Fed/Treasury combine – good or bad?

I came across two good perspectives from Peterson Institute on the recent crisis. One is by Morris Goldstein and other by Adam Posen.

Goldstein discusses Fannie/Freddie, Lehman, AIG and the future of financial regulation. Posen focuses on AIG and damaged US leadership.

Goldstein says we are in the middle of the crisis:

Well, I think you know we’re probably only midway through this crisis. There are various ways you can look at it to see sort of where we are. One way is to look at previous banking crises in industrial countries and large emerging markets. And if you do that, what you see is once you have one of this crises, economic growth usually stays below potential for two or three years after the onset of the crisis.

So if you say that this crisis started last summer, let’s say August 2007, then we’re talking about it not being over until the middle of 2009 or maybe 2010. That’s one indicator. A second one you can look at is, look at the scale of write-downs relative to your estimate of ultimate credit losses. We’ve had about 500 billion written down. And now, it looks like the ultimate credit losses, not just subprime but everything—consumer loans, commercial real estate, et cetera—is going to be perhaps a trillion or so.

His solution for future reform:

  • One is we need an international quantitative standard for liquidity for banks and investment houses.
  • we need to overhaul the ball to capital regime for banks. We need to make it countercyclical, not pro-cyclical.
  • We need to raise capital requirements; that’s very important.
  • We need to improve the incentives in the securitization model.
  • The covered-bonds idea is a good idea for the mortgage market.
  • We’ve got to change Wall Street compensation.
  • As I mentioned earlier, we got to have a clearing house for our OTC derivatives.

Final words of wisdom:

Well, I think the more serious the crisis, the better the prospects for reform. And I think, by this time, almost everybody is saying, “Never again. We’ve got to have something different. And we’ve got to change the regulatory structure.”

 

This is true across the world.

Both disagree on the Treasury-Fed combine on the crisis.

 

Goldstein: I think the level of cooperation has been pretty good. I don’t think that’s the main problem with the crisis. I mean, they all seem to be on the same page. We’ve seen a lot of coordination on liquidity support. So I think unlike in some earlier episodes, I don’t think this is really something we have to worry about too much. Trying to get a common answer on what to do about regulatory reform, which is the longer-term issue, I think is going to be more troublesome.

Posen: The usual reaction to this kind of bailout, although there’s never been one on this scale, is initial relief and long-term worry. Everyone’s initially relieved because this buys time to unwind the positions of AIG so assets don’t get dumped on the market, further cutting off credit and value for everybody else.

But over the long term, people get worried because then this tends to erode the Fed’s credibility, that they’re focused on price stability, that they’re willing to let the market take its slumps…

 

So short term, everyone breathes a sigh of relief. Long term, everyone worries a little more.

 

Interesting times.

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