Sentences to Ponder

This is from an argument by Kevin Drum about the size of banks:

It’s true that I think trying to break up big banks is politically unfeasible, but that’s not the main reason I’m lukewarm on the idea. The main reason is that I think it’s a second-best idea. By far the most fundamental issue in the 2008 meltdown was excessive leverage and inadequate capital. It wasn’t the only problem, but it was absolutely the core one. And I want to focus my energy on facing up to the biggest, most fundamental problem, not a side issue.

Now I agree that the size of banks is of no consequence. In fact, our regulatory structure is the only reason we have such a proliferation of local and regional banks. Our laws favor such institutions…and there is literally no reason (besides lobbying) that this should be so.

However, Drum runs into a lot of trouble by stating that “the most fundamental issue in the 2008 meltdown was excessive leverage and inadequate capital.” He may as well have gone to Waltham, MA and slapped Scott Sumner in the face. But, minus the violence, this assertion is literally at odds with what actually happened in 2008.

If, in fact, leverage and capital were a problem in 2008, then why did the crash not happen until 10 months after the start of the recession? Well, that’s because leverage and capital ratios weren’t the sole problem, it was falling NGDP.

Think about the events of 2008. An ongoing sub-prime mortgage crash, an auto and construction industry crash in a few large markets, and an energy price shock, and its ensuing collapse. All of these events wrought havoc on the balance sheets of both consumers and financial institutions — but the economic consequences remained contained within the markets and industries that were largely affected…that is, until monetary policy became too tight (as signaled by the energy price crash in 2008Q3) relative to the needs of the economy. From 2008Q3 until the end of 2008, forward-looking inflation expectations fell precipitously, as did NGDP (5%, and we haven’t recovered to previous trend!).

The crash happened during the latter period of falling NGDP, not the former period of financial turmoil.

What should financial regulation look like? How about removing branch banking laws? I think the focus on “transparency” is mostly misplaced — but having a strong resolution authority for all financial institutions (or all institutions?) would be a step in the right direction. Such an authority should be governed by hard rules about debt and equity structure (and as far removed from politics as possible).

But the most important part of “financial reform” isn’t much financial at all: redraft the charter so that the Federal Reserve is governed by a contract which states that the institution must set a nominal goal variable, and do everything in their power to hit that variable. Stabilize the growth path of NGDP, and financial panics have a funny way of working themselves out fairly quickly and painlessly.

— — — —

Update: The countervailing opinion, courtesy of Bond Girl. Her statements are persuasive if you happen to a) lean to the left, and b) buy into the popular narrative of how the recent recession happened…a narrative that is tenuous, at best.


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