A Note on the Latest Debt Limit Legislation

Many of the news articles and commentary on the legislative deal that President Trump made with House Minority Leader Nancy Pelosi and Senate Minority Leader Chuck Schumer implies that the new deadline for increasing the debt limit is in December of this year. What the legislation that was enacted actually does, though, is suspend the debt limit until December 9, when the new debt limit will be set at the amount of public debt subject to limit on that date. The Treasury is precluded from borrowing to increase its cash holdings above “normal operating balances” in anticipation of this deadline.

Note though that Treasury has been able to meet its obligations even though the debt limit has been frozen since March 15, the end of the last suspension period. It has been able to free up borrowing room while staying in compliance with the debt limit by the use of “extraordinary measures.” The Treasury described these measures on March 16.

These measures will now be reversed and will be able to be reactivated on December 10 if the Congress has not increased the debt limit. There are a couple of things worth noting about this.

First, this is a relatively new way for Congress to deal with the debt limit. Prior to using the suspension measure, Congress would increase the debt limit by an amount which it estimated would give Treasury the desired time before it needed to come back to Congress for another increase. The suspension method makes it unnecessary to do any estimation of borrowing needs.

Second, the date for which the debt limit needs to be increased to avoid default does not coincide with the date for which the continuing resolution provides funds for government spending. The date for which the legal authority for the government to spend money ends is December 8. If Congress does nothing, there will be a government shutdown in December, but the Treasury will be able to avoid default for some time after that. (An article in Business Insider speculates that Treasury might be able to manage without an increase in the debt limit until next summer.)

This second point has been missed by much of the political commentary on the deal. Contrary to much of the political commentary, the debt limit may not be a political tool for the Democrats at the end of this year, but it may provide them leverage at some point next year.

Of course, the reason the debt limit provides the Democrats with political leverage is that the Republicans do not have the votes, even in the House where there is no filibuster, to pass an increase in or suspension of the debt limit on their own. They need Democratic votes, because there are Freedom Caucus members who will not vote for a debt limit measure without it containing politically unacceptable provisions. In other words, the political tactics of the Freedom Caucus give Congressional Democrats more legislative power than they otherwise would have.

Book Review: “Adults in the Room: My Battle with Europe’s Deep Establishment” by Yanis Varoufakis

I recently read the UK version of former Greek finance minister Yanis Varoufakis’s new book: Adults in the Room: My Battle with Europe’s Deep Establishment. The U.S. version will be available for purchase on October 3. It has a different subtitle, apparently to attract American readers: “My Battle with the European and American Deep Establishment.” I assume it is the same book with perhaps some punctuation, spelling, and some words changed to reflect American usage. Also, I should mention that the U.S. title is somewhat misleading since, while U.S. officials play a role in the book, most of it concerns negotiations with European and IMF officials and disagreements among Greek officials. 

Yanis Varoufakis writes that many of his counterparts agreed that the austerity measures imposed on Greece were counterproductive, but were not willing to say that publicly. The reason is that too much austerity slows growth, and therefore the ability to pay down the country’s external debt. Moreover, in support of his negotiating stance, Varoufakis says he was not willing to play the hypocritical game of his predecessors and Greece’s creditors, which at this point, were the European Union, the European Central Bank, and the IMF.  He calls it “extend and pretend.” The loans the so-called troika (the above-named creditors) made to Greece were essentially used to service the debt and refund maturing debt. The money was not Greece’s to spend on development. But the debt burden did not go down; actually it increased as a percentage of Greek’s GNP, as growth rates became negative. Because of this, Varoufakis argues, Greece was essentially always having to take orders from the troika, because there was no way out of the debt. 

Another problem is that Greece could not devalue its currency because it had joined the Eurozone, and consequently did not have a helpful central bank. In fact, as Varoufakis says, Greece’s adopting the euro was a mistake, but he contends that it does not follow that Greece should exit the euro and establish its own currency. The pain would be too great. However, Varoufakis was prepared to do that if he could not get debt relief of some sort from the troika. It was not his preferred outcome. 

