My spin on the Dodd Frank watering

Update on Jan. 7: Here is Larry Summers on this same issue. I like his argument that a government run by businessmen might not necessarily be great for the country or even business.  More to the point, financial deregulation should not be an end in itself. Smarter regulation might make sense.


Financial regulation is beyond my competence, so I don’t have much to add to the substance of this debate, beyond pointing out that The Bankers’ New Clothes does a nice job of explaining how the banking lobby misuses the concept of capital and its link to lending. Banks do not “retain” capital.  They lend it out just as they lend out other sources of funding, which for banks is primarily debt. *



Instead of weighing in on the substance here, I want to link this whole discussion back to monetary policy.  One reason I assigned a probability of zero – not low, zero – to the risk of the Fed tightening to prevent a bubble was that the political culture, in which the Fed participates, cannot see the case for implementing policies that might actually have some shot at preventing or containing a bubble. The problem, invariably, is that somebody’s ox gets gored in the process, and those somebodies often have a strong lobby.  So if the political culture can’t deliver what might work, why would we expect the Fed to try what they know can’t work?

Yellen was once quite honest on this. She said that even in retrospect, it was not clear to her that monetary policy in the mid 2000s should have been any different from what is actually was. On other occasions, she was less clear, implying that she could at least imagine (unlikely) conditions that might require the Fed actually to use monetary policy to ward off a bubble.

Somewhat related, there was a very strong overlap during the early recovery period between those agitating for the Fed to raise interest rates to prevent a bubble and those agitating for a loosening of financial regulations, which would seriously raise the risk of triggering another bubble.  (Not to imply that Dodd-Frank is perfect. But I think my point stands even though it is not.)

The reason many people agitated for Fed tightening to prevent a bubble is because they were confident it would not work. (I went over this issue in some detail in this post from just under a year ago.)  Unsurprisingly, the Fed chose not to participate in that charade, regardless of how many times they trotted out Jeremy Stein to hint at policy initiatives that would never be implemented. To me, that was all so incredibly transparent. * And it remains so.

Anyhow, I guess we are now at the point in the financial cycle where memories of the last bubble are sufficiently dim that the actual creators of bubble risk – outside the Fed – feel that it is safe to be brazen again.  While it is easy to predict the role that the Fed will play in this, I confess to being confused by the extreme gullibility around this issue among policy analysts and Fed watchers.  People drone on and on about the Fed, and are much quieter about the other more obvious sources of bubble risk. Weird.

* Arguably, the false claim rhymes with the idea that capital requirement slow bank debt growth and thereby slow lending.  But why not just say what is the case?

** At the Chicago Booth Monetary Policy Forum in New York in February 2014, Jeremy Stein effectively endorsed a paper arguing that the Fed might want to put a proxy for financial instability into its loss function to see how that might affect estimates of optimal interest rate strategy. Commenting on that same paper, Narayana Kocherlakota pointed out that the idea had some merit in principle, but that the effect would need to be quantified, not just signed.  Kocherlakota presented one possible quantification, implying that the issue could roughly be ignored while the Fed directed monetary policy to more traditional objectives. At the time, I was surprised that the audience did not interpret Kocherlakota’s comments as effectively settling the debate, for practical purposes.  In fairness, he was in the minority and expressed his take politely and with the appropriate caveats. But he was apparently right — or at least predictive of the Fed’s actual behavior.