Tuesday, April 29, 2008

Is the Federal Reserve Becoming too Powerful?

Is the Federal Reserve becoming too powerful? This question comes up following the events of the arranged marriage of Bear Stearns with JP Morgan. It also comes up following the Fed’s trading of US Government securities for other securities of lesser credit held by securities dealers. It comes after the Federal Reserve has created its new auction facility for bank reserves. And, this is in addition to its role as providing the “Greenspan put” to protect investors on the downside of an asset bubble. Oh, and there is the role of providing liquidity to the financial markets when there is a liquidity crisis. And, the Fed has responsibility for examinations of commercial banks and enforcing regulatory requirements. And, there are many other responsibilities the Federal Reserve is charged with, like the check-clearing system.

Furthermore, the Treasury proposal for the modernization and strengthening of the regulatory system puts the Federal Reserve at the center of the new regulatory universe.

Then there is monetary policy. If inflation is “everywhere and at every time a monetary phenomenon” then the Federal Reserve has responsibility for conducting a monetary policy aimed at maintaining relatively stable prices.

There are two problems connected with this plethora of responsibilities. First, the different responsibilities can have different, even conflicting objectives. By resolving one difficulty, the Fed may be creating another difficulty that must be addressed by another one of its functions. As a consequence, the Federal Reserve may always be attempting to resolve something that it initiated itself in other actions. For example, how does the Fed avoid a financial crisis and constrain inflation at the same time?

Second, when difficulties occur, the public turns to the Federal Reserve as the “savior of last resort” regardless of what the difficulty is. The public is not turning to the Treasury Department, or the SEC, or any other branch of government. It is turning to the Fed as the only agency that can resolve the problems.

The Federal Reserve cannot be allowed to lose its focus! Over the past twenty years or so, nations around the world have discovered that central banks must be independent of its national government in the conduct of economic policy and the central bank must have inflation as its primary focus. While other central banks have taken on this approach to central banking and while many of them have accepted ‘inflation targeting’ as they primary operating function, the Federal Reserve System in the United States has moved in the opposite direction.

Jean-Claude Trichet, the president of the European Central Bank stated on Monday that the ECB would set interest rates based on “no other considerations than the delivery of price stability in the medium term.” That is, the ECB cannot be counted on to set interest rates to help the Americans with their financial and economic problems or on anything else at the present time. The focus is on inflation because that is the responsibility of a central bank.

We, in the United States, must be careful going forward in what we ask of the Federal Reserve. Within the current environment there may be too much of a vacuum in other areas of the government to provide the Fed with much assistance in tackling the problems that lie ahead. However, we must beware of what power is given the Federal Reserve, for in adding more responsibilities to the Fed’s portfolio, people will only be causing the Federal Reserve to reduce its attention from the main thing it should be doing.

If this happens it will only create more problems for us in the future.

Saturday, April 26, 2008

The Discussion About Taxes

The real discussion on taxes, hopefully, has begun. The New York Times, in it’s lead editorial of Thursday, April 24, 2008, headlined the “Empty Talk on Taxes” presented a case for raising taxes. It began by saying—

“One of the toughest questions that will face the next president is what to do about taxes. There can be no real progress on health care, rebuilding the military or any other major issue without dealing with rising budget deficits and mounting debt…”

And, it ended—

“Perhaps the candidates are afraid the American people can’t handle the truth about what it would take to meet the nation’s economic challenges. Or perhaps they are underestimating those challenges.”

For the complete editorial, see http://www.nytimes.com/2008/04/24/opinion/24thu1.html?_r=1&scp=1&sq=empty+talk+on+taxes&st=nyt&oref=slogin.

I have been arguing for quite some time now that the number one issue that will be facing any new administration will be the decline in the value of the United States dollar. There is only one way to halt the decline in the value of the dollar, let alone strengthen it, and that is to substantially reduce the government’s budget deficit and follow a monetary policy that is focused (almost) solely on constraining inflation. The problem is the timing.

