Lending in times of financial crisis: the ECB and the Fed

When the financial crisis came, central banks followed Baghot’s rule: in a financial panic, lend freely against good collateral. It turns out that the US Federal Reserve did this well, in that it is making profits for the US taxpayer and not losing money. (One interpretation, they are earning returns for bearing risk which is another way of saying they were lucky; the other interpretation, they were savvy and profited from providing liquidity when it was scarce.) The New York Times has a piece today noting both how profitable the Fed is and how similar to a hedge fund except for the compensation of its employees. Two differences the article glosses over are the advantage of the Fed — it always can have access to liquidity so can take illiquid positions — and the fact that most hedge funds are quite unprofitable lately (after fees). In contrast, the ECB seems to have lent against bad collateral (article here). It looks like the collateral it received from Lehman did not cover the value of the loan, although it will be close if one thinks of a billion dollars as close and one ignores the costs of asset management. Of course, the US Federeal Reserve in part did so well because the US Treasury took first losses on many loans.

The Effects of Being in the Eurozone on the Rating of Sovereign Debt

Here is a nice short piece by Martin Feldstein explaining the error in the argument made by some French politicians – including the head of the French central bank — that UK sovereign debt should be downgraded before French sovereign debt.  In short, it seems they do not understand what it means to be in a monetary union.  The piece could emphasize more that while France is at a greater danger of default, inflation is also a pernicious destroyer of investor returns on debt, just not one covered by bond ratings.

Some Economic Graphs of the Year from the UK

It is maybe a little early for year-in-review pictorial essays, but the BBC is swinging into the season with the Economic Graphs of the Year.  Not exactly break-out-the-Champaign and Mistletoe stuff, but interesting nonetheless.  Here they are.

The United States of Europe

Tom Sargent’s Nobel lecture is one of the most interesting and topical ever.  As he says “between 1780 and 1884 . . . the United States faced institutional choices and policy choices that remind me today of present day Europe.”   In it he considers the question: should a government default on its debt?  Should a central government bail out subordinate states?  Should a monetary union precede a fiscal union or vice versa?  In short, the U.S. began without centralized fiscal power, much as Europe today.  The U.S.  Federal Government faced a fiscal crisis in the 1780’s which lead to increased fiscal authority for the Federal government (the Articles of the Confederation were replaced by the Constitution), which in turn was followed by Federal bailouts of state government debts in the 1790’s.  Fascinating stuff.  The lecture is here, starting at about the 17 minute mark (very nice introduction by my former colleague (and very smart and nice person) Per Krusell starting at about the 10 minute mark). Not sure why the Nobel folks can’t figure out how to edit out the first ten minutes of people filling the lecture hall.

Dear Politicians, Please resolve the Debt Threat and only then Fight over the Size of Government

The biggest threats to the future economic growth of the US are those associated with the large explicit and implicit government debts at the Federal, state, and local levels.  Postponing for a moment what I mean by implicit and explicit debt, I think that the failure of the two-and-a-half political parties to reach an agreement to deal with these government debts places us dangerously close to the political disfunctionality that characterizes countries with poor economic outcomes.  The failure of the so-called Debt Supercommittee is a failure of Americans to apply the non-partisan pressure needed to ensure good government and good growth.  And continued partisanship over dealing with our rising debts will lead to the slow economic growth if not outright economic crisis.  From an economic perspective, it is more important that we pass legislation to deal with our fiscal imbalances than it is whether we increase taxes or cut spending to get there.

History shows that many financial crises become fiscal crises.  Being the United States, markets have given us the breathing room to deal with our problems.  But markets could turn quite quickly and if we have a government debt crisis, the damage to the US economy will make the recent recession will seem trivial.

This is not partisan in that all major parties are to blame, so let me hand out some blame.  At the Federal level, the Republican presidents deserve most blame.  This is part of Reaganomics come home to roost.  By cutting taxes and increasing spending in the Reagan years and the Bush years, the US borrowed in good times and we now have fewer resources to deal with the bad times.  At the state and local level, the Democrats are mostly to blame.  The states with the biggest problems spent and handed out pension promises without raising the revenue to cover the spending.  The states that have done large levels of implicit borrowing by underfunding public pensions are those that have been mostly Democratic, like New Jersey, California, and Illinois.  Finally, the Tea Party does not seem to understand that a big part of our problem is borrowing already done.  Debt makes governments appear inefficient — we get few benefits and pay high taxes because we are paying interest, and hopefully some principal too, thanks to previous borrowing.  Yes, this is annoying, but “cut taxes” is not a solution.

