Monday, June 22, 2009

Reviewing the Administration’s Financial Reform Proposals

Reviewing the Administration’s Financial Reform Proposals. By Douglas J. Elliott, Fellow, Economic Studies, Initiative on Business and Public Policy
The Brookings Institution, June 17, 2009

The Obama administration’s financial reform proposals to be announced today are virtually all sensible, necessary reforms. Unfortunately, some bolder steps have been left out, apparently due to the expectation of intense opposition from entrenched interests. The key proposals, as described in leaked “near-final draft” form are:
  • A greater focus on systemic risks
  • Higher capital and liquidity requirements for financial institutions, especially the largest
  • Tougher regulation of systemically important financial institutions
  • Expanded “resolution authority” for regulators to take over troubled financial institutions
  • Modest consolidation of regulatory functions
  • New regulations for securitizations and derivatives
  • Stronger consumer protections led by a new Consumer Financial Protection Agency
  • Greater international coordination
Systemic regulation

Regulation has largely focused on ensuring that each financial institution was sufficiently sound in its own right with less attention paid to how the dominos could fall if a major institution fails. Banks and other financial institutions are now so interconnected that problems at one can lead to problems at others which are then magnified throughout the entire system. The level of systemic risk before this crisis was much higher than had been appreciated, spurring the government into significantly more extreme responses than one would have expected to be necessary.

There is a dual response in the proposals to the need for more systemic oversight. First, Treasury will head a new Financial Services Oversight Council (FSOC) whose role will be to identify emerging risks to the system as well as coordinating regulatory activities in general. Second, the Fed will have regulatory power over individual systemically important financial institutions of all types, as discussed later.

This dual approach appears to be a political compromise. The administration’s initial impulse was apparently to give the Fed sole authority over systemic risk regulation, both at the systemwide level and in regard to individual systemically important financial institutions. There would have been the usual consultation with its peers, but nothing like a veto power wielded by the other regulators. However, Congress is not happy with the Fed at the moment. The Fed’s role in the bailouts, especially of AIG, has annoyed many in Congress. This has magnified concerns about the huge financial power of the Fed and its dramatically expanded role in the credit markets, where it operates with little Congressional oversight.

It makes sense to have a regulator responsible for watching over risks to the system as a whole, but there is a real limit to how effective it can be because it would be asked to do something extremely difficult. Ideally, the regulator would spot problems before they spawned bubbles whose bursting would cause great economic pain afterward. However, it is not necessarily easy to spot a bubble in advance, no matter how clear it seems in retrospect. Some things which may appear to be bubbles are not, but rather reflect true long-term changes in the economy. Other trends may be bubbles, but seem as if they were not. For example, what happens if commodity prices go up further and oil reaches $100 a barrel. Is that a commodity bubble or a natural response to tight energy supplies in a recovering world economy? Bubbles almost always start as a reasonable response to changing circumstances – the problem comes when they accelerate beyond reason as investors pile in to a rising market.

The actual powers of the FSOC in practice will matter, as will its approach to using them. At one end of the spectrum, there could effectively be little more than a power to warn about danger, which could be useful, but might not make much difference. At the other end of the spectrum, there would be solid authority to force changes, perhaps by raising capital standards or even limiting certain activities outright. Ironically, the stronger the power, the harder it may be to use. Bubbles grow because there is a widespread belief in the underlying thesis driving the market and investors are profiting from following that belief. Thus, there will be strong resistance to any regulator who argues against the prevailing belief, especially if they are seen as about to destroy a profitable market opportunity that will be argued to be beneficial to society at large. For that reason, there is little risk of the opposite problem, that a systemic regulator will act too strongly or too soon, although this remains a theoretical possibility.

Despite the risks of ineffectiveness, it is better to have a regulator responsible for leaning against the wind when market forces are pushing too hard in a particular direction. Warnings and the threat of specific actions may still help rein in at least some of the excesses associated with bubbles, even if the regulatory actions themselves were to be thwarted. It would be better, however, to have a single regulator play this role rather than a council. The need to win a consensus across all the regulators, with their different views, constituencies, and institutional interests is likely to make it excessively hard to achieve the desired systemic safety.

