Friday, July 30, 2010

St. Louis Fed President James Bullard on Deflation

The President of the Federal Reserve Bank of St. Louis, James Bullard, has put out on the web a "preprint" of an article for the September-October issue of the FRBSTL Review entitled "Seven Faces of 'The Peril."   That Bullard, who has been known as an inflation hawk, now expresses concern about deflation seems to signal that the Fed is ready to do something if it materializes, though there does not appear to be any unanimity among Fed officials that this is likely to happen.

The article, though, is a bit perplexing.  Bullard points out the obvious; there is a zero-bound limiting what the Fed can do with interest rate targeting to combat deflation.  He also says that the Federal Open Market Committee, of which he is currently a voting member, may be making things worse by saying that the Fed is likely to keep interest rates very low for an extended period.  This may, he says, move the U.S. economy to an equilibium point of low nominal interest rates and deflation. He apparently thinks that the Fed's statement may cause the private sector to form expectations that this will happen which will be self-fulfilling.  I do not find this reasoning persuasive.  If Bullard wants to make this case, he needs to expand his discussion of this point.

Obviously, though, Bullard is right that the Fed can still expand the monetary base even if it is not targeting nominal rates.  This is called "quantitative easing," a term which serves to obscure the fact that the Fed uses its ability to create money and to extinguish it when it is targeting interest rates.  If the Fed wants to lower the fed funds rate or to increase the monetary base in a situation where the fed funds rate cannot go lower, it will expand its balance sheet, usually by buying securities.  (It can also make loans, but this has not been a major tool of monetary policy, though the discount window is used to help out commercial banks, and, in some cases, other financial institutions which face liquidity problems.)

Mr. Bullard does not go into the relative merits of  what maturity of Treasury securities the Fed should consider buying when trying to expand the monetary base.  For example, if the Fed were to buy more long-term Treasuries, this would have implications for Treasury debt management, since it would affect the maturity structure of outstanding marketable Treasury securities held by the public (not including the Federal Reserve Banks).  It is conceivable that the Treasury would consider issuing a greater proportion of its debt at the longer end in response to such a policy.  Mr. Bullard does not address this issue, nor does he discuss whether the Fed would be trying to flatten the yield curve through a quantitative easing policy.  (Whether or not the Fed, or the Fed and the Treasury acting in concert, can affect the shape of the yield curve is an unsettled issue.  The evidence from an attempt to do this, "Operation Twist" of the 1960s, is inconclusive because Treasury debt management worked at cross purposes to the Fed's open market operations.)

Bullard also does not discuss the decline in the M1 money multiplier, which compares the monetary base and the M1 measure of the money supply.  The St. Louis Fed has a chart of this decline and a table of the data on its website.  The multiplier is now a bit over 0.8, which means that the monetary base is larger than the M1 measure of money held by the public.  Prior to the last quarter of calendar year 2008, the multiplier had been in the 1.6 to 1.7 range for a number of years.  This decline in the multiplier has implications for the effectiveness of monetary policy that Bullard could have discussed.

Also, Bullard too easily dismisses fiscal expansion as a policy tool in the U.S. context.  He looks at the sovereign debt problems in Europe and concludes:  "The history of economic performance for nations actually teetering on the brink of insolvency is terrible.  This does not seem like a good tool to use to combat the possibility of a low nominal interest rate steady state."  He also goes on to state that Japan's "aggressive fiscal expansion" has not worked.  The U.S. is not on the brink of insolvency, and he should have discussed what he thinks are the reasons fiscal policy has not worked in Japan and how these are relevant to the U.S.

It is significant that a member of the FOMC is thinking about deflation and what the Fed can do about it should it occur.  If deflation does happen, I suspect that the Fed will do what it can through quantitative easing.  I also suspect that, if the deflation seems to be locked into place, the politics of deficit spending will radically change and there will be fiscal expansion, probably through some combination of increased spending and tax cuts.  The deficit hawks need to know that the only way their concerns about long-term fiscal issues can be addressed is by getting the economy to grow again.  A sustained deflationary period would be a disaster.