The current focus of America is on the recession and the financial instability that now exists within U. S.-based, as well as internationally-based, financial institutions. And, with new reports coming out almost daily about weak economic conditions or another bank being in desperate need of raising additional capital, the focus of the press will not be taken off the current economic conditions within the United States. To begin any discussion about the economic and financial policies that are necessary for strengthening the dollar will be difficult, at best.

The “economic challenges”, to quote the NY Times, are going to be substantial and to talk of this “truth” is difficult if one is trying to get elected. Also, the best guess is that the “challenges” are being underestimated because those connected with the candidates are trying to get nominated and then elected. These “challenges”, whatever they are can be dealt with later.

But, the problems are not going to go away. Whereas the inflation that took place in asset prices has burst, the inflation in commodity prices continues on apace. And, as long as this takes place the value of the dollar will continue to decline. My best guess is that, in terms of family, business, or investment decisions, individuals must be prepared for a lengthy period of time in which uncertainty will be substantial and volatility in markets will be commonplace.

The reason why I believe this will be the case is that the United States is the only major country in the world that is not playing by the rules of the international monetary system. (I discussed this on my April 14 post.) Other nations have given up a lot in order to bring themselves into line with these rules and have suffered further because they have stuck with the rules while the Bush administration has not. This is why the United States is not getting a lot of cooperative movement on the part of other central banks to help it bail itself out. Eventually, it, the United States, will have to join the international financial community and go through the necessary pain to get itself on the right path.

I believe that this fact need to be considered in every decision to be made concerning the family, business, or investment interests of Americans over the next two to three years.

Aside: Robert Barro, Professor of Economics at Harvard, in the latest edition of his book “Macroeconomics” (pages 359-360), discusses how a presidential administration might “strategically” manage the federal budget so as to have a large impact on the budget decisions of the administration that follows it. Basically, he writes, the incumbent administration can create such large budget deficits that the following administration will be severely limited in what it can do because it must deal with the deficits that it has inherited. Barro specifically mentions the Reagan (and Bush 41) administration creating a situation in which the Clinton administration was limited in what it could do, once it attained office. To quote Barro:

“Arguably, this is what happened in the 1990s. In this sense, the Reagan-Bush strategic budget deficits may have worked.” (page 360)

Is this what Bush 43 has done?

Is the budget mess, the dislocation of the economy, the inflating commodity prices, and the declining value of the dollar…all to keep the following Democratic administration from initiating policies that the Bush administration does not want to see enacted?

You decide!

Monday, April 14, 2008

Is it Time to Focus on the Value of the Dollar?

Critics of John Maynard Keynes have charged the great man with changing his mind too often. They said that he could not maintain a position for an extended period of time. Keynes countered this criticism with the remark: “When the situation changes, I change my mind. What do you do?”

It seems to me that it is time for Keynesians, and others, to change their minds with respect to policy prescriptions pertaining to employment and the value of the dollar. In this highly integrated world, countries cannot conduct their monetary and fiscal policies independently of one another as the United States has been attempting to do in recent years and did for most of the latter part of the 20th century. The basic philosophy behind this effort is the desire for a county to achieve low rates of unemployment independently of what monetary and fiscal policies are being followed in any other country.

I am not arguing that we should not be in favor of low unemployment. It is just that the philosophy supporting current thinking in the United States emphasizes this one goal over any other and is captured in both The Employment Act of 1946 and the so-called Humphrey-Hawkins Full Employment Act of 1978. There is a long history preceding these “acts” and this history needs to be reviewed to put the current situation into a proper perspective. A good reference is the book by Donald Markwell, “John Maynard Keynes and International Relations: Economic Paths to War and Peace.” (Oxford University Press, 2006)

We pick up the story around 1919 at the Paris Peace Conference. Historically, Keynes had taught and written about the Purchasing Power Parity theory of relative foreign exchange values and had been in favor of flexible foreign exchange rates. However, given the events taking place in the second decade of the 20th century, he changed his mind about how the world economy should be set up in order to save capitalism. At the peace conference, Keynes became a very vocal advocate for fixed exchange rates which would allow countries to seek high rates of employment within their own borders and do this independently of other countries. He worked very hard, both theoretically and practically, to devise a system of exchange rates in which this national independence could be achieved.

