I agree with several points Dr. Calomiris makes in his Jackson Hole paper, including:

– Investors incorrectly assumed that the low loss rate on subprime mortgages in the 2000-02 slowdown could be projected forward, and thus inappropriately discounted the risks associated with subprime lending;
– The US government subsidized borrowing to buy a home rather than home ownership per se. While end these subsidies is impossible right now, they certainly aren’t something that the US should try to encourage other countries to emulate;
– The GSEs hybrid public/private status and the associated implicit guarantee of their debt generated a host of incentive problems;
– Agency problems in the private asset management industry contributed to excess demand for certain types of risky securities (though I am not sure charging 2% for assets under management rather than 1% necessarily reduces the incentive to garner assets).

I also thought we would agree that the “subprime boom and bust occurred largely outside the realm of government-sponsored programmes.” The Federal Reserves’ flow of funds data suggests – at least to me — that the GSEs were not the main source of demand for the private-label MBS and CMOs that absorbed many of the most risky kinds of mortgages at the peak of the housing boom. From the end of 2003 to the end of q2 2007, the GSE’s holdings of “corporate and foreign debt” (a line item that I think captures their holdings of MBS) increased from $277b to $501b – and increase of roughly $225b (See table L124, line 10). Over that time frame the stock of private label MBS – proxied by the mortgage holdings of ABS issuers — increased from $1024b to $3007b, an increase of nearly $2 trillion (See table L126, line 5). As Desmond notes, the Fed could and should have used its regulatory authority to slow this process – and also could and should have drawn more attention to the risks associated with increased financial opacity.

I would argue that the Agencies greatest contribution to the recent crisis may well have been indirect. The Agencies’ implicit guarantee transformed US mortgages into an acceptable reserve asset for a host of central banks. Part of me wonders if some Asian countries would have reconsidered their policies of targeting the exchange rate and accumulating so many reserves if the Agencies had not been around. From 2004 on, the increase in the outstanding stock of Treasuries significantly lagged the growth in central bank dollar reserves; if all the growth had been directed into Treasuries central banks would have rather quickly bought up most of the outstanding stock. Instead, several major central banks increased their Agency purchases, freeing up private funds to be redeployed into riskier assets.

While the motives of buyers and sellers in this fiasco can be understood, what is more difficult to fathom is the complete dereliction of duty by the Federal Reserve in its role as supervisor and regulator of the US financial system. Surely the Fed should have exercised its regulatory authority to rein in the creation of around US$2 ½ trillion of sub-prime and Alt-A mortgages that has poisoned the global financial system, rather than act as a cheerleader for financial innovations, like ARMs and negative amortization loans, of highly dubious value. Surely the Fed should also be held accountable for feeding the myth that housing prices do not decline in the long run and that spreading risk in highly opaque instruments was good for the financial system.

It is ludicrous to argue, as Mr. Setser does, that one should not blame buyers of subprime assets for making bad purchases. Just blame the originators he tells us. But Fannie, Freddie, and institutional investors that bought or retained these risks made the markets in these instruments that encouraged the reckless underwriting. Institutional investors, including the banks that retained much of their own securitization risks, and portfolio investors who bought them (including Fannie and Freddie) severely harmed their clients, shareholders, and in Fannie and Freddie’s case, the taxpayers. They have legal and moral responsibilities to have behaved differently. Does Mr. Setser really want to argue with a straight face that fiduciaries who buy securities should not be held responsible for imprudent risk management in their asset purchases because they were not the ones who originated the assets? I hope he is kidding. It is especially ludicrous to make this argument in the case of subprime, where one can show pretty convincingly that the buyers purposely ignored obvious ex-ante information about the junk they were overpaying for.

In fact, we must blame the buyers much MORE than the sellers. The sellers don’t represent us (us being portfolio holders, stockholders, and taxpayers). Sellers should be held to account for fraud, but not for selling assets at inflated prices. It is not the sellers’ job to prevent buyers from overpaying. Snake oil is always available for purchase if someone is willing to make a market for it as a buyer.

The most remarkable scandal about subprime assets is that ex ante these were obviously not good investments, and yet the most sophisticated buyers in the world (including the management of Fannie and Freddie) bought them massively, wasting the resources of the principals who these agents were supposed to protect. I do not say this lightly or on the basis of ex post performance. I refer readers to my paper for the details. It is true that there are lots of lessons from this crisis. The depth of private sector buy-side agency problems is one of the main ones. Fannie and Freddie’s politically motivated buy-side recklessness, driven by their affordable housing mandate and their Faustian bargain with the Congress, as well as managerial greed, is another main one. I fully recognize that Fannie and Freddie were not alone in their recklessness, but they were the largest offenders. Of the roughly $3 trillion in outstanding junk, they had more than a third of it.

The US has continuing advantages over other financial centers in nine dimensions: 1. derivatives 2. cheap, efficient trade execution, clearing, settlement and funds transfer. 3. Anonymity. 4. Venture capital firms that spot and finance the next generation of exciting companies. 5. Mutual fund industry. 6. Private equity boutiques. 7. Reliable court system. 8. English language. 9. Ability to work with counterparts, firms and individuals from different cultures.

Minister Steinbrueck may not be well-briefed on these important advantages and would do well to look around Europe to see where there is work to be done in order to boost competitiveness in several segments of the financial services industry.

One. Putting all the blame for the housing crisis on DC (the CRA, Fannie and Freddie) lets the lightly-regulated profit-maximizing (or so we thought) firms on the Street off a bit too easily. The worst excesses of the housing boom came from private mortgage originators selling mortgages that didn’t qualify for an Agency guarantee to private banks and broker dealers who packaged these mortgages into securities that were sold to private investors that wanted a bit more yield than could be obtained in the Treasury and Agency m markets. In 2005 and 2006 in particular, the net issuance of private MBS/ private ABS dwarfed net Agency issuance – in part because the Agencies were constrained by the fallout from their accounting difficulties. Moreover, the value of private institutions existing housing collateral would be far lower – and the current crisis far deeper – if the Agencies were not still providing mortgage financing to American households. Right now they are the only game in town.

