Bordo: Some Historical Reflections on the Governance of the Federal Reserve

From the Introduction:

Since the Financial Crisis of 2007-2008, there has been considerable interest in
reform of the Federal Reserve System. Many blame the Federal Reserve for causing  the crisis, for not handling it well and for mismanaging the recovery. Criticisms  include: keeping the policy rate too loose from 2002 to 2005 and thereby fueling the  housing boom: lapses in financial regulation that failed to discourage the excesses that occurred; the bailouts of insolvent financial firms; the use of credit policy; and conflicts of interest between Directors of the New York Federal Reserve Bank and Wall Street banks.

The Dodd Frank Act of 2010 made some minor changes to Federal Reserve governance –removing the voting rights of Class A Reserve bank directors for selection of the President and vice President of the Reserve bank; and to the Federal Reserve’s lender of last resort policy—limiting the use of 13(3) discount window lending. Some have urged that the reform process go further, e.g., Conti Brown (2015) argued that the Reserve bank Presidents be appointed by the President while the recent Shelby bill includes requiring this change only for the President of the New York Federal Reserve Bank.

A similar cacophony of criticism and call for reform of the Fed occurred after the Great Contraction of 1929 to 1933, which President Franklin Roosevelt blamed on the banks and the Federal Reserve. This led to a major reform of the Federal Reserve System in Congressional Acts in 1933 and 1935. In this paper I examine the historical record on Federal Reserve governance and especially the relationship between the Reserve banks and the Board from the early years of the Federal Reserve to the recent crisis. From the record I consider some lessons for the current debate over reform of the Federal Reserve.

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Lupu: The Indirect Relation between Corporate Governance and Financial Stability


In the wake of last crises, there is an increased awareness regarding the role of a sound corporate governance framework for enhancing the financial stability. We believe, however, that the relationship between corporate governance and financial stability is an indirect one; companies are not obliged to pursue financial stability unless specific legislation or regulations require it. Interestingly, having such targets, large firms, especially those operating in the financial system, can lead to systemic risks, supporting financial contagion. Classical problems of corporate governance such as top management compensation, board composition, and independence of the director, agent theory or the correct valuation are problems envisaged to be analyzed when assessing how they affect financial stability.

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Joffe: Why does capital flow from poor to rich countries?


Lucas’ classic paper (1990) highlighted the paucity of capital flows from rich to poor countries, in contrast with predictions of standard theory. He suggested four explanations – but they cannot explain the copious capital flows from certain emerging relatively low-income countries, notably China, to the USA. Empirical studies confirm Lucas’ observation. Additionally, Prasad et al (2007) showed that developing countries with less reliance on foreign capital grow faster. Gourinchas & Jeanne (2009)

added a second puzzle, the “allocation puzzle”: flows are not only too low, they are directed toward countries with lower productivity growth and lower investment, i.e. the “wrong” ones; they attribute this to a distortion in savings, e.g. financial repression.

This paper traces the causal processes in post-reform China. Starting around 1978, reforms allowed rural households to keep their own surpluses, facilitated “township-village enterprises”, established enterprise areas open to FDI (e.g. Shenzhen), and began making state-owned enterprises (SOEs) more efficient. High productivity at comparatively very low cost was gradually achieved, and openness to trade allowed Chinese goods to conquer the world.

Statistical analysis shows that the generated profits led to high levels of capital accumulation, both corporate and public sector. Together with high household savings, channelled by state banks into (primarily) SOEs, this provided ample capital for reinvestment, as well as a large surplus. No capital inflows were required, except for FDI which had a vital technology-importation role. In particular, the massive export success generated hard currency, allowing large-scale purchase of overseas assets, e.g. US Treasury Bonds.

China is not unique: previous East Asian economies had parallel experiences on a smaller scale (cf. also Buera & Shin (2011)).

Thus, a relatively simple explanation of both puzzles is possible. More sophisticated interpretations, e.g. Kalemli-Ozcan et al (2010), Sandri (2010), Reinhardt et al (2013), are discussed from a methodological viewpoint.