Higher capital and liquidity requirements

The current crisis has reinforced the importance of a strong level of capital at banks and other key financial institutions. Capital represents the portion of a bank’s assets on which no one has a call except the owners of the bank, whose role is to absorb any losses. Thus, it is available to pay for mistakes and misfortunes, which we have vividly seen are a real possibility in this business. The more capital is held, the greater the level of mistakes and bad luck that can be handled.

The administration supports tougher capital requirements, which are clearly needed. The key will be finding the right balance; tough and effective without overshooting. Capital is not free, for the banks or for society. The investors who provide the capital expect a return on their investment which has to be built into the price of loans and other services or taken out of the rate paid to depositors.

Similarly, the administration supports tougher liquidity requirements, since key financial institutions have been forced to the wall because they allowed themselves to become too exposed to the risk of a “run” by creditors. Within limits, it is a useful economic function for banks to borrow short-term and lend long-term, but it needs to be carefully balanced against the risk that short-term borrowings will run off without new creditors being willing to step in at a reasonable price in a time of trouble.

Tougher regulation of systemically important financial institutions

A newly designated group of Tier 1 Financial Holding Companies (Tier 1 FHCs) would be established by the Fed, in consultation with the FSOC. These entities would be required to hold more capital and perhaps bear additional restrictions not applicable to other financial institutions. The theory is that certain financial institutions are so large or interconnected with other key market players that they cannot be allowed to fail. In practical terms, this means that there is an implicit government guarantee covering those institutions and therefore a potentially large cost to taxpayers if they begin to fail. It is reasonable to take regulatory steps to reduce the risk of failure for those institutions below the risk for less significant ones. Those restrictions may also reduce the temptation for smaller institutions to find a way to become too important to fail and thereby gain the same implicit federal guarantee. Expanded “resolution authority,” discussed next, is a key element of regulation being proposed for Tier 1 FHCs.

Expanded resolution authority

Regulators have available an elaborate set of powers to deal with banks that have fallen into trouble, powers that allow intervention well short of when a bank becomes formally insolvent. There is a regime of “prompt corrective action” steps that regulators can require banks to take once they become undercapitalized or hit other severe problems. Federal regulators have much less authority to deal with troubled financial institutions of other types, with the level of authority falling to zero for insurers or hedge funds.

The administration is proposing to give the Federal Reserve and the FDIC powers over systemically important financial institutions, including bank holding companies and Tier 1 FHCs that are not bank holding companies, that are similar to the prompt corrective action powers already enjoyed by regulators of banks. The Fed would be principally responsible for using these powers while the financial institutions remain solvent, with the FDIC taking over any institutions that actually fail.

This would be a major and controversial change to existing regulation and insolvency laws. It seems clearly necessary in regard to bank holding companies, which are standard corporations covered by regular bankruptcy rules, but which are so bound together with their bank subsidiaries as to form one integral whole. My earlier paper, “Pre-emptive Bank Nationalization Would Face Thorny Problems,” discussed some of the serious difficulties in dealing with a bank and its holding company under different legal bases.

There is also a good case for extending bank-like resolution authority to insurers, finance companies, and securities firms that are affiliated with Tier 1 FHCs, although the answer is not as clear-cut as with bank holding companies. Here the arguments for resolution authority are tied quite closely to the basic premise for tougher regulation of Tier1 FHCs in general. If we establish a separate class of Tier 1 FHCs, they will be implicitly guaranteed by the government, giving the taxpayer a greater stake in their health. We therefore need to optimize the way we deal with such entities if they become insolvent, including, preferably, establishing rules and authorities that make it less likely that they will reach insolvency. The prompt corrective action requirements on banks are a sensible way of doing this.

There are two broad arguments against extending resolution authority, as well as numerous more technical concerns. First, some analysts do not think that the separate status should be established in the first place. In part this is because it makes it more likely in their view that taxpayers will have to subsidize failures and in part because it could give an unfair competitive advantage to the largest competitors, leading them to become bigger still. Second, there are fairness issues involved in changing the insolvency regime for investors who have held bonds of the affected institutions for years under the clear understanding that they would be protected by regular bankruptcy law in the event of an insolvency.

I support extending resolution authority, but it is too complex an issue to fully discuss here. I intend to issue a separate paper in the near future expanding on the brief discussion here.