To avoid crisis, we must close the deficits first – a combination of raising taxes and cutting spending – then and only then the partisans can fight over the size and scope of government.  We have screwed up.  We let (mostly not entirely) Democrats spend without taxing and let (mostly not entirely) Republicans cut taxes without cutting spending.  We are now stuck with higher taxes than spending to pay existing debts.  The only other choice is default, and if you read the list of countries that have done this I think we do not want to be on that list.  Currently both parties lack the courage to break the truth to the public.  Instead, we need RINO’s and DINO’s.  We need a center that can solve the problem before going back to fighting.  The question is whether this happens before or after causing a major recession.

To conclude, what do I mean by explicit and implicit debt?  The explicit debt is simple to observe; it is the outstanding debt held by the public.  The implicit debt is much harder to observe; it is (primarily) the market value of the health insurance and pension benefits currently promised by governments based on past work, less the market value of the funds currently set aside to meet these obligations.  The implicit debt is larger than the explicit debt.  Another correct way to measure our true (implicit and explicit) debt is to calculate the market value of all the future payments or entitlements based on current and past contributions and payments, and then subtract the current assets held against these promised payments.  In this accounting promised payments are now all explicit, but of two types.  Some promised payments have been accrued by people working in return for them (like Medicare, Social Security, and state pensions) and some have been accrued by people working for money and then giving the government money for promises of future payments (like Treasury Bonds).  Other incorrect measures of government debt are usually used, such as the present value of forecasted deficits given current law (which exaggerates the debt), the value only of explicit debt (which understates true debt), and measures that understate the market value of future obligations (accounting rules allow risk to be mispriced, as emphasized by recent research by my colleague Joshua Rauh).

The Acceleration of the Euro Crisis

Fiscal crisis and financial crises are intimately linked.  Fiscal crises damage financial sectors by destroying the wealth of financial institutions which are holding government debt.  This in turn means that the financial sector cannot perform the central role of allocating capital to its most efficient uses, leading to large declines in productivity, output, employment and all other good economic indicators great and small.  In the other direction, financial crises usually end up as fiscal crisis because governments back up their economies through explicit guarantees like despoitor insurance or implicit guarantees that stem from the unwillingness to let the economy suffer as it would from a complete collapse of the financial sector (the Great Depression was a collapse of roughly half the US financial sector).  As Reinhart and Rogoff show, the typical financial crisis is associated with a whopping 86 percent increase in government debt.  This dual causality — fiscal to financial and financial to fiscal — can lead to a deadly spiral.

 

Thus, the big fear in Europe — that is causing so much hot air (talk of leadership, determination, coordination, etc.) — is that the fiscal crisis of the few becomes the financial crises and then fiscal crises of the many.  And Germany is struggling with the question of whether it is better to co-sign Italy’s borrowing and take the hit to its national debt now, or to let the fiscal crisis become a European banking crisis and take the hit to its national debt when it bails out its financial sector.  That is the choice.  And it looks like the financial crisis is coming, according to this FT article.

 

Not to be rude, but if you don’t like my description of the central issues in the Euro crisis, you may enjoy the amusing “Absolute Moron’s Guide to the Euro Debt Crisis” instead.

Eurodebts Around the World

The BBC has a very nice graphic here summarizing, for US, Japan, and Europe, the extent to which different countries’ sovereign and private bank debts are held by banks in each other country.  You can click on a country, see how much trouble it is in and which country is holding its debt and so would be in trouble if that country’s banks and government defaulted.  The graphic is missing information on assets (this is not net debt), but is still interesting.

My Academic Research Sees the Light of Day

My work with colleague Annette Vissing-Jorgenson is getting out of academe and into the mainstream media due to a new book and Occupy Wall Street.  What we showed in our research is that the large rise in income of the highest-earners in the US has been accompanied by a large change in the riskiness of this income.  Prior to the early 1980’s, the total income earned by the top 1% of
earners was less cyclical than the average income, meaning that these incomes fell less than average in downturns and increased less in booms.  But starting in the early 1980’s this reversed, so that since then the average income in the top 1% falls roughly two and a half times more than average income in recessions and increases roughly two and a half times more in booms. We also document how closely linked the increase in top income share and top income cyclicality are.  And we speculate on what economic forces are driving this change. Now along with the renewed attention on the increases in income inequality coming from the Occupy Wall Street movement (and Occupy Chicago here), there is a new book entitled “The High-Beta Rich” by Robert Frank.  Here is the adapted piece from the Wall Street Journal.  I always work on what interests me.  But it is nice when my work also turns out to interest others as well.

