‘Summer’ Rerun: Buiter Provokes Wrath at Jackson Hole, Says Fed Too Close to Wall Street

This post first appeared on August 24, 2008

Go Willem Buiter! The London School of Economics prof and former Bank of England and European Bank for Reconstruction and Development official has been saying for some time that the Fed suffers from “cognitive regulatory capture” and has been far too responsive to the needs of Wall Street. It’s been puzzling to watch his detailed, well argued criticisms go unnoticed, particularly when they have been offered at forums where one would think they’d be impossible to ignore (for instance, a conference co-hosted by the New York Fed where Buiter presented a pretty harsh paper on what he called the North Atlantic Financial Crisis).

Well, he finally seems to have gotten through, perhaps because he is forward enough to criticize Fed officials to their face at an event they are hosting. Or maybe it’s because the pattern of conduct he decries is so patently obvious that the key actors can no longer fool themselves. From Bloomberg:

Former Bank of England policy maker Willem Buiter sparked the biggest debate at the Federal Reserve’s annual mountainside symposium, saying the central bank pays too much heed to the concerns of financial institutions.

“The Fed listens to Wall Street and believes what it hears,” Buiter said yesterday in a paper presented to the Fed’s conference in Jackson Hole, Wyoming. “This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.”

The Wall Street Journal’s Economics blog provides a similar account and a link to the paper.

Mr. Buiter slams the Federal Reserve, European Central Bank and Bank of England for what he says was a mishandling of the financial crisis and monetary policy over the past year. He gives the worst marks to the Fed, saying it’s too close to Wall Street and financial markets — responding to their needs to the detriment of the wider economy. Mr. Buiter, a former member of the BOE’s Monetary Policy Committee, said the Fed overreacted to the economic slowdown — misjudging the importance of financial stability to the overall economy — and created a deeper inflation problem as a result.

The paper is quite long, but it is very well written and moves very quickly for this sort of exercise (it does get geeky from time to time). I will confess to having read only the first 30 pages, but his argument seems spot on:

My thesis is that both monetary theory and the practice of central banking have failed to keep up with key developments in the financial systems of advanced market economies, and that as a result of this, many central banks were to varying degrees ill-prepared for the financial crisis that erupted on August 9, 2007.

The Fed gets disproportionate attention, in part due to the venue of the presentation, in part because Buiter contends that the Fed did the worst job of the major central banks. Note that Buiter is more of inflation hawk than we are, but as a result, Buiter thinks that letting housing prices decline is not the end of the world and implicitly, adjustments need to run their course (per his point 4). Even though we think this deleveraging will be nastier than Buiter anticipates, we think that trying to hold asset prices at inflated levels will inevitably fail and the effort will only create more damage. To Buiter again:

[T]hree factors contribute to Fed’s underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.

The second is a sextet of technical and analytical errors: (1) misapplication of the ‘Precautionary Principle’; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on ‘core’ inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom
that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.

All three central banks have been too eager to blame repeated and persistent upwards inflation surprises on ‘external factors beyond their control’, specifically food, fuel and other commodity prices. The third cause of the Fed’s macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.

Of his three charges, Buiter is on solid ground on the first and third. The second set (his points 1-6) are debatable, but you can make a case for them, and he does.

Some of his comments are blunt:

In the case of the Fed, the nature of the arrangements for pricing illiquid collateral offered by primary dealers invites abuse….

All three central banks have gone well beyond the provision of emergency liquidity to solvent but temporarily illiquid banks. All three have allowed themselves to be used as quasifiscal agents of the state, providing subsidies to banks and other highly leveraged institutions, and assisting in their recapitalisation, while keeping the resulting contingent exposure off the budget and balance sheet of the fiscal authorities. Such subservience to the fiscal authorities undermines the independence of the central banks even in the area of monetary policy.

There is a lot of good stuff. For instance, Buiter discusses the “asymmetric” response of regulators to asset bubbles (they let the bubble run but jump in to try to arrest the collapse) and discusses remedies.

Unfortunately, a lot of participants seemed more interested in defending the Fed than in sifting through Buiter’s analysis to see what might be valid and useful:

Fed Governor Frederic Mishkin said Buiter’s paper fired “a lot of unguided missiles,” and former Vice Chairman Alan Blinder “respectfully disagreed” with his analysis of the central bank’s crisis management…..

Mishkin lashed out against Buiter’s assertion that the Fed’s rate reductions may cause higher consumer prices.

“I wish he had actually read some of the literature on optimal monetary policy, because it might have been very helpful in this context,” said Mishkin, who collaborated with Bernanke on inflation research in the 1990s.

Mishkin, a leading advocate of the Fed’s effort to sustain economic growth through rapid rate reductions, said research shows that “what you need to do is act more aggressively.”

In reply, Buiter said the value of such a strategy “is not at all obvious to me.”

[Bank of Isreal’s Stanley] Fischer, drawing laughter from the audience, held up a red fire extinguisher saying, “I asked the organizers for some technical assistance in dealing with this discussion.”