The reason for this change of mind was the unrest the Western nations were feeling concerning recent events in Russia and the growing support for the ideas of Marx and Engels. In particular, the Communist movement was gaining ground in most of Europe and the Russian Revolution cemented the idea that a Bolshevik uprising could actually take place. There were legitimate fears that the working classes, if unhappy enough, could rise up and gain control of a nation’s government. This concern supplied the rationale for attempting to develop governmental policies that would help to ensure that a country achieved and then maintained low rates of unemployment. The old ideas had to be revised in the light of new events and new information. The situation had changed so Keynes changed his mind.

Keynes worked for the next twenty-five years or so to create such a system. His efforts were directed along three different paths. First, he attempted to develop the philosophical and scientific foundation for this new way to look at economic policy making. Second, he conducted an almost continuous campaign in the popular press, newspapers and magazines, in an attempt to educate the public along the lines he was thinking as well as to advocate policies. Third, when asked, he devoted time and energy toward the actual creation of such a system; a system that would achieve the integrated world for which he hoped.

The philosophical and scientific work that he did resulted in the publication of his masterpiece, “The General Theory of Employment, Interest, and Money.” This book became the basis for what became known as Keynesian Economics and provided the intellectual rationale in the United States for the passage of The Employment Act of 1946. The Bretton Woods Conference, which began in 1944, produced the world financial system that incorporated much of what Keynes wanted. He was very active in this conference and, in fact, dominated the result. The system included fixed foreign exchange rates that would or could be changed over time as was required. This basis became the operational standard for the world during the next 30-40 years. It was thought that this system “freed-up” national governments so that they could pursue economic policies aimed at full employment in a relatively independent fashion.

Actually, the next 30-40 years saw the system set up at Bretton Woods slowly unravel. The reason…no country could really isolate their economic policies from the economic policies of other countries. The calm of the fixed foreign exchange rate regime was continually punctuated by periodic re-adjustments that had to be made when the currency of a country had to be devalued. The devaluation usually took place after pressure built up on the currency while, at the same time, the government denied that they were going to devalue and the central bank and treasury of the country valiantly made efforts to shore up the value of the currency. Finally, the pressures became so great that the currency had to be devalued.

In the 1960s in the United States, inflation became an issue as the Johnson administration mismanaged the government’s fiscal affairs attempting to pay for both ‘guns and butter’. This era ended as the Nixon administration ‘froze’ wages and prices in 1971 in an effort to gain control over inflation. This government also set free the dollar price of gold (which had been set at $35 per ounce) and let the dollar float in foreign exchange markets. And, as they say, the rest is history.

After this, country after country came up against the inflation dragon as the world continued to give preference in their economic policies to the goal of full employment. Yet, country after country found that they could not independently follow this kind of policy and maintain a strong currency. Country after country came to realize that they must get their fiscal budget under control and make their central bank independent of the central government so that it could follow a policy based upon controlling inflation. More and more central banks adopted ‘inflation targeting’ as their operating goal so as to achieve creditability and trust in world financial markets.

The United States has resisted this trend. As a dying gasp, the Congress enacted the Humphrey-Hawkins Full Employment Act in 1978, but this soon had to be put aside as the Carter administration was forced to confront renewed inflationary pressures and bring in Paul Volcker to lead the Federal Reserve and bring inflation under control. Once inflation was brought under control and some discipline was re-established over the conduct of monetary policy, economic growth was renewed and high levels of employment were attained. With inflation not an issue, businesses tended to concentrate on productivity and not on how to protect themselves from inflation. The unemployment rate dropped to period lows.

