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Cognitive Regulatory Capture

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The term was defined as following:

It can be called cognitive regulatory capture (or cognitive state capture), because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator, like the Fed, but instead through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate and supervise in the public interest instead.

-Willem H. Buiter

There is one additional factor in groupthink that is seldom mentioned  which Willem Butler called  it "cognitive regulatory capture".

It explains why laws, including copyright laws, are all too often perverted into serving powerful commercial interests and harm the society. The perversion of laws in this case is archived by powerful interests in a more subtle way that direct buying, blackmailing or bribing their way toward the control  of interpretation of laws.  Instead judges and lawyers are internalizing, as if by osmosis, the objectives, interests and perception of reality of the vested interests and due to this betray public interest.

This is a kind of social construction of reality that happens in this case. In a way we all have a "collective consciousness," to quote sociologist Maurice Halbwachs. This selective reinforcement of  certain memories and facts creates the  "artificial reality". While you also formulate those concepts in terms of "brainwashing" (which is pretty common concept here in the USA), the mechanism itself is not something that the general public understands.

NEWS CONTENTS

Old News ;-)

[Apr 27, 2017] Elizabeth Warren on Big Banks and Their (Cozy Bedmate) Regulators

Notable quotes:
"... "Regulatory failure has been built into the system," Ms. Warren said in our interview. "The regulators routinely hear from the banks. They hear from those who have billions of dollars at stake. But they don't hear from the millions of people across this country who will be deeply affected by the decisions they make." ..."
"... There was a time when everything that went through Washington got measured by whether it created more opportunities for the middle class," Ms. Warren said. "Now, the people with money and power have figured out how to invest millions of dollars in Washington and get rules that yield billions of dollars for themselves. ..."
"... "Government," she added, "increasingly works for those at the top." ..."
Apr 27, 2017 | www.nytimes.com

Wells Fargo's board and management are scheduled to meet shareholders at the company's annual meeting Tuesday in Ponte Vedra Beach, Fla. With the phony account-opening scandal still making headlines, and the company's stock underperforming its peers, it's a good bet the bank's brass will have some explaining to do.

How could such pernicious practices at the bank be allowed for so long? Why didn't the board do more to stop the scheme or the incentive programs that encouraged it? And where, oh where, were the regulators?

Wells Fargo's management has conceded making multiple mistakes over many years; it also says it has learned from them. In a meeting this week with reporters at The New York Times, Timothy J. Sloan, Wells Fargo's chief executive, said the bank had made substantive changes to its structure and culture to ensure that dubious practices won't take hold again.

But there's a deeper explanation for why Wells Fargo's corrosive sales practices came about and continued for years. And it has everything to do with the bank-friendly regulatory regime in Washington and the immense sway that institutions like Wells Fargo have there. This poisonous combination contributes to a sense among giant banking institutions that they answer to no one.

  • "This Fight Is Our Fight" contains juicy but depressing anecdotes about how our most trusted institutions have let us down. It also shows why, years after the financial crisis, big banks are still large, in charge and, basically, unaccountable for their actions.

    "In too many of these organizations, there are rewards for cheating and punishments for calling out the cheaters," Ms. Warren said in an interview Wednesday. "As long as that's the case, the biggest financial institutions will continue to put their customers and the economy at risk."

    Ms. Warren's no-nonsense views are bracing. But they are also informed by a thorough understanding of how dysfunctional Washington now is. This failure has cost Main Street dearly, she said, but has benefited the powerful.

    Wells Fargo got a lot of criticism from Ms. Warren, both in her book and in my interview - and on live television during the Senate Banking Committee hearing on the account-opening mess in September. She was among the harshest cross-examiners encountered by John G. Stumpf, who was Wells Fargo's chief executive at the time. "You should resign," she told him, "and you should be criminally investigated." (Mr. Stumpf retired the next month.)

    This week, Ms. Warren called for the ouster of the company's directors and a criminal inquiry into the bank.

    "Yes, the board should be removed, but that's not enough," she told me. "There still needs to be a criminal investigation. The expertise is in the regulatory agencies, but the power to prosecute lies mostly with the Justice Department, and if they don't have either the energy or the talent - or the backbone - to go after the big banks, then there will never be any real accountability."

    Banks are not the only targets in Ms. Warren's book. Others include Wal-Mart, for its treatment of employees; for-profit education companies, for the way they pile debt on unsuspecting students; the Chamber of Commerce, for battling Main Street; and prestigious think tanks, for their undisclosed conflicts of interest.

    My favorite moments in the book involve the phenomenon of regulatory capture: the pernicious condition in which institutions that are supposed to police the nation's financial behemoths actually come to view them as clients or pals.

    One telling moment took place in 2005, when Ms. Warren, then a Harvard law professor, was invited to address the staff at the Office of the Comptroller of the Currency, a top regulator charged with monitoring the activities of big banks.

    She was thrilled by the invitation, she recalled in the book. After years of tracking various problems consumers experienced with their banks - predatory lending, sky-high interest rates and dubious fees - Ms. Warren felt that, finally, she'd be able to persuade the regulators to crack down.

    Her host for the meeting was Julie L. Williams, then the acting comptroller of the currency. In a conference room filled with economists and bank supervisors, Ms. Warren presented her findings: Banks were tricking and cheating their consumers.

    After the meeting ended and Ms. Williams was escorting her guest to the elevator, she told Ms. Warren that she had made a "compelling case," Ms. Warren writes. When she pushed Ms. Williams to have her agency do something about the dubious practices, the regulator balked.

    "No, we just can't do that," Ms. Williams said, according to the book. "The banks wouldn't like it."

    Ms. Warren was not invited back.

    Ms. Williams left the agency in 2012 and is a managing director at Promontory, a regulatory-compliance consulting firm specializing in the financial services industry. When I asked about her conversation with Ms. Warren, she said she had a different recollection.

