Has Trump Captured the Fed?
US President Donald Trump has an uncanny ability to embrace economic policies, such as the Republicans' proposed tax cuts, that benefit him personally. In choosing the relatively moderate Jerome Powell to chair the Federal Reserve, he realized that an extremist would raise interest rates – any real-estate developer’s worst nightmare.
NEW YORK – One of the important powers of any US president is to appoint members and heads of the many agencies that are responsible for implementing the country’s laws and regulations and, in many cases, governing the economy. Perhaps no institution is more important in that regard than the Federal Reserve.
In exercising that power, Donald Trump has broken a long-standing pattern, going back almost a half-century, whereby the president reappoints (on a non-partisan basis) the incumbent Fed chair, if he or she has been seen to be doing a good job. Probably no chair has done a better job, in a particularly difficult moment, than Janet Yellen.
Whereas her two immediate predecessors greatly tarnished the Fed’s reputation by looking the other way as massive risk was accumulating – and massive fraud occurring – within the financial sector, Yellen restored the Fed’s reputation. Her calm and balanced hand nurtured broad consensus among a Federal Reserve Board characterized by divergent economic philosophies, and she navigated the economy through a slow recovery in a period when fiscal policy was unnecessarily constrained, as duplicitous Republicans hyped the dangers of deficits. The Republicans’ shallow commitment to fiscal rectitude is now being exposed as they advocate massive tax cuts for corporations and billionaires that will add one and half trillion dollars to the deficit over the next decade.
To be fair, Trump chose a moderate, when many in his party were pushing for an extremist. Trump, never shy about conflicts of interest, has an uncanny ability to embrace economic policies, such as the proposed tax cuts, that benefit him personally. He realized that an extremist would raise interest rates – any real-estate developer’s worst nightmare.
Trump broke with precedent in another way: he chose a non-economist. The Fed will face great challenges in the next five years, as it reverts to more normal policies. Higher interest rates could give rise to market turmoil, as asset prices undergo a significant “correction.” And many are expecting a major downturn in the next five years; otherwise, the economy would have experienced an almost unheard-of decade-and-a-half expansion. While the Fed’s tool kit has been greatly expanded in the last decade, the Fed’s low interest rates and huge balance sheet – and the possibly massive increase in debt, should Trump get his tax cuts – would challenge even the best-trained economist.
Most importantly, there has been a bipartisan (and global) effort to depoliticize monetary policy. The Fed, through its control of the money supply, has enormous economic power, and such power can easily be abused for political purposes – say, to generate more jobs in the short run. But lack of confidence in central banks in a world of fiat money (where central banks can create money at will) weakens long-term economic performance, owing partly to fears of inflation.
Even in the absence of direct politicization, the Fed always faces a problem of “cognitive capture” by Wall Street. That’s what happened when Alan Greenspan and Ben Bernanke were in charge. We all know the consequences: the greatest crisis in three quarters of a century, mitigated only by massive government intervention.
Yet, somehow, the Trump administration seems to have forgotten what happened less than a decade ago. How else to explain its efforts to rescind the 2010 Dodd-Frank regulatory reforms, designed to prevent a recurrence? The consensus beyond Wall Street is that Dodd-Frank didn’t go far enough. Excessive risk taking and predatory behavior are still real problems, as we are frequently reminded (for example, by reports about the growing volume of subprime auto loans). In one of the more insidious recent instances of malfeasance, bankers at Wells Fargo simply opened accounts on behalf of customers, unbeknownst to them, so that it could collect additional fees.
None of this bothers Trump, of course, who as a businessman has been no stranger to nefarious practices. Fortunately, it appears that Powell recognizes the importance of well-designed financial regulations.
But politicization of the Fed should be viewed as just another part of Trump’s battle against what his former chief strategist, Steve Bannon, has referred to as the “administrative state.” That battle, in turn, should be viewed as part of a larger war against the Enlightenment legacy of science, democratic governance, and the rule of law. Upholding that legacy entails employing expertise as needed, and creating, as Edward Stiglitz of Cornell Law School has emphasized, trust in public institutions. A large body of research now supports the idea that societies perform more poorly without such trust.
