...Archive for October 2011

Expectations can be frustrated

As the previous post suggests, I support targeting an NGDP path. I think an NGDP path target is superior in nearly every respect to an inflation target, and so would represent a clear improvement over current practice. [1]

But, unlike the “market monetarists”, I do not believe that central banks can sustainably track their target, whether NGDP or inflation, given the set of tools currently at their disposal. If those tools are (misguidedly) expanded to permit central banks to lend more freely or purchase a wider range of debt instruments, “success” might prove counterproductive. Although Scott Sumner and Bill Woolsey and Matt Rognlie hate the idea, I think we need to add direct-to-household “helicopter drops” to our menu of instruments. Ultimately, I have a different theory of depressions than the market monetarists do.

Self-fulfilling expectations lie at the heart of the market monetarist theory. A depression occurs when people come to believe that income will be scarce relative to prior expectations and debts. They nervously scale back expenditures and hoard cash, fulfilling their expectations of income scarcity. However, if everybody could suddenly be made to believe that income would be plentiful, everyone would spend freely and fulfill the expectations of plenty. The world is a much more pleasant place under the second set of expectations than the first. And to switch between the two scenarios, all that is required is persuasion. The market-monetarist central bank is nothing more than a great persuader: when “shocks happen”, it persuades us all to maintain our optimism about the path of nominal income. As long as we all keep the faith, our faith will be rewarded. This is not a religion, but a Nash equilibrium.

If the market monetarists’ theory of depressions is correct, then their position is correct. They are famously vague and prickly on the question of what instruments or “concrete steps” central banks will use to achieve their objective. That is because it doesn’t matter one bit, as long as those instruments are persuasive. Whether police wield pistols or tanks or tear gas or nightsticks to keep the peace really doesn’t matter, as long as their choice is sufficiently intimidating that people are deterred from resisting their authority. We only care about the weapon they’ve chosen when deterrence has failed and they are forced to act. Then we are faced with damage from the violence required to sustain their credibility. Even then, if we are certain they will restore order quickly and that incidents of disorder will be rare, we might not worry so much over means. But if conditions are such that lawlessness will not be deterred, there will be no general peace but frequent mêlées on the streets, then it matters very much how the police fight their battles. We start to ask whether the medicine is better than the side effects, whether police tactics are well tailored to improve the underlying conditions and restore a durable peace.

I have a Minsky/Mankiw theory of depressions. The economy is divided into two kinds of people, spenders and savers. Perhaps some people lack impulse control and have bad character, while others are patient and provident. Perhaps structural inequality renders some people hungry but cash-constrained, while others have income in excess of satiable consumption. Let’s put those questions aside and just posit two different and reasonably stable groups of people. Variation in aggregate expenditure is due mostly to changes in the behavior of the spenders. Savers spend at a relatively constant rate and save the rest. Spenders spend whatever they can earn or borrow, which varies with the level of wages, the cost of servicing debt they’ve accrued in the past, and the availability of new credit.

In this world, a central bank that targets something — NGDP, inflation, whatever — doesn’t regulate behavior via expectations. Instead, the central bank regulates access to credit and wages. When the economy is “overheating”, the central bank raises interest rates to increase debt servicing costs, tightens credit standards to diminish new borrowing, and if absolutely necessary squeezes so hard that a recession reduces spenders’ wages via unemployment. When the economy is below potential, the central bank reduces interest rates and relaxes credit standards, encouraging spenders to borrow and leaving them with higher wages net of interest payments.

This is a pretty good gig, it works pretty well, especially when the marginal dollar of expenditure is borrowed and easily regulated by the central bank. But if there are lower bounds on interest rates and credit standards, the scheme is not indefinitely sustainable. Even when spenders hold consistent, reasonably optimistic expectations about the economy, it becomes continually more difficult to persuade them to maintain their level of spending. The cost of debt service grows as their indebtedness grows, reducing their ability to spend. New borrowing becomes more difficult as wages are dwarfed by liabilities. Individuals become more nervous that some blip in their complicated lives will leave them unable to meet their obligations. In order to hold expenditure constant, interest rates must fall, credit standards must loosen, the value of spenders’ one consumption good that survives as pledgeable collateral — their homes — must be made to rise. Stabilizing expenditure requires continual easing. Any sort of lower bound provokes a “Minsky moment”, as expenditures that can no longer be sustained unexpectedly contract, rendering maxed-out spenders unable to service their debts.

