Topic: Finance, Banking & Monetary Policy

A Monetary Policy Primer, Part 1: Money

It occurs to me that, despite the unprecedented flood of writings of all sorts — books, blog-posts, newspaper op-eds, and academic journal articles —  addressing just about every monetary policy development during and since the 2008 financial crisis, relatively few attempts have been made to step back from the jumble of details for the sake of getting a better sense of the big picture.

What, exactly, is “monetary policy” about?  Why is there such a thing at all?  What should we want to accomplish by it — and what should we not try to accomplish?  By what means, exactly, are monetary authorities able to perform their duties, and to what extent must they exercise discretion in order to perform them?  Finally, what part might private-market institutions play in promoting monetary stability, and how might they be made to play it most effectively?

Although one might write a treatise on any one of these questions, I haven’t time to write a thesis, let alone a bunch of them; and if I did write one, I doubt that policymakers (or anyone else) would read it.  No sir: a bare-bones primer is what’s needed, and that’s what I hope to provide.

Do Market Failures Justify Bank Capital Adequacy Regulation?

One of the most important elements of contemporary financial regulation is bank capital adequacy regulation — the regulation of banks’ minimum capital requirements.  Capital adequacy regulation has been around since at the least the 19th century, but whereas its previous incarnations were relatively simple, and usually not very burdensome, modern capital adequacy regulation is vastly both more complicated and more heavy-handed.

After I first began research on this subject years ago, I watched the Basel Committee take part in a remarkable instance of mission creep: starting from its original remit to coordinate national banking policies, it expanded into an enormous and still growing international regulatory empire.  Yet I also noticed that no-one in the field seemed to ask why we needed any of this Basel regulation in the first place.  What, exactly, were the market failure arguments justifying Basel’s interventions generally, and it’s capital adequacy regulation in particular?

We’ll Never Improve the Tax System by Clinging to Partisan Folklore

top marginal tax rates over time

A stubborn myth of the pro-tax left (exemplified by Bernie Sanders) is that the Reagan tax cuts merely benefitted the rich (aka Top 1%), so it would be both harmless and fair to roll back the top tax rates to 70% or 91%.

Nothing could be further from the truth. Between the cyclical peaks of 1979 and 2007, average individual income tax rates fell most dramatically for the bottom 80%  of taxpayers, with the bottom 40 percent receiving more in refundable tax credits than paid in taxes.  By 2008 (with the 2003 tax cuts in place), the OECD found the U.S. had the most progressive tax system among OECD countries while taxes in Sweden and France were among the least progressive.

What is commonly forgotten is that before two across-the-board tax rate reductions of 30% in 1964 and 23% in 1983, families with very modest incomes faced astonishingly high marginal tax rates on every increase in income from extra work or saving (there were no tax-favored saving plans for retirement or college).

From 1954 to 1963 there were 24 tax brackets and 19 of those brackets were higher than 35%.  The lowest rate was 20% -double what it is now.  The highest was 91%.

High and steeply progressive marginal tax rates were terrible for the economy but terrific for tax avoidance. Revenues from the individual income tax were only 7.5% from 1954 to 1963 when the highest tax rate was 91%, which compares poorly with revenues of 7.9% of GDP from 1988 to 1990 when the highest tax rate was 28%. 

Wonkblog’s Debt Denial

A Time article by James Grant warning about rising federal debt has prompted pushback by columnists questioning whether debt is really so bad. At the Washington Post, Wonkblog columnist Matt O’Brien says “there’s no reason to cut the debt today.” Fellow Wonkblog columnist Max Ehrenfreund suggests that Grant’s figure of $42,998 government debt per person overstates the problem.

O’Brien suggests that the only reason to fear debt would be if it was leading to a financial crisis, but it isn’t because interest rates are low. But O’Brien neglects to mention that interest rates may rise substantially in coming years. CBO projects that as rates rise, federal interest costs will triple from $253 billion this year to $839 billion by 2026.

As for Ehrenfreund, he is right that $42,998 overstates the debt problem because it does not take into account our future rising population. At the same, however, $42,998 understates the problem because each year the government adds more debt. Over the next 10 years, the U.S. population will grow 8 percent, but the CBO says federal debt will rise 69 percent. So Grant’s simple debt metric will increase over time.

