L. Randall Wray, an economics professor at the University of Missouri – Kansas City, presented a paper at the 22nd Annual Hyman P. Minsky Conference on the State of the US and World Economies at the Levy Institute in New York titled "Report of a Research Project On Improving Governance of the Government Safety Net In Financial Crisis."
This article is a continuation of yesterday's article
and discusses Wray's proposals for reform.
Wray tread on ground that is shaky for all concerned when he raised the issue of so-called "shadow banking." The concept behind this cliche is that transactions that would be forbidden for supposedly highly regulated insured depository institutions can be done by non-banks that operated outside these regulations — in the shadows.
He pointed out that financial institutions are involved in complex, layered, interconnected relationships that can create the illusion that more liquidity is available than is actually the case. Some of these transactions involve the creation of securitized products that could be sold to remote customers willing to rely on brand names, ratings and sales pitches as they pursue so-called "safe" assets, many of which turned out not to be as safe. In some of the transactions, the same collateral would be pledged on more than one deal in a practice called "rehypothecation."
Where I would quibble with the analysis is over the emphasis on so-called "shadow" banking. The mainline bankers have been so effective at capturing and taming the regulators that the distinction between banks and non-banks blurs, perhaps to the point where all banking is shadow banking.
Wray took a closer look at the question of the quality of collateral. At last year's conference, a panelist predicted with approval that the Federal Reserve would reduce the standards for collateral it would accept at the discount window. The most telling observation by Wray was that banks have been taking their worst collateral to the window. I would add that at one point during the 2008 episode of the ongoing financial crisis, banks seemed to be originating bad assets for the express purpose of creating dodgy collateral for discount at the Fed.
Wray added his voice to the prediction last year that central banks would relax their policy in order to save the "too big to fail" banks. However, he urged, "Central banks should not provide unlimited official support to a financial system that has been growing too fast." He called for stronger regulation to limit the growth of private liquidity, to an extent that would require a "paradigm shift" in the banking model. (I would point out that whenever parties to this debate advocate a drastic change, no matter how persuasively, this is much more difficult than taking out one ball from an electric typewriter and replacing it with a different font, for those who remember electric typewriters.)
The presenter offered some suggestions as to what central banks should do under "a Minskian approach": 1) call the bluff of the too big to fail banks and allow them to fail, wiping out the shareholders; 2) open the discount window to dealers; 3) legislate against speculative finance; and 4) restore stable, real growth and profits by public spending.
My response would be that he proposed No. 1 a third of a century ago, with creditors wiped out along with shareholders. This is much more difficult now. It is the government that is bluffing, while the managers and other dependents are laughing.
As for No. 2, opening the discount window to another protected class, namely dealers, at first look, hardly seems like a way to reduce moral hazard and taxpayer exposure.
And for No. 3, legislating against speculative finance would require more specifics. Certainly banks should be prevented from speculating with insured funds, but the Volcker rule fails in that regard, because once one makes exceptions for market making and so-called "hedging," the game is over, and the dependents get to laugh again.
Finally, as for No. 4, acknowledging that the capital markets are unstable does not imply that governmental intervention can achieve lasting improvement in the economy. This is where conservatives must part company with Herman Minsky.
However, a valuable insight of Wray is the observation, in "a Minskian view of banking," that the attribution to banks of the role of liquidity provider is misplaced, that liquidity grows in booms and disappears in busts and that bank credit is the source of the instability that lies at the core of Minsky's theory that financial markets are unstable.
Wray argued that the appropriate response to the current economic stagnation, which I expect to lead eventually to stagflation, is a combination of structural reform of the financial system, as a condition of further liquidity support, and greater fiscal intervention by the government.
Wray sees the current challenge as to fulfill Minsky's vision of 1982: "To control and guide the evolution of finance." My vision, contemporaneous with that of Minsky, was to remove the subsidies propping up the banks and let them meet their fates as decreed by the market.
Wray's policy proposals have attraction for both conservatives and liberals, and this explains why a coalition is building in support of legislation taking shape under the leadership of Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La. Wray's ideas, not all of which are expected to make it into the bill, are to enhance the Basel III version of global capital standards by adding "more radical measures," including imposition of a leverage ratio at the holding company level, separation of the payment system from the banking industry, limiting the lender of last resort role of central banks, implementing tougher collateral rules and ending the policy of too big to fail.
To this list Wray adds five functions he sees as the key elements of a financial system that promotes capital development: 1) a safe and sound payment system; 2) short-term loans to households and firms and possibly to state and local governments; 3) a safe and sound housing finance system; 4) a range of financial services, including insurance, brokerage and retirement plans; and 5) long-term funding of positions in expensive capital assets.
Wray concluded with a caveat on all of this, one that sets the stage for a protracted policy debate between liberals and conservatives: There is no reason why these should be consolidated (fine), or that they all should be privately supplied (not so fine).
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