All of this is just a theory, but I think it fits the facts better than a theory that takes stable demand and depression as arbitrary “sunspot” equilibria, selected by expectations. If the demand-stable “great moderation” had been an equilibrium, one might expect parameters like interest rates and aggregate indebtedness to be stable or to mean-revert around their long-term values. They were not. Interest rates were in secular decline throughout the period, and the indebtedness of some households to others was consistently rising as a fraction of GDP. Credit standards declined.

If my theory is right, absent significant structural change, attempting to restore demand merely by shocking expectations would be like trying to defibrillate a corpse. Yes, NGDP expectations absolutely did collapse over the course of 2008, but that was not due to a transient shock but a secular change which made the prior stabilization regime untenable. The housing collapse and credit crisis made it impossible to sustain expenditure by loosening credit standards. That left interest rates as the only tool by which to encourage spenders, but the zero nominal bound and rising credit spreads rendered that lever insufficient. Since 2008, whenever expectations have begun to perk up — and they have, several times — yet another “shock” has come along and returned us to pessimism (“OMG, Europe!”). Eventually you have to wonder whether there isn’t something more than arbitrary about these negative expectations.

The market monetarists might retort that a sufficiently determined central bank, if given license to lend and purchase assets as it sees fit, can always meet a nominal spending target, and therefore can always set expectations of nominal demand. That may be true. But in the context of an economy structurally resistant to increasing expenditure, expectations of stable nominal income become equivalent to expectations of continual central bank expansion. NGDP expectations can be maintained, if and only if the central bank demonstrates its willingness to continually intervene.

If intervention will be frequent and chronic, precisely what instruments the central bank intends to use becomes a matter of great public concern, rather than a technocratic detail best left to professionals. Central banks may significantly shape patterns of consumption and investment by choosing to whom they are willing to lend and on what terms. They may pick winners and losers, not for a brief Paul Volcker Chuck Norris moment but for the indefinite future.

So, I am all for targeting an NGDP path. I think it’s a great idea, and have more nice things to say about it. I hope the market monetarists are right, that merely by announcing an NGDP target and showing resolve in a one-time wrestling match with skeptics, central banks can restore a high-demand equilibrium. But if we adopt an NGDP target and are serious about it, there is significant risk that we will be committing to chronic intervention. The market monetarists owe us a more serious conversation than they’ve offered so far about how monetary policy would be conducted if resetting expectations turns out not to be enough. Would the interventions they propose be fair, if pursued cumulatively over many years? Would they be wise? Would they help resolve the structural problems that have rendered it so difficult to sustain demand, or would they exacerbate those problems?

[1] Yes, the US Federal Reserve has its murky triple mandate. But in practice tracking a tacit inflation target seems to dominate. Other central banks are at least explicit in their poor choice of a target.

Update History:

  • 29-Oct-2011, 7:10 p.m. EDT: Changed “a more durable peace” to “a durable peace”. “there is a significant risk” to “there is significant risk”.

The moral case for NGDP targeting

The last few weeks have seen high-profile endorsements of having the Federal Reserve target a nominal GDP path. (See Paul Krugman, Brad DeLong, Jan Hatzius and colleagues at Goldman Sachs.) This is a huge victory for the “market monetarists”, a group that includes Scott Sumner, Nick Rowe, David Beckworth, Josh Hendrickson, Bill Woolsey, Marcus Nunes, Niklas Blanchard, David Glasner, Kantoos, and Lars Christensen. Sumner in particular deserves congratulations. He has been on a mission from God for several years now, and has worked tirelessly to persuade us all that central banks should target NGDP, and that they have to ability to do so even after interest rates fall to zero.