However, high employment has continued to be a goal of many politician and intellectuals within the United States. There has been reluctance to establish ‘inflation targeting in the U. S. Every wiggle in the unemployment rate brings cries for new and more effective government stimulus to ensure a low unemployment rate. Yet, reality continues to put holes in the arguments given to support governmental efforts to achieve such a goal. The times are not what they once were. As the times have changed, the politicians and intellectuals that continue to supports such goals need to change their minds.

The United States cannot ‘go-it-alone’. The United States must join the rest of the world and give more attention to the value of the dollar and less to immediate unemployment goals. The ‘revolt of the masses’ is not the threat it was in the 1920s and 1930s (although food issues, particularly in Asia, Africa and Latin America, may have taken over). And, as we saw in the 1990s, fiscal discipline and a non-inflationary monetary policy focused on a strong U. S. dollar, coupled with policies that support private innovation and change, can produce not only low inflation but high employment. It is my belief that Keynes, in the present world environment, would be more supportive of this kind of policy than a ‘Keynesian’ policy based upon achieving full employment, whatever that is. It is time for others to change their minds as well.

Sunday, April 13, 2008

Finance Ministers Concerned with U. S. Dollar

The G-7 Finance Ministers and Central Bank Governors met in Washington, D. C. this past week and expressed concern over the decline in the value of the dollar. The United States dollar has fallen by about 15% against the Euro over the past year and has fallen by about 8.0% since the end of 2007. Against the yen it has fallen by the same amount over the past twelve months and by almost 10% since the close of 2007. The dollar has fallen by almost 10% against the currencies of major trading partners of the United States in the past year. Over the past six years the dollar has been in almost constant decline against most major currencies and against major U. S. trading blocks. The data all seem to show the same result.

The Group of Seven, generally, is relatively subtle about the statements they make. However, most observers agree that the statement put out by these people last Thursday evening was relatively blunt. The statement reads, “Since our last meeting, there have been sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability.” They followed this up by saying “We continue to monitor exchange markets closely, and cooperate as appropriate.”

But, what can be done. The possibilities are not very pleasant. The United States can raise interest rates. Or, Europe, and other countries, can lower their interest rates. Or, there can be direct intervention in markets. Although the English lowered rates last week, the European Central Bank has not followed. The English are in the midst of their own housing crisis and felt that they could not go any longer avoid lowering rates. Other central banks are not so willing to lower rates because, world wide there is a fear of setting off inflation again.

Much of the rest of the world has gone through the battle to get inflation under control and realign their fiscal and monetary affairs so as to keep inflation under control. This has meant that governments could not lose control of their fiscal discipline and that central banks had to become independent of the national government. In many cases, central banks pursued inflation targeting in order to establish their credibility and gain the confidence and trust of the global investment community. These countries, once they paid the price to achieve this control and credibility, are not willing to give up what came at such a cost. Other central banks will only reluctantly, if at all, lower their interest rates.

The United States has not conformed to the rest of the world in this respect. There has been little or no discipline established over its fiscal affairs and the Federal Reserve, especially between 2002 and 2005, conducted a policy that seemed anything but independent of the administration in Washington, D. C. There is now little or no confidence in the ability of the leaders in the Bush administration to gain the control necessary to regain fiscal discipline and monetary independence. Any necessary action on the part of Washington is going to have to wait until, at least, there is a new administration sworn in. So, don’t bet on the Federal Reserve raising interest rates in the near term.

What about direct intervention? This may work in the very short run, but the long term consequences of such action is worse than the benefits gained in the short run. These should not be relied upon unless absolutely necessary and then probably not even then.

Sooner or later the United States is going to have to bite-the-bullet and pay for the dislocations it has caused. Like almost every other country in the world, the United States is going to have to pay by the current international rules. America has ‘gone-it-alone’ for almost eight years now, in foreign affairs, as well as in economics and finance. In economics and finance, ultimately you have to pay for the way you have lived. You can only postpone things for so long.

The G-7 Finance Ministers and Central Bank Governors have given the United States a ‘mild’ slap on the hand. But, many financial experts believe that having this issue reach this level is a sign that the rest of the world is tired of the United States doing just what it wants to do. This administration is not going to really do anything about it. The G-7 statement, however, should be taken seriously by everyone of the candidates running for the office of President of the United States.

