November 23rd, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the November 2013 Longbrake Letter. To read the letter in its entirety, click here.
Over the last 50 years finance theorists extended the neo-classical economic theory of competition to financial instruments and markets. The neo-classical economic theory of competition is highly idealized and is based on rigid simplifying assumptions that are not consistent with observed behaviors. Financial economics theory is subject to the same limitations. However, the elegance of mathematical models that flowed directly from the assumptions and the utilization of these models in designing and pricing a plethora of financial instruments coupled with the fact that the models appeared to be reasonable in “normal” times, led many theorists and practitioners alike to blindly embrace the theory and models as accurate and complete. The theory dictates that market participants should seek to maximize value and based upon the theory’s assumptions, the operation of the market will assure that no participant benefits at the expense of another participant – the optimal collective outcome will always be achieved. In time this mantra of “the market knows best” came to dominate beliefs and behavior. Regulation was judged to be intrusive and unnecessary. In effect, Brock’s third pillar – the constitution/rule of law – was replaced with assumption that the market would do the job. Obviously, we know from hard experience that it did not.
1. Neo-Classical Economic Theory
Neo-classical economic theory was developed in the late 1800s and early 1900s. It is based on the theory of perfect competition, which results in the maximization of aggregate economic welfare. The theory is based on simplifying assumptions of human behavior that describe in broad general and ideal terms behaviors of participants in the economy.
Neo-classical economists understood that the real world is far more complex than the world assumed under the tenets of perfect competition. They realized that the actions of individuals do not adhere strictly to the simplifying assumptions. Nonetheless, the theory of perfect competition is a useful construct for understanding how an economy functions. By comparing the idealized assumptions to actual behaviors, economists and policymakers can better understand how to govern the economy to maximize aggregate public welfare, given the inherent self-interested and sometimes irrational behaviors of individuals.
2. Rise of Financial Economics and the Efficient Markets Hypothesis
Modern finance had its genesis in the 1950s. The defining event was Harry Markowitz’s doctoral dissertation on portfolio theory. Development of modern financial theory proceeded rapidly during the 1960s and 1970s and keyed off of the neo-classical theory of perfect competition.
3. Assumptions of the Financial Economics Theory
• All participants are rational
• All participants have access to complete information
• All participants share the same decision-making framework for using information to make decisions
• The decision-making framework is accurate and complete
All of these assumptions are oversimplifications of observed real world behaviors. The fourth assumption, if accepted uncritically, is especially problematic. What the term “accurate and complete” means is that the decision-making framework is stable and does not change over time. But that assumption is patently inconsistent with the rapid development of new financial technologies and the constantly evolving structure of the global economy and financial markets.
Financial economics theory posits that if all of these assumptions hold (which they do not), the collection of all individual decisions, which is “The Market”, will assure optimal outcomes both for individuals and the community as a whole. Thus, any form of intervention will lead to a suboptimal outcome.
4. Operationalization of Financial Economics Theory
Had financial economists been content to stay in the world of theory as had neo-classical economists financial economics theory would have remained a useful device for understanding the imperfect working of financial markets.
However, the theory, which assumes that financial events (phenomena) are random and normally distributed – both simplifying theoretical assumptions –, was operationalized through the development of market-traded financial instruments. The assumptions of randomness and normal distribution are a simplification of the fourth assumption that the decision-making framework is stable over time.
The famous Black-Scholes option-pricing model embedded the assumptions of randomness and normal distribution. This model was relied upon to develop pricing methodologies for a plethora of financial derivatives using historical data. The historical data were presumed to be normally distributed and to be stable over time. In other words, the pricing algorithms assumed that future price variability could be defined by and explained by past price variability.
These pricing models appeared to work well over a variety of market circumstances. As a consequence, the mathematical elegance of the model and the apparent accuracy of how it explained financial market behaviors strengthened the political movement toward deregulation and embracement of “The Market” as an effective and efficient market governance mechanism.
5. Failure of the Theory of Financial Economics
But, people lost sight of the reality that financial phenomena are neither random nor normally distributed. They lost sight of the reality that the model is not stable but ever changing as technological innovation and global competitiveness has evolved.
The macroeconomic consequences of growing income/wealth inequality had no place in the theory of financial economics.
Myopia and faith in the efficacy of micro financial theory blinded people to the building macroeconomic fragility.
There were warnings along the way that the assumptions underlying the construction and pricing of financial derivatives were deeply flawed. The collapse of Long Term Credit Capital, a mathematically-based arbitrage operation, in 1998 exposed the limitations of the assumption of normally distributed events. The reality was that the distribution had large fat tails in times of extreme duress. This hardly was a startling revelation. The centuries-long history of booms and busts and of speculation indicates that extreme events and fat tails are a natural occurrence in human existence.
Yet, the elegance of the theory and its operationalization led to uncritical belief in its efficacy. As financial markets embraced the theory and developed lucrative financial instruments based on it, self-interest entrenched commitment to its tenets and led to the capture of government policy and regulatory processes.
Thus, in this way modern finance theory contributed to rising income inequality and was a significant contributor to the escalation of unchecked market euphoria during the bubble years.
Perhaps disturbingly, in spite of the failure of the application of modern finance theory in recent years in governing market processes, the pricing of financial derivatives continues to be based on the simplified theory. Moreover, the beliefs, vested interests and political influence of the financial elite remain relatively unchanged.
It is in this vein that a debate about the future of capitalism is just beginning to emerge. The risk is that the debate will not develop into a substantive and critical evaluation of the causes of income inequality and the shortcomings of the application of simplified financial theory to the operation of financial markets. Without such an in depth assessment solutions, which have broad-based consensus, will not emerge. We have already witnessed the consequences of the current paradigm. So, clearly the status quo is not an optimal outcome. Indeed, adherence to the status quo could either lead eventually to social unrest and political reform under duress or alternatively it could foster the gradual decline in America’s economic, financial and political ascendancy.
6. Asset Price Bubbles
Asset pricing theory, which was developed by Myron Gordon¹, is based on the same general assumptions of financial economics theory. It posits that the price of an asset is determined by the discounted expected return of holding an asset for one
time period. This price depends upon three factors: any cash payment received during the period, the expected price at the end of the period and the discount rate. However, numerous studies have found that actual fluctuations in asset prices do not conform to the dictates of theory.
In a recent article, John Williams², president of the Federal Reserve Bank of San Francisco, quipped: “We economists like to explain things using highly stylized models. We build make-believe worlds, populate them with creatures that act according to strictly prescribed rules, and analyze what happens. … Often the simplest model – with patently unrealistic assumptions – yields the keenest insights into how a market or an economy works. … Much of the research on asset prices continues to rely on highly stylized models with identical agents, rational expectations, and optimizing behavior.”
If the assumptions of the theory held without exception, asset prices would never lead to price bubbles. In fact asset price bubbles form rather frequently. Williams states that the actual behavior of asset prices can be explained by replacing the assumption of rational expectations with people’s perceptions of what they believe will happen in the future. The record clearly shows that people’s expectations of the future depend on what has happened in the recent past. Thus, if prices have risen, the collective expectation is that they will continue to rise. This introduces a positive feedback loop that propels asset prices into bubble territory.
Williams concludes that asset price models need to incorporate an assumption of procyclical investor optimism and cites Charles Kindleberger’s seminal work: “The lesson of history is clear: asset price bubbles are here to stay. They appear to be a consequence of human nature.”³
1. Gordon, Myron J. (1959). Dividends, Earnings, and Stock Prices
. Review of Economics and Statistics
41(2), pp. 99-105.
2. Williams, John C. Bubbles Tomorrow, Yesterday, but Never Today? Federal Reserve Bank of San Francisco Economic Letter 2013-27.
3. Kindleberger, Charles P. (1978). Manias, Panics, and Crashes: A History of Financial Crises. New York: Basic Books.
October 17th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the October 2013 Longbrake Letter. To read the letter in its entirety, click here.
Without attempting to dig deeper into the details of the current situation, which is evolving hourly, I think it might be instructive to provide some commentary about how we got to this point in our political affairs because it will shed light on what we might expect going forward.
While the proximate primary cause of the current political dysfunction is traceable to the rise of the Tea Party and the substantial number of Tea Party House Republicans, to appreciate the reasons that this minority faction of the Republican Party has such commanding influence one needs to understand how the mechanics of political party leadership determination has evolved over the last 45 years.
George Friedman recently wrote an insightful analytic commentary entitled “The Roots of the Government Shutdown.”¹ Beginning in the late 1960s, at the same time as the Civil Rights and anti-Vietnam War movements were gaining momentum, political reformers sought to break the power of party bosses by sponsoring reforms, principally by selecting leaders through primaries, but also by establishing rules governing financial contributions.
In the old party-boss system, money was important in politics just as it is today and it flowed through the party bosses, who used it and the ability to control patronage jobs, such as local postmasters, to maintain their power bases. The reformers objected to the inherently corrupt aspects of the party-boss system. However, as Friedman points out, the party-boss system produced some truly great presidents, such as the two Roosevelts – Theodore and Franklin, Woodrow Wilson, Harry Truman, Dwight Eisenhower and John Kennedy.
In addition, and this is key, party bosses were generally political pragmatists. They were more interested in acquiring, exercising and maintaining power than they were in pursuing highly ideological agendas.
Primaries destroyed the power of political bosses and in that regard the reform movement was successful. But there was an unintended and unexpected consequence. In most states party registration is required and only registered members of a party can vote for candidates of that party in a primary.² By itself this would not necessarily lead to narrowly-based outcomes. But, because typically a small percentage of voters participate in primaries and “true believers” are more likely to vote in primaries than centrists or independents, fervent party members who often have focused, ideological agendas, can dominate primary outcomes.