Varoufakis is surprisingly somewhat sympathetic to his chief antagonist, Wolfgang Schäuble, the formidable German finance minister. At one point, in a private meeting, he asked Schäuble whether he would sign the agreement the Eurogroup, which is composed of the finance ministers of the Eurozone countries, was pressing him to sign if he were in Varoufakis’s position. Schäuble said no, because it would hurt the Greek people, but he had no real solution for the impasse the two were in. Schäuble’s preferred solution was for Greece to leave the Eurozone and for Germany and likely other European countries providing substantial financial resources to ease the transition. Varoufakis was willing to discuss this, but Schäuble could not, because he did not have the authority to propose this from German Chancellor Angela Merkel.

Ultimately, Varoufakis was not able to pursue his negotiating strategy to the end, which included setting up a parallel payment system using the Greek tax authority and threatening to haircut the bonds governed by Greek law held by the ECB, which would cause the ECB legal problems with some of its other activities. The Greek prime minister, Alexis Tsipras, decided on holding a referendum on whether to accept the terms of the troika for a new loan. In Varoufakis’ telling, Tsipras and others in his cabinet were hoping for an affirmative vote in order to have an excuse to accept the terms. The Greek voters, though, provided a convincing no in the referendum. The Greek government then decided to ignore the voters and proceeded to accept the troika’s terms. Varoufakis resigned as finance minister.

There is a lot of interesting detail in the book. One that particularly stands out to an American reader concerns a telephone call between Varoufakis and Jeffrey Sachs, an American economist who, among others, was providing advice to Varoufakis. In the call, Varoufakis told Sachs that he thought “Alexis means it this time. The next payment to the IMF will not be made [if the troika did not “release some liquidity].”  A half hour after the phone call ended, Sachs called Varoufakis back, “laughing uncontrollably. ‘You will not believe this, Yanis…Five minutes after we hung up, I received a call from the [US] National Security Council. They asked me if I thought you meant what you said! I told them that you did mean it and that, if they want to avert a default to the IMF, they’d better knock some sense into the Europeans.’” As Varoufakis comments, it is amazing that U.S. officials were this brazen in admitting that they were tapping Varoufakis’s phone.

Varoufakis’s book is more candid, some would say indiscreet, than most books by senior government officials. He does not hold back in this criticisms of many of his counterparts in European governments and in the Greek government. He does have some nice things to say about Emmanuel Macron, then French economic minister and now the President of France. However, Macron, while sympathetic to what Varoufakis was trying to do, could not convince then French President François Hollande to be more helpful.

Future writers about this period, especially the government and international officials involved in the Greek debt negotiations, will have to address Varoufakis’s narrative and analysis. When they do, we may have a more complete understanding of what happened. In the meantime, those interested in Greece, international monetary affairs, or the future of the European project should read this engrossing and well-written book.

Book Review: Faster, Higher, Farther: The Volkswagen Scandal by Jack Ewing

Jack Ewing’s book on the Volkswagen diesel scandal, Faster, Higher, Farther, is of more than passing interest to me, since, until recently, I was the owner of a 2010 VW Jetta SportWagen TDI, one of the cars with the “defeat device,” which enabled cheating on emissions tests. In fact, I ordered the book the day after I finalized selling back my car to VW under the settlement agreement approved by U.S. District Judge Charles Breyer (the brother of Supreme Court Justice Stephen Breyer).

Mr. Ewing, a Frankfurt-based business reporter for the New York Times whose beat included reporting on the VW scandal, details the lengths VW went in perpetrating a fraud on regulators and consumers, which also affected public health and contributed to greenhouse gases present in the atmosphere. VW had aggressively marketed its passenger diesel cars starting in 2009 as “clean diesel,” but these cars had polluted the air with various forms of nitrogen oxides. Researchers at the University of West Virginia discovered that VW diesel cars polluted way in excess of legal limits on nitrogen oxides when tested on the road rather than in the lab. The VW researchers were not initially hired to prove fraudulent behavior by VW. The hope was that their work would demonstrate the efficacy of diesel emission technology. They were surprised by what they found and reported it to both the California Air Resources Board (“CARB”) and the EPA.

Nitrous oxide (N₂O) is a powerful and long-lasting greenhouse gas and nitrogen dioxide (NO₂) contributes to smog and can cause respiratory and other serious health problems. VW’s attempt at a cover-up after its diesel cars were found to vastly exceed the permitted level of nitrogen oxides emissions in road tests wasted regulators’ time and resources. VW piled lie upon lie. Even an implemented software fix was a lie. The software download of recalled cars (mine was one of them) actually served to improve the defeat device. When VW ran out of lies and came clean about what they had done, government officials threw the book at the company.

