FROM THE OFFICE OF PUBLIC AFFAIRS

The Cycle of Boom and Bust

As we look back through history, the speculative excesses of other times and other places can easily amaze us. We see tulip mania strike the staid burghers of seventeenth century Holland, who mortgaged their shops and homes to buy tulip bulbs and even tulip futures. Some tulip bulbs fetched multiples of their weight in goldCuntil prices crashed ignominiously. In early eighteenth century Britain, we see a huge rise in the stock price of a little-understood company with a scant record of producing products or operating profits. When the South Sea Bubble finally burst, it shook the country's monetary and political foundations. More recently, in the "bubble economy" of 1980s Japan, we see some Tokyo real estate change hands at prices implying that the grounds of the Imperial Palace might just be worth about as much as California. But not for long.

More generally, we see in history a pattern of speculative mania followed by painful adjustment. We may agree with the Duc de la Rochefoucauld, a seventeenth century nobleman who probably steered clear of tulip bulbs, that "We are all strong enough to bear the misfortunes of others." And yet we know that similar misfortunes could easily be our own.

For the cycle of boom and bust has its roots in human nature. Benjamin Graham touched on these roots in his classic book, The Intelligent Investor. In discussing how to allocate investments between stocks and bonds, he noted the logic of moving money into stocks when stock prices are down and out of stocks when stock prices are up: buy low, sell high. But he went on to make the following observation:

'These copybook maxims have always been easy to enunciate and always difficult to follow--because they go against the very human nature which produces the excesses of bull and bear markets. It is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline. It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and . . . are likely to have them in the future.

In my remarks today, I want to take that observation as a starting point and explore some of its implications for banking policy.

Banks are vulnerable to the ups and downs of the economic cycle, and particularly vulnerable to speculative booms and busts. Their liabilities are more liquid than their assets, and they must redeem deposits at par if they plan to stay in business. If widespread depositor panic forced banks into wholesale asset-dumping, the result could be a vicious spiral destabilizing the financial system and harming the real economy.

To help maintain financial stability, the FDIC insures deposits and the Federal Reserve stands ready to act as a lender of last resort. Yet these and other government interventions in the name of financial stability carry their own costs, their own risks. By impairing market discipline, they can let banks take greater risks without having to face a correspondingly increased cost of funds. The result can be excessive risk-taking -- and the potential for accentuating both speculative mania and the ensuing hardships of adjustment.

In my view, such an impairment of market discipline figured significantly in the U.S. thrift debacle of the 1980s. The old system of deposit insurance and thrift regulation inadvertently encouraged thrift institutions' owners and managers to act in ways that harmed the deposit insurance fund. Owners and managers faced "moral hazard" -- the tendency for insurance to encourage the persons insured to take greater risks than they would without insurance. All thrift institutions paid premiums at exactly the same rate, meaning that safe institutions subsidized risky institutions. Moreover, deposit insurance impaired market discipline, permitting weak institutions to remain open and compete aggressively with healthy institutions. Weak institutions tended to pay higher-than-average rates to attract deposits, and also tended to channel the proceeds into riskier-than-average investments. This behavior represented a rational response to the incentives created by the combination of flat-rate deposit insurance, limited liability, and low capital: if the risk-taking paid off, the institutions' owners kept the profits and their managers kept their jobs; if it failed, the insurance fund bore the loss.

But this behavior harmed healthy institutions. It squeezed net interest margins both by increasing the cost of funds and by decreasing interest rates on loans. It undermined credit standards by making credit more freely available to marginal borrowers. Too much money chased too few bankable loans, and lenders received inadequate compensation for credit risk. The erosion of credit standards increased loan losses and depository institution failures. The failures depleted the insurance fund, necessitating higher premiums that further undercut healthy institutions' profitability.

The Challenge for Public Policy

What, then, should public policy seek to do in the face of these patterns? We want to maintain adequate stability. Yet by intervening to promote stability, we can impair market discipline, exacerbate the cycle of boom and bust, and end up promoting instability.

So it seems to me that we face a paradox: To maintain long-term financial stability, we must be willing to tolerate some short-term financial instability. To avoid fueling speculative excess, we need to preserve the credibility of the adjustment process -- and the corresponding incentives to refrain from overextending oneself.

One can liken the adjustment process in an economy to fire in a forest. In the short run, both are destructive. But consider the alternative. If you suppress all fires in a forest, year after year and decade after decade, you actually make the forest more susceptible to a major conflagration. Vegetation grows unnaturally dense. Dead wood accumulates. And the forest becomes more vulnerable to drought, insects, and disease -- and to devastating wildfires that burn longer and more intensely than those that would otherwise have occurred. Similarly, if we go too far in shielding banks (and others) from the consequences of their own excesses, we will render the ultimate adjustment needlessly costly, painful, and destructive.