I have reservations about the market monetarists’ project. I’m not certain that the Fed has the tools to meet an NGDP target, or if it does have the tools, that the costs of deploying them to establish its credibility are supportable. Moreover, I don’t think that the market monetarists have sufficiently thought through the consequences of success, in accounting terms, if they restrict themselves to lending to the private sector (or, equivalently, purchasing debt instruments from the private sector). The market monetarists have grown in parallel with another fringe monetary theory, MMT. The two groups don’t consider themselves aligned, but I think they are two sides of the same coin. It would be great if they would combine their insights — the market monetarists with their NGDP-targeting central bank, the MMT-ers with their concern for balance sheet health and their understanding that transfers-to-be-taxed deleverage private sector balance sheets while advances-to-be-repaid do not.

But such quibbles are for another time. Here I want to join the market monetarists’ happy dance, and point out several moral benefits of NGDP targeting.

  • The most plain moral benefit of NGDP targeting is that it is activist. Relative to the status quo, it demands a serious effort to combat the miseries of depression. This is a big improvement over our current strategy, which is to shrug off and rationalize mass deprivation and idleness.

  • A second moral benefit is that under (successful) NGDP targeting, any depressions that occur will be inflationary depressions. Ideally, we’ll find that once we stabilize the path of NGDP, the business cycle is conquered and there will be no more depressions ever again. But that probably won’t happen. If depressions occur even while the NGDP path is stabilized, then they will reflect some failure of supply or technology. Our aggregate investment choices will have proved misguided, or we will have encountered insuperable obstacles to carrying wealth forward in time. It is creditors, not debtors, whom we must hold accountable for patterns of aggregate investment. There always have been and always will be foolish or predatory borrowers willing to accept loans that they will not repay. We rely upon discriminating creditors to ensure that funds and resources will be placed in hands that will use them well. Creditors allocate capital by selecting the worthy from innumerable unworthy petitioners. An economic downturn reflects a failure of selection by creditors as a group. It is essential, if we want the high-quality real investment in good times, that creditors bear losses when they allocate funds poorly. When creditors in aggregate have misjudged, we must have some means of imposing losses without the logistical hell of endless bankruptcies. Our least disruptive means of doing so is via inflation.

    I do not relish inflation for its own sake, or advocate punishing creditors because they are rich and the tall poppies must be cut. But if, despite NGDP stabilization, real GDP cannot be sustained, someone has to bear real losses. There are only two choices: current producers can be taxed in order to make creditors whole in real terms, or past claims can be devalued so that losses are borne at least in part by creditors. In my view, the latter is the only moral choice, and the only choice that creates incentives for investors to maximize real-economic return rather than, say, hide behind guaranteed debt and press politicians to ensure the purchasing power of that debt is sustained regardless of the cost to aggregate wealth. (Sumner makes a similar point in his excellent National Affairs piece.)

    Note that NGDP targeting doesn’t prevent the honorable Austrian remedy to credit misallocation: having creditors individually to bear losses via default and/or bankruptcy of borrowers. When it is possible to equitize or liquidate particular claims quickly and without creating terrible costs for the rest of the economy, we should do so. Every completed restructuring promotes real activity by reducing valuation uncertainty and debt overhang, and so reduces the degree to which an NGDP targeting central bank will need to tolerate inflation and spread losses to creditors generally. We should try internalize the costs of credit decisions via default and bankruptcy as much as possible, as doing so keeps investment incentives sharp. (On a stable NGDP path, we don’t have to worry so much that loans that should have been good turned bad because of a scarcity of aggregate income.) But whether it is particular bad lenders who suffer or creditors in aggregate, current producers should not be forced to bail out the bad or unlucky investment decisions of earlier claimants.

  • In fact, NGDP targeting, despite the stench of sugar-high money games that Austrians perceive in it, might actually increase our ability to impose losses on foolish creditors via default and bankruptcy. This would pay a huge moral dividend, in terms of our ability to avoid the unfairness of arbitrary bail-outs. Both Nick Rowe and Scott Sumner have suggested to me that if we had sufficiently aggressive monetary stabilization, we could avoid acquiescing to “emergency” rescues that flamboyantly reward bad actors, because allowing bad actors to collapse would no longer threaten the rest of us. Rajiv Sethi has made a similar point:

    The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed’s intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries. While I do not subscribe to Baker’s view that Ben Bernanke “deliberately misled” Congress in order to gain approval for TARP, his main point still stands: if the Fed can increase credit availability to non-financial businesses and households by direct purchases of commercial paper, than why is any financial institution too big to fail?

