Forum Post: Solutions rest upon legal reform
Posted 13 years ago on Oct. 28, 2011, 8:37 p.m. EST by jhoffman
(22)
This content is user submitted and not an official statement
The Monetary base which is largely controlled by the Federal Reserve adjusts with the changes in interest rates with the goal of effecting the Greater Money Supply(M3 series). In the previous decade the Federal Reserve started out by slashing interest rates to historical lows, but by 2003 it was clear that central banking policy was centered on raising the Fed’s fund rate. Thus by 2006 a series of interest rate hikes brought the Federal Funds rate to be around 5%. Therefore It should be assumed that the monetary base(M2 series) should have decreased in the middle of the Decade. After looking at various charts published both by Federal Reserve board of Governors and independent sources it is confirmed that this did indeed occur. Henceforth, shouldn’t it also be probable to conclude that if the monetary base decreases shouldn’t the greater money supply do the same as well? Under particular circumstances the answer may be a yes, but In more recent times the more correct answer would probably be a no. This is because as the Decade wore on both bank and non-bank entities became increasingly dependent on the Shadow Banking Industry. This industry is primarily composed of non-depository banks that grew rapidly after the year 2000. These non-banking institutions primarily consist of investment banks, and insurance companies, but can also be separate divisions in a company. For example J.P Morgan Chase not only engages in investment banking, but has also used Credit Default Swaps in conjunction with other companies as an insurance policy. Therefore the Shadow banking industry in the previous decade was not only compromised by major lending institutions not backed by the FDIC, but also institutions that operated as a lender of last resort. The most important observation to made here is that because the Shadow Banking Industry became the dominant lending institution it should be of no surprise that the greater money supply operated separately from changes in the monetary base. This is because the M3 money supply, which is separate from the monetary base, is M1+M2+ large time deposits, liquid assets, and money market funds, and all three of these things after M2 Increased after the mid 2000’s. Therefore large financial institutions began to increase their portfolio with riskier assets and acted as a lender of last resort while ignoring Federal Reserve Interest Rate policy. Although the gap between changes in interest rate policy, and the greater money supply are slightly more pronounced then some economists assume, it is still a generally observed principle that an increase in interest rates should inform firms and consumers to tighten up. For the most part this did occur and proof of this is derived from the fact that consumer spending and the velocity of money began to decrease in the middle of the decade. Thus Federal Reserve Policy may have indeed reigned in consumer spending, and tightened the chord around regular loans, but their policy had no effect on the Shadow Banking System. A system comprised of massive financial institutions like Bear Stearns, AIG, JP Morgan, and Goldman Sachs. All of these institutions operated as commercial banks, investment banks, and insurers. Therefore not only did these financial institutions operate as primary lenders that eclipsed the role of central bank policy, but most importantly they operated as lenders of last resort(insurers). Thus the Shadow banking system operated beyond monetary policy because of financial practices, and debt instruments that were constructed in a manner that could operate beyond central bank policy. Furthermore as these major loans begin to pick up, and thereby leading to increase in the Greater Money Supply it was done so without any risk protection. For example when JP Morgan operated as an insurer and bailed out Exxon it did so without being backed by the FDIC. Such Credit Default Swap loans were common place through out the decade, and by simply being an insurer to another company it is easy to see how monetary policy probably had a very small effect in changing the direction of the Greater Money supply.