    "I told her I agreed with her concerns," Ms. Williams wrote in an email, "but when I said, 'We just can't do that,' I explained that was because the Comptroller's office did not have jurisdiction to adopt rules to ban the practice. I told her this was the Federal Reserve Board's purview."
    Interestingly, though, Ms. Warren's take on regulatory capture at the agency was substantiated in a damning report on its supervision of Wells Fargo, published by a unit of the Office of the Comptroller of the Currency on Wednesday.

    The report cited a raft of agency oversight breakdowns regarding Wells Fargo. Among them was its failure to follow up on a slew of consumer and employee complaints beginning in early 2010. There was no evidence, the report said, that agency examiners "required the bank to provide an analysis of the risks and controls, or investigated these issues further to identify the root cause and the appropriate supervisory actions needed."

    Neither did the agency document the bank's resolution of whistle-blower complaints, the report said, or conduct in-depth reviews and tests of the bank's controls in this area "at least from 2011 through 2014." (The agency recently removed its top Wells Fargo examiner, Bradley Linskens, from his job running a staff of 60 overseeing the bank.)

    "Regulatory failure has been built into the system," Ms. Warren said in our interview. "The regulators routinely hear from the banks. They hear from those who have billions of dollars at stake. But they don't hear from the millions of people across this country who will be deeply affected by the decisions they make."

    This is why the Consumer Financial Protection Bureau plays such a crucial role, she said. The agency allows consumers to sound off about their financial experiences, and their complaints provide a heat map for regulators to identify and pursue wrongdoing.

    But this setup has also made the bureau a target for evisceration by bank-centric politicians.

    "There was a time when everything that went through Washington got measured by whether it created more opportunities for the middle class," Ms. Warren said. "Now, the people with money and power have figured out how to invest millions of dollars in Washington and get rules that yield billions of dollars for themselves."

    "Government," she added, "increasingly works for those at the top."

  • [Dec 22, 2016] Regulatory Capture 101

    It's not regulation per se is deficient, it is regulation under neoliberal regime, were government is captured by financial oligarchy ;-). But that understanding is foreign to WSJ with its neoliberal agenda :-(.
    Notable quotes:
    "... Impressionable journalists finally meet George Stigler. ..."
    "... The secret recordings were made by Carmen Segarra, who went to work as an examiner at the New York Fed in 2011 but was fired less than seven months later in 2012. She has filed a wrongful termination lawsuit against the regulator and says Fed officials sought to bury her claim that Goldman had no firm-wide policy on conflicts-of-interest. Goldman says it has had such policies for years, though on the same day Ms. Segarra's revelations were broadcast, the firm added new restrictions on employees trading for their own accounts. ..."
    "... On the recordings, regulators can be heard doing what regulators do-revealing the limits of their knowledge and demonstrating their reluctance to challenge the firms they regulate. At one point Fed officials suspect a Goldman deal with Banco Santander may have been "legal but shady" in the words of one regulator, and should have required Fed approval. But the regulators basically accept Goldman's explanations without a fight. ..."
    "... The journalists have also found evidence in Ms. Segarra's recordings that even after the financial crisis and the supposed reforms of the Dodd-Frank law, the New York Fed remained a bureaucratic agency resistant to new ideas and hostile to strong-willed, independent-minded employees. In government? ..."
    "... "as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit." ..."
    "... Once one understands the inevitability of regulatory capture, the logical policy response is to enact simple laws that can't be gamed by the biggest firms and their captive bureaucrats. ..."
    "... And it means considering economist Charles Calomiris's plan to automatically convert a portion of a bank's debt into equity if the bank's market value falls below a healthy level. ..."
    Oct 05, 2014 | Casino Capitalism and Crapshoot Politics
    Regulatory Capture 101

    Impressionable journalists finally meet George Stigler.

    The financial scandal du jour involves leaked audio recordings that purport to show that regulators at the Federal Reserve Bank of New York were soft on Goldman Sachs . Say it ain't so.

    ... ... ...

    The secret recordings were made by Carmen Segarra, who went to work as an examiner at the New York Fed in 2011 but was fired less than seven months later in 2012. She has filed a wrongful termination lawsuit against the regulator and says Fed officials sought to bury her claim that Goldman had no firm-wide policy on conflicts-of-interest. Goldman says it has had such policies for years, though on the same day Ms. Segarra's revelations were broadcast, the firm added new restrictions on employees trading for their own accounts.

    The New York Fed won against Ms. Segarra in district court, though the case is on appeal. The regulator also notes that Ms. Segarra "demanded $7 million to settle her complaint." And last week New York Fed President William Dudley said, "We are going to keep striving to improve, but I don't think anyone should question our motives or what we are trying to accomplish."

    On the recordings, regulators can be heard doing what regulators do-revealing the limits of their knowledge and demonstrating their reluctance to challenge the firms they regulate. At one point Fed officials suspect a Goldman deal with Banco Santander may have been "legal but shady" in the words of one regulator, and should have required Fed approval. But the regulators basically accept Goldman's explanations without a fight.

    The sleuths at the ProPublica website, working with a crack team of investigators from public radio, also seem to think they have another smoking gun in one of Ms. Segarra's conversations that was not recorded but was confirmed by another regulator. Ms. Seest means. For example, a company offering securities is exempt from some registration requirements if it is only selling to accredited investors, such as people with more than $1 million in net worth, excluding the value of primary residences.

    The journalists have also found evidence in Ms. Segarra's recordings that even after the financial crisis and the supposed reforms of the Dodd-Frank law, the New York Fed remained a bureaucratic agency resistant to new ideas and hostile to strong-willed, independent-minded employees. In government?

    ***

    Enter George Stigler, who published his famous essay "The Theory of Economic Regulation" in the spring 1971 issue of the Bell Journal of Economics and Management Science. The University of Chicago economist reported empirical data from various markets and concluded that "as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit."