Thus, in the thrift debacle, the federal safety net played the role of Smokey the Bear, suppressing market discipline just like Smokey suppressed fires. Just as the forest grew unnaturally dense, depository institutions suffered from persistent overcapacity -- with too many dollars chasing too few good loans. Dead wood accumulated in the form of poorly managed and economically insolvent institutions. By weakening market discipline and by letting policymakers postpone the day of reckoning, the safety net let problems grow worse and increased the ultimate cost of resolving them.

In the FDIC Improvement Act of 1991, Congress sought to correct defects in the old system of deposit insurance and depository institution regulation. Through such reforms as prompt corrective action, least-cost resolution, and risk-based premiums, FDICIA sought to bring the incentives of depository institutions' owners, managers, and regulators more closely into line with the interests of the deposit insurance funds. In my view, these incentive-oriented reforms made an important contribution to strengthening our banking system in the early 1990s. Although not yet fully tested, they have worked well thus far. They have helped create a better set of incentives. They have reduced the potential for moral hazard. And they have helped regulators be more faithful agents of the taxpayers.

FDICIA's key reforms are consistent with the paradox I described earlier. Specifically, they seek to protect the deposit insurance funds -- and maintain long-term financial stability -- by fostering market discipline or some regulatory surrogate for that discipline. That necessarily involves some stress on weak institutions, and some increased potential for short-term instability.

Recent Progress -- and Some Backsliding

But how has domestic banking policy done more recently? Are we maintaining a healthy set of incentives for the owners, managers, and regulators of depository institutions? And in particular, do banks that take excessive risks face a credible prospect of having to internalize the costs of that risk-taking?

Among the achievements of the past six years, I would point to the following:

$ Completion of the thrift clean-up.

$ Enactment of legislation removing the remaining federal restrictions on interstate banking and branching -- which should improve opportunities for banks to diversify their loan portfolios and thus become better able to withstand shocks.

$ Enactment of legislation tightening constraints on treating large banks as "too-big-to-fail" -- by explicitly prohibiting the FDIC from using the deposit insurance funds to protect troubled banks' shareholders, and by giving depositors priority over other creditors.

$ Enactment of legislation resolving the problems of the FDIC's Savings Association Insurance Fund -- a notable example of Congress acting to head off a crisis before it started. Thus, for the first time since 1980, no federal deposit insurance fund has significant problems.

$ Full capitalization of both FDIC funds.

$ More rigorous disclosure standards for instruments with off-balance-sheet risks, including derivatives.

But there has also been some backsliding, notably the 1996 legislation that made FDIC insurance free of charge to most banks whenever the deposit insurance fund exceeds its statutory target of having $1.25 in reserves for each $100 of insured deposits. A well capitalized bank pays no premiums unless regulators find it to have significant financial, operational, or compliance weaknesses. So institutions holding nearly 98 percent of FDIC-insured deposits currently get their insurance for free.

The Treasury strongly opposed this partial ban on insurance premiums. The ban undercuts FDICIA's risk-based premium system, and needlessly complicates the FDIC's efforts to improve that system. It rests on a mistaken premise: namely, that the insurance funds belong to insured institutions, so that the interest earned on the funds' reserves constitutes an implicit premium. On the contrary, the insurance funds belong to the nation's citizens and taxpayers. The funds represent the net proceeds of premiums received in return for the insurance protection provided. After all, FDIC insurance is valuable. It is certainly worth more than nothing. Giving it away represents a conspicuous subsidy.

Also on the minus side, I would note the growing potential for the Federal Home Loan Bank System to serve in the future as a lender of last resort, in competition with the Federal Reserve discount window.

Conclusion

I'd like to close by citing two classic views about the lessons of history: the first by the English poet Samuel Taylor Coleridge; the second by the German philosopher Georg Wilhelm Friedrich Hegel.

Coleridge, the gentler and more accommodating of the two, voices a longing to learn from history, but stresses the intrinsic difficulty of doing so: "If [we] could learn from history, what lessons it might teach us! But . . . the light which experience gives is a lantern on the stern, which shines only on the waves behind us."

Hegel, by contrast, goes right to the bottom line, and a very hard line it is: "What experience and history teach is this--that people and governments never have learned anything from history, or acted on principles deduced from it."

There's evidence to support both views.

Meanwhile, our history has yet to be written. We will have plenty of choices to make about public policy towards our financial system. And in making those choices, we should weigh the costs as well as the benefits of government intervention, and be careful about purchasing short-term tranquility at the price of greater long-term instability.