Government Unions and Public Sector Compensation

Last week I attended an engrossing two-day conference hosted by the Searle Center at Northwestern Law School on Government Unions in the United States. Scholars from economics, finance, law, and political science presented their research on an number of different dimensions of this theme.

One question that received a great deal of attention was whether public sector employees are compensated more generously than private sector employees with similar skills and engaging in similar tasks. This is a difficult question for two reasons. First, it is challenging to obtain comparability across individuals and jobs. Many public sector jobs have no private sector equivalent. Second, it is widely agreed that public sector accounting does not accurately represent the value of the benefits that public employees receive.

Presenters reviewed existing research and provided their own evidence. Essentially everyone who looked at the data found that public sector workers on average have slightly lower salaries. The contention was over whether higher public sector benefits more than offset this wage differential in total compensation. My own research with Robert Novy-Marx translates public sector pension costs from accounting where new benefits are discounted at 8% to accounting where new benefits are discounted at a rate that represents the liability as a promise that is invariant to asset returns. This reveals that pension benefits are around 15% of pay more expensive on average than is recognized. Conference participant Andrew Biggs argued that the differences are even larger.

Even going with our lower number, 15% of pay is larger than the public-private salary differential that are found in the data. That suggests to me that total compensation for an average public sector employee might be somewhat higher than that for a private sector employee whom these studies characterize as having comparable individual and job characteristics. I am, however, skeptical that comparability of individual and job characteristics in the public and private sector has been or really can ever be achieved. Attempting to benchmark the compensation of, say, public safety officials to private sector employees is obviously problematic. In such a case, the appropriate level of pay is simply whatever the employers and employees can agree upon – but that only leads to efficient outcomes if there is transparency about the public sector compensation packages that allows all parties, including taxpayers, to understand the value of the benefits. That transparency is currently lacking.

A related question at the conference was whether public sector collective bargaining and public sector unionization actually succeed in raising compensation. Here there was in fact no conclusive evidence. A number of speakers noted that it is possible for workers to be unionized but lack collective bargaining rights. Neither collective bargaining nor unionization seemed strongly correlated with compensation in the studies that were presented — although it is impossible in this setting to have counterfactuals (that is, to know what a given public sector employee would have earned in the absence of the union’s influence).

This all suggests that public sector unions may not be very effective at raising compensation on a case-by-case basis. But one role they clearly have played as a group is to resist measures that would bring the true costs of public sector benefits to light. Currently these costs are concealed from the public by the flawed economics of the Government Accounting Standards Board (GASB) methods. And public sector unions are clearly not in favor of changing these standards, as revealed for example by their opposition to the Public Employee Pension Transparency Act.

For the very reason that many public sector jobs have no private sector counterpart, transparency in public sector benefit costs is essential. Public sector unions could probably gain support with the public if they stopped defending the lack of transparency in public sector accounting.

The Volcker Rule Moves Forward

A small army of Federal Agencies — the Treasury, Fed, FDIC, and SEC – have set forth a proposed implementation of the Volcker rule contained in the Dodd-Frank legislation, here.  In short, the Volcker rule is a rule to disallow proprietary trading by banks and non-bank financial companies.  The proposed rule does this and also covers relationships with hedge funds or private equity funds. There are exceptions for running a hedge fund under certain conditions, for example hedging investments or making some international investments.  But in general, the rule limits investments in hedge funds to be small relative to the hedge fund size and to be small relative to the bank’s size.

 

There are potential adverse effects of this rule when combined with the restrictions imposed by the qualified investors rules.   This is all about efficiently getting investment funds to businesses from savers.  It makes sense to provide insured, liquid ways to save and to monitor and restrict the activities of banks that are insured.  But then can people save in illiquid, risky ways?  And how do businesses with illiquid risky investments get funding.  Seems like we are pushing funds into banks and then forcing to make direct loans rather than hire others to make investments for them that are not debt contracts.  Is this the right channel and are these the right contracts for getting fund to businesses from savers?  I tend to think we want more equity-type contracts and less debt type contracts.