"Blanchard roundtable: Pursue contingent policies
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- The Economist l WASHINGTON
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- Blanchard roundtable
This discussion can be followed in its entirety here.
UNCERTAINTY is a constant in economic life, but Olivier Blanchard notes that at present it is sufficiently pervasive as to be a major exogenous source of restraint on demand. He recommends policies that reduce uncertainty, as distinct from policies that simply boost aggregate demand.
Many of his policies, however, would take effect regardless of the state of the economy. It seems to me, by contrast, that the way to deal with uncertainty is through contingent policies that are triggered when a predetermined bad state of the economy is reached. Such policies will be all the more powerful if they are widely known in advance. They would thus reassure households, investors, and businesses that tail risks are less likely to be realised, who should become more willing to spend or invest, further reducing those tail risks.
Many traditional economic policies are contingent. Deposit insurance is triggered when a bank fails, which means banks are less likely to fail in the first place. Unemployment insurance benefits are paid out when unemployment rises, which gives households less incentive to build in precautionary saving during recessions, aggravating the downturn. Even monetary policy that follows a Taylor rule is contingent—the more unemployment rises above its natural rate and the more inflation falls below target, the lower real interest rates will go. This may not be prescribed well enough to affect behaviour, but it has gotten us out of most past recessions. Of course, monetary policy in America (and perhaps, before long, in other countries) has reached the zero bound and can no longer fill this contingent role.
Can other contingent policies be created or enhanced to eliminate tail risks? Tyler Cowen suggests, sensibly, strengthening the automatic stabilisers. That is what the Obama fiscal package does by expanding unemployment insurance benefits and extending health care subsidies to the newly unemployed. (By contrast, provisions such as infrastructure spending and tax cuts are not contingent; they will be implemented regardless of the state of the economy). The automatic stabilizers could be put on steroids by, for example, cutting taxes if the unemployment rate rises to predetermined levels. Yes, this would aggravate the deficit, but given that monetary policy is less potent, fiscal policy should assume more of its pre-emptive and contingent character (Of course, fiscal policy is costlier and more difficult to reverse, and Alberto Alesina notes this is a constraint on its open-ended use.).
Arguably uncertainty is most damaging in the financial sector, as it has caused precautionary hoarding of capital and liquidity which is fueling the pullback in aggregate demand. Nowhere are contingent policies more necessary.
As lenders of last resort, central banks are contingent suppliers of liquidity. When private funding dries up, they will lend without limit to any solvent bank willing to pay a penalty rate. The Fed built on this principle with its new liquidity facilities. Term auction credit is available at a slight penalty rate to the overnight index swap rate (OIS), and commercial paper can be issued to the Fed for 100 to 300 basis points over OIS. The benefits of these programmes go well beyond the actual credit extended; their mere existence reduces funding uncertainty for banks and corporations and makes them less likely to hoard cash and cut investment. When Blanchard says the fiscal authority should sell Treasury bills and recycle the proceeds into risky assets, this is precisely what the Fed’s liquidity facilities have done. But because they are contingent, they will wind down of their own accord. The penalty ensures that once private sources of funding become easer to access, official facilities will become less attractive (as is now happening), and this limits the associated risk of inflation.
Policy makers have attempted to implement contingent financial stability policies more generally with much more mixed results. Treasury offered contingent capital to Fannie Mae and Freddie Mac (which would be supplied as their own capital eroded) but then allowed Lehman Brothers to fail and Washington Mutual’s bond holders to be wiped out. The G7 declaration in October that no systemically important institutions would be allowed to fail removed tail risks, but those benefits have been partly undone as policy makers have added uncertainty through the risk of nationalisation or dilution of common shareholders.
A better contingent financial stability policy would offer a relatively clear template to supply additional capital as banks’ capital is depleted, and insurance against further losses on assets, which is what Ricardo Caballero is driving at. Nationalisation without just compensation would be ruled out, but not “creeping nationalisation” via repeated injections so long as the state acquires its shares on the same terms as the private sector. There are of course countless obstacles to overcome for such a policy to work, and political interference will remain a permanent source of uncertainty.
The financial crisis is grave, but there are, believe it or not, worse cases of Knightian uncertainty in our recent past. In the aftermath of 9/11, no one knew if there would be another terrorist attack or how serious it would be. America was either lucky, smart, or both in that no such attack ever came. We still cannot place odds on terrorists using a weapon of mass destruction or on climate change triggering catastrophic natural disasters. By comparison, we have a better chance of dealing with Knightian uncertainty in the economic world."
A short riposte:
"Don the libertarian Democrat wrote:
Posts
In order for insurance or guarantees to work, they must in fact be known in advance. The whole point is forestall a run, in this case a Calling Run, by having in place an orderly and effective process of exchanging assets. Such a process would end up costing less and destroying less wealth. It's like the Doomsday Machine in Dr. Strangelove. It was intended to deter us, but remember what happened when the Russians didn't tell us about it.
However, what exactly is being insured? CDSs?CDOs? And how much would it cost? With banks, we insure the depositors up to a certain amount, which just went up, although it's scheduled to go back down. Who are we going to insure? The banks and brokers, or the actual investments? People will want their money back, in any case, if they're afraid they might not get it back if they wait. On the other hand, insuring for a world crisis seems hard to value and set premiums on.
"Nationalisation without just compensation would be ruled out, but not “creeping nationalisation” via repeated injections so long as the state acquires its shares on the same terms as the private sector."
I'm a follower of Bagehot. Surely Free Exchange remembers him. For moral hazard to be effective, it must be onerous. Let me be plain: In the US, we need nationalization for moral hazard because it is what our bankers fear and get really pissed off about. The fact that they're hoarding cash to avoid being nationalized tells me all I need to know about what they really consider onerous
terms. Anything short of that they consider completely acceptable.
As for insurance, let me be plain again: The Bankers and Investors believed that they had it. They paid for it through lobbying. That's cheaper than an actual insurance policy. The actions of investors show that they were investing under the belief that government had implicitly guaranteed to intervene in a financial crisis, both swiftly and effectively. They believed people in the Investor Class, like Hank Paulson, knew this. Unfortunately for everyone on planet Earth, Hank decided to get cute and cut Lehman loose to show that the government can apply free market principles on a whim. Guess who turned out to be nearer to the truth? The Investor Class. Once they panicked and demanded their insurance, the government came to the rescue, armed with some very poor ammo and commanders. Nothing against Paulson, since , for a Bush person, he's a raving genius.
By the way, not only did our Investor Class believe that there was an Implicit Guarantee, but, according to Brad Setser, China did as well. Certainly the foreign investors in Citi believed that they would be bailed out, and, indeed, they were.
Finally, on the Sunday before Lehman's demise, there was an emergency trading session held. I've read reports that, during that session, many investors believed that if Lehman fell, and the government continued to stay out of guaranteeing more businesses, Merrill would go down as well due to counterparty concerns with Lehman. If that's true, then, on that Sunday, many people were aware that a Calling Run ( Debt-Deflation ) was a real possibility. That would explain much of the panic that began on Monday. I'm sure that such an insurance idea is well intended, but the Banking Lobby prefers lobbying.