Senior Advisor, Pew Charitable Trusts and Chairman, Systemic Risk Council; former Chairman, Federal Deposit Insurance Corporation; former Assistant Secretary of the Treasury for Financial Institutions; former Commissioner of the Commodity Futures Trading Corporation; and former Counsel, Senate Majority Leader Robert Dole.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Chairman Bair: It has made me more – not less – worried about the considerable power of the Fed. I am more concerned about how extensively their power has been used and could be used in the future, and the way that power has and could disrupt markets now and in the future.
Zero interest rates have gone on for far too long. We had a crisis that was based on solvency problems: banks and households were borrowing too much. They needed to go through a process of deleveraging. Monetary policy cannot address that.
That deleveraging is a process that needs to take place. It has taken place to some extent, in some sectors more than others. But, we've seen debt increasing on the public and corporate balance sheets. Though household and bank debt have decreased, total public and private sector debt have increased. And that is a function of monetary policy, which has made it very cheap to borrow. That is what low interest rates do: they encourage borrowing and penalize savings.
So, I am very concerned that we've distorted the markets. We needed zero interest rates for a time: there was a window in late 2008 when the system just froze up. Big financial institutions didn’t want to lend to each other. Nobody was sure where the bad assets were hidden. That caused a liquidity crisis that needed to be addressed by monetary policy. But that time has long since passed. Monetary policy has been used too long and too aggressively in ways that have not been helpful.
I also fear the Fed’s power to do bailouts. If you think about the tremendous lending programs that the Fed undertook during the crisis, some were needed, but some were quite generous. They perhaps went beyond what was needed. Of course, hindsight is always 20/20. But I do think that the ability of the Fed to do unfettered bailouts – including supporting institutions that were poorly managed and that should be punished by the markets – that power, in and of itself, distorts market discipline. It creates incentives for risk taking.
So I was very supportive of the Dodd-Frank limitations, modest as they are, on the Fed’s bailout authority. I think it is appropriate that there be some limitations on the ability of the central bank to use its lending powers, even in times of market turmoil. They should be able to provide generally available assistance to healthy institutions, but not to insolvent institutions. I think it was appropriate to create a separate regime under Dodd-Frank to force insolvent firms into a bankruptcy-type process. And I hope that these modest reform limitations are maintained by the Federal Reserve. I know they would like to get rid of them, but there need to be limits on their power, and this is an appropriate one.
Where should we be looking now for financial stability risks given this experience?
Chairman Bair: Again, I think monetary policy is contributing to risk taking. The whole point of zero interest rates is to force borrowers and lenders out on the risk curve. So, if you are a bank and you can't make your cost of capital if you are holding a lot of government securities or highly-rated corporate debt, you go out on the risk curve to get a higher rate of return and that is what we are seeing now.
So, we're seeing banks that traditionally held large quantities of high quality debt dramatically reduce those holdings. They are holding less liquid, riskier assets, which in and of itself creates problems. One is because they have more risk – the risk of credit losses is greater. The other is that the market may need liquidity if we have a lot of volatility in the fixed income markets as the Fed moves to raise interest rates. The traditional providers of liquidity are not there anymore and that creates instability in the system.
And, then, unfortunately, you are seeing households taking on more debt now, too. They are borrowing more. Their rising debt levels are outstripping their meager income gains. That always raises a red flag: when income gains are insufficient to support repayment of that debt, that’s when you start having instability build in the system. That’s what we saw prior to the crisis: when real wages were flat, mortgage debt was increasing dramatically. That is unsustainable. At some point it collapses on itself. I think we are still some ways away from that happening, but nonetheless you see that trend is again at play.
What we really need is coherent fiscal policy. We need infrastructure spending. We need to invest in our futures, in our kids’ futures, instead of just loading them up on debt. We need fundamental corporate tax reform. We have the most uncompetitive corporate tax system in the world. We affirmatively create incentives for companies to leave this country or not to come here in the first place.
And, so, I think we need to reduce our reliance on monetary policy, which creates instability by encouraging leverage and encouraging lenders and investors to go further and further out on the risk curve. Instead, we need fiscal policies that can provide some real stimulus to sustainable economic growth. But, so far, Washington doesn’t seem to be with the program. So, you have the Fed now struggling to get out of zero interest rates. They need to do that. It’s going to be painful, I think, but some of that pain could be countered if we closed corporate tax loopholes, lowered marginal rates, and launched major infrastructure programs. That could help counter the negative effects of rising interest rates on our economy. So far, our elected officials don’t seem to be up to that task.
What do we need to do to preserve the benefits of global finance?
Chairman Bair: We need to have a stable system of global finance – one that is based on sustainable lending, that provides support for real economic growth, that is not excessively leveraged, and that is not excessively reliant on short-term borrowing. That is the system that we had prior to the crisis. There has been some improvement, but it still is not as stable as it should be.
Banks need more capital if we are to have a global financial system that functions in both good times and bad. There needs to be more reliance on long-term financing – long-term debt, in addition to much thicker cushions of shareholder equity. Then we need to have institutions that are focused on real economic needs – not financial engineering, not tax arbitrage or regulatory arbitrage, or trying to make a quick buck through tricks and traps as opposed to real economic growth. Making loans to businesses and households to support economic activity through lending that they can afford to repay – that is really how we have a stable global financial system. But this idea that we need to feed the beast by letting them take on higher and higher levels of leverage so that they can make levered returns and generate more shareholder profits for themselves is not sustainable in the long term. That’s a global financial system that is going to collapse again. I don't know about you, but I don't want to see 2008-2009 repeated!