Tuesday, September 29, 2009

Capital replenishments and requirements

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

3. Capital replenishments and requirements

I consider two mistaken policies: (A) The recent emergency infusions of capital and (B) the use of capital as a regulatory guide in general.


Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

Paul Krugman, “Cash for trash,” New York Times, Sept. 22, 2008.

Isn’t it shameful that financial institutions receive capital infusions from the government, and instead of lending it out, they hoard it? I hear this complaint a lot.

Jack Guttentag, “Why banks ‘hoarding’ bailout funds is good,” Washington Post,

Jan. 24, 2009.

The government’s capital infusions to financial institutions were rationalized as help to home-buyers.However, distressed institutions avoided further risky investments. This was desirable as well as understandable, Guttentag wrote: “The justification for the capital infusions is [or ought to be] that they will increase capital, not loans [as critics in and out of Congress complained]. The goal is to avoid future shocks from the failure of undercapitalized firms. The fundamental purpose is to prevent the crisis from getting worse. Other measures are needed to cure it.”


Obviously, the U.S. financial sector’s condition today is excellent. Capital ratios stand at levels we have not seen in sixty years, credit quality has been strong, and innovative financial instruments can spread risks more broadly than ever before…. Supervisory reforms also deserve substantial credit, particularly those aimed at raising bank equity ratios.

Mark Flannery, “Supervising bank safety and soundness,” Federal Reserve Bank of Atlanta Economic Rev., 1st and 2nd quarters, 2007.

It sounds reasonable that, since a bank’s Assets = Liabilities (mostly deposits) + Capital (equity or new worth), large capital relative to assets protects depositors against falls in the value of assets.This simple observation is the foundation of most bank regulation, including the international capital requirements agreed at Basel, Switzerland. There are several problems with the capital approach to bank regulation: (i) The capital measures used by regulators are of doubtful meaning; (ii) however measured, capital has not been a good predictor of bank failure; and (iii) capital cannot be imposed independently of the overall portfolio choice.

Regarding the first, regulators look mainly at book (accounting) rather than market values. This misses the information contained in market prices but is simple because capital requirements are preserved from stock-price fluctuations.

A primary reason for the second problem is that assets are sensitive to economic conditions and can deteriorate quickly. This was evidenced in the recent decline in house prices, as in the falls of agricultural and oil prices in the 1980s and the deflations of 1920-21 and 1929-33. Regulators try to adjust capital needs by the riskiness of assets, but this is difficult for at least two reasons: regulators are not competent to judge risks at any given time except in the most egregious cases, and conditions can change rapidly and substantially.

Third, large capital might be more a consequence of risk that a guarantee of safety. Credibly low-risk operations need little capital to satisfy creditors. U.S. bank capital ratios were high, and so was the rate of bank failures, in the volatile 19th century. Whether increased capital requirements (even if properly measured) reduce risk-taking depends on bankers’ preferences. For a bank that maximizes expected profit subject to a given probability of failure, more capital leaves that probability unchanged as it is directed to risky assets.

The most common message of the Basel Committee on Bank Supervision is that its measures of bank risk have failed – but they’re working on the problem. Never discussed is evidence for the usefulness of the approach even if it could be done.

When Sam Peltzman found that deposit insurance had induced banks to take on more risk, he observed:

Bank examiners devote the greater part of their efforts to a determination of the “riskiness” of a bank’s assets, on the one hand, and the “adequacy” of its capital, on the other…. However, the preponderant emphasis is placed on regulating bank capital rather than the details of the asset portfolio. While there is no specific reason for this emphasis on capital adequacy, it can be explained on institutional grounds. It is surely difficult for a bank examiner to judge accurately the riskiness of the many different asset items he comes across, since they reflect a great variety of [changing] local [and national] market conditions, bank management judgments, and special circumstances. Instead of attempting an independent assessment of these details, a much easier course of action is to accept bank management judgment while substituting for this acquiescence a strong insistence that depositors be protected with adequate capital against the consequences of mistakes.

“Capital investment in commercial banking and its relationship to portfolio regulation,”

J. Political Economy, Jan-Feb 1970.

Nothing has changed. Rules at variance with preferences can still be satisfied without achieving regulators’ objectives (such as reducing risk). The only potentially effective regulation of complex operations must be aimed at results, with penalties for defaulters. Public policies that bail them out do the opposite.


