Brookings Papers on Economic Activity: Spring 2009 - Brossura

Brossura

ISBN 10: 0815703376 ISBN 13: 9780815703372

Casa editrice: Brookings Inst Pr, 2009

Riassunto

Brookings Papers on Economic Activity (BPEA) provides academic and business economists, government officials, and members of the financial and business communities with timely research on current economic issues.

Contents:

Editors' Summary

The Financial Crisis: An Inside View By Phillip Swagel

Understanding Inflation-Indexed Bond Markets By John Y. Campbell, Robert J. Shiller, and Luis M. Viceira

Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending By Christina D. Romer and David H. Romer

Causes and Consequences of the Oil Shock of 2007-08 By James D. Hamilton

Why Doesn't Capitalism Flow to Poor Countries? By Rafael Di Tella and Robert MacCulloch, reviewing a previous edition or volume

Su questo libro

Informazioni sull?autore

The New Editors

David Romer is the Herman Royer Professor of Political Economy at Berkeley and is currently a senior resident scholar at the International Monetary Fund. He is director of the Program in Monetary Economics at the National Bureau of Economic Research and is a member of the NBER's Business Cycle Dating Committee.

JustinWolfers is an associate professor in the Business and Public Policy department at theWharton School. He is also a faculty research fellow with the National Bureau of Economic Research.

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Brookings Papers ON ECONOMIC ACTIVITY

BROOKINGS INSTITUTION PRESS

Copyright © 2009 THE BROOKINGS INSTITUTION
All right reserved.
ISBN: 978-0-8157-0337-2

Contents

Editors' Summary..........................................................................................................................viiPHILLIP SWAGEL The Financial Crisis: An Inside View......................................................................................1JOHN Y. CAMPBELL, ROBERT J. SHILLER, and LUIS M. VICEIRA Understanding Inflation-Indexed Bond Markets....................................79CHRISTINA D. ROMER and DAVID H. ROMER Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending.....................139JAMES D. HAMILTON Causes and Consequences of the Oil Shock of 2007–08...............................................................215RAFAEL DI TELLA and ROBERT MACCULLOCH Why Doesn't Capitalism Flow to Poor Countries?.....................................................285

Chapter One

PHILLIP SWAGEL Georgetown University

The Financial Crisis: An Inside View

ABSTRACT This paper reviews the policy response to the 2007–09 financial crisis from the perspective of a senior Treasury official at the time. Government agencies faced severe constraints in addressing the crisis: lack of legal authority for potentially helpful financial stabilization measures, a Congress reluctant to grant such authority, and the need to act quickly in the midst of a market panic. Treasury officials recognized the dangers arising from mounting foreclosures and worked to facilitate limited mortgage modifications, but going further was politically unacceptable because public funds would have gone to some irresponsible borrowers. The suddenness of Bear Stearns' collapse in March 2008 made rescue necessary and led to preparation of emergency options should conditions worsen. The Treasury saw Fannie Mae and Freddie Mac's rescue that summer as necessary to calm markets, despite the moral hazard created. After Lehman Brothers failed in September, the Treasury genuinely intended to buy illiquid securities from troubled institutions but turned to capital injections as the crisis deepened.

This paper reviews the events associated with the credit market disruption that began in August 2007 and developed into a full-blown crisis in the fall of 2008. This is necessarily an incomplete history: events continued to unfold as I was writing it, in the months immediately after I left the Treasury, where I served as assistant secretary for economic policy from December 2006 to the end of the George W. Bush administration on January 20, 2009. It is also necessarily a selective one: the focus is on key decisions made at the Treasury with respect to housing and financial markets policies, and on the constraints faced by decisionmakers at the Treasury and other agencies over this period. I examine broad policy matters and economic decisions but do not go into the financial details of specific transactions, such as those involving the government-sponsored enterprises (GSEs) and the rescue of the American International Group (AIG) insurance company.

