The S&L Crisis Foretold the Panic of 2008, Part II
To me, liquidity is multi-dimensional in the wholesale system, as the ability to hedge and design risk parameters can be just as much of an impediment as it is to find "cash" funding in overnight markets - arbitrage opportunity itself is not enough. I would argue, again, that Bear's (and Lehman's, and especially AIG's) pending bankruptcy had as much to do with that as it had to do with funding market constraints. Indeed, that was the entire purpose of funding market tightness as "agents who are in surplus" existed at that moment but refused to engage regardless of the "ultimate payment constraint."
From that, even though I disagree with the remedy proposed, I think Mehrling absolutely nails the systemic focal point (which demonstrates the complexity here, as we can look at the same process almost identically and come to very different conclusions about what to do about it):
"In a market-based credit system, one wants to backstop asset markets, not individual institutions...The too-big-to-fail problem comes substantially from the fact that, until now, there has been no central clearing mechanism, so that the only way to backstop markets (a legitimate public good) has been to backstop individual dealers (not a legitimate public good). In future, given adequate support of the dealing system as a whole, individual dealers can be allowed to fail without fear of triggering downward liquidity spirals."
I think this is, again, exactly right except its conclusion. The problem is certainly where individual institutions are given "too big to fail" and know it, and we should not care about the rise and fall of individual institutions. We actually have a vested interest in seeing many fail since that would instill market discipline that is sorely lacking here. But it does not follow that such distortion disappears under the central clearing model, as it didn't under the S&L's. The central clearing model only transfers "too big to fail" just as what occurred under interest rate targeting throughout the 90's. The Fed, disposing of the depository system in favor of wholesale, but maintaining deposits themselves and mixing the clearing aspect with evolutions of further finance, implicitly backed the wholesale model and created "too big to fail" rather than looking to what Mehrling described above about a robust system without all these chokepoints.
We already glimpsed this problem up close in 2008 where JP Morgan as triparty repo custodian was front and center of every major failure, playing probably a direct role in those by requiring collateral and margin that may not have been proper (or, in the case of Lehman as the estate there alleged, legal). The clearinghouse model still looks upon the financial system as a whole without regard to whether specific functions of money should or need to be entangled within it. By keeping clearing functions as a full measure of finance and funding for assets, that opens the door to the idea of finance as something "special" in need of this half-baked oversight; heavy government intrusion is predicated on the idea of protecting ordinary people and their deposits when it might better be served of protecting the clearing function as separate and distinct from the financial system as a whole.
There is entirely too much deference to the idea that government-run institutions would be better for, or absolved of, these kinds of issues, especially conflicts of interest. If anything, the potential power given by any further centralized arrangement is axiomatic in its potential for conflict. Clearinghouse systems run afoul of decency just as much as financial institutions (just look at the CFTC and MF Global). Worse, however, I don't think it solves any of these problems, just transfers the location of them to a greater bottleneck potential.
I would prefer a real market-based system rather than these piecemeal approaches that only go in the same direction (conceptually). The problem, in general terms as I see it, is one of again those deposits and the special place they are given which "forces" banks and institutions to engage in shell games where they do whatever they want anyway and then hide all that via legalese and accounting "conventions." When problems arise, they really arise because those risks were entirely and purposefully hidden before, thus were not accurately priced by markets, and become a total "shock" upon the system which cannot, by definition of being asymmetric, readily absorb them. Further, this distrust is exactly the mechanism by which those "arbitrage" chains break down and where the central bank, even acting through a clearinghouse, is so ill-equipped to intercede.
It is taken as a given by orthodox economists that somehow the "market" creates bubbles but then the "market" is wrong in trying to clear them. Creative destruction is essential and there is no reason at all to believe it is a smooth process. One of the ways the system introduces rigidity is by repression as a means to "smooth out" the business cycle, which is one of the primary reasons the wholesale system was so apparently acceptable post-S&L's. Of course, that attempt has the very dubious effect of making the cost of "capital" very high. And thus banks are "forced" by high rates of repression to do unsavory things (again!). However, because of the deposit "anchor" they have to make those risky bets look far less so to satisfy Basel rules that are far too attentive to specific bank activities rather than systemic monetary functions.
As long as repression remains, banks will find ways to carry out risky behavior all the while cloaking it. I don't see how a clearinghouse will change that; all that will change is the direct manner and methods banks will use to "hide" what they are doing. And regulators won't see it coming because they will have assumed the clearinghouse did their work for them. The arms race, so to speak, was won a long, long time ago (in the 1980's and surely by the mid-90's) by the banks.