Wednesday, September 23, 2009

Stimulus Package

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

This is the first of the critiques of government reactions to the current economic downturn that were promised in my previous blog.

The [tax] surcharge of 1968 … should never, on basic theoretical grounds, have been considered an effective anti-inflationary device.

Robert Eisner, “Fiscal and monetary policy reconsidered,” American Economic Review,

Dec. 1969.

The income of Americans unexpectedly surged [0.5%] in April, elevated by the economic stimulus package, while spending declined [0.1%].

Wall Street J., June 1, 2009.

1. The tax rebates and relief in the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 may be seen in the spikes in Disposable (after taxes) Personal Income in the figure.

Not seen, however, are positive responses of personal outlays (consumption expenditures and interest payments). The failure of spending to respond to obviously temporary changes in income is well known, and has been seen on several occasions, including the ineffective tax rebate of 2001 and the income-tax surcharge of 1968. The latter was a compromise by which the Johnson administration secured funding for the Vietnam War that would not be inflationary because the fall in consumption would offset the rise in government spending. Consumers’ spending was not repressed, however, as they continued to make decisions on the basis of expected future income available through the capital markets. The policy’s failure should have been anticipated, Eisner wrote (see the quotation above).

The smoothness of consumption relative to income in the figure is explained by the permanent income hypothesis (PIH), which is often associated with Milton Friedman (1957), but was well-known before him, for example by David Ricardo (1819) and Irving Fisher (1906). The hypothesis states that individuals plan consumption over time in light of their perceived wealth, which consists primarily of expected income.

The Keynesian (1936) consumption function, which still dominates the textbooks and is the theoretical basis of the stimulus packages, asserts that spending depends solely on current income. This makes sense for impoverished individuals or even societies in deep depression, but is impossible to teach with a straight face to students who are in the midst of carrying out long-term plans involving large consumption (college expenses and foregone earnings) in anticipation of future income.

Income fluctuations affect consumption under the PIH to the extent that income expectations respond to income changes. But the hypothesis implies that consumption is unresponsive to changes known to be temporary and even reversible. The apparently perverse effect of the recent stimulus packages, when consumption has actually fallen instead of being merely unresponsive, could be due to the administration’s warnings of future tax increases.

Research has qualified the PIH in light of uncertainty and psychology, but the ineffectiveness of stimulus packages implied by the simplest form of the theory continues to hold.


G. Angeletos, et.al. “The hyperbolic consumption model,” J. Economic Perspectives, Summer 2001.

Irving Fisher. The Nature of Income and Capital. Macmillan, 1906.

Milton Friedman. A Theory of the Consumption Function. Princeton Univ. Press, 1957.

J.M. Keynes. The General Theory of Employment, Interest and Money. Macmillan, 1936.

David Ricardo. The Principles of Political Economy and Taxation. John Murray, 1819.

Matthew Shapiro and Joel Slemrod. “Consumer response to tax rebates,” American Economic Rev., March 2003.

Wednesday, September 16, 2009

September 14, 2009

The consequences of economic decisions depend on the incentives of those affected. Unfortunately, this fundamental truth has been overlooked by government reactions to the recent downturn – which is my reason for starting this blog. As an economist I have an interest in economic theory, and am disturbed when officials, cheered on by their economic advisors, disregard or violate economic truths that rest on the best theory and have been confirmed by experience. They raise problems for teachers who would like to be able to consider applications of theory to policy.

The next several (weekly) issues of this blog ask:

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-09

with Contents, or Menu of Mistakes:

1. The stimulus packages

2. Operation twist again

3. Capital replenishments and requirements

4. Excess reserves again

5. Confusion of liquidity and risk

6. We need more regulation

7. We’ve got to do something

8. Monetary policy as credit controls

The failures of these policies are explained by their inconsistencies with theory (even of logic) and experience. It is hard to comprehend them except as products of the hysterical atmosphere that pervades the centers of power:

We heard from the chairman of the Federal Reserve that unless we act the financial system of this country and perhaps the world will melt down…. There was complete silence for twenty seconds. The oxygen left the room.

Senate Banking Committee Chairman Christopher Dodd on a meeting of legislative leaders leading to the $700 billion Emergency Economic Stabilization Act of 2008.

If we don’t do this [authorize $700 billion] tomorrow, we won’t have an economy on Monday.

Federal Reserve Board Chairman Ben Bernanke.

We were looking at the abyss.

New York Federal Reserve Bank President (later Treasury Secretary) Timothy Geithner.