I first explain some constraints on the policy process—legal, political, and otherwise—that were perhaps not readily apparent to outsiders such as academic economists or financial market participants. These constraints ruled out several policy approaches that might have appeared attractive in principle, such as forcing lenders to troubled firms to swap their bonds for equity. I then proceed with a chronological discussion, starting with preparations taken at the Treasury in 2006 and moving on to policy proposals considered in the wake of the August 2007 lockup of the asset-backed commercial paper market.

The main development following the events of August was a new focus on housing and in particular on foreclosure prevention, embodied in the Hope Now Alliance. The Treasury sought to have mortgage servicers (the firms that collect monthly payments on behalf of lenders) make economic decisions with respect to loan modifications—to modify loans when this was less costly than foreclosure. This approach involved no expenditure of public money, and it focused on borrowers who could avoid foreclosure through a moderate reduction in their monthly mortgage payment. People whose mortgage balance far exceeded the value of their home—so-called deeply underwater borrowers—would still have an incentive to walk away and allow their lender to foreclose.

But political constraints bound tightly in addressing this situation, since there was little appetite in Congress for a program that would transparently reward "irresponsible" borrowers who had purchased homes they could never have hoped to afford. Even after the October 2008 enactment of the Emergency Economic Stabilization Act of 2008 (EESA) gave the Treasury the resources and authority to put public money into foreclosure avoidance, the need to husband limited resources against worsening financial sector problems ruled out undertaking a foreclosure avoidance program at the necessary scale until after the change in administrations in January 2009. The foreclosure avoidance initiative eventually implemented by the Obama administration in March 2009, which took the form of an interest rate subsidy, was a refinement of a proposal developed at the Treasury in October 2007.

Returning to events on Wall Street, the paper picks up the chronology with the failure of Bear Stearns in early 2008, the rescue of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac that summer, and the failures of the investment bank Lehman Brothers and AIG the week of September 14, 2008. The run on money market mutual funds in the wake of Lehman's collapse led to a lockup of the commercial paper market and spurred the Treasury to seek from Congress a $700 billion fund—the Troubled Assets Relief Program (TARP)—with which to purchase illiquid assets from banks in order to alleviate uncertainty about financial institutions' viability and restore market confidence. However, as market conditions continued to deteriorate even after the early-October enactment of EESA, the Treasury shifted from asset purchases to capital injections directly into banks, including the surviving large investment banks that had either become bank holding companies or merged with other banks. The capital injections, together with a Federal Deposit Insurance Corporation (FDIC) program to guarantee bank debt, eventually helped foster financial sector stability. Even in late 2008, however, continued market doubts about the financial condition of Citigroup and Bank of America led the Treasury and the Fed to jointly provide additional capital and "ring fence" insurance for some of the assets on these firms' balance sheets. In effect, providing insurance through nonrecourse financing from the Fed meant that taxpayers owned much of the downside of these firms' illiquid assets.

The paper concludes with a brief discussion of several key lessons of the events of the fall of 2008. An essential insight regarding the policies undertaken throughout the fall is that providing insurance through nonrecourse financing is economically similar to buying assets—indeed, underpricing insurance is akin to overpaying for assets. But insurance is much less transparent than either asset purchases or capital injections, and therefore politically preferable as a means of providing subsidies to financial market participants. A second lesson is that maintaining public support is essential to allowing these transfers to take place. These two lessons appear to have informed the policies put into place in the first part of 2009.

I. Constraints on the Policy Process

Legal constraints were omnipresent throughout the crisis, since the Treasury and other government agencies such as the Fed necessarily operate within existing legal authorities. Given these constraints, some steps that are attractive in principle turn out to be impractical in reality, two key examples being the notion of forcing investors to enter into debt-for-equity swaps to address debt overhangs, and that of forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time they use the verb "force" (as in "The policy should be to force banks to do X or Y"), the next sentence should set forth the section of the U.S. legal code that allows that course of action. Otherwise the policy suggestion is of theoretical but not practical interest. Legal constraints bound in other ways as well, including with respect to modifications of loans.

