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| News and events > In the news |
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| Donald Kettl Q&A | The impact of Obama's financial reforms |
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Financial Times | Monday, June 29
Barack Obama, US president, is pushing for reforms to the regulation of the financial system to address the ”disastrous consequences” of the ”epidemic of irresponsibility that took hold from Wall Street, to Washington to Main Street”. Among the government's proposals, the Federal Reserve would have a greater supervisory authority over any institution that may pose a threat to the financial system and, if necessary, assume control of them if they fail. Critics say such wide-ranging powers would put too much pressure on the Fed, and that over-regulation would stifle innovation. Dr. Donald Kettl, dean of the School of Public Policy, University of Maryland, will answer readers' questions on financial reforms, the likely impact on markets and the future role of central banks, on Monday, June 29. An overburdened Fed is still not likely to take its eye off its primary goal, but is adding another layer of regulatory control the answer? Donald Kettl: There's a twin puzzle here for the Fed, Mo. One is the right regulatory structure for government regulation. The Obama administration has proposed a new system designed to prevent financial institutions from shopping for the regulators with the lightest touch and to prevent any of them from slipping through the cracks. Those are both essential in devising a new regulatory scheme. The challenge, as you suggest, is making sure that the Fed has the capacity. But underlying this is a second puzzle. What is the role of central banks in the new structure? Especially the Fed, which for most of its history has celebrated political independence from the government of the day? In the rough-and-tumble response to the crisis, the Fed has worked more closely with the administration (Bush and Obama) than at any time in its history. That, of course, is a good thing. But will it need to reassert its political independence, to return to the Volcker-like tradition? That will prove a very tough road in what's likely to be a very bumpy environment for a very long time. If it remains in close collaboration with the administration, how will political accountability for its decisions work? There has long been some political convenience for elected officials in taking credit for times when easy money from the Fed promotes growth and sidestepping blame when tight money tries to rein in inflation. It will be harder for both the Fed and the administration to do this dance if, operationally, the two become more tightly joined. We'll see the first real test of this puzzle when it's time for the Fed to take its foot off the accelerator and begin to apply the brakes. Whenever that happens, it will be politically inconvenient. If it happens in the runup to the 2012 election, it could prove VERY inconvenient, and the Fed could find itself torn between new-style collaboration and old-style independence, with the coming war against new inflation hanging in the balance. The Fed has proven its chops as a tough regulator. So it's not so much the regulatory burden as how it exercises that burden, in the context of monetary policy and political responsiveness, that's likely to prove THE big issue for the next stage of the Fed's strategies. ..................................................................................................................... Where will all this change leave the Securites and Exchange Commission – if it is left as a toothless watchdog, can it be said that more unpredictable problems could emerge behind the dominance of the Fed? DK: The SEC is trying to reinvent itself on the fly. As the nature of securities has morphed, it's struggled to redefine its mission. Throughout the crisis, the Fed has become part of a new triumvirate, along with the White House and the Treasury, in shaping financial policy. That leaves the SEC to reshape its role. Obama is proposing a new multi-agency co-ordinating body, to oversee regulation. He is proposing to shift authority for regulating investment banks away from the SEC. The SEC will get big new responsibilities in reshaping money market mutual funds, which suffered enormous pressure during the crisis. It will tackle credit rating firms, whose bad guesses helped paved the way for the crisis. And it will play a leading role in devising the transparency strategies that will lie at the core of the next wave of regulation. So: there's plenty here for the SEC. It will be far from toothless. But it has been battered by the crisis and it will struggle mightily to regain its former lustre. ..................................................................................................................... Should central banks aim at controlling the levels of leverage allowed over the economic cycle for financial intermediaries such as hedge funds? DK: One of the biggest issues we face is trying to get a handle on what constitutes the money supply and how stimulus/contraction is working. The hedge funds proved very important in fuelling growth but very, very tough to understand, steer, and rein in. Central banks are going to have to work very hard to understand the role and behavior of these complex instruments – and how to co-ordinate their actions to ensure that the hedge funds aren't always one step ahead. Money is still likely to move faster than regulators. As the global economy begins to