For those interested in the VW scandal or the car industry, there is much to learn from this book, including the origins and history of this peculiar car company and its culture. When it comes to diesel, and its pollutants, I learned that the nitrogen oxides emissions are not due to the chemical makeup of diesel (as carbon dioxide pollution is), but to the heat of the engine acting on the nitrogen and oxygen in the air. Since diesel engines run hotter than gasoline engines, nitrogen oxides are a bigger problem with diesel. No amount of refining will eliminate this; emission control systems have to either trap the nitrogen oxides or break up the molecules.

Also, I learned the reason I got better mileage on the highway with my car than the advertised EPA number. The car was rated at 42 miles per gallon on the highway, but in actuality, I got closer to 50. I was not alone in experiencing the excellent highway mileage. Of course, the highway mileage was nice, but one of the reasons for it isn’t. My car had a “lean NOx trap” which periodically needed to be flushed with diesel fuel. Because of the defeat device, less fuel was used for this purpose than was optimal for the trap to work properly, and consequently mileage improved.

The other technology used to reduce emissions of nitrogen oxides is a selective catalytic reduction system (SCR) which uses a urea fluid to break down nitrogen oxides into nitrogen, water, and a minor amount of carbon dioxide. Recent VW Jetta TDI’s were equipped with an SCR, but, according to Ewing, VW decided to use less fluid than necessary because they did not want owners to have to fill the urea tank between oil changes and they did not want to put in a larger urea tank. These cars are easier to fix than the ones with the trap and some have an approved fix. It is worth noting in this connection that the non-VW car the researchers from the University of West Virginia tested, a BMW diesel, had both a trap and an SCR, and there were no significant discrepancies in emissions between testing on rollers and on the road. Presumably VW could not afford to do that, given that it customers are not willing to pay BMW prices for a VW car.

While this is all very informative, it is fair to warn what this book will not tell you is who the responsible parties were for the decisions leading to this massive fraud. Ewing obviously does not give any credence to VW’s initial story that this was just the work of a few engineers. Management had to have known. However, we still do not have the definitive story about who initially suggested using a defeat device, who made the decision to install these devices worldwide, and how a flat-out fraudulent market campaign about clean diesel came about.

The author does, though, paint a devastating picture of the company’s culture, which ultimately led to its mishandling of this fraud once government official learned that there was an emissions problem with these cars. They provided excuse upon excuse, and initially officials at the EPA and CARB gave the company the benefit of the doubt. Describing the scene at an industry conference at Asilomar, a California resort near Monterrey, when Stuart Johnson, a VW official, finally admitted to a CARB official, Alberto Ayala, about the use of a defeat device, Ewing writes: “Ayala was furious, and he let Johnson know it. He allowed he might have used a few obscenities. For well over a year, CARB had been giving Volkswagen the benefit of the doubt, expending countless hours to solve what the company insisted was a technical problem. Now Ayala realized that Volkswagen had knowingly squandered California taxpayer dollars. The company had drained resources that CARB should have been using to help other automakers get their new cars certified. Volkswagen had prolonged the amount of time that polluting vehicles were on California highways.” The author notes that Johnson made this confession to Ayala and to an EPA official present at the conference “apparently…despite orders from above not to.”

VW’s cheating and subsequent handling of the diesel crisis makes it difficult to trust the company. For example in the epilogue, Ewing points out that VW may have been cheating in 2016 on the carbon dioxide emissions of certain Audi models. Apparently the automatic transmission of these vehicles worked differently in test conditions than on the road in such a way as to reduce the emission of carbon dioxide. Whether this was deliberate is unclear, but regulators in the U.S. and Europe are unlikely to give VW the benefit of the doubt.  

While this book is an important contribution to our understanding of a major fraud, the story of which is still ongoing, I will mention a few quibbles.

Ewing explains that diesel engines get better mileage than gasoline ones because they are more efficient. That is not the whole story. Diesel weighs about 7.5 pounds per gallon, while gasoline weighs about 6.3 pounds per gallon. In other words it takes more crude oil to make a gallon of diesel than a gallon of gasoline. If one calculated miles per pound, diesel would likely in most, if not all, cases still have an advantage, but it would be less. (I wrote about what I call volume illusion here.)

