Gary Stern isn't the sort of guy to say "I told you so."
The former president of the Federal Reserve Bank of Minneapolis is perfectly entitled to. Amid the heady economy of 2004, he and colleague Ron J. Feldman published a book titled "Too Big To Fail: The Hazards of Bank Bailouts" in which he all but predicted the financial collapse to come three years later, the factors to bring it, and the probability of controversial bailouts.
Gary H. Stern, Ph.D., will be speaking at Misericordia University on Wednesday and will discuss the notion of "Too Big To Fail," which he feels distorts the market by giving creditors an incentive to ignore risk. Risk is under-priced because creditors of too-big-to-fail institutions know they can rely on government support in the event of failure.
BusinessWeekly caught up with Dr. Stern to talk about his book and the financial crisis.
Q: How many times have you said, "I told you so"?
A: I've refrained from saying "I told you so." The book was published in 2004 and Brookings reissued it in 2008, and they asked if we wanted to make changes. We thought we got it right the first time.
The practical lesson of the book is that you need to be prepared going into a crisis. Clearly we were unprepared - in a world of improvisation in which some things will go well, others will not. If our book had been taken to heart, we would have been better prepared.
When the book was released, people thought there was merit to our arguments, which rely on incentives instead of a world where creditors anticipate full protection. People saw the merit in the incentive argument, but thought either a crisis was unlikely or that there was nothing we could do about it.
Q: Did you support the bailouts? They were paid back, and prevented a complete collapse and seemed to work.
A: Once you are in the crisis you are beyond preparation. Yes, I supported them. I believed they were effective in limiting the damage. There would have been more. In general, it was the right thing to do after the crisis. But that is not the world you want to have persist over time.
Q: How do you feel about the policy response after the crisis?
A: The jury is still out. There is plenty in Dodd-Frank (Wall Street Reform and Consumer Protection Act) that would not pass cost-benefit test. But there is lots of potential. I don't have enough information to speak on the status of that with confidence. Large institutions have had to submit their living wills as part of that, which is good. Regulations are backward-looking; regulators are always playing catch-up. It's difficult to get the incentives right and subject creditors and institutions to market forces.
Q: What role did derivatives play in the crisis? Should they be regulated?
A: I like the idea of putting most derivative trading on an exchange or a clearinghouse. It's not a perfect solution, but it would help. Derivatives exist to allow distribution of risk to those more willing to bear it. Regulation may be helpful, but by itself is not likely to be sufficient. You can regulate the problems identified today, but clever financial engineers will find ways around today's regulations.
Q: The presidential campaign is full of discussion about regulation and the good and evil of them. Do you think the discussion has gotten more polarized?
A: To be honest, I haven't followed the pronouncements carefully. It's almost inevitable some people will assert regulations are too costly and we need fewer or we need more and point to the crisis. I say you want a cost-benefit analysis. Some regulations will pass with flying colors, some will fail, others will be in some gray area. Let's at least narrow down the range of dispute and focus to where we are certain a regulation would help.
Q: The housing crisis is thought to be the key to driving the economy. Should the government pressure banks to write down principal on certain mortgage loans?
A: It appears a recovery in housing is underway in the aggregate, but not in each and every location. We should look at steps that can be taken that won't interfere too much with normal market processes. There's not a blanket solution. We want to encourage institutions to consider dealing with underwater mortgages on a case-by-case basis.
Q: Throughout your time with the Fed, you were viewed as "hawk" advocating for tighter monetary policy. How do you feel about the Fed's current strategy?
A: The fed got to 0 in the later part of 2008, when I was still there and I supported it. We were in the midst of a serious crisis. The Fed has a dual mandate, when inflation is not an issue and unemployment is at 8 (percent), there's not of lot of debate. That said, I think this talk of QE 1, 2, and 3 and "Operation Twist" has been somewhat entertaining, because none of them are potential game changers. At best they will make a marginal difference.
Contact the writer: dfalchek@timesshamrock.com