Consolidation of regulatory functions

There are significantly too many bank regulators in the United States. Different banks and bank-like institutions are regulated by: state regulators; the Office of the Comptroller of the Currency (OCC); the Federal Reserve; the Office of Thrift Supervision; the National Credit Union Administration; and, for certain important purposes, the Federal Deposit Insurance Corporation (FDIC). It appeared earlier that the administration would propose significantly reducing the number of bank regulators, perhaps to as few as a single regulator. This thought appears to have died in the face of intense opposition by many in Congress and elsewhere. No one would design the banking regulatory system the way it is now if they were starting from scratch, but there are many entrenched interests who do not want the present system to change.

The Office of Thrift Supervision is the only regulator who appears to have lacked the institutional support to retain their separate existence. The administration has proposed merging them with, and effectively into, the OCC. This move makes sense, but does not provide nearly the advantages the broader consolidation would have brought. Different regulators will inevitably have different approaches, especially as they are generally given substantial independence in order to reduce the politicization of regulatory decisions. These differing approaches can reduce the effectiveness of systemic regulation, in part by opening up the possibility of “regulatory arbitrage,” where financial groups put their various activities into the affiliates which have the softest regulatory requirements. It is true that tighter regulation of consolidated groups at the holding company level will reduce the ability to arbitrage the regulators, but it is unlikely to entail supervision as detailed as that which will occur at the level of the regulated subsidiaries.

Outside of bank regulation, there are two financial market regulators, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). It makes compelling sense to combine them, but the politics are apparently too difficult. (For one thing, the Agriculture committees of the two houses strongly wish to retain authority over a robust CFTC.) Instead, there will be additional fragmentation as some of the consumer protection functions of the SEC will overlap with that of the new consumer protection regulator discussed later.

New regulations for securitizations and derivatives

Many of the losses by financial institutions and other market players came from problems with securitizations of mortgages and other assets or from problems with derivatives, particularly credit default swaps. The administration proposes greater regulation in both areas, in line with previous statements.

The biggest change to securitizations would be a requirement that the originators of the loans underlying the securities retain at least 5% of the risk. The idea of “keeping some skin in the game” is intuitively appealing and should help. However, it is important not to take excessive comfort from this change. Banks will indeed pay more attention to the quality of the assets they securitize if they retain even a small fraction of them. But, the financial incentives in a bull market for those assets will still push them towards taking greater and greater risks, since they will immediately gain most of the benefits through securitization while only having a future risk on a small fraction of the asset pools. Also, banks are not immune to the euphoria that grips the larger markets during an asset bubble. The banks, to their regret, actually retained much of the mortgage risk from the bubble period, sometimes even buying more in the open market.

The administration is also proposing other positive steps related to securitization, including: greater transparency about the assets backing the securities; clearer guidance from the rating agencies about the differences between asset-backed securities and regular corporate debt; and changes to the compensation structure for the parties involved in securitization.

On the derivatives side, the administration had already indicated that it would push for all standardized derivatives to be traded through an organized exchange or cleared through a clearing house. An exchange is a centrally organized marketplace for the purchase and sale of financial products. The best known is probably the New York Stock Exchange, but there are also several prominent exchanges that do a major business in derivatives already. Exchanges bring a real benefit from transparency about the pricing and volume of trades, as well as making it easier for regulators to track trading positions of major parties. In contrast, much of the trading volume in derivatives now takes place “over the counter,” between two counterparties who are not generally required to report details of the trade and who take each other’s credit risk in regard to the transaction. This credit risk is often mitigated by requiring collateral, but it is clear in retrospect that this process was not well-managed in many cases, leaving a large number of institutions very exposed to the credit risk of AIG, for example.

The major exchanges dealing in derivatives use central clearing houses that act as the counterparty to both sides. If A sells an option to B on the exchange, the clearing house would interpose itself, buying from A and selling the option on to B. The sole purpose of this interposition is to eliminate B’s credit exposure to A. If the option becomes valuable over time, B needs A to make good on its promise. If A doesn’t, the clearing house would make good, protecting B. Such clearing houses can also handle trades that were done off of an exchange, which will be an allowed alternative in certain cases.

It should be noted that using a clearing house does not eliminate counterparty risk altogether. The clearing house could become insolvent itself if enough of its counterparties fail to meet their obligations. This should still represent a diminution of the total credit risk in the system, since clearing houses are well-capitalized and operate in a clearly defined business that is easier to manage than a broader business, but there could be extreme circumstances where a government rescue would be required.