unfreeze, this will prove one of the biggest puzzles that central bankers will have to crack. ..................................................................................................................... Don't you think that regulation proves of limited use if excessively loose monetary conditions over a long period narrows spreads to such an extent where risk awareness is weakened? Isn't this cheap money to a large extent responsible for creating the conditions of this crisis? DK: Everyone likes cheap money. It always more fun to pump it out than to rein it in. But one of the biggest lessons learned in the late 1980s and early 1990s is that, cheap money can cause an enormous amount of mischief and that righting the ship can prove tremendously painful. In retrospect, it's clear that there was too much money in the system fuelling too many risky ventures. The problem wasn't the policy – no one intended for this to happen, and central bankers were trying to set a less rocky course. The problem, rather, was that the central bankers didn't have a good handle on the instruments through which the money was flowing. It was like operating the great Alaska pipeline. It can seem fine as long as the right amount of oil seems to be starting at the beginning and the right amount of energy seems to be coming out at the end. If it springs a catastrophic leak along the way, though, it can take a while to discover its source and patch it up – usually after a lot of damage has been done. The problem wasn't so much excessively loose money as much as the inability of central bankers to understand and manage the instruments through which the money was flowing. What seemed like lively economic energy masked a large and, ultimately, catastrophic breakdown of the system. ..................................................................................................................... The need for market supervision at an international level has been made by many, but does the degree of inter-governmental co-operation needed for it to happen mean it will never actually be possible? DK: With the financial crisis, we've discovered the soft underbelly of globalisation: we have big problems with huge implications that don't match the institutions we have to control them. We just don't have international regulatory systems that can effectively regulate financial institutions. In an era where financial markets never really close, big problems can ripple almost instantly through the world financial scene. There's lots of discussion about creating some kind of international regulatory body, but the national interests are so strong it's hard to imagine individual countries surrendering that much sovereignty. We've had a great deal of effective co-ordination among finance ministers and central banks, but that's collaboration born of inescapable crisis. The big question is going to be how we put the regulatory system back together to keep such a crisis from recurring. We don't have a good answer for that yet. In fact, we have a strong tug of war between some interests (including the French) for strong regulation and some interests (including in the US) for a return to market forces. The best we can hope for in the short term is a resort to transparency, to keep the harsh light of publicity on the activities of financial institutions and national governments alike. ..................................................................................................................... Could all this regulatory reform undermine New York's status as the world's main financial centre? DK: It's already happened, at least in the short run. And with the ”let's make sure this never happens again” imperative, it might well stick in the long run. Fed Chairman Ben Bernanke was skewered on Capitol Hill last week for the Fed's involvement in Bank of America's decisions. Leaving aside the debate over how much involvement actually occurred and whether it was good or bad, the central issue was the fact that the Fed clearly nudged BofA into the acquisition of Merrill Lynch and then in the big decisions that shaped the merger. Now we have the federal government owning 70 per cent of General Motors and a controlling stake in AIG. Add to that the fact that many national governments are politely but firmly pressing the point, ”We'd surely appreciate it if you New York financiers didn't take the world financial system down again.” There's a lot of grumbling out there about the concentration of financial decision making. The erosion of the dollar as the world's bedrock currency, coupled with the rise of Washington's power over New York and the concern to prevent a repeat of the crisis, will leave New York a far less powerful centre. It's not going away, but the go-go days of the late 1990s and early 2000s are gone forever. ..................................................................................................................... What more can regulators do to ensure every individual is more responsible for their own actions and make them more aware of investment risk? DK: In the end, of course, the collapse couldn't have happened unless a lot of people chose to make individual investment decisions that turned out to be very, very risky. Last fall, in the middle of the crisis, my wife and I (Americans) found ourselves on a tour bus in London being hosted by a guide (English) who had lost his savings in a big bank (in Iceland, then besieged by British regulators). This is part of the new meaning of globalisation – and of how individual decisions that seem perfectly