Yves here. Richard Alford chose to put aside the questions of corruption and kleptocracy to look at another issue that is plaguing the financial system, that of failing to learn from mistakes. I suspect that this lapse is on the rise due to the fact that investigating a mistake requires admitting a mistake happened. I’ve harped before on the fact that in the 1987 Crash, President Reagan authorized the Brady Commission to investigate it and had a report on his desk a smidge over two months later. By contrast, the Financial Crisis Inquiry Commission was late to get started, politically hamstrung, understaffed, and decided to focus on flash (hearings before doing groundwork, hiring six journalists to produce easily-digestible text) at the expense of substance. In our hall-of-mirrors logic, escaping liability (or if you are a politician or regulator, blame) is more important than preventing the recurrence of disasters.
I also want to turn to this issue in a broader sense in later posts, because I’ve been seeing a decline in competence in providing banking services, an increase in errors that would have been unthinkable 10 or 20 years ago. And that is before we consider the horrorshow known as mortgage servicing.
By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
The US has experienced numerous disasters both natural and man-made. Unfortunately, the authorities have not always availed themselves of the opportunity to learn from these episodes. This post highlights the failure of the financial authorities to learn from past crises by juxtaposing the official enquiries in to, and success in learning from, the Teton Dam disaster of 1976 on the one hand and both the Long Term Capital Management (LTCM) crisis of 1998 and the financial crisis of 2007 on the other.
Juxtaposing the response to a dam disaster with the response to financial crises might appear to be artificial, but it is useful and appropriate. First, designers of both dams and economic policy must deal with problems and risks inherent in complex systems. Dam design and construction reflects the complexity and interactions embedded in the design of the dam, materials employed in building the dam, and risk mitigation efforts as well as the geology of the site. Design and execution of economic and regulatory policy reflects the complexity of the economy and financial systems as well as institutional arrangements. Second, the responses to both the dam failure and the financial crisis played out in the political arena. Unfortunately, while the public debate over the cause of the dam disaster contributed to an informed and successful response, the limited debate over the cause of the financial crises ignored factors other than faulty regulation and has not resulted in a response that mitigates the likelihood of future financial/economic crises.
In June of 1976, the Teton Dam in Idaho failed as it was filling for the first time. The failure resulted in the loss of life and damages estimated as high as $1 billion. There was a public outcry. Finger pointing was rampant and recriminations flew. The geologists, the dam designers and builders, and the US Bureau of Land Reclamation, which had overseen the site selection, planning and construction of the dam, were all viewed as suspects.
Numerous competing reasons for the dam failure were presented as the parties to the design and construction of the Teton Dam attempted to avoid any blame. The Governor of Idaho and the Secretary of the Interior called for an independent engineering and geological review to determine the cause of the failure. The review panel was chosen from names suggested by the National Academy of Engineering and the National Academy of Science, among other organizations. The panel was comprised of a former president of the Society of Civil Engineers, professors of engineering, consulting engineers, and engineers and directors of public bodies responsible for the management of water resources. Notably, no panel member was attached to any Federal agency that played a role in the site selection, design or construction of the Teton Dam or any other dam or federal water project.
The report explicitly rejected possible single causes, e.g., the site, the dam design, the rapid filling of the dam or seismic activity. The conclusions drawn were rather nuanced, but stressed that the failure had multiple causes. From the summary of conclusions:
…Clearly many aspects of the site and the embankment design contributed to the failure…
The fundamental cause of failure may be regarded as a combination of geological factors and design decisions that, taken together, permitted the failure to develop…
The independent review panel also pointed out specific mistakes that were necessary for the failure. Some of recommendations are generalizable to risk controls in other complex dynamic systems. For example, the panel concluded that the failure could have been avoided had the Bureau of Land Reclamation based:
..the design on the most unfavorable assumptions compatible with the geologic conditions …
It also cited the absence of any real-time ability to monitor possible risks that the dam would not function as intended:
The dam and its foundations were not instrumented sufficiently to enable the Project Construction Engineer and his forces to be informed fully of the changing conditions in the embankment and its abutments…
The geology of the site and certain elements of the dam’s construction were all necessary for the failure to have occurred, but none alone was sufficient to cause the dam to fail. This conclusion is supported by the Ririe Dam. The Ririe Dam is about 30 miles from the site of the Teton dam. The geology of the site is nearly identical. The Ririe Dam is of the same general design. Construction was completed in 1975. It never failed.
