Pro-cyclical Capital Requirements

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Tobias Adrian and Nina Boyarchenko write,

Value-at-Risk constraints were incorporated in the Basel II capital framework, which was adopted by major security broker-dealers in the United States—the investment banks—in 2004. Thus, capital constraints are imposed by regulation. In our staff report, we embed the risk-based capital constraint in a model with three sectors: a production sector (firms), a financial intermediary sector, and a household sector. Intermediaries serve two functions: 1) they create new production capacity through investment in the productive sector, and 2) they provide risk-bearing capacity to the households by accumulating wealth through retained earnings. The tightness of the capital constraint—measured by the maximal allowed ratio between intermediary leverage and one over the VaR on the intermediary’s assets—thus affects household welfare. When this ratio is decreased, the intermediaries are more restricted in their risk-taking and can therefore finance less investment. At the same time, since intermediaries take on less leverage and less risk, the systemic risk of the intermediary sector decreases. Accordingly, there is a trade-off between the amount of risk-taking and the price of credit in the real economy.

Pointer from Mark Thoma.

Using value-at-risk to regulate capital is one of the worst ideas ever. First, it assumes a normal distribution of returns, which is not valid far from the mean. Second, as the authors point out, it tends to be procyclical. Third, it is not a measure of the size of the loss in a bad scenario; instead, it is a measure of the size of the loss in scenario that is just a bit better than a bad scenario.

A better approach would be to spell out a specific scenario–an x percent drop in house prices, or a y percent decrease in bond prices, or something along those lines.

Why Interest on Reserves?

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Scott Sumner writes,

Back in late 2008 a few money market funds got into trouble and were in danger of “breaking the buck.” That’s due to their policy of pricing each share at $1. The solution is to allow the price to fluctuate. The Fed should have given the industry 6 months to prepare for negative interest rates. Instead they bailed them out and propped up interest rates at 25 basis points, in order to insure they would never break the buck.

If not for the money market industry the Fed could have already cut the fed funds target to around negative 0.25%, and the same for the interest rate on reserves. In that case (and assuming the IOR also applied to vault cash) it’s likely that most of the ERs would exit the banking system and end up in safety deposit boxes. But three trillion dollars is a lot of Benjamins, and despite the cash hoards you observe in places like Japan, a more likely outcome would have been hyperinflation. Obviously that would not be allowed, so what this thought experiment really shows is that with that sort of negative IOR the Fed could have gotten the stimulus it wanted with much less QE.

The decision to pay interest on reserves is one of the great mysteries of the 2008 response to the financial crisis. In terms of monetary policy, it is clearly contractionary, and a financial crisis seems like an odd time to engage in a contractionary policy.

The Fed acts in mysterious ways. At the time, the Fed said,

Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.

Which to me says exactly nothing. It could be that the only way to find out the basis of the Fed decision is with an audit.

Doc Shock

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The Washington Post reports,

The Obama administration made it a priority to keep down the cost of insurance on the exchanges, the online marketplaces that are central to the Affordable Care Act. But one way that insurers have been able to offer lower rates is by creating networks that are far smaller than what most Americans are accustomed to.

In our discussion of Obamacare implementation the earlier this week, Megan McArdle warned of this. She called it “doc shock,” as people find that the most reputable health care providers are not in their plans. She said that the out-of-network co-payments are often 100 percent, meaning that the insurance company pays zero and the consumer has to pay everything. This will probably not go over well.

The Year in Books

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Note that on December 5, I will be talking at Cato about one book that came out this year, George Gilder’s Knowledge and Power. In it, he gives credit to the widely-unread Unchecked and Unbalanced. Another author who credits me is Kevin Williamson in The End is Near.

This was also the year in which I e-published The Three Languages of Politics and also had a chapter in the Routledge Handbook of major events in economic history.

This year, there were three books that were widely heralded that I thought were more “eh:” Michael Huemer on political authority; Martin Hellwig and Anat Admati on banks; and Jeremy Adelman’s Hirschman bio (an admirable book, but I cannot count it as a must-read).

Books that I thought deserved more acclaim than they got include:

Lant Pritchett on education
Zvi Eckstein on The Chosen Few
Ara Norenzayan on Big Gods
Mark Weiner on Rule of the Clan
Edmund Phelps on flourishing
Hasan Comert on monetary impotence
Nick Schulz on marriage

Olivier Blanchard on the Macroeconomic Consensus

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He writes,

Turning to liquidity provision: in advanced countries (but, again, the lesson is more general), we have learned that runs are relevant not only for banks, but also for other financial institutions, and for governments. In an environment of high public debt, rollover risks cannot be excluded. An implication, and one of the themes emphasized by Paul Krugman, is that it is essential to have a lender of last resort, ready to lend not only to financial institutions but also to governments. The evidence on periphery sovereign bonds in the Euro area, pre and post the European Central Bank’s announcement of outright monetary transactions, is quite convincing on this point.

I cannot say that I agree. In fact, I cannot say that I agree with a single point that he makes in the essay. But he represents the consensus.

Scott re-interprets Larry

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Scott Sumner writes,

Summers claims that some sort of exogenous shock has reduced the long run real interest rate on safe assets.

That is not what I heard. Go back and listen to Larry’s response to Jeff’s question. Larry is talking about a savings glut and a decline in the cost of physical capital.

Think of an economy with three assets: money, risk-free Treasuries, and physical capital. What I heard Larry saying was that because of the savings glut and the low price of computers, the full-employment real return on physical capital is negative. That is a silly idea and a false idea, but that is what I heard Larry say. Ben Bernanke heard the same thing.