reasonable (seek high returns through investments in foreign banks) can cascade into crisis. I know only two things for sure. One is this: the answer to the problem is transparency: making the nature of investments and their risks much more clear to everyone. The second is this: I have no idea what this really means. We have an increasingly complex global financial system, with enormous interdependence that makes it hard to identify and understand the risks involved in many investment decisions. Even if investors decide to deposit all their money in the corner bank, they can't really know where the money is going (Into a neighbor's mortgage? Can the neighbor afford to repay the loan?) It's awfully hard for individuals to know where their money is going. The more serious flaw came from major financial firms that did not understand the risks they were taking and, in some cases, did not fully understand the instruments in which they were investing. At the beginning of the crisis, many government officials concluded that the key to solving the problem was getting ”toxic assets” off the books. That is a very good plan – but no one has been able to figure out how to do it, because the toxic sludge is intermingled with solid assets. No one knows the proportions or how, easily and cheaply to separate them. As individual investors, we have to be a lot smarter about where we put our money. We have to do more homework about the risks we take in exchange for the rewards we're promised. But the really tough problems lie in regulating the risks incurred by those we trust with making our investments: how to make sure they don't take dangerous risks while making sure we don't wring entrepreneurialism out of capitalism. ..................................................................................................................... Will European regulators have to follow Obama's lead – if they do, when do you think they are most likely to act, and at the EU-level, are policymakers even capable of reaching a consensus and seeing it through? DK: No and no. Maybe that's a bit too cynical, but there's no consensus yet on how to get consensus. And there's no consensus on whether we HAVE to get consensus. We're already lost some momentum in the search for fundamental reform, and there are strong pressures for governments to release their hold of the economic engines. No one, including Obama, has a firm handle on what is likely to work best. Europeans are understandably reluctant to surrender too much power to American regulators, given the system's failure to prevent the crisis. There isn't an institution in which to work these issues out – no Bretton Woods-like body that can harmonise regulatory strategies. And there isn't a consensus on what strategy to pursue. We're likely to move through several phases. We're taking a deep breath, we hope, in exiting Phase I: crisis management. With luck, we've seen the worst. We're now entering Phase II: putting markets afloat again. We need to slowly pull away the government supports and get private markets moving again. Phase III is where your questions will become sharp, Stuart: creating a governance system that can devise strategies to prevent a recurrence of the crisis. Phase II, like Phase I, is likely to involve a lot of trial and error. Maybe even some painful mistakes. With a lot of leadership and skill and luck, we'll steer through Phase II relatively quickly. But we're embarking on a Phase III that will be nothing less than a redefinition of capitalism AND a redefinition of the role of government AND a recalibration of citizens' expectations of government. It's a tall order. But it's where we're heading in the coming decade. The stakes couldn't be larger or more important, and we're going to need to find fresh ways of global collaboration to build an effective strategy. ..................................................................................................................... Why don't regulators deal with the problem of certain financial institutions being ”too big to fail” by setting an upper limit on the size of their balance sheets? DK: Everyone recognises that this is a central problem. No one wants to choke off entrepreneurial energy, and no one really knows how big is ”too big.” There are some interesting proposals about an escalating tax on assets, to change the incentives for getting large. But there's a balancing concern that large institutions help fuel the global economy, and that breaking up the institutions might make it harder to provide that economy with the fuel it needs. There is a big strategic debate underway: Do we enforce greater transparency, regulate risky behavior, and allow financial institutions to grow as makes sense in the new economy? Or do we do all these things – and also limit their growth, as added insurance, but with the risk we might also be putting limits on the growth of the economy? One way or another, this is a nut we have to crack. The financial costs to governments of the financial crisis have been multiplied by enormous institutions that couldn't be allowed to go under without taking the world economy down with them. Governments have found their policy options sharply limited by the need to negotiate around the ”too big to fail” institutions. We clearly can't afford to allow private financial institutions to create big problems or to restrict government's options in solving them. The key is in figuring out how to prevent dangerous behavior without choking future economic growth. My sense is that this is a problem that government regulators have put on