Category Archives: Financial Crises

State and Local Health Obligations

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From a new working paper by Bryan Lutz and Louise Sheiner.

A major factor weighing down the long-term finances of state and local governments is the obligation to fund retiree benefits. While state and local government pension obligations have been analyzed in great detail, much less attention has been paid to the costs of the other major retiree benefit provided by these governments: retiree health insurance. The first portion of the paper uses the information contained in the annual actuarial reports for public retiree health plans to reverse engineer the cash flows underlying the liabilities given in the report. Obtaining the cash flows allows us to construct liability estimates which are consistent across governments in terms of the discount rate, actuarial method and assumptions concerning medical cost inflation and mortality…Relative to pension obligations discounted at the same rate, we find that unfunded retiree health care liabilities are 1/2 the size of unfunded pension obligations.

Perhaps the most interesting aspect of the paper is the amount of effort it took on their part to find the data to do the calculations. Similarly, one of the biggest challenges for Reinhart and Rogoff is to find data on government debt outstanding. There are strong incentives for politicians to avoid transparent accounting, and not much in the way of countervailing power.

DY2VTSC

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Larry Summers writes.

[we need] policies that restore a situation where reasonable growth and reasonable interest rates can coincide. To start, this means ending the disastrous trends toward ever less government spending and employment each year

The CBO wrote,

By 2038, CBO projects, federal spending would increase to 26 percent of GDP under the assumptions of the extended baseline*, compared with 22 percent in 2012 and an average of 20½ percent over the past 40 years.

Did you two visit the same country?

*The “extended baseline” is an unrealistic scenario, which includes spending cuts that are embedded in current law but unlikely to be retained by Congress. The more realistic “alternative fiscal scenario” projects even higher spending relative to GDP.

Brad DeLong’s Questions

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His post is here. I will insert my answers.

Why is housing investment still so far depressed below any definition of normal?

In the U.S., politicians shifted from punishing mortgage lenders for making type II errors (turning down borrowers for loans that might have been repaid) to punishing them for making type I errors (lending to borrowers who might default). In addition, politicians interfered with the foreclosure process. This kept markets from returning to normal, and it further discouraged mortgage lending. What good is the house as collateral for a loan in a world where the government keeps the lender from getting at it?

Why has labor-force participation collapsed so severely?

I believe that this is a trend, amplified by the cycle. Many workers are facing stiff competition from foreign labor and from capital. At the same time, the non-wage component of compensation has gone up, because of health insurance costs. These factors put extreme downward pressure on take-home pay for many workers, and they have responded by dropping out of the labor force.

Why the very large spread between yields on safe nominal assets like Treasuries and yields on riskier assets like equities?

I lean toward a Minsky-Kindleberger answer. During the Great Moderation, confidence in financial intermediation grew. We thought that banks had discovered new ways to manufacture riskless, short-term assets out of risky, long-term investment projects. Then came the financial crisis, and distrust of financial intermediation soared. This made it harder to convince people that you could provide them with riskless, short-term assets backed by risky, long-term projects.

Why didn’t the housing bubble of the mid-2000s produce a high-pressure economy and rising inflation?

It took place in the context of the long-term trend to displace many American workers with capital and with foreign labor. The bubble took us off that trend and the crash put us back on it.

To what extent was the collapse of demand in 2008-2009 the result of the financial crisis and to what extent a simple consequence of the collapse of household wealth?

Great question. It appears that the collapse of household wealth is a sufficient explanation. But if so, then what was the point of TARP and the other bailouts? Of course, putting on my PSST hat, I would reject a phrase like “collapse of demand.” I would say instead that in the wake of the financial crisis, the psychology of existing businesses was that it was a good time to shore up profits by trimming the work force, and the psychology of entrepreneurs was that it was not a good time to try to obtain funding for new businesses.

Why has fiscal policy been so inept and counterproductive in the aftermath of 2008-9?

Not a question that I can answer, given that we disagree on what constitutes inept and counterproductive.

Why hasn’t more been done to clean up housing finance (in America) and banking finance in Europe)?

Politicians care about what happens on their watch. That is why you can count on them to bail out failing financial firms (“Yes, we should worry about moral hazard. But risk some sort of calamity because of a visible financial bankruptcy? Not on my watch.”) That is why you can count on them not to institute major financial reforms. (“Of course, we need a new design here. But do something that could cause short-term disruption to some constituents? Not on my watch.”)

