Wednesday, December 30, 2009
Saturday, December 19, 2009
A strong financial sector is essential to a modern economy, but private actions can impose enormous costs on taxpayers; a balance must be struck. This column explains why the UK Government believes that there is a case for increasing the costs of risk-taking to banks and their shareholders while reducing those borne by taxpayers.
A strong and competitive financial sector is essential to a productive modern economy. But when banks fail the costs are high. Following the failure of Lehman Brothers in September 2008, governments around the world acted decisively to protect retail depositors, maintain financial stability, and enable banks to continue lending. Without such action the consequences of the financial crisis would have been far worse – but the result was a significant burden on taxpayers.
To reduce the probability of a repetition of these events, G20 finance ministers and leaders have committed to implementing higher regulatory and supervisory standards to guard against excessive risks. The objective of these reforms is to ensure that the costs of failure of institutions are borne by shareholders and other creditors in an orderly way without triggering a systemic crisis. This should limit the circumstances in which any future government intervention is necessary. But in practice there may always be a risk that the potential costs to the wider economy of a systemic crisis will be sufficiently great that government intervention is appropriate. After all, systemic financial crises have been an intermittent but pervasive feature of financial systems throughout recorded economic history.
A key question is therefore how to ensure that any costs of government intervention are distributed more fairly across those in the financial sector who benefit, reflecting the risks and rewards associated with financial intermediation. This should mean ensuring that the costs of bank failure fall primarily to banks and bank investors, rather than taxpayers. A paper published by the UK government last week (HM Treasury 2009) considers in detail options for ensuring banks meet the immediate costs of interventions to prevent systemic failure. The provision of emergency liquidity facilities and of deposit insurance is already well established, so this article concentrates on the potential new proposals in the paper: contingent capital and systemic risk levies. It also discusses the case for additional taxation of the financial sector to ensure that the sector makes a fair contribution to society and broader social objectives.
Contingent capital and capital insurance
The Basel Committee is considering how to reform global capital standards and banks are likely to have to significantly strengthen the quantity and quality of capital that they hold. In the recent crisis existing subordinated debt and hybrid capital largely failed in its original objective of bearing losses, so the focus of regulatory capital requirements should be on capital that can absorb losses on a going concern basis, typically common equity. More equity will enhance the resilience of banks to shocks. However, if equity is insufficient to absorb losses, banks may have to try to raise more. And in a systemic crisis the cost of raising new capital could be prohibitively high, so that banks may find it difficult to raise new capital when they need it most.
Contingent capital or capital insurance held by the private sector could help address this potential issue and supplement common equity in times of crisis. There are a variety of proposals (e.g. Raviv 2004, Flannery 2009) under which banks would issue fixed income debt that would convert into capital according to a predetermined mechanism, either bank-specific (related to levels of regulatory capital) or a more general measure of crisis. Alternatively, under capital insurance, an insurer would receive a premium for agreeing to provide an amount of capital to the bank in case of systemic crisis.
From an economic perspective, the attraction of contingent capital or insurance is clear; creating such instruments, especially if they were traded, would improve both market discipline and market information. Unfortunately, however, as we have seen, it is precisely in a crisis that markets for such instruments – which will essentially be put options sold by investors to banks – can fail. Such instruments may ultimately not be appropriate for many fixed-income investors such as insurance funds which have in the past invested in subordinated debt and hybrid capital instruments; and the systemic stability consequences would need to be explored.
Alternatively, the Government could offer a capital insurance scheme. For example, Caballero and Kurlat (2009) propose that the central bank should issue tradable insurance credits, which would allow holders to attach a central bank guarantee to their assets during a systemic crisis; or the government could set out an explicit arrangement to deliver capital and liquidity to banks in times of a systemic crisis in return for an up-front fee, as proposed by Perotti and Suarez (2009). Trigger events, fees and the equity conversion price would all be set in advance.
Such a scheme would provide greater certainty for market participants about the circumstances and limits of government intervention, while also ensuring government receives an up-front fee for implicit support. However, there would be potential for moral hazard resulting from reduced loss-sharing across subordinated debt and hybrid capital, unless such capital converted to equity ahead of any government injection. In general government-provided capital insurance would seem to be less useful and less flexible than a wider systemic levy or resolution fund, an option outlined below, although capital insurance could be an element of any wider solution.