the back burner until things settle down a bit more. ..................................................................................................................... Are the central banks now going to regulate the ratings agencies, since it was them that allowed the incorporation of so-called ”NINJA” and other forms of sub-prime loans to be incorporated into the various financial instruments which were contributory factors in the current economic crisis, or is this just more ”box ticking” and another excuse for more governmental control over the financial sector? DK: This probably isn't a job that the central banks need to take on – or want to. But some one in government is going to need to take on far more comprehensive responsibility for the ratings agencies. It's one thing to call for more transparency. It is quite another to ensure that the transparency has teeth, and self-enforcement through the ratings system broke down in the financial crisis. The financial instruments evolved faster than the ratings agencies could keep up, and public agencies relied on the private ratings agencies more than, in the end, proved responsible. We might need to fundamentally rethink how the ratings system works. We are heading to a policy grounded in more transparency and to investment decisions better grounded in risk. That, of course, was precisely what the ratings agencies were supposed to provide, and the specter of highly rated securities collapsing in the meltdown demonstrated how far the ratings agencies were from what we need. Governments have avoided jumping into this issue too deeply, at least so far. It's a tangle of brambles from which it would be hard to escape, and there is lingering hope that the ratings agencies and financial institutions can put a new system together. But that's a very big hope, not grounded in a very strong reality. The puzzles keep circling back to more transparency, better identification and management of risk, more individual and corporate responsibility, and a return to private entrepreneurialism. But when the complexity of the financial system exceeds the ability of private raters or government regulators to understand what's happening, and when the costs of failure can be instantaneous and catastrophic, we're going to need something far better. We're sure to abolish some of the more aggressive ninja financial instruments. But we're not likely to create a world straightforward enough for most of us to understand as we invest our money. Rolling the clock back to simpler times just isn't an option. Government is going to need to be a better regulator but, perhaps even more important, it needs to be strategically smarter, in deciding just where to limit the aggressiveness of the forces that will drive the 21st century economy without undermining the flow of the capital needed for economic growth. That's the next big conversation we need to have with ourselves. ..................................................................................................................... Do you believe that these financial regulations are a large step toward socialism? DK: If by ”socialism” we mean government ownership of the means of production, we're just in a short-term stage. The US government, for example, wants to get out of owning companies like AIG and GM as soon as possible, though that's going to take more time and involve many, many more tough questions than we've thought through so far. (How will GM return to profitability? How can government exercise its fiduciary role to taxpayers to make that happen? And how can government balance the competing goal of preserving as many union jobs as possible.) More fundamentally, though, we've crossed the line into much deeper government regulation of business. Citizens expect government to protect them from risks. The number and scope of risks from which they expect protection has grown enormously, from finance to swine flu. Government has expanded its role dramatically and broadly over the last nine months. History shows that, once government's role increases, it never goes back to the previous status quo. Building the capacity to exercise that expanded role and redefining the market economy within the world of this stronger government will prove a huge challenge, once we get beyond crisis decision making. So: we aren't making a large step toward socialism. But we're creating a new brand of state-directed, citizen-protected capitalism, whose implications will be huge but are now only dimly visible in the haze of the financial meltdown. ..................................................................................................................... The phrase too big to fail now evokes the term bail out rather than break up. Should this remain the case? DK: We're going to run out of cash if we make it the former. We could, of course, just keep printing money to continue bailing out, but that raises the nasty specter of inflation. Public opinion polls are already pushing back on the enormous increase in government debt that the US government has accumulated. The ”too big to fail” debate is in part about politics: which institutions would pose unacceptable political consequences if they collapsed? It's in part about economics: whose failure would create too much collateral damage? But it's also in part about government's role in shaping the economy: is government smart enough to know how big is too big? The mega-financial institutions greased economic growth in the last couple of decades. What are the economic consequences if they no longer exist, or if they're