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State of thought on financial regulation

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I'm at a conference on "Financial cycles and regulation" at the Deutsche Bundesbank. Beyond the individual papers, I find the conversation interesting.Groups of researchers develop a common language and a common set of assumptions. This is productive -- to push a research frontier we have to agree on a few basic ideas, rather than argue ...

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I'm at a conference on "Financial cycles and regulation" at the Deutsche Bundesbank. Beyond the individual papers, I find the conversation interesting.

Groups of researchers develop a common language and a common set of assumptions. This is productive -- to push a research frontier we have to agree on a few basic ideas, rather than argue about basics all the time. I, as an outsider, parachute in, and learn as much what the shared assumptions are, as I do about particular points in elaboration of the program.

Here,  it is pretty much taken for granted that there is such a thing as a "financial cycle." It's in the conference title, after all! That means a "cycle" of credit expansion, usually "unwarranted," "excessive," or an "imbalanced," followed by a bust. It is also agreed that it is the job of financial regulators to manage this "cycle."


In his Keynote speech, Claudio Borio of the BIS described a sort of Taylor rule, in which monetary and financial policies should respond systematically to the "credit gap." Jan Hannes Lang described a model for estimating that "credit gap." Marco Lombardi applied Jim Stock's time-deformation models to characterize the "financial cycle." Michael McMahon showed a very elegant model in which banks over-lend and hence society over-invests in good times. The government bails out in bad times, so the discount factor for investment excludes bad-time outcomes.  (All paper titles at the above program link, papers aren't posted yet but you can google them.)

I parachute in from the outside. Understanding this language and shared set of assumptions is important.  I'm a bit skeptical, of course. Yes, there is regression evidence that large debts and high prices forecast crises. But there is always supply and demand in economics, always the possibility of a boom rather than a bubble. "Large" is not always "excessive." And the passage from an interesting set of historical correlations to structural understanding to something stable enough, and without unintended consequences, for policy exploitation seems to have passed while I was napping. As McMahon pointed out, credit controls in the 1970s were not a huge success. But these are just the skeptical questions of a newcomer. I come to conferences to listen primarily.

My own view is that the crisis was a run, and the central way to stop runs is with lots more capital and lots less short-term debt. Then you can have booms and busts without runs. I note ruefully that capital is under attack in the US, and that 10 years after the crisis, so much for those countercyclical buffers. Karsten Müller presented some nice regression evidence that governments typically loosen regulations just before elections, as the US just did.  Systematic countercyclical capital remains remains a dream in the eyes of many writers especially at the Fed, BIS, and other institutions. Monetary and "macro-prudential" policy that successfully and systematically lowers house and asset price volatility is even further away. How much nicer if the financial system were run-proof and did not require so much management.

At least though, this little discussion reflects a large agreement that capital is the central buffer and so much else in current regulation is not very useful.
John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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