Two. It seems pretty clear now that governments are not will to subject financial institutions to the full force of market discipline and thus there is a need for additional regulation of the financial sector’s capital and aggregate leverage – particularly among the set of institutions that are almost certainly too big and systematically important to fail. The fact that the Fed has had to provide over a trillion dollars in liquidity to the financial sector over the past year; regulation needs to adapt to this reality. One of the lessons of this crisis is that in extreme situations, the government ends up either assuming the liabilities of the financial sector (see Ireland) or the financial sector’s bad assets (see the United States). Under-capitalized and over-leveraged financial institutions could even be considered a potential strategic vulnerability. This crisis originated in a breakdown in credit intermediation in the US – not a withdrawal of external financing. But I suspect that if some global shock had led China to scale back its purchases of Treasuries and Agencies, the result would have been much the same. Higher rates would have pushed down home prices, and falling home prices would have caused problems for an under-capitalized financial system that had bet heavily (with borrowed money) that homes prices never fall. The US financial system as a whole bet that macroeconomic and financial volatility had fallen permanently, allowing more leverage — a rather risky bet for a country whose financial stability rested heavily on ongoing financial inflows. Moreover, a country whose regulated banks end up turning to another country’s government for emergency equity infusions reduces in some small way its strategic options. Democratic change in some countries that hold non-trivial stakes in core US financial institutions might now prove to be financially destabilizing.

Three. The current angst about the dollar’s status as a global reserve currency seems hard to square with the IMF’s data on global reserve growth. While most of that growth now comes from countries that do not report data on the currency composition of their reserves to the IMF, it is almost certainly the case that the world’s central banks added record sums to their dollar, euro and pound reserves over the past year – just because they added record sums to their total reserves. Counting China’s hidden reserves and the Saudi central banks’ non-reserve foreign assets, I would estimate that total reserve growth over the last four quarters of data (q23 07 to q2 08) was around $1350b – and dollar reserve growth was at least $900 billion. Rather than debating the dollar’s status as a global reserve currency, we should be debating whether it ever made sense to rely so heavily on central bank dollar reserve growth to sustain a large external deficit.

Global reserve growth likely slowed significantly in the third quarter – but a somewhat reduced pace of dollar reserve growth doesn’t imply the end of the dollar as a reserve currency. Indeed, I would argue that a world with somewhat slower global reserve growth – and even a world where the dollar is the reserve currency for the Americas, the euro is the reserve currency for Europe (as is increasingly the case now) and the yuan or a mix of the yuan, the rupee and the yen were the reserve currencies of Asia and each of the major regions floated against each other – would be in the United States strategic interest. The US would get a bit less cheap financing from excessive reserve growth from countries targeting an undervalued exchange rate v the dollar – but the US also would run a smaller trade deficit, have a more balanced economy and have less exposure to the risk that a government might suddenly reduce its desire to add to ever-more dollars to already bloated reserves.

For the first seven years of this decade, the dollar exhibited a negative relationship between depreciation and inflation, which may be explained by higher U.S. inflation leading to market expectations of higher U.S. interest rates, thus encouraging a shift towards dollar assets. Those expectations were entirely absent in early 2008, when the Fed, diverging from practice over the previous 25 years, made clear that it would continue to cut interest rates to ward off recession in spite of elevated inflation levels. Of course, even an economy the size of the United States is not immune from imported inflation when depreciation is so large that the opportunities for substitution are not sufficient to suppress it. And indeed, inflation and dollar depreciation began moving in tandem as the dollar fell sharply in 2007 and early 2008.

A more remarkable dimension of monetary independence that the Fed has retained has been the ability to set interest rates without regard to those of other currencies. This was easy for central banks to do when they operated in closed monetary markets, but became far more difficult as financial markets globalized. Local currency interest rates around most of the world get driven up as the currency depreciates against the dollar, irrespective of the wishes of the central bank. The Fed has not been similarly constrained in its setting of interest rates.

The fact that the United States has been able to conduct monetary policy independently of interest rates in other currencies is a reflection of the fact that investors in the United States and elsewhere, particularly central banks, have accorded a remarkable premium to dollar-denominated assets. Yet there is little basis for presuming that this premium will persist, that investors will indefinitely sacrifice yield vis-à-vis investments denominated in other credible currencies.

The signs are already there: in early 2008, American investors reacted to dollar weakness by pouring money into U.S.-managed foreign bond funds, assets in which had nearly doubled since two years prior. This is consistent with the observation of the president of the Federal Reserve Bank of Dallas, Richard Fisher, that “in today’s world, where investors can move their funds instantly from one currency to another to avoid depreciation, the price central bankers pay for high inflation is much higher than in the past.”

Suppose, for example, that in an environment of much greater U.S. investor sensitivity to foreign asset yields the Fed pursues an expansionary monetary policy by lowering interest rates. This would depreciate the dollar and reduce the relative yield of U.S. financial instruments. Up to this point, nothing would be new. The new element would be that an enormous mass of people, controlling most of the world’s dollar financial assets, would have a greater awareness of alternatives and feel impelled to take defensive action, selling dollars and driving down their value further. Market rates on dollar assets would have to rise in order to attract investment back, thus nullifying the Fed’s easing. The Fed will have lost its ability to set dollar interest rates and determine the rate of dollar creation. It will have become dependent on the decisions of the other major central banks, especially the ECB. It will, in essence, have become a mortal central bank like all the others.