    Perhaps we ought to think of “liquidationism” and stimulus as complementary rather than pin them to bitterly opposed camps. The palliative of stimulus might enable the medicine of consequences to work its pain without killing the rest of us. Obviously, fiscal and monetary interventions can be used to bail out failing incumbents, and as a matter of political economy, we might find ourselves unable to prevent this misuse. But precommitting to aggressive macro stabilization via tools that don’t discriminate in favor of particular firms or sectors might allow for more liquidation of bad claims than pretending we will be laissez-faire when the consequences of nonintervention would prove catastrophic.

  • In constrast to an inflation-targeting central bank, an NGDP-targeting central bank need not distort the division of income between capital and labor. Under current practice, the Fed tends to encourage asset price inflation but worries frenetically over any growth in unit labor costs, or, equivalently, labor’s share of income. Labor share of income has been collapsing since about 1970. I don’t mean to claim that the Fed has caused the collapse of labor share: globalization, automation, and deunionization would have put pressure on wages regardless of Fed action. But the credibility of the Fed’s consumer-inflation targeting regime is closely tied to moderation of wage growth. Managers, union leaders, and policymakers know that bargains whose effect would be to increase labor share might provoke contractionary monetary policy and even recession. This undoubtedly has had some effect. I don’t want to overattribute, but it seems more than coincidental that Rubinism and Clintonesque hypersensitivity to bond-market concerns arose after George H.W. Bush’s reelection was thought to have been crippled by cautious monetary policy and the jobless recovery it engendered. I think many labor-sympathetic observers view the Federal Reserve as an organization which tilts the scales against workers in subtle and unaccountable ways. I know that I do.

    An NGDP-targeting central bank trying to contract would be indifferent between restraining wage and capital income. Wage income growth puts more pressure on consumer prices than capital income growth, but under NGDP targeting it’s all nominal income. In practice, devils live in details, and how the Fed actually works to achieve its target might or might not be neutral. But labor has a better shot of being treated equitably under an NGDP-targeting regime than under an inflation target that is inherently threatened by wage growth.

It’s a bit ironic that the “market monetarists” are gaining prominence at the same time as “End the Fed” is a rallying cry of social movements across the political spectrum. It is a mistake to associate “End the Fed” solely with Ron Paul’s unpersuasive sound-money fetish. (Unpersuasive, because the Fed over its history has preserved the purchasing power of a dollar held in any financial instrument other than a mattress.) Many Americans, including me, feel a strong antipathy towards the Fed, not because of it has debauched the currency, but because we believe that it has played favorites in the economy and in politics, usually in the shadows but brazenly over the course of the financial crisis. We think the Fed behaves immorally and unfairly. An NGDP-targeting Fed could be a better Fed, in a moral as well as technocratic sense. I wish the market monetarists luck in trying to make it so.

Update History:

  • 25-Oct-2011, 3:30 a.m. EDT: Changed “Clintonesque hypersensitivity to deficits and bond-market concerns” to “Clintonesque hypersensitivity to bond-market concerns” in order to make an awkward sentence slightly less awkward.
  • 25-Oct-2011, 4:30 a.m. EDT: Changed “a loan” to “loans” to match plural subjects…
  • 25-Oct-2011, 11:45 p.m. EDT: Corrected misattribution of Sumner article to “Nation Interest”. The piece appeared in “National Affairs”. Many thanks to commenter Matt for calling attention to the error!

IOR caps: a new instrument of monetary policy?

As the MMT-ers emphasize, in aggregate bank lending is almost never reserve-constrained. Unless a central bank is willing to tolerate arbitrarily high interest rates, it must be willing supply reserves in response to increasing demand.

