The Price of Inequality: How Today's Divided Society Endangers Our Future (65 page)

24.
There is a huge literature on the subject discussed in this section. My own views are set out in a lecture in memory of one of the great economists of the twentieth century, and the (first) Nobel Prize winner in economics, Jan Tinbergen, delivered at the Central Bank of Netherlands, “Central Banking in a Democratic Society,”
De Economist
146, no. 2 (July 1998): 199–226, esp. 28. See also Alex Cukierman,
Central Bank Strategy, Credibility, and Independence
(Cambridge: MIT Press, 1992); and J. Furman, “Central Bank Independence, Indexing, and the Macroeconomy,” unpublished 1997 manuscript.

25.
See chapter 3 for more details.

26.
Edward M. Gramlich not only anticipated the bubble and its breaking but also argued forcefully that something should be done to avoid the foreclosures. The Fed did nothing on either front. See his book
Subprime Mortgages: America’s Latest Boom and Bust
(Washington, DC: Urban Institute, 2007).

27.
This was a position that was clearly political and consistent with his known ideological views. See chapter 8 for a discussion of the specious arguments that were put forward in defense of his position.

28.
The 2010 Dodd-Frank regulatory reform bill made some improvements in governance.

29.
“Remarks by Governor Ben S. Bernanke,” October 2004, available at
http://www.federalreserve.gov/boarddocs/speeches/2004/200410072/default.htm
.

30.
An argument sometimes put forward for secrecy is that disclosing information will roil the markets, and could lead to a run against a bank that has borrowed money from the Fed. But at issue in this case was disclosure of information long after the transactions had occurred. Besides, capital markets can’t exercise discipline in the absence of relevant information. Those who advocate secrecy are advocating policies that would undermine the discipline of the marketplace.

31.
JPMorgan Chase benefited through the Bear Stearns bailout. In another instance of questionable governance, Stephen Friedman became chairman of the Federal Reserve Bank of New York in January 2008, while he was simultaneously a member of the board of Goldman Sachs and had a large holding in Goldman stock. He resigned in May 2009 after the controversy over the obvious conflicts of interest (including share purchases, which enabled him to make $3 million). See Joe Hagan, “Tenacious G,”
New York
, July 26, 2009, available at
http://nymag.com/news/business/58094
/ (accessed March 28, 2012); and Kate Kelly and Jon Hilsenrath, “New York Fed Chairman’s Ties to Goldman Raise Questions,”
Wall Street Journal
, May 4, 2009, p. A1.

32.
See, e.g., Binyamin Applebaum and Jo Craven McGinty, “The Fed’s Crisis Lending: A Billion Here, a Thousand There,”
New York Times
, March 31, 2011, available at
http://www.nytimes.com/2011/04/01/business/economy/01fed.html
(accessed March 5, 2012). From the article: “And the Fed helped to save some of the largest banks in Europe by pumping desperately needed dollars into their American subsidiaries. In fact, the biggest borrower from the Fed program was Dexia, a French-Belgian bank that frequently held more than $30 billion in outstanding loans from the program from late 2008 to early 2009.”

33.
The central mission of a central bank (such as the Fed) is to act as a lender of last resort for the banks within the country, that is, when no one else is willing to lend to banks that are solvent (i.e., whose assets exceed its liabilities), the Fed steps in to provide liquidity.

34.
On March 27, 2007, Bernanke testified before Congress, “Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely.” See “Chairman Ben S. Bernanke: The Economic Outlook: Before the Joint Economic Committee, U.S. Congress,” available at
http://www.federalreserve.gov/newsevents/testimony/bernanke20070328a.htm
(accessed February 24, 2012).

35.
There are other important institutional reforms that would make for a more effective monetary policy. A fashionable doctrine in economics holds that separate institutions should be created to pursue different objectives and to control different instruments. In this view, the central bank should focus on inflation, and its instrument of choice should be the interest rate. Fiscal authorities should focus on employment, using tax and expenditure policy. Unfortunately, while in some very simple theoretical models this institutional arrangement can achieve desirable outcomes, in the real world there needs to be coordination. It is often desirable to use multiple instruments to pursue even a single objective. Bank lending is as affected by regulatory requirements (like capital adequacy standards) as by interest rates; and quantitative restrictions (e.g., down payments on housing) can be a much more effective instrument in controlling excesses than a blunt instrument like the interest rate.

36.
The sense of loss of sovereignty that countries in Europe have felt is reflected in a statement made by Giulio Tremonti, Italy’s finance minister at the time, privately to a group of European finance ministers. He is quoted as saying that in August his government had received two threatening letters—one from a terrorist group, the other from the ECB. “The one from the ECB was worse.” From Marcus Walker, Charles Forelle, and Stac Meichtry, “Deepening Crisis over Euro Pits Leader against Leader,”
Wall Street Journal
,
December 30, 2011.