Every few days, Trump does something to rend the fabric of US society and inflame its already-deep social and partisan divisions. The clear and present danger is that the country is growing so accustomed to Trump’s outrages that they now appear “normal.” For more than seven decades, America has fought – often fitfully, to be sure – to redeem its stated values, taking on bigotry, fascism, and nativism in all their forms. Now, America’s president is a misogynist, racist xenophobe whose policies embody profound contempt for the cause of human rights.
One may approve or disapprove of the Republicans’ tax proposals, efforts to “reform” health care (oblivious to the tens of millions who might lose insurance coverage), and commitment to financial deregulation (ignoring the consequences of the 2008 crisis). But, while the Fed may be safe for now, whatever possible economic benefits this agenda could bring pale in comparison to the magnitude of the political and social risks posed by Trump’s assaults on America’s most cherished institutions and values.
Donald Trump’s Federal Reserve
Jerome Powell, US President Donald Trump's pick to succeed Janet Yellen as Fed Chair, will face some extraordinary challenges at the outset of his five-year term. But the greatest challenge of all will be to stay out of Trump's shadow and uphold the Fed's independence.
CAMBRIDGE – With the appointment of Jerome Powell as the next Chair of the United States Federal Reserve Board, Donald Trump has made perhaps the most important single decision of his presidency. It is a sane and sober choice that heralds short-term continuity in Fed interest-rate policy, and perhaps a simpler and cleaner approach to regulatory policy.
Although Powell is not a PhD economist like current Fed Chair Janet Yellen and her predecessor, Ben Bernanke, he has used his years as an “ordinary” governor at the Fed to gain a deep knowledge of the key issues he will face. But make no mistake: the institution Powell will now head rules the global financial system. All other central bankers, finance ministers, and even presidents run a distant second.
If that seems hyperbolic, it is only because most of us don’t really pay attention to the Fed on a day-to-day basis. When the Fed gets it right, price stability reigns, unemployment remains low, and output hums along. But “getting it right” is not always easy, and when the Fed gets it wrong, the results can be pretty ugly.
Famously, the Fed’s efforts to tame a stock-market bubble in the late 1920s sparked the Great Depression of the 1930s. (Fortunately, of the candidates Trump was considering for the Fed post, Powell is the one least likely to repeat this mistake.) And when the Fed printed mountains of money in the 1970s to try to dull the pain of that decade’s oil shocks, it triggered an inflationary surge that took more than a decade to tame.
At times, the rest of the world seems to care more about Fed policy than Americans do. Little wonder: perhaps more than ever, the US dollar lies at the heart of the global financial system. This is partly because much of world trade and finance is indexed to the dollar, leading many countries to try to mimic Fed policies to stabilize their exchange rates.
Powell will face some extraordinary challenges at the outset of his five-year term. By some measures, stock markets look even frothier today than they did in the 1920s. With today’s extraordinarily low interest rates, investors seem ever more willing to assume greater risk in search of return.
At the same time, despite a strongly growing US and global economy, inflation remains mystifyingly low. This has made it extremely difficult for the Fed to normalize policy interest rates (still only 1%) so that it has room to cut them when the next recession hits, which it inevitably will. (The odds of a recession hitting in any given year are around 17%, and that seems like a good guess now.)
If Powell and the Fed cannot normalize interest rates before the next recession, what will they do? Yellen insists that there is nothing to worry about; the Fed has everything under control, because it can turn to alternative instruments. But many economists have come to believe that much of this is smoke and mirrors.
For example, so-called quantitative easing involves having the Fed issue short-term debt to buy up long-term government debt. But the US Treasury owns the Fed, and can carry out such debt purchases perfectly well by itself.
Some argue for “helicopter money,” whereby the Fed prints money and hands it out. But this, too, is smoke and mirrors. The Fed has neither the legal authority nor the political mandate to run fiscal policy; if it tries to do so, it runs the risk of forever losing its independence.
Given that monetary policy is the first and best line of defense against a recession, an urgent task for the new chair is to develop a better approach. Fortunately, good ideas exist, and one can only hope that Powell will quickly move to create a committee to study long-term fixes.