Wednesday, July 28, 2010

OFAC, Cuba, and the United Nations Federal Credit Union

In a development that did not get very much attention, the Treasury's Office of Foreign Assets Control ("OFAC") announced on July 15 that the United Nations Federal Credit Union ("UNFCU") had paid $500,000 to the U.S. government to settle charges that it had violated the Cuban Assets Control Regulations ("CACR").

OFAC's description of its allegations is quite cryptic: "OFAC alleged that UNFCU dealt in property in which Cuba or a Cuban national had an interest in violation of the CACR by engaging in certain unauthorized financial transactions on behalf of its members/accountholders who were blocked Cuban nationals pursuant to the CACR. The transactions involved financial services that were routinely provided by UNFCU to its members."

Clif Burns, a Washington, DC lawyer, criticizes OFAC in his ExportLaw blog for not providing more detail.  He says that the lack of details "makes OFAC look foolish by suggesting the possibility that OFAC is penalizing the UNFCU for providing banking services to Cuban diplomats posted to the U.N."  He claims that, if this were the case, it would violate the U.N. Headquarters Agreement.

Mr. Burns speculates that the allegations may refer to banking services the UNFCU may be providing to Cuban nationals at U.N. facilities outside the United States.  If that is what the OFAC allegations concern, though, Burns argues that "the UNFCU’s extra-territorial application of U.S. sanctions could create a new problem for itself because these sanctions could well violate local laws that prohibit discrimination based on national origin."

Because OFAC did not provide much in the way of explanation, what exactly going on here is a bit of a puzzle.  Even though the Obama administration is inclined to be more flexible about the Cuban sanction regime than the Bush Administration, OFAC seems to be doing what it thinks it must, enforce the existing sanctions until such time as they are changed.

Saturday, July 24, 2010

John Walsh to be Acting Comptroller

On Friday the Treasury issued a press release announcing that Secretary Geithner has chosen John Walsh,Chief of Staff and Public Affairs at the OCC, to be Acting Comptroller when John Dugan leaves the agency on August 14.  This was a surprise.  I had thought that Julie Williams, the OCC's First Senior Deputy Comptroller and Chief Counsel, would take on that role, as she did when Dugan's predecessor, John D. Hawke, Jr., left the OCC.

John Walsh was brought into the OCC by Dugan and has worked closely with him.  Dugan clearly thinks highly of him.  However, it is not clear why Geithner chose to bypass Williams.

Since it may take some time to get a new Comptroller in place and financial regulatory reform legislation has just been recently enacted, the role of acting Comptroller will entail more than a caretaker role.  Among other tasks, the OCC has to administer taking over much of the Office of Thrift Supervision, and it needs to define its role among other regulators under the changes made by the new law.  Geithner obviously has made the judgement that Walsh, who has an impressive résumé, has the necessary political skills as well  as substantive knowledge to lead the OCC during this transitional period.

Friday, July 23, 2010

Dodd-Frank, the OCC, and Federal Preemption

While the Dodd Frank Wall Street Reform and Consumer Protection Act expands the jurisdiction of the Office of the Comptroller of the Currency by abolishing the Office of Thrift Supervision and transferring many of its functions to the OCC, the Act also restricts the OCC's preemption power over state law.  A good summary of the changes in federal preemption for federally chartered institutions can be found at Arnold & Porter's website.  One of the contacts listed is Jerry Hawke, who was an Under Secretary of Treasury for Domestic Finance in the Clinton Administration and the Comptroller under the Clinton and George W. Bush Administrations.

One of the effects of the Act is to change the law with respect to operating subsidiaries of national banks.  In 2007, the Supreme Court held in Watters v. Wachovia Bank that the operating subsidiary of a national bank benefited from the same preemption applicable to its parent.  Consequently, the Michigan Office of Insurance and Financial Services could not subject Wachovia Mortgage Corporation to its regulatory requirements.  (The Court divided 5 to 3 on this issue.  Justice Ginsburg wrote the opinion of the Court, and Justice Stevens wrote the dissent.  Chief Justice Roberts and Justice Scalia joined Stevens' dissent.  Justice Thomas did not participate in the case.)