This means that because of the realities of how the primary system works in most states, ideological minorities often can control election outcomes or can threaten more centrist Republicans with the possibility of primary challengers. Take, for example, the case of Mitch McConnell (R-KY), who has been a senator for 28 years and is the Senate Republican minority leader. He already has an announced Tea Party challenger for the 2014 primary election. It is much too early to speculate how this election could turn out. The challenger could defeat McConnell in the primary or so weaken McConnell that he could lose to the Democrat challenger in the general election. Since both are very real possibilities, it seems possible these threats to his re-election could influence McConnell’s political decisions in the current crisis.
Friedman also discusses the importance of money in politics. The reformers sought to reduce the influence of money by limiting individual contributions to political candidates. But other reforms, such as political action committees, circumvented the effectiveness of individual contribution limits. Then, the Supreme Court’s decision in the Citizens United case opened up the flood gates for corporations and large individual donors to contribute to candidates who espouse the donor’s ideological agenda.
There is one more ingredient that has contributed to the current situation. Several years ago the Supreme Court opined that House district boundaries needed to be drawn in a way that did not discriminate against specific groups of Americans – the one-man, one-vote rule. In practice this resulted in drawing boundaries that concentrated the percentage of certain groups and assured election of minority candidates. But, this also enabled boundary drawers to gerrymander remaining district boundaries to create safe seats for either Republicans or Democrats. The Constitution requires a census of the U.S. population to be conducted every ten years and for House districts to have approximately equal numbers. Because of population shifts over time, this leads almost always to the need to redraw district boundaries. Typically this is the task of a state legislature and whichever party controls the state legislature has the upper hand in drawing the boundaries.
2010 was the year of the most recent decennial census and it fell to state legislatures elected in 2010 to draw House district boundaries. 2010 just happened to be the landslide election year for Republicans, not just in the House of Representatives but also in many states, as voters reacted negatively to President Obama’s policies in general and to the Affordable Care Act in particular. The outcome was that Republicans were able to gerrymander many districts to create a high probability of a Republican House majority. Many of these gerrymandered Republican seats were designed to be safe, so that other than a primary challenger the incumbent need not worry about a serious challenge from a Democratic opponent. Because district boundaries will not be redrawn until after the 2020 decennial census these safe seats will persist for at least another eight years.
Now all of the elements are in place that have fostered and will continue to sustain the ideological tilt that is driving the House’s approach to the federal budget, the debt ceiling and attempts to delay or defund ObamaCare. Most Tea Party Republicans come from safe, gerrymandered districts. They are not threatened by moderate Republican challengers. Many moderate Republicans, because of primary registration requirements and typical voting patterns of party members, are threatened by potential Tea Party challengers. Finally, money flows freely and abundantly to politicians with ideological agendas.
A politician with an ideological agenda in a safe seat has no incentive to compromise. Friedman points out that ideologues have always been a part of the American political fabric. The problem is not one of their existence but of their overrepresentation in the Congress: “… the problem is that the current system magnifies the importance of the ideologues such that current political outcomes increasingly do not reflect the public will, and that this is happening at an accelerated pace. It is not ideology that is the problem. It is the overrepresentation of ideologues in the voting booth. Most Americans are not ideologues, and therefore the reformist model has turned out to be as unrepresentative as the political boss system was. … Each faction is deeply committed to its beliefs, and feels it would be corrupt to abandon them. Even if it means closing the government, even if it means defaulting on debt, ideology is a demanding mistress who permits no other lovers.”
There is little to be hopeful about. What got us into the current predicament cannot be changed overnight. It is difficult for “reason” to prevail and compromise is more challenging to achieve. In the longer run, perhaps reforms will evolve that restore a more democratically representative political process. That is not the case today and the road to reforms that would achieve such a change in the political process is murky at best.
1 George Friedman. “The Roots of the Government Shutdown,” Stratfor Global Intelligence, October 8, 2013.
2 There are a few states that have open primaries. For example, in Washington State, there is no party registration requirement and thus there are not separate primaries based on party registration. The two candidates with the most votes advance to the general election. Thus, it is possible for two members of the same political party to be on the ballot in the general election.
September 19th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the September 2013 Longbrake Letter. To read the letter in its entirety, click here.
It is conventional wisdom that when the economy is at full employment and booming the Federal Reserve should raise the federal funds rate. When unemployment is high and the output gap is large the Federal Reserve should lower the federal funds rate. The rationale is that by changing the cost of money, the Federal Reserve can either stimulate or discourage investment and spending and in so doing boost or dampen economic activity. The objective of monetary policy is to promote full employment at low and stable rates of inflation and dampen cyclical fluctuations.
While the federal funds rate is one of many market rates of interest, it is the one traditionally that the Federal Reserve manipulates in its attempt to modulate economic activity over the business cycle. Because the level of long-term interest rates depends upon the current short-term interest rate, the federal funds rate, and future expected values of the federal funds rate, the Federal Reserve can influence interest rates across the maturity spectrum by setting the current value of the federal funds rate and signaling its future intentions.
Policy risk arises if the Federal Reserve’s implementation of monetary policy results in setting the market rate of interest at a level that is above or below the natural rate of interest. But because the natural rate is unobservable it is difficult to know when the market rate of interest differs from the natural rate. To understand why divergence between the two rates leads to policy risk, it is important to know what the natural rate of interest is and why, when it differs from the market rate of interest, policy risk is triggered and can build to troublesome levels if the divergence between the market rate and the natural rate is large and persists for a long period of time.
Investment, Saving and the Natural Rate of Interest. The natural rate of interest is that rate of interest at which intended investment and intended saving balance. This is the same concept as the intersection of a demand and supply curve for a product, such as sugar, which determines its market price.
After the fact, or ex post in economic jargon, investment and saving are always equal. But realized investment and saving may not be what investors and savers intended, which is an ex ante concept in economic jargon. Because intended investment and intended saving are not directly observable it follows that the natural rate of interest cannot be known with certainty.
According to theory, if the expected return on an investment in a productive asset is greater than the natural rate of interest, that investment should be undertaken. A saver has a choice between current and future consumption. A low interest rate encourages current consumption; a high interest rate encourages saving and a deferral of consumption. The equilibrium natural rate of interest occurs at the rate that induces enough savings – supply of funds – to fund investments – demand for funds – whose expected returns exceed the equilibrium rate of interest.
Since the natural rate of interest is not observable, actual decisions are based upon the market rate of interest. But, if the market rate of interest is different from the natural rate, some decisions will be “incorrect”. This initiates policy risk and its magnitude will depend on the size, direction, and persistence of the divergence between the natural and market rates of interest. Because the Federal Reserve controls the market rate of interest, it can become the source of policy risk by setting a market rate of interest that is inconsistent with the natural rate of interest.
What Happens When the Market Rate and Natural Rate of Interest Diverge? When the market rate of interest is set below the natural rate of interest, money is said to be cheap and investments will be funded whose expected rates of return are below the natural rate of interest but above the market rate of interest. While this is intuitively obvious, the macroeconomic implications are less obvious.
Economic growth depends upon investment in new productive assets. When money is too cheap investment will occur not only in productive assets but also in less productive assets such as building roads and bridges to nowhere. But when money is cheap it will also flow into existing investments with the result that the prices of existing assets are bid up. This can happen directly into real assets, such as real estate, or indirectly into financial assets, such as stocks and bonds. Prices of existing assets, then, inflate above “fair” value.
This is the phenomenon that Hyman Minsky described in his financial instability hypothesis. A market rate set below the natural rate leads to speculation and in the extreme to Ponzi finance and unsustainable bubbles. As a reminder, Minsky’s financial instability hypothesis posits three levels. The first level is “normal finance” where investments are made based on expected cash flows from the investment sufficient to cover payment of principal and interest on the debt that finances the investment. This is the level that is consistent with a market rate of interest that equals the natural rate of interest. The second stage is “speculative finance” where investment cash flows are sufficient to cover principal repayment but insufficient to cover interest payments, thus requiring perpetual refinancing. The third stage – the bubble stage – is “Ponzi finance” where cash flows from investments are insufficient to cover both principal and interest. Asset prices are bid up to unsustainable levels which eventually lead to a bust.
Cheap money and debt leverage are a deadly combination as we have seen from experience. They combine to facilitate speculative and Ponzi finance. Profits accrue to speculators rather than to investors in new productive assets with the result that funds are diverted into existing assets and away from new productive assets. A quick buck can be made through speculation while returns on productive investments are uncertain and are only realized over a long period of time. This misallocation of profits is contributing to a worsening of income inequality. Moreover, it should not come as a surprise that private investment growth, as measured in the national income accounts, began to decline in 2006 well before Lehman collapsed in September 2008. The 2006 to 2008 period was clearly one in which Minsky’s “Ponzi finance” held full sway.
Thus, a market rate of interest that is below the natural rate of interest will lead over a period of time to the misallocation of funds into speculative activity involving existing assets. Investments in new productive assets will be neglected with the consequence that growth in the stock of capital will slow or even decline. Growth in the stock of capital is necessary to raise productivity. So, it follows, that slower growth in the capital stock or even shrinkage in the capital stock will depress productivity. And, as discussed above, lower productivity results in decreasing the structural potential real rate of GDP growth.
When bubbles burst, asset values fall back to levels consistent with the natural rate of interest. But the nominal value of debt remains unchanged. This forces bankruptcies. The provision of copious amounts of liquidity by the Federal Reserve at cheap market rates can forestall contagion and a downward and lethal debt-deflation spiral. But, this kind of market stabilization intervention can also slow the process of right-sizing the stock of nominal debt relative to the stock of assets fairly valued at the natural rate of interest. The overhang of too much debt serves as a barrier to new investment. This phenomenon is probably an explanation, at least in part, for the on-going depressed level of new business formation. In any event, debt overhang is correlated with depressed or negative growth in the stock of capital. And, slower growth in the capital stock or shrinkage depresses productivity and the structural rate of real GDP growth.