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Bang, Mitra & Wunnava: Financial Liberalization and Remittances – Recent Panel Evidence


We investigate the impact of financial liberalization on remittances to 84 countries over the period 1986-2005. Explicitly accounting for the multidimensionality of financial reform, we find that the various dimensions impact remittances differently: Increased economic freedom in the financial sector, as captured by absence of direct government control over the allocation of credit, has a positive and immediate impact. However, the improved robustness of financial markets, as captured by the development of security markets, improvement in the quality of banking supervision, and removal of stringent restrictions on interest rates and international capital, has a negative and lagged effect. The net combined effect reveals that financial liberalization may have a modest negative impact on remittances in the long run.


Available for download here.

Kornai: The Soft Budget Constraint

From the Introduction:

I first expressed my thoughts on the soft budget constraint in a lecture series I gave at Stockholm University in 1976. Two years later came my first publication to deal with it (along with other matters). That piece appears in this volume as Chapter 1. Almost four decades have passed since the idea was conceived, and during that time, all those of us who have dealt with the problem have advanced in understanding it. The introduction to this volume sums up how I interpret the soft budget constraint today, in 2014, and reviews the research done into explaining and analyzing it.

The syndrome

I have taken the expression syndrome from medicine, to mean the set of symptoms – recognizable, observable phenomena – absent from an ideally healthy organism. There can be one or more causes for such a set of symptoms to develop.

Medical science strives to find causes, but clinical practice must set about treating the syndrome even if the causes are still not sufficiently understood.2 In living organisms, a syndrome will usually appear in several variants: here one, here another symptom or group of symptoms will appear more strongly, while others are less apparent or fail to appear at all.

Economists make only sporadic use of the expression syndrome, apt though it is for describing some phenomena in economic organisms. Although it is not customary to refer to the crisis syndrome of the capitalist economy, for example, I gladly do so. There are many kinds of crisis with many kinds of symptoms and many kinds of factor to explain their development. Yet they have something in common: all the various types of crisis frequently appear bundled together.

That is the sense in which I use the expression soft budget constraint (SBC) syndrome in what follows.

The phenomenon

The major common feature of the many variants of the SBC syndrome is as follows: the behavior of every organization concerned is affected by the expectation that it will be bailed out if it gets into serious financial trouble. Each of the expressions in this basic interpretation calls for more detailed explanation.

There are many types of budget-constrained organization in whose behavior the SBC syndrome may appear: households, firms, non-governmental organizations (NGOs), investment projects not tied to a for-profit enterprise, distinct local government organizations (LGOs) within the apparatus of state, or other publicly funded institutions, and finally, central government on a national level. Initially SBC researches were centered on the enterprise sphere, but they later spread to organizations of other types.


Available for download here.

JOENVÄÄRÄ & KOSOWSKI: The Effect of Regulatory Constraints on Fund Performance – New Evidence from UCITS Hedge Funds


Based on geographically disparate regulatory constraints, such as share restrictions and risk/leverage limits, we economically motivate and test a range of hypotheses regarding differences in performance and risk between UCITS-compliant (Absolute Return UCITS (ARUs)) and other hedge funds. We demonstrate that hedge funds have more suspicious patterns in their reported returns than ARUs, which have stricter reporting rules. Inconsistent with the notion that UCITS rules reduce operational risk we find that ARUs are more exposed to operational risk measures and exhibit more external conflicts of interest than hedge funds. Although ARUs deliver lower risk-adjusted returns than other hedge funds on average, this difference disappears when we compare subsets of the two groups of domicile matched funds that have the same liquidity or share restrictions. Leverage and margin constraints are less binding for funds that impose tight share restrictions, and thereby, these funds tend to have more exposure to betting-against-beta factor. Finally, we find that there are limits to the ability of investors to exploit the superior liquidity of ARUs through portfolio rebalancing since they exhibit lower
performance persistence.


Available for download here.

Auerbach: Fiscal Uncertainty and How to Deal with It



Long-term projections of the federal budget show significant future imbalances, but these projections are enormously uncertain. Some argue that this uncertainty means we should pay less attention to the long-term budget projections, so as to avoid taking painful measures that may prove to be unnecessary. But in general, the appropriate response to uncertainty is instead to take more action now, as a precautionary measure against the possibility of worse-than-expected outcomes. “What is clear is that hoping for a better  future does not constitute an appropriate policy response to uncertainty, and waiting until the size of the problem is known is waiting too long.”

