By R. Glenn Hubbard
Friday, September 19, 2008
There are 46 days until the election. This is not a time for silence or slogans. While the presidential candidates' policy positions are evolving, it's reasonable to hope that they can agree on key steps to create a firebreak for our financial crisis. They should start by calling for a structural fix for the near-term crisis and regulatory improvements to keep it from being repeated.
The Treasury and the Federal Reserve have been aggressive about injecting liquidity into the U.S. and global financial systems. But their actions -- intended to limit a vicious cycle of asset fire sales in a scramble for liquidity by individual firms -- are not without consequences. With the government's "conservatorship" of Fannie Mae and Freddie Mac and its rescue of insurance giant AIG this week, there is now substantial credit risk on the Fed's balance sheet that will be borne by taxpayers.
The Treasury and the Fed should not ignore systemic risk just to limit moral hazard, but this firefighting has still left us with problems: Additional write-downs are coming. We cannot and should not try to protect every institution.
Now, consider the candidates' economic philosophies. John McCain champions openness, low taxes and efficient regulation. Barack Obama is more skeptical of gains from trade and global finance, and he favors tax increases on capital and a variety of regulatory solutions. In this environment, these differences are revealing (and the advantage goes to McCain).
First, it is clear that openness to foreign investment in U.S. firms and economic opportunity for financial services outside the United States will help to resolve many financial institutions' problems. Second, rebuilding the internal net worth and capital of major financial institutions is essential to relieving credit stresses. Taxes on savings -- including dividend, capital gains and corporate taxes -- are at least partly capitalized in the value of existing assets. Raising capital taxes -- undesirable economic policy at any time -- would also raise macroeconomic concerns for righting Wall Street's ship. Clarity about the extension of the 2001 and 2003 tax cuts, which bolster collateral values, along with a corporate tax cut, would yield a potent tonic. Third, the financial meltdown that engulfed Lehman and AIG, and policymakers' uncomfortable responses to it the past several months, clearly highlight the need for regulatory reform.
To limit the further spread of real estate woes to the broader economy, Federal Housing Administration authority for mortgage refinancing should be expanded. In addition, putting in place a cleanup agency that could absorb bad loans, modeled after the 1930s-era Home Owners' Loan Corporation or the Resolution Trust Corporation of the 1980s, would help. Taxpayer funds used to support such vehicles would offer more economic stimulus and market stabilization than temporary tax cuts or public spending.
The fiscal costs of inaction would be significant, both in lost tax receipts and in larger "crisis" bailouts down the road. We need to ensure that taxpayer support is effective and cost-efficient.
We need regulatory reform, but the problem is actually not too little regulation -- both lightly and heavily regulated institutions are in trouble. We must put in place smarter regulation. Regulation itself is not blameless in the growth of high-risk mortgage lending. A key step would be to broaden capital and liquidity requirements and increase them during financial booms to push back against excessive risk taking.
Regulation of capital adequacy should require more capital to support incremental risk-taking in a boom and lower such capital requirements in a bust. With such requirements, financial institutions would find risk-taking marginally more costly in a credit boom, in which credit risk and liquidity risk are very low. In a downturn, any scramble for liquidity to meet capital requirements would be reduced.
While strong supervision would be necessary, this approach would offer a significant addition to the policy tool kit. It could be implemented by raising banks' capital requirements proportionately as risk-weighted bank assets grow. By varying capital cushions over credit cycles, the consequences of risk distortions for actual lending and borrowing decisions would be reduced, along with the likelihood of asset fire sales and extraordinary central bank liquidity provisions. Here again, there is a cost: Such provisions, while stabilizing the near-term outlook, raise important questions about the Fed's long-term independence.
Bold near-term action to address the unfolding crisis should occur parallel to longer-term action, not only in capital requirements but also in the structure of regulation and supervision. We are asking too much of the Fed, and putting a strong umbrella financial regulator alongside it should be an item for serious discussion.
Despite their policy differences, both candidates should put the country's economic well being first. They can start by calling for structural improvements to help limit the damage of the financial crisis and seek regulatory improvements to avoid its repetition.
The writer, who was chairman of the President's Council of Economic Advisers from 2001 to 2003, is dean of Columbia University's Graduate School of Business.