Monetary Policy Can Contribute to Reducing the Structural Potential Real Rate of GDP Growth. Monetary policy’s role is to drive the market rate of interest down when the economy is underperforming. The objective is to stimulate investment and consumer spending. But, if the market rate is set too low and is maintained at too low a level for too long, it will prompt misallocation of investment into price speculation involving existing assets. This policy risk is not trivial and is inherent in the Federal Reserve’s recent monetary policy. The question worth pondering is whether monetary policy has migrated from serving as a cyclical stabilizing influence to contributing to a permanently lower level of potential real GDP growth.
Recovery in real economic activity and employment following the Great Recession has been disappointingly lethargic given the Federal Reserve’s exceptionally easy monetary policy. And, recovery has been accompanied by some troublesome trends. For example, income equality is worsening according to an updated study by Emmanuel Saez and Thomas Piketty. At the same time corporate profit margins have escalated to all-time highs. New job creation is anemic and appears to be related to a low level of new business formation and barriers to investment.
 Annie Lowrey. “The Rich Get Richer Through the Recovery,” New York Times, September 10, 2013. The share of income of the top 1% was 22.5% in 2012 compared to 19.7% in 2011 and matched the highs that preceded the Great Depression and Great Recession. The top 1% has “captured” about 95% of the aggregate increase in income since the end of the Great Recession.
September 11th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Rabah Arezki, Senior Economist, Research Department, IMF, Gregoire Rota-Graziosi, Senior Economist, Fiscal Affairs Department, IMF, and Lemma W. Senbet, Executive Director, African Economic Research Consortium and CFP Founding Director
This was originally published in the September 2013 issue of IMF’s Finance & Development magazine.
This article is based on the authors’ forthcoming IMF Working Paper, “Abnormal Capital Outflows, Natural Resources, and Financial Development.”
The Democratic Republic of the Congo, widely considered among the world’s richest countries in terms of mineral deposits, also regularly sits high on various lists of the world’s poorest countries. Each year, it loses billions of dollars in tax revenue as wealthy individuals and multinational corporations take advantage of weak tax legislation and enforcement to funnel profits abroad, including to foreign financial centers. A similar situation plays out repeatedly in many countries in Africa and other parts of the world.
Natural resources are indeed a window of opportunity for economic development. In principle, revenues derived from their exploitation can help alleviate the binding constraints that governments in developing countries often face when attempting to transform their economies, boost growth, and create jobs. The experiences of resource-rich countries (especially those rich in hydrocarbon and minerals), however, suggest that resource wealth is not always a blessing. It can, in fact, be a curse. Over the past few decades, economic growth in resource-rich countries has, on average, been lower than in resource-poor ones (Frankel, 2012).
Blessing or curse?
There are several explanations as to why the exploitation of natural resources could have negative consequences for the economy (Frankel, 2012). One is the corruption of political and public administration elites. Because revenues derived from natural resources in many cases flow directly through the government’s coffers, these elites may be able to take advantage of weak checks and balances to misappropriate those riches for themselves and channel them abroad.
Capital flight, here defined broadly as money or securities flowing out of a country, can take several forms. One form of capital flight for good reason has received a lot of attention in both academic and policy circles: illicit financial outflows. Global Financial Integrity, a research and advocacy organization working to curtail such flows, estimates that those from developing countries amounted to $5.9 trillion from 2001 to 2010. In comparison, major donors disbursed $677 billion in net official development assistance over the same period. Over the past decade, the democratization process in developing countries and the subsequent increase in transparency and accountability suggest that illicit financial outflows may be on the decline.
But while governments may be seeing more constraints, the globalization of trade and finance has made multinational corporations even more powerful, leaving some critics to argue that they have unfettered access to capital, labor, and natural resources at the expense of the citizenry. In contrast to illicit financial flows instigated by political elites, the form of capital flight brought on by multinational corporations that manipulate prices and take advantage of loopholes in tax codes has received less attention. However, the latter may have far-reaching consequences for developing countries—especially the resource-rich ones whose wealth is concentrated in one sector.
In response to mounting criticisms, the Group of Twenty advanced and emerging economies (G20) has placed tax avoidance and profit shifting in general at the top of its agenda. In July 2013, the group adopted an action plan to rein in tax avoidance by multinational corporations, drawing from recommendations in a report by the Organisation for Economic Co-operation and Development (OECD, 2013). The IMF is now engaged in a major effort to monitor the macroeconomic implications of cross-country spillovers from national tax design and practices (IMF, 2013).
Movers and shifters
Because multinational corporations operate in different countries and sometimes on different continents, they can readily pick and choose from varying regulations and tax laws across countries to avoid paying taxes both in the countries where they extract the wealth and where their headquarters are located. Specifically, some multinational corporations practice what is known as “transfer pricing” or “profit shifting,” which involves attributing a corporation’s net profit or loss before tax to opaque jurisdictions where taxes are low—so-called tax havens. Tax havens serve as domiciles for more than 2 million companies and thousands of banks. Some analysts estimate the wealth in those tax havens to be on the order of $20 trillion (The Economist, 2013)—yet it is hard to know with certainty given the secrecy prevailing in tax havens.
Multinational corporations can shift profits in a variety of ways. One of the most widely used methods is through “thin capitalization,” when a company chooses to be more indebted than similar independent entities. Indeed, companies are typically financed (or capitalized) through a mixture of borrowing (debt) and stock issuance (equity). The way a company structures its capital will often significantly lower the amount of profit it reports for tax purposes, because tax rules typically allow a deduction for interest paid, but not for remuneration of equity (dividends). This debt bias is exacerbated for multinational corporations, which are able to structure their financing arrangements in such a way that their affiliates in high-tax countries pay deductible interest to their affiliates in low-tax countries, or tax havens, thereby minimizing their global tax burden.
What’s at stake?
The resource sector is the main game in town in many developing countries. Governments should thus try to collect as much revenue as they possibly can from the hefty profits generated in this sector while remaining attractive to investment (see “Extracting Resource Revenue,” in this issue). But striking the right balance to generate the most economic gains is often fraught with peril not least because the exploitation of natural resources, particularly minerals, oil, and gas, requires much technical expertise, which multinational corporations are not keen on sharing.
Tax avoidance, including through profit shifting by multinational corporations, is a serious problem for many developing countries, especially those rich in natural resources. For example, the Zambian government estimates that it loses $2 billion a year—15 percent of GDP—to tax avoidance by corporations operating copper mines within the country. Profit shifting erodes the tax base in the countries in which multinational corporations operate but also in the countries where they are headquartered.
An important aspect of profit shifting is the loss of positive spillovers that natural resource exploitation can bring to a country, including through the development of the domestic financial system. Preventing capital flight that stems from multinational corporations operating in the resource sector would help the development of a domestic financial system, particularly an equity market with its attendant benefits in risk sharing and liquidity provision. This in turn would aid in the financing and development of the nonresource sector to diversify their economies and avoid economic growth supported only by nonrenewable natural resources.
The historical development of South Africa’s stock market illustrates the potential benefits from discoveries of natural resources. In 1886, the discovery of gold was rapidly followed by the establishment of the Johannesburg Stock Exchange. The stock exchange helped raise money for the then-booming mining and financial industry. Today, the Johannesburg Stock Exchange has a capitalization of more than $800 billion and 411 listed companies, including an overwhelming majority in the nonresource sector.
It is legitimate for developing countries endowed with natural resources to require affiliates of multinational corporations involved in the exploitation of their resources to pay a fair amount of tax and to avoid manipulating their capital structure for tax purposes. To prevent such practices, several countries have put in place a so-called thin capitalization rule, which essentially specifies a “safe haven” debt-to-equity ratio that limits the amount of deductible interest for tax purposes. It is designed to counter cross-border shifting of profit through excessive debt and thus aims to protect a country’s tax base. The rule was first introduced in 1972 in Canada and is now in place in about 60 countries. It is often implemented in countries with large resource sectors in which multinational corporations operate and was most recently introduced in resource-rich developing countries in Africa, including Sierra Leone, Uganda, and Zambia.
But trade-offs exist. Although the rule is designed to prevent excessive tax avoidance, the potential negative impact on foreign direct investment is the price countries may have to pay to avoid the erosion of their tax base and help their domestic financial system to develop. The implementation of the rule affects the financing of company operations by increasing their cost, because it limits the tax benefit resulting from deducting the interest paid on borrowed funds. In addition, in the absence of a well-functioning domestic financial system, the company’s domestic cost of equity capital would be higher. In that regard, the thin capitalization rule may, to some extent, deter foreign direct investment. However, these multinational corporations are likely to generate large internally generated funds from domestic profits, and they can channel them to investments at a lower cost of capital rather than shifting profits to foreign affiliates.
A thin line
Establishing whether the thin capitalization rule promotes more equity finance in the resource sector can also help determine if it improves the prices of countries’ natural resource assets (and therefore helps with the development of a domestic stock market). Of equal interest is whether the sensitivity of host countries’ external debt to the resource tax rate is altered by the presence of such a rule. To get some answers, we conducted an event analysis using cross-country variation in the timing and size of large oil, gas, and mineral discoveries for more than a hundred countries during 1970–2012. Our empirical framework controls for time-invariant factors, including the quality of institutions, that can play an important role in the development (or the lack thereof) of a stock market.
Results suggest that following a resource discovery, stock market capitalization decreases. This result is consistent with the work of Beck (2011), who found evidence that resourcerich countries tend to have less developed financial systems. However, our findings show that the presence of a thin capitalization rule allows countries to reverse the negative effect on capitalization of the resource discoveries. That effect is large in terms of its impact on the economy. Our results hold for mineral, oil, and gas discoveries, although the timing varies by the type of discovery. Following a large discovery, stock market capitalization increases by up to 20 percent of GDP in the presence of a thin capitalization rule, and the sensitivity of countries’ external debt to the resource sector tax rate decreases. This occurs because the tax subsidy provided to corporations paying interest on their foreign debt is lower in the presence of the rule.