The big controversy with derivatives is what to do about customized derivatives. The use of derivatives to manage risk by sophisticated corporations is pervasive. Sometimes those derivatives are significantly cheaper or more effective if they cover the exact risk rather than using one or more standard derivatives to approximate the desired protection. It would be a great shame to lose those efficiencies altogether by banishing customized derivatives, but there is also a fear that financial firms will deliberately sell slightly non-standard derivatives in order to avoid the tougher rules on standardized ones.

This is another area where the devil is in the details. The trick will be to provide incentives or requirements to use standard derivatives where possible, while leaving the ability to use customized ones where they serve a genuine need. The administration’s proposal attempts to strike this balance. It will be interesting to see what comes out the other end of the legislative process, given the combination of a high degree of public anxiety about derivatives combined with a lack of understanding of this complex topic by many who are voicing opinions about the proper course of action.

Stronger consumer protections

The administration has proposed creating a Consumer Financial Protection Agency (CFPA), responsible for all aspects of regulation of mortgages, credit cards, and other consumer-focused financial products, with a few exceptions, such as mutual funds, which are left with the SEC. This appears to be a fairly powerful agency, with the power to set binding regulations, impose fines, etc. It will specifically be authorized to impose an obligation to offer “plain vanilla” products, such as a standardized 30-year fixed rate mortgage, with the possibility that consumers who wish to make another choice will have to specifically waive their right to have the standardized product.

There have been many bad practices that developed in the bubble period which harmed consumers, especially related to sub-prime mortgages. It will be useful to have a clear regulatory focus on eliminating those problems and avoiding others in the future. The critical issue will be the extent to which the CFPA is able to find the right balance between promoting consumer safety and allowing innovation. Everyone can agree on the need for transparency. What is harder is when there are both risks and rewards to a given product, from the consumer’s viewpoint. How much will the CFPA try to protect consumers from taking risks that might actually be legitimate in light of the potential rewards?

Another key issue that will be determined by a combination of legislative wording and regulatory choices over time is the extent to which the CFPA will move out of products that are clearly consumer products into a wider range of financial products. For example, would the CFPA ever find itself imposing regulations on derivative products, perhaps on the basis that some individuals do invest in them? This appears not to be the intent of the proposal, but there will doubtless be gray areas in practice.

Greater international coordination

Finally, the administration has also highlighted the need for greater international regulatory cooperation. This would indeed be useful, particularly if the United States develops tougher rules in some areas than currently exist elsewhere. However, it is not likely that there will be a large effect on U.S. policy from this international cooperation. As has already been seen with the failure to propose significant regulatory consolidation, financial regulation in the United States is a very parochial affair, with entrenched interests fighting their corner with relatively little regard for what is going on in the rest of the world.


The proposals are generally quite sensible. The unfortunate aspect is that political constraints have caused the administration to stop short of a full solution in certain areas, most notably in the consolidation of regulatory functions into fewer hands. Nonetheless, the country should be better off if these proposals are passed than if we were to remain as we are now.

Does the "Smart Grid" Have a Smartest-Guys-in-the-Room Problem?

Does the "Smart Grid" Have a Smartest-Guys-in-the-Room Problem? By Ken Maize
Master Resource, June 19, 2009


However politically incorrect my conclusion, I’m convinced that the “smart grid” is not smart and even dumb. It diverts attention from what is a more important objective–a strong grid. And it politicizes in the very area where we need more consumer-driven, free-market incentives.

Following the Northeast grid collapse of 2003, the Electric Power Research Institute (EPRI) popped out the smart grid concept, largely the brainchild of then EPRI’s CEO Kurt Yeager. The blueprint was for an interconnected intelligent network reaching from the generating station to your toaster, able to talk up-and-down the line, matching supply and demand seamlessly.

Sounds cool, but doesn’t stand up to analysis in my judgment.

Where Did ‘Smart Grid’ Come From?