However, to point out that the banking system is not reserve constrained does not imply that individual banks are not reserve constrained. Macro types tend to assume there is an interest rate and an interbank market to which any bank can turn for reserves at the policy interest rate. But that’s simply not true, at least in the United States. Most banks do not regularly borrow at all on interbank markets, or at the central bank discount window. [1] The largest banks have ready access to interbank loans and use them to finance substantial portions of their balance sheets. But small banks do not. This is understandable. Borrowing in the “Federal Funds market” occurs via bilateral unsecured loan contracts. Small banks are perfectly comfortable lending to large, implicitly backstopped banks. But banks large and small are reluctant to make cheap unsecured loans to the Bank of Palookaville, whose exposure to the local Cadillac dealer is hard to evaluate from a distance. So small banks tend to amass precautionary stashes of reserves and lend them overnight to big banks, who may borrow at will. Prior to the financial crisis, the net reserve position of the largest 20% of US banks was negative. All of these banks’ reserves and then some were borrowed on the interbank market. That has changed since the Federal Reserve has flooded the banking system with cash, but small banks continue to devote a larger fraction of their balance sheets than large banks to reserves and near-reserves. While large banks happily rely upon central-bank guaranteed liquidity, small banks maintain buffers in case that abundance fails to trickle down. Aggregate lending cannot be reserve constrained, but lending by small banks may well be.

If small bank lending is reserve constrained, then policies that redirect flows of reserves from larger banks to smaller banks might be expansionary. At the margin, Bank of Palookaville is more likely to fund a loan if its reserve stockpile is well above what it requires for self-insurance. As the stockpile dwindles, a small bank’s cost of lending must include an increasing charge for the bank’s liquidity risk. There is evidence for this. In an influential paper, Kashyap and Stein famously documented a “bank lending channel” of monetary policy that operates predominantly through smaller banks.

But how could a central bank oppose the general tendency of reserves to flow from smaller to larger banks? Once the Fed buys an asset or makes a loan, the reserves are “out there”, no longer under its control. In the past, affecting patterns of reserve flow might have been difficult. But now the Fed pays interest on reserves, on terms that are entirely at its discretion. Suppose that the Fed were to cap, in absolute dollars, the quantity of reserves on which it is willing to pay interest to any single bank. Then banks with “too many” reserves would look to shed the excess, an unremunerated asset they need to finance. They might reduce the interest they pay (or raise the fees they charge) to depositors, which, at the margin, would cause funds to flow to banks whose reserve level is below the cap. Alternatively, reserve-heavy banks might lend their excess directly to smaller banks. This would allow the two banks would split the interest payment that would otherwise have been foregone, while reversing the usual direction of reserve flow in the interbank market. In either case, smaller banks might find any liquidity constraints they face substantially reduced.

The level at which reserve remuneration is capped would become a new instrument of monetary policy. The most contractionary setting would be where we are now, with no cap at all and the vast majority of excess reserves held by the largest banks. A hyperexpansionary policy would determine the cap by dividing the total quantity of excess reserves by the nearly 7000 US banks, unleashing forces of arbitrage that would inflate the balance sheet of every Podunk bank. Between these two poles there are infinite gradations, a tunable instrument of monetary policy.

Beyond the important but sterile dimension of “contraction” vs. “expansion”, there are other reasons to like this idea. Banking activity in the United States is quantitatively dominated by a small number of very large banks for whom the absence of reserve constraint is a competitive advantage. Reducing or eliminating the reserve constraint faced by small banks would even up the playing field. From a Hayekian perspective, status quo banking has devolved from an enterprise in which dispersed decisionmakers compete for advantage based on context-specific information towards a notionally private form of central planning, a Soviet backed by a few giant data-crunching hierarchies. If your inner Hayek is strong, you should applaud increasing the ability of small bankers to lend to people they know and projects they understand, while bearing much more of the risk than employees of large banks would. Smaller banks lend disproportionately to small and medium-sized enterprises, so if you think small entrepreneurs are at the heart of the economy, shifting activity towards smaller banks should help. Finally, small banks are not too big to fail. If we can’t break up the TBTF banks (I still hope we can), perhaps we can slowly deflate them by creating incentives for activity to migrate elsewhere.