The thin capitalization rule is a unilateral response to one of the main practices in aggressive tax optimization behavior by multinational corporations and looks to be the most viable option right now. It not only protects the tax base of resource-rich countries, but also helps link the financial development of these countries with the exploitation of their resources.
Yet other alternatives have been floated. Based on the U.S. experience, Nobel laureate Joseph Stiglitz recently proposed taxing the global profits of multinational groups and redistributing a proportion of those tax receipts to the country in which the value is created. This would be analogous to converging to a source-based tax system, which many multinational corporations are vehemently lobbying against. While Stiglitz’s proposal is conceptually appealing, it might be impractical given the limited level of disclosure now required of such corporations, not to mention the difficulty in coordinating all the actors involved, including tax havens.
Several recent initiatives have contributed to the increase in the level of disclosure of multinational corporations operating in the resource sector. More disclosure is certainly an important step in the right direction. It will help make multinational groups more accountable to tax authorities in the countries where they operate and to the broader public. However, increasing transparency is only a first step toward tax base protection and does not deter tax avoidance through such tax optimization methods as thin capitalization.
Overall, the concern over massive capital flight from developing economies, particularly those rich in resources, should go well beyond illicit financial flows and consider the seemingly legitimate behavior of corporations and their growing ability to shift profits and minimize the tax base. Thus, effective mechanisms, such as a thin capitalization rule, should be in place to deter massive outflows stemming from tax avoidance schemes.
Beck, Thorsten, 2011, “Finance and Oil: Is There a Resource Curse?” in Beyond the Curse: Policies to Harness the Power of Natural Resources, ed. by Rabah Arezki, Thorvaldur Gylfason, and Amadou Sy (Washington: International Monetary Fund).
The Economist, 2013, “The Missing $20 Trillion,” Feb 16.
Frankel, Jeffrey, 2012, “The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,” in Commodity Price Volatility and Inclusive Growth in Low-Income Countries, ed. by Rabah Arezki, Catherine Pattillo, Marc Quintyn, and Min Zhu (Washington: International Monetary Fund).
International Monetary Fund (IMF), 2013, “Issues in International Taxation and the Role of the IMF,” IMF Policy Paper (Washington, June 28).
Organisation for Economic Co-operation and Development, 2013, Action Plan on Base Erosion and Profit Shifting (Paris). www.oecd.org/ctp/BEPSENG.pdf
August 27th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
By Stijn Claessens, Assistant Director, Research Department, IMF and CFP Policy Fellow, and Lev Ratnovski, Economist, Research Department, IMF
This was originally posted on The Global Dispatches website on August 23, 2013.
There is much confusion about what shadow banking is and why it might create systemic risks. Shadow banking is ‘all financial activities, except traditional banking, which require a private or public backstop to operate’.
There is much confusion about what shadow banking is and why it may create (systemic) risks:
- Some equate it with securitisation.
- Others with non-traditional bank activities, or non-bank lending.
Regardless, most think of shadow banking as activities that can create systemic risk. This column proposes to describe shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’.
Backstops can come in the form of franchise value of a bank or insurance company, or a government guarantee. The need for a backstop is a crucial feature of shadow banking, which distinguishes it from the “usual” intermediated capital market activities, such as custodians, hedge funds, leasing companies, etc.
It has been very hard to ‘define’ shadow banking
The Financial Stability Board (2012) describes shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. This is a useful benchmark, but has two weaknesses:
- First, it may cover entities that are not commonly thought of as shadow banking, such as leasing and finance companies, credit-oriented hedge funds, corporate tax vehicles, etc. (Figure 1).
- Second, it describes shadow banking activities as operating primarily outside banks.
But in practice, many shadow banking activities, for instance, liquidity puts to securitisation structured investment vehicles, collateral operations of dealer banks, repos, and so on, operate within banks, especially systemic ones (Pozsar and Singh 2011, Cetorelli and Peristiani 2012). Both reasons make the description less insightful and less useful from an operational point of view.
Figure 1. Spectrum of financial activities
Note: see Claessens et al. (2012) for more discussion of the mechanics of shadow banking processes.
An alternative – ‘functional’ – approach treats shadow banking as a collection of specific intermediation services. Each of them responds to its own demand factors (e.g., demand for safe assets in securitisation, the need to efficiently use scarce collateral to support a large volume of secured transactions, etc.). The functional view offers useful insights. It stresses that shadow banking is driven not only by regulatory arbitrage, but also by genuine demand, to which intermediaries respond. This implies that in order to effectively regulate shadow banking, one should consider the demand for its services and – crucially – understand how its services are being provided (Claessens et al. 2012).
The challenge with the functional approach is that it does not tell us what the essential characteristics of shadow banking are. While one can come up with a list of shadow banking activities today, it is unclear where to look for shadow banking activities and risks that may arise in the future. And the functional approach is challenged to distinguish activities that appear, on the face of it, similar, yet differ in their final (systemic) risk (e.g., a commitment to provide for credit to a single firm vs. liquidity support to structured investment vehicles). Related, most studies focus on the US and say little about shadow banking elsewhere. In Europe, lending by insurance companies is sometimes called shadow banking. ‘Wealth management products’ offered by banks in China and lending by bank-affiliated finance companies in India are also called shadow banking. How much do these activities have in common with US shadow banking?
A new way to describe shadow banking: all activities that need a backstop
To improve on the current approaches, we propose to describe shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’. This description captures many of the activities that are commonly referred to as shadow banking today, as shown in Figure 1. And, in our view, it is likely to capture those activities that may become shadow banking in the future.
Why do shadow banking activities always need a backstop?
Shadow banking, just like traditional banking, involves risk transformation – specifically, credit, liquidity, and maturity risks. This is well accepted by the existing literature, and fits all shadow banking activities listed in Figure 1. The purpose of risk transformation is to strip assets of ‘undesirable’ risks that certain investors do not wish to bear.
Traditional banking transforms risks on a single balance sheet. It uses the law of large numbers, monitoring, and capital cushions to ‘convert’ risky loans into safe assets to back deposits. Shadow banking transforms risks using a different mechanism. It aims to distribute the undesirable risks across the financial system (‘sell them off’ in a diversified way). For example, in securitisation shadow banking strips assets of credit and liquidity risks through tranching and providing liquidity puts (Pozsar et al. 2010, Pozsar 2011, Gennaioli et al. 2012). Or it facilitates the use of collateral to reduce counterparty exposures in repo markets and for over the counter derivatives (Gorton 2012, Acharya and Öncü 2013).¹
While shadow banking uses many capital markets type tools, it differs also from traditional capital markets activities – such as trading stocks and bonds – in that it needs a backstop. This is because, while most undesirable risks can be distributed away by shadow banking processes, some residual risks, often rare and systemic ones (‘tail risks’), can remain. Examples of such residual risks include systemic liquidity risk in securitisation, risks associated with large borrowers’ bankruptcy in repos and securities lending, and the systematic component of credit risk in non-bank lending (e.g., for leveraged buyouts). Shadow banking needs to show it can absorb these risks to minimise the potential exposure of the ultimate claimholders who do not wish to bear them.
Yet shadow banking cannot generate the needed ultimate risk absorption capacity internally. The reason is that shadow-banking activities have margins that are too low. To be able to easily distribute risks across the financial system, for example, shadow banking focuses on ‘hard information’ risks that are easy to measure, price and communicate, e.g., through credit scores. This also means these services are generally contestable, with too low margins to generate sufficient internal capital to buffer residual risks. Therefore, shadow banking needs access to a backstop, i.e., a risk absorption capacity external to the shadow banking activity.
The backstop for shadow banking needs to be sufficiently deep:
- First, shadow banking usually operates on large scale, to offset significant start-up costs, e.g., of the development of infrastructure;
- Second, residual, ‘tail’ risks in shadow banking are often systemic, so can realise en masse.
There are two ways to obtain such a backstop. One is private – by using the franchise value of existing financial institutions. This explains why many shadow banking activities operate within large banks or transfers risks to them (as with liquidity puts in securitisation). Another is public – by using explicit or implicit government guarantees. Examples include, besides the general too-big-to-fail implicit guarantee provided to those large banks active in shadow banking, the Federal Reserve securities lending facility that backstops the collateral intermediation processes, the implicit too-big-to-fail guarantees for tri-party repo clearing banks and other dealer banks (Singh 2012), the bankruptcy stay exemptions for repos which in effect guarantee the exposure of lenders (Perotti 2012), or implicit guarantees on bank-affiliated products (as widely described in the press regarding so called ‘wealth management products’ in China (see The Economist 2013, Bloomberg 2013a, 2013b)) or on liabilities of non-bank finance companies (as noted for India, see Acharya et al. 2013).
The need for a backstop as a ‘litmus test’ for shadow banking
Assessing whether an activity requires access to a backstop to operate could be used as the key test of whether it represents shadow banking. For example, the ‘usual’ capital market activities (in the right column of Figure 1) do not need external risk absorption capacity (because some, like custodian or market-making services, involve no risk transformation, while others, like hedge funds, have high margins), and so are not shadow banking. Only activities that need a backstop – because they combine risk transformation, low margins and high scale with residual ‘tail’ risks – are systematically-important shadow banking.
Acknowledging the need for a backstop as a critical feature of shadow banking offers useful policy implications:
- First, it gives direction on where to look for new shadow banking risks.
Among financial activities that need franchise value or government guarantees to operate. Non-traditional activities of banks or insurance companies are ‘prime suspects’. It is hard to point to the shadow banking-like activities which may give rise to future (systemic) risks conclusively, but one example could be the liquidity services provided by sponsor banks to exchange traded funds, or large-scale commercial bank backstops for leveraged buyouts.