The idea of a smart grid has been laying around in bits and pieces for many years. I recall visiting Southern California Edison (SEC) in the 1980s where a group of us energy reporters visited the utility’s “smart house.” It kinda reminded me of the Betty Furness advertisements for Westinghouse kitchens when I grew up in Pittsburgh in the 1950s and 1960s. SCE assured us that the smart house, connected to the utility over phone lines (this was pre-World Wide Web) and through radio signals, would dominate home construction in the coming years. (Enron would have a ’smart house’ a decade later to awe visitors to 1400 Smith Street in Houston, but that’s another story.)

Didn’t happen, for lots of reasons, most of them good. It didn’t make economic sense for consumers (although it did for the utility — remember all-electric “gold medallion” homes?). It was way too technologically optimistic, assuming communications protocols that really didn’t exist, and appliances that weren’t remotely ready to talk to each other and the utility. Heck, this was largely before cell phones were making a big impact in the market.

Fast forward to the 21st Century. The grid has shown that it is in trouble. The Internet has demonstrated the utility of Vint Cerf’s IP communications protocol. EPRI is facing an existential moment (what the heck is our role here?). Presto! The smart grid. It controls power flows, adjusts supply demand on the fly, instantly corrects for frequency and power imbalances. It slices, it dices, it’s the latest, biggest, best Ronco product of all time. We can get Billy Mays (no relation, he spells it differently) to peddle it on late-night cable.

Rescuing Dumb Renewables

The concept of the smart grid (if not the reality) also fits into the allegedly new paradigm of renewables. We want lots of power from the wind and the sun (water doesn’t count). But the places where the winds blows a lot and the sun shines a lot are a long way away from where there are a lot of people.

Hence proposals to build a transcontinental, high-voltage (AC and DC) backbone grid on top of the existing transmission and distribution network (which former energy secretary Bill Richardson famously and erroneously called a “third world” grid following the 2003 grid collapse). What’s a trillion dollars or so to bring unreliable power to market?

So here is the Big Green Grid Dream: tie renewables to consumers, with a smart grid to govern (Big Brother?) usage. We could imbue the entire grid — high-voltage transmission and lower-voltage distribution with smarts, from the generator to the substation to the refrigerator. It’s the Big Rock Candy Mountain–or Dream Green Machine.

Another Problem: Cybersecurity

Another problem with the concept of a smart grid (which most advocates assume will use IP/TCP communications protocols) is cybersecurity. It’s hard to bring down a dumb but strong grid in a cyber attack. The smarter it is, the more vulnerable it becomes. There was a report in the Wall Street Journal not long ago that hackers from China and Russia had successfully penetrated the U.S.”grid,” which was undefined in the article.

I don’t believe it, and no other mainstream media outlet backed up the story. But the “smarter” the grid becomes, the more likely such hacking becomes. That’s a real problem.

The Legacy Problem

The U.S. transmission grid (and I’m talking about the big pipes — 365 kV and above) has clear weaknesses. We don’t have a U.S. grid, but loosely-interconnected regional grids. East and West don’t meet very easily. Texas is an island unto itself. Florida is aspiring to the same. Without strong physical interconnections, it’s impossible to dispatch and control a national grid. So a lot of “smart grid” is putting the cart before the horse.

Color Me Skeptical

I don’t buy any part of it, and it ain’t going to happen. It’s what I have described elsewhere as lemon-meringue pie-in-the-sky. Among other problems, the costs are simply unknown, and who will bear them is also unknown. Most of what I’ve seen implicitly suggests that taxpayers will get the check, since customers would revolt if the costs showed up on their monthly bills.

I’ve tuned into recent FERC discussions about grid issues, and heard what I think is a lot of nonsense about smart grids. I’d rather our regulators and policy makers were focusing on muscle, not brains. It’s heavy lifting we need, not heavy thinking.

Ken Maize is executive editor of MANAGING POWER magazine and editor of POWER Blog. He was the founder and editor of Electricity Daily (1993-2006) and a reporter and editor at The Energy Daily for a dozen years, starting on March 28, 1979, the date of the Three Mile Island problem. Contact address:

The Potential Gas Committee has raised its gas resource estimate for the US

U.S. Gas Resources: Julian Simon Lives! (Malthus, Hotelling, Hubbert are wrong again). By Michael Lynch
Master Resource, June 22, 2009

The Potential Gas Committee has issued its new biennial gas resource estimate for the United States and once again raised its estimate, this time by 15%, or from 1,321 trillion cubic feet (Tcf) to 1,525 Tcf. This equates to a 70-year domestic cushion, given annual U.S. consumption of 20 Tcf. The evaluation of available shale gas, production of which is now soaring, played a major role in this re-evaluation and potently demonstrates how new technology (aka human ingenuity, what the late Julian Simon called the ultimate resource) creates resources, refuting the static fixity/depletion view of the mineral-resource world.