    Stigler knew he was fighting an uphill battle trying to persuade his fellow academics. "The idealistic view of public regulation is deeply imbedded in professional economic thought," he wrote. But thanks to Stigler, who would go on to win a Nobel prize, many economists have studied the operation and effects of regulation and found similar results.

    A classic example was the New York Fed's decision to let Citigroup stash $1.2 trillion of assets-including more than $600 billion of mortgage-related securities-in off-balance-sheet vehicles before the financial crisis. That's when Tim Geithner ran the New York Fed and Jack Lew was at Citigroup.

    Once one understands the inevitability of regulatory capture, the logical policy response is to enact simple laws that can't be gamed by the biggest firms and their captive bureaucrats. This means repealing most of Dodd-Frank and the so-called Basel rules and replacing them with a simple requirement for more bank capital-an equity-to-asset ratio of perhaps 15%. It means bringing back bankruptcy for giant firms instead of resolution at the discretion of political appointees. And it means considering economist Charles Calomiris's plan to automatically convert a portion of a bank's debt into equity if the bank's market value falls below a healthy level.

    GS4

    Buiter Provokes Wrath at Jackson Hole, Says Fed Too Close to Wall Street

    Go Willem Buiter! The London School of Economics prof and former Bank of England and European Bank for Reconstruction and Development official has been saying for some time that the Fed suffers from "cognitive regulatory capture" and has been far too responsive to the needs of Wall Street. It's been puzzling to watch his detailed, well argued criticisms go unnoticed, particularly when they have been offered at forums where one would think they'd be impossible to ignore (for instance, a conference co-hosted by the New York Fed where Buiter presented a pretty harsh paper on what he called the North Atlantic Financial Crisis).

    Well, he finally seems to have gotten through, perhaps because he is forward enough to criticize Fed officials to their face at an event they are hosting. Or maybe it's because the pattern of conduct he decries is so patently obvious that the key actors can no longer fool themselves. From Bloomberg:

    Former Bank of England policy maker Willem Buiter sparked the biggest debate at the Federal Reserve's annual mountainside symposium, saying the central bank pays too much heed to the concerns of financial institutions.

    ``The Fed listens to Wall Street and believes what it hears,'' Buiter said yesterday in a paper presented to the Fed's conference in Jackson Hole, Wyoming. ``This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.''


    The Wall Street Journal's Economics blog provides a similar account and a link to the paper.
    Mr. Buiter slams the Federal Reserve, European Central Bank and Bank of England for what he says was a mishandling of the financial crisis and monetary policy over the past year. He gives the worst marks to the Fed, saying it's too close to Wall Street and financial markets - responding to their needs to the detriment of the wider economy. Mr. Buiter, a former member of the BOE's Monetary Policy Committee, said the Fed overreacted to the economic slowdown - misjudging the importance of financial stability to the overall economy - and created a deeper inflation problem as a result.

    The paper is quite long, but it is very well written and moves very quickly for this sort of exercise (it does get geeky from time to time,). I will confess to having read only the first 30 pages, but his argument seems spot on:
    My thesis is that both monetary theory and the practice of central banking have failed to keep up with key developments in the financial systems of advanced market economies, and that as a result of this, many central banks were to varying degrees ill-prepared for the financial crisis that erupted on August 9, 2007.

    The Fed gets disproportionate attention, in part due to the venue of the presentation, in part because Buiter contends that the Fed did the worst job of the major central banks. Note that Buiter is more of inflation hawk than we are, but as a result, Buiter thinks that letting housing prices decline is not the end of the world and implicitly, adjustments need to run their course (per his point 4). Even though we think this deleveraging will be nastier than Buiter anticipates, we think that trying to hold asset prices at inflated levels will inevitably fail and the effort will only create more damage. To Buiter again:
    [T]hree factors contribute to Fed's underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.

    The second is a sextet of technical and analytical errors: (1) misapplication of the 'Precautionary Principle'; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on 'core' inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom
    that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.

    All three central banks have been too eager to blame repeated and persistent upwards inflation surprises on 'external factors beyond their control', specifically food, fuel and other commodity prices. The third cause of the Fed's macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.


    Of his three charges, Buiter is on solid ground on the first and third. The second set (his points 1-6) are debatable, but you can make a solid case for them, and he does.

    Some of his comments are blunt:

    In the case of the Fed, the nature of the arrangements for pricing illiquid collateral offered by primary dealers invites abuse....

    All three central banks have gone well beyond the provision of emergency liquidity to solvent but temporarily illiquid banks. All three have allowed themselves to be used as quasifiscal agents of the state, providing subsidies to banks and other highly leveraged institutions, and assisting in their recapitalisation, while keeping the resulting contingent exposure off the budget and balance sheet of the fiscal authorities. Such subservience to the fiscal authorities undermines the independence of the central banks even in the area of monetary policy.


    There is a lot of good stuff. For instance, Buiter discusses the "asymmetric" response of regulators to asset bubbles (they let the bubble run but jump in to try to arrest the collapse) and discusses remedies.

    Unfortunately, a lot of participants seemed more interested in defending the Fed than in sifting through Buiter's analysis to see what might be valid and useful:

    Fed Governor Frederic Mishkin said Buiter's paper fired ``a lot of unguided missiles,'' and former Vice Chairman Alan Blinder ``respectfully disagreed'' with his analysis of the central bank's crisis management.....

    Mishkin lashed out against Buiter's assertion that the Fed's rate reductions may cause higher consumer prices.

    ``I wish he had actually read some of the literature on optimal monetary policy, because it might have been very helpful in this context,'' said Mishkin, who collaborated with Bernanke on inflation research in the 1990s.

    Mishkin, a leading advocate of the Fed's effort to sustain economic growth through rapid rate reductions, said research shows that ``what you need to do is act more aggressively.''

    In reply, Buiter said the value of such a strategy ``is not at all obvious to me.''

    [Bank of Isreal's Stanley] Fischer, drawing laughter from the audience, held up a red fire extinguisher saying, ``I asked the organizers for some technical assistance in dealing with this discussion.''