Systemic risk levies and resolution funds
Since it is impossible to eliminate entirely the risk that some of the costs of intervention will have to provided by government, there is a case for ensuring that in future the financial sector itself meets these residual costs through a systemic risk levy or resolution fund. A “systemic risk scheme” would have a wider scope than existing deposit-guarantee schemes in that contributions would be sought from all systemically important firms rather than just retail deposit-takers; and wider coverage in that it would fund the costs of restoring financial stability more broadly rather than just the costs of compensating retail depositors. Funds could be used towards the recapitalisation of failing or failed banks, to cover the cost of other guarantees to creditors, or potentially other costs from resolution.
Such a levy might be charged on either a pre- or post-funded basis. It could be weighted towards financial firms which, because of their size or the nature of their business, were a potential source of significant risk to the stability of the financial system. The levy would not fund insurance for any individual firm but rather would support intervention, if needed, to stabilise the system as a whole, hence avoiding some of the moral hazard problems typical of insurance schemes. Given that financial crises requiring direct government intervention are relatively rare in developed economies, any fund would have to be built up over an extended period. When financial crises do occur, however, they can be exceptionally costly to the public finances, and therefore the fund may ultimately need to be quite large.
A key consideration in designing any systemic levy or general resolution fund would be how to assess systemic significance and/or a firm’s contribution to systemic risk, and how to reflect that in any levy. In principle, a well-designed levy could achieve two objectives. It would both raise funds to cover the costs of restoring financial stability and, to the extent that the levy accurately reflected both systemic risk and institution-specific risk and charged for individual institutions’ contribution to those risks, it would embed incentives that would reduce the probability that such costs would ever materialise. For these reasons, a prefunded, rather than a “survivor pays” approach appears more attractive in principle.
Ensuring the financial sector makes a fair contribution
Going beyond the measures described above to deal with systemic risk, there might be other reasons why the financial sector should make a greater fiscal contribution:
- to defray the wider fiscal, economic and social costs of the recent crisis;
- to help correct what might be considered excessively risky or destabilising activities that may have negative externalities;
- if elements of the financial services industry were shown to be generating supernormal returns to executives or shareholders – economic rents – because of the existence of market failures, then there may be a case for increasing taxation on these returns;
- the global nature of the financial services industry and the mobility of its activities might suggest that a more internationally coordinated approach would help ensure the sector makes a fair contribution through tax, irrespective of where firms are located or where the activity takes place.
A financial transaction tax has been suggested as a potential method of ensuring that the global financial services sector makes a fair contribution. It has been argued that some financial transactions have little or even negative social value (see e.g. Krugman (2009), Turner (2009)); that even if such a tax reduces liquidity in some markets, there are likely to be diminishing marginal returns to liquidity, and so any negative impact would be minimal; and that the potential revenues could be large. Full analysis of the potential economic implications of introducing a transaction tax will help determine the desirability of such a tax, the level at which it should be set if it were introduced and the likely consequences.
As well as considering the economic impact of a financial transaction tax, there are some significant issues to explore regarding its design and implementation. Key points include:
- identifying the tax base: to protect against avoidance a financial transactions tax would ideally have as broad a base as possible, including over-the counter transactions;
- establishing a means of tracking transactions in order to implement the tax, given financial transactions are currently recorded through a range of exchanges and other systems;
- setting a rate, or rates, to ensure the introduction of a financial transaction tax does not have a negative economic impact, given the different margins on particular types of transactions;
- determining a means for allocating revenue raised, given the international nature of many financial transactions; and
- defining a method for monitoring and ensuring compliance, and determining action that should be taken in the event of avoidance or evasion.
Common principles and next steps
The IMF will report in April to the G20 on these issues. Any proposals should respect the following principles:
- Global – some options could realistically only be implemented at a global level, while others would require international agreement and coordination on key principles to be effective;
- Non-distortionary – avoiding measures that would damage liquidity, drive inefficient allocation of capital or lead to widespread avoidance;
- Stability enhancing – actions must support and not undermine the regulatory action already being taken. This is likely to mean any option would take several years to implement; and
- Fair and measured – financial services must be able to continue to contribute to economic growth and any additional costs should be distributed fairly across the sector. A thorough impact assessment must be conducted prior to implementation.
Caballero, Ricardo J and Pablo Kurlat (2009), "The 'Surprising' Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal," Federal Reserve Symposium at Jackson Hole, August.
Flannery, Mark (2009), "Contingent Tools Can Fill Capital Gaps," American Banker, 174(117).
HM Treasury (2009), "Risk, Reward and Responsibility: The Financial Sector and Society," December.
Krugman, Paul (2009), "Taxing the Speculators," New York Times, 27 November.
Perotti, Enrico and Javier Suarez (2009), "Liquidity Insurance for Systemic Crises," VoxEU.org, 11 February.
Raviv, Alon (2004), "Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes," Unpublished working paper.