What Scott heard Larry say was that the demand for risk-free Treasuries is high, but the demand for physical capital is not so high, so that there is still a sizable risk premium on risky assets. My comments:

1. That may be a good story for, say, the fourth quarter of 2008. Larry claims to be talking about a decades-long phenomenon, pre-dating the crisis and continuing into the indefinite future.

2. The policy implications of that story are somewhat different than the policy implications of “secular stagnation.” If there is too much savings, then Larry wants to argue that the government needs to use up the savings. If what is holding back investment is high risk premiums, then more government spending is not such an obvious remedy.

Jeff Sachs vs. Summers/Krugman

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He writes,

Keynesians like to say that there is a savings glut (an excess of saving over investment). They try to remedy it by spurring consumption. This is a mistake. There is an investment shortfall, because the financial, regulatory, and policy barriers to high-return investments have not been addressed. America urgently needs investments in modernized infrastructure, advanced science and technology, and job skills appropriate for the 21st century. We are sitting on top of an information revolution and nanotechnology revolution that could positively reshape healthcare, education, transportation, low-carbon energy systems, green buildings, water conservation, and environmental safety.

Pointer from Mark Thoma. Sachs and I would probably disagree about the proportion of the solution that consists of government leading vs. getting out of the way. However, his diagnosis seems to me to make some sense, unlike the savings glut story.

Megan McArdle on Obamacare Defection

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Using terms from the Prisoners’ Dilemma, she writes,

if you think the other side might waver, then your best move is to defect immediately. If insurers stand strong but politicians end up repealing the mandate, then they will have lost a bunch of money for nothing. If politicians stand strong but insurers raise prices and/or exit the market, they’ll get slaughtered at the polls.

You can expect to read a lot about “risk corridors” now. There is a provision in the law which, like many provisions, is unclear and subject to different interpretations. The idea is to protect the insurers against having an adverse risk pool by giving them taxpayer compensation if they lose money. Obviously, to the extent that the insurance company is confident that the government has its back, it will lowball the premiums on the plans that it submits.

Senator Marco Rubio has figured out this game, and he intends to try to stop it.

On Tuesday I am introducing legislation that would eliminate the risk corridor provision, ensuring that no taxpayer-funded bailout of the health insurance industry will ever occur under ObamaCare. If this disaster of a law cannot survive without a bailout rescue valve, it is yet another reason why it should be repealed.

So now you have the Obama Administration desperately trying to make government the friend of the insurance industry and a Republican Senator desperately trying to stop that from happening.

Notes from a Health Care Implementation Discussion

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Among people along all three axes.

1. The progressives are much less forgiving of the Obama Administration’s management failures than are the rest of us. Some of us saw the problem as baked into the law. It was pointed out that the law mentions the word “web site” over 130 times, which is an indication of how complex the requirements could be. I made my point that Amazon and Kayak emerged out of a tournament involving thousands of companies. I said that if Obamacare had been a private-sector start-up, its odds of success would have been less than one in a thousand. Others pointed out that in the private sector you usually start with a small, minimally-functional prototype, not with a full-blown, full-featured system. Still others pointed out that the features of Obamacare are so tightly interconnected that it required perfect execution, which was extremely unlikely.

The progressives (especially those over age 40) wanted instead to emphasize the fundamental management flaws, such as not having a strong executive in charge of the project. They insist that Obamacare could have worked. Clearly, to suggest otherwise was to cast some doubts about the progressive approach.

2. The suggestion that some of us had of creating a “data extract” for the web site, so that it did not have to access other databases in real time, could not have been implemented. There is a law against the IRS giving out copies of its data.

3. The story was told that when Medicare Part D debuted out (in 2003, I believe), the launch was delayed three weeks because the system was not considered ready. Someone said that the Bush Administration put out the story that they did not want to launch the site on the Jewish Holiday of Yom Kippur. Of course, that is only a one-day holiday. Someone (not Jewish) joked that “But then you have sukkot” (a week-long holiday that comes a week after Yom Kippur). The best hope for Democrats is that the web site works well quickly

4. Nobody of any persuasion was buying David Cutler’s line that the slowdown in health care spending since 2008 reflects Obamacare.

5. Some of the state exchanges may be working better because states have been given an exemption from verifying eligibility for subsidies (at least, that is what I heard people say, but I may be wrong)

6. One journalist insisted that when President Obama announced his recent “fix” that would allow insurers to renew old plans, everyone knew that this could not possibly be implemented. The journalist said that the whole point was to keep the Senate from voting on a proposal to implement the fix. I guess the choice is between believing that Obama was an idiot (for thinking that state insurance commissioners and insurance companies could pull off a renewal so quickly) or a liar, and this journalist, who tends to be sympathetic to the President, implied that Obama (once again) was being cynically deceptive.

7. It was pointed out that non-libertarian Republicans should be sad about the failure of healthcare.gov, because many Republican health-care reform proposals have involved some sort of health exchanges.

8. People said that it is hard to make big policy moves in today’s environment. Trying Obamacare was like trying to privatize Social Security. President Bush wisely backed off of the latter (although he was not trying to privatize the entire program), and perhaps the Democrats would have been wise to back off the former.

9. President Obama’s reputation with young people as being “cool” has taken a tremendous hit. This could have long-term implications for how young people look at politics. My thought (which I kept to myself) is that at the moment President Obama seems to be adapting Atlas Shrugged for the 21st century.

10. The scenario for Obamacare’s death is that the insurance companies “defect” by leaving the exchanges or raising rates to unacceptable levels. As Obama’s personal political strength weakens, the “defect” scenario becomes more plausible.