Incidentally, I diagnosed the “not on my watch” bias toward bailouts way back in 2008. Also in September of 2008, I wrote,

Five years from now, we could find ourselves with no exit strategy. My guess is that we’ll be pretty much out of Iraq by then. But it would not surprise me to see Freddie and Fannie still in limbo.

You can read Robert Waldmann’s answers here. Pointer from Mark Thoma.

Ben Bernanke’s Valedictory

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He says,

The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions

The Bagehot policy is to lend freely, at a penalty rate. If you lend freely at a penalty rate, you effect financial triage. Banks that are fine don’t borrow. Banks that are insolvent go under anyway. And banks that are temporarily illiquid use your loans to recover. Instead, if all you do is lend freely, then you are simply handing out favors, which turns banking into an exercise in favor-seeking.

He goes on to say,

Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries.

This is a popular story among Keynesians now. It was not in the textbooks before the crisis.

Scott Sumner will be disappointed to see that Bernanke does not believe in the theory of monetary offset.

What is Financial Repression?

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Ken Rogoff and Carmen Reinhart are still paying attention to sovereign debt. In fact, there are so many links in this paper to recent work of theirs that surely another book is in the offing. Here, they write,

the current stage often ends with some combination of capital controls, financial repression, inflation, and default. This turn of the pendulum from liberalization back to more heavy-handed regulation stems from both the greater aversion to risk that usually accompanies severe financial crises, including the desire to prevent new ones from emerging, as well as from the desire to maintain interest rates as low as possible to facilitate debt financing. Reinhart and Sbrancia (2011) document how, following World War II (when explicit defaults were limited to the losing side), financial repression via negative real interest rates reduced debt to the tune of 2 to 4 percent a year for the United States, and for the United Kingdom for the years with negative real interest rates. For Italy and Australia, with their higher inflation rates, debt reduction from the financial repression “tax” was on a larger scale and closer to 5 percent per year. As documented in Reinhart (2012), financial repression is well under way in the current post-crisis experience.

(Can anyone find the 2012 paper? It’s not listed in the references.)

Reinhart’s story is that once upon a time, countries emerged from WWII with a lot of sovereign debt. They used financial repression to keep interest rates low, and they got out from under that debt. Then they liberalized, and the financial sectors went crazy, growing rapidly and fueling bubbles. Then the crash came, governments took on a lot of debt again, and now we are back in the cycle of financial repression.

As a story, this is cute. But I cannot buy into it, at least for the United States. Re-read my history of U.S. government debt. Most of the reduction in the ratio of debt to GDP from 1946-1979 was due to the government running primary surpluses in the 40’s, 50’s, and 60’s. That is, if you took out interest payments, outlays were below revenues. The negative real interest rates were during the Great Stagflation, and they only reduced the debt/GDP ratio by a small amount.

Also, I am not sure where the financial repression is coming from today. Reinhart cites risk-based capital requirements that favor sovereign debt, but we have had those since before the financial crisis.

I think my larger issue is that I am unclear about the concept of financial repression. Some possibilities.

1. Financial repression consists of regulations that subsidize purchases of government debt and/or penalize risky private investment. In this case, the interest-rate differential between private securities and government securities is wider than normal. How does one distinguish this from a shift in the risk premium due to market psychology?

2. Financial repression reduces the amount of financial intermediation. But what does that mean?

To me, financial intermediation consists of the financial sector holding long-term, risky assets and issuing short-term, risk-free liabilities. The nonfinancial corporate sector and the household sector get to issue long-term, risky liabilities and to hold short-term, risk-free assets. The household sector ultimately owns the equity in the nonfinancial corporate sector and in the financial sector. The government, through deposits insurance and ad hoc bailouts, has in some sense written put options on firms in the financial sector, and as taxpayers we are on the hook for those put options.

If the government comes up with regulations that make it more difficult for the financial sector to expand and exploit its put options, then you might call that financial repression. But in that case, it is not clear that financial repression is a bad thing.

Fun Re-reading

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For the macro book that I am working on, I wanted to refresh my memory for how the financial crisis played out. I went back to blog posts that I wrote in 2007. You can find them here. Scroll down to December, and look for posts “subprime daily briefing” (sometimes named slightly differently).

I staked out an early position against bailing our borrowers. I have no regrets there. At one point I said that the total wealth loss from the crisis would not be as large as the loss from popping the dotcom bubble–I think I was wrong about that.