Few realize that the PGC has been raising the estimates of conventional resources throughout history, even as the United States has consumed large amounts of natural gas. Thus gas has been and is an expanding resource, not a depleting one.

In 1966, the PGC’s estimate of ultimately recoverable resource (i.e., including cumulative production) was 1,283 Tcf, versus the current estimate of approximately 2,600 Tcf, including 1,100 Tcf of cumulative production. While that includes several hundred Tcf of shale gas and coal-bed methane (CBM), conventional gas resources have surpassed 2,000 Tcf and are far beyond even the most optimistic estimates of a quarter century ago.

An excellent summary of those estimates can be found in the Office of Technology Assessment’s U.S. Natural Gas Availability: Conventional Gas Supply Through the Year 2000, which noted that the pessimistic projections for production in 2000 were about 9 Tcf. Total production that year proved to be over twice that amount, at 18.7 Tcf, of which less than 2 Tcf were shale gas and CBM.

In fact, resource estimates from that era have proved wildly pessimistic. A review of URR estimates from 11 different sources, including M. King Hubbert and Richard Nehring, found none that came close to current levels, with the highest at 1,800 Tcf. Indeed, five of the nine estimates of lower-48 remaining undiscovered resources came in below 200 Tcf, whereas production since then has been 500 Tcf.

Against this background, we have any number of pundits decrying the optimists arguments that resources will be sufficient for our needs, pointing to a few years of elevated prices, and encouraging the building of numerous—now idle—LNG import terminals. Even more, arguments that global gas resources are somehow constrained should be put to bed.

How to Get The Fed Out Of Its 'Box'

How to Get The Fed Out Of Its 'Box'. By FREDERIC S. MISHKIN
A commitment to fiscal discipline could enable expansionary monetary policy.
The Wall Street Journal, Jun 22, 2009, p A15

When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma.

Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around 70 basis points (0.70%), with the result that the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates is particularly worrisome, because it has the potential to choke off economic recovery and lead to further deterioration in the housing market. That would put an already weakened financial system under stress. Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?

To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause of the rise in long-term rates is the more positive economic news of the past couple of months, particularly in financial markets. The bad news is that long-term interest rates are higher because of concerns about the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. To fund these budget deficits, the Treasury has to sell large quantities of bonds both now and in the future, causing bond prices to fall and interest rates to rise. The increased supply of Treasury debt puts pressure on the Fed to buy it up.

Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, want to make it easy for the Treasury to sell its debt and thereby be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.

The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy to lower long-term interest rates through the purchase of Treasurys. The fiscal situation argues against this policy action, because it would weaken the Fed's inflation-fighting credibility.

How can the Fed get out of the box and pursue the expansionary monetary policy that is needed right now? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions when tax revenue undergoes a substantial decline. In addition, fiscal stimulus to promote economic recovery when the economy is in a severe recession is a sensible prescription.

However, the failure to take steps to get future budgets under control is a recipe for disaster. Not only does it make it difficult for the Fed to take the actions needed to promote economic recovery, but it may even make the fiscal stimulus package less effective. After all, if you know that the government is issuing a lot of debt that has to be paid back someday you can expect to pay much higher taxes in the future. With the prospect of higher taxes, you will be less likely to spend today.

How can the Obama administration and Congress help the Fed do its job and help the fiscal stimulus package work? It needs to address exploding spending on entitlements -- Social Security and particularly Medicare -- which are causing future deficit projections to be so bleak.

One possibility is to establish a nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s. It produced recommendations that for a time helped put Social Security on a more solid footing. Another is taxing health-care benefits as part of any package to reform health care. Taxing health-care benefits would not only generate large amounts of revenue. It would also increase the incentive for people to lower the costs of their health care. There are surely many other ways to promote more fiscal responsibility.

The Fed can assist this process. It could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past. In the current extremely difficult economic environment, we surely need such a deal now.