    While defending the Fed, Blinder said Buiter's papers ``often feature an alluring mix of brilliant insight and outrageous statements.'' The central bank's performance, though not flawless, has been ``pretty good'' given the magnitude of the crisis, he said.

    European Central Bank President Jean-Claude Trichet also came to the Fed's defense, saying ``what has been done until now has been pretty well done under very difficult circumstances.''


    Although the Wall Street Journal coverage of the response is less detailed, it says that Blinder, who was tasked with critiquing the paper, told a long-form version of the Dutch boy putting his finger in the dam, and said that Buiter would rather have the dam leak out of obedience to his belief in moral hazard, and let the dam burst.

    I may be reading too much into this, but it strikes me that Blinder went out of his way to be insulting (anyone who regularly participates in critiques of academic papers please read the WSJ post and comment).

    Part of the problem is stylistic. Even though Buiter is Dutch by descent and dislikes the idea of national identity, his writing style often echos the cut and thrust of Parliamentary debates, a posture that is also well received in English academe and drawing rooms but not well received in the US. So his bluntness is over-the-top by US standards.

    From this vantage point, it's obvious that the Fed has become far too dependent on current Wall Street incumbents and thus can be manipulated by them (and in fairness, the people who are doing the persuading may be completely sincere in their views). There were ways to compensate: cultivate contacts with former executives who no longer have close ties, find independent analysts who have useful data and perspectives. No doubt Fed officials have extensive contacts, but it appears they have not been used in a deliberate, orchestrated fashion to test and validate information provided by those currently employed by major financial firms.

    The second issue is that even if the Fed is too close to the financial services industry, it still may have made the right policy decisions. The jury is still out. Many people (probably including the Fed officials) hope the crisis has passed, while readers of this blog know there is good reason to think the worst has not arrived in earnest.

    Buiter has taken a bold position, The Fed needs to be able to explain why what is good for Wall Street is also good for the economy as a whole. The sort of questions that Buiter is raising are notably absent from the media and US-based first rank economists. The Bloomberg story may not give a full enough account to be certain, but the responses to Buiter's charges do not seem persuasive. They amount to disputes over analytical methods and assertions that everything is working fine (after providing a $400 billion fix with no withdrawal plan and getting support from foreign investors equivalent to $1000 a person. So what's your next act?).

    It will take some time to see if events prove Buiter right. And as Cassandras like Nouriel Roubini know, it can sometimes take longer than you anticipate for bad policies to finally yield the expected dismal harvest.

    31 comments:

    Independent Accountant said...
    I first was exposed to "regulatory capture" in 1968 when I read "The Politics of Industry" by C. Walton Hamilton, 1957. That's the way it is. The Fed is owned by Wall Street. I've posted on regulatory capture at my blog. As for the Fed, KILL THE BEAST! REPEAL THE FEDERAL RESERVE ACT! Buiter was too kind to the Fed. Much too kind.
    As for Blinder, I have had e-mail contact with him. Blinder can take his ad hominem attacks and shove them. I can't stand the guy.
    Independent Accountant said...
    I have a number of posts about "The Bloodless Coup", concerning Goldman Sachs takeover of Treasury. Americans have been reduced to the level of serfs in their own country.
    Anonymous said...
    Mishkin, Fischer, Blinder and Trichet all too obviously circle the wagons around their Fed peers and colleagues. It reminds me of the reception Colbert received when he dared speak truth to power at the press/Bush dinner. Unfortunately -- even tragically really -- these people are so stewed in their own convictions that we'll all just have to wait for economic apocalypse for any possible hearing of the Buiter viewpoint. And, if we avoid economic apocalypse -- which we all hope we will -- then Buiter will be written off as a crank and the entire episode will repeat itself in the future.

    So much for reason, skepticism, learning and open mindedness. Today's central bankers and their Wall St partners 'know what's best' -- just as they knew what was best during the many years of 'financial innovation' that proved there was no such thing as risk, all things fit within Great Moderation, and the only truly free markets are those in which government sets no rules other than the firm readiness to bail out Wall Street as insurance for freedom for all.

    Don't you just love the smell of napalm in the morning?

    Anonymous said...
    "Give me control over a nation's currency and I care not who makes its laws."
    Baron M.A. Rothschild

    The FED knows exactly what they are doing. They want more power over the economy to transfer wealth to themselves and they won't get that by saying no.

    Jesse said...
    Buiter makes some good points, and as a credible source he elevates the discussion from the blogosphere.

    Unfortunately this is going to be an academic food fight rather than a reasoned discussion for the time being. Anyone who is familiar with university and departmental politics will understand exactly what I mean.

    The net of this is that the Fed is a private concern, heavily weighted with bankers, academic economists, and a banking perspective. Their customers, at the end of the day especially for the NY Fed, are the banks.

    Thanks to Yves for an excellent thumbnail sketch of the Buiter paper and its reception.

    GeorgeNYC said...
    Excellent post!

    You have hit on the crux of the problem, that is, whether what is good for Wall Street is good for the rest of the economy.

    It appears that whenever a huge financial institution is about to fail, everyone scream Systemic Failure Warning! and runs for the fire hose full of money to save whatever company is going bust.

    Of course, there could be thousands of other businesses in the real economy dying and no one ever says a word. That is just the "market" working for goodness sake.

    Its as if the Financial sector was like the Officer Corps in the First World War sitting safely behind the lines while ordering hordes of regular people to their death.

    I do not entirely buy into the "conspiracy" idea either that these entities are just acting to ensure that they will gain all the "wealth." If they were coordinated enough to pull that off, they would be coordinated enough to realize that they would all do better if they could ferment true growth in the economy.

    No. It is probably far worse that that. There is no conspiracy. There are just a sorry bunch of "elites" who have all gone to roughly the same schools and have been taught or learned to believe that the "market" was king and that was all they ever need to worry about. They lack any real capacity to look at anything other than purely abstract numbers or their own small world of wealth and comfort. It's as if they were told to figure out how to drive crosstown but instead of being given a map of the city, they have been given a map of the world.

    Anonymous said...
    Anyone that expects the Fed to reverse course now is delusional; to do so would be an admission of error and would undermine confidence in the financial system to a greater degree.

    Below is an excerpt from HG Wells writing in 1933 'The Shape of Things To Come'...after the US stock market had lost 85% of its value.

    '"Currencies rose and towered above others and broke like Atlantic waves, and people found the good money in their banks changed to useless paper in a period of a few months. It became more and more difficult to carry on foreign trade because of the increasing uncertainty of payment. Trade and industry sickened and lost heart more and more in this disastrous uncertainty; it was like being in an earthquake, when it seems equally unsafe to stand still or run away; and the multitudes of unemployed increased continually. The economically combatant nations entrenched themselves behind tariffs, played each other tricks with loans, repudiations, sudden inflations and deflations, and no power in the world seemed able to bring them into any concerted action to arrest and stop their common dégringolade [quick deterioration or breakdown]." [pg 115]

    '"The year 1933 closed in a phase of dismayed apprehension. It was like that chilly stillness, that wordless interval of suspense, that comes at times before the breaking of a storm. The wheels of economic life were turning only reluctantly and uncertainly; the millions of unemployed accumulated and became more and more plainly a challenge and a menace…There had been a considerable if inadequate building boom after the Peace of Versailles, but after 1930 new construction fell off more and more." [pg 116]

    Bernanke has chosen a course of economic response to attempt to prevent what happened in the great depression from happening again. For anyone to expect Bernanke to change course in spite of any amount of criticisim from any quarter is a foolish notion. I am not saying that Bernanke is right, simply that he is on a mission to avoid catastrophe and he will not be deflected except by catastrophe or success. He is going to be a hero or a goat, and all our fortunes and futures are riding on the outcome, like it or not.

    River

    jest said...
    i love buiter's response.

    the single notion overarching the paper attacks the intellectual piers on which most modern fed policy stands.

    it's sort of a nassim taleb-esque rebuke of all the fed stands for; most of which was ensconced fairly recently in the greenspan era.

    there's too much experimentation/tinkering going on with the fed. one of the reasons the ECB & BoE performed better was because they were more disciplined in their approach, rather than experimenting & doing everything by the seat of the pants. the latter approach was rather unprofessional and amateurish.

    i did disagree with his claim that the effect of falling are exaggerated. he is right that "Housing wealth isn't wealth," it's really just credit. but that is liquidity for consumers, and therefore can have the same effect as an increase in wealth in the short term. a wealthy yet illiquid person may not be bankrupt, but they may easily become insolvent.
    burnside said...
    On the matter of style, I see two cultural tropes working against any published or policy response to Buiter.

    First, academics for the most part publish - they don't debate - and were therefore ill-prepared and indisposed to return fire. They don't know how. And they're accustomed, from positions of power, to waving away uncongenial questions. Probably they will in this instance as well.

    Second, Jackson Hole is essentially a boys' club. A locker room. Cronies. Call it what you wish. I think Willem Buiter turned out to be an unanticipated wild card there and will be discounted on that basis, i.e., "not our kind."

    But I'm pleased he did it, regardless.

    David Pearson said...
    Blinder's counter-argument is deeply flawed.

    First, the Dutch Boy story is a metaphor for self-sacrifice. In the case of the Fed, their actions accumulate contingent liabilities to the U.S. taxpayer. Their own self-sacrifice is difficult to ascertain. If anything, the Bernanke Fed had good reason to expect their reputation to improve as a result of coddling Wall Street. The fact that Buiter is one of the few "scolders" in the Fed's peer group only erodes Blinder's argument.

    Second, in the Dutch Boy story, the adults quickly stepped in to remedy the situation. In this case, the Fed has had its finger in the dike since "saving us from deflation" in 2002 and avoiding a crisis in 1998. No such adult-like behavior exists here. If anything, the moral is, "don't maintain the dikes as the Dutch Boy will always be there to save us." And of course, this was one of Buiter's key points.

    Third and finally, it is not clear that the Fed has prevented the dike from breaking (credit spreads are back to former levels), and it is possible that it has only made matters worse. The inability to consider this possibility is rooted in the Fed's academic, "we know better", arrogance.

    mdubuque said...
    Perhaps Buiter's paper cited here will settle once and for all the silly debate as to whether HYPERLEVERAGING played a key role in the development of this catastrophe.

    Exhibit A in support of this proposition is page 13 of Buiter's Jackson Hole paper generously provided by Yves. That chapter is entitled "LEVERAGE IS THE KEY". I urge everyone to read it.

    Exhibit B in support of the proposition that HYPERLEVERAGING is absolutely instrumental to the develpment of this crisis is the seminal paper "Monetary Policy and Asset Price Volatility" by Bernanke (1999) Economic Review of Kansas City, 84:4, wherein he states on page 31:

    "...the impact of the bubble on real activity also depends on initial financing conditions, such as THE DEGREE OF LEVERAGE AMONG BORROWERS."

    Now if Bernanke and Buiter BOTH AGREE on this essential point, I remain profoundly mystified why the central role of hyperleveraging in the formation of asset bubbles is so controversial in the blogosphere.

    If Buitin and Bernake agree, does that make the idea somehow ridiculous?

    Of course not.

    It leads strong credence to the notion. Buitin and Bernanke have dramatically different views on how to go forward. Yet they BOTH agree on a fundamental cause:
    Hyperleveraging.

    Matt Dubuque

    dearieme said...
    "So his bluntness is over-the-top by US standards." Isn't that the root of many US prolems? Free speech may be Constitutional, but it isn't practised much.
    mdubuque said...
    There is much less to this summary description of Buiter's criticism of the Fed as "too close to Wall Street" than meets the eye. A careful reading forces one to conclude it is much more than that, according to Buiter.

