Why Didn’t Canada Riding Interview with Have a Financial Crisis? the Rails Mark Gertler VOLUME 17 NUMBER 4 FOURTH QUARTER 2013 Econ Focus is the economics magazine of the Federal Reserve Bank of Richmond. It covers economic issues affecting the Fifth Federal Reserve District and the nation and is published on a quarterly basis by the Bank’s Research Department. The Fifth District consists of the COVER STORY 14 District of Columbia, Maryland, North Carolina, Risky Business? Insurance is boring … or at least it’s supposed to be South Carolina, Virginia, and most of West Virginia. DIRECTOR OF RESEARCH FEATURES John A. Weinberg 18 EDITORIAL ADVISER Directing Traffic: Development patterns and other factors have Kartik Athreya EDITOR shaped transportation options in the Fifth District. Where does Aaron Steelman rail transit fit in? SENIOR EDITOR David A. Price MANAGING EDITOR/DESIGN LEAD 22 Kathy Constant STAFF WRITERS Why Was Canada Exempt from the Financial Crisis? Canada has Renee Haltom avoided crises for 180 years, while we have been prone to them. Jessie Romero Can we recreate its stability here? Tim Sablik EDITORIAL ASSOCIATE Lisa Kenney CONTRIBUTORS 26 Jamie Feik Charles Gerena Credit Scoring and the Revolution in Debt: How a number Santiago Pinto changed lending (and got some Americans in over their heads) Karl Rhodes D ESIGN ShazDesign 28 Published quarterly by The Future of Coal: Prospects for West Virginia’s highest-paying the Federal Reserve Bank industry appear bleak of Richmond P.O. 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The views expressed in Econ Focus 38 Economic History/Water Wars are those of the contributors and not necessarily those of the Federal Reserve Bank 42 Around the Fed/The Power of Words of Richmond or the Federal Reserve System. 43 Book Review/Fortune Tellers: The Story of America’s First ISSN 2327-0241 (Print) Economic Forecasters ISSN 2327-025X (Online) 44 District Digest/Urban Crime: Deterrence and Local Economic Conditions 52 Opinion/Down But Not Out COVER CONCEPT: KATHY CONSTANT PRESIDENT’SMESSAGE Rethinking the ‘Lender of Last Resort’ any people have come to think of central banks have argued that the Fed’s as a necessary, almost inherent, part of a healthy “emergency” lending powers M financial system. But for some functions the Fed under section 13(3) of the has adopted since it was created in 1913, there is no reason, Federal Reserve Act — which in principle, that they must be performed by a central bank. enables the Fed to extend An example is the function of “lender of last resort,” broad-based loans to troubled a phrase often used to describe how central banks have markets — must be preserved tended to respond to financial crises. When many market to enable a response to participants withdraw funding at once, it can mean all manner of “runs” in the financial distress for fundamentally solvent borrowers, financial system. a situation often called a “run.” Temporary central But one important source bank lending to sound institutions can, therefore, prevent of excessive risk, in my view, unnecessary failures. is the government safety net itself, which includes the Two articles in this issue of Econ Focus explore alternatives lender of last resort. A government backstop reduces the to a central bank as lender of last resort. One discusses the borrowers’ incentives to design contracts and credit market little-known Panic of 1914, which occurred before the Fed instruments that are less vulnerable to runs. It also diminish- had officially opened its doors. To end the crisis, the es the incentives of lenders to monitor borrowers. That Treasury issued fully collateralized emergency currency, and makes crises more likely and the government’s liquidity private clearinghouses extended loan certificates to their support more likely to be called upon. As a result, the members. Both helped banks meet depositors’ demands. government’s financial “safety net” only grows over time. While the Treasury played a strong role in this response, the Estimates by Richmond Fed researchers show that 57 per- episode demonstrated that fast access to an asset-backed cent of the entire financial sector is either explicitly currency — which need not come from the central govern- guaranteed by the government or market participants can ment — could stem a run. reasonably expect guarantees based on past statements and Another article in this issue explores why Canada has actions. To the extent that the safety net results in excessive been able to fend off financial crises almost entirely, while risk-taking, the Fed’s present-day lender of last resort