Thursday, April 10, 2008

How can you talk about inflation now?

The value of the dollar has been declining for six years!

For six years......

And, all we heard from the Bush administration was that the administration supported a 'strong dollar'.

The Bush government then went off on its own, merry way.

We are just beginning to see the extent of the Bush legacy...and it is not pretty.

The Wall Street Journal headlines this morning: "Inflation, Spanning Globe, Is Set to Reach Decade High"!

In the United States alone, it is estimated that securitized debt rose at a compound annual rate of about 7% for the past sixteen or seventeen years. In addition, the estimated volume of derivatives placed rose at about a 12 % compound annual rate over the same time period. This produced bubbles in asset values, even though inflation rates as represented by the consumer price index did not show much increase. The consumer price index includes rent or as estimate of rental value...it does not include asset prices. Bob Shiller has estimated that the United States has never seen, in the past 150 years or so, a spike in rising housing prices as we have seen in the past eight years! And, the bubble has spilled over into commodities, especially gold and oil.

The Bank of England did cut its key lending rate this morning but the European Central Bank did not move its rate today. Inflation still is the major concern of the ECB...as it is for much of the rest of the world.

The United States is 'out-of-step' with the rest of the world because the Bush administration had to 'go-it-alone' in terms of economic policy...as well as foreign policy. Now, we reap the consequences of this go-it-alone attitude.

Paul Volcker, on Tuesday evening, claimed that we were in a 'dollar crisis'. I believe that he is right and that we, and the next President, will be working to resolve this situation for several years into the future.

Wednesday, April 9, 2008

Paul Volcker and the "Dollar Crisis"

Paul Volcker gave a speech yesterday. There was no mention of it in the New York Times and the only place the topic was mentioned in the Wall Street Journal was in the lead editorial. Paul Volcker thinks that we are in a "Dollar Crisis." We should all pay attention.

The 'take-aways' from the speech seem to be:
1. The dollar crisis will be with us for a while;
2. The Fed can't ignore the decline in the value of the dollar and just focus on a recession;
3. The Fed can't give in to efforts to solve the housing situation (these efforts are political);
4. The Fed can't sacrifice the 'integrity of the currency" by holding suspect mortgage-backed securities;
5. The Fed can't give away the shop by bailing out investment banks, hedge funds or private equity.

The bottom line is that the Federal Reserve is a central bank and "should be" independent of the political process. That is, the Fed needs to be the Fed!

Monday, April 7, 2008

Time Goes By: the Solvency Issue Once Again

In my post of February 25, 2008 I discussed “the solvency issue” and stated how important it was for financial institutions to ‘recognize and disclose problems earlier rather than later’. The crucial thing about acting in this way is that it limits, as much as possible, the deterioration of the value of asset portfolios. Postponing dealing with the issue merely delays the realization that there is a problem and also delays taking actions that might lessen the pain and even turn the situation around.

Here we are now, more than a month later. During this month or so, the Federal Reserve moved to salvage what was left of Bear Stearns. This has seemingly calmed markets and has indicated that the central bank, with the support of the Federal government, will do what is necessary in order to keep the financial system functioning. Greater write-downs and charge-offs have been taken during this time period, both nationally and internationally. Executives have been let go and have been replaced. Additional capital has been sought and, in most cases, found. The system seems to be working through the crises.

It, obviously, is too early to say that we are out-of-the-woods, but it is crucial that time is passing. In the case of liquidity crisis, everything happens within a very narrow window in the time spectrum. Action has to be immediate in order to stem a crisis and allow for order to return to the market. In the case of credit crises it is crucial for firms to have time to work out the problems that are on their balance sheets. Bear Stearns ran out-of-time. But, it seems, other institutions are experiencing the time that they need to discover the value of their troubled assets and to do something about them.