One idea is to raise the Fed’s inflation target. But this would be problematic, not least because it would breach a decades-long promise to keep inflation around 2%. Moreover, higher inflation would induce greater indexation, ultimately undermining the effectiveness of monetary policy. Paving the way for effective negative-interest-rate policy is a more radical – but by far the more elegant – solution.
Bank regulation is also part of the Fed’s mandate. The 2010 Dodd-Frank financial-reform legislation, which has spawned 30,000 pages of rules, has been a boon for lawyers. But the massive compliance costs ultimately fall on small and medium-size businesses. It would be far better simply to require banks to raise much more of their resources in equity markets instead of through bonds. That way, shareholders, not taxpayers, would take the big hit in a crisis.
I have not mentioned the elephant in the room: the threat to the Fed’s independence posed by a president seemingly intent on challenging all institutional norms. When President Richard Nixon was intent on being re-elected in 1972, he put heavy pressure on then-Fed Chair Arthur Burns to “juice” the economy. Nixon was re-elected, but inflation soared and growth collapsed. No one should be wishing for a replay – even if Nixon eventually was impeached.
The Perils of a Trumped Fed
The US Federal Reserve has spent decades establishing its credibility as an apolitical guarantor of growth and stability. But now that US President Donald Trump has a chance to pack the Fed Board with his own appointees, the institution's tradition of careful, dispassionate economic stewardship could come to a sudden end.
ITHACA – While he attempts to overhaul American tax, trade, and immigration policies, President Donald Trump is mulling over a set of decisions that could prove even more consequential for the US economy. With Federal Reserve Vice Chair Stanley Fischer having retired this month, three of the seven seats on the Fed Board of Governors are now vacant. And in February 2018, Fed Chair Janet Yellen’s first term will end, giving Trump a unique opportunity to stamp his brand on the institution.
Trump’s nominees to fill these positions, and how he goes about choosing them, could have an enduring impact not just on the Fed, but also on the US economy and its central position in the global financial system.
The Fed’s credibility has been methodically and painstakingly established over the course of many decades. A case in point is former Fed Chair Paul Volcker’s decision, in the early 1980s, to hike interest rates and accept a temporary increase in unemployment. Had Volcker not acted, the US would have suffered from spiraling inflation. Volcker’s move induced the short-term pain; but it also bolstered the Fed’s long-term credibility.
Inflation is driven by many factors that the Fed cannot control, including productivity, foreign prices, and government deficits. But expectations about the future can also play a key role. When firms and workers think the Fed is not committed to holding down inflation, inflation tends to rise.
The same is true for deflation. At first blush, falling prices for goods and services may sound like a good thing. But deflation can be disastrous. When prices are expected to fall, consumers will hold off on making purchases, and businesses will postpone investments. These decisions can then create a vicious cycle in which falling demand leads to reduced employment, growth, and prices, causing demand to fall further.
After the 2008 global financial crisis, many countries faced the specter of deflation. But, thanks to the Fed, the US avoided both severe deflation and inflation, and recovered faster than most other advanced economies. The Fed managed to ward off deflation in the US by aggressively loosening monetary policy. At the time, many economists feared that a rapidly expanding money supply and sharply rising government debt would fuel inflation and weaken the dollar. But these fears proved unfounded, and the Fed’s credibility was bolstered once again.
The Fed’s credibility is what underpins the US dollar’s dominance in international finance. About two-thirds of global central banks’ foreign-exchange reserves – that is to say, their rainy-day funds – are invested in dollars. And foreign investors, including central banks, hold more than $6 trillion in US government securities, up from $3 trillion a decade ago. The dollar’s status as the main global reserve currency has helped to keep US interest rates low, thus reducing borrowing costs for US consumers and the US government.
The Fed’s independence, along with the US’s institutionalized system of checks and balances and its adherence to the rule of law, is crucial for sustaining investors’ confidence in the dollar. Yet the Trump administration is weakening the checks and balances between the executive and legislative branches of government, and his indifference to the rule of law could pose a direct challenge to the judicial branch. Under these circumstances, any act that undermines the Fed’s independence could seriously damage the institutional framework upon which US economic strength rests.
The Fed has international credibility precisely because it is independent from any political master. But the Fed also has legitimacy, because it is accountable to the government and to the people. That accountability is, or at least should be, based on pre-established economic targets – namely, low inflation and unemployment – rather than on the political whims of whoever is in power at a given moment.
