The Way Forward
Now that we are in the eye of the financial crisis, it is useful to catch our breath, consider how we got here and what to do about it going forward. Significant efforts are being made to ensure that this downturn is not as severe as many now fear. But we also need to look to the future. The modern economy depends on confidence. That confidence can be shattered quickly and it is regained much more slowly. Any actions we take now must ensure that we regain that trust.
After the last recession and bear market, we took policy actions that amounted to a national temper tantrum. We satisfied our impulses toward vindictiveness but did not change policy to mute the next downturn. In fact, we may have exacerbated it. A great global power can do better. Structural changes and incentives are needed, not the toothless nostrums we attempted before.
The goal is not to avoid future recessions and eliminate business cycles. We know now that those efforts are futile and in fact may make cycles worse. What we can do is significantly cushion the downturns, reduce suffering and lessen the chances of systemic failure. Achieving these goals would be a huge benefit to the broad population and our national well-being as well as bringing significant benefits to the world.
To do this, we need structural reforms in several areas as well as changes in attitudes. We need to recognize that in the modern intertwined global economy, timing is as important as actions. We need to convey by our actions as well as our words that the "casino mentality" is inappropriate among institutions. We need to reinvigorate the capitalist model by integrating intelligent regulation and not just hoping that everyone will do the right thing on his own.
The first step is to recognize that bad decisions in both the private sector and the government contributed to the severe problems in this downturn. The idea that the free market can police itself should be considered tried and failed. When we pull umpire crews from the World Series and referees from the Super Bowl, then we can revisit this notion.
By the same token, we should recognize that no other economic system has proven more effective at creating jobs and wealth and fostering innovation than free market capitalism. We need to re-energize this system by strengthening checks and balances and tying them to the overall welfare of society. We don't need to worship the free markets but we should respect them and recognize that they convey significant information.
We also need a major effort to foster long-term thinking in the private sector as well as the public sector. Significant changes can be achieved through relatively modest changes as long as we our clear on the goal of promoting long-term actions and investments.
Our policy recommendations include: the Federal Reserve, fiscal policy, regulatory initiatives, tax policy, financing of Government debt, and the rating agencies.
First, changes for the Federal Reserve. The Federal Reserve has acted appropriately but with a lag. Taking the right action but at the wrong time is almost as bad as simply doing the wrong thing. Going back to the Greenspan Fed, the Federal Reserve has exacerbated the last three crises by lagging the markets and ending up taking exaggerated and ultimately destructive actions. The Fed has emphasized inflation fighting and kowtowing to the bond markets to the detriment of its equally important goal of promoting growth.
If we are to promote free-market ideology and the apotheosis of the free markets, the Fed should not thumb its nose at the markets. At an absolute minimum the Fed should improve its communications. While Fed Chairman Bernanke has espoused this goal and has made significant efforts in this direction, Fed communication is clearly worse than it was under Greenspan. Properly communicating its reading of the economy and its intention is one of the most powerful tools at the Fed's disposal and is critical to economic success.
It is beyond explanation that in the middle of the worst week in stock market history and global financial panic, the Fed should stand pat and talk about significant concerns on inflation as it did in its September 16, 2008, statement. It is also baffling -- and we would say a significant failure to understand his job -- that one member was advocating tightening as recently as the August FOMC meeting.
Failing to act and then taking emergency action within two weeks has been a pattern with the Fed since at least December, 2000. While we would grant that long-term economic forecasting is impossible, we would note that in each case the financial markets have offered the prescription on a timely basis that the Fed ultimately endorsed. These delays have proven costly and arguably were a big factor in the global housing bubbles. While people can point to other policy mistakes in the U.S., much of the world had a housing bubble and the major commonality was the level of interest rates and the relative attractiveness of other asset classes.
In short, the Fed needs to get back to balancing its dual statutory obligations, recognize that it needs to act in a timely way and get over the notion that its inflation-fighting bona fides are constantly open to question.