Both Houses of Congress also held hearings to determine the cause of the disaster. Legislation was enacted to reduce the likelihood of future dam failures. It is generally believed that resulting new standards and oversight have and will mitigate dam disasters in the US. It is not entirely coincidental that the Teton Dam was the last large dam built in the US.
Like the Teton Dam failure, the financial crisis of 2007 took the relevant government agencies by surprise. The crisis caused economic dislocation, increased unemployment and lost output, and the failure of numerous financial institutions. It would have caused grater losses and more failures if not for efforts by government agencies to support markets and illiquid and insolvent firms.
In many regards, the response to the financial crisis of 2007 was similar to the response to the Teton Dam failure. There was public outcry, finger pointing, name calling, Congressional hearings and legislation in the form of Dodd-Frank. However, Dodd-Frank is widely recognized as an incomplete series of awkward compromises that leaves the financial system and the economy open to future financial disasters.
It is also clear that the economic policymakers had made mistakes that parallel the mistakes that contributed to the failure of the Teton Dam. Despite a history of financial crisis and resulting economic dislocations, the Fed ignored risks and based regulatory and interest rate policy on the most favorable assumptions regarding financial and economic stability. Furthermore, despite a less than stellar record of forecasting turning points in the economy, the Fed was so confident of its own model/forecast that it failed to monitor economic and financial risks closely enough to assign even a low probability to the crisis that was brewing. It also dismissed warnings by outside economists, analysts and commentators about the housing price bubble and other economic and financial unsustainabilities.
However, there is an additional reason to be disappointed with the response. While Congress held hearings in to the cause of the financial crisis, there was no independent review. In looking for an explanation for the financial crisis, the Congress, the press and public turned to and relied on the same policymakers and regulators who at a minimum had failed in their regulatory responsibilities as well as having failed to see the financial and economic imbalances building.
The independent panel that investigated the Teton Dam failure recognized that causality is complicated in dynamic systems where the outcomes are the result of the interaction of numerous systems and variables. Despite a financial/economic system that was more complex and dynamic than any dam, the financial authorities promoted two ideas;
1. That weaknesses in the regulatory system coupled with financial institutions that evaded and avoided existing regulations was a complete explanation for the crisis; and
2. The recession of 2007 was an unforecastable inexplicable “black swan” event.
It is clear that many financial institutions had engaged in unethical and criminal behavior. It is also clear that they had exposed the financial system to unjustifiable risks. No one can argue that regulation has been satisfactory. However, unlike the parties to the design and building of the Teton dam, the financial institutions were not in a position to mount a defense of any kind. Who would believe that a defense was anything but self-serving? In addition, the financial institutions were not in a position to point a finger or shift any of the blame to policymakers or regulators, as they were dependent on the same policymakers and regulators for their continued existence.
Examinations in to the possibility that other factors contributed to or were necessary for the crisis and recession were pushed aside. The policymakers got off with a “keep moving, nothing to see here” defense of their sins of omission, the opportunity to write the history of the crisis, and a role in reforming financial and regulatory systems without detailing what went wrong and why.
However, the case for a nuanced, multivariate explanation for the financial crisis is even stronger than it was for the Teton Dam failure. The economic, financial and regulatory systems are interdependent and adaptive as well as dynamic and complex. They evolve together in response to regulations, the incentives, and opportunities in the financial climate, e.g., the structure of interest rates and the rate of inflation. The appropriateness of the regulatory structure cannot be accurately assessed independent of the interest rate climate and financial innovations spurred by the regulations and the economic climate.