From this perspective, Trump could seriously damage the Fed’s credibility. He need only appoint political loyalists instead of the best available technocrats; or appoint competent technocrats whom he has cajoled into professing personal loyalty to him, rather than to their mandates as Fed governors.
A Fed dominated by Trump acolytes might prioritize economic growth over other objectives, such as maintaining financial stability and low inflation. But while this approach may boost GDP growth for a brief period, it would hurt growth in the long run, by fueling inflation and financial-market instability.
Another danger is that Trump will get his wish for a weaker dollar – permanently. Even the mere possibility of reduced faith in the dollar, alongside higher inflation, could push up interest rates, leading to larger budget deficits, lower growth, and an inflationary spiral.
If Trump does try to press the Fed into the service of his own political agenda, he could do irreparable harm to an institution that ensures financial stability, low and stable inflation, and sustainable growth. Rather than putting “America first,” he would be undercutting the dollar’s status as the dominant global reserve currency, and clearing the way for others to fill its role in global financial markets.
How Stable Is the Global Financial System?
There is little disagreement that the immediate response to the 2008 financial crisis averted another Great Depression. But whether the safeguards in place today are enough to prevent a similar large-scale disaster remains an open question.
SANTA BARBARA – Just over a decade ago, on August 9, 2007, the French bank BNP Paribas limited investors’ access to three of its money market funds, worth a total of around $2.2 billion. The BNP freeze was unprecedented, but it received little attention outside the financial world at the time.
It would later prove to be the canary in the coal mine. In the months that followed, payment systems and capital markets seized up everywhere, and the global financial system narrowly avoided total collapse. By late 2008, the world was facing the worst economic crisis since the Great Depression.
Even after a decade and as the US Federal Reserve, the Bank of England, and the European Central Bank begin to normalize interest rates and move away from the extraordinary policies (quantitative easing in particular) used to confront the crisis, we are still trying to decide what lessons to draw from that near-death experience. And while much has been done to reduce the risk of a repeat performance, a critical question remains: Are we safer now than we were ten years ago?
Whether or not recent policy reforms are enough to sustain global financial stability is a matter of intense debate – one in which Project Syndicate commentators have been prominent participants all along.
How It Happened
Few would question the advantages of an open, competitive global financial system. Broad, deep, and resilient financial markets are essential to keeping the wheels of global commerce turning. They help savers diversify risk, and enable borrowers to obtain credit at lower cost. And they confer the benefits of convenient exchange and capital certainty on everyone.
But a global financial system also has distinct disadvantages. Above all, it is prone to crisis. As former US Federal Reserve Chairman Paul Volcker pointed out in 2012, all “financial systems, whether in Asia in the 1990s or a decade later in the United States and Europe, are vulnerable to breakdowns.”
Crises can take a long time to develop. But once they erupt, Allianz chief economic adviser Mohamed El-Erian explains, “they tend to spread rapidly, widely, violently, and (seemingly) indiscriminately,” as “overall financial conditions quickly flip from feast to famine.” We know this because such crises have been a recurring, painful feature of financial markets ever since the first banks emerged in the city-states of Renaissance Italy. Of course, like Leo Tolstoy’s unhappy families, each “unhappy in its own way,” the particulars of financial crises will always differ, with each inflicting its own type of pain.
In a nutshell, BNP Paribas’s canary drank itself to death, as global capital markets binged on debt. Most observers agree that the crisis started in the US, with the swelling of a real-estate bubble that ultimately burst in mid-2007. But subprime mortgages in America were only the tip of the iceberg. Beneath the surface, massive accretions of risky derivative claims had been allowed to pile up worldwide, as investors and institutions sought ever-more liquidity and leverage. Once asset prices began to sink, many claims became toxic. And when everyone dashed for the lifeboats, they almost capsized the ship.
More fundamentally, notes Stefan Gerlach, a former deputy governor of the Central Bank of Ireland, the crisis was due to “a combination of weak internal risk management and inadequate government regulation.” On the one side were bankers and others who, convinced of their own financial acumen, had become increasingly blind to the dangers latent in recent market innovations. And on the other side were national supervisory authorities inclined to leave the sector to its own devices and trust that it would self-correct as needed.
