For millennials, the 2008 financial crisis was the defining economic shock of their lifetime.  I believe I know how the Democrats think about his issue.  But what about the GOP?  For some bizarre reason, I have no idea what policy stance the GOP favors as a way of avoiding a repeat of 2008.  If a student asked me to describe the GOP position, I’d wouldn’t know what to say.  That’s not true of any other major public policy issue.  I may not always agree, but at least I know where the GOP stands on abortion, tax cuts, coal burning, etc.  I know they are split on trade.  But I know nothing of their views on banking reform.

The Dems seem to favor something like Dodd-Frank.  I don’t like that approach, as it’s overly complex and avoids most of the key problems (subprime loans, FDIC, the GSEs etc.)  But what about the GOP?  It would be nice if they favored a more sensible approach, which might include higher capital requirements for banks (or convertible debt), abolishing the GSEs, reforming or abolishing FDIC, more expansionary monetary policy during periods such as the Great Recession.  Another option is to adopt the Canadian (big bank) system, which doesn’t have crises every few decades.  But I never see any evidence for GOP support of any of those options.  They favored tighter money during the Great Recession.  (Oddly many Republicans are now calling for easier money, even as inflation is much higher than in 2009.)  I see no evidence that the GOP has any interest in abolishing the GSEs or reforming FDIC.  They seem to favor small banks, which are the biggest flaw in our financial system.  The FT says the GOP is opposed to higher capital requirements, an option that seems greatly preferable to Dodd-Frank.

So what does the GOP actually favor?  The 2008 financial crisis happened during a Republican administration.  What lessons has the GOP learned?

I’m not being sarcastic, I’d actually like to know the GOP position on banking crises.

PS.  The Mexico trade deal is good news, despite being a very slight net negative.  There is a tiny bit more protection for industries, as well as tighter IP rules.  I see those as small negatives.  There will be freer trade in digital goods. The stock market hates protectionism and is rallying on the (good) news that Trump only cares about symbolic “wins”, not content (something I’ve been arguing for quite some time.)  Let’s hope there is a similar agreement with Canada and China.

As far as the “downtrodden workers” in the Rust Belt—this agreement says the administration doesn’t care about you.  The steel and aluminum tariffs will hurt manufacturing by more than the rules of origin changes will help.

PPS.  Hopefully the Dems will take the House and refuse to ratify the agreement.  But I suspect they’ll cave.

In a recent post I suggested that higher capital requirements might be called for if policymakers were unwilling to bite the bullet and remove moral hazard from our financial system.

The FT has a new article discussing a Treasury proposal to end Too Big To Fail, by setting up a new type of bankruptcy for big banks.  I wish them well, but remain skeptical.  In my view, the only way we’ll ever be able to remove moral hazard is with monetary policy reform.  If we can get to a policy of NGDPLT, then policymakers will no longer have to worry about the consequences of the failure of a big bank.  Unfortunately, that’s likely to take many decades, as we first need to implement the policy, and then see how it does during a period of financial distress.  Only then would policymakers begin to feel comfortable rolling back TBTF.  (And even then, special interest groups will try to keep it in place.)

PS.  The NYT has a new post showing that historians view Trump as being the worst President in American history.  That’s also my view.  Some people judge presidential performance by how the country is doing.  That’s about like judging my blogging based on how monetary policy is doing.  A couple posts I’d recommend are Yuval Levin explaining why Trump is not actually the President, in the conventional sense of the term.  He’s not qualified to be President, so day-to-day decisions are made by others.  Thus the GOP “deep state” wisely vetoed his recent attempt at crony capitalism, which would have re-regulated the coal and nuclear industry as a backdoor way of bailing them out.  The outcome was good, but Trump’s specific input into the process was destructive.  Matt Yglesias also has a good post, explaining why Trump is much more corrupt that even lots of left-of-center reporters assume.

PPS.  I have a new post on budget and trade deficits, over at Econlog.

David Beckworth has an excellent interview with The President and VP of the Minneapolis Fed.  I did a post on the portion of the podcast that interviewed Neel Kashkari, over at Econlog.  Here I’ll address the part where David interviewed VP Ron Feldman, mostly on banking regulation.  I’ve always thought that eliminating moral hazard is the only way out of this mess.  Feldman says that’s politically impossible:

I think you just need to look at what happened with Fannie Mae and Freddie Mac. This was in a prior regime. People used to talk about what’s called subordinated debt, but it’s the same idea, that they would be forced to issue debt that would be very junior, so it would get converted, and there would be no problem.

Now, flash forward. You’re in a crisis, and what people are worried about is, am I going to lose my money? You’re in the middle of a crisis, and you’re telling me that the solution to making people feel comfortable, not freaking everybody out, is that you’re going to impose more losses on more people. It just seems implausible.

The only active creditor in the US where we have a record that we do impose losses on them is equity holders. We do treat equity holders differently from fixed income holders, depositors, or bond holders. I think CoCos and bail-in debt, it’s very elegant. If it worked, I think that would be great. But we have a record of it here.

I should just add, in Italy and other places, they’re using the same idea. Last year, they were confronted with this issue: what are they going to do about the bail-in debt of the Italian banks that are in trouble? They said, “We want a special exception. We’re going to need to protect those folks.”

I think that’s the history. We talked about, is the five-year delay credible? The thing that’s not credible is that in a crisis, a government is going to want to impose more losses on debt holders.