New legal authorities can be obtained through legislative action, but this runs hard into the political constraint: getting a bill through Congress is much easier said than done. This difficulty was especially salient in 2007 and 2008, the first two years after both chambers of Congress switched from Republican to Democratic leadership. A distrustful relationship between the congressional leadership and President Bush and his White House staff made 2007 an unconstructive year from the perspective of economic policy, although, ironically, it had the effect of making possible the rapid enactment of the early-2008 stimulus: Democratic leaders by then appeared to be eager to demonstrate that they could govern effectively. More legislative actions were taken in 2008 as the credit crisis worsened and the economy slowed, but political constraints remained a constant factor in the administration's deliberations.

Political constraints were an important factor in the reluctance at the Treasury to put forward proposals to address the credit crisis early in 2008. The options that later turned into the TARP were first written down at the Treasury in March 2008: buy assets, insure them, inject capital into financial institutions, or massively expand federally guaranteed mortgage refinance programs to improve asset performance from the bottom up. But we at the Treasury saw little prospect of getting legislative approval for any of these steps, including a massive program to avoid foreclosures. Legislative action would be possible only when Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke could go to Congress and attest that the crisis was at the doorstep, even though by then it could well be too late to head it off.

Political constraints also affected the types of legislative authorities that could be requested in the first place, notably with regard to the initial conception of the TARP. Secretary Paulson truly meant to acquire troubled assets in order to stabilize the financial system when he and Chairman Bernanke met with congressional leaders on Thursday, September 18, 2008, to request a $700 billion fund for that purpose. One criticism of the initial "Paulson plan" is that it would have been better to inject capital into the system in the first place, since the banking system was undercapitalized, and asset purchases inject capital only to the extent that too high a price is paid. But Congress would never have approved a proposal to inject capital. House Republicans would have balked at voting to allow the government to buy a large chunk of the banking system, and Democrats would not have voted for such an unpopular bill without a reasonable number of Republican votes to provide political cover.

A final constraint was simply time. Decisions had to be made rapidly in the context of a continuous cascade of market events. Certainly this was the case by the week of September 14, 2008, when Lehman Brothers and AIG both failed; a major money market mutual fund, the Reserve Fund, "broke the buck," allowing its value per share to fall below the $1 par level; a panicked flight from money market mutual funds ensued; and then the commercial paper market locked up, with major industrial companies that relied on commercial paper issuance telling the Treasury that they faced imminent liquidity problems. This was the situation in which the TARP was proposed, and the decisions and actions surrounding its creation must be understood in the context of the events of that week. Time constraints meant that sometimes blunt actions were taken, notably the guarantees on the liabilities of AIG, of money market mutual funds, and several weeks later of banks' qualified new senior debt issues. A blanket guarantee is certainly not a preferred policy approach, but in the face of broad runs on the financial system, guarantees were needed to deal with the problems in real time.

Other impediments to decisionmaking were self-imposed hurdles rather than external constraints. Notable among these was chronic disorganization within the Treasury itself, a broadly haphazard policy process within the administration, and sometimes strained relations between the Treasury and White House staff that made it difficult to harness the full energies of the administration in a common direction. To many observers, the Treasury also lacked an appreciation that the rationales behind its actions and decisions were not being explained in sufficient detail; without understanding the motivation for each decision, outside observers found it difficult to anticipate what further steps would be taken as events unfolded. Part of the problem was simply the difficulty of keeping up, of providing adequate explanation in real time as decisions were being made rapidly, while another part was a lack of trust in the Treasury and the administration. Many journalists and other observers did not believe simple (and truthful) explanations for actions. For example, the switch from asset purchases to capital injections really was a response to market developments. It was too easy—and wrong—to believe that Secretary Paulson was looking out for the interests of Wall Street, or even of a particular firm, rather than the interests of the nation as he saw them. Whatever the reason, such communication gaps led to natural skepticism as the Treasury's approach to the crisis evolved in the fall. There were valid reasons behind the initial plan to purchase assets (even if many people found them inadequate), and valid reasons for the switch to capital injections. But the insufficient explanations of these moves led to skepticism and growing hostility in Congress and beyond to the rescue plan as a whole.

Notwithstanding these criticisms with regard to the Treasury, a paper such as this will inevitably be seen as defensive, if not outright self-serving. Since this is unavoidable, I simply acknowledge it up front. Other accounts of the credit crisis will come out in due course and can be correlated with the discussion here.