In hindsight, it is clear that both sides let themselves be seduced by the relative calm that had prevailed since the 1997 Asian financial crisis. In an era that became known as the Great Moderation, notes Jim O’Neill, a former chairman of Goldman Sachs Asset Management, “complacency had set in.” This sanguine mood was captured by the tongue-in-cheek title of a serious 2009 book by Harvard University’s Carmen Reinhart and Kenneth Rogoff. In This Time is Different, Reinhart and Rogoff showed that the run-up to the latest crash wasn’t really different at all. It was part of an age-old pattern.
All Hands on Deck
At the height of the crisis in 2008, Harold James of Princeton University recalls, politicians concluded “that they could not rely on business as usual.” In order to prevent a total collapse, most of the G20 governments – including the two largest economies, China and the US – “launched large-scale stimulus programs.” At the same time, central banks stepped in “to provide liquidity on a massive scale” for frozen financial markets. Remarkably, these initiatives worked. The so-called Great Recession actually turned out to be a brief v-shaped downturn, after which global growth resumed, albeit haltingly, and monetary conditions stabilized. Government leaders, James concludes, “were right to pat themselves on the back for having prevented a repeat of the Great Depression.”
This was particularly true of the Fed, which quickly stepped in as a global lender of last resort, by agreeing to currency swaps with 14 other central banks, so that they could meet their economies’ demand for dollars. At its peak in December 2008, the Fed’s outstanding credit under these arrangements totaled $580 billion, together with an additional $500 billion or more through various programs to support private banks abroad. As James wrote in 2014, the Fed “effectively emerged from the crisis as the world’s central bank.”
Once it became clear that another Great Depression had been averted, policymakers shifted their attention to the financial sector, where, as Antonio Foglia of the Institute of New Economic Thinking points out, “around half of the 101 banks with balance sheets larger than $100 billion as of 2006” had failed. The ensuing reforms, Simon Johnson of MIT Sloan explains, focused primarily on financial institutions that “were so large relative to the economy that they were ‘systemically important’ and could not be allowed to go bankrupt.”
To a surprising degree, notes Howard Davies, the Chairman of the Royal Bank of Scotland, “Governments that had been suspicious of international interference” were suddenly “eager for tougher global rules to prevent banking crises from spilling across borders and infecting others.” Those rules would come from global standard-setters such as the Basel Committee and the Financial Stability Board (FSB), which was established in April 2009 as an expanded version of the old Financial Stability Forum. The Basel Committee, operating under the aegis of the Bank for International Settlements, issued a broad set of post-crisis banking rules, known as Basel III, in 2010-2011. And the FSB regularly convenes central bankers and financial regulators from more than two dozen countries to monitor global risks and coordinate supervision.
As a result of these efforts, banks in advanced economies are now required to bolster their risk-absorbing capital reserves, clean up murky balance sheets, increase liquidity, improve transparency, narrow the scope of high-risk activities, and realign internal incentives to discourage reckless behavior. Moreover, governments now conduct regular “stress tests” to assess financial institutions’ solvency. And, under the 2010 Dodd-Frank Act, the biggest US banks are obliged to develop “living wills” to ensure an orderly bankruptcy.
El-Erian speaks for many when he declares that “ongoing efforts to buttress the global financial system have undoubtedly paid off, especially when it comes to strengthening capital cushions and cleaning up balance sheets.” But he is quick to note that “it is too early to declare victory.” Similarly, Gerlach cautions against overestimating “the crisis-preventing power of the new regulatory environment.” For him, “the danger of another financial crisis” cannot be ruled out, given the systemic risks that remain.
For example, Mark Roe of Harvard Law School identifies “a serious weakness in the global financial system’s architecture” that still has not been addressed: “the trillion-dollar overnight repo market in housing mortgages.” According to Roe, reforms to this area of the financial sector fall short, “largely because they depend on the authorities and the banks to complete a complex and untested repayment process within 48 hours of a bank’s collapse.” If an “economy-wide financial event” occasions the “simultaneous collapse of multiple financial firms,” he warns, this process would be “extremely difficult,” if not impossible, to complete. Roe worries that when the US housing market retreats, as it eventually must, “financial stability could be threatened” once again.