The Watters case was very important to the OCC in 2007, and there was relief and happiness when the decision came down.  It vindicated the OCC in its reading of the law and its policy position with regard to preemption.  It is now turns out that the Watters victory was short-lived.

Also, in the area of consumer protection requirements, the Dodd-Frank Act limits the OCC's ability to preempt state law.  In general, in order to preempt state consumer protection laws, the Comptroller needs to find on a case-by-case basis that state law is "inconsistent" with federal law.  Tougher state requirements are not deemed to be inconsistent with federal law. [This is incorrect.  See correction below.]

While federal courts have generally upheld the OCC's assertion of preemption, which has been controversial, the Congress has as a matter of policy now limited federal preemption for federally chartered institutions.  The advantages of a national charter over a state charter have consequently been reduced, which may affect the decisions of banks going forward on what type of charter to have.  The OCC will now have to adjust to this change.

Correction (6/30/11):  The discussion above concerning what the OCC must determine on a case-by-case in order to preempt state consumer financial laws with respect to national banks is incorrect.  What the Dodd-Frank Act does in this area is currently a matter of contention, with the Treasury Department publicly disagreeing with the OCC, which is nominally a bureau of the Treasury, on what the statute does.  The Arnold & Porter paper referenced in this post summarizes the provision relating to the OCC and preemption of state consumer financial laws as follows:

"With respect to national banks and federal savings banks 
themselves, the NBA and HOLA (and their respective 
implementing regulations) will be deemed to preempt 
a state consumer financial law only if: (i) the state law 
would have a discriminatory effect on a national bank 
or federal savings bank in comparison with the effect 
of the law on a bank chartered by that state; (ii) under 
the legal standard for preemption articulated in Barnett 
Bank v. Nelson, 517 U.S. 25 (1996), the application of the 
state law would “prevent or significantly interfere with” 
a national bank’s or federal savings bank’s exercise 
of a federally granted power; or (iii) the state law is 
preempted by another federal law."    

The current controversy concerns with whether the words "prevents or significantly interferes with" narrows the OCC's preemption authority and whether earlier preemption prior to the effective date of the Act need to be reviewed on a case-by-case basis.  The OCC Notice of Proposed Rulemaking, which prompted the Treasury comment letter can be found here.  The OCC does agree that preemption does not extend to the subsidiaries of national banks.

Thursday, July 22, 2010

Financial Regulatory Reform, the Elizabeth Warren Controversy, and the Importance of Political Leadership

Now that President Obama signed the Dodd-Frank regulatory reform bill yesterday, the focus will shift to the Executive branch.  The various agencies involved are likely not to be in total harmony.  As I have indicated in a previous post, there was a missed opportunity here to do more serious regulatory restructuring in order to help mitigate the problem of regulatory capture.

One agency, though, that may be more resistant to regulatory capture under the new structure is the new Bureau of Consumer Financial Protection.  One sign of the nervousness of financial institutions and their advocates about the Bureau is the controversy over whether Elizabeth Warren should be appointed as director.  A lot of liberals are pushing for her, because of her record of advocating for a stronger consumer protection role for the federal government with respect to financial products and services and her expertise in consumer finance issues.  (For a somewhat skeptical view on whether she should be appointed, see Neil Irwin's post on the Washington Post's website.  Ezra Klein, also of the Washington Post and a Warren supporter, comments on Irwin's post here.)  

Part of the reason for the controversy over Warren, I suspect, is fueled by the fear of financial institutions that this would be a person with strong views who would establish precedents on the agency's role and its relationships with the other regulators.  Because of the focus of the bureau on consumer protection, it could be more difficult for regulated entities to influence, and a strong head at the outset could make the agency more powerful than some might want.

