The doom loop - are we in one?

Question during the Bernanke confirmation hearings.

Q: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?

A. The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. A. (continued) In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.

Simon Johnson has written on this issue and has been pushing for an answer from the Fed. He argues that the time inconsistency issue is key to the problem. We say we will not bail-out and then we go ahead and do it. The further bail-out of Fannie and Freddie which was announced this week is a perfect example. We will talk tough and then cave-in and everyone in the financial world knows it.

I would argue that the doom loop is more an issue of monetary policy than regulation. If you do not let rates fall to such low levels, there will not be the speculative behavior seen by financial institutions. There is not a need for special regulation and monitoring if there is not loose monetary policy. The time inconsistency policy is also an issue of Fed credibility and whether investors believe there is a Bernanke (formerly Greenspan) put in the market. Whether there is the Fed credibility should be the focus of the confirmation hearings. Put differently, what should the Fed be creditable about?