On the fiscal front, several big changes are needed. These include stronger incentives to long-term investing, reinvigorating regulators, structural changes in the financial markets and a significant overhaul of the rating agencies. To avoid a future crisis, we also think the Treasury needs to extend the term structure of debt financing and bring it back more into line with historic patterns.
A good first step would be to make it an explicit goal to foster long-term investment. Beyond that much can be done through concrete actions. We would consider raising the capital gains tax rate for holding periods of less than one year and providing modest tax reductions for each year an asset is held going out at least five years. We would also ensure that institutions that are exemption from taxation because of their long-term mission, such as pension funds and foundations, act appropriately. If they engage in excessive short-term trading themselves or through their managers (such as hedge funds), their excessive short-term trading should be subject to taxation.
We shouldn't indulge in hedge-fund bashing for its own sake. But we should recognize that these institutions, which have flourished partly in response to rigidities in the system, have grown too big and too active to remain largely outside the regulatory apparatus. Regulation has been creeping into the hedge fund world but it needs to be done in a more comprehensive way and with international cooperation. It serves no purpose if we are successful in encouraging the migration of the hedge fund world offshore without succeeding in effective regulation. One of the failures of the response to the last bear market, Sarbanes-Oxley, was to drive the IPO market to London, Frankfurt and Hong Kong. The U.S. cannot afford similar failures this time.
Beyond encouraging long-term investment, the stock markets need significant reforms. This will require a comprehensive study and industry cooperation but the need is self-evident. The historic trust crushing volatility and the demise of the traditional Wall Street investment banking model, indicate that change is needed. Program trading has overrun the markets, decimalization has bred many poor practices and the tendency of derivatives to overwhelm the stock market must be changed.
The rating agencies have been central players in the last two recessions and are in dire need of overhaul. Congress has held many hearings and made some changes but the root problems remain. A contributing factor behind the troubles in the last two recessions has been poor information made available to the capital markets by the rating agencies. Their current models have inherent conflicts of interest. Importantly, their ratings are imbedded in the structure of institutional decision making. If we are to move beyond these recurrent crises, the agency model has to change.
A significant problem in recent years has been the failure of regulatory agencies to act effectively in a timely manner. The housing bubble could not have been prevented and the dire consequences could not have been foreseen. But the bubble could have been muted and effective action could have moderated the outcome.
With the huge concentration of financial power and the growing international ties, we need to replace the patchwork pattern of regulation and foster new levels of global cooperation. The Fed already has significant regulatory power and its role at the center of fighting the crisis has increased this even more. But concentrating so much institutional power in one place may be a mistake. Thought should be given to separating the monetary and regulatory powers. We should also consider ways to foster smaller institutions in the private sector. In the information age, it should be possible to have healthy smaller institutions as well.
Once the crisis passes, fiscal policy needs to be put on a healthier footing. The long-term increase in the deficit is a symptom of lax spending controls and creates sloppiness in spending. Lacking the many controls that the private sector has, the government has to be more watchful of spending restraint.
Also, the financing has to be put on a more sound footing. Over the last eight years, while the level of debt has doubled, the average financing period has halved. This puts significantly more strain on the government to finance its operations. While rates remain historically low, the government should take advantage to extend average maturities at least back to the previous range.
Financial institutions tend to learn the lessons of the current crisis and make new mistakes in the next. They move between taking interest rate risks and credit risks. In this cycle the problems have been poor credit decisions. While we need to remain vigilant about these, we also need to ensure that they do not take undue interest rate risk in the next cycle.
Needless to say, increased scrutiny needs to be paid to derivatives. Properly used, they can spread risk to appropriate institutions and serve other valid purposes. However, we have seen that they have not been subject to the same scrutiny as other investments. They have also been used to vastly inflate the leverage in the system.
The unprecedented depth and global scope of the current crisis impel us to take a serious look at all of our policy options. We should learn from the recent mistakes and launch structural reforms in concert with authorities around the world. We also need to understand that confidence, trust and communication are integral to the effective functioning of our complex global economy and these must be given high priority.