Aug. 1 (Bloomberg) -- The summer debate that has dominated
Washington seems straightforward. Under what conditions should
the U.S. government be allowed to borrow more money? The numbers
that have been bandied about focus on reducing the cumulative
deficit projection over the next 10 years, as measured by the
Congressional Budget Office.
But there is a serious drawback to this measure because it
ignores what will probably prove to be the U.S.’s single largest
fiscal problem over the next decade: The lack of adequate
capital buffers at banks.
The Congressional Budget Office was created in 1974 to
provide nonpartisan analysis of budget issues. This was a major
breakthrough. It’s hard to exaggerate the lack of serious and
timely budget information that existed previously. The CBO still
does great work, but it has a major blind spot. (Disclosure: I’m
a member of the CBO’s panel of economic advisers; I don’t speak
for them here or anywhere else.)
The CBO is very good at explaining how the U.S. got itself
into a fiscal mess. The primary cause of the government debt
surge in recent years was a huge recession. A big loss of gross
domestic product and a fall in employment in any country will
collapse tax revenue. To appreciate the magnitude of this
disaster in the U.S., compare the CBO’s baseline forecasts
immediately before and after the financial crisis.
Debt Projections
In January 2008, before anyone thought the crisis would
spin out of control, the CBO projected that total government
debt in private hands -- the best measure of what the government
really owes -- would reach only $5.1 trillion by 2018, which was
then the end of its short-term forecast horizon. That
represented a fall in real terms to just 23 percent of GDP. Some
House Republicans might argue that even this level of debt
relative to the size of the economy is too large, but there is
no evidence that such debt levels by themselves stall growth or
cause other ill effects. The U.S. carried government debt at or
slightly above this level throughout the 1950s and the decades
that followed.
As of January 2010, once the depth of the recession became
clear, the CBO projected that over the next eight years debt
would rise to $13.7 trillion, or more than 65 percent of GDP --a
difference of $8.6 trillion. In January 2011, CBO moved the
forecast for 2018 to $15.8 trillion, or 75 percent of GDP,
primarily because the damage to growth had proved even more
prolonged than anticipated.
Fiscal Impact
Most of this fiscal impact is not due to the Troubled Asset
Relief Program -- and definitely not to the part of TARP that
injected capital into failing banks, most of which has been
repaid. Of the change in the CBO baseline (comparing 2008 and
2010 versions), 57 percent is due to decreased tax revenue
resulting from the financial crisis and recession, and 17
percent is due to increases in discretionary spending, including
the stimulus package made necessary by the financial crisis (and
because the “automatic stabilizers” in the U.S. are relatively
weak). An additional 14 percent came from increased interest
payments on the debt, and the rest from increases in mandatory
spending, otherwise known as entitlements. Some of the
entitlement spending, which includes food stamps, unemployment,
and other support payments, is also due to the recession.
Why was the financial crisis so devastating to the real
economy? The answer is that, in large part, financial firms had
become so highly leveraged, meaning they had very little real
equity relative to their assets. This was a great way to boost
profits during the economic boom, but when the markets turned,
high leverage meant either that firms failed or had to be bailed
out. Many financial firms in trouble at the same time means
systemic crisis and a deep recession. In effect, a financial
system with dangerously low capital levels creates a
nontransparent contingent liability for the U.S. budget through
the fall in GDP and loss of tax revenue.
Important Paper
The single most important paper to read on future fiscal
crises is actually about bank capital -- why the U.S. and other
countries need to increase it and why arguments to the contrary
are wrong. The paper was written last year and revised in March
by Anat Admati, Peter DeMarzo, Martin Hellwig and Paul
Pfleiderer, and is called “Fallacies, Irrelevant Facts, and
Myths in the Discussion of Capital Regulation: Why Bank Equity
is Not Expensive.” The work by Admati and her colleagues is not
partisan. In fact, her work has drawn support from finance
experts across the political spectrum, including John Cochrane,
a professor of macroeconomics and finance at the University of
Chicago, who recently wrote an op-ed supporting the Admati
approach.
Larger Buffers
Low levels of bank capital are just one way to measure the
extent to which banks endanger the broader economy by financing
themselves with debt rather than equity. Higher capital in any
system means more equity and larger buffers against losses. In a
brilliant speech recently, Narayana Kocherlakota, president of
the Minneapolis Federal Reserve Bank, connected the dots by
showing the extent to which the U.S. Tax Code encourages
dangerously excessive use of debt by households, companies and
banks.
Kocherlakota argues persuasively that U.S. policy should
aim to reduce the use of leverage -- and that there are much
safer ways if the U.S. wants to subsidize first-time homebuyers
or business investment. Tax reform that encourages financial
firms to use equity instead of debt should be scored as lowering
likely future government deficits.
Fiscal Risk
Many House Republicans -- including some who say they are
fiscal conservatives -- as well as some House Democrats remain
strongly in favor of lowering capital requirements. But any true
fiscal conservative should fight to strengthen the legislative
and regulatory safeguards that aim to make the financial system
less prone to collapse. Pushing for lower capital requirements
in the financial system poses a major fiscal risk. It is
unfortunate that fiscal risks arising from the financial sector
are not currently scored as claims on the federal budget by the
CBO. This introduces a false separation between financial and
fiscal issues on Capitol Hill.
The CBO is only as good as Congress allows it to be. The
CBO itself should push hard in this direction. The agency is
good about scoring other contingent liabilities and implicit
guarantees. Future health-care costs, for example, are assessed
on the basis of probabilities. No one knows what the world will
look like in 2050, but the CBO should be able to warn taxpayers
and lawmakers what will probably happen in the future, based on
the immediate past.