37.
An alternative explanation is that the ECB knows that the financial system lacks transparency and knows that investors know that they cannot gauge the impact of an involuntary default, which could cause credit markets to freeze, reprising the aftermath of Lehman Brothers’ collapse in September 2008. The ECB should have insisted on more transparency—indeed, that should have been one of the main lessons of 2008. Regulators should not have allowed the banks to speculate as they did; if anything, they should have required that the banks buy insurance—and then insisted on restructuring in a way that ensured that the insurance pays off. The one argument that seems, at least superficially, to put the public interest first is that an involuntary restructuring might lead to financial contagion, with large eurozone economies like Italy, Spain, and even France facing a sharp, and perhaps prohibitive, rise in borrowing costs. But that raises the question of why an involuntary restructuring should lead to worse contagion than a voluntary restructuring of comparable depth. If the banking system were well regulated, with banks holding sovereigns having purchased insurance, an involuntary restructuring should perturb financial markets less. Another explanation is that by insisting on its voluntariness, the ECB may be trying to ensure that the restructuring is not deep. It might worry that if Greece gets away with a deep involuntary restructuring, others would be tempted to try it as well. Financial markets, worried about this, would immediately raise interest rates on other at-risk eurozone countries, large and small. But the riskiest countries already have been shut out of financial markets, so the possibility of a panic reaction is of limited consequence. Moreover, they would be tempted to do so only if Greece were indeed better-off restructuring than not doing so. That is true, but there’s no news in that. In the end, the restructuring did trigger a credit event, and there was no trauma to the financial markets—the ECB’s concerns were proven baseless.

38.
On July 15, 2011, the European Banking Authority, as part of its European bank stress tests, gave Dexia a clean bill of health (
http://www.bloomberg.com/news/2011-10-13/no-1-financial-strength-ranking-spells-doom-commentary-by-jonathan-weil.html
). On October 4, 2011, Dexia shares fell 22 percent. On October 10, 2011, Dexia was bailed out (
http://online.wsj.com/article/SB10001424052970203633104576620720705508498.html
). The ECB’s position was odder still. Whether a credit event had occurred was determined by a secret committee of the International Securities Dealers Association (ISDA), which might be described as a cooperative group—or a cartel—of the writers of derivatives, some of whom might have a strong financial interest in the outcome. They—or their employer—might receive or have to pay billions. One member of the committee reportedly even used her position to try to influence bondholders’ cooperation in restructuring, hinting that if they didn’t, the committee might still put a high bar on whether it was or was not a “default” event. The decisions of the ISDA were not appealable, either to arbitration or to the courts. It seemed curious that the ECB was apparently willing to delegate authority to a private institution, operating in secret, on what was or was not an acceptable restructuring. So much for democratic accountability.

39.
The term “Chicago school” has come to refer to Milton Friedman and his disciples who believed in market fundamentalism, the idea that unfettered markets are always efficient even in the absence of government regulation. Milton Friedman taught for many years at the University of Chicago. But, of course, many economists who teach there do not subscribe to market fundamentalism—and many economists at other schools do. See chapter 3 for a longer discussion.

40.
See the website of the Board of Governors of the Federal Reserve for the most up-to-date balance sheet figures,
http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
.

41.
There’s another theory of the Great Depression that is relevant to what has been going on more recently. Some put blame for the Great Depression on the gold standard. It impeded adjustment. Countries that left the gold standard did better. In some ways, the euro has imposed on Europe some of the same kind of rigidity that the gold standard imposed on much of the world in the 1930s. And yet, there’s a sense that the gold standard didn’t
cause
the Great Depression, just as the euro didn’t cause the Great Recession. The origins of the disturbance to the economy lay elsewhere. And some of the benefits accruing to those countries that left the gold standard were
at the expense
of others. If they had
all
moved to a flexible exchange rate system, would that, by itself, have been sufficient to restore the global economy to prosperity? I doubt it.

42.
For a discussion of these bubbles and the repeated financial crises that are often associated with the bursting of the bubbles, see Charles Kindleberger,
Manias, Panics, and Crashes: A History of Financial Crises
(New York: Basic Books, 1978), and Kenneth Rogoff and Carmen M. Reinhardt,
This Time Is Different: Eight Centuries of Financial Folly
(Princeton: Princeton University Press, 2009).

43.
Or, similarly, increasing margins in the purchase of stock (which act like a house down payment). Interestingly, in the tech bubbles of the 1990s, the possibility of increasing margin requirements was briefly discussed, but then evidently dismissed: perhaps the free marketers that dominated the Fed didn’t like this kind of interference with the wonders of the market. See J. E. Stiglitz,
The Roaring Nineties: A New History of the World’s Most Prosperous Decade
(New York: W. W. Norton, 2004).

44.
Among the list of those who have officially adopted inflation targeting in one form or another are Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway. The United States never fully adopted inflation targeting—as we have noted, the Federal Reserve’s mandate requires that it look also at the level of unemployment and the rate of growth. But over long periods of time, its policies have been little different from those of countries that have explicitly adopted inflation targeting.

45.
This list is not meant to be exhaustive. Another hypothesis is that the best way to fight inflation—regardless of its source—was to increase interest rates. There are other macroeconomic tools (fiscal policy), and even within the domain of monetary policy, there are other instruments (e.g., restraining credit availability through raising reserve requirements). It can be shown that the best way to respond to inflation depends on the source of the disturbance—what caused the bout of inflation.

46.
There is another rationale for the view that a central bank should focus only on inflation. It isn’t that the advocates of inflation targeting don’t recognize the importance of these other issues, but rather that they believe that there should be different institutions and policy instruments for different objectives. Fiscal authorities, for instance, might want to focus on unemployment, or even on distribution. The notion that there can be a simple pairing of instruments and objectives is associated with the Nobel Prize–winning economist Tingbergen. This notion is valid in simple linear models. However, it’s known now that it’s not true in general, and especially so in the context of uncertainty.

47.
See data on the website of the World Bank, “Inflation, consumer prices (annual %),” available at
http://data.worldbank.org/indicator/fp.cpi.totl.zg
(accessed March 5, 2012).

48.
Indeed, given the size of the U.S. economy, a slowdown there might conceivably have had a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, U.S. interest rates, not those in developing countries, should have been raised.