Also, the author provides quite a bit of detail concerning the relationship of VW and Porsche, including takeover attempts. This is a complicated story, and the author does not clearly explain why he thinks this story’s details are relevant to the diesel scandal.

It would have been more useful to focus in greater detail on European government officials’ mistake of encouraging diesel cars, including taxing diesel less than gasoline. Their focus was on carbon dioxide and not on nitrous oxides. The prevalence of diesel cars in Europe has caused serious pollution problems in London and Paris. This was an enormous public policy mistake.

Also, I would have been interested to know more about Michael Horn, the CEO of the Volkswagen Group of America when the diesel scandal broke. Many observers though he was candid about the problems, which included testifying at Congressional hearing, and U.S. dealers acted to save his job when VW’s German headquarters apparently wanted to remove him. The dealers thought he was the man to lead them through this crisis. One of his actions in the aftermath was designed to help dealers while at the same time making a small amend to owners of VW diesel cars. VW offered U.S. owners of diesel cars a $500 gift card that could be used anywhere and another $500 gift card that could only be used at a VW dealer. The second gift card likely drove more parts and service business to dealers that may have otherwise gone to independent shops. However, on March 9, 2016, Horn abruptly resigned and left the United States and has disappeared from public view. He may have feared legal action against him in the U.S., and also he may have lost favor with his bosses in Germany, who reportedly were not thrilled with the gift card offer and may have had other reasons to see Horn gone. The story of what happened has not been told, and Ewing may not have been able to find out much about this.

As a final note, followers of current developments in Washington, DC will be interested to know that both Robert Mueller and Sally Yates have significant roles in this story. Judge Breyer appointed Robert Mueller, the former director of the FBI and the current special counsel investigating the Trump Administration, as a special settlement master. In effect, he was a mediator between VW and the lawyers representing diesel car owners while they were in talks that eventually resulted in the settlement. Mueller was at the time a partner at WilmerHale, a major law firm.

Sally Yates, who was fired by President Trump after she announced that the Justice Department would not defend the Administration’s travel ban as long as she was acting Attorney General, was Deputy Attorney General in 2015 when she wrote a memo, according to Ewing, “instructing the [Justice] department’s lawyers not to agree to settlements with corporations accused of wrongdoing unless they also included punishment for the people responsible. The memo, which attracted wide attention, made it clear that the government should not be content with nabbing a few middle managers. Investigators should target ‘high-level executives, who may be insulated from the day-to-day activity in which the misconduct occurs.” This memo was presumably a response to the 2008 financial crisis, in the aftermath of which, Ewing points out that “shareholders often wound up bearing the financial burden of fines, while managers walked away richer.” Currently, there are individuals who held responsible positions at VW while the diesel cheating was taking place who cannot leave Germany, even to another European country, because of fear of being extradited to the U.S. One VW executive, Oliver Schmidt made the mistake of traveling to the U.S. He was arrested by FBI agents on January 7, 2017, and according to the author, a federal judge in Detroit refused his request for bail, and his case is scheduled to go to trial in January 2018.

Comments on The Spider Network by David Enrich

I recently read David Enrich’s new book, The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History. This book focuses on Tom Hayes, a derivatives trader who was sentenced in Britain to prison for 14 years for his role in manipulating Libor (the London Interbank Offered Rate) in August 2015. The sentence was later reduced to 11 years.

The author highlights that Hayes was treated much more harshly than other people involved in Libor manipulation. Many of them are still working in the financial industry. Hayes’ prison sentence seems to be due to a flawed legal strategy, his own misjudgments, and his inability to distinguish between friends and enemies, and the fact that many people did not like him because of his strange personality. Enrich writes:

“Hayes still didn’t grasp what had really happened. These friends who were not friends, these bosses who now claimed not to be bosses, together they had just engineered their greatest trade of all: Hayes for their own freedom. He was the genius, the university man, the millionaire, the star. And he was the fool. Most of them had their money; his would be seized. They had their liberty; he was in prison. Yes, there had been a spider network. Hayes still didn’t realize that in the end, he’d been the fly.”

While Enrich, who had extensive access to Hayes and his wife, the lawyer Sarah Tighe, is clearly sympathetic to Hayes, his account of Hayes' trading practices and conduct, and that of others, portrays an unsurprising but dark view of this industry. Enrich presents clear evidence that Hayes was manipulating Libor and the public quotes for other interest rates, whatever he thinks of the relative severity of his punishment. 