Capping interest on reserves might or might not prove helpful. Quantitatively, I don’t think we have a sense of how much more lending would occur if small banks, like large banks, faced no liquidity constraint. On one hand, “the 99%” of banks currently account for only 22% of activity (measured by balance sheet size) and the smallest 90% of banks account for less than 8%. You can argue that with numbers like these, smaller banks just can’t make a difference. On the other hand, finance flows fast and the hyperconcentration of banking may prove reversible. An IOR cap has no financial cost, can be implemented at will, and would be expansionary at the margin however large or small the effect. Perhaps it is worth a try.

[1] According to bank call reports (June, 2011), only about 40% of US banks borrow funds from the interbank or repo markets. Both the fraction of banks that use interbank finance at all and the degree to which banks finance their assets in the interbank market strongly correlates with size. As of the most recent reports, 71% of banks in the largest size decile reported using some interbank or repo finance, which financed more than 4% of these banks’ balance sheets. Only 6% of banks in the smallest size decile reported any interbank or repo funding at all. Of these few small banks that do borrow reserves, interbank and repo finance accounts for only 2% of their funding. Prior to the financial crisis (September 2006), banks in the top decile relied on interbank and repo markets to fund roughly 9% of their (gigantic) balance sheets, while the smallest decile (all banks) received less than 1% of its funding from these markets.

Call reports are end-of-quarter snapshots, and so will undercount banks that transiently tap the interbank market to cover sporadic reserve shortfalls. But that would be true across deciles, and wouldn’t alter the lower frequency structure of interbank funding.

The lump of unfairness fallacy

Note: rootless_e asks over Twitter that I “please put in some explicit indication that TARP was [enacted under] Bush/Paulson because many people don’t recall”. I am glad to do so. I bring up TARP to illustrate a policy error, not to pin that error on Barack Obama.

Ezra Klein is a wonderful writer, but I don’t love his retrospective on the financial crisis. (Kevin Drum and Brad DeLong do.) The account is far too sympathetic. The Obama administration’s response to the crisis was visibly poor in real time. Klein shrugs off the error as though it were inevitable, predestined. It was not. The administration screwed up, and they screwed up in a deeply toxic way. They defined “politically possible” to mean acceptable to powerful incumbents, and then restricted their policy advocacy to the realm of that possible. The administration could have chosen to fight for policies that would have been effective and fair rather than placate groups whose interests were opposed to good policy. They might not have succeeded, but even so, as Mike Koncazal puts it, they would have lost well. We would be better off with good policy options untried but still on the table than where we are now, with policy itself — monetary, fiscal, whatever — discredited as both ineffective and faintly corrupt.

There is a lot in Klein’s piece that I could react to, but I want to highlight one point that is particularly misguided:

But when talking about what might have worked on a massive, economy-wide scale — that is to say, what might have made this time different — you’re talking about something more drastic. You’re talking about getting rid of the debt. To do that, somebody has to pay it, or somebody has to take the loss on it.

The most politically appealing plans are the ones that force the banks to eat the debt, or at least appear to do so. “Cramdown,” in which judges simply reduce the principal owed by underwater homeowners, works this way. But any plan that leads to massive debt forgiveness would blow a massive hole in the banks. The worry would move from “What do we do about all this housing debt?” to “What do we do about all these failing banks?” And we know what we do about failing banks amid a recession: We bail them out to keep the credit markets from freezing up. There was no appetite for a second Lehman Brothers in late 2009.

Which means that the ultimate question was how much housing debt the American taxpayer was willing to shoulder. Whether that debt came in the form of nationalizing the banks and taking the bad assets off their books — a policy the administration estimated could cost taxpayers a trillion dollars — or simply paying off the debt directly was more of a political question than an economic one. And it wasn’t a political question anyone really knew how to answer.

