It is a particular pleasure to participate in a conference named in honor of my good friend, Hy Minsky, whose ideas are enjoying renewed appreciation, as they do in every financial crisis.
Let me start with a phrase from Winston Churchill: "the unteachability of mankind"--at least when it comes to financial hopes and fears.
Financial cycles have related political cycles. In the wake of every bust, with its crisis, its overoptimism turned to overpessimism, with its inevitable scandals, comes the political reaction.
First, the search for the guilty. In every cycle, this makes me think of a song from Gilbert and Sullivan's Mikado:
"As someday it may happen that a victim must be found, I've got a little list. . . ."
Since bubbles are always accompanied by fraud, in addition to mistakes, there is always someone to put on the list. As Walter Bagehot said, people are most credulous when they think they are making a lot of money, and this provides the opportunity for "ingenious mendacity."
Second, there is an overpowering desire by politicians to show that they can Do Something--increase regulation, create new regulatory bodies, reorganize existing ones. The urge to reorganize is natural, in companies as well as governments. "We tend to meet any new situation by reorganizing, and a wonderful method it can be for creating the illusion of progress," goes the quote spuriously attributed to an ancient Roman.
A reorganization may be a worthy idea. But as pointed out by Bernard Shull in 1993, at one of the earliest of these conferences (when Hy Minsky was still with us), these actions are usually accompanied by what proves to be unwarranted optimism about their future effectiveness.
A favorite case of Bernie's was the conclusion of the Comptroller of the Currency in 1914 about the expected results of newly-created Federal Reserve System: "financial or commercial crises seem to be mathematically impossible."
Needless to say, they weren't.
Indeed, it turned out that the Fed could aggravate and even create the problems.
My banking career started during the credit crunch of 1969, which was followed shortly after by the failure of the Penn Central railroad and panic in the commercial paper market. Half way from then to now, was the financial crisis of 1989-91, with the final collapse of the savings and loans, a terrific commercial real estate bust, and severe problems for the commercial banks, of which more than 1,400 failed in the decade ending in 1991.
Here's a familiar-sounding headline: "Banks Entering Era of Painful Change--More Bailouts, Bankruptcies, Layoffs Likely." The date? July 22, 1991.
Major regulatory reforms and reorganization marked the era, including three Acts of Congress: the Financial Institution Reform, Recovery and Enforcement Act of 1989; the FDIC Improvement Act of 1991; and the Housing Act of 1992. Such actions would insure, the then-Secretary of the Treasury said, "This will never happen again."
But it did happen again.
Today we hear high ranking officials once again saying, "We must make sure this never happens again."
Recently Secretary of the Treasury Geithner said the reform theme has to be, "Capital, capital, capital." This brought back a vivid memory of a speech by a mid-level savings and loan regulator in 1989. "Our program is the Three C's," he said, "Capital, capital, capital."
Professor Yellen said last night that several years ago she had high hopes for "new methods of managing credit risk," in which she was later greatly disappointed. This made me think of the banking crisis of 1825, which featured the first widespread defaults of Latin American countries on their debt. It is said that Disraeli argued in those days that the boom would not turn to bust "because the period was distinguished from previous ages by superior commercial knowledge."
Alas, there are few new ideas in finance.
Short-Term Funding and Leverage
Let us turn to my title, "Does Changing Boxes on the Regulatory Organization Chart Alter Minsky's Financial Fragility?"
No, it doesn't.
This is because Minsky's financial fragility reflects human nature. My favorite Minsky quote is that when everybody makes money for an extended period, "Short term financing of long positions becomes a normal way of life." How true. In other words, there is a complacent build up of leverage by the use of short-term debt.
Essential to understanding panics and crashes is the behavior of the very risk-averse short-term lenders who provide this debt. They do not intend to take any real risk. They have no upside potential. They just want to employ funds in a very safe way for a modest interest rate.
In a financial panic, such as in 2007-08, these risk-averse lenders suddenly realize they are, contrary to their intentions, seriously at risk. When formerly prominent names like Lehman Brothers fail, everyone naturally thinks: what other financial firms might collapse? How do I know who is really solvent and who is broke?
As a result, the short-term lenders all become conservative at once and withdraw. They seek the greatest safety of Treasury bills, even for no yield. There is a discontinuous drop in the ability of leveraged firms to roll over the short-term borrowing which had up to then seemed "a normal way of life." As described by David Ricardo two centuries ago:
"On extraordinary occasions, a general panic may seize the country, when every one becomes desirous of possessing himself of the precious metals [now: cash and Treasury bills]--against such panic banks have no security on any system."
From this recurring experience, we can see that liquidity is not a substance, but a metaphor.