If one is interested in this world, the book offers a compelling read. Not only does it show bad behavior and over indulgence, it also depicts a world where the temptations to cheat are significant. Not all cheating will come to light, but from time to time it will, and, unfortunately, it will sometimes cause market problems that hurt the general economy.

However, if one is looking for analysis of the economic significance of the Libor manipulation, which went both ways—up and down—this is not the place to find it. Some people and entities, such as pension funds which made unwise investments at the urgings of the financial industry, were no doubt hurt at times, but it is not clear how significant this was. The traders who did not play this game as well as Hayes were obviously hurt as well.

The damage to the economy from what financial actors did in the housing mortgage market and related markets was obviously far more significant. While the exact causes of the financial crisis of 2008 are open to debate, it is clear that financial market participants were acting badly. With respect to derivatives, one particular type, credit default swaps, played a role. The Libor manipulation seems puny in comparison, but perhaps it was easier to build a legal case against a significant player for Libor manipulation than it was for the broader 2008 financial debacle for which blame was widespread.  

One issue regular readers of this blog will not be surprised that I would point out is a misconception about Gary Gensler in the Clinton Administration. Enrich points out that he was a key person in some of the deregulatory initiatives of the Clinton Administration. Nevertheless, those of us who were there at the time were not surprised that he would take a tough line as head of the CFTC. (I mentioned this here before Gensler was confirmed.) Also, I have no doubt that lobbyists for the derivatives industry who met with Gensler and seemed to have fairly accurate information concerning debates in the Clinton Administration about what the CFTC was trying to do were also not surprised. The Treasury’s position as determined by both Secretary Rubin and Secretary Summers was that the CFTC under Chair Brooksley Born was on track to undermine legal certainty concerning certain OTC derivatives and legislation was needed to address this. Gensler carried out Treasury’s policy. In the event, bank regulators failed in the job of supervising what the banks were doing in this market. (The Dodd-Frank legislation in the Obama Administration provided the CFTC, as well as the SEC, explicit authority for OTC derivatives.)

Also, with regard to Gensler, as a New York Times review of this book comments: “Mr. Enrich takes particular pleasure in pointing out the irony that Mr. Gensler falsely took credit for initiating the Libor investigation (it had been underway for a year before his installation at the agency) given his historic role in undermining the C.F.T.C.’s authority.” I have no personal knowledge about what was happening at the CFTC during this period and don’t know whether, or to what extent, Gensler exaggerated his role.

Finally, for those interested in reading more about Libor manipulation, another interesting account is Erin Arvedlund’s 2014 book, Open Secret: The Global Banking Conspiracy That Swindled Investors Out of Billions. While this book discusses Hayes, it is not focused on him. Reading Arvedlund’s book in addition to Enrich’s book will provide as much information about the Libor manipulation as most readers will probably want.  

Book Review: “The Man Who Knew: The Life and Times of Alan Greenspan” by Sebastian Mallaby

I read this excellent biography with a great deal of interest since I worked with (and debated) Federal Reserve officials on a variety of issues when I worked at the Treasury Department and Alan Greenspan was Chairman of the Federal Reserve Board. While long, the book is well written and exhaustively researched. It does deal with some contentious economic issues, but does so in an accessible way. It also discusses the political situation and Greenspan’s political maneuverings during key points in his career, and goes into some detail about his personal life. It is a well-rounded portrait of a very strange man who became one of the most powerful economic players in the world.

There are two issues I was particularly interested in because of my involvement with them during my Treasury career. The first is Greenspan’s public advocacy that Treasury issue five-year gold-backed notes in a September 1981 Wall Street Journal article, and, as I recall, in a submission before the Reagan Administration’s Gold Commission. I was early in my Treasury career working on Treasury debt management issues among other domestic finance policy issues, and I was tasked to write internal memos rebutting Greenspan’s arguments for gold-backed notes. I did not find Greenspan’s argument that the Treasury would save money convincing as an analytical matter, and, as a practical matter, I pointed to the disastrous French experience with gold-backed bonds under President Giscard d’Estaing. 

What I did not know and learned from this book is that one of the reasons that Greenspan proposed this was as a ruse to stop the Gold Commission from advocating a return to the gold standard. At Treasury, we did not think this was a real possibility because of the presence of Administration officials on the Commission who would follow Treasury’s lead on this, even if the new President was intrigued with the idea. Any decision to return to the gold standard would involve Treasury as well as the Fed. Treasury owns the U.S Government’s gold, not the Fed, and an issue this important would have to be an Administration initiative.