- Second, it explains why shadow banking poses significant macro-prudential and other regulatory challenges.
Shadow banking uses backstops to operate. Backstops reduce market discipline and thus can enable shadow banking to accumulate (systemic) risks on a large scale. In the absence of market discipline, the one force which can prevent shadow banking from accumulating risks is regulation.
- Third, it suggests that shadow banking is almost always within regulatory reach, directly or indirectly.
Regulators can control shadow banking by affecting the ability of regulated entities to use their franchise value to support shadow banking activities (as was done in the aftermath of the crisis by limiting the ability of banks to offer liquidity support to structured investment vehicles). Or by managing the (implicit) government guarantees (as is attempted in the US Dodd-Frank Act by limiting the ability to extend the safety net to non-bank activities and entities; or by general attempts underway to reduce the too-big-to-fail problem).
- Finally, it suggests that the migration of risks from the regulated sector to shadow banking – often suggested as a possible unintended consequence of tighter bank regulation – is a lesser problem than some fear.
Shadow banking activities cannot migrate on a large scale to areas of the financial system that do not have access to franchise values or government guarantees. This by itself does not make spotting the activity occurring within the reach of the regulator necessarily easier, but at least it narrows the task.
Editor’s note: The views expressed are those of the authors and do not represent those of the IMF.
Acharya, V & T S Öncü (2012), “A proposal for the resolution of systemically important assets and liabilities: the case of the repo market”, International Journal of Central Banking.
Acharya, V, H Khandwala & T S Öncü (2013), “The Growth of a Shadow Banking System in Emerging Markets: Evidence from India”, forthcoming in Journal of International Money and Finance.
Bloomberg (2013a), “Wealth Products Threaten China Banks on Ponzi-Scheme Risk”, 16 July.
Bloomberg (2013b), “Black Holes at China’s Shadow Banks”, 30 July.
Cetorelli, N and S Peristiani (2012), “The role of banks in asset securitization”, Federal Reserve Bank of New York Economic Policy Review, 18(2), 47-64.
Claessens, S Z Pozsar, L Ratnovski, and M Singh (2012), “Shadow Banking: Economics and Policy”, IMF Staff Discussion Note 12/12.
The Economist (2013), “China’s shadow banks: The credit kulaks”, 1 June.
Gennaioli, N A Shleifer and R W Vishny (2013), “A model of shadow banking”, The Journal of Finance, 68(4), 1331-1363.
Gorton, G and A Metrick (2012), “Securitized banking and the run on repo”, Journal of Financial Economics, 104(3), 425-451.
FSB (Financial Stability Board) (2012), “Strengthening Oversight and Regulation of Shadow Banking”, consultative document.
Perotti, E (2012). “The roots of shadow banking”, VoxEU.org, 21 June.
Pozsar, Z T Adrian, A Ashcraft, and H Boesky (2010, revised 2012), “Shadow Banking”, New York Fed Staff Report 458.
Pozsar, Z (2011), “Institutional cash pools and the Triffin dilemma of the US banking system”, IMF Working Paper 11/190.
Pozsar, Z, and M Singh (2011), “The nonbank-bank nexus and the shadow banking system”, IMF Working Paper 11/289.
Singh, M (2012), “Puts in the shadow”, IMF Working Paper 12/229.
Shin, H S (2009). “Securitisation and financial stability”, The Economic Journal 119(536), 309-332.
1 Note the difference between banking as an activity and a bank as an organisational entity. Both traditional banking and shadow banking business processes can coexist within a single bank.
August 13th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the August 2013 Longbrake Letter. To read the letter in its entirety, click here.
We tend to think that U.S. economic activity and financial markets are driven exclusively by what happens within our own borders. In an increasingly interconnected world that is a gross oversimplification. What happens in the U.S. affects what happens in other countries and what happens there, in turn, feeds back into the U.S. economy and financial markets. The recent sharp increase in long-term interest rates has been a global phenomenon. Financial conditions tightened not just in the United State but around the globe as well.
For example, a relatively immediate consequence of higher interest rates in the U.S. has been an increase in the value of the trade-weighted dollar. This will make U.S. exports less attractive and could have negative consequences for U.S. manufacturers over time. Ordinarily, the mirror reflection of this phenomenon would be favorable to foreign exporters. But this is not true for countries that have tied the values of their currencies to that of the U.S. dollar.
From a financial markets perspective, the long period of low nominal interest rates and negative real interest rates in the U.S. spawned “carry trades” in foreign currencies, particularly those of emerging economies. But, as interest rates have spiked in the U.S. real yields have gone from -0.6% to +0.6% and made the carry trade much less attractive financially.
This has occurred at the same time as it is increasingly apparent that the Chinese economic model really is in transition to more of a consumer focus and less of an investment focus. Emerging economies have benefited enormously over the last several years from insatiable Chinese demand for commodities. That demand has now subsided as indicated by falling prices for commodities. Thus, growth prospects have changed dramatically for the worse for those economies heavily dependent on China.
Put both sets of developments together and the result is massive reversals in the flows of hot money. Indonesia and India will be severely impacted because both countries run large trade deficits and are highly dependent upon favorable capital flows which are now drying up. Consequences for these two countries will involve slower economic growth and higher inflation. India’s central bank has been forced to defend its currency by raising short-term interest rates. As a result the yield curve has inverted. At the very least it appears that growth will slow substantially in India just as it did in Brazil earlier this year.
Emerging economies with large trade surpluses are not dependent upon capital inflows but their economies tend to be tightly tied to the strength of China’s economy and those of developed countries. China’s economy is slowing; in spite of optimism about the end of recession in Europe, this remains a glimmer in the eyes of the beholder; and in the U.S. the apparent acceleration in economic activity may fall short of expectations as tighter financial conditions and a more expensive U.S. dollar depress U.S. domestic demand and as slower foreign economic growth causes negative feedbacks for U.S. economic activity.
This is not yet a gloom and doom scenario. In other words, a deflationary bust is not yet inevitable. But, U.S. economic activity needs to accelerate to support other global economies. If U.S. growth falls short it doesn’t appear that any other country or countries are positioned to pick up the slack.
Remember from the experience of the mid-2000s that risks can be hidden from view and appear to be minimal. But the accumulating underlying economic and financial market imbalances slowly and inexorably build until the dam bursts. This is not to assert that we are approaching such a moment once again. But, it is to suggest that caution is warranted.
July 16th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the July 2013 Longbrake Letter. To read the letter in its entirety, click here.
Increasingly it is looking like the global economy is at an inflection point. Economic trends that have held sway for much of last four years appear to be giving way and whiffs of turbulence and change are emerging, such as China’s short-lived liquidity crunch last month. The global equilibrium of sorts that developed in the wake of the global Great Recession was one engineered by massive public policy intervention. In China it was aggressive state stimulus of investment. In the U.S. it was a combination of Keynesian deficit spending initially and a flood of monetary policy driven liquidity. In Europe initial fiscal stimulus quickly led to sovereign solvency issues and a response to deal with these issues through a combination of austerity, bailouts and massive liquidity injections. The list of interventions goes on with Japan the most recent major economy to embrace significant government policy intervention in an attempt to revive a deeply troubled economy.
These interventions generally had two effects – one good, but the other was not because it involved denial. The interventions did lead to a semblance of normality, calmed financial markets and probably avoided global depression. So, in that sense the interventions were constructive. However, the policies pursued more often than not did not address deep-seated structural flaws and imbalances in the global economy. In effect, policies papered over problems.
1. European Union
Europe steadfastly refuses to address fundamental governance flaws in the makeup of the European Union and its common currency, the euro. As a consequence it is only a matter of time before the European Project endures a great cataclysm.
Germany’s economic policies are self-serving and in the context of the euro currency union are contributing to the deep depressions gripping many peripheral European Union members. Even France is wobbling.
China bootstrapped its phenomenal growth by linking its currency to the dollar and pursuing trade-based mercantilist policies. While those policies were essential in the early going to galvanize China’s economic breakout, an economic model driven primarily by investment by repressing consumption, which is what China did, leads in the long run to unsustainable imbalances.
When the global Great Recession hit, Chinese policy makers doubled down by cranking up the state-driven investment economic model. Growth surged and many countries, particularly those that were resource rich, benefited handsomely. But as Hyman Minsky described in his “financial instability hypothesis”, overinvestment leads first to “speculative financing” which is often followed later on by “Ponzi financing”. When cash flows from real economic activity are not sufficient to support servicing of interest and principal on the credit used to finance the investment, momentum and state support can sustain the situation at the cost of ever growing imbalances.
China pretty clearly has been in the Minsky “speculative financing” phase for a while. But the recent explosion in credit growth while real growth rates are actually slowing suggests that China may have entered the “Ponzi financing” stage. This is the stuff of bubbles and short of massive state intervention, bubbles always burst eventually. An ever increasing number of dollars (renminbi) is required to generate a dollar of output. This is a telltale sign of the Minsky “Ponzi financing” phase. And that is exactly what has been happening in China over the last several months.
China’s leaders understand the need to transition the economy from one in which investment and exports have driven growth to one in which domestic consumption will eventually dominate. Such a transition is typical in a developing economy as consumer incomes rise and a large middle class evolves. This transition is also necessary for sustaining social and political stability. However, the transition which is in its early stages already appears to be resulting in a slowing in the rate of GDP growth. China reported that year-over-year GDP growth edged down to 7.5% in the second quarter.
While what needs to happen is clear, the new Chinese leadership will face formidable implementation challenges. This means that there will be plenty of bumps along the way and it is possible that the transition process will stall or move too slowly. The possibility of a hard landing, though unlikely, cannot be ruled out.