The whole process of resolving a credit crisis is not really in the hands of a central bank or of a central government. The process is really in the hands of the financial institutions themselves: it is dependent upon their willingness to suffer the immediate pain they must suffer; it is dependent upon their willingness to get the right people in place to resolve the problems that exist and restructure the organization. The more time that passes the more hopeful the situation becomes.

Part of the problem in trying to analyze an environment such as the current one and make prognostications about the future is that we are working with very incomplete information. We don’t really have a good handle on how grave the condition is of specific financial institutions and how effective boards and managements have been in attempting to get the situation under control. There is a tremendous amount of uncertainty out there!

This is where time is so important. We get this piece of news about Bank XYZ charging off another billion or two, dollars of loans. We hear that the board of the investment bank of M & M is letting go its CEO and bringing in so-and-so to take charge of their organization. Company ABC is getting additional capital. Yes, there are still problems ‘out there’ but something is being done about them. And, time is passing!

As I have mentioned before, since so much of the dislocation has seem to be centered upon assets that, in one way or another, are connected to some form of security that is ‘traded’ the problems have been determined relatively quickly. When financial institutions just originated assets that were kept on their balance sheets, discovery was not so rapid. Identification of problems and the taking of action seemed to get postponed with the hope that ‘things would work out’ and the loans would right themselves. None of this information, however, was available to anyone else other than the organization, itself.

Now, everything takes place in larger quantities and with a much shorter fuse. This is what we get with the advancement of Information Technology and the innovation in financial assets that have gone alone with it. If information is transferred much more rapidly and is much more public, then markets will be more efficient, but they also may be subject to periods of greater volatility. The reason for this is that traders and arbitrageurs who have tended to take similar positions in certain assets may all have to adjust positions at the same (relative) time and this can create imbalances in the marketplace. With the new technology all this can happen in a very short period of time and in very large numbers.

I use the term ‘relative’ for a very specific reason. The time horizon that is relevant in each case is, of course, dependent upon the particular situation under review. In a case where a position must be ‘unwound’ as, say, in the case of the French bank, Society General, a large volume of assets must be sold within a very short period of time. This results in a ‘liquidity crises’. In the case of the value of assets being written down, the timing is somewhat different. Yet, the identification of such a problem at an earlier time than would have been the case in the past, leads an organization to move on to resolving the problem faster than formerly. This is possible in the current environment.

It is also true that larger numbers are likely to be involved in the current situation than before. The reason is that financial institutions need to be very conservative at this stage of the process. I have heard organizations being criticized because they might be charging off too much so that they can recognize the excessive charge offs later and make the ‘turnaround’ look good. My experience in working with troubled institutions is that the real tendency is to charge off too little, with management hoping, with a false optimism, that things will get better and the managements will be able to hold onto their jobs. The emphasis is on the management trying to protect itself and not on what is the best for the shareholders. I conclude from this is that it is better for managements to be ‘conservative’ in their marking down of asset values and write them down far enough to make sure that you will not have to face another write-down in the future. The reason for this is that you don’t want to have to ‘surprise’ the financial markets with more future write-downs than you have to.

The aim of all of this activity is for order and confidence to be restored to financial markets. If order and confidence are to be restored, the troubled institutions themselves must show that they are ‘in charge’ of the situation and that they have control over the value of their portfolio. Until market participants believe that managements are in charge they will continue to be nervous. This nervousness is because they still do not have sufficient information concerning the quality of the portfolios and the ability of the managements to do what is necessary.

I am sure that there are still surprises ahead. There is still great uncertainty to overcome. We all hold our breaths, hoping that the next week we face will not contain any shocks that may set things off again. Time is important because financial institutions need time to work things out. Financial markets need time in order to digest information and adjust incrementally to the news they are receiving. Each week that goes by without further shocks is good. But, we continue to keep our fingers crossed.