Recent US economic history provides examples of the interdependence of regulation, financial innovation and monetary policy. The inflation of the 1970s contributed to the rapid growth of the futures markets. The increased interest rate and currency volatility that followed the adoption of monetary targeting in 1979 contributed to the growth of the use of options on financial instruments. The high interest rates post-1979 also combined with Reg. Q (interest rate ceilings on deposits) contributed to the introduction and spread of money market mutual funds. Money market mutual funds helped undermine the relationship between the monetary aggregates and economic performance that had been the basis for monetary policy. As a result, the Fed ceased targeting non-borrowed reserves and monetary aggregates. Changes in monetary and regulatory policy drove financial innovations that in turn drove changes in the monetary policy regime. And yes, the rise of the money market mutual funds that are now perceived as a serious threat to financial stability was a direct financial market response to incentives inherent in earlier monetary and regulatory policies. Interest rate policy can compromise the regulatory system just as changes in the regulatory and financial systems can compromise the effectiveness of monetary policy.
Post-2001, both interest rate policy and the Basel capital standards gave affected financial institutions incentives to increase the riskiness of their balance sheets. The interest rate structure was an incentive for financial institutions to use leverage and borrow short-term to finance positions in long-term investments. The Basel capital rules encouraged investment in certain classes of instruments by assigning inappropriately low risk weighting (e.g., residential mortgage- based products). The Basel rules also spurred the introduction of new instruments and structures (e.g. CDSs and off-balance sheet entities) that enabled financial institutions to reduce the amount of capital that they were required to hold for regulatory purposes. The bank regulatory structure and interest rate environment also provided an impetus for the further growth of the unregulated “shadow banking system.”
Weakness in the regulatory regime cannot be a complete explanation for the increased risk taking prior to the crisis or the crisis itself. Regulation allowed increased risk taking, but the interest rate structure, the perception of a Fed “put” on asset prices as well as the commitment to raise interest rates at a measured pace certainly gave financial institutions and other economic agents the rationale and incentive to increase maturity mismatches and leverage (dancing until the music stopped), and to create new instruments and structures to avoid and evade the regulations that existed, as well as to lobby for further relaxation of regulatory constraints.
Given the dynamic and interactive nature of the economic, financial and regulatory systems, it makes less sense to accept the idea that regulatory policy alone (or any one subset of the financial/regulatory policy system) caused the financial crisis than it would have been to blame the failure of the Teton Dam on the geology of the site while holding the design of the dam blameless (or vice versa).
There is also reason to reject the position that the recession was a “black swan” event. The “black swan” (non)explanation assumes that that the crisis and recession were both unforecastable and inexplicable. This assumption implies the economy and financial system were on stable and sustainable footing prior to the crisis and that there is nothing to learn from trying to identify and examine the causes of the crisis and recession of 2007 beyond the regulatory breakdown. This in turn implies that there is no need for a full review, let alone an independent review.
However, while inflation and unemployment were well behaved, there were a number of inter-related unsustainabilities of macroeconomic importance in the real economy as well as in the financial sector. The trade deficit at 6% of GDP was an unsustainably high. The US economy had become unusually dependent on the growth of residential investment. As a fraction of GDP, residential investment had for a number of years been well above historical norms and housing prices were unusually high relative to incomes and rental rates. Consumption expenditures had also been unusually high relative to income. Despite the aging of the population, the household sector had reduced its savings rate (lowest since the Great Depression). Households employed more leverage as they reduced down payments on homes purchased and borrowed against unrealized capital gains in housing and other assets to finance consumption expenditures. Households also increasingly relied on mortgage products that minimized initial payments, allowing them to take on more debt.
