Long-Term Economic Challenges*
Remarks by Charles L. Evans
President and Chief Executive Officer
Federal Reserve Bank of Chicago
Allied Social Science Associations
San Franciso, CA
If I were here to address this group simply as an economic researcher, I might start with something like this. Both the Federal Reserve and the Treasury have taken actions recently in order to address exceptional problems in financial markets. Without these moves, the costs to our financial infrastructure and real economy would have soared far beyond those we are experiencing today. But these necessary actions also have the unfortunate consequence of distorting incentives for future behavior. Unchecked, they could lead to costly future problems in the functioning of markets.
Some might say that incurring such future costs would simply be reaping what is being sown today by ignoring the lessons of the "rules v. discretion" literature. Although I don't subscribe to this view, it does cause me some concern. But, I think the current environment is also one in which we have to worry about the evil agent in Hansen and Sargent's robust control analyses. Recall that the "evil agent" is a parable for how we might end up in states of the world that fall outside of our typical probability distributions and entail huge downside costs to the economy. Robust policy guards against these outcomes, and I interpret the Fed's aggressive and innovative lending programs to be "robust responses" to probability distortions caused by a particularly evil agent.
But, of course, I'm not here to speak simply as an economic researcher so let me give you my perspective as a Fed president instead. As always, these are my own views and not necessarily those of my colleagues in the Federal Reserve System.
Today, the U.S. economic and financial systems are facing their greatest challenges since World War II. Turmoil in the housing market accelerated in the summer of 2007. We have experienced large-scale disruptions to financial intermediation and the destruction of something on the order of ten trillion dollars of U.S. household wealth.1 We are now a full year into a recession: Many non-financial industries are facing substantial risks of long-term structural impairment; and according to most economic forecasts, the unemployment rate will likely exceed 8 percent this year.
Beyond these serious immediate concerns, the U.S. economy is facing a number of diverse and difficult longer-term challenges. First, significant weaknesses have been revealed in our system of financial regulation. Market discipline did not prevent excessively leveraged portfolios and inadequate risk-management, and a patchwork of regulatory authorities failed to curb excessive risk-taking or detect systemic vulnerabilities. These failures call for a reassessment of the roles of market discipline and our regulatory structures in supporting the efficient functioning of financial markets.
Second, the Federal Reserve has undertaken policy actions of historic proportion. We have aggressively cut the federal funds rate, our traditional policy lever. We have also created multiple new lending facilities and transformed the asset side of our balance sheet. And, going forward, we will be expanding nontraditional policies now that the fed funds rate is approximately zero. Accordingly, we are faced with the challenge of calibrating these unfamiliar policies and, in the future, determining the appropriate time and methods for winding them down.
Third, public policy responses have increasingly moved toward fiscal interventions. To date, these have mostly been aimed at improving market functioning: the Treasury's TARP program, FDIC guarantees, and the Hope for Homeowners Act, and other programs to re-work mortgages. Looking ahead, we expect large amounts of more traditional types of fiscal stimulus to increase aggregate demand. I believe a big stimulus is appropriate. But it is also sobering to be deploying large amounts of tax-payer funds at a time when our fiscal balance sheet is already coming under significant stress: The federal debt held by the public is 38 percent of GDP, states have large unfunded liabilities, and growing numbers of retiring baby-boomers will further pressure the unfunded liabilities for Social Security and Medicare. Furthermore—especially in light of current economic difficulties—many taxpayers already consider their tax burdens to be very high.
Finally, the monetary and fiscal policy interventions have been fast-moving and complex responses to extraordinary events. As such, they are difficult to communicate succinctly, require periodic re-calibrations as events change, and are often misunderstood—even by well-informed segments of the public. There is a great need for effective communications and transparency in policy-making. This extends beyond communications with financial market participants. Efforts to enhance the general public's understanding of economic and financial issues are essential. In a democracy, an informed public is critical if government officials are to carry out policies for the public good. So it is important that policy makers and informed private citizens—like you in the NABE—continue to enhance communication efforts.
Although each of these topics is worthy of an extensive discussion, time will allow me to make only a few modest observations on these long-term challenges.
The Future of Market Discipline and Regulation
Market discipline plays a vital role in testing and validating corporate strategies and business execution. In most cases during normal times, financial markets can assimilate the relevant information to provide these important signals to investors. They then serve as a restraint on individual institutions taking undue risks.
But I think we've learned from recent events that the force of market discipline can fail in unexpected ways. The mechanisms are not fully clear, but it seems that in the quiescent period before the current crisis, market prices indicated a high value for residential housing and housing-related investments, such as MBSs and CDOs, with little perceived risk. Markets responded to these signals by increasing their provision of these investments, but with little attention paid to risk management. Then, after the crisis hit, market prices swiftly reversed. Now, they signaled what were arguably extremely low values for these same housing-related securities. It's likely that the true value of these securities lies somewhere between the euphoria of 2005 and the pessimism of 2008, but one could not infer this from market signals. Rather, it seems that these abrupt swings in market valuations were due at least in part to equally abrupt changes in market liquidity conditions. I don't claim to fully understand these changes in liquidity conditions. But the high prices earlier this decade may have been associated with the flood of liquidity into U.S. capital markets from abroad. And the current low valuations may derive in part from reduced liquidity due to balance sheet constraints and counterparty concerns surrounding financial institutions that have suffered significant losses. In any case, it appears that at least in extreme cases, market-liquidity distortions can defeat price transparency. This, in turn can inhibit the effect of market discipline on individual firm behavior.