Thursday, April 3, 2008

The New Environment for Financial Regulation

It seems as if almost everyone agrees that the United States should take a long look at the system that regulates its financial institutions. Many argue for the need to reform or modify the system so as to take account of the existence of new financial instruments and the new, global nature of financial institutions and relationships. However, this is not going to happen overnight. First, we have to get beyond the current period of financial market disarray. Second, we have to elect a new President and a new Congress. Third, we need to have a substantial debate and dialogue concerning the nature of the new regulatory system.

Furthermore, these events are all going to take place within a time period where discipline must be brought to the Federal budget in order to strengthen the value of the United States dollar. (See “What is Possible in the Next Four (Eight) Years?” http://masepoliticalcommentary.blogspot.com/.) It is going to take time to create the ‘new’ regulatory structure and this is not necessarily a bad thing. In fact, it is much to be preferred to a ‘quick fix’ solution. Rushing to implement a new regulatory system is not going to ease the current situation, but we can’t let the discussion of what this system should look like fade away.
There is no doubt that the regulatory system that exists in the United States needs to be reviewed and reconstituted. Much of the existing system goes back to at least the 1930s if not before. Little or nothing in the system relates to the events and innovations of the last ten to fifteen years. And, we still don’t fully understand many of the instruments and the risks that are related to them that have been constructed during this time.

The Treasury plan introduced this week provides us with a starting point. It presents something in black and white that can lead to discussion and dialogue. I think it was smart of the administration to get such a proposal out into the open to foster the interchange that is going to take place. I don’t believe it is anywhere near what will result from such deliberations. But, we had to start somewhere.

That said, I would like to add three points to the discussion that seem to me to be very relevant.

First, we need to be very wary in terms of acting ‘during’ a financial crisis. This seems obvious, but needs to be reiterated over and over again. People tend to over-react in such situations…especially politicians. We don’t fully understand what has happened over the past year or two and what this implies for specific suggestions about the regulatory environment. There are a lot of questions that must be asked and many of them we can’t really articulate at the present time. We need time to reflect on the ramifications connected with the changes that might be selected. A time when emotions are high is not the time to overhaul or revamp the financial regulatory system. We also need to be wary of politicians who like to hog the spotlight during periods such as these and bask in the drama of the situation.

Second, we need to take full consideration of the fact that we are a member of the world financial community and not act in a unilateral fashion. A major reason we are in the current situation is that the Bush administration acted in a unilateral way with regard to its conduct of monetary and fiscal policy (as well as with regard to its conduct of foreign policy). In working through a restructuring of the United States regulatory environment, major thought needs to be given to how a ‘new’ regulatory system will exist within the operation of world financial markets. Any resulting regulatory system that is achieved without including discussions with other nations will not only create further resentment towards the United States, but will not be nearly as effective as it might be. It seems to me that a good start has been made in this direction in the efforts of the Federal Reserve System to bring foreign central banks into the effort to calm world financial markets through a common borrowing facility. The only way a truly effective system can be constructed is with input from the different players in the world’s financial markets.

Third, in developing a regulatory system for financial institutions, consideration must be given to the speed at which new financial innovations are brought to market and the speed at which markets move. Oversight is always ‘after the fact’ and regulatory enforcement is usually slow and cumbersome. This is true in almost all other areas of the modern economy and is not just present in the financial industry. As a consequence, the regulatory system will always lag behind the actions of financial institutions. Thus, the evolution of the regulatory system must be more toward a ‘principles-based system’ rather than just a ‘rules based system.’ People and organizations respond to incentives and a ‘rules-based system’ tends to create incentives for people and organizations to work around or create new instruments or structures to avoid the existing rules. This not only is costly to those ‘getting around’ the rules, but it puts a lot of pressure on the regulatory system to ‘catch up’ with these ‘avoiders’. Then, when the regulators do ‘catch up’ with the innovators, the innovators have usually moved on to something else. A ‘principles-based system’ is more concerned with process than it is with specific outcomes or rules and hence avoids this problem.

Regulatory reform of the United States financial system is going to take place in some fashion. Let’s hope that it is achieved with due deliberation and is inclusive, not only of all that are affected in the United States itself, but of those nations that play a role in world financial markets.