While defending the Fed, Blinder said Buiter’s papers “often feature an alluring mix of brilliant insight and outrageous statements.” The central bank’s performance, though not flawless, has been “pretty good” given the magnitude of the crisis, he said.

European Central Bank President Jean-Claude Trichet also came to the Fed’s defense, saying “what has been done until now has been pretty well done under very difficult circumstances.”

Although the Wall Street Journal coverage of the response is less detailed, it says that Blinder, who was tasked with critiquing the paper, told a long-form version of the Dutch boy putting his finger in the dam, and said that Buiter would rather have the dam leak out of obedience to his belief in moral hazard, and let the dam burst.

I may be reading too much into this, but it strikes me that Blinder went out of his way to be insulting (anyone who regularly participates in critiques of academic papers please read the WSJ post and comment).

Part of the problem is stylistic. Even though Buiter is Dutch by descent and dislikes the idea of national identity, his writing style often echos the cut and thrust of Parliamentary debates, a posture that is also well received in English academe and drawing rooms but not well received in the US. So his bluntness is over-the-top by US standards.

From this vantage point, it’s obvious that the Fed has become far too dependent on current Wall Street incumbents and thus can be manipulated by them (and in fairness, the people who are doing the persuading may be completely sincere in their views). There were ways to compensate: cultivate contacts with former executives who no longer have close ties, find independent analysts who have useful data and perspectives. No doubt Fed officials have extensive contacts, but it appears they have not been used in a deliberate, orchestrated fashion to test and validate information provided by those currently employed by major financial firms.

The second issue is that even if the Fed is too close to the financial services industry, it still may have made the right policy decisions. The jury is still out. Many people (probably including the Fed officials) hope the crisis has passed, while readers of this blog know there is good reason to think the worst has not arrived in earnest.

Buiter has taken a bold position, The Fed needs to be able to explain why what is good for Wall Street is also good for the economy as a whole. The sort of questions that Buiter is raising are notably absent from the media and US-based first rank economists. The Bloomberg story may not give a full enough account to be certain, but the responses to Buiter’s charges do not seem persuasive. They amount to disputes over analytical methods and assertions that everything is working fine (after providing a $400 billion fix with no withdrawal plan and getting support from foreign investors equivalent to $1000 a person. So what’s your next act?).

It will take some time to see if events prove Buiter right. And as Cassandras like Nouriel Roubini know, it can sometimes take longer than you anticipate for bad policies to finally yield the expected dismal harvest.

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12 comments

  1. F. Beard

    Even though we think this deleveraging will be nastier than Buiter anticipates, we think that trying to hold asset prices at inflated levels will inevitably fail and the effort will only create more damage. Yves Smith

    If the victims of the counterfeiting cartel, both borrowers and savers, were equally bailed out* then the deleveraging would be painless. Even the banks would be fixed in nominal terms. State tax revenues would be fixed. And if the banks were put out of the counterfeiting business, the cause of our problems, with a 100% reserve requirement, then an inflationary spiral would be precluded too.

    So assets prices could be held up with a bailout of the population without a serious inflation risk.

    And a after the one-time bailout of the population, then fundamental reform in money creation should be implemented including separate government and private money supplies.

    Its time to move on from banker fascism to genuine capitalism if we wish to prosper.

    *with new debt and interest free United States Notes.

  2. M Nimmo

    In Hong Kong in the aftermath of the Asian Crisis in 1997/8 and the bursting of the domestic property bubble that preceded the handover in June 1997, property prices fell by over 60%. No bank went bust in the territory despite the property collapse: some foreign branches may have been bailed out by their parent but no domestic bank went under. Individuals and some companies were not so fortunate, of course, but the economy survived a huge shock, at least as big as the US bubble. Why? The banks, led by the HKMA (and HSBC, the dominant and conservative lender) imposed increasingly tighter restrictions on loan to value ratios as prices went higher.

    It is possible for competent central banks to prepare their charges to withstand a huge crash, so I propose that the Basel III Tier1 capital ratios should have one extra component added: a reserve to be added to Tier1 to reflect the competence or otherwise of their governing regulatory authorities. On a scale of 0 to 5%, I would suggest that HK and Canadian based banks add 0% to their Tioer1 ratios while at the other end of the spectrum US; UK and Irish banks should add 5%. Spanish banks should add 2.5% as their central bank wisely avoided toxic subprime securities but failed to notice their domestic property bubble. France allowed its main banks to operate with too little capital so I would add 2% there. Germany has for many years failed to address the issue of its Landesbanks and should have a penalty of 3%.

    I leave it up to other readers to fill in the blanks in the map, and to comment on the idea.

  3. F. Beard

    I leave it up to other readers to fill in the blanks in the map, and to comment on the idea. M Nimmo

    An interesting question: Can fractional reserve banking (theft by private counterfeiting) be done “prudently”?

    In the short run, the answer is yes. In the long run, I would bet the answer is no unless God is mocked and He isn’t.