Turner, Adair (2009), "Responding to the Financial Crisis: Challenging Assumptions," Speech to the British Embassy, Paris, 30 November.
Republished with permission of VoxEU.org
Thursday, December 17, 2009
As the US debt-to-GDP ratio rises towards 100%, policymakers will be tempted to inflate away the debt. This column examines that option and suggests that it is not far-fetched. US inflation of 6% for four years would reduce the debt-to-GDP ratio by 20%, a scenario similar to what happened following WWII.
Since the start of 2007, the financial crisis has triggered $1.62 trillion of write-downs and credit losses at US financial institutions, sending the American economy into its deepest recession since the Great Depression and the global economy into its first recession since World War II. The US Federal Reserve has responded aggressively. Fiscal policy has become expansionary as well. The US is now facing large deficits and growing public debt. If economic recovery is slow to take hold, large deficits and growing debt are likely to persist for a number of years. Not surprisingly, concerns about government deficits and public debt now dominate the policy debate (Cavallo & Cottani 2009).
Many observers worry that the debt-to-GDP ratios projected over the next ten years are unsustainable. Assuming deficits can be reined in, how might the debt/GDP ratio be reduced? There are four basic mechanisms:
1. GDP can grow rapidly enough to reduce the ratio. This scenario requires a robust economic recovery from the financial crisis.
2. Inflation can rise, eroding the real value of the debt held by creditors and the effective debt ratio. With foreign creditors holding a significant share of the dollar-denominated US federal debt, they will share the burden of any higher US inflation along with domestic creditors.
3. The government can use tax revenue to redeem some of the debt.
4. The government can default on some of its debt obligations.
Over its history, the US has relied on each of these mechanisms to reduce its debt/GDP ratio. In a recent paper (Aizenman & Marion 2009), we examine the role of inflation in reducing the Federal government’s debt burden. We conclude that an inflation of 6% over four years could reduce the debt/GDP ratio by a significant 20%.
Figure 1 depicts trends in gross federal debt and federal debt held by the public, including the Federal Reserve, from 1939 to the present. In 1946, gross federal debt held by the public was 108.6%. Over the next 30 years, debt as a percentage of GDP decreased almost every year, due primarily to an expanding economy as well as inflation. By 1975, gross federal debt held by the public had fallen to 25.3%.
Figure 1. Debt as a share of GDP
The immediate post-World War II period is especially revealing. Figure 2 shows that between 1946 and 1955, the debt/GDP ratio was cut almost in half. The average maturity of the debt in 1946 was 9 years, and the average inflation rate over this period was 4.2%. Hence, inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade.
Figure 2. US debt reduction, 1946-1955
In recent years, the debt/GDP ratio has increased dramatically, exacerbated by the financial crisis. In 2009, it reached a level not seen since 1955. Figure 3 shows three 10-year projections, indicating debt held by the public could be 70-100% of GDP in ten years.
Figure 3. America’s projected debt burden
A government that has lots of nominal debt denominated in its own currency has an incentive to try to inflate it away to decrease the debt burden. If foreign creditors hold a significant share of the debt, the temptation to use inflation is greater, since they will bear some of the inflation tax. Shorter average debt maturities and inflation-indexed debt limit the government’s ability to reduce its debt burden through inflation.
Figure 4 shows the share of US public debt held by foreign creditors. The foreign share was essentially zero up until the early 1960s. It has risen dramatically in recent years, particularly since the 1997-98 Asian financial crisis, and was 48.2% of publicly held debt in 2008. Thus foreign creditors would bear about half of any inflation tax should inflation be used to reduce the debt burden, with China and Japan hit hardest.
Figure 4. Foreign share of publicly held debt
Figure 5 illustrates the average maturity length for US marketable interest-bearing public debt held by private investors, along with the debt held by the public as a share of GDP. As noted by a number of authors, the US exhibits a positive relation between maturities and debt/GDP ratios in the post-World War II period. Most developed countries show little correlation between maturities and debt/GDP ratios. The US appears to be an exception. Maturity length on US public debt in the post-World War II era went from a 9.4 years in 1947 to a low of 2.6 years in 1976. In June, 2009, the average maturity was 3.9 years. Most of this debt is nominal. (1)
Figure 5. Average maturity length and share of debt held by the public
Inflating away some of the debt burden
Figure 6 illustrates the percentage decline in the debt/GDP ratio under various inflation scenarios.(2) Inflation yielded the most dramatic reduction in the debt/GDP ratio – and the real value of the debt – in the immediate post-World War II period. A 5% inflation increase starting in 1946, for example, would have reduced the debt/GDP ratio from 108.6% to 59.3%, a decline in the debt ratio of 45%. Not only was there a large debt overhang when the war ended, but inflation was low (2.3%) and debt maturity was high. Thus there was room to let inflation rise – and it rose to 14.4% in 1947 before dropping considerably. Average inflation over the decade was 4.2%. Moreover, long maturities allowed inflation to erode the debt burden. Maturities were over 9 years in years 1945-48 and then fell gradually to 8.17 years in 1950.