Other than possibly causing a financial crisis, rising federal debt creates other harms:

Fannie and Freddie: Expropriation?

In the April 13, New York Times an article discusses developments in the civil proceeding between an owner of shares in Fannie Mae and Freddie Mac and the federal government over the latter’s decision in August 2012 to revise the terms of its conservatorship of Fannie Mae and Freddie Mac.  The original agreement stated that the U.S. Treasury would receive a 10 percent dividend on its 189.5 billion dollar injection of capital.  The revised terms gave all positive cash flows from Fannie and Freddie to the Treasury leaving little for the firms’ shareholders.  Granting a request from the government, materials produced under discovery in the case have been under seal.  Responding to a request by the New York Times the judge in the case has released two depositions.  In one the former chief financial officer of Fannie Mae said that she told Treasury officials before their 2012 decision that Fannie Mae would soon earn profits again and that she believes her briefing played a role in the government’s decision to alter the terms governing the conservatorship. 

For some background on this issue you should read my Working Papers column in the Fall 2014 issue of Regulation in which I discuss two papers relevant to the issue.  In “Stealing Fannie and Freddie,” Yale Law School professorJonathan Macey argues that the decision by the Treasury to take all of the profits now earned by Fannie and Freddie erodes the rule of law and violates shareholder rights.

In “The Fannie and Freddie Bailouts Through the Corporate Lens,” Adam Badawi, professor of law at Washington University, and Anthony Casey, assistant professor of law at the University of Chicago argue that in the third quarter of 2012, when the federal government changed the financial arrangements to take all future positive cash flows, the value of shareholder equity in Freddie alone was negative $68 billion.  That is, for the shareholders to earn anything, Freddie would first have to earn $68 billion, which was more than Freddie had earned in the 19 years prior to its financial difficulties (1988–2006). But if Freddie lost only $4 billion more (which is the amount of losses per week in 2008–2009), the senior preferred Treasury shares would be worthless.  The data for Fannie were even worse: it would have to earn $114 billion before common shareholders would earn anything, which is more than it had earned in the 27 years prior to the financial crisis.  The authors argue that when equity’s real value is negative, the directors’ duty to maximize the value of the firm is the practical equivalent of a duty to creditors and not shareholders.  The authors argue that the government’s actions are consistent with what we would expect from a private creditor and do not violate shareholder rights.

I think both papers may be relevant.  As my colleague Mark Calabria has argued the Treasury may have violated the spirit if not the letter of the law.  And in a commentary written at the time he argued creditors were advantaged rather than taxpayers.

But similar to the decision in the AIG case in which a judge ruled that the federal government exceeded its authority in its takeover of AIG but that the government owed no damages to shareholders, the damages to Fannie and Freddie shareholders also may be zero because at the time the firms had negative net worth and would continue to have negative net worth for the foreseeable future.

What’s Killing U.S. Growth

On April 6th, the Wall Street Journal published an editorial that merits careful examination: “Jack Lew’s Political Economy”. The Journal correctly points out that the Obama administration’s meddling with regulations and red tape is killing U.S. investment and jobs. The most recent example being the Treasury’s new rules on so-called tax inversions, which burried a merger between Pfizer, Inc. and Allergan PLC.

As the Journal concluded: “This politicization has spread across most of the economy during the Obama years, as regulators rewrite longstanding interpretations of longstanding laws in order to achieve the policy goals they can’t or won’t negotiate with Congress. Telecoms, consumer finance, for-profit education, carbon energy, auto lending, auto-fuel economy, truck emissions, home mortgages, health care and so much more.”

On Free Banking, Monetary Rules, and Crusades

I often find myself described, not as a monetary economist, plain vanilla or otherwise, but as a “free banker,” and (therefore) as someone who wants to “abolish” the Fed.  Yet I’ve also been accused of lacking consistency, and even of being an outright apologist for monetary central planning, because I also have some nice things to say about monetary rules in general, and about nominal spending rules in particular.

So, am I a free banker or not?  The short answer is…well, there isn’t a short answer other than “it’s complicated.”