II. On the Verge of Crisis

Secretary Paulson, on his arrival at the Treasury in summer 2006, told Treasury staff that it was time to prepare for a financial system challenge. As he put it, credit market conditions had been so easy for so long that many market participants were not prepared for a financial shock with systemic implications. His frame of reference was the market dislocations of 1998 following the Russian debt default and the collapse of the hedge fund Long Term Capital Management (LTCM). Starting that summer, Treasury staff worked to identify potential financial market challenges and policy responses, both in the near term and over the horizon. The longer-range policy discussions eventually turned into the March 2008 Treasury Blueprint for a Modernized Financial Regulatory Structure. Possible near-term situations that were considered included sudden exogenous crises such as terror attacks, natural disasters, or massive power blackouts; market-driven events such as the failure of a major financial institution, a large sovereign default, or huge losses at hedge funds; as well as slower-moving macroeconomic developments such as an energy price shock, a prolonged economic downturn that sparked wholesale corporate bankruptcies, or a large and disorderly movement in the exchange value of the dollar. These problems were not seen as imminent in mid- to late 2006.

The focus at the Treasury was on risk mitigation beforehand and on preparing broad outlines of appropriate responses in the event that a crisis did develop, always recognizing that the details would vary with the situation. To help ensure smooth teamwork in the event of a problem, Secretary Paulson reinvigorated the President's Working Group on Financial Markets (PWG), which had been formed after the October 1987 stock market crash. The PWG brought together senior officials from the Treasury, the Fed, the Securities and Exchange Commission (SEC), and the Commodities Futures Trading Commission (CFTC) to discuss financial and economic developments and potential problems. The heads of these agencies met regularly to discuss market developments, and interaction at the staff level was both frequent and routine. Secretary Paulson also talked regularly in both public and private settings about the need for financial institutions to prepare for an end to abnormally loose financial conditions.

Treasury staff recognized that changes in financial markets since 1998 would affect the contours of any new financial crisis and the policy response. These developments generally had positive impacts in that they contributed to increased financial market efficiency, but they often increased complexity as well. Such developments included

—Deeper international capital market integration. Tighter linkages between financial markets in different countries lowered financing costs for U.S. borrowers, given the low national saving rate and the need to import capital to fund spending. But under some views of the international financial architecture, capital market integration also contributed to the housing bubble that helped precipitate the crisis.

—The rise of securitization. Financial assets of all types, including credit card debt, auto loans, and residential and commercial mortgages, were increasingly being packaged into ever more complex securities. Securitization reduced finance costs and contributed to stronger aggregate demand; it also allowed the risks of lending to be diversified more widely across market participants than if the loans had remained on bank balance sheets. These benefits, however, came with the downsides of increased complexity and diminished transparency. When problems with mortgage performance did emerge, the bundling of mortgages into securities made it difficult to gauge the distribution and magnitude of credit losses.

—The growth of private pools of capital. Hedge funds and private equity firms were becoming increasingly important players. The rise of these nontraditional asset managers should in general increase the efficiency of financial markets: the presence in the market of asset management approaches that include both long and short positions rather than just long would be expected to improve liquidity and efficiency. But these funds tend to be nontransparent; indeed, calls for increased disclosure of their trading positions are at odds with the hedge fund business model. Particularly in Europe, hedge funds were seen as the source of the next financial markets crisis. In the event, many hedge funds suffered massive losses in 2007 and 2008, and their deleveraging certainly contributed to the downward spiral in asset markets. But hedge funds do not appear to have been the fundamental source of the problem.

(Continues...)

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Dettagli dell?edizione

• Editore: Brookings Inst Pr
• Data di pubblicazione: 2009
• Lingua: Inglese
• ISBN 10: 0815703376
• ISBN 13: 9780815703372
• Rilegatura: Copertina flessibile
• Numero di pagine: 332
• Redattore: Romer David H., Wolfers Justin
• Contatto del produttore: non disponibile
• Persona responsabile: non disponibile