Whoever becomes the head of the new bureau can expect that there will be strong pushback as the bureau begins the rulemaking process.  What is unknown is how hard the other financial regulators will try to clip the wings of the new agency.  Possibly exacerbating the turf considerations of agencies with different missions and constituencies, there are areas of overlapping jurisdiction.  For example, loose underwriting standards for loans is obviously a financial safety and soundness issue (which the financial regulators should have done more about during the buildup to the financial crisis).  Making loans, sometimes with confusing terms, to people who are not likely to be able to afford them is also a consumer protection issue.  

In regard to the tension between the various regulators, two other upcoming appointments are critical.  John Dugan, the Comptroller of the Currency, will be leaving that post next month as he finishes his 5-year term.  The Administration has not announced whom they intend to nominate as the new Comptroller.  When he leaves, Julie Williams, the First Senior Deputy Comptroller and Chief Counsel, who is known as a strong and effective advocate for her agency, will likely become acting Comptroller.  How the acting Comptroller and the new one, once that person is nominated and confirmed, work with the director of the new consumer bureau, and more generally with the other financial regulators, will be important.

Also, Sheila Bair's term as chair of the FDIC ends next summer and, according to Bloomberg News, she has indicated that she will not request to be reappointed for another term.  This is another key position whose occupant will be in a position to influence how the regulators will work together under the new legislation.

The new Financial Stability Oversight Council ("FSOC") will have the power to veto new rules of the Bureau if two-third of its members agree. The FSOC could work harmoniously together or could become similar to the President's Working Group on Financial Markets of the 1990's when the Treasury, the Fed, and the SEC thought that the CFTC was attempting to regulate or effectively ban products (OTC derivatives) that were not, in their view, subject to CFTC jurisdiction.  Other areas of tension among the agencies can emerge, but a likely candidate at the outset is disagreements over consumer protection rules.  It will be very important how the members of the FSOC manage their disagreements at its inception.  The leadership abilities and political skills of the heads of the FSOC agencies will be critical in this regard.

Monday, July 12, 2010

Krugman, Makin, Deflation, and Wall Street

Paul Krugman has started to cry the alarm about deflation in his column today and in his blog.  (Just to clarify, deflation is distinct from disinflation.  The latter is a slowing down of the rate of inflation, while deflation is the opposite of inflation -- the general price level declines.)  He was impressed by an article economist John Makin wrote for the American Enterprise Institute -- "The Rising Threat of Deflation."  As Krugman points out, AEI is a conservative ("right-wing") think tank.

Makin's article is indeed "scary";  he makes a good case that deflation is very possible.  One hopes that policymakers in the U.S. and in Europe take note of it.  At the end of the article, Makin writes:  "Growth has suffered and subsequently recovered given powerful monetary and fiscal stimulus.  And yet, the damaged financial sector, unable to supply credit; a jump in the precautionary demand for cash; and a persistent overhang of global production capacity have combined to leave deflation pressure intact.  The G20's newfound embrace of fiscal stringency only adds to the extant deflation pressure."

In contrast to this pessimism, The New York Times put on the front page yesterday an article entitled "Wall St. Hiring in Anticipation of a Recovery."  The fixed-income traders at these firms, though, are trading Treasury 2-year notes at a shade over a 0.6% yield, which hardly seems to be a market prediction that we are headed for good times in the near future.

Sunday, July 11, 2010

A Note on the Supreme Court's Decision on Business Method Patents -- Bilski v. Kappos

The  U.S. Supreme Court issued its decision in Bilski v. Kappos on June 28.  This case involved a "business method" patent application which the U.S. Patent and Trademark Office had denied.  The  application was "for a claimed invention that explains how commodities buyers and sellers in the energy market can protect, or hedge, against the risk of price changes."  All members of the Supreme Court agreed that the patent should be denied, but  otherwise the court was split.  To my eyes, the decision is a muddle and does not provide much guidance for future cases of this sort.

