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.

The Financial Times has a debate over recent Congressional attempts to loosen bank regulation.  Hal Scott supports looser regulation:

The Fed’s stress tests are effectively the binding constraint on bank capital and thus lending. They require banks to prove they could survive extreme adverse scenarios while still complying with global capital requirements. The process has two major deficiencies.

First, the Fed’s adverse scenarios are extreme to the point of incredulity. For example, the latest stress test assumes an increase of the unemployment rate from 4.1 to 10 per cent over seven quarters. That has not happened in the 70 years since today’s measure for unemployment was adopted. There is no open consultation with experts, industry or the general public as to whether these scenarios make sense.

Do we really want banks to hold enough capital to survive events that have no US historical precedent? If such an extreme economic event did occur, would any amount of capital be enough to withstand the panic it could trigger?

We absolutely do want to have banks be able to survive a recession that pushes unemployment up to 10%.  The unemployment rate hit 10% in 1982 and again in 2009 (albeit from a higher base than today.)  In the early 1930s, it rose from 3% to 25%.  After what happened in 2008, how can anyone seriously claim that we don’t want our banking system to be able to survive a recession that leads to 10% unemployment?  That makes no sense.

I don’t know enough about bank regulation to have an informed opinion on stress tests, but this argument actually makes me more likely to support the other side. I didn’t even have to read the arguments made by Lisa Donner, in opposition to loosening regulations.

Ideally we’d have a laissez faire banking regime.  But until we get rid of the GSEs, FDIC and TBTF, we probably need some sort of capital requirements and/or stress tests.  Since neither party favors removing moral hazard from banking, we are unfortunately stuck with regulation.

Off Topic:  The clown show continues:

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 suppose I ought to say something about recent stock market turmoil, even though I don’t have any great insights.  (I recommend John Cochrane’s recent post.)

I generally divide shocks up into two types.  There are negative demand shocks, like 1929 and 2008.  Then there are real shocks, when the market crashes without any big drop in NGDP growth expectations.  That might have been the case in 1987 and 2000, although I’m not certain.

As far as I can tell, the recent market decline seems more like a real shock.  I don’t see any sign of slower NGDP growth expectations.  The Hypermind market is almost unchanged, and there’s not much change in nominal bond yields or TIPS spreads.  If anything, bond yields have risen, which is not reflective of declining NGDP growth expectations.

So if it’s a real shock, then what caused it?  Keep in mind that thus far the decline has been modest, less than 10%.  And that follows a huge stock price run-up.  So don’t look for a huge real shock, merely something that means investors are still quite optimistic, just a bit less optimistic than a week ago.  It’s all about levels.

One possible culprit is an increasing sense that things are “unsustainable”.  Here are a couple areas where that perception may be building:

1.  Perhaps RGDP growth is unsustainable.  Unemployment has fallen to 4.1%, the working age population is growing very slowly, immigration reform seems unlikely, and nominal wage growth is accelerating.  The recent 2.9% wage growth number seemed to hit stocks.

2. Perhaps fiscal policy is unsustainable.  The GOP passed a big tax cut (which will end up costing much more than estimated.)  After you do that, you are supposed to tighten up on spending if you are the small government party.  Instead they basically took off all the restraints on spending.  The deficit is about to get much worse.  And when the next recession hits?  Don’t even think about it.

[Remember when Blair and Brown enacted a big fiscal stimulus at a time when the UK was booming in the early 2000s?  And then there was no money for fiscal stimulus when the Great Recession hit.  That’s basically the current GOP.]

I don’t have a lot of confidence that fear of unsustainable trends is what caused the recent market setback, but I can’t see any other plausible culprits.  Have I missed anything?