Just to be clear, I don’t think it would be a problem doing this in a technical sense.  Crisis or no crisis, there’s no reason why bonds can’t be converted to equity when a bank gets into trouble.  But I suspect he is right about the politics, at least in highly corrupt countries like Italy and the US.  (Perhaps it would work in the Nordic countries, or Canada.)

I find this to be profoundly depressing, and pushes me toward reluctantly supporting tighter bank regulation, especially higher capital requirements.  The Minneapolis Fed has developed a plan that calls for a 23.5% capital requirement for large banks:

We would require banks to fund themselves with equity that would be equal to 23.5 percent of their risk-weighted assets. Risk-weighted assets means there’s a bigger weight that’s put on something, an asset that’s risky, and a lower weight that’s put on something that’s safe, like a Treasury bill.

I actually think the main problem is reckless smaller banks.  That’s where our tax dollars go.  I’m much less worried about the bigger banks, where moral hazard is less of a problem.  Unfortunately, it seems like higher capital requirements are just as politically infeasible as reducing moral hazard through convertible bonds:

The capital ratio rose from 10.5% before the crisis to 12.7% after, but has since slipped back below 12%.  A 23.5% ratio sounds great, but only if applied to all banks, not just large banks.  Unfortunately there’s probably almost zero political support for doing some something like this.

As with healthcare reform, as with zoning reform, as with FAA privatization, as with a hundred other issues, there’s simply no interest in banking reform.  In either party.

I’ve always thought that the 2008 financial crisis was basically tight money plus moral hazard, with the latter factor playing the biggest role.  I’m no expert on banking, but I’d guess that these three factors increased moral hazard (in order of importance):

1.  FDIC (deposit insurance)

2.  The GSEs (Fannie and Freddie)

3.  Too Big to Fail

I’ve already spent a lot of time discussing the role of tight money, but I also believe that deposit insurance is a massively underrated problem.

A new NBER working paper by Charles W. Calomiris and Matthew S. Jaremski relied on rich set of panel data for banks in states with and without deposit insurance. They found that states that created deposit insurance during the early 1900s tended to see faster than normal rates of deposit growth, and then higher than average levels of bank failures after WWI:

First, we are able to show that deposit insurance increased insured banks’ deposits and loans, and lowered their cash to asset ratios and capital to asset ratios. Second, we find that deposits flowed from relatively stable banks to risky banks. Deposit insurance increased risk by removing the market discipline in the deposit market that had been constraining erstwhile uninsured banks.  .  .  .  Deposit insurance encouraged banks to increase their insolvency risk because doing so did not prevent them from competing aggressively for the deposits of uninsured banks operating nearby. In fact, increasing risk was necessary to fund the higher interest payments that presumably attracted depositors.

The extent to which insured banks attracted deposits away from uninsured banks, and used those funds to expand their lending, depended on the risk opportunities available in their local economic environment. Variation across in counties in the extent to which they produced commodities that appreciated during the World War I agricultural price boom explains between one-third and two-thirds of the observed effects of deposit insurance on deposit growth, loan growth and increased risk taking by insured banks. The fact that a large part of the moral hazard associated with deposit insurance is dependent on the time-varying and location-specific opportunities for risk taking has important implications for empirical analysis of the consequences of deposit insurance in other contexts. The potential costs of deposit insurance may appear low in environments that are relatively lacking in risk-taking opportunities, but those costs can appear much higher when greater risk taking opportunities present themselves.  (Emphasis added)

That’s final sentence is a warning not to become complacent.  Just because deposit insurance didn’t cause many problems in the decades after WWII (when borrowers were bailed out by higher than expected inflation), doesn’t mean that it could not do so in the 1980s or 2000s.

They also show that voluntary insurance systems were less destabilizing than mandatory insurance systems, presumably because they created less moral hazard.

Their paper ends with a warning:

The history of deposit insurance in the United States and internationally has been a process of increasing systemic risk in the name of reducing systemic risk. 

I.e. the regulatory structure that gave us the mid-2007 to mid-2008 banking crisis (the late 2008 crisis was also on the Fed.)

That’s what I infer from this letter sent to the Fed from an important GOP Congressman.

I have been a big critic of Dodd-Frank and wouldn’t mind seeing it repealed.  But only if other simpler and more effective regulatory changes are made.  Those might include higher bank capital requirements, getting rid of Fannie and Freddie, and/or reforming FDIC.  But as far as I can tell, the GOP is opposed to all of these actions.  Indeed the letter warns that higher capital requirements will slow economic growth.

So it looks to me like the GOP favors the regulatory system that led to the 1980s banking crisis and the 2007 banking crisis.  Am I wrong?  (I hope so.)

PS.  The letter is hard to quote from, as it’s a photo that’s difficult to copy.  But the gist of Congressman Patrick McHenry’s letter is, “Give banks liberty, or give me death.”

HT Lars Christensen

Update:  You heard it here first.  Trump will replace Mike Pence with Noam Chomsky in 2020—a better fit for his views:

When Fox News’s Bill O’Reilly challenged Mr Trump in the interview, saying “Putin’s a killer,” the president replied: “There are a lot of killers. We have a lot of killers . . . What, you think our country is so innocent?”  .  .  . ” I do respect him [Putin].”

How many times have top GOP figures had to totally disavow the embarrassing statements made by Trump over the past 12 months?