greenspan, Rubin and Summers, financial institutions were allowed to benefit from opacity both with regards to their own disclosure and the innovative financial products they created.
“All the problems which are being attributed to the lack of bank regulation could have been contained by higher levels of capital,” Greenspan said. “You can’t forecast which products are going to fail or become toxic. You can, however, let banks do what they want to do over a broad range of activities, but require that they have enough capital to thwart default and contagion.”...
Actually, you can forecast which products are going to fail or become toxic.  In the 1920s, we learned that these products are all characterized by opacity and a lack of ultra transparency.

As for higher levels of capital, if it is never used to absorb losses, then higher levels of capital are of no value.

Given that Mr. Greenspan feels that capital is there to thwart default and contagion, he must subscribe to the Swedish model and requiring banks to absorb the losses on all the excesses in the financial system today.
The three “were a lot too optimistic about the capacity of the financial markets to stabilize themselves and absorb shocks,” Robert Solow, winner of the 1987 Nobel prize for economics, said in an interview.

Still, he said, it’s “wrong just to blame three individuals who were prominent and overconfident.” If Greenspan, Rubin and Summers had “taken action about leverage, including in the shadow-banking system, there would have been an enormous outcry and they’d have been vilified from the other side.”...
All that was needed was enforcement of the ultra transparency requirement.

With this information, market participants could have protected themselves.
Summers, asked after a Feb. 13 speech in Calgary whether regulators missed a chance to take action on derivatives that could have prevented part of the financial crisis, said “there’s no question that it would be better if the kinds of regulation that have now been put in place to ensure much greater transparency, much greater transparency on runs, much more reliance on exchanges, had been put in place earlier.”
“Just how much different the path would have been would depend on a large number of details,” he said. “It’s very hard to judge. It’s clear that we’ve learned a lot about the dangers of unregulated markets.”
Yes we have, however, based on Dodd-Frank and the resulting regulations, it is not at all clear that anything has been learned about the need for ultra transparency.

For example, Congress is passing the JOBS bill which repeals 1930s era disclosure requirements for firms with less than $1 billion in revenue.
Both the financial industry and regulators should have done more to curb the excesses, Donald Kohn, who spent 40 years with the Federal Reserve, including as vice chairman from 2006 to 2010, said in an interview. 
“First and foremost, the private sector didn’t assess the assets it was buying very well, didn’t look under the hood very hard,” he said.
That the private sector didn't assess the assets it was buying very well was and still is a function of the lack of ultra transparency.

As Mr. Kohn knows well, disclosure by banks leaves them resembling what the Bank of England's Andrew Haldane calls 'black boxes'.
“And the cops weren’t on the beat. Regulators saw some problems coming, but not all of them. I wish we had done more on the mortgage side, but especially on the financial- intermediary side. The private sector didn’t do enough and we didn’t override them.”...
Under the FDR Framework, the role of the regulators is to ensure that there is ultra transparency and market participants have access to all the useful, relevant information in an appropriate, timely manner.

In fact, the regulators have been a barrier to providing market participants with ultra transparency.  Simply put, the financial regulators have protected their monopoly on this information (remember, the bank examiners have access 24/7/365).

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