Mr. Mishkin, an economics professor at Columbia University, is a former member of the Board of Governors of the Federal Reserve and the author of "Monetary Policy Strategy" (MIT Press, 2007).

Treasury's reform plan gives the credit raters a pass

A Triple-A Punt. WSJ Editorial
Treasury's reform plan gives the credit raters a pass.
The Wall Street Journal, Jun 22, 2009, p A14

If world-class lobbying could win a Stanley Cup, the credit-ratings caucus would be skating a victory lap this week. The Obama plan for financial re-regulation leaves unscathed this favored class of businesses whose fingerprints are all over the credit meltdown.

The government-anointed judges of risk at Standard & Poor's, Moody's and Fitch inflicted upon investors the AAA-rated subprime mortgage-backed security. They also inflicted upon the world's nest eggs the even more opaque AAA-rated collateralized debt obligation (CDO). Without the ratings agency seal of approval -- required by SEC, Federal Reserve and state regulation for many institutional investors -- it would have been nearly impossible to market the structured financial products at the heart of the crisis. Yet Team Obama suggests only that regulators reduce the agencies' favored role "wherever possible."

It's a revealing phrase, implying that there are situations when it's appropriate to rely on ratings from the big three instead of actually analyzing a potential investment. Can anyone name one? Probably not, which makes one wonder how the ratings-agency lobby could be so effective.

The truth is that the strongest defenders of this flawed system are mutual funds, state pension administrators and the federal regulators now managing the various bailout programs. Digging into the underlying assets in a pool of mortgages or judging the credit risk in a collection of auto loans is hard work. But putting taxpayer or investor money in something labeled "triple-A" is easy. Everyone is covered if the government's favorite credit raters have signed off.

The Obama plan also calls for regulators to "minimize" the ability of banks to use highly-rated securities to reduce their capital requirements when they have not actually reduced their risks. Minimize, not eliminate? Does the Treasury believe that some baseline level of fakery is acceptable in bank financial statements? To review, a critical ingredient in the meltdown was the Basel banking standards pushed by the Federal Reserve. Among other problems, Basel allowed Wall Street firms to claim that highly-rated mortgage-backed securities on their books were almost as good as cash as a capital standard.

The Obama plan does make plenty of vague suggestions, similar to those proposed by the rating agencies themselves, to improve oversight of the ratings process and better manage conflicts of interest. The Obama Treasury has even adopted the favorite public relations strategy of the ratings agency lobby: Blame the victim. "Market discipline broke down as investors relied excessively on credit rating agencies," says this week's Treasury reform white paper. After regulators spent decades explicitly demanding that banks and mutual funds hold securities rated by the big rating agencies, regulators now have the nerve to blame investors for paying attention to the ratings.

Even the Fed, which until recently would accept as collateral only securities that had been rated by S&P, Moody's or Fitch, has lately acknowledged the flaws in this approach. The New York Fed has anointed two more firms, DBRS and Realpoint, to judge the default risk of commercial mortgage-backed securities eligible for the Term Asset-Backed Securities Loan Facility (TALF). Since the passage of a 2006 law intended to promote competition, the SEC has also approved new firms to rate securities that money market funds and brokerages are required to hold.
But inviting more firms to become members of this exclusive club isn't the answer. As long as government requires investors to pay for a service, and then selects which businesses may provide it, it's unlikely investors will get their money's worth. History says it's more likely that investors who use the agencies' "investment-grade" ratings as a guide will be exposed to severe losses -- ask people who went long on Enron and WorldCom.

It's time to let markets decide how to judge creditworthiness. One lesson of the crisis is that the unregulated credit default swap (CDS) market provided a more accurate measurement of the risk of financial firms than the government's chosen ratings system. Apparently even the largest provider of these government-required ratings, S&P, has taken this lesson to heart. The company recently introduced a new "Market Derived Signals" model that incorporates the prices of CDS contracts "to create a measure that facilitates the interpretation of market information."

This looks like a signal that even the prime beneficiaries of a government policy believe that the policy failed. So why won't the Obama Administration embrace real reform?

Is Government Health Care Constitutional? The right to privacy conflicts with rationing and regulation

Is Government Health Care Constitutional? By DAVID B. RIVKIN JR. and LEE A. CASEY
The right to privacy conflicts with rationing and regulation.
The Wall Street Journal, Jun 22, 2009, p A15

Is a government-dominated health-care system unconstitutional? A strong case can be made for that proposition, based on the same "right to privacy" that underlies such landmark Supreme Court decisions as Roe v. Wade.