I also staked out an early position in favor of capital forbearance by bank regulators, meaning that they would not force banks to sell assets at distressed prices to meet capital requirements. I still think that compared with what regulators actually did, this was a better approach.

Also interesting are the various links from the posts. For example, I found a paper by Michael Bordo, dated September 28, 2007.

Many of the financial crises of the past involved financial innovation which increased leverage. The 1763 crisis was centered on the market for bills of exchange, Penn Central on the newly revived (in the 1960s) commercial paper market, the savings and loan crisis of the early 1980s on the junk bond market, LTCM on derivatives and hedge funds.

In the most recent episode, the financial innovation derived from the securitization of subprime mortgages and other loans has shifted risk away from the originating bank into mortgage and other asset backed securities which bundle the risk of less stellar borrowers with more creditworthy ones and which were certified by the credit rating agencies as prime . These have been absorbed by hedge funds in the US and abroad, by offshore banks and in the asset backed commercial paper of the commercial and investment banks. As Rajan ( 2005) argued, shifting the risk away from banks who used to have the incentives to monitor their borrowers to hedge funds and other institutions which do not, rather than reducing overall systemic risk increased it by raising the risk of a much more widespread meltdown in theevent of a tail event as we are currently witnessing.

Bernanke and History

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the WSJ presents Five takes, three positive and two negative. Michael Bordo writes,

During the Fed’s first 100 years, it has shifted gradually from being a banker-run to an economist-run central bank, culminating in Ben Bernanke’s assumption of the chairmanship in 2006. His appointment promised to bring the academic rigor of modern monetary economics to the chairmanship. Bernanke’s research, advocating greater transparency and better communication to enhance the central bank’s credibility, augured well for continuing low and stable rates of inflation.

Bordo’s take is negative. I have to say that I cannot agree that Bernanke made the Fed an economist-run central bank. During the crisis, it seemed to me to be a banker-run central bank.

Perspective on Fiscal Policy, Revisited

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From the comments on this post:

the entire discussion is about accounting for “money” which while very important is not the same as real output.

Let us assume, as a first approximation, that real output is the same, regardless of the path of the government budget. In that case, we are talking only about distribution issues. Kotlikoff tends to worry about the intergenerational distribution. We may be on a path in which Baby Boomers consume a lot, and their children and grandchildren are taxed heavily to pay of this.

My own concern is that the distribution issues cause damage to our social and political fabric. We set ourselves up for ever-increasing strife. Please re-read Lenders and Spenders.

Normal AD vs. the Credit Channel

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‘Uneasy Money’ writes,

try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

Pointer from Tyler Cowen. This argument broke out five years ago, and it is no closer to being settled. I might phrase it as the following multiple choice question:

a) the economic slump caused the financial crisis (the Sumnerian view, endorsed above)

b) the financial crisis caused the slump (the Reinhart-Rogoff view; also the mainstream consensus view).

c) both are symptoms of longer-term structural adjustment issues (I am willing to stand up for this view. Tyler Cowen also is sympathetic to it. Note that I do not wish in any way to be associated with Larry Summers’ view, which is that the structural issue is that we have too much saving relative to productive investments.)

d) both are symptoms of a dramatic loss of confidence. As people lose confidence in some forms of financial intermediation, intermediaries that are heavily weighted in those areas come to grief. Se see disruptions to patterns of trade that depend on those forms of intermediation. Moreover, as businesses lose confidence, particularly in their ability to access credit, they trim employment and hoard cash.

I want to emphasize that I see a reasonable case to be made for any of these views. There may be yet other points of view that I would find reasonable (although Summers’ “secular stagnation” is not one of them). In macroeconomics, if you think you have all the answers, then I cannot help you. I think that this is a field in which doubts are more defensible than certainties.

Perspective on Fiscal Policy

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From Laurence Kotlikoff:

The US fiscal gap now stands at an estimated $205 trillion, or 10.3 percent of all future US GDP. Closing this gap is imperative, and requires a fiscal adjustment of an immediate and permanent 37 percent reduction in spending (apart from servicing official debt), an immediate and permanent 57 percent increase in all federal taxes, or some combination of the two. The necessary size of this adjustment increases the longer it is put off.

Meanwhile, all reasonable centrists can celebrate the Ryan-Murray budget compromise.

The bill will authorize $1.012 trillion worth of discretionary spending in 2014, more than the $967 billion scheduled under sequestration

Have a nice day.