4. Resource-Based Economies
Growth in China’s demand for raw materials has already slowed. At the same time substantial increases in capacity to supply commodities are coming on line in many resource-based economies. Not surprisingly, prices of most commodities are falling. This is not a short-term phenomenon. Until recently rising prices for commodities partially offset powerful deflationary forces; falling commodity prices will now reinforce deflationary forces.
5. United States
Policy makers in the U.S. prevented potential depression by instituting deficit spending and pursuing aggressive monetary easing. But, both sets of policies have been insufficient to galvanize a robust economic recovery.
Fiscal policy was probably insufficient in size and definitely did not have an optimal composition. Too many dollars were spent on low multiplier activities. Investment in infrastructure was totally inadequate. Then, when the recovery proved to be feeble and deficits grew apace, it became easy for deficit hawks to capture the political momentum and institute austerity. This “prudent” fiscal policy will extend the length of time required for closing the output gap. Worse, the recent blunt cutting of government expenditures through the sequester is starving investment with the likely long-run result that the potential rate of growth in the U.S. will decline.
Other structural imbalances, such as growing income inequality, concentration of financial resources, allocation of financial resources (historical overinvestment in housing), and the aggrandizement of politically well-connected elites, have not been addressed and the potential long-run consequences of these imbalances appear to be growing.
Monetary policy, although it has the appearance of having been extremely accommodative, may not have been accommodative enough (see the discussions of financial conditions in Sections II and VI). Here, too, just as has been the case for fiscal policy, the failure of monetary policy to accelerate recovery is leading to a loss of political support. Federal Open Market Committee members and other Federal Reserve officials probably do believe that the economy is poised to grow more rapidly and, therefore, monetary policy accommodation will need to be phased out sooner than later. However, an early exit also would relieve intense political pressure. There are economic risks both to maintaining accommodative monetary policy too long and to not maintaining it long enough. But the political risks are primarily concentrated on the side of maintaining accommodation. Thus, the U.S. increasingly faces the risk of adding premature withdrawal of monetary stimulus to the policy mistake of instituting fiscal austerity and failing to support investment in infrastructure and research.
Japan has yet to come to grips with the challenges of an economy whose population and work force are shrinking. Its failure to understand this problem and develop effective policies assured 20 years of malaise and deeply embedded deflation.
Now nearly all the policy stops have been pulled out. Developing “third arrow” policies, which involve increasing competitiveness and growing the size of the labor force, are essential for dealing with the consequences of an aging and shrinking population. These policies are mostly conceptual at this juncture and will soon need to be turned into concrete programs. Aggressive fiscal and monetary policies are already having favorable impacts on growth and deflation, but their effectiveness will wane in time without effective “third arrow” programs.
7. Other Countries
The list of global imbalances could go on. For example, the recent rapid growth of the Indian and Indonesian economies may turn out to be the product of liquidity-driven financial flows seeking yield, rather than to deliberate enabling economic policies. If that turns out to be the case, since both of these countries have large trade deficits the recent reversal of “hot money” capital flows, if sustained, will put intense pressure on their ability to finance themselves with the dual consequences of increasing inflation and slowing growth.
8. Nouriel Roubini’s “New Abnormal”
Nouriel Roubini, the economist who correctly foresaw the consequences of the U.S. housing bubble and the global speculative frenzy it spawned, recently penned an article titled the “New Abnormal”.¹
Roubini notes that the theme of the “New Normal” has been embraced by many. The “New Normal” involves the presumption that economic progress will be slow but steady and will be supported by an abundance of central bank provided liquidity. But this “New Normal” involves papering over significant structural imbalances. Policy intervention has sedated the disease but it has not cured it. But in the absence of crises policymakers have lost fear, complacency has taken over. Ignoring serious issues does not make them go away. In fact, history suggests that problems tend to get much worse by virtue of neglect.
Roubini puts it this way: “… this situation is one that is not a stable equilibrium, is not even a stable disequilibrium. It’s an unstable disequilibrium. Take for example the Eurozone. You cannot have just a monetary union without banking, political, economic, fiscal union. Either you move towards more integration or you’re going to have more fragmentation and disintegration. So the situation we face right now in the global economy, same in the Eurozone, is of an unstable disequilibrium, therefore a new abnormal, that cannot be sustained. … liquidity has been like a drug, a palliative, it doesn’t resolve the disease, you have to do fundamental, structural changes that’s going to increase the productivity.”
Roubini concludes that: “The deeper questions that created the recent convulsions have not been answered, and the easing of so much useful fear will make them much more difficult to address. That’s why the uncertainty and volatility of the past half-decade is far from finished – and is almost sure to trigger new crises. We have entered the New Abnormal, a period in which every market assumption must be questioned and the wise investor is prepared to be surprised.”
¹Nouriel Roubini. “Roubini and Bremmer on Charlie Rose: Unveiling New Abnormal,” EconoMonitor, June 27, 2013.
June 18th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the June 2013 Longbrake Letter. To read the letter in its entirety, click here.
With the notable exception of the European Central Bank (ECB), central banks in developed countries have been trying to ignite higher growth rates by purchasing large amounts of financial assets to drive down long-term interest rates. The theory is that lower interest rates, by decreasing the cost of capital and boosting the value of financial assets, will stimulate new investment and increase aggregate demand for goods and services. This, in turn, and over time, would create positive reinforcing feedbacks that accelerate growth and diminish more quickly the very large output gaps that prevail in many developed economies.
Monetary policy affects the cost of money and determines the extent of financial liquidity. It does not directly cause economic agents to engage in behaviors in ways that will change real economic activity; that is, it does not directly result in decisions to make capital investments or to increase purchases of goods and services. The transmission mechanism is indirect. Monetary policy is only effective if the lower cost of money and its greater availability induces economic agents to change behaviors in ways that boost real economic activity.
Because the linkage between monetary policy and real economic activity is indirect there cannot be certainty that current monetary policy will work as intended. In this sense current monetary policy is an enormous experiment. It is uncertain whether it will work as intended and it is uncertain what longer run impacts it will have on the economy. Some fear that it will lead to inflationary growth (see Section II 6 below for a discussion of how inflationary growth might occur) . But, a few fear that the experiment will fail to ignite sustainable growth and will end in a deflationary bust.
Policymakers could assure the intended impact of monetary policy is realized by increasing government investment in infrastructure projects and by directly or indirectly boosting government purchases of goods and services. But in the U.S. the exact opposite is occurring. Government spending is being reduced. This means that not only is monetary policy on its own in attempting to stimulate economic activity, it also has to contend with the negative impact of falling government spending.
This combination of easy monetary and tight fiscal policies implies a continuation of slow growth and only small reductions in the size of the output gap. This is exactly what has been occurring in the U.S. and more generally in other developed global economies.
As summer begins, economic activity around the globe remains sluggish. Although volatility in global financial markets has risen in the last month, this appears to be due mostly to technical factors, some of which are linked to Japan’s reflation policies, and to a tentative reassessment that growth prospects are improving in the U.S.
1. United States
While it is now clear in the U.S. that tax increases and spending cuts collectively are much greater than expected a few months ago, their negative effects, particularly the sequester, on economic activity don’t appear to be as great as feared and appear to being offset by rising consumer optimism and maintenance of consumer spending, which has occurred by virtue of decreasing the saving rate in the face of reduced disposable income growth. The favorable reassessment of growth prospects is rooted in an expectation that private sector improvement will continue in coming months while the negative effects of tax increases and reduced government spending gradually diminish.
Since early May ten-year U.S. Treasury note yields have jumped 60 basis points to 2.25%. Bank of America Merrill Lynch (B of A) believes two-thirds of the increase is the result of the market’s belief that economic momentum is improving and that the Federal Reserve will scale back (“taper”) asset purchases sooner. The remainder of the increase in rates stems from technical factors such as hedging convexity risk in mortgage backed securities, impacts of rising Japanese bond yields on carry trades, outflows from bond funds and underperformance of emerging market bonds and currencies.
Although much of Europe remains mired in recession, conditions no longer appear to be worsening and there is considerable hope that Europe will return to modest growth by 2014. French President, Francois Hollande, recently declared that Europe’s crisis is over. That pronouncement is decidedly dubious. Policy actions have limited investor risk, but the fundamental structural and governance flaws inherent in the European Union (EU) and Eurozone (EZ) have not been addressed. High unemployment is gradually undermining political stability. While the crisis may be in abeyance for the moment, it is certainly not over. Signs of political and social fragmentation continue to accumulate, all be it very slowly.
China’s economy is in transition from one in which investment and exports have driven growth to one in which domestic consumption will eventually dominate. Such a transition is typical in a developing economy as consumer incomes rise and a large middle class evolves. This transition is also necessary for sustaining social and political stability. However, the transition will result in a slowing in the rate of GDP growth. There are already early indications that a gradual slowdown in growth has begun. Most forecasters generally have not yet recognized that slower growth in China is at hand, so forecasts are likely to be lowered incrementally over time. As a greater proportion of the Chinese population benefits from a consumer-based economy, a slower rate of GDP growth is not likely to be problematic. While what needs to happen is clear, the new Chinese leadership will face formidable implementation challenges. This means that there will be plenty of bumps along the way and it is possible that the transition process will stall or move too slowly. The possibility of a hard landing, though unlikely, cannot be ruled out.
Growth in China’s demand for raw materials has already slowed. At the same time substantial increases in capacity to supply commodities are coming on line. Not surprisingly, prices of most commodities are falling. This is not a short-term phenomenon. Until recently rising prices for commodities partially offset powerful deflationary forces; falling commodity prices will now reinforce deflationary forces.
Recent Japanese data indicate that a strong cyclical economic recovery is underway. It is too early yet to know whether Shinzo Abe’s reflation policies will defeat entrenched deflation and result in sustained nominal, as well as real, GDP growth.
