For automatic stabilizers

Simon has a good discussion on whether fiscal or monetary policy is better at stabilizing output. I’d suggest, though, that neither is in practice particularly good and that what we need instead are stronger automatic stabilizers.

I say so for a simple reason: recessions are unpredictable. Back in 2000 Prakash Loungani studied the record of private sector consensus forecasts for GDP and concluded that "the record of failure to predict recessions is virtually unblemished" – a fact which remained true thereafter.

The ECB, for example, raised rates in 2007 and 2008, oblivious to the impending disaster. The Bank of England did little better. In February 2008, its “fan chart” attached only a slight probability to GDP failing in year-on-year terms at any time in 2008 or 2009 when in fact it fell 6.1% in the following 12 months. Because of this, it didn’t cut Bank Rate to 0.5% until March 2009.  

Given that it takes around two years for changes in interest rates to have its maximum effect upon output, this means that monetary policy does a better job of repairing the economy after a recession than it does of preventing recession in the first place. And of course, as there’s no evidence that governments can predict recessions any better than the private sector or central banks, the same is true for fiscal policy.

All this suggests to me that if we want to stabilize in the face of unpredictable recessions, we need not just discretionary monetary or fiscal policy but rather better automatic stabilizers.

In this context, I’ve long been attracted to Robert Shiller’s proposals for macro markets. These would allow people vulnerable to recession - such as those in cyclical jobs or with small businesses - to buy insurance against a downturn. I can see why some of you might be sceptical about this: the sort of people who’d sell insurance against recession are the sort who’d be unable to pay out in the event of one. (As with all markets, so much hinges on precise details).

If private sector insurance markets don’t exist, the job of stabilization is better done by government. The most obvious measures here include more progressive taxation – so that falls in income are shared with government – and higher welfare benefits, both for the unemployed and for those who suffer drops in hours.

There’s something else. Another way to stabilize the economy is to ensure that there are fewer institutions that propagate risk – ones that turn small downturns into big ones. This means ensuring that banks are strong and well-capitalized, so that bad loans don’t deplete capital so much as to prevent lending to other companies.  Whether this is currently the case is questionable: UK banks capital ratios, for example, are still below the levels recommended by Admati and Hellwig.

It is measures such as these, rather than discretionary macro policy, which perhaps offers better hope for genuinely stabilizing output and jobs.

I suspect, though, that I’m making two more general points here.

One is that macroeconomic stability isn’t just a matter for macro policy. It’s also about the quality of institutions – the nature of the welfare state; how far financial institutions propagate risk; whether we have markets to pool risks or not; and so on.

The other is that the inability of policy-makers (and everybody else) to predict recessions is not some accidental contingent feature we can abstract from. A lack of foresight is an inherent part of the human condition. Policy must be based upon this big fact. This, of course, applies to much more than just macro policy. 

Comments

[Dipper]

"recessions are unpredictable."

unless we are talking Brexit, when they become really easy to predict, apparently.

Economists. Like Astrologers, but not as much fun.

[Ralph Musgrave]

Car owners have to insure against the catastrophically large costs involved in doing someone a permanent life impairing injury, which can be a good million pounds per person injured. Likewise there is absolutely no reason why banks should not have to insure against a similar third party risk: causing trillions of dollars of lost output when an economy tanks for five or ten years as a result of bankster incompetence.
If that insurance was imposed on banks, my guess is that the insurance premium for any bank with a capital ratio below the “Admati & Hellwig” ratio (about 25%) would be plain prohibitive. (Incidentally Martin Wolf goes along with that 25% ratio.)

But of course there is a huge obstacle to implementing that idea: the fact that bank regulators and politicians are such prats, that banksters can talk them into doing absolutely anything, including disappearing up their own (choose whichever orifice you like).

[Dipper]

@ Ralph Musgrave what are you on about?

"Likewise there is absolutely no reason why banks should not have to insure against a similar third party risk". They did this regularly. the problem in the financial crash was that the organisation they insured with, AIG, went bust.

Now they clear all wholesale derivative trades in clearers, so they are only at risk to Clearing houses. And no government is going to let one of those go bust.

The GFC happened because western governments and the US government in particular stoked a massive credit boom. when that fell off the rails, it took the whole system with it. Bankers are messengers, governments write the messages.

[UserