As he constantly consumed information on the financial crisis that recently pushed the country into a recession, Richmond Federal Reserve Bank President Jeffrey Lacker saw a lot of reports that placed blame on economists for failing to predict the factors leading up to it.
“I’m going to attack that notion for you today,” Lacker told his audience of mostly business and politics students at West Virginia University on Wednesday (April 14). “I’m going to try and demolish that notion.”
Calling the assumption that economists should have predicted the details of the recession “unfair,” Lacker pointed to the ways in which economists had tracked and predicted in the last few decades the forces that led to the financial crisis.
As he gave the audience a background of economic research, Lacker brought up points of concern that the researchers had noted. As far back as 1977 economists noticed that depository insurance had an influence on the risks taken by banks and consumers. If the bank was insured, it took on more risk and its consumers were less likely to monitor the bank’s practices.
Lacker spoke of other economists who noted that as banks became insured, oversight on their behavior would relax. Also, with the insuring of banks, panic attacks of bank runs were rewarded by the promise of a 100 percent return immediately. An alternative strategy proposed was that of offering something like an 80 percent return on investment after a certain point, which put a penalty on panicking.
But what may have been most telling about the most recent financial crisis was that the government took on a role of rescuing large financial institutions, those “too big to fail,” fueled by an undefined perception by the public that these banks would be shepherded by the government in the event of a crisis.
“This is a huge problem,” Lacker said.
He pointed to two of the biggest names in news in the last two years as an example. Fannie Mae and Freddie Mac, both mortgage insurers, were not regularly financially supported by the government, but they were bailed out due to a public perception that they would be bailed out.
“Fannie Mae and Freddie Mac have been more expensive than anything else in this crisis,” Lacker said. “Over $100 billion and still there’s more losses to come for us taxpayers. They were able to borrow at much lower interest rates than competitors in the mortgage securitization market because they were perceived to be too big to fail.”
Lacker pointed to how the recent bailout precedents have only enlarged this undefined safety net. In 1999, economists at the Richmond Federal Reserve Bank found that 45 percent of the liabilities in the country’s financial community “enjoyed explicit or implicit government support.”
Following the last round of bailouts, that percentage has climbed to 59.
The problem, Lacker believes, is ambiguity and “a lack of clarity.”
What policymakers can do to change this is define who is in the safety net and who is not, and to make the safety net smaller in an effort to encourage individual responsibility.
And institution failure doesn’t have quite the consequences that some feared, Lacker said. When Lehman Brothers Holdings Inc. filed for bankruptcy protection, the only firm that failed as a result was a money market investor engaged in fraudulent activity.
Lacker said bills are in both the Senate and House side of Congress now that are attempting to fix this problem, but which offer government leeway with an option for bailout funding to use at Congress’ “discretion.”
“That to me just sets up this dynamic, just perpetuates this dynamic that gave us ‘too big to fail’ to begin with, and so I think it would be a mistake,” he said.
After discussing the hows and whys of the recession, Lacker underlined his belief that economics has a positive role to play in the discussion.
“I hoped to have convinced you not to give up on economics if you ever did,” he said.
Lacker’s division of the Federal Reserve oversees Virginia, Maryland, North Carolina, South Carolina, the District of Columbia and West Virginia, except for the northern panhandle.