In the last few weeks the Japanese stock market has experienced a swift 20% correction and the exchange value of the yen has increased substantially. Both developments have blunted the “shock and awe” effects of Japan’s reflation policies on expectations. Changing expectations to accelerate investment and consumption has been an important part of the plan to defeat deflation. As described in previous letters, driving down the value of the yen helps Japan “export” its saving surplus to other countries. That, too, is a significant part of the plan to defeat deflation. The remaining necessary reflation policy, which has yet to be implemented, involve reforms that will increase the supply of labor, particularly women, and worker productivity. Apparently because of the difficulty in enacting far reaching reforms, Abe is waiting until the upper house elections has occurred later this summer before attempting to pass legislation. In the meantime his general commentary has lacked specificity and that fact may have also contributed to the recent setback in financial markets.
There appear to be some plausible technical reasons for the decline in stock prices, but sentiment is a fragile thing. First, the most obvious explanation is that rapid price appreciation, nearly 80% in the case of the Nikkei, eventually invite profit taking. Second, a less understood explanation, but a truly significant one, is that a significant portion of Japanese equities is held by Japanese trust companies. These trust companies have strict asset allocation guidelines. The rapid price appreciation in Japanese equities resulted in breaching the upper bound of the allocation guidelines and forced selling to rebalance portfolio composition. Third, Japan’s central bank botched its asset purchase program in the initial stages which created volatility. And, fourth, some increasingly began to question whether reflation policies would work as intended and whether there might be significant risks in the longer term. These worries were not helped by Abe’s recent speeches, which appeared to confuse matters more than clarifying them. This latter concern, if it comes to dominate thinking, would lead to a deflationary bust outcome.
My own sense is that the recent volatility in Japanese markets will diminish and implementation of reflation policies, including labor market reforms, will proceed. Japan is likely to experience a continuation of a cyclical recovery in growth and policies already implemented assure a return to a modest level of inflation, at least temporarily. What matters is whether the reflation policies can have a longer-term structural impact and permanently alter the way in which the Japanese economy works. I and many others have our doubts. Thus, the Japanese experiment entails high stakes and high risks. It’s possible failure, which will not be known for a long time, would have disastrous consequences for Japan and the rest of the world would not emerge from such a possible failure unscathed.
5. Deflationary Bust
What is occurring currently in the U.S., Chinese, Japanese and in many emerging economies is encouraging. However, the outlook for Europe remains bleak because, even if most European countries emerge from recession in coming months, the failure to address structural and governance defects, coupled with demographic trends, assures that at best growth will be very weak and at worst stagnation will occur.
So, economic momentum appears to be building slowly across the globe. To the extent this trend continues the world economy will strengthen gradually. However, the current extraordinary monetary stimulus might lead to another outcome, one that is not benign – a deflationary bust. How might that happen? The most articulate discussion of this possibility has been penned by Charles Gave.
Recessions occur when an increase in liquidity preference leads people to attempt to increase their savings by reducing consumption. Policy responses to combat recession are directed toward increasing demand through direct government purchases and by replacing lost spendable income through government transfers. Policy also attempts to stimulate demand by decreasing the attractiveness of saving by reducing interest rates. When nominal interest rates fall below the rate of inflation, real rates of return become negative and saving is discouraged.
But, remember, realized investment must equal saving. If saving is discouraged, realized investment must also fall. In the long run declining investment, as I have discussed in previous letters, depresses productivity growth and leads to lower potential real GDP growth. Unfortunately, this is exactly what appears to be happening in the U.S.
Private investment depends upon the availability of credit. The Federal Reserve can create liquidity through asset purchases but it cannot create credit. Creation of credit depends on the willingness of financial intermediaries to lend – to supply credit. Willingness to lend, while improving slowly, is still being held back by tight underwriting standards and conservative regulatory supervisory standards and increased capital requirements.
Demand for credit also depends upon the extent to which returns on investment are expected to exceed the cost of financing it. Demand for credit has been slack because of uncertainty about future growth. For example, the National Federation of Independent Businesses (NFIB) monthly survey continues to register high negative ratings about sales prospects; credit availability, in contrast, is not cited as a significant problem. In other words, very low borrowing interest rates appear to be insufficient to prompt investment in the face of enormous uncertainty. In short, investors prefer safe assets, even though they have negative real rates of return, than capital investments with uncertain returns, which could turn out to be even more negative.
Negative real interest rates pump up the value of financial assets and create the illusion of greater wealth. And for a while this feels good. But, artificially induced financial wealth must eventually be ratified by an increase in real wealth. If that does not materialize, a financial bubble builds. You will recall from the work of Hyman Minsky that financial bubbles occur when speculative forces predominate, which drive up financial valuations to levels that greatly exceed those justified by likely cash flows from real economic activity. Speculative activity can persist for a very long time and the risk in the present instance is that the Federal Reserve is feeding the beast with its large scale asset purchase policy. But, eventually bubbles burst and when that occurs, a deflationary bust follows.
This is not a foreordained outcome. It is possible that policies currently in place will lead to gradual strengthening in economic activity which would ratify higher financial asset valuations. As I explain in Section V, stock valuations appear to be reasonable at the present time and the equity risk premium is inflated, which is holding back potential further increases in stock prices.
Nonetheless, an economy whose real rate of growth is declining has a profound structural problem which over time could lead to an insufficient amount of real wealth creation to ratify the artificially inflated financial wealth. If that is the pathway we are really on, then the market will eventually realize that financial valuations are not supported by real economic growth. When, and if, this realization takes hole, a deflationary bust will unfold with a vengeance. Financial asset prices will decline precipitously as real rates of interest return to positive levels that are consistent with potential economic growth.
 Charles Gave. “More On the Deflationary Bust Risk.” GKResearch, June 10, 2013. This commentary is proprietary and is not available for distribution without permission by GaveKal.
May 16th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the May 2013 Longbrake Letter. To read the letter in its entirety, click here.
Much ink has been spilled in recent weeks about computational errors, which have been acknowledged, and methodological errors, which have been disputed, embodied in a paper published, “Growth in a Time of Debt” by Carmen Reinhart and Kenneth Rogoff.¹ The latest round of controversy was ignited by a paper published by Thomas Herndon, Michael Ash and Robert Pollin.² The controversy has been heated because it is more than an esoteric intellectual debate among economists.
Reinhart and Rogoff’s research finds that economic growth declines as the government-debt-to-GDP ratio increases. Specifically, when the ratio eclipses 90%, economic growth drops sharply. The computational error had to do with the importance of the 90% cliff. Reinhart and Rogoff have acknowledged this error and agree that there is not a cliff effect, but argue vehemently that economic growth declines, nonetheless, as the government-debt-to-GDP ratio rises.
Reinhart and Rogoff’s research, and especially the so-called 90% cliff effect, has been cited by some as justification for curtailing government deficits. The name for the fiscal policy that focuses on driving down government deficits is referred to as “austerity.” Austerity can involve spending cuts or tax increases or both. In the U.S. austerity policy has been championed by Republicans and is expressly embedded in Paul Ryan’s House of Representatives version of the 10-year federal budget. Ryan’s austerity plan encompasses only spending cuts.
European Union (EU) fiscal policy is decidedly focused on austerity but encompasses spending cuts, tax increases and other kinds of economic reforms. The EU has set a 3% annual budget deficit target and member countries are expected to adopt policies to attain that level within a relatively short period of time, generally two years.
Critics of austerity argue that withdrawing fiscal stimulus through spending cuts and tax increases will depress GDP growth and could decrease growth to such an extent that the debt-to-GDP ratio would rise, rather than fall, because the denominator falls faster than the numerator.
To put this debate into perspective requires a discussion of macroeconomic theory.
1. Keynesian Macroeconomic Policy
There has been an ongoing policy debate among economists and policy makers about the conduct of fiscal policy in times of economic duress. The Keynesian response is that when private aggregate demand declines government must intervene and replace the lost spending power. Then, as private sector demand improves, government stimulus can gradually be withdrawn. Keynesians view fiscal policy as a macroeconomic stabilization instrument. Government stimulus should be added when the economy is at less than full employment but be withdrawn when the economy is at full employment. Government fiscal policy should be neutral over the entire cycle.
Keynesians further argue that without government stimulus there is no assurance that an economy operating at less than full employment will be able to return to full employment on its own. The economy can get caught in a liquidity trap or worse in which a negative reinforcing downward spiral takes hold. The famous economist, Irving Fisher, described this phenomenon in a seminal paper published during the Great Depression which described the debt-deflation process.
Politicians, being the people who they are, especially in democracies, have difficulty withdrawing government stimulus when the economy is strong with the result that a permanent structural budget deficit tends to become embedded. Then, when the economy falters and the budget deficit explodes, the government-debt-to-GDP ratio spirals out of control. And, as Reinhart and Rogoff argue, economic growth may be permanently depressed.
2. Austerity Macroeconomic Policy
Those who espouse a policy of austerity generally are skeptical of government interference in the marketplace. They argue that government intervention is inefficient and messes things up. Worse, those who promote government intervention seek to reallocate resources in ways that diminish aggregate social welfare. In other words, proponents of intervention sponsor income transfer programs that may increase opportunity for those who are less well situated but that reduce opportunity in the aggregate for everyone – that is, total potential GDP contracts.
Thus, those who favor austerity tend to be advocates of the view that government is better when it is small than large and, thus, a policy of “starve the beast” should be pursued. This interconnects with a bias to minimize deficits even in a time of economic duress. In this context evidence that growth is slower as deficits pile up is taken as direct proof that deficit reduction needs to be pursued vigorously.
3. Good Deficits and Bad Deficits – Fiscal Multipliers
There is plenty of evidence that government replacement of lost spending power in an economic downturn is essential to interdict the vicious circle inherent in a liquidity trap and to prime a virtuous circle. In other words, government deficits are an essential ingredient in arresting an economic decline and initiating recovery.