The answer, I believe, is full transparency and/or a separation of banks from wholesale - get the depositors out so that the wholesalers can do whatever they want and markets can readily and easily price a truer picture of risk in the first place. That would, by definition, also mean the end of interest rate targeting and central banking as anything other than a payment systems entity (which it is actually good at). I think we are moving in that direction anyway, with technology advancing to the point that we just may be able to separate deposits from finance (ApplePay and such), and what a wonderful world that would be.
Under a payment systems approach, the central bank might be more readily thought of as the FDIC, and indeed may take on that role. The market for funding would be left as the market for funding and assets, and the central bank would only guarantee the "deposits" or the balances that people and businesses use for non-financial purposes. The focus of regulation in finance would be only on transparency on that finance side, with severe penalty for "hiding" risks. That way banks can do whatever they want, including being innovative about it, and the real market gets to price it all under disciplinary constraints that are just as dynamic as the marketplace.
Of course, that setup is far too idealistic, as this is just a broad sketch, and would need more fine tuning to the complexity of the real world. It's like the gold standard in theory, as that is really no longer a viable option for return (pains me greatly to say that) simply because that well is far too poisoned (orthodox economists did their job well in that respect) and the world has been inflated too much for a realistic re-imposition (meaning actual gold in personal holding, not just global exchange; since the "dollar" is so devalued, you couldn't really hold such small quantities of gold to engage regular commerce - taking 1-10,000th of an ounce to buy a soda?). Instead, we should seek to identify the best characteristics of the gold standard and apply them to the modern framework, which does have many redeeming qualities despite the tendency toward so much persistent ill-function.
Some are critical of the arrangement from the other side, meaning that they view deregulation itself as the primary defect; I would agree but only to the extent that deregulation was a partial and ill-formed process that left in pieces some arbitrary limitations that were bound to cause trouble in dynamic circumstances. The continued ill-function is itself derived from that half-in/half-out existence, where the central bank imposes its will up to a pre-determined point but then stands back and proclaims that the "market" should pick it up from there.
Should we expect regulators to predict and act, ahead of time, all financial innovation? Of course not, nor would we really want to stifle it all because depositors are present. I think both the S&L crisis and the panic in 2008 proved that a half-regulated system is actually worse than no regulations because those distortions provide both the means and motive for the worst outcomes (and a great deal of criminality, so it seems). To that end, we need to do all one thing or all the other; regulate banks to death, treat them as public utilities or set them free and watch the dynamism improve function and reaction. Embrace capitalism again, or be honest about the opposite intent.
By removing the deposit end, and separating out the payment clearing function, the banks lose that "special privilege" thus eliminating the need to hide so much risk to begin with. As the market for money comes back to full, free and honest trade, as repression ends, the need to be devious should be reduced (not eliminated) anyway as returns aren't so paltry as to open that door like the 1980's and then the securitization wholesaling in the 2000's. The problem of the clearinghouse, in its most basic essence, is that it is just another means of rigidity upon a system that abhors it. We can impose more ill-fitting rules designed far too simplistically, or we can seek simplicity itself and instead take more notice of pure function.
I have tremendous respect for Perry Mehrling and the work he is doing, so this should not be construed in any way as an attempt to discredit. Instead, it is a companion through process as I have little doubt that even the imposition of the clearinghouse model would represent a significant advance. My disagreements relate to past history of how banks react to such artificial rigidities, so in that sense I don't believe it is enough of an improvement. In fact, Wall Street seems to have positioned to at least partially escape the intended clearinghouse already, as the curious shift of UST securities to Belgium starting at the end of 2013, and amounting to more than a $200 billion one-time transfer to the home country of Euroclear, seems to have injected an enormous pile of collateral into the "looser" pastures of eurodollar Europe. The first "rule" of regulation in finance is that banks by the time of effect have already circumvented it, arguing for a repeal not of specific regulations but rather of this so overwhelming desire they have to do so.
Rather than keep these same kinds of constraints and alter them, the systemic break in 2008 still argues for, I believe, a systemic reorientation more adapted for the 21st century. Pay for your groceries through your smartphone and let the financial behemoths tear each other apart to their heart's content; at least it will then be productive and not so eagerly catastrophic. The world is by pure nature messy and chaotic, there is no reason to try to tame it and think it possible or even beneficial to do so; nor is there good reason any longer to entangle your trip to the gas station in that clutter.