While this case does not appear to be one that would necessarily cause a split between the "liberal" and "conservative" members of the court, this is, in fact, what happened.  Justice Stevens, writing for himself and Justices Ginsburg, Breyer, and Sotomayor, concurred in the the judgment but argued that it should not be possible to patent business methods.  The majority opinion, written by Justice Kennedy, held that business methods can be patented, but that the application in question should be rejected because it presented an "abstract idea," which cannot be patented.  Complicating the decision is that Justice Scalia did not join in all of Kennedy's opinion, and joined most of a separate comment written by Justice Breyer.  Scalia, though, did not join  the Steven's opinion, but Breyer joined it in full.

This case reminded me of patent issues that I worked on while at Treasury.  During the Clinton Administration, Treasury Assistant Secretary for Financial Markets Lee Sachs was concerned about the increasing use of patents on financial products.  In conducting research on this issue, we learned from broker-dealers that there was a fear of being sued.  For example, there were entities that would take out patents on what would seem to be obvious ideas, and then sue firms for patent infringement.  The scheme was to to get a licensing fee from the firm for the patent.  Firms sometimes agreed to pay the licensing fee, since this would often be cheaper than going to court to argue either that there was no patent infringement or that the patent should never have been granted.  We also heard that some firms took out "defensive patents," i.e., not for getting licensing fees but as protection against suits for patent infringement.

Mr. Sachs was right that there was a problem in this area, but since there was no inclination to set up a senior-level meeting with the Patent Office to express concerns about inappropriately granted business method patents, Treasury did not have a big impact on policy in this area.  At one point, though, Treasury had the Justice Department file a brief in a court case involving a patent.  The brief argued against a requested preliminary injunction which would have reduced competition in the government securities market.

I am happy to see that the Patent Office seems to be giving business method patents more scrutiny and was willing to defend its position all the way to the Supreme Court.  The Supreme Court, though, appears to be really struggling in this area.  Congress should make the law clearer with respect to business method patents, but this is not the type of issue for which a lot of political points can be gained.  Unless a chairman of either the House or Senate judiciary committees takes an interest, nothing is likely to happen in Congress on this issue for some time, and the courts will somehow have to develop the case law.

Tuesday, July 6, 2010

Gary Gensler. Clearinghouses, and Interconnections

I recently ran across a Wall Street Journal op-ed article by CFTC Chairman Gary Gensler headlined "Clearinghouses Are the Answer" (subscription required).  In the article, Mr. Gensler argues that OTC derivatives cause financial institutions to be dangerously interconnected.  As examples, he points to Long-Term Capital Management, which he dealt with as a Treasury Under Secretary in the Clinton Administration, and to the more recent problems at AIG.

While it is no doubt true that both LTCM and AIG highlighted the risk of a domino effect if a firm is allowed to fail abruptly, Gensler's assertion that clearinghouses would address this, without making any effort to outline why, is surprising.  Derivatives clearinghouses entail the mutualization of risk; if a large clearing member cannot make good on its financial obligations, then this impacts the other members. This is interconnectedness.

While no futures clearinghouse has ever failed in the United States, it is of course possible.  If a large, systemically important clearinghouse were on the brink of failure, the federal government would no doubt find a way to prevent the failure from happening.

There are pros and cons to mandating that most derivatives be submitted to a clearinghouse.  A clearinghouse that is well-run and has effective margin requirements arguably makes the financial system safer and makes regulators' job of spotting problems easier.  But if something goes wrong and the clearinghouse has to draw on the resources of its members to cover others in a large way, there is the potential for a disastrous situation.

In other words, clearinghouses concentrate risk.  While their rules may make it impossible for firms to take the large risks that some have in the past, clearinghouses, by their very nature, entail interconnectedness.

It is puzzling why Gensler wrote this article the way he did.  He could have made a perfectly reasonable case for clearinghouses without saying that they reduce interconnectedness.  The article probably had little effect on the legislation in any case, and Gensler has been able to obtain for the CFTC much of the authority he wanted.