While Mallaby does not conclude how wedded Greenspan was to the idea of Treasury issuing gold-backed notes, I was and am under the impression that he thought it was a good idea. He would later propose a more realistic alternative, inflation-indexed notes and bonds, which Treasury resisted for years but finally decided to start issuing in 1997 during the Clinton Administration. (I was involved in these discussions over the years and was delegated to formulate and write the key terms and conditions of these securities once the decision was made to issue them.)

The other issue that I was particularly interested in was Mallaby’s description of the dispute over the regulation of over-the-counter (OTC) derivatives in the President’s Working Group on Financial Markets in 1998. Brooksley Born, the Chair of the Commodity Futures Trading Commission (CFTC) wanted to claw back some of the exemptions that the CFTC had made pursuant to legislation from CFTC regulation for many OTC derivatives (without making a determination whether the instruments in question were subject to the Commodity Exchange Act, the statute the CFTC administers and enforces). Because of the 2008 financial crisis in which credit default swaps played a role, Born has been lionized for advocating for regulation of OTC derivatives.

I have argued on this blog that what happened at the PWG meeting has been misrepresented by a PBS Frontline documentary and elsewhere. (See here, here, here, and here.) Mallaby’s account of what happened at the key PWG meeting generally agrees with what I have written. He talked to Pat Parkinson, who worked at the Federal Reserve Board at the time and was present at the PWG meeting, as was I. In an endnote, Mallaby quotes Parkinson remarking that Born “snatched defeat from the jaws of victory.” Here is what I wrote about this:

“…One of the reasons for her [Born’s] failure is that she stubbornly maintained that OTC derivatives were subject to the Commodity Exchange Act (“CEA”), an argument, which, for technical reasons, put into question the legality of certain outstanding derivatives, such as total return swaps based on equity securities. It also seemed by her insensitivity to this issue that she was motivated too much by turf considerations. That guaranteed that others, especially the bank regulators, would oppose the CFTC on this.

“Secretary Rubin was, in fact, concerned about OTC derivatives because he felt that they might be increasing systemic risk. (It should be kept in mind that the Treasury had little turf to be concerned about with regard to this issue, except that of the Office of the Comptroller of the Currency, which is fairly independent from the Departmental Offices and, consequently, is often left to fend for itself.) Because Rubin had sympathy with Born’s policy concerns, though not her legal arguments or apparent turf grabbing, he proposed that the President’s Working Group on Financial Markets ask a series of questions to the public about OTC derivatives, similar to the questions the CFTC had prepared for a concept release on the subject. Born refused, and despite pleas from the other members of the PWG, went ahead with the concept release in May 1998.

“Her intransigence on this subject drove Rubin into Chairman Greenspan’s corner, much to the relief of the major OTC derivatives dealers who were not unaware that the Secretary was not entirely comfortable with their business. There is a chance that, if Born had approached Rubin and SEC chairman Arthur Levitt with her policy concerns rather than with her legal arguments, she might have been able to get their support for some greater oversight of the derivatives industry. It is possible that some of the discussion would have focused on how to do it and who should do it, though Greenspan and others would have continued to argue that any government interference in the form of regulation of this market would be harmful. In any case, that would have been a healthier and more productive debate than the endless, and ultimately boring, legal debate over whether swaps are futures.”

I was happy to see that this major book provides an account of what happened at the PWG meeting on derivatives that is more accurate than that which is generally believed. Mallaby, though, does not mention that Rubin proposed that the CFTC’s proposed Concept Release be issued by the PWG as a way of reducing the legal uncertainty for certain OTC derivatives and that Born flatly refused to consider this. Her intransigence, which I ascribe to political incompetence, was key to her failure to achieve greater regulation of OTC derivatives.

Also, Mallaby does not discuss that regulating the OTC derivatives market could be accomplished in a different way than that proposed by the CFTC. Financial regulation can hinge on the regulation of certain types of instruments or on certain types of financial entities. While many OTC derivatives could be viewed as not subject to regulation as instruments at the time of the PWG meeting, many of the market makers and key market participants for these instruments were subject to regulation by the various bank regulators, the SEC, and, in some cases, the CFTC. The big players were the commercial and investment banks, and Treasury staff, including me, thought that the bank regulators and the SEC would do an adequate job in this area. We were mistaken, but that was not the only area where there was a failure of the regulators to use their existing authority to head off, or at least mitigate, the 2008 financial crisis. It is also not clear, though, what the relatively small CFTC would have been able to do if they clearly had the authority to regulate this market, which they did not.

