If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]
But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....
Narayana Kocherlakota, Lionel W. McKenzie Professor of Economics, University of Rochester; former President, Federal Reserve Bank of Minneapolis.
Has the experience of the crisis changed your view of the central bank policy toolkit?
Former President Kocherlakota: Yes. I’m going to focus on the U.S. experience—with which I am most familiar—aside from one comment later that relates to Europe.
I would divide the U.S. response to the crisis into two pieces. One is the liquidity interventions that the Federal Reserve undertook, largely under the rubric of Section 13(3) of the Federal Reserve Act, beginning in 2008 and then moving on into the fall of 2008 and 2009. I was not President of FRB Minneapolis yet, so my comments are really those of an economist observing those interventions from the outside....
Eight years after the financial crisis began, the regulatory reforms it spawned continue apace. Over the past year, regulators introduced total loss absorbing capacity (TLAC) and the liquidity coverage ratio (LCR) to make banks more resilient. And, with an eye toward strengthening market function, authorities continue to push for central clearing of derivatives (CCPs).
Overlapping with these goals—and extending to nonbanks—is the recent move to establish standards for margin requirements in securities transactions: that is, the maximum amount that someone can borrow when using a given security as collateral...
Charles Bean, Professor of Economics, London School of Economics; former Deputy Governor for Monetary Policy, Bank of England; former Chief Economist, Bank of England.
Has the experience of the crisis changed your view of the central bank policy toolkit?
Former Deputy Governor Bean: Most certainly. First, the natural real safe rate of interest has been persistently depressed by a combination of high savings, weak investment and portfolio shifts in favor of safer assets. That means prolonged periods when policy rates are at their (near) zero lower bound are more likely, necessitating greater reliance on unconventional monetary policies instead.
Last week, our friend, Harvard Professor John Y. Campbell, delivered the American Economic Association’s 2016 Ely Lecture, the group’s most prominent invited lecture. His topic—a central challenge for policymakers and practitioners alike—is how to make modern finance work better for consumers who lack understanding of the opportunities and risks they face. Professor Campbell discussed how we can take the lessons from behavioral finance and household finance—a relatively new field that he helped establish—to help households manage the choices that they face. The ultimate goal is to foster decisions consistent with economic rationality (hence his title, “Restoring Rational Choice: The Challenge of Consumer Finance”) while minimizing the costs of government intervention.
We take this opportunity to highlight a few important points from Professor Campbell’s presentation (text here and webcast here)...
Switzerland is an amazing place, not least the skiing, the chocolate, and the punctual trains. The latter is part of the country’s exquisitely maintained infrastructure: there are no potholes, and no deferred maintenance of train tracks, tunnels, airports, or public buildings. Few countries go so far, but many can take a lesson: it pays to maintain infrastructure at least so that it doesn’t fail.
We bring this up now because financial markets are telling us that it’s a very good time to build and repair infrastructure: real (inflation-adjusted) interest rates have fallen so low that it has become exceptionally cheap to finance the improvement and repair of neglected roads, bridges, transport hubs, and public utilities. Yet, in the United States, we are doing less public investment than ever: net government investment has fallen to what is probably a record low...
Back in August, we explained the mechanics of how the Fed can tighten policy in today’s world of abundant bank reserves. Now that the first policy tightening under the new framework is behind us, we can review how the Fed did it, if there were any surprises, and what trials still lie ahead.
So far, the new process has been extraordinarily smooth – a tribute to planning by the Federal Open Market Committee (FOMC) and to years of testing by the Market Desk of the Federal Reserve Bank of New York (FRBNY). But it’s still very early in the game, so uncertainties and challenges surely remain.
Former President, Federal Reserve Bank of Philadelphia; former Dean, Graduate School of Business Administration, University of Rochester.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Former President Plosser: I would say that the tool kit has not changed so much but the willingness to exploit it has expanded. Central banks have long had a great deal of power to intervene in financial markets in the conduct of monetary policy. Wide differences, however, have prevailed in central banks' regulatory and supervisory responsibilities over the financial sector...
The goal of every central banker is to stabilize the economic and financial system—keeping inflation low, employment high, and the financial system operating smoothly. Success means reacting to unexpected events—changes in financial conditions, business and consumer sentiment, and the like—to limit systematic risk in the economy as a whole. But as they do this, policymakers try their best to respond predictably to news about the economy. That is, there is a central bankers’ version of the Hippocratic Oath: be sure you do not become a source of instability...
On December 16, the Federal Open Market Committee is poised to hike interest rates, putting an end to the near-zero interest rate policy that began in December 2008. So, it’s natural to step back and ask what this episode has taught us about monetary policy at the near-zero lower bound for nominal interest rates. This is not merely some academic exercise. The euro area and Japan are still constrained by the zero bound. And, in this era of low inflation and low potential growth, policy rates in advanced economies are likely to hit that lower bound again (see, for example, here). How the Fed and other central banks respond when that happens will depend on the lessons drawn from recent experience...
