Paul Krugman responds to Martin Wolf and John Cochrane arguing for narrow banking [allowing banks simply to take our cash and invest in risk free securities] in part by commenting that the banking crisis came and went quickly, and that the real problem lay elsewhere, in the debt overhang and deficient demand. Therefore, the banking crisis was not decisive in bringing about the recession. For that reason, don’t get so excited about the need to outlaw traditional banking.
Leaving aside the debate about how to regulate banks, this description of the crisis, although it’s an intriguing idea [if it’s just a matter of the occasional spike in spreads, why not run things as they are?] caused me some trouble. Some reactions below.
1. Although many spreads have normalised [accounting, I guess, for that normalisation of the St Louis Fed stress index Paul Krugman points to], I conjecture that the harm to banks is more persistent. They have found themselves, in part pressured by their shareholder valuations, to delever. This has constrained net lending, and aggravated the depth and length of the recession.
2. Some markets remain closed, even now. I guess these prices must be excluded from such a stress index.
3. Weighing on banks’ behaviour has been the uncertainty about the long run regulatory regime. And, in the UK, surrounding the regulators’ preferred path of getting the banks to that [uncertain] point.
4. Also weighing is the desire not to crystallise losses, given current accounting and regulatory practices. This has been talked about as an acute problem in Japan. It’s an emerging one in the UK, with the FPC spending much effort pondering how much forbearance there is.
5. Part of the normalisation of some prices is perhaps the expectation that the authorities will not allow a repeat of Lehmans’. This is must surely be why peripheral EZ spreads have normalised: banks are not really solvent, but with the ECB bluffing that it will buy whatever quantity of sovereign debt necessary, the sovereigns are solvent, and therefore they can credibly stand behind the peripheral banks. It is probably also why similar measures are normalised for the UK. This is less satisfactory as a description of the US, where it seems the Fed would be unable to repeat the bail out of Bear Sterns. Unless we are to fathom that, in another crisis, the executive would find away to change course again, and Republican insistence on non-intervention could be won over. Anyway, the point of this is to argue that the crisis hasn’t gone away, it’s just that the risk has been socialised. And that socialisation of the risk is constraining fiscal policy to some degree, and that is contributing to a more protracted recession than we would otherwise have had; and/or spending is weak because private agents worry about the long term health of their sovereigns, whom, ultimately, they stand behind.
6. Although it may be true that the proximate cause of the protracted recession is household and corporate debt, the real reason may lie in the crisis in banking and intermediation. Borrowers were offered debt at unsustainably low prices by a financial sector mis-pricing, over-optimistic about the future, or leaning on the state’s future support, or all three. Now, with either normal or still abnormally high spreads, debt has to fall and demand is therefore weak. If [excuse mixed metaphor] there was a magic wand to iron out surges and troughs in intermediation, we would not have had the debt build up, and would not be suffering a period of protracted weak demand as it was paid down.
Following this reasoning, it’s vital to sort out whether something can be done to get banks and other intermediaries to behave better. And it may well be that their behaviour even now, with the immediate threat of deposit or market runs receded, is dragging on activity.