Liquidity is the group belief in the reliability of prices and the solvency of counterparties. When Minsky's fragility turns that to disbelief, we call it the "panic."
In late 2007, I attended a conference on the panic which had begun in August. A senior economist there present intoned, "What we have learned from this crisis is the importance of liquidity risk."
"Yes," I replied, "that's what we learn from every crisis."
As Minsky taught, when markets are stable, everybody comes to think leverage is safe. But a highly levered financial system--one with assets of 10, 15, 20, let alone 25 or more, times equity--will always bust from time to time. Running at high leverage means you are vulnerable to, and thus will periodically have, crashes.
How low would leverage have to go to have a financial system with no busts? I don't know, but maybe leverage of no more than 4 or 5 times? That would be 20% to 25% capital ratios, as opposed to 6% or 7%.
Since that won't happen, Minsky's financial fragility thesis is safe, any movement in the regulatory boxes notwithstanding.
A Systemic Risk Regulator?
We need to address one particular regulatory reorganization proposal: to create a "systemic risk regulator."
About this we may ask two questions:
- Should there be one?
- Should it be the Fed?
As to the first question: No.
To correctly forecast and moreover control the financial future is a literally impossible task. This is because of the exceptionally complex and rapid recursiveness of financial markets and the resultant Uncertainty. That is "Uncertainty" with a capital "U," which means, remembering Frank Knight, that you not only do not know the odds of events, but you cannot know the odds. You can apply math to finance, but that doesn't make it science.
The transcendent genius, Isaac Newton, having lost a lot of his own money in the collapse of the South Sea Bubble, wrote in disgust, "I can calculate the motions of the heavenly bodies, but not the madness of people."
If the politicians set up a systemic risk regulator anyway, should it be the Fed?
Such an assignment would make the Fed too conflicted, when combined with its role as monetary manager. Besides, why would we reward with even more power that same Fed whose monetary policy played a key role in inflating the bubble?
As Senator Bunning said to Fed Chairman Bernanke at a Congressional hearing, "You are thinking of becoming the overseer of systemic risk, but in my view you are the systemic risk." There's a lot of truth in that.
Although I oppose a systemic risk regulator, I do favor creating a new box on the government's organization chart for a very senior systemic risk advisory function. This advisory body should have a heavyweight board, a small staff of top talent, and be free to speak its mind to Congress, the Administration and private financial actors. In other words, I favor a philosopher, but not a philosopher-king.
What should our philosopher look for? Well, first of all, this should be a Minskian philosopher, intent on understanding the build-up of leverage, hidden as well as stated, and of short-term funding of long positions being considered increasingly "normal," on an international basis. The deliberations, deeply informed by the financial travails of the past century at a minimum, should reflect the reality that losses often turn out to be vastly greater than anyone thought possible--yet also that since risk-taking is essential, the failure of individual firms is not only necessary, but in the systemic sense, desirable.
Our philosopher should apply Gould's Principle, which is to look for concentrated points of vulnerability to system failure. If you allow such points to develop, the argument is, sooner or later they will fail. Good examples of such concentrated points of possible failure, which failed in the current bust, are the government-mandated use of credit rating agencies, with their mistaken ratings of mortgage securities; and Fannie Mae and Freddie Mac, which made under government sponsorship a great contribution to making the housing and mortgage bubble worse.
Would a systemic risk advisor have caught such concentrated vulnerabilities? Perhaps. In any case, my idea of what it should try to do seems quite similar to Richard Bookstaber's proposed activities or "tasks" for market stability, which he just presented.
Although I think the systemic risk advisor is distinctly worth a try, it is in vain to think that it or anybody can or could foresee all future problems or prevent all future bubbles and busts. Everybody, no matter how intelligent and diligent, no matter how many economists and computers are employed, makes mistakes when it comes to predicting, let alone controlling, the future.
So Minskian mistakes will continue to be made by entrepreneurs, by bankers, by borrowers, by central bankers, and by governments, whatever is done with the regulatory organization charts.
This is because uncertainty is fundamental.
Knight wrote, "If the law of change is known, no [economic] profits can arise." Likewise: "If the law of change is known, no financial crises can arise."
But the law of change is never known.
So change reflecting uncertainty goes on, bringing both Minsky's fragility periodically, and Adam Smith's "progress of opulence" on the trend.
I will close with a witty observation by Professor George Kaufman: "Everybody knows Santayana's line that those who fail to study the past are condemned to repeat it. When it comes to financial history, those who do study it are condemned to recognize the patterns they see developing, and then repeat them anyway!"
Alex J. Pollock is a resident fellow at AEI.