The details of this year's health-care reform bill are still being hammered out. But the end result is sure to be byzantine in complexity. Washington will have immense say over how, when and through whom Americans are treated. Moreover, despite the administration's public pronouncements about painless cuts in wasteful spending, only the most credulous believe that some form of government-directed health-care rationing can be avoided as a means of controlling costs.

The Supreme Court created the right to privacy in the 1960s and used it to strike down a series of state and federal regulations of personal (mostly sexual) conduct. This line of cases began with Griswold v. Connecticut in 1965 (involving marital birth control), and includes the 1973 Roe v. Wade decision legalizing abortion.

The court's underlying rationale was not abortion-specific. Rather, the justices posited a constitutionally mandated zone of personal privacy that must remain free of government regulation, except in the most exceptional circumstances. As the court explained in Planned Parenthood v. Casey (1992), "these matters, involving the most intimate and personal choices a person may make in a lifetime, choices central to personal dignity and autonomy, are central to the liberty protected by the Fourteenth Amendment. At the heart of liberty is the right to define one's own concept of existence, of meaning, of the universe, and the mystery of human life."

It is, of course, difficult to imagine choices more "central to personal dignity and autonomy" than measures to be taken for the prevention and treatment of disease -- measures that may be essential to preserve or extend life itself. Indeed, when the overwhelming moral issues that surround the abortion question are stripped away, what is left is a medical procedure determined to be "necessary" by an expectant mother and her physician.

If the government cannot proscribe -- or even "unduly burden," to use another of the Supreme Court's analytical frameworks -- access to abortion, how can it proscribe access to other medical procedures, including transplants, corrective or restorative surgeries, chemotherapy treatments, or a myriad of other health services that individuals may need or desire?

This type of "burden" analysis will be especially problematic for a national health system because, in the health area, proper care often depends upon an individual's unique physical and even genetic history and characteristics. One size clearly does not fit all, but that is the very essence of governmental regulation -- to impose a regularity (if not uniformity) in the application of governmental power and the dispersal of its largess. Taking key decisions away from patient and physician, or otherwise limiting their available choices, will render any new system constitutionally vulnerable.

It is true, of course, that forms of rationing already exist in our current system. No one who has experienced the marked reluctance to treat aggressively lethal illnesses in the elderly can doubt that. However, what may be permissible for private actors -- including doctors and insurance companies -- is not necessarily lawful when done by the government.

Obviously, the government does not have to pay for any and all services individual citizens may desire. And simply refusing to approve a procedure or treatment under applicable reimbursement rules, as under the government-run Medicare and Medicaid, does not make the system unconstitutional. But if over time, as many critics fear, a "public option" health insurance plan turns into what amounts to a single-payer system, the constitutional issues regarding treatment and reimbursement decisions will be manifold.

The same will be true of a quasi-private system where the government claims a large role in defining acceptable health-insurance coverage and treatments. There will be all sorts of "undue burdens" on the rights of patients to receive the care they may want. Then the litigation will begin.

Anyone who imagines that Congress can simply avoid the constitutional issues -- and lawsuits -- by withdrawing federal court jurisdiction over the new health system must think again. A brief review of the Supreme Court's recent war-on-terror decisions, brought by or on behalf of detained enemy combatants, will disabuse that notion. This area of governmental authority was once nearly immune from judicial intervention. Over the past five years, however, the Supreme Court (supposedly the nonpolitical branch) has unapologetically transformed itself into a full-fledged, policy-making partner with the president and Congress.

In the process, the justices blew past specific congressional efforts to limit their jurisdiction and involvement like a hot rod in the desert. Questions of basic constitutionality (however the court may define them) cannot now be shielded from judicial review.

It is, of course, impossible to predict how and when the courts will ultimately rule on the new health system. Much depends on the details and the extent to which reasonable and practical private alternatives to the national plan remain. In crafting the law, however, its White House and congressional sponsors must keep privacy -- that near absolute right to personal autonomy they have so often praised and promoted -- squarely before them. The only thing that is certain today is that the courts, and not Congress, will have the last word.