powers the United States has been especially prone to them. Part of exist to counteract instabilities created by flawed policies, the answer is that, from Canada’s inception, its banking just as they did when the Fed was founded. system was structured to be less vulnerable to shocks. Banks A better way to deal with financial instability would be to could establish wide networks of branches to diversify their scale back the incentives for excessive risk-taking. A smaller portfolios. They were also allowed to issue new currency government safety net would give markets greater incentive backed by their own general assets to meet the demands of to adopt their own protections against runs. This may not depositors. Both features enabled banks to lend reserves rule out runs entirely. But history has convinced me that the to one another in emergencies and expand the supply of self-fulfilling nature of government backstops cannot reli- currency elastically. ably prevent runs either and can in fact cause instability. The These responses were effectively ruled out by laws in the experiences of 1914 and Canada force one to consider that United States, as the articles discuss. The lack of diversifica- there could be alternatives to a centralized role of lender of tion and reliable access to reserves made banks rather last resort, some which could conceivably be devised by vulnerable to local economic shocks and seasonal shifts in markets themselves under the right set of incentives. currency demand — which often led to the very bank runs In American history, we have often treated financial that our currency and branching restrictions left the bank- system instabilities with reforms that don’t address the fun- ing system ill-equipped to handle. damental problem. My hope is that the Fed’s second century The Fed was given lender of last resort powers in order to will prove that policymakers are willing to take a harder look provide a more elastic currency to stave off panics in a way at the true sources of instability in our financial system. EF that existing laws prevented the banking system from doing on its own. Thus, the Fed was founded to ameliorate the destabilizing effects of other policies. There is a parallel to today. The Fed’s functions have evolved, now with a much larger role in setting monetary JEFFREY M. LACKER policy, the core mission of the Fed and other central banks. PRESIDENT But its lender of last resort powers remain. Many people FEDERAL RESERVE BANK OF RICHMOND E CON F OCUS | FOURTH Q UARTER | 2013 1 PFRONT U Regional News at a Glance Bringing Home the Bacon China’s WH Group Buys Virginia’s Smithfield Foods Last September, shareholders of Virginia-based Smithfield Foods, the United States’ largest pork producer, approved the company’s purchase by the Chinese company WH Group for $4.7 billion. The deal valued Smithfield at $7.1 billion taking into firms, including the private equity arm of Goldman account assumed debt. Shareholders received $34 per Sachs, but the company started taking orders for a share, a 31 percent premium over the closing price the $5.3 billion initial public offering in mid-April. The IPO day before the purchase was announced in May. The will be the largest in Asia since Japan Airlines raised acquisition was the biggest purchase ever of an $8.5 billion in September 2012. American company by a Chinese company. For Smithfield, the deal is an opportunity to keep WH Group, a holding company that also owns growing despite a stagnant domestic market. Total U.S. China’s largest meat processor, purchased Smithfield pork consumption has been flat for the past three primarily to gain access to a reliable source of imports. decades as per capita consumption has steadily Pork accounts for more than three-quarters of China’s declined. “China is the fastest-growing and largest over- meat consumption, and demand has multiplied as more seas market,” Smithfield CEO Larry Pope said in a OLLECTION people move into the middle class. But the country’s statement. “Increasing our sales to China is central to . C OS farm system is fragmented and inefficient, and proces- our growth strategy.” sors have struggled to keep pace. At the same time, American pig farmers also stand to benefit from TICHNOR BR Y/ Chinese consumers are increasingly wary of Chinese increased exports; the North Carolina Pork Council brands after a history of food safety scandals, including endorsed the deal for leading to “expanded overseas ON PUBLIC LIBRAR the discovery of the illegal additive clenbuterol in the sales and more opportunities for the thousands of ST pork of a WH Group subsidiary.