Figure 6. Impact of inflation on publicly-held debt as a share of GDP
In contrast, inflation would have had little impact on reducing the debt burden in the mid-1970s. That period was characterised by a lower debt overhang, inflation was higher, and debt maturities were shorter (under 3 years). As a result, in 1975 a five-point increase in inflation would have reduced the debt/GDP ratio from 25.3% to 21.9%. The estimated impact of inflation on today’s debt/GDP ratio is larger than in the mid-1970s but not as large as in the mid-1940s. If inflation were 5% higher, the debt/GDP ratio would be about 20% lower, a debt ratio of 43.4% instead of 53.8%. Our computations of the impact of inflation on the debt overhang assume that all debt is denominated in domestic currency, none is indexed, and the maturity is invariant to inflation. Regression analysis confirms that US debt maturities over the period 1946-2008 are not responsive to inflation.
We develop a stylistic model that illustrates both the costs and benefits associated with inflating away some of the debt burden. The model, inspired by Barro (1979), shows that the foreign share of the nominal debt is an important determinant of the optimal inflation rate. So is the size of the debt/GDP ratio, the share of debt indexed to inflation, and the cost of collecting taxes. A lesson to take from the model and the simulations is that eroding the debt through inflation is not farfetched. The model predicts that inflation of 6% could reduce the debt/GDP ratio by 20% within four years. That inflation rate is only slightly higher than the average observed after World War II. Of course, inflation projections would be much higher than 6% if the share of publicly-held debt in the US were to approach the 100% range observed at the end of World War II.
The current period shares two features with the immediate post-World War II period. It starts with a large debt overhang and low inflation. Both factors increase the temptation to erode the debt burden through inflation. Even so, there are two important differences between the periods. Today, a much greater share of the public debt is held by foreign creditors – 48% instead of zero. This large foreign share increases the temptation to inflate away some of the debt. Another important difference is that today’s debt maturity is less than half what it was in 1946 –3.9 years instead of 9. Shorter maturities reduce the temptation to inflate. These two competing factors appear to offset each other, and the net result in a simple optimising model is a projected inflation rate slightly higher than that experienced after World War II, but for a shorter duration.
In the simulations, we raise a concern about the stability of some model parameters across periods, particularly the parameters that capture the cost of inflation. It may be that the cost of inflation is higher today because globalisation and the greater ease of foreign direct investment provide new options for producers to move activities away from countries with greater uncertainty. Inflation above some threshold could generate this uncertainty, reducing further the attractiveness of using inflation to erode the debt.
Moreover, history suggests that modest inflation may increase the risk of an unintended inflation acceleration to double-digit levels, as happened in 1947 and in 1979-1981. Such an outcome often results in an abrupt and costly adjustment down the road. Accelerating inflation had limited global implications at a time when the public debt was held domestically and the US was the undisputed global economic leader. In contrast, unintended acceleration of inflation to double-digit levels in the future may have unintended adverse effects, including growing tensions with global creditors and less reliance on the dollar. (3)
(1) Treasury inflation-protected securities, or TIPS, account for less than 10% of total debt issues.
(2) The calculation assumes that maturity is invariant to inflation. We test and overall confirm the validity of this assumption for U.S. data in the post-World War II period.
(3) For the threat to the dollar from the euro, see Chinn and Frankel (2008) and Frankel (2008).
Aizenman, Joshua and Nancy Marion (2009), "Using Inflation to Erode the US Public Debt,” NBER Working Paper 15562.
Barro, Robert (1979), “On the Determination of the Public Debt,” Journal of Political Economy, 87, 940–71.
Cavallo, Domingo and Joaquín Cottani (2009), “A Simpler Way to Solve the 'Dollar Problem' and Avoid a New Inflationary Cycle,” VoxEU.org, 12 May.
Chinn, Menzie and Jeffrey Frankel (2008), "Why the Euro Will Rival the Dollar,” International Finance, 11(1), 49-73.
Frankel, Jeffrey (2008), "The Euro Could Surpass the Dollar within Ten Years,” VoxEU.org, 18 March.
Republished with permission of VoxEU.org