I know Jeremy Stein. He is a good economist, is a pioneer in macroprudential analysis that studies the interplay of financial regulation and macro stability, and served with distinction as a Governor of the Federal Reserve. It is disappointing that, in his efforts to come up policies that effectively respond to the 2007-09 Great Recession, he has become another prominent victim of the stabilization-irrelevance mainstream micro-coherent general-market-equilibrium modeling. The crucial stumbling block is the inability of consensus thinking to motivate causality from total-spending disturbances to involuntary job loss and recognizably sized movements in employment and output. The academy has responded to that fundamental failure by deemphasizing the role of nominal aggregate demand, greatly damaging its capacity to advise macro policymakers.
Since he left the Board, Stein has become a leading voice in a much-debated public-policy issue. What are the macro consequences of some banks being Too-Big-to-Fail? Unfortunately, like many of his New Keynesian colleagues, Stein’s TBTF analysis and conclusions are badly off-base. The GEM Project demonstrates that he is steered off-course by consensus macro theory, the misdirection from which is illustrated in his contribution to the recent volume, What Have We Learned: Macroeconomic Policy after the Crisis (2014).
From Stein (2014): “I should note at the outset that solving the TBTF problem has two distinct aspects. First, and most obvious, one goal is to get to the point where all market participants understand – with certainty – that if a large SIFI were to fail, then the losses would fall on its shareholders and creditors, and taxpayers would have no exposure. However, this is only a necessary condition for success, not a sufficient one. A second aim is that the failure of a SIFI must not impose significant spillovers on the rest of the financial system. ”
Stein ignores the two-aspect distinction that practitioners know is essential to dealing with the TBTF problem. Useful macroprudential analysis must begin with the context of bank failure:
- A large bank may fail, i.e., its liabilities exceeding its assets, because of mismanagement. This problem class is particular to the troubled bank and affects its creditors and equity owners. The GEM Project sensibly demonstrates that such failure is most efficiently addressed by an insurance fund financed by the large banks themselves.
- A large bank may fail, again its mark-to-market assets fall below its liabilities, because of a broad, outsized decline in asset prices and a substantial jump in the incidence of credit default. This problem class is general to all banks and is necessarily rooted in contracting nominal demand. Failure risk becomes acute when a stationary demand disturbance (SDD) mutates into a nonstationary demand disturbance (NDD). NDD is a necessary condition for instability to produce depression.
Stein makes a huge mistake by confining his analysis to the first, relatively benign context of bank failure. Especially in the aftermath of the Great Recession, stabilization authorities need to understand why and how SDD → NDD occurs. Of course, given that NDD has little significance in their consensus market-centric modeling, it is unsurprisingly ignored by Stein and his New Keynesian colleagues. Fortunately, two-venue micro-coherent theory takes the actual range of demand disturbances seriously, identifying their factually important causes and consequences.
Take a moment to think about the micro-coherent GEM analysis. In it, SDD captures the contained, temporary weakening of total spending associated with garden-variety recessions. NND captures the unchecked spending collapses associated with acute instability and depression. (Chapters 5, 6, and 10) NDD overwhelms the automatic stabilizers and central-bank purchase of short-term treasury debt that are effective in ameliorating SDD. The crucial difference between the two classes of spending disturbances is centered on prevailing investor/lender perceptions of the macro future. In NDD circumstances, which were in fact being organized in 2008-09, investors/lenders are sufficiently uncertain about the credibility of stabilization authorities’ trend real-side objective to become rationally inactive, moving to the sidelines to await credible bottoms in collapsing asset prices. Containing NDD requires much more aggressive use of the central-bank balance sheet, supporting the crisis-imposed roles of buyer and guarantor of last resort in downward-spiraling markets, in order to restore recycling of saving into spending adequately to reverse the contraction of nominal demand.
The management of the TBTF problem class rooted in NDD differs little from the management of NDD itself. First, aggressively use monetary and fiscal means to halt and reverse contracting total spending. Once accomplished, asset prices quickly rebound and the gathering credit-default problem recedes. Public capital-infusions into large banks (and other financial institutions) are quickly repaid with handsome returns for taxpayers. The TBTF problem simply dissipates. Second, in the crisis aftermath, stabilization authorities must focus on assembling the most powerful demand-management tools and must credibly pledge to use them whenever faced with circumstances of gathering NDD.
Stein’s micro-coherent, general-market-equilibrium crisis management ignores all that. He relies wholly on the future prevention of significant financial crises. We know that strategy cannot succeed. Three facts headline its debilitating problems:
- Powerful macro shocks that are then propagated by aggregate-demand disturbances are not confined to financial crises.
- Financial shocks are intrinsic to modern, highly specialized economies and, in their highly variable forms, cannot be prevented. In the same volume, David Romer shows that such shocks are both “commonplace” and heterogeneous. He identifies six such U.S. crises in the past three decades. The lesson of history and logic is that the prevention of financial shocks is a fool’s errand. Moreover, future financial crises are more likely to follow the nature of the most recent macro disorders and originate in nonbank financial institutions. The “shadow banking system” largely exists, and therefore rapidly evolves, to avoid regulation. It is devastating for the good intentions of Stein and his New Keynesian colleagues that the next Great Recession (or depression) is very unlikely to originate in TBTF banks.
- Misguided, aggressive TBTF-related attempts to prevent another Great Recession, e.g., the Fed’s recent policy of ever increasing capital requirements on the largest banks in order to force them to break up, will damage economic efficiency and the economy’s capacity to generate rising living standards.
Blog Type: New Keynesians Saint Joseph, Michigan