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January 10, 2010
David Warsh, Proprietor


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Obama and FDR

ATLANTA – Now that health-care restructuring has begun, the big item on the legislative agenda in 2010 has to do with how to regulate and organize the banks. We’ve been through the most alarming economic crisis since the October Crash of 1929 ushered in the Great Depression. What assurance is there that the same damn thing won’t happen again, next time even worse? At the meetings of the Allied Social Science Associations here last week, there was the glimmer of an answer.

The similarities between Barack Obama’s first term in office and that of Franklin Roosevelt have often been noted: the atmosphere of dire emergency; the sense of new beginnings; the conviction that the most serious problems began with the banks. In 1933, Congress acted swiftly to separate the banking system from the securities business. Today, slower action is required for a very different world.

Three broad camps exist. Populists, AKA progressives, of whom the most engaging may be Simon Johnson, of the Massachusetts Institute of Technology, want to break the big banks into smaller units so that none is too big to fail, or at least separate them into lending utilities, their deposits insured by government, and high-flying capital market players who work without a safety net. There are meliorists,  practical-minded reformers representing a broad array of banking, financial and economic types (for whom, Paul Krugman, of The New York Times, is often an effective spokesman), who believe that American banks must be large in order to compete in global markets. They think that efficiency and safety can be achieved through a combination of higher capital ratios, greater transparency, and improved consumer protection. Then there those who reflexively expect that changes in the existing order will be futile, or produce unintended consequences, or sacrifice some other interest to an unacceptable extent.  The latter are conservatives.  All contribute to the debate.

Caught in the middle is President Obama, between the progressives of his own party, who rag him for “kid-glove treatment” of the bankers, and the Republicans, who are eager for him to fail no matter what. Thomas Mann, of the Brookings Institution, says that the president is “a very well-informed and open-minded policy wonk who will continue to disappoint those who have it all figured out.” David Rogers, veteran Congressional correspondent of Politico, the Washington free newspaper and website, describes Obama’s predicament this way: “[W]rapped in the bubble of the Oval Office, and surrounded by Ivy-educated budget and economic advisers, this detachment is magnified and hurts him with lawmakers and voters alike, looking for more of a connection amid tough times. For all he shares with FDR, ‘Mr. Fireside Chat’ Obama is not.”  He is, however, a thorough-going meliorist.

The ASSA meetings, which include the proceedings of the American Economic Association, the American Finance Association, and another fifty-odd smaller professional societies, were the second to occur since the crisis went critical in September 2008. Last year, in San Francisco, the effects of panic were all but invisible in the city’s buoyant downtown. This year in Atlanta, they were unmistakable. Peachtree Street, the city’s famous boulevard, looks as though a tank battle might have been fought there, with abandoned buildings, empty storefronts, churches, an army surplus store, a hospital and a homeless shelter connecting the office towers at its opposite ends.

A striking fact was the lack of administration participation among the dozens of sessions – a sign perhaps that its economists were too busy working to preach to the choir. Only Federal Reserve Board chair Ben Bernanke accepted an invitation to speak – he blamed lax regulation, not faulty monetary policy, for the subprime bubble. The biggest sessions – on deficits, development, growth, why economists failed to see the looming crisis – drew crowds, and an evening program of stand-up economic comedy filled the room. But the most interesting session this year was presaged last year, by the American Financial Association presidential address that Jeremy Stein, of Harvard University, delivered in San Francisco.

Stein began by noting the extensive changes that had taken place in capital markets in recent years. Professional asset managers were taking over. Direct individual ownership of equities had declined from nearly 48 percent of the stock market in 1980 to 21.5 percent by 2007. Hedge funds’ global assets had grown from $39 billion in 1990 to $1.93 trillion in the second quarter of 2008. Hedge funds, in particular, deployed their assets in highly leveraged fashion – meaning they routinely borrowed as much as they could to place their bets.

At least two complicated strategies had arisen. One was “crowding,” meaning that institutional investors relying on quantitative modeling – rocket science, in common parlance – had no way of knowing how many other rocket scientists were simultaneously entering into the same trade. The second was leverage, and the fire-sale scenario that can arise when one highly-leveraged player after another is forced to liquidate holdings on short notice. Such goings-on had been observed in the collapse of Long Term Capital Management in 1998, and in the “quant crisis” of August 2007; perhaps they were at the heart of the 2008 panic. It was possible, Stein concluded, that, in some cases, “capital regulation may be helpful” in dealing with the leverage problem.

This year in the ‘tweendecks of the meetings, a group of leading financial economists reported on their latest attempts to incorporate in policy-oriented models real-world features such as down payments, collateral and haircuts (meaning the amount arbitrarily subtracted from the face value of assets held as collateral, to reflect their perceived degree of riskiness). Ana Fostel, of George Washington University, reported on joint work with John Geanakoplos, of Yale University, that sheds light on managing the leverage cycle. Lasse Pedersen, of New York University, explained why capital-asset pricing models should be liquidity-adjusted, the better to understand what happens When Everyone Runs for the Exits, and, in joint work with Markus Brunnermeier, of Princeton University, how it may help to manage leverage. Tobias Adrian described some further work with Hyun Shin, of Princeton University. And Emmanuel Farhi, of Harvard University, presented joint work with Jean Tirole, of the Toulouse School of Economics, on how collective moral hazard can lead to systemic bailouts. (For a new look at the interaction of credit and monetary policy over the past century and a half, see this gloss on “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008,” a recent working paper by Alan Taylor, of the University of California at Davis, and Moritz Schularick, of the Free University of Berlin.)

Some of the new work will find its way into this year’s legislation. Most of it is years away from the simultaneous closing and opening of doors that signify completion. Only experience, however, will resolve the fundamental question of safety. For all that has been learned recently – or perhaps precisely because of it – it is a good idea to proceed with caution. The cool, deliberate Obama is as temperamentally well-suited to these fast-paced times as was the warm, impulsive FDR to a somewhat slower age.

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