Streetwise Professor

April 8, 2009

Captivating II

Filed under: Financial crisis,Politics — The Professor @ 9:07 pm

Willem Buiter weighs in the regulatory capture theme:

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The   banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors – pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds – have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

I used to believe this state capture took the form of  cognitive capture, rather than  financial capture.   I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture.

Like me, Buiter is concerned about Fed independence and credibility:

sible way from the point of view of medium- and longer-term economic performance, by surrendering central bank independence to the fiscal authorities.

When the Fed lends on a non-recourse basis to the private sector with only a $100 bn Treasury guarantee for a possible $1 trillion dollar Fed exposure (as with the TALF),   when the Fed purchases private securities outright with just a similar 10-cents-on-the-dollar Treasury guarantee or when the Fed is party to an arrangement that transfers tens of billions of dollars to AIG counterparties – money that is likely to be extracted ultimately from the beneficiaries of other public spending programmes or from the tax payer, either through explicit taxes or through the inflation tax – the Fed is acting like an off-balance sheet and off-budget special purpose vehicle of the US Treasury.

When the Chairman of the Fed stands shoulder-to-shoulder or sits side-by-side with the US Treasury Secretary to urge the passing of various budgetary proposals – involving matters both beyond the Fed’s mandate and remit and beyond its competence – the Fed is politicised irretrievably.   It becomes a partisan political player.   This is likely to impair its ability to pursue its monetary policy mandate in the medium and long term.  

The bottom line?  Another SWP mantra:

But with the banking system on its uppers and many key financial markets still disfunctional and out of commission, external financing will be scarce and costly.   This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out  banking  , must be a top priority and a top claimant on scarce public resources.

Until the authorities are ready to draw a clear line between the  existing banks  in western Europe and the USA, – many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer – and the  substantive economic activity  of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery.

But with the regulators and legislators captured, cognitively, primally, or otherwise, the line is not being drawn.  And hence, “a robust, sustained recovery” is not in the offing.

The compromising of Fed independence and credibility; ballooning, unprecedented fiscal deficits that will be financed either by inflation, or by higher income taxes; and a chronically ill banking system operating under dysfunctional incentives enabled by arguably captive governments is a recipe for prolonged stagnation/stagflation.  The fact that the Fed and Treasury are also fighting against the equilibration of the economy, by propping up sectors of the economy that should contract, only aggravates these problems.  A Lost Decade looms.

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