The possible remedies to the current financial crisis are numerous, but should all be categorized under two goals. The first being creating policy that will put Americans back to work, and secondly changing the law in order to ensure that a similar financial crisis does not reoccur. In order for the unemployment rate to decline government policy should be premised upon the goal of increasing consumer spending. When this is done it provides business with the incentive to create new goods, and hire new workers. This can be done through tax cuts, direct government spending, and even more obscure ideas like the implementation of stamped money. These are all things that the government can do in order to fill in the out-put gap and therefore create the pre-conditions needed to produce the brighter side of the business cycle. The second thing that needs to be done is that government needs to pass laws that protect the general public from systematic risk, and prevent the contagion of stock market collapses from spreading. This is important because throughout the 20th century the Stock Market crashed almost a dozen times, but only three of those crashes caused a recession. This is important to highlight, because prior to the 2000’s the stock market, and the speculation of investors routinely created Asset bubbles, but when these bubbles popped they rarely affected all aspects of the market. This is probably due in part because prior to the 2000’s most Asset’s were not so heavily intertwined with housing, and therefore speculation on these Asset’s posed little risk to the economy as whole. Thus if things are to change the first issue that needs to be addressed is creating laws that ensure markets are not so interconnected, and finally introducing policy that will curb speculation. Ensuring that the housing market in the future will be protected from systematic risk may require tighter regulation of the shadow banking system for reasons discussed previously, and therefore this part will be skipped over so that the concept of speculation is explored. Speculation in the economy is premised upon the idea that the value of a good or asset will continually increase, and therefore investors whom are working off this assumption will incur a debt in order to invest in this asset. Investors take this risk because they are assuming that their investments will more then likely pay off their loan, and create a profit. This poses a risk though, because if they are wrong then they are left in a position where they are unable to pay off their creditors. Henceforth when the housing market finally began to depreciate in value, investors were unable to pay off their loans, and therefore many lending institutions were unable to gain payments for their loans. This is a rather simple explanation and although the 2007 financial crisis was caused by more complex reasons, it did indeed arise because of asset speculation. In general Speculation has always been the primary reason as to why a financial bubble occurs, and the practice has created these economic phenomena since the 17th century( tulip bubble). Therefore Asset speculation and economic bubbles are a social phenomena that has existed even in pre-capitalist time periods, but what is important is that this kind of investment behavior does not always cause the economy to collapse because in many cases different sectors of the economy were not so dependent on investor speculation. Upon further observation two conclusions can be made from this. The first being that speculation may indeed be a primary culprit in causing a recession only if stock markets are highly interconnected with the rest of the economy. The second conclusion being that if speculation has always produced a negative result then policy must be introduced to curb this kind of behavior.
The idea of curbing speculation relies on tax policy because generally tax’s effect investment behavior. One such a Idea is a multilateral Tobin-Tax system which would directly effect international trading in regards to currency transactions. In General Speculation is an inherent feature of those investment agencies whom play the stock market, and therefore the practice can not be abolished. Thus The legal remedy here should primarily rely on changing the law so that when Asset Bubbles do occur, the general public can continue their affairs without worry about the financial contagion spreading into their every day life. For example prior to deregulation we had a legal system that ensured Stock Market crashes would not bring down the entire system. Case in point, the 1987 stock market crash was considered at the time to be far worst then the stock market crash of 1929, but the effects it had in the real economy were anything but a great depression. Henceforth in order for an economy to thrive it must rest upon a legal structure that protects the general public from the fallout of a financial crisis.
The total sum of these three passages imply that the financial institutions which came to dominate Wall Street in the early part of the 21st century not only operated as a defacto FDIC, but also managed to eclipse Federal Reserve Monetary Policy in importance. In Brief such companies as Goldman Sachs, Morgan, and AIG now stand not only as the most powerful financial institutions but also have replaced and become immune to institutions that were designed to prevent economic panics.
Finally as to why all of this is important primarily has to do with two things. The first being that many of these huge loans compromised the primary component in generating the previous decades increases in the M3 money supply, and was done so despite an increase in the Federal Funds rate. In general whenever the money supply increases and as long as the velocity of money is stable inflation should increase. As a result of Fed Policy Price Inflation continued its historically low trend that it has incurred since the 1980’s, while at the same time the velocity of money decreased. Henceforth The Federal Reserve did indeed achieve what it was supposed to do by controlling price inflation, but unfortunately the Increase in the M3 supply on behalf of the Shadow banking Industry allowed for Asset Price Inflation to go beyond the real value of many of these assets. In turn as the M3 money supply increased, financial institutions continued to overvalue the price of many Assets whether they be mortgages or credit default swaps. In brief the Federal Reserve had almost no barring on this financial crisis, primarily because speculation in the financial markets fuelled by the M3 money supply were largely a result of the Shadow Banking industry. Therefore during this entire decade arguably the most powerful institution in regards to finance being the Federal Reserve was almost entirely overshadowed by the abilities of the Shadow Banking System. Sometimes it is often mind boggling to wonder how the Federal Reserve could be second in importance compared to this unregulated banking industry. The only other historical example that could possible compare is the financial structure of the 1920’s or the wildcat banking system in the 19th century.
Perhaps the greatest example of lending institutions being the dominant factor in all of this came about when Alan Greenspan had already given a speech that interest rate policy was going to increase. This is because in the Same Speech he suggested that homeowners should switch to Adjustable Rate Mortgages. Traditionally, and for many good economic reasons federal reserve chairmen should never suggest what financial assets to invest in, but most importantly Greenspan’s statements imply that lending institutions should be allowed to operate separately, and go in a different direction from central bank policy. In brief the Shadow Banking System which came to dominate wall street in the recent decade operated in an environment that allowed them participate without adherence to central banking policy, and absurdly create a loose lending/credit/M3 environment with approval from Alan Greenspan. Therefore the entire decade operated under the ability of financial institutions to not only buck the trend, but win approval from individuals that clearly implemented monetary policy which would have reigned in all of that speculation.