But not all forms of government fiscal policy intervention have the same impact dollar for dollar. The important aspect of stimulus is that it leads to spending that creates jobs. If the stimulus goes into the bank without being spent its impact on economic activity will be limited. The relationship between a type of government stimulus and its longer-term impact on economic activity is measured by the fiscal multiplier. If a dollar of stimulus stimulates a dollar of economic activity, the multiplier is equal to one. Multipliers greater than one are highly desirable while multipliers less than one are not.
When the EU reinforced discipline to reduce budget deficits a couple of years ago it believed fiscal multipliers were less than one. Were this actually true, then debt-to-GDP ratios would have contracted even as GDP declined. In addition, per Reinhart and Rogoff, future GDP growth potential would rise as deficits fell.
Unfortunately, we know from the experience of the last two years that the belief that multipliers were less than one was false. European countries forced to adopt stringent austerity measures have seen their economies collapse with limited if any improvement in their debt-to-GDP ratios. The International Monetary Fund (IMF) owned up to this outcome in research published last year which concluded that fiscal multipliers in times of enormous economic slack are much greater than one.
What all of this means is that when there is a large output gap fiscal policy should focus first on boosting aggregate demand but the mix of fiscal policy programs should emphasize high-multiplier initiatives. Then, only as economic recovery gains traction should deficit reduction rise to the fore.
4. U.S. and European Experiences
Europe has pursued austerity aggressively and has limited its use of monetary policy. Many European countries are still mired in recession and prospects for imminent turnaround are doubtful. Little progress has been achieved in addressing government deficits and high levels of debt. In the meantime social unrest is building and political stability is slowly unraveling.
In contrast, the U.S. initially pursued a traditional Keynesian stimulative fiscal policy. However, many argue that the policy was deficient both in scope and also in composition as the program did not allocate significant resources to high multiplier programs such as investment in infrastructure, education and research.
The U.S. emerged from recession nearly four years ago, but growth has been disappointingly slow since then. Could the recovery have progressed more rapidly in the U.S.? Keynesians argue in the affirmative, but that would have required greater amounts of stimulus.
Now U.S. policy has switched from stimulus toward austerity while the output gap remains extremely large. In the short run this will slow growth. What is important is whether the slowdown is temporary or protracted. My sense is that the negative consequences will linger and the expected strong bounce back in GDP growth that most expect may not materialize. I continue to be concerned about a sustained decrease in productivity growth because of insufficient investment. When deficit reduction is the policy of choice government investment suffers along with other forms of government spending. Reduced investment spending will depress productivity growth and that will decrease potential GDP growth.
5. Does a High Debt-to-GDP Ratio Cause Slow Growth or Does Slow Growth Cause a High Debt-to-GDP Ratio?
Although Reinhart and Rogoff’s 90% cliff finding that economic growth drops dramatically after the government-debt-to-GDP ratio reachs that level has been discredited, GDP growth is still negatively correlated with that ratio. Critics have correctly pointed out that the statistical analysis merely reveals that a correlation exists but does not prove that high debt ratios cause slower growth. The reverse could be true – lower growth leads to higher debt ratios. This debate will continue and I cannot shed any light on the issue of causality.
However, from my own statistical analysis I can corroborate Reinhart and Rogoff’s finding that there is a strong negative correlation. Reinhart and Rogoff analyzed three data sets. The data set that Reinhart and Rogoff (RR) and their critics, Herndon, Ash and Pollin (HAP) focused on covers 20 advanced economies over the period 1945 to 2009. Data were grouped by ranges of debt-to-GDP ratio and the arithmetic mean and median were provided for each range. Table 4 shows the results of both RR’s and HAP’s calculation based on this data set.
Because RR and HAP used the same data set the differences in medians has to do with HAP’s and RR’s disagreement about calculation methodology. To my way of thinking the differences are not particularly material. The negative correlation is apparent and that correlation is monotonic, which means that growth steadily declines as the debt ratio rises. Clearly, there is no 90% cliff effect and RR acknowledged that fact when they corrected their data.
GDP Growth for Developed Countries Covering the Period from 1949 to 2009 Classified by the Size of the Government-Debt-to-GDP Ratio
*Originally reported by RR as -0.1%; this was the errant calculation that led to the assertion that there is a 90% cliff effect
#Bill’s analysis is a statistical correlation for the U.S. only covering the time period from 1971 to 2013; debt/GDP ratio is public debt only rather than total debt
Also shown in the last column of Table 4 are the results of statistical analysis I conducted on U.S. GDP and the U.S. public-debt-to-GDP ratio for the period 1971 to 2013. For a lot of reasons my analysis is not strictly comparable to that of RR and HAP. However, the direction of correlation and the general order of magnitude among all of these results are similar.
Whether high debt-to-GDP ratios lead to slower GDP growth will continue to be debated. However, what is clear from the analyses is that neither low growth nor high debt ratios is a desirable place to be. However, driving down debt ratios without understanding the transitional impacts on GDP growth can have disastrous consequences. Austerity entails high risks. Outcomes for countries that have pursued austerity are discouraging. Keynesian stimulus appears to achieve better outcomes but a Keynesian fiscal policy, too, can be designed poorly and produce troublesome results.
1 Carmen Reinhart and Kenneth Rogoff. “Growth in a Time of Debt,” American Economic Review” Papers and Proceedings, May 2010.
2 Thomas Herndon, Michael Ash and Robert Pollin. “Does High Public Debt Consistently Stifle Economic Growth?” PERI Working Paper 322, April 2013.
May 15th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
This is an excerpt from CFP Academic Fellow Phillip L. Swagel’s testimony before the U.S. Senate’s Committee on Banking, Housing, and Urban Affairs on May 14, 2013. Click here for the full transcript.
Bringing private capital back to fund mortgages and take on credit risk is an essential element of housing finance reform, particularly with respect to reform of the government-sponsored enterprises (GSEs) of Fannie Mae and Freddie Mac. Housing finance reform should ensure that mortgages are available across economic conditions, while shielding taxpayers from taking on uncompensated risk and protecting the broader economy from the systemic risks that arose in the previous system. Bringing about increased private capital as part of housing finance reform will help protect taxpayers and improve incentives for prudent mortgage origination by lenders and investors with their own resources at risk.
The situation in housing finance today is that taxpayers fund or guarantee more than 90 percent of new mortgages through the GSEs and through government agencies such as the Federal Housing administration (FHA). Fannie Mae and Freddie Mac stand behind virtually all new conforming mortgages through the two firms’ guarantees on the mortgage-backed securities (MBS) into which the two firms bundle the home loans they purchase from originators. There is loan-level capital to absorb losses in the form of homeowner down payments and private mortgage insurance (PMI), but no private capital at the level of the mortgage-backed security (MBS) ahead of the financial resources of Fannie and Freddie. With the U.S. Treasury committed to ensuring that Fannie and Freddie remain solvent, the U.S. government effectively backstops conforming loans, leaving taxpayers exposed to considerable losses in the event of another housing downturn—and this risk remains even while the two firms are now profitable. Taxpayers further take on credit risk in housing through the government backstop on the Federal Home Loan Bank (FHLB) system, and through guaranteed mortgages supported by the Federal Housing Administration (FHA) and other federal agencies. I have previously testified on reforms to the FHA that would better protect taxpayers while focusing the agency on its mission to expand access to mortgage financing for low- and moderate income families who have the financial wherewithal to become homeowners.¹ I thus focus here on GSE reform.
Bringing back private capital into housing finance would mean that private investors would absorb losses as some mortgage loans inevitably are not repaid. In some instances, this could involve mortgage loans with no government guarantee, while in others there could be a secondary government guarantee that kicks in only after private capital absorbs losses (or the guarantee could be alongside private capital, with losses shared). Private investors would be compensated for taking on housing credit risk, so that it should be expected that mortgage interest rates will increase as housing finance reform proceeds. This interest rate impact reflects the facts that the previous system was undercapitalized and provided inadequate protection for taxpayers.
It would be useful for reform to allow for a diversity of sources of funding for housing, and for private capital to come in a number of forms and through a variety of mechanisms. This will help make the future housing finance system more resilient to economic and market events that affect particular parts of financial markets and thus impinge on the availability of funds for housing.
At the level of the individual loan, capital for conforming mortgages will continue to be present from a combination of homeowner down payments, private mortgage insurance, and the capital of originators that carry out balance sheet lending. The recent housing bubble and foreclosure crisis highlighted the importance of homeowner equity as a factor in avoiding foreclosures, as foreclosure rates were especially elevated for underwater borrowers—those who owed more on their mortgages than the value of their home. As reform proceeds, it is vital to ensure that meaningful down payments remain a central aspect of underwriting and a requirement for mortgages to qualify for inclusion in MBS that benefit from a government guarantee. Similarly, regulators must ensure that private mortgage insurers have adequate levels of their own high-quality capital to participate in mortgages that receive a government guarantee.
The larger changes involved with the return of private capital to mortgage origination will come at the level of the mortgage-backed security. With nearly all securitization of conforming mortgages going through the GSEs, there is essentially no capital at the MBS level. The so-called profit sweep agreement between the Treasury Department and the two GSEs prevents Fannie and Freddie from building up the capital that would be the norm for an insurer.
Fannie and Freddie are setting up risk-sharing mechanisms to allow private investors to invest in securities that will take losses ahead of the firms’ guarantee (that is, ahead of the taxpayer guarantee). There is still little securitization of mortgages taking place without a guarantee (private label securitization of non-conforming loans), and firms other than Fannie and Freddie are not allowed to compete in the business of securitization of conforming mortgages with a government guarantee.Housing finance reform should involve changes on all of these dimensions so that private capital is present at the MBS-level.
¹February 28, 2013, Senate Banking Committee hearing on “Addressing FHA’s Financial Condition and Program Challenges, Part II.”