Financial institutions grew their balance sheets. Many institutions employed record-setting levels of leverage. Numerous types of financial entities, including banks and “shadow banks,” funded increased purchases of long-lived assets with short-term instruments (commercial paper), and thereby exposed themselves and the system to funding/liquidity risk. Quality spreads were compressed as economic agents levered-up and reached for yield.
If any of the unsustainabilities cited above (save the trade deficit) were to correct for any reason, it would exert downward pressure on incomes and output. The downward pressure on incomes and output would cause more of the unsustainabilities to correct, putting more downward pressure on output and incomes. This self-reinforcing unwinding of these unsustainabilities was exactly the process by which the reversal in the housing market spilled over into the real economy and the financial system. The process continued until policy steps either stopped the unwinding of the unsustainabilities, e.g., various policies served to maintain consumption as households attempted to increase savings as a fraction of disposable income, or replaced them, e.g., the growth in public debt replaced the private sector deleveraging.
Closer, to home, the financial authorities also failed to learn lessons from the LTCM crisis of 1998. These lessons, which if taken to heart, would have at a minimum, reduced the severity of the financial and economic dislocations of 2007. LTCM was a highly leveraged hedge fund that financed positions in long-dated assets with short-term borrowings (maturity transformation structures). It was part of the emerging “shadow banking system.” When the market turned against LCTM, it and a wide variety of other financial entities with sympathetic positions were forced by marginal calls to liquidate their positions. The resulting disturbances threatened the functioning of the financial markets. The Fed used moral suasion to cobble together a coalition of the largest financial houses to stabilize the system, allowing for an orderly unwind of LTCM’s positions.
The behavior of the Fed and other regulators between 1998 and 2007 suggests that the lesson that they learned from the LTCM crisis was that unusually high use of leverage and maturity mismatches (even in the shadow banking system) are of no systemic importance as long as the core banking institutions remain sound or at least sound with the help of access to the Fed Discount Window. The authorities had failed to grasp the implications for financial stability of the increasing use of leverage in the growing shadow banking system. This became obvious in 2007. The authorities were surprised by the crisis, the leverage in the system and the demand for liquidity stemming from the leverage and use of maturity transformation structures in non-core and core institutions. They were also surprised, when, despite prior statements to the contrary, they discovered that they did not have adequate tools to deal with even the liquidity dimension of the crisis. The Fed could supply liquidity to US banks through the Discount Window, but not to shadow banks. Hence the need to devise and introduce the alphabet soup of programs to supply liquidity to an array of institutions and markets.
Post-2007, the authorities have started to learn (at great cost) the lessons that could have been learned in 1998. The authorities are now concerned about the shadow banking system and leverage, although the regulatory focus remains primarily on the large banks and other large systemically important firms.
Over time, the authorities have demonstrated an unwillingness and/or an inability to learn from their mistakes or the mistakes of others. This is reflected in the superficial analysis of the cause of the Great Recession. The bankster/black swan hypothesis is insufficient as an explanation of the crisis and recessions. It leaves unanswered a number of questions regarding economic policy. They include:
• What was the exact role of interest rate policy in the decisions of regulated and non-regulated economic agents to increase their use of leverage and maturity mismatches prior to the crisis?
• Why did policymakers ignore their regulatory responsibilities despite an acceleration in the pace of financial innovation and an interest rate climate that encouraged increase risk taking?
• Why does the Fed continue to view interest rate policy as if it is independent of financial stability policy even as the authorities agree to postpone the new regulatory initiatives presumably because they would detrimentally affect economic performance?
• Why did policymakers ignore warnings about risks in the financial sector?
• Why did policymakers ignore the trade deficit and undesirable and unsustainable patterns of real expenditures (elevated levels of residential investment and consumption relative to income) prior to the crisis?
Given the costs of the crisis and recession, the public deserves an independent review of the crisis and recession of 2007. It deserves an encompassing review that identifies the necessary and sufficient conditions that for the crisis and recession and provides a basis upon which relevant lessons can be learned. This is of increasing importance as even the regulatory reforms are being watered down even before they are implemented.