Similarly, Johnson contends that, despite Dodd-Frank’s living-will proviso, “there has been almost no progress in terms of ensuring that large financial firms actually can go bankrupt.” American legislators have effectively reached a stalemate over how best to “finish this important piece of Dodd-Frank business.” And as New York University’s Nouriel Roubini reminds us, banks are confronting a number of new challenges, such as “the rise of financial technology that threatens to disrupt their already-challenged business models.”
More broadly, notes Nobel laureate economist Robert Shiller, no policy responses to the last crisis “can anticipate all the kinds of change in narratives that underlie public animal spirits.” He worries that even though the world’s 24 largest economies have formally agreed to adopt Basel III’s risk-based capital requirements, those mandates “may not be high enough.” And, at any rate, “there has been much less progress in a dozen other regulatory areas that the FSB tabulates.”
Indeed, according to the FSB’s latest annual progress report, adoption of Basel III standards on leverage, funding, and other areas has been spotty, at best. The problem, according to Davies, is that “many countries, while ostensibly supporting the development of tighter global rules, have been taking other measures to protect their own financial systems.” Thus, from his perspective, “the future for global standards looks more uncertain than it has for some time.”
Another problem is that US and eurozone regulators disagree on the role that a bank’s internal models should play in measuring its assets. Because US and European financial institutions have different lending practices and asset portfolios, negotiations over this issue have dragged on for years. Given these hurdles, a degree of caution seems warranted. The defenses in place today are certainly better than they were before. But no one can account for every possible contingency that might befall the banking sector. Shiller is right to warn that unforeseen events “may once again reveal chinks in our financial armor.” Bankers and regulators alike should heed the Boy Scout motto: Be prepared.
Another area of concern lies outside of formal banking. By focusing so intently on traditional banks, governments may be overlooking other potential threats, like a general who prepares for the next war by reenacting the last one. Gerlach, for his part, analogizes the current “regulatory environment” to “a new highway: It is technically safer than a country road, but it also attracts more cars that are traveling at much higher speeds, so traffic accidents continue.”
Once we start looking for threats on the road ahead, they are not difficult to see. For example, Shiller points to the danger of money market funds, which offer “somewhat higher interest rates, but without the insurance that protects bank deposits in many countries.” Money market funds have increasingly become “an alternative to banks for storing one’s money,” and could be ruined “if a large number of people try to withdraw their money at the same time.” It is as if we had traveled back in time to the nineteenth-century era of wildcat banking.
Similarly, El-Erian worries about the unintended consequences of banks being subjected to tougher rules than non-banks. He points out that “more carefully regulated banks have ceased certain activities,” only to be replaced “by non-banks that are not subject to the same supervisory and regulatory standards.” Moreover, he describes “certain segments of the non-bank system” as being “in the grips of a ‘liquidity delusion.’” In the absence of proper supervision, companies are offering products that “risk over-promising the liquidity they can provide for clients transacting in some areas – such as high-yield and emerging-market corporate bonds – that are particularly vulnerable to market volatility.”
And then there are the dangers that we have not yet detected, what former US Secretary of Defense Donald Rumsfeld famously called “unknown unknowns – the ones we don’t know we don’t know.” Somewhere in the complex recesses of global finance, there are almost certainly unknown unknowns that could trigger a new crisis. “[I]t would be premature,” El-Erian rightly warns, “to assert that we have put all the risks confronting the financial system behind us.”
Central Bankers Gone Wild
A third area of concern is monetary policy. Central banks played a key role in rescuing the global economy back in 2008-2009, by pumping enough liquidity into the system to keep it afloat. But many observers now fear that central banks wouldn’t be able to muster such a response again, if needed.
Central banks are inherently conservative, and can be slow to react in the face of sudden shocks. And as Davies reminds us, they “were widely seen to have been dozing at the switch through the early years of this century.” In addition to allowing “global imbalances to build up,” central bankers “looked benignly on a massive credit bubble, ignored flashing danger signs in the mortgage market, and uncritically admired the innovative but toxic products devised by overpaid investment bankers.” When the collapse came, the minders of the money were as surprised as anyone.