Washington seems straightforward. Under what conditions should
the U.S. government be allowed to borrow more money? The numbers
that have been bandied about focus on reducing the cumulative
deficit projection over the next 10 years, as measured by the
Congressional Budget Office.
But there is a serious drawback to this measure because it
ignores what will probably prove to be the U.S.’s single largest
fiscal problem over the next decade: The lack of adequate
capital buffers at banks.
The Congressional Budget Office was created in 1974 to
provide nonpartisan analysis of budget issues. This was a major
breakthrough. It’s hard to exaggerate the lack of serious and
timely budget information that existed previously. The CBO still
does great work, but it has a major blind spot. (Disclosure: I’m
a member of the CBO’s panel of economic advisers; I don’t speak
for them here or anywhere else.)
The CBO is very good at explaining how the U.S. got itself
into a fiscal mess. The primary cause of the government debt
surge in recent years was a huge recession. A big loss of gross
domestic product and a fall in employment in any country will
collapse tax revenue. To appreciate the magnitude of this
disaster in the U.S., compare the CBO’s baseline forecasts
immediately before and after the financial crisis.
Debt Projections
In January 2008, before anyone thought the crisis would
spin out of control, the CBO projected that total government
debt in private hands -- the best measure of what the government
really owes -- would reach only $5.1 trillion by 2018, which was
then the end of its short-term forecast horizon. That
represented a fall in real terms to just 23 percent of GDP. Some
House Republicans might argue that even this level of debt
relative to the size of the economy is too large, but there is
no evidence that such debt levels by themselves stall growth or
cause other ill effects. The U.S. carried government debt at or
slightly above this level throughout the 1950s and the decades
that followed.
As of January 2010, once the depth of the recession became
clear, the CBO projected that over the next eight years debt
would rise to $13.7 trillion, or more than 65 percent of GDP --a
difference of $8.6 trillion. In January 2011, CBO moved the
forecast for 2018 to $15.8 trillion, or 75 percent of GDP,
primarily because the damage to growth had proved even more
prolonged than anticipated.
Fiscal Impact
Most of this fiscal impact is not due to the Troubled Asset
Relief Program -- and definitely not to the part of TARP that
injected capital into failing banks, most of which has been
repaid. Of the change in the CBO baseline (comparing 2008 and
2010 versions), 57 percent is due to decreased tax revenue
resulting from the financial crisis and recession, and 17
percent is due to increases in discretionary spending, including
the stimulus package made necessary by the financial crisis (and
because the “automatic stabilizers” in the U.S. are relatively
weak). An additional 14 percent came from increased interest
payments on the debt, and the rest from increases in mandatory
spending, otherwise known as entitlements. Some of the
entitlement spending, which includes food stamps, unemployment,
and other support payments, is also due to the recession.
Why was the financial crisis so devastating to the real
economy? The answer is that, in large part, financial firms had
become so highly leveraged, meaning they had very little real
equity relative to their assets. This was a great way to boost
profits during the economic boom, but when the markets turned,
high leverage meant either that firms failed or had to be bailed
out. Many financial firms in trouble at the same time means
systemic crisis and a deep recession. In effect, a financial
system with dangerously low capital levels creates a
nontransparent contingent liability for the U.S. budget through
the fall in GDP and loss of tax revenue.
Important Paper
The single most important paper to read on future fiscal
crises is actually about bank capital -- why the U.S. and other
countries need to increase it and why arguments to the contrary
are wrong. The paper was written last year and revised in March
by Anat Admati, Peter DeMarzo, Martin Hellwig and Paul
Pfleiderer, and is called “Fallacies, Irrelevant Facts, and
Myths in the Discussion of Capital Regulation: Why Bank Equity
is Not Expensive.” The work by Admati and her colleagues is not
partisan. In fact, her work has drawn support from finance
experts across the political spectrum, including John Cochrane,
a professor of macroeconomics and finance at the University of
Chicago, who recently wrote an op-ed supporting the Admati
approach.
Larger Buffers
Low levels of bank capital are just one way to measure the
extent to which banks endanger the broader economy by financing
themselves with debt rather than equity. Higher capital in any
system means more equity and larger buffers against losses. In a
brilliant speech recently, Narayana Kocherlakota, president of
the Minneapolis Federal Reserve Bank, connected the dots by
showing the extent to which the U.S. Tax Code encourages
dangerously excessive use of debt by households, companies and
banks.
Kocherlakota argues persuasively that U.S. policy should
aim to reduce the use of leverage -- and that there are much
safer ways if the U.S. wants to subsidize first-time homebuyers
or business investment. Tax reform that encourages financial
firms to use equity instead of debt should be scored as lowering
likely future government deficits.
Fiscal Risk
Many House Republicans -- including some who say they are
fiscal conservatives -- as well as some House Democrats remain
strongly in favor of lowering capital requirements. But any true
fiscal conservative should fight to strengthen the legislative
and regulatory safeguards that aim to make the financial system
less prone to collapse. Pushing for lower capital requirements
in the financial system poses a major fiscal risk. It is
unfortunate that fiscal risks arising from the financial sector
are not currently scored as claims on the federal budget by the
CBO. This introduces a false separation between financial and
fiscal issues on Capitol Hill.
The CBO is only as good as Congress allows it to be. The
CBO itself should push hard in this direction. The agency is
good about scoring other contingent liabilities and implicit
guarantees. Future health-care costs, for example, are assessed
on the basis of probabilities. No one knows what the world will
look like in 2050, but the CBO should be able to warn taxpayers
and lawmakers what will probably happen in the future, based on
the immediate past.
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