In times of market stress, price movements are dominated by aggregate risk conditions, rather than the fundamental condition of individual firms. These movements can be driven by many factors. Industries, firms, or financial products which seem unrelated may become unexpectedly interconnected due to deterioration, or simply the perception of deterioration, in the health of one or more key financial intermediaries or market-makers. Separately, financial investors may suddenly reassess the relative risk/return profiles of certain classes of financial instruments and transactions, and may simply adopt a heightened level of risk aversion.
How might we mitigate some of the potentially adverse consequences of such interconnectedness? The futures and derivatives industry is weighing whether privately negotiated derivatives contracts should be centrally cleared or remain collateralized bilaterally among pairs of counterparties. An increasing number of derivatives contracts are now being multilaterally netted by central counterparties, or clearinghouses. Central clearing of such contracts shifts exposures from particular counterparties' balance sheets to the clearinghouse. For example, a significant effort is underway to begin central clearing of credit-default swaps. This effort is a reaction to the lack of transparency that left market participants not knowing which of their counterparties might be liable for large losses on credit-default swap positions. Arguably, this uncertainty caused many market participants to withdraw from trading a wide spectrum of financial instruments in which counterparty performance might be called into question. Of course, centralized clearing does not eliminate performance risk; it simply concentrates it at the clearinghouse. This means the clearinghouse itself becomes a potential single point of failure. Accordingly, adequate capital, good risk-management and prudential oversight are essential for such clearing facilities.
Although forecasting is usually a very difficult task, some forecasts are easier than others. For example, it is not difficult now to predict that financial institutions will face more intense supervision and regulation. Indeed, investment banks and other financial institutions have already agreed to added scrutiny by applying to become bank holding companies. Presumably, the enhanced supervision will take aim at some of the obvious culprits of the recent turmoil. One objective would be to prevent a reoccurrence of imprudent mortgage lending practices: in particular, lending decisions that were not properly based on a borrower's underlying "ability to pay" but instead were viable only if housing prices continued to rise. Another aim would be more realistic assessments of firms' exposures to seemingly remote off-balance sheet assets.
We have also seen that a range of firms and institutions can be systemically important for financial stability. So it seems likely that the scope of financial enterprises subject to "systemic" supervision might need to be expanded as well. Here, too, the regulatory decisions will be difficult. Questions about changes in the treatment of clearing houses, exchanges, hedge funds, and private equity investors must be studied carefully. Furthermore, the types of financial entities that are systemically important may change over time. Of course, tighter regulation carries with it risks that must be taken into consideration, including the potential effect on innovation, the higher financing charges to recover the added costs of regulation, and the possibility that riskier activities may simply shift to off-shore jurisdictions. This latter risk highlights the need for international cooperation and coordination on regulatory reforms.
Discussions about systemic risks lead naturally to the topic of how to respond to asset price bubbles. The first issue in this discussion must be how to identify asset price bubbles. This was the famous question asked by Alan Greenspan in December 1996. It is important to get this right—I continue to be concerned that, as Chairman Greenspan pointed out, an aggressive campaign to fight a perceived asset bubble could entail large downside costs if the assessment proves to be wrong. That said, we are currently bearing enormous downside costs from the fallout from large mortgage-related asset losses, and this fact reinforces the need for changes in policy. My view is that we should concentrate on designing macro-prudential regulatory policies aimed at helping to prevent and protect against the consequences of asset price bubbles. Strong systemic supervision and enhanced market discipline will need to be a part of this design.
Finally, strong supervision and market discipline will periodically determine that a financial institution is no longer viable. So a high-priority issue is the need to design a more efficient and orderly process to resolve the insolvency of large complex non-banking institutions. Such a process should be aimed at reducing the systemic ramifications of an imminent insolvency on the financial system and the economy. This raises a number of questions. What functions and size thresholds should be used to determine which institutions are covered? What are the appropriate triggers to invoke the insolvency resolution process? How should the priority of creditors' claims be established? Should the process include the possibility of a bridge bank type institution established by the regulatory authority? The answers to these questions must also confront the possibility that systemic problems may arise before insolvency, as counterparties may be reluctant to trade with an institution that is in distress.
Fiscal Implications of Policy Actions
The second long-term issue that will influence the future course of monetary and public policy is the quantity of government debt. The Federal Reserve has responded to the financial crisis by establishing a number of lending facilities, which have altered the composition and size of our balance sheet. And the Federal Reserve System has begun outright purchases of GSE debt and mortgage-backed securities to enhance liquidity in those markets and further reduce interest rates. Aggressive fiscal policy responses have also taken place during this recession: the initial tax cut stimulus, the Troubled-Asset Recovery Plan (TARP), FDIC guarantees for senior bank debt, and several programs aimed at delivering relief for troubled homeowners. And more traditional stimulus packages will be coming soon.