Much of the uncertainty in the short and medium run deficit is related to the business cycle. For the long run, the main sources of budget uncertainty over the next 25 years are the rate of productivity growth, the interest rate on the federal debt, and the rate of excess health cost growth. Whether these factors move in a favorable or unfavorable direction will determine the nature and extent of the fiscal response needed for stabilizing the national debt as a share of GDP. A possibly unfavorable outcome should weigh more heavily in future planning than should the opportunity cost of saving now if outcomes turn out to be better than expected. The United States should actively respond to this uncertainty by increasing its rate of saving, either through a reduction in spending, an increase in taxes, a reduction in the size of implicit government liabilities, or some combination of these actions. A precautionary savings buffer would allow for longer-term planning, more flexibility to meet economic shocks, and would reduce the need to increase marginal tax rates in the face of budget pressures.

More effectively conveying uncertainty, perhaps by requiring the Congressional Budget Office to include a quantitative assessment of the degree of uncertainty present in its forecasts, would be a step in the right direction towards addressing the uncertainty involved with fiscal policymaking. Another policy option would be to subject the government budget to some sort of a “stress test,” in order to determine the government’s ability to meet its needs if unfavorable conditions arise. Finally, if automatic adjustments were used to provide budget stability and ensure appropriate risk-sharing across generations, it would reduce the need for Congress to continually make changes to legislation in response to changes in circumstances.


Available for download here.

Höpner, Petring, Seikel & Werner: Liberalization Policy – An Empirical Analysis of Economic and Social Interventions in Western Democracies


Political-economic classics of different schools agreed that capitalism inherently and inevitably leads to a decline of market principles. Analyzing indicators of liberalization policies for 21 OECD-countries in five economic and social policy fields, we demonstrate that Western industrialized countries are subject to a convergent trend towards market-creating policies. This stands in stark contrast to the theoretical expectations of classical works in the field of political economy. Since the first half of the 1980s at the latest, Western democracies have entered a new phase of economic liberalization. From a methodological perspective, our findings suggest that the methods for the causal analysis of convergent liberalization policies cannot be identical with the methods that have been used for analyzing the development and consolidation of the varieties of capitalism in the postwar era.


Available for download here.

Bernes: IMF Leadership and Coordination Roles in the Response to the Global Financial and Economic Crisis

From the Executive Summary:

This paper explores the IMF’s leadership and coordination roles in the global response to the financial and economic crisis. It is principally based on interviews with country authorities, IMF staff and staff of other international organizations and reflects their perceptions. The paper finds that many authorities perceive that the IMF played an important role in responding to the crisis by calling for a concerted fiscal stimulus in 2008–09, as well as in designing programs and putting together lending packages for affected emerging market economies. The IMF also led the effort to obtain bilateral borrowing agreements to support lending, inter alia, to euro area countries. Beyond this, the IMF was seen by many authorities as having played an effective but secondary role to that of the G20’s leadership in crystallizing responses to the crisis. Earlier failures in Fund surveillance and in its “standing” or “legitimacy” with advanced economies and major emerging markets constrained its ability to play a central coordinating role in the response to the crisis.

Available for download here.

Gabilondo: The rise of risk-based regulatory capital – liquidity and solvency standards for financial intermediaries

From the Introduction:

In a capitalist economy, a private firm seeking finance must negotiate with prospective investors in the open market, which establishes standards about the terms on which debt and equity investment will be forthcoming. In addition to these market-financing standards, the capital structure of some financial firms—particularly broker-dealers, federally insured depository institutions, and insurance companies—must satisfy other requirements imposed by federal or state regulators to promote liquidity and solvency. Regulators take a heightened interest in these firms because they serve a public function in providing credit and other financial services. To grasp what regulatory capital rules try to accomplish, the reader must make a conceptual shift to see these financial firms as highly leveraged borrowers, contending with the demands of their own creditors. From this perspective, the financial stability of these firms becomes a matter of public concern.

Available for download here.