  4. readerOfTeaLeaves

    Fed Governor Frederic Mishkin said Buiter’s paper fired “a lot of unguided missiles,” and former Vice Chairman Alan Blinder “respectfully disagreed” with his analysis of the central bank’s crisis management…..
    Mishkin lashed out against Buiter’s assertion that the Fed’s rate reductions may cause higher consumer prices.

    “I wish he had actually read some of the literature on optimal monetary policy, because it might have been very helpful in this context,” said Mishkin, who collaborated with Bernanke on inflation research in the 1990s.

    Mishkin, a leading advocate of the Fed’s effort to sustain economic growth through rapid rate reductions, said research shows that “what you need to do is act more aggressively.”

    Same Mishkin who was interviewed for “Inside Job”, I presume. Same Mishkin who couldn’t believe that Charles Ferguson had the journalistic chops to inquire as to why he had not divulged his payment for writing about the glowing opportunities for dereg and investment in (IIRC, it was Iceland)?

    I don’t mean to slam an individual (Mishkin), but as a proxy for the dynamic that Buiter points to, I don’t see how anyone could offer up a better example.

    And the timing of the original post is almost spooky: just prior to the Soviet Georgia kerfuffle, a few weeks before Obama was nominated for Democratic presidential candidate, and about 5 weeks before Hank Paulson handed the Democratic Congress a 3-page edict to respond to the financial meltdown, specifying that no questions could later be raised about Paulson’s approach to addressing ‘the crisis’.

      1. The Derivative Projrct

        Inside Job also tried to interview Harvard Economist, Martin Feldstein, who refused on camera. Here is a link to Prof Feldstein’s speech at the 2007 Jackson Hole Conf. Here he qoutes Schiller’s projection for a 50 % drop in housing, while at the same time AIG said their losses on their credit defaul swap contracts were contained. Didn’t Prof Feldstein have an obligation to work with AIG management to go into “workout mode” on these CDS contacts in 2007, when it was clear in his 2007 Jackson speech these contacts would bankrupt AIG?

        Looks like Paulson, Geithner and Feldstein waited to the bitter end to cry wolf and hand the debts to the taxpayer.

        http://www.nber.org/feldstein/KCFed2007.revised.90307.pdf

  5. ddf

    Neither Bernanke nor Buiter. What is scary about recent US economic data is that it shows Bernanke may have succeeded in the short run in fighting a debt-driven crisis with more debt. US bank lending is perking up and US banks are once again mailing credit cards, which may explain why production, employment and demand indicators are looking up. This means 2011 US growth could be higher than in a deleveraging scenario (and incidentally outside of the US private sector deleveraging has not really started). At the same time, the Japanese and Taiwanese experiences suggest demand growth in a highly leveraged economy is unlikely to be strong enough to generate much inflation. But in the longer run, a further increases in leverage leaves the economy even more exposed to shocks (look at the depth of the recent Japanese recession) and is not sustainable. It only adds to the deleveraging that needs to take place before the economy can move back to the pre-crisis growth path. And debt dynamics in the US are likely to be much less benign than in Japan or Taiwan because the private sector savings rate is much lower in the US, that is relying on foreign savings. With China well on its way to reducing its current account surplus (through lower corporate savings and a higher share of wages in GDP), US policy makers would be grossly imprudent if they took the current abundance of foreign savings for granted. I really think the greater risk created by Bernanke’s debt reflation is eventual debt deflation rather than goods price inflation.

    1. Credit Risk

      Do you mean the credit card offers I am getting today from the same bank I stopped paying on last year and they wrote off after 6 months? I have collection agencies calling me on my walk to the mail box from the same bank I just got a new credit card offer from.

      My brother in California is going on 2 years of living in a big house making no payments and shopping and traveling big for Christmas.

  6. 60sradical

    There are now so many Fed crirics who understand fractonal reserves and fiat money. So I have trouble even readng the above post. As we speak, the Fed is “buying” billions of $$ of US treasury bonds simply by pushing electronic buttons–This “money” is literally counterfeit–fiat money. Yet, the fed bankers cannot address this phenomenon in the same way they cannot cop to the hard fact that the TBF bankstaz are not lending, notwithstandng the enormous amounts of fiat money they received, because these billions simply keep the ponzi shceme going a little longer. The outstanding toxic debt(cds, etc.)must be kept at bay. They cannot bring themselves to criticize that which is most important and most blatant. So, even though it’s good to see the above critical post, the Fed and their banksta buddies will never step from behind the curtain and spill the real beans.Tick tock.

  7. ddf

    It is totally insane but that is what Bernanke and co are aiming for. The alternative, repaying our debts, is simply too painful to be politically feasible. Of course more leverage now only adds to the eventual deleveraging and pain, but policy makers’ time horizon ápparently does not extend that far. I actually think that a once and for all large scale debt reduction with bank recapitalization would be more efficient than protracted private sector deleveraging and/or public deficits and leveraging (it would also set incentives right). But that is even more politically unfeasible than market based deleveraging. We’ll just have to wait for a bigger crisis and a revolution…

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