    By analogy, let's look at the medical profession.

    Does anyone claim that bodies that govern and discipline medical malpractice should be absolutely clueless about the practice of medicine?

    Of course not.

    Those who oversee and discipline doctors should be familiar enough with standard medical practice so as to be able to comment intelligently upon the alleged malpractice conduct of the doctor.

    Similarly, the Federal Reserve should not simply be composed entirely of ditch diggers, the homeless and the mentally retarded.

    It only stands to reason that banking regulatory officials of the Fed should have a strong, working familiarity with Treasury markets, income velocity, capital ratios and derivatives.

    So it only stands to reason that bankers and Wall Street should be properly regulated by those with a substantial working knowledge of the subject matter.

    How do you obtain this familiarity? By going to the same business schools and moving in the same professional circles as bankers and Wall Street.

    I'm now halfway through Buiter's paper and it deserves to be read in its entirety because it is indeed a serious paper; that's why it was allowed to be presented in this prestigious forum of Jackson Hole.

    But to characterize Buiter's main thesis as "The Fed is too close to Wall Street" shortchanges Buiter's work dramatically and seems completely inconsistent with a complete reading of it in its entirety.

    I urge serious members of this forum (rather than those simply interested in politically correct Fed-bashing) to read all of Buiter's paper so that they may grasp its finer points.

    Matt Dubuque

    etc said...
    The only good thing about Bernanke is that he's telegraphed his foolish plans, so investors can guard against the higher taxes and, by turns, inflation and disinflation, they will bring.
    Yves Smith said...
    Matt,

    You are missing my, and I think Buiter's point. He has said repeatedly on his blog, in his May paper (where he discussed cognitive regulatory capture at much greater length) that the Fed is too attentive to Wall Street's needs and demands. I pointed in the post to possible remedies. I did not advocate that the Fed start hiring people with no financial experience. I said the Fed needed to go to greater lengths to cross check what current incumbents are telling them against the views of others who have market knowledge but no axe to grind.

    And even though Buiter may have spent less time on that issue in the body of this paper, he does consider to be a major failing, He put it first on his list of charges. Given his attention to style and rhetoric, I would imagine that to be a deliberate move.

    Anonymous said...
    um, i'm not sure there's anything _really_ new here -- the NYC-WDC/wall street-k street praxis has been in operation for generations -- it's like a sudden revelation about an iron triangle in japan or a military industrial complex; not that it isn't welcome antiseptic sunlight, just that speaking truth to power is hardly, er, revelatory... or, i guess i should say, not *as* revelatory as some people may think ;)

    cheers!

    Anonymous said...
    uh, i think 'naive' was the word i was searching for! besides, isn't everyone's interests aligned when it comes to a healthy and thriving economy and housing and credit markets? :P

    Fair Game: What Will Mac 'n' Mae Cost You and Me? Up and down Fannie's and Freddie's capital structure, debt and equity holders want to know how a bailout would affect them.

    Freddie, Fannie Ills Leave Experts at Loss: The U.S. Treasury will likely be forced to inject funds into Fannie Mae and Freddie Mac, some top economists think, but they're not sure whether it will be enough to bolster the sagging economy.

    Mark Sunshine said...
    I think that Buiter has some good but not new analysis of the causes of the credit crisis.

    However, his suggestions for current Fed policy are both dangerous and poorly thought out.

    I read both his May, 2008 article and his August, 2008 article (which was a follow up to the May article). The worst of his analysis is when in a single sentence he dismisses the difficulty of correcting a recession brought on by monetary stock destruction (i.e., the Great Depression) and says "Output contraction can be reversed easily through expansionary policy". The sentence rejects without analysis or thought the whole point of the Fed policy he doesn't like, i.e., SOMETIMES output contraction CANNOT be reversed easily through expansionary policy.

    I have a blog where I wrote about Buiter after reading this blog. Please feel free to check it out at http://www.firstcapital.com/blogs/mark_sunshine/?p=90.

    In case anyone is interested (and before anyone accuses me of being a "corporate tool") I also have written two articles where I suggest that enforcement of current rules and regulations has been at best "lax" and that criminal enforcement has been non-existent. I think that the moral hazard issue should be addressed by regulators enforcing the laws and regulations on the books and not ignoring them. Those blog references are http://www.firstcapital.com/blogs/mark_sunshine/?p=87 and http://www.firstcapital.com/blogs/mark_sunshine/?p=74.

    Yves, I think your blog is great and look foward to reading the multiple articles each day.

    Thanks for helping us stay informed.

    Anonymous said...
    I agree with Buiter's criticism of the Fed as being too much under Wall Street sway. But as for inflation, wait-n-see. The stats show that European wages are keeping up with inflation, American wages - not so much. The back of labor is broken, and in our coming recession we will all witness the tormented flopping of "consumers" as they cope with that by retrenching.
    http://online.wsj.com/article/SB121935236568761377.html?mod=hpp_us_whats_news
    Anonymous said...
    Tar and feather every last Fed member, then shut down the lobby groups that push synthetic derivative solutions to this corruption!
    doc holiday said...
    You have to keep in mind that this circus is put on by The Fed, so obviously they are there to slap each other on the back and thus to not engage in meaningful debate.

    The truth is in the fact that a shadow banking system is out of control and the bailout of bear Stearns is an antitrust matter, which relies on taxpayer support and thirdparty hocus pocus, in the form of Blackrock liquidating Bear assets in a process that is not public, or disclosed. This entire bailout is filled with government fraud, which is backed by the central bank members. Buiter should be praised for his work!!!!

    http://www.maidenlanellc.com/


    On June 26, 2008, the Federal Reserve Bank of New York (FRBNY) extended credit to Maiden Lane LLC under the authority of section 13(3) of the Federal Reserve Act. This limited liability company was formed to acquire certain assets of Bear Stearns and to manage those assets through time to maximize repayment of the credit extended and to minimize disruption to financial markets. Payments by Maiden Lane LLC from the proceeds of the net portfolio holdings will be made in the following order: operating expenses of the LLC, principal due to the FRBNY, interest due to the FRBNY, principal due to JPMorgan Chase & Co., and interest due to JPMorgan Chase & Co. Any remaining funds will be paid to the FRBNY.

    Anonymous said...
    Clearly both the consumers and the banks have been playing footloose and fancyfree with OPM(other peoples money) and leverage.

    Meanwhile, the supposed referee, the Fed has been busy drinking the Harvard Business School's Koolaid and flirting with the cheerleaders.

    Lately, I am becoming a fan of the Will Rogers Common Sense School of Business and his attitude towards money and bankers.

    I was raised on a Cattle Ranch and I never saw or heard of a Ranchman going broke (except) the ones who had borrowed money. You can't break a man that don't borrow; he may not have anything, but Boy! he can look the World in the face and say, 'I don't owe you Birds a nickel.' You will say, what will all the Bankers do? I don't care what they do. Let 'em go to work, if there is any job any of them could earn a living at. Banking and After-Dinner Speaking are two of the most Non-essential industries we have in this country. I am ready to reform if they are." WA #14, March 18, 1923

    joe said...
    independentCPA SAYS, and doc h suggests, a re-doing of the FED's existence.
    As do others.
    My agreement leads me to question,
    and replace it with what?
    The Paulistas and the Austros seem to revert back past wildcat banking.

    I still say, we're $50 TRILLION in DEBT service, and ALL new money is created as debt, so there is no way out that route.

    So-called liquidity is the hair of the dog that bit ya.

    Anyone?

    Alfred said...
    Consider these two statements, one is from Bernanke the other from Trichet:

    Bernanke (opening remarks to JH 2008): Although we have seen improved functioning in some markets, the financial storm that reached gale force some weeks before our last meeting here in Jackson Hole has not yet subsided, and its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment."

    Trichet (Introductory statement Aug08, Q&A): "But, if everything is taken into account, the dynamism of loans to non-financial corporations has given us an overall level of lending to the private sector that is still very dynamic and I would say again that, in that domain too, we have to be respectful and pragmatic and will have to see what the facts and the figures are."

    As Buiter points out the 'Precautionary Principle' is misused by the Fed. Central bankers as the ultimate guardians for macro economic stability should be pragamtic and respectful in the face of facts and figures.

    It must be absolutly obvious to everyone interested that the Federal Reserve acted on behalf of Wall Street in complete and utter disregard of their dual mandate.

    Anonymous said...
    From an academic pov I favor Buiter's vision, but the question is not whether he's right or wrong. After all not even the future will point out what was the right action.
    The question is rather whether the CB's can afford not to intervene in the market. Even if the odds are leaning towards Buiter's theory, then interventions at these levels are still to be preferred considering the desastrous outcome if it went wrong.
    So it is a question of probabilities and consequences.
    Will the CB's worsen the situation? We don't know. Solve what you think you should solve today, judged on probabilities, and solve tomorrow based on what you know tomorrow.
    geert

    Part 1 Behaviour and the Policy Development Process Behavioural Analysis for Policy New Lessons from Economics, Philosophy, Psychology, Cognitive Science, and Sociology Behavioural Analysis for Policy

    Within this section …

    New Zealand's economy and society are becoming more complex over time, and as a result policy makers need to keep up to date and ensure that government policies reflect the dynamics of the modern New Zealand economy and society.

    Government policy interventions are fundamentally about inducing a desired response from a target population. It is therefore important to understand our assumptions about how people behave to ensure that policies can work most effectively. It is also important to get assumptions about behaviour right so as to minimise potential unintended consequences.

    The Policy Development Process

    4. The Policy Development Toolkit sets out the steps in the policy development process, including defining the problem, setting objectives, designing options, getting decisions, implementation, monitoring and evaluation. The assumptions which the policy analyst brings to each of these steps can have a large role in the ability of the policy to achieve its intended effects.

    5. Problem definition, setting objectives and designing options are particularly amenable to a behavioural analysis. Whereas the traditional economic approach would see any deviation from rational behaviour as a problem, a behavioural approach accepts that people are influenced by factors such as peers, culture and social networks. Policies which are based on the assumption that it is necessary to correct these "problems" may therefore be out of step with general public views.

    6. The types of policy instrument available to the analyst include: new (or amending existing) legislation, increasing enforcement, information and education campaigns, economic instruments (taxes, subsidies and tradable property rights), voluntary standards/codes of practice, and self-regulation/co-regulation. The different types of policy instruments are intended to achieve different behavioural responses and so must be designed based on the analyst's assumptions about behaviour. The choice of policy instrument adopted requires consideration of the context in which it will be implemented to ensure that it achieves the right behavioural response.

    7. A behavioural approach is also vital at the implementation stage. For example, the way a policy is presented or framed can have a large influence on the way the policy is interpreted and responded to by the people targeted by the policy.

    8. It should also be noted that the success of a policy intervention depends not just on the response by the target population - whether businesses or consumers - but also on the behaviour of regulators. This is particularly important in deciding how to implement a policy to achieve best effect.


    Case Study 1: Regulatory Capture

    It is important to consider behaviours and incentives of people responsible for implementing a given policy/regulation in addition to those who are regulated.

    In the UK, large publicly owned companies were privatised during the 1980s including the monopoly telecommunications provider (British Telecom), the monopoly gas supplier and provider (British Gas) and the monopoly electricity provider (The National Grid). These privatisations were complemented by prescriptive regulation of maximum prices and quality standards that were enforced by regulatory bodies that the UK government set up. Most of these privatisations, combined with subsequent opening of the markets to some competition from other players, have been considered successes and are widely recognised to have reduced prices and improved services.

    However, many critics of this privatisation have pointed out that rates of return on capital (a measure of profit) of these privatised companies have often noticeably exceeded rates of return on capital in other industries that are subject to more market competition. Excess profits have been seen as detrimental for society as a whole since this usually means that companies are keeping prices higher than the minimum level needed to be in business. Some critics of this privatisation process argue that the agencies set up by the government to regulate the industries have sometimes been captured by interest groups (regulatory capture). For example, the regulatory agencies may at times have not placed sufficient pressure on regulated companies to reduce prices, due to the regulatory bodies themselves being over-influenced by political considerations and also by groups of shareholders who hold company assets and who seek to obtain a large return (value of shares increase when company profits increase). However, evidence that regulatory capture has ever occurred in the UK is limited, although regulatory capture is always a risk where companies with limited market competition are regulated. The important role of implementation is to consider the likely behaviour of regulators who will implement the policy, as well as the likely response from targets of the policy.

    Source: Alain Anderton, Economics, third edition, Causeway Press, 2000


    The Neoclassical Economic Model

    9. Many aspects (but by no means all) of current public policy analysis and design have their roots in neoclassical economic theory. This theory also underpins much of the content of university economics degrees. Although neoclassical economic theory and its assumptions have progressed significantly since it was first developed in the 19th century, at its core are a number of simplifying assumptions (that are still sometimes used in policy analysis) about how those impacted by a policy would behave. These big assumptions or simplifications have often been made because of knowledge gaps of actual behaviour or reactions to policy in a complex world, particularly when trying to predict the behaviour of a large number of firms. Behavioural theory (or behavioural economics) is intended to complement neoclassical economics by filling in some of these gaps and challenging some of these assumptions.

    10. The traditional (core) neoclassical assumptions include:

    11. Traditional economics models behaviour as occurring as a result of perfectly rational choices made with perfect information. Government intervention is therefore only needed when markets fail, which would be rare, given that people would have the ability to make excellent, profitable choices ensuring all possible opportunities would be fully realised.

    12. Neoclassical economics and how it is modelled to formulate policy and understand behaviour has progressed significantly and variations of the neoclassical model used for some policies often relax some of the above assumptions and incorporate sophisticated real world data. Alternative aspects for policy design explored in this paper are designed to complement the wealth of currently applied theoretical models.

    Alternative Approaches to Understanding Behaviour

    13. Alternative theories, from diverse disciplines such as behavioural economics, psychology, cognitive science, philosophy and sociology, provide alternative approaches to understanding behaviour. For example, behavioural economics asserts that people systematically misjudge the costs and benefits of their actions, as a result of cognitive ability, emotional responses or moral judgements in individual decision-making. Policies which blindly assume rational behaviour may not be effective. Interpersonal behavioural theories emphasise the importance of other people on an individual's behaviour which could support government intervention towards correcting "bad" influences.

    14. This paper discusses alternative theories of behaviour, contrasting them with the traditional economic approach. These disciplines allow us to take alternative perspectives which complement traditional neoclassical economics. In particular, behavioural theories can provide insights into people's motivations, inter-personal relationships, understandings and choices that allow a richer analysis of human behaviour than one constrained by the assumptions of neoclassical economics.

    Fireworks at Jackson Hole: Buiter Let's It Rip At the Jackson Hole, Wyoming Federal Reserve conference, London School of Economics professor and former Bank of England and European Bank for Reconstruction and Development official, Willem Buiter, ripped into the manner in which the Federal Reserve, the European Central and Bank of England have handled the current financial crisis. His remarks were particularly critical of the Federal Reserve claiming the the Fed is too close to Wall Street:

    Cognitive regulatory capture of the Fed by Wall Street resulted in excess sensitivity of the Fed not just to asset prices (the 'Greenspan- Bernanke put') but also to the concerns and fears of Wall Street more generally.

    The Fed listens to Wall Street and believes what it hears. This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.

    He charged that all three banks went well beyond what was necessary to stabilise the financial sector:

    All three central banks have gone well beyond the provision of emergency liquidity to solvent but temporarily illiquid banks. All three have allowed themselves to be used as quasifiscal agents of the state, providing subsidies to banks and other highly leveraged institutions, and assisting in their recapitalisation, while keeping the resulting contingent exposure off the budget and balance sheet of the fiscal authorities. Such subservience to the fiscal authorities undermines the independence of the central banks even in the area of monetary policy.
    He listed three factors contributing to the Fed's poor performance in handling the crisis:
    [T]hree factors contribute to Fed's underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.

    The second is a sextet of technical and analytical errors: (1) misapplication of the 'Precautionary Principle'; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on 'core' inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.

    All three central banks have been too eager to blame repeated and persistent upwards inflation surprises on 'external factors beyond their control', specifically food, fuel and other commodity prices. The third cause of the Fed's macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.

    It is difficult to argue with Buiter on these points. Indeed, the Fed's reliance on the Fed Funds rate target as its chief monetary tool is currently ignoring the fact that there is little growth in the money supply. Ignoring money growth is also a charge Buiter makes of the Fed: "too little attention paid...to the behaviour of broad monetary and credit aggregates."

    Unfortunarly, reports out of Jackson Hole suggest that rather than take Buiter's critque to heart and learn from it, members of the Fed and others have chosen to attack the analysis:

    Fed Governor Frederic Mishkin said Buiter's paper fired ``a lot of unguided missiles,'' and former Vice Chairman Alan Blinder ``respectfully disagreed'' with his analysis of the central bank's crisis management.....Mishkin lashed out against Buiter's assertion that the Fed's rate reductions may cause higher consumer prices.` `I wish he had actually read some of the literature on optimal monetary policy, because it might have been very helpful in this context,'' said Mishkin, who collaborated with Bernanke on inflation research in the 1990s. Mishkin, a leading advocate of the Fed's effort to sustain economic growth through rapid rate reductions, said research shows that ``what you need to do is act more aggressively.''



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