broken up? Would the economic whole still be the sum of a larger number of smaller parts? If the answer is ”we're not sure” or ”perhaps not,” governments will be treading very carefully. The one thing they won't want is a handcuffed economic recovery from this devastating collapse. But neither will they want to pave the road for another similar crisis. We're feeling our way down a road that's dark and curved with lights that brighten our way for only a short distance. ..................................................................................................................... Do you think that Obama's financial reforms will help to preserve the political power and wealth within the US or will they destabilise the financial system as a result of over-regulation and bureaucracy? DK: That's one of his central political problems, Viktor. But in just a few short months, some of America's most powerful financial firms, like Lehman Brothers, have simply evaporated. Some of its most important companies, like Chrysler and GM, have turned into pale shadows of their former selves. And some of its most important political forces, like the unions, have found themselves clawing to save the jobs of their members. The balance of political power has fundamentally and permanently changed. Obama will emerge the winner if Americans conclude, at least by the 2012 election, that he saved the economy and protected them from threats. Republicans are helping him so far, because they simply haven't been able to define a potent source of opposition. Their biggest potential line of attack, and the biggest threat to Obama's strategy, is a sense that the effort to save the economy has created a government that's simply too big, too clumsy, too bureaucratic, too regulated. That debate is now underway not only in financial regulation but also in climate change and health reform. These are policies that Americans say they want, but the big debate will be how big a government these initiatives will create. It will take us a long time to determine whether government's intervention has been too much, whether it crippled the economy has it's tried to grow again after the collapse. The political verdict will come much more quickly, and Obama knows he has a small window through which to push his big initiatives for financial reform, climate change, and health policy. ..................................................................................................................... Does the increasing politicisation of central banks, on both sides of the Atlantic, leave us in danger of irrevocably undermining the once-importantprinciple of independent regulation of markets and the sector? DK: We've crossed an historically important line in the last few months. Central bankers, even when their heads (as in the UK) are part of the government, have always prided themselves on their independence. Elected officials tend to like easy money. Central bankers fear instability. So there's always been a battle on how to set the balance. That thudding noise you hear if you listen carefully is the sound of previous generations of central bankers rolling over in their graves: never before have central bankers co-ordinated their decisions so carefully with elected officials, and never before have central bankers thrown inflationary cautions to the winds to so aggressively fuel the economy. They carry in their core the lessons of the Great Depression: tight money in the middle of an economic collapse can plunge the economy into a tailspin. But two big problems now loom. First, how do the central bankers decide to switch gears and begin tightening the money supply, to forestall a surge in inflation? The one thing we can be sure of is that, whenever that happens, it will be politically inconvenient. Given the tight co-ordination of central bankers and their government in the current crisis, that decision is sure to lead to high tension. Second, where will central bankers reposition themselves on the critically important question of independence. Elected officials always like easier money than central bankers want to provide. Central bankers, on the other hand, need to maintain political support for their actions. Central bankers will never return to the role they had before September 2008, but they won't be able to operate effectively in managing inflation if they maintain the close political ties to the governments that they have now. Resetting their roles is going to require an incredibly difficult tightrope walk. They'll need to guard themselves against a third threat: a moral-hazard-within-the-government problem. Elected officials might push for a bit more independence by central bankers, offload the really tough questions to them, and shrug their shoulders when central bankers administer the inevitable tough medicine. The risk here is a disconnection between political responsibility for economic policy and the decisions that shape it. We could have a paradox of close but quiet co-ordination of policies, between elected officials and central bankers, and a disconnection of political responsibility, as elected officials point to independent central bankers. (This especially a risk in the US.) If we think that there have been tough decisions over the last nine months, the coming policy decisions have the potential to be game-changing, in terms both of economic policy making and in democratic governance. We're certain to wake up in a decade with a governance system far, far different than the one we had just a year ago.
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