Moreover, many central banks’ initial reaction to the last crisis was sluggish and unsure. Davies, not without a touch of sarcasm, observes that, “The Bank of England lectured on moral hazard while the banking system imploded around it, and the European Central Bank continued to slay imaginary inflation dragons.” Not until the Fed stepped in did other central banks become more proactive.
Whether central bankers have learned from their mistakes remains to be seen. Yale’s Stephen Roach surmises that they have not. Indeed, once they launched unconventional policies such as quantitative easing (QE) and ultra-low interest rates, they couldn’t stop. All of the excess liquidity being pumped into financial markets, he warned in September 2016, was encouraging “reckless risk taking,” and creating an “environment of asset-based excess” not unlike that which “incubated the 2008-2009 global financial crisis.”
Of course, in the absence of sustained fiscal stimulus after the Great Recession, unconventional monetary policies were arguably justified by the need to keep a sluggish recovery from faltering. And in September of this year, the Fed announced that it would finally begin to shrink its bond holdings, and hinted that another modest interest-rate increase could come as soon as this December.
Still, Roubini worries that, with the benchmark rate at 1-1.25% today, “even if the Fed can get the equilibrium rate back to 3% before the next recession hits, it still will not have enough room to maneuver effectively.” In the case of another downturn, he warns, “[i]nterest-rate cuts will run into the zero lower bound before they can have a meaningful impact on the economy.” Echoing this point, Gerlach argues that “the tools available to central banks to prevent deflation and a collapse of the real economy are severely constrained.” That means that “if a financial crisis were to occur today, its consequences for the real economy might be even more severe than in the past.”
Complicating matters further, central bankers have become the targets of a public backlash. Having acquired far-reaching macroeconomic and regulatory powers after the 2008 crisis, they are now seen as “over-mighty citizens” in need of more oversight. As Davies puts it, “an institution buying bonds with public money, deciding on the availability of mortgage finance, and winding down banks at great cost to their shareholders demands a different form of political accountability.”
The problem is that political oversight, unless it is “designed with extraordinary care,” could undermine central-bank independence. And even the mere threat of lost independence could make central bankers more hesitant to use all of the tools at their disposal, even when circumstances demand it.
The Post-Crisis Ebb
This points to the role of politics in determining whether our economic systems are safe today. The 2008 crisis was immediately followed by a wave of public support for reform, which crested in 2010-2011 with the Dodd-Frank Act and the Basel III agreement. But as memories of the near-death experience have faded, so has enthusiasm for reform. The danger now is that badly needed follow-up measures will not be enacted. “The political window of opportunity for bold actions,” El-Erian laments, has “essentially closed.”
One such action would be to strengthen the FSB, which, as Ngaire Woods of Oxford University points out, “has no legal mandate or enforcement powers, nor formal processes for including all countries.” But proposals to expand the FSB’s mandate have met with indifference. For the time being, Woods concludes, the FSB will remain “a ‘standard setter’ in a world with strong incentives to evade standards and negligible sanctions for doing so.”
Worse, there is now mounting political pressure to reverse key post-crisis reforms. US President Donald Trump has not hidden his distaste for both Dodd-Frank and Basel III. “Making America great again,” Davies muses, “is not likely to involve new enthusiasm for more intrusive rules.”
Indeed, almost immediately upon taking office, Harvard University’s Jeffrey Frankel writes, “Trump issued an executive order directing a comprehensive review of the Dodd-Frank financial-reform legislation,” with the goal of scaling back “significantly the regulatory system put in place in response to the 2008 financial crisis.” Then, in June, the US Treasury Department published a 150-page paper detailing the Trump administration’s proposals to deregulate large financial institutions. The plan prompted an immediate public rebuke from both Fed Chair Janet Yellen and her vice chair, Stanley Fischer, among many others.
At the international level, Davies argues that banking rules could stand to be rationalized, given that they have grown in complexity since 2008. But that is not to support “a return to a pre-crisis free-for-all.” Once the political pendulum begins to swing back toward deregulation, financial institutions can be counted on to press for as much leeway as possible. Sooner or later, the age-old pattern of hubris, vulnerability, and crisis will re-emerge, and another canary will die.