There are other areas where Mallaby debunks the accepted story, such as in his discussion of Fed Governor Edward Gramlich, Greenspan, and what the Fed did or did not do with respect to subprime mortgages. Mallaby’s account is more favorable to Greenspan than what is commonly believed. It would be interesting if people with direct knowledge of this were to weigh in with their account of what happened and whether they support Mallaby’s account. (I have no reason to doubt Mallaby’s account, but this is a contentious issue.)

At the conclusion of the book, I think Mallaby is perhaps a bit too generous in his assessment of Greenspan. He writes: “Greenspan’s passivity as a political actor exacerbated his single error as an analyst—his underestimation of the potential costs from financial fragility.” However, one could argue that another failure was that monetary policy was too loose at the end of Greenspan’s tenure, leading to stock market and real estate bubbles, though not consumer price inflation, and that this was an error. To be fair, Mallaby does discuss these issues elsewhere. (In an amusing 2008 article, the satirical website The Onion wrote: “A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.” See “Recession-Plagued Nation Demands New Bubble To Invest In.”)

While one I could go through the book and mention other points of disagreement, mostly minor, and some not terribly significant errors and omissions, which the author may correct in subsequent editions, this book is a very impressive biography and highly readable. If you are interested in Alan Greenspan or generally interested in U.S. economic developments from the 1970s on, this book is well worth reading. Because Mallaby did an incredible amount of research, including numerous interviews with many people, even those who were directly involved in some aspects of the story can likely learn things they did not know. Mallaby set out a very ambitious goal when he started this project, and he succeeded.   

Tim Geithner’s Per Jacobsson Lecture

One of the events at the IMF annual meetings is a Per Jacobsson Lecture on issues involving finance, usually delivered by a prominent or current policymaker. The quality of these lectures varies; I have attended three, and one was particularly boring. (Information about the Per Jacobsson foundation can be found here, and a list of the lectures is here.)

This year former Treasury Secretary Tim Geithner gave the lecture. (Links: prepared text, slides, and video.) Previously, I had not been overly impressed with Geithner as a public speaker, but I was pleasantly surprised about how good this speech was, both substantively and as a performance.

The title was “Are We Safer? The Case for Updating Bagehot.” Geithner’s main point is that improved regulation has made a financial crisis less likely than before the crisis beginning in 2007, but that the emergency authorities for government officials in the U.S. to use if there is a crisis are more restricted than in the last crisis. If there is a major, financial crisis, officials would have to go to Congress to ask for more emergency authority.

One of the reasons for the restrictions on emergency authorities is to deal with the moral hazard problem. The thinking is that, if the government does not have the legal authority to bail out financial institutions, they will be more careful. Geithner recognizes that argument, but he argues that you have to rely on both regulation and a commitment to use the emergency authorities in the event of a systemic crisis. He argues that, just as you do not convene a meeting of the town council to decide whether to send fire trucks to a burning house, you should not have to go to the legislature to deal with a massive, fast moving financial crisis.

Geithner is correct, but he did not address some other issues.  For example, he did not address the too big to fail issue or whether resolution of a failing institution would work for a large, complex financial company with a global business. There is some question of how this would work with multiple regulators from different countries trying to protect their citizens and companies with business with the failing entity. Also, the insolvency regimes and commercial codes of different countries vary, which would pose challenges that might be difficult to resolve quickly.

As a last criticism, Geithner did not mention the problem of regulatory capture or regulatory structure. As readers of this blog know, I have been concerned about the issue of regulatory capture in the U.S., which is made worse by having too many regulators. This has caused each regulator to advocate for its regulatees. After all, the primary regulator’s significance and budget shrinks (with the exception of the Fed, which controls its own budget), if the business it regulates contracts. Also, the many contacts between the staff of a regulatory agency and the staff of the entities it regulates provides many opportunities for the regulated entities to convince regulatory staff of the correctness of their views. This does not imply that anything illegal or unethical is taking place; regulatory capture does not need that and regulatory capture is never total. Regulatory agencies and their staffs do try to do their assigned jobs, but partial capture did contribute to the last financial crisis. Regulatory agencies did have authorities that they did not use to curtail the recklessness that was taking place. They apparently did not see the magnitude of the risks that were piling up, and the regulated institutions, which to some extent may have been fooling themselves, probably played a role in convincing the regulators that everything was fine.