For me, the economic rationale is clear: Without these policy actions, the downturn—and its costs to society—would be even more severe than what we are currently facing. They hold open the promise of mitigating the losses in jobs and output during the downturn. And avoiding unnecessary realignments of financial, physical, and human capital would reduce any permanent impairment to the economy's productive infrastructure. Since most economic forecasters envision the current downturn as rivaling the deep recessions of 1974–75 and 1981–85, I think these fiscal programs must be large in order to be effective and to instill badly needed confidence.
No matter how necessary these actions may be, there are some devilishly difficult judgments involved. Our profession needs many constructive voices to remind us all of the effects that these public policies may have on the nation's long-term finances.
By historical standards, our current fiscal debt is not unusually large; but our expected future obligations are enormous. The war on terrorism continues generating great human cost and sacrifice, and mounting government debt. The onset of the baby-boomers' retirement will further pressure intergenerational insurance programs, such as Social Security and Medicare. In addition, many state pension plans are underfunded relative to future obligations. So the value of prudent fiscal management is high.
Communications and Policy Risks
With much of my time used up, I now come to one of the most important challenges policymakers face: communications. While we at the Fed pride ourselves on always conducting extensive, thorough analyses of all economic issues, our efforts to analyze the current situation and design appropriate policy initiatives are probably unprecedented in scope. But policymakers face another very important challenge: In a complex and dynamic environment, the public needs effective and transparent communications. As our lending facilities and other policy responses continue to evolve, this is a daunting task.
It would be nice if we could provide a simple summary of the country's financial predicament. I'll give it a try,—and, you will quickly see that it is inadequate in many ways. Here goes: Many investments and bets were placed on the assumption of ever increasing housing values. These positions were leveraged and amplified by innovative financial engineering based on an overly confident belief that risks could be dispersed to the winds. These beliefs became assurances that were too often accepted by investors, credit agencies, and regulators. All parties failed to see the possibility and extent of systemic vulnerabilities. As the bets turned sour and correlations among seemingly unrelated financial returns increased, losses cascaded into large disruptions to our financial system. These disruptions have negatively affected real economic activity, causing further losses in the financial sector and worsening the disruption. So, policy has responded in a number of new and targeted ways to these financial disruptions with the intention of mitigating the negative impact on economic activity.
As a communications device for explaining why we have transformed and expanded the Fed's balance sheet, this summary is simple but incomplete. It leaves out many critical details and fails to capture three key issues: complexity, speed, and uncertainty.
My earlier comments on market discipline and financial product structure have already touched on the complexity issue, but here's another example. Following the use of TARP funds to inject capital into the banking system, a notable public concern has been the absence of any obligation for banks to lend in exchange for this new capital. We have not done a good enough job in communicating that even though analyses of previous banking crises suggest that capital injections are more likely to unlock lending capacity at banks, it is not beneficial to substitute a policymaker's judgment over a banker's judgment with regard to initiating individual loans. We can productively insert judgment in some broad ways—such as on the supervisory side in questioning risk-management practices—but not on the ex ante review of individual lending decisions.
Turning to speed, it is sometimes necessary to address emerging distress with quick action; and the time between that action and the communication of a full explanation of the events can seem uncomfortably long. We have provided a good deal of information to the public. In the past 18 months, Chairman Bernanke and Secretary Paulson have testified before Congress many times, and Federal Reserve officials have given numerous speeches about our policies. The minutes of our FOMC meetings also provide further context for our actions. And we now publish extended forecasts quarterly, with a commentary describing the forces shaping these outlooks. Still, we should strive to do more.
Undoubtedly, the greatest challenge we face is the enormous uncertainty of this situation. Yes, the irony between "undoubtedly" and "uncertainty" is fully intended here. I discussed the challenges earlier of assessing financial risk from liquidity, credit, solvency or agency sources.
Those are surely large. But I am also thinking of an important observation made by Robert Lucas long ago: As advice-giving profession, we economists are in way over our heads. At any time, this is a sobering and humbling thought to remember. Nevertheless, in the current environment, this reminds me that the pursuit of robust policies in the face of large uncertainties is likely to be most efficacious. A good Bayesian decision maker can't place all of his or her policy bets on a single hypothesized diagnosis when the evidence is still ambiguous. If Hansen and Sargent's evil agent is out there somewhere distorting probability distributions, he is doing a devilishly good job.
The need to act in the presence of ambiguity and such unusual events certainly adds to our policy and communications challenges. These challenges are further compounded by the fact that in order to restore the best balance between market discipline and government intervention, it is important for all of us to recognize that the current situation is a once in a 100-year event, not to be repeated in our lifetimes (or at least not to be expected sooner).
Consequently, I think the communications response must be to "never give up." We need to work very hard to explain the risks that we are facing and the rationale for why we think our policy actions best address those risks. As I alluded to earlier, much digital ink has been spilled in these attempts so far. More is on the way. If ink were fiscal stimulus, we might see a more rapid economic recovery in 2009.
1This figure incorporates rough estimates of changes in household wealth since the end of the third quarter.
*The views presented here are my own, and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.