On first blush, there are few groups more sympathetic than underwater homeowners or foreclosed families. They remain so until about two seconds after their neighbors are asked to pay their mortgages. Recall that Rick Santelli’s famous CNBC rant wasn’t about big government or high taxes or creeping socialism. It was about a modest program the White House was proposing to help certain homeowners restructure their mortgages. It had Santelli screaming bloody murder… If you believe Santelli’s rant kicked off the tea party, then that’s what the tea party was originally about: forgiving housing debt.

This all sounds very hard-nosed. There were debts. There were economic losses, such that the debts could not be serviced at initially agreed terms. The consequences of leaving those unserviceable debts in place — frozen household spending, bankruptcy courts and litigation, blown up banks — were intolerable. Therefore, the losses were going to have to be socialized, borne by taxpayers, one way or another. Ultimately, in this view, it is all a matter of dollars and cents. The taxpayer is going to eat the loss, so what’s the best sugar to make the medicine go down?

But human affairs are not about dollars and cents. Santelli’s rant and the tea party it kind-of inspired were not borne of a financial calculation — “Oh my God! My tax bill is going to be $600 higher if we refinance underwater mortgages!” Santelli’s rant, quite legitimately, reflected a fairness concern. The core political issue has never been the quantity of debt the government would incur to mitigate the crisis. It was and remains the fairness of the transfers all that debt would finance. A fact of human affairs that proved unfortunately consequential during the crisis is that people perceive injustice more powerfully on a personal scale than at an institutional level. Bailing out the dude next door who cashed out home equity to build a Jacuzzi is a crime. Bailing out the “financial system” is just a statistic. So the anger Santelli channeled led to economically stupid bail-outs of intermediaries rather than end-debtors.

Once you understand that the problem is a fairness issue rather than a dollars-and-cents issue, the policy space grows wider. Holding constant the level of expenditure, one can make bail-outs more or less fair by the degree to which you demand sacrifice from the people you are bailing out. TARP was deeply stupid not because it meant socializing risks and costs created by bankers. TARP was terrible public policy because it socialized risks and costs while demanding almost no sacrifice at all from the people most responsible for those risks. The alternative to TARP was never “let the banks fail, and see how the bankruptcy system deals with it.” The alternative would have been to inject public capital (socialize risks and costs!) while also haircutting creditors, writing-off equityholders, firing management, and aggressively investigating past behavior. It was not the money that made TARP unpopular. It was the unfairness. And the unfairness was not at all necessary to resolve the financial problem.

If the Obama administration, or any administration, decided to encourage principal writedowns by having the government simply cover half the loss, that would be unfair. The Rick Santellis of the world might object more than I would, but that would be to my discredit more than theirs. Fairness should never be a policy afterthought. Widely adhered norms of fair play are among the most valuable public goods a society can hold. A large part of why the financial crisis has been so corrosive is that people understand that major financial institutions violated these norms and got away with it, which leaves all of us uncertain about what our own standards of behavior should be and what we can reasonably expect from others. When policy wonks, however well meaning, treat fairness as a public relations matter, they are corroding social infrastructure that is more important than the particular problems they mean to fix.

The good news is that there are lots of ways to craft good economic policy without doing violence to widely shared norms of fairness. See, for example, Ashwin Parameswaran’s “simple policy program“. On a less grand-scale, you’ll find that very few fairness concerns arise if underwater borrowers enjoy principal writedowns in the context of bankruptcy. Such “cramdowns” are consistent with a widely shared social norm, that society will grant (and creditors must fund) some relief from past poor choices to individuals who go through a costly and somewhat shameful legal process. Including mortgages and student loans in that uncontroversial bargain will piss-off bankers who wish to avoid responsibility for bad credit decisions. But it won’t provoke a revolution in Peoria.

The Obama administration campaigned on “cramdowns”, but ultimately decided not to push them. I wonder why? Perhaps Ezra Klein will explain how research by Reinhart and Rogoff shows that this too was inevitable.

Update History:

  • 9-Oct-2011, 1:25 a.m. EDT: Changed a “poor credit decisions” to a “bad credit decisions” to avoid repetition.
  • 10-Oct-2011, 1:35 a.m. EDT: Added note re enactment of TARP under Bush in response to rootless_e’s request.