Nevertheless, Geithner’s speech is worth reading or viewing. I have not summarized everything he said. Clearly, he has given a lot of thought to the subject of financial crises, and what he has to say is worth paying attention to.

Unfortunately, while in his spoken lecture, he ends by saying “we can do better,” it is unlikely that any legislation will be enacted in the U.S. to deal with his legitimate concerns. This is not a top legislative priority, and legislation in this area is difficult to pass, given the diverse interest of various interest groups. It may take another crisis to make changes, and that is something none of us wants.

IMF Annual Meeting Seminars – Observations

Last week I attended seminars and other events sponsored by the IMF in conjunction with its annual meeting in Washington, DC. Here are some observations.

The IMF had fewer “open” events than in the past, and fewer big-name economists were present on panels, though they may have spoken at the conferences and events sponsored by banks and other private organizations that are put on in conjunction with the World Bank/IMF annual meetings. Nevertheless, it appears that the IMF organizers, probably including IMF managing director Christine Lagarde, had issues they wanted to highlight. Three main themes were preponderant: globalization, technology, and income inequality.

The IMF and its sister organizations, the World Bank and the World Trade Organization, are staunchly in favor of free trade. There is hand-wringing concerning that the case for free trade – that the benefits for countries outweigh the costs – is difficult to make on the public square in an economic environment of slow economic growth, growing economic inequality, visible job losses due to trade, and fear of change. While the great majority of economists across the political spectrum believe in free trade, the institutions implicitly recognized that this is not enough to convince the public. I do not remember hearing, though, any solutions except to be more forceful in presenting the economic arguments.

Regarding trade agreements, there was some, but not enough, discussion that some of the opposition to certain free trade agreements center on factors such as dispute resolution procedures, labor practices, and environmental concerns, rather than lowering of tariffs. Interestingly, one speaker (this may have been at a J.P. Morgan event) did say that the chances of U.S. ratification of the Transatlantic Trade and Investment Partnership (“TTIP”) are greater than ratification of the Trans-Pacific Partnership (“TTP”). The countries of the TTIP are more similar with respect to labor practices and environmental issues than the countries of the TPP, and U.S. workers are less fearful of job losses to many of the countries of the EU than they are to losses to Asian countries.

As to technology, the message was that the pace of change has been remarkable with profound effect on jobs. Technology facilitates globalization, making it easier to outsource jobs to other countries. It also eliminates existing jobs. This causes unease among certain sectors of developed nations’ populations about their economic prospects.

I am suspicious of arguments that technology make the goal of full employment unattainable. I remember that, when I was in grade school in the late 50s and early 60s, there was much concern about how automation would have these economic deleterious effects. It did not happen. I do recognize, though, that the changing nature of available work will create winners and losers, and that, if not handled right, can create political movements that are at core undemocratic.

I think the IMF is right to highlight this issue, though I was disappointed by many of the speakers on this subject. There was a tendency to make bold assertions, such as that more than half of the largest U.S. companies are going to disappear in the coming decade or that the U.S. educational system needs fixing. Absent was any analysis to convince one of the inevitable failure of companies or any analysis of what is wrong with U.S. education and how it should be fixed. That does not mean the speakers are wrong, but bold assertions without analysis is not that useful.

As for growing economic inequality, which to some extent may be exacerbated by technological change, and slow economic growth, this is indeed a problem that needs to be highlighted and is a major factor of populist movements in developed countries. Besides making some changes to tax codes and to government spending, I do not recall hearing any proposals on how to address this problem nor any analysis of why it is occurring. To be fair, though, it is a difficult issue to analyze and there does not appear to be any consensus about the cuases of economic inequality. The IMF’s highlighting of this issue is appropriate and it will hopefully spur more thinking and research on this topic by economists and others.

In short, while not conveying to attendees fear of a coming economic cataclysm, the overall message was decidedly not one of optimism. To be more positive, the IMF was warning that there are currently developments that could lead to creeping disasters if problems are not addressed. There is the hope that they will be.