Mussa Draws Insights on Financial Crisis from Adam Smith

When he delivers the Adam Smith address at NABE’s 50th Annual Meeting in October, Michael Mussa plans to draw upon Smith’s writings to help explain today’s financial crisis and its ramifications for the broader U.S. economy.

While it might seem unusual to extract lessons learned from an 18th century Scottish banking system crisis, Mussa says there are parallels to the current financial crisis facing U.S. policymakers. “They had their own Fannie Mae and Freddie Mac, and Smith talks about those concerns,” he said in an early August interview. 

Mussa, former economic counselor and director of research at the International Monetary Fund, is the recipient of the 2008 Adam Smith Award, NABE’s highest honor.  He is currently a senior fellow at the Peterson Institute for International Economics.  In the late 1980s, he served as a member of President Reagan’s Council of Economic Advisers.

Mussa said the tentative title of his Adam Smith address is:  “Adam Smith and the Political Economics of a Modern Financial Crisis.”  He talked briefly about the parallels between 18th century Scotland’s financial crisis and the 2008 financial crisis brought on by the housing downturn and related credit crunch that many forecasters believe has pushed the U.S. economy into recession.

It’s too soon to tell whether the downturn is a recession, Mussa said, but the distinction may be more one of definition and semantics, he argued.  “It feels like a recession to many people.  Whether it is one to the NBER [National Bureau of Economic Research], we’ll have to wait and see,” he said.

Were Federal Reserve’s Actions Too Aggressive?

The Federal Reserve’s aggressive response to the financial sector’s slump has posed significant questions about the central bank’s policies and possible reforms that could result, Mussa said.  He said he is especially concerned about the potential for Congress to overreach as lawmakers assess the “moral hazard” created by the Fed’s support for the financial system.

“Whether they were too aggressive or not remains to be seen.  Clearly the inflation problem now looks more worrying to most people than the general level of concern Aaround the beginning of the year,” Mussa said.  Between mid-December 2007 and
April of this year, the Fed lowered its federal funds target rate from 4.25 percent to 2.0 percent, stating its concerns for a weak economy as a result of the housing downturn and related credit crunch.

After its April 30 meeting, when the Federal Open Market Committee cut the target another 25 basis points, to 2.0 percent, the FOMC said, in part: “The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity.”

Economists are split on whether this “substantial easing” will prove to be a source of inflation.  Mussa said that recent acceleration in the inflation rate—combined with the weak economy—has put the Fed in an uncomfortable corner.  “It’s hard for the Fed to move. There is always a possibility to tighten later, but I don’t anticipate they would do that before year-end.”

As of early August, most of the economic data shows that “the crisis has been much more in the financial sector than in the real economy,” Mussa said.  The tax rebates from the economic stimulus package boosted economic growth in the second quarter, probably taking away from growth later in the year, he said.  Plus, exports have held up well and that source of growth has meant higher capital spending in those industries even as domestic demand has fallen, he pointed out. “If it weren’t for the boost we’re getting from net exports, we would be in recession,” he said.

The unemployment rate, a lagging indicator of the economic health, is likely to continue climbing from its August level of 5.7 percent and stay higher after the economy turns around, he predicted.

Reforms Needed; More After Fall Election

Crises “inevitably generate reform,” and this time will be no different, Mussa said.  Congress and the White House already have put in place new programs for helping homeowners in trouble and there are reform proposals pending on Capitol Hill.  More reforms are sure to see legislative action after the national elections in November, he said.

“We already have seen the Federal Reserve impose more rules on mortgage lenders and you’ll see more along that line coming out of Congress,” Mussa said, adding that to him,  “it’s not clear yet what they’re going to do to in terms of the extension of the financial safety net to investment banks.”

The question of extending more support to investment banks prompted Mussa to pose the critical question of how the central bank will deal with “the moral hazard problem” that many economists “rightly perceive will be a consequence of that type of extension of the safety net.”  The deal brokered by the Fed and the Bush administration to facilitate JP Morgan’s acquisition of the failing Bear Stearns is among the chief factors that prompted critics of the central bank to question policies that would expand the safety net.  And some members of Congress are considering a wide-ranging review of Fed policies and the scope of its powers.

The prospect of greater Congressional scrutiny should not be taken lightly, Mussa warned.  He agrees that recent action taken by the Fed have raised “a number of concerns in different dimensions: there are monetary policy issues as to whether they managed policy appropriately” and there are issues related to “whether they are paying proper attention to the development of asset markets.”

Mussa put it this way:  “The important question for the Federal Reserve is:  if we give them a range of important new responsibilities, inevitably does that conflict with responsibilities they already have? That is a serious concern—that they may have heightened the danger of inflation meaningfully with their effort to rescue the financial system.  If you try and do too many things, chances are you’re not going to do any of them very well.”

“Mischief Is Certainly Possible”

Fed Chairman Ben Bernanke “seemed to be suggesting” in recent testimony to Congress that the central bank should consider making financial stability, in a broad sense, an objective of monetary policy. Mussa said that believes “that was a serious mistake because you begin to open up the Federal Reserve Act for discussion by the Congress.  What would come out of that—who knows?  Mischief is certainly possible.”

Given the policy actions taken to address the housing and credit crises, Mussa said that “we probably do need to have a serious rethink of the question of how we regulate the financial system and how we ensure more effectively that private risks are private and that we don’t socialize losses and privatize the gain to the extent that seems to have happened recently.”

The moral hazard comes about when lower interest rates greatly diminish yields on short-term assets even as they pump liquidity into the system that benefits risk-taking, he said.
 “Most people don’t understand the hundreds of billions of dollars of public money that has been used to stabilize the system and that somebody else was the beneficiary of that; somebody got to use that money,” he said.

“Now that the Federal Reserve has cut the funds rate from 5.25 to 2 percent and the yield on $10 trillion in short-term assets, to you and me and people with money market accounts, the yields that we’re receiving now have dropped,” he said. “So our income is down and somebody else is getting the benefit and that is the principal means through which monetary policy can generate significant moral hazard because it takes money out of the pockets of people who want to invest in relatively safe short-term assets and it makes it much cheaper for people who want to use the leverage that is made possible by the availability of those cheap funds, to engage in various risk-taking activities. If you take $10 trillion and you assume that interest rates were kept 2 percentage points below where they might normally have been for four years, that’s a lot of money.”