Financial Tornados Part 2: Satellites falling from the sky

In my last blog I suggested that it is important to distinguish between events that will likely repeat and those that won’t. Policy cannot be backward looking or we waste the people’s money. No matter how devastating it might be to have part of an orbiting satellite fall on your head, it makes absolutely no sense to spend huge sums of money to prevent something that almost never happens. Yet, more and more evidence is piling up that policymakers continue to suggest remedies that make little sense when a repeat of the past financial crisis is so unlikely. That does not mean that there are not affordable and reasonable things that can be done. Building better satellites or programming them to fall in the ocean seems more reasonable than building a roof over the globe.

I want to continue this line of reasoning with some comments about various solutions that keep popping up in the business news. For example, in the Financial Times of October 25^th, William Dudley, president of the NY Fed called for a “comprehensive approach that should start with an urgent effort to remove the obstacles that make it difficult for all borrowers to refinance at today’s low mortgage rates.” In my previous blogs I have been a strong advocate of finding ways to solve the housing finance crisis. And refinancing is clearly important in that regard. But Dudley’s message misses the point. What got us into this mess is exactly what Dudley is suggesting. It is like telling an alcoholic that he needs to drink more to cure his addiction. The “obstacles” he refers to include the very things that are necessary to make sure that loans are repaid by the people who borrow the money. Dudley should be more direct. He really wants the government to subsidize the loan process. If that’s what he really wants, then he should recommend that bankers continue to use good banking principles while he asks for direct government support to those who cannot afford to pay back the loans. The latter would be temporary and more befitting of the problem. Suggesting that banks use poor policy is more permanent and guarantees a replay of the financial crisis.

In the same issue of the FT is an article by Barry Eichengreen and Raghuram Rajan recommending that central banks expand their responsibilities to include a dual mandate for monetary policy.  Instead of central banks focusing on employment and inflation alone, they recommend central banks also aim their policies at financial stability. While it is true that financial regulators were and are part of the problem of the financial crisis, it is not clear that the lack of a dual mandate for central banks caused the current crisis. Every country has a regulatory system with one or more institutions that oversea financial stability. In some cases they have too many overlapping institutions. But the industry is covered. I do not know what it is that suggests that central banks have an advantage in producing good financial policy. Most experts believe that central banks have a difficult enough time with just one mandate – finding a satisfactory balance between inflation and unemployment. E&R want to saddle these struggling central bankers with tradeoffs between unemployment, inflation, and financial stability? Wow. Crazy.  It’s like asking a one-armed juggler to add a few more flaming rings to his act.

Then there are the recommendations for increased European integration. George Soros has a plan to save the eurozone. It was not enough to have a stability pact that required that eurozone nations be mindful of the sizes of their deficits and debt. This pact had penalty fines attached and seemed like a great solution to protect the value and reputation of the euro. That worked until Germany had a little problem with the requirements and fines and the Germans simply said nein. That ended that. So now we are to believe that since there is a sovereign debt crisis, Europeans will enact a new treaty that creates a common European Treasury, a newly empowered European Central bank with direct controls over credit lines and portfolios of all banks, and more.  Did the lack of explicit policy integration stop countries from exerting their own preferences for fiscal policy? The answer is no. There was a treaty and when it infringed their own sovereignty, they found ways to avoid it. When Frenchmen and Finns feel threatened by European events they will always find ways to preserve France and Finland, regardless of agreements and treaties. Perhaps in 50 years Finns and Frenchmen will believe their interests are best served by a United States of Europe. For now, however, the recommendations of Soros and others amount to treating a one-time bout of the flu with an Iron Lung Machine.

The problem with Soros’ and other proposals for more European integration of fiscal and monetary policy is that these are solutions to problems that do not exist. The EU is not the United States of America. The EU is mostly a single market with a single currency designed to make its members more productive and competitive. It was designed to be a loose federation of sovereign states. This worked well until 2008. Then a “satellite fell on their heads”. This satellite is likely not to return yet serious economists and political leaders want to "build a roof" over all of Europe.  The sovereign crisis of Europe is serious. But the solutions should fit the causes of the problem. It makes no sense to enact permanent edifices for rare events. It would be much better to find short-term remedies designed to overcome the worst problems and then get on with the task of being a loose federation of sovereign states with a single market and money.