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On Risk And Financial Reform
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I am for reasonable regulatory reform. There are many aspects of our financial system that need attention. The phrase "too big to fail" needs to vacate the English language. The ability of a central authority to take over institutions that threaten to bring down the monetary system and liquidate them through bankruptcy proceedings in an orderly way would be helpful. The enforcement of laws against fraud -- something sadly lacking the last several years is essential. The establishment of leverage limits and capital requirements, especially regarding derivatives need to be looked at. And rating agencies that actually rate rather than ratify would be nice. But while I encourage reform I really don't expect regulation to prevent the kind of panic we just came through or prevent future financial crises.
It's like stop sign's. I'm for them. But those that claim that if we put a stop sign at a busy street corner we will never have a wreck again are naive. There's always going to be somebody who runs the stop sign. The same is true with risk. Regulation, like stop signs attempt to set rules and standards. Sometimes they work pretty well and other times they do more damage than good. It comes down to a case by case basis. But more importantly those that are bent on committing fraud will find a way of doing so no mater what a law says. I give you Bernard Madoff as a case in point.
Transparency, capital requirements, limits on leverage, a resolution authority to liquidate institutions that pose systemic damage are all good in theory. I'm for them. But don't tell me they will prevent a repeat of panics and crises or would have prevented the last one. For that we all need to protect ourselves and not rely on government. We know that there are laws against the use of force and fraud in this country, but we also know that there are those intent in violating them and that we can not always count on government to protect us. It is no different in the world of business and finance.
In July of 2008, almost two years ago, I wrote an article called Central Banking In The 21st Century. Given the attention these issues are getting today I would like to reiterate my views with the following excerpt from that article. Very little has changed or has been resolved since I wrote this assessment. I believe we should have financial reform, but it needs to be fundamental reform. Here is what I proposed then -- and now.
"...The fed of the 21st century needs to change, but change for the better. We know the lessons of the past. We know what has worked and what has not. To avoid going through unnecessary and very unpleasant experiences again, the fed needs to do the following things.
First, it should set the money supply to increase at a low and stable rate permanently. The late Milton Friedman, the modern day father of monetarism, said that the Federal Reserve Board could be replaced by a computer. Some argue that the money supply is irrelevant in today's global economy. If that's true then there is no reason not to fix the increase of money. You don't need 12 men sitting around a table arguing about it. Just set it and leave it alone! A steady 2 to 3% increase in the monetary base would be just fine. This means that there will be a little inflation and a little deflation from time to time. They need to let both occur-- it's a natural result of sound money.
Next, don't set interest rates. Let the fed funds rate float just like any other interest rate. Why argue about what an interest rate should be when the market is telling you every minute of the day? And if they can't do that, peg it to the 1 month or 3 month T-bill rate. That is a market oriented short term rate. At least the funds rate will be market oriented and not set by arbitrary decree.
This means ending the dual, and impossible, mandate of Humphrey -Hawkins. It means ending the feds attempt to target growth which they can not do, and control inflation something they can do. This requires that the fed allow the economy to go into recessions from time to time if rates rise. There is nothing wrong with a recession anymore than there is something wrong with winter. It just happens -- and there is nothing government can do about it anyway. Recessions are like the change of seasons. No act of Congress will change them or stop them from occurring. The same is true with panics and crises. They come with the territory and that territory is freedom. Freedom requires both the freedom to succeed and the freedom to fail. This is how we learn. The recent assumption that the government should do something to prevent the economy from going into recession presupposes that they can.Not the government nor the fed has the power to achieve that goal. They can only make things worse by trying.
Finally, a 21st Century fed in these times, and given a fiat standard, must be a banker of last resort. The concept of a bankers banker was invented as a man made device to shore up market failures and severe economic disruptions. I see nothing wrong with this Idea in general. The fed buying assets, or lending against assets, or guaranteeing assets at desperation prices, is fine as long as they do not create or prevent victims.
The standard by which government decides to intervene must always be the same: to prevent structural damage to the monetary and/or economic system.The line drawn between government intervention, regulation, and the sanctity of free markets is that such intervention must be to prevent fraud through regulation, insure transparency, and/or facilitate markets that are unable to function. It needs to provide transparency on such things as leverage and risk so that the markets can provide individuals with the information to judge such risk and take actions to protect themselves.
The fed can assist in the orderly liquidation of large institutions in order to protect against economic contagion and structural damage. But this extraordinary intervention should always be a last resort. It should not be to prevent victims nor create or protect new victims. The question of moral hazard needs to be answered by example. Every central bank action to preserve the system must result in those responsible or involved in such action ending up where they would have been without fed intervention.
So, I'm not talking about a bail out. On the contrary. Companies, homeowners that can't make their mortgage payments, cities that have floated bad bonds, and financial institutions, creditors, and investors, all must be allowed to fail. The point is not to try and save a company or group of individuals. The point is to preserve the system and promote open and orderly markets. If successful the intervention of the central bank will have been neutral. There will be failures and victims specific to the institutions involved but without the spill over into the broad economy in general. This can prevent the onslaught of innocent victims who had nothing to do with the troubles of specific institutions. I see no sense in the fed ever taking action or not taking action to try and solve a problem that would ultimately hurt the economy at large. Not when a surgical solution is possible.
But, intervention should only be an option and never a mandate. Intervention during financial panics and crises is not always necessary and rarely the same. For example, the government let thousands of savings and loan banks go under in the 80's without structural damage occurring. Hundreds more failed in the 90's. These were controlled liquidations. The government guaranteed the savers deposits, as promised. But the bankers and the banks themselves were allowed to fail. Other examples are Long Term Capital which was one of the largest financial institutions around. Then Fed Chairman Greenspan brought the interested creditors together and persuaded them to refinance the risky loans rather than "run" the bank. LTC was saved and not a penny of tax payer money was spent. More, the investors ended up making money rather than loosing it. And there was no financial melt down.
The role of a modern day central bank should amount to a stop-gap insurance program. Nothing more -- nothing less. All the rest, of it's functions, money creation and the setting of interest rates should be abandoned in favor of a market oriented and automatic process. This is the best a fiat standard can be.
But, if you are going to have a fiat standard, it's going to come with more regulation than desired. That's the trade off. A fiat standard requires more transparency, more monitoring, and more regulation and more tax payer dollars to run and support it than a gold standard. Fiat standards can work, but they are more costly and more intrusive than the automatic market process of the gold standard. The best a fiat standard can do is impersonate a gold standard. Such has been the case with having to regulate the money supply and interest rates rather than allowing the market to do it.
Much has been written and said of the fed lately. Most of it is not flattering and belies the fact that if the gold standard was flawed as its critics argue, certainly it can be argued that the present day fiat system has proven to be flawed as well. It is more closely watched than ever before. It is also more criticized today than in decades. And because of it we have the best chance of changing the nature of the fed today than at any time since the eighties. In doing so we can end up with a more reliable, less disruptive, and more market oriented monetary policy than at any time in the last hundred years. Such a change would be most welcomed."
As we work our way through the issues of risk management and financial reform we need to remember: There are regulations that provide rules and standards, and regulations that attempt to tell us how to run our businesses, invest our money, and basically substitute government decisions for individual decisions. Some regulations aid society, others smother it. The key is to know the difference between the two. Let's establish reasonable rules of the road. But let's always look both ways before we cross the street -- stop sign or not.
Paul Nathan
March 16th 2010
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Paul Nathan has specialized in gold and gold stocks and has written extensively on monetary and economic matters since 1968. He also writes a weekly blog and can be contacted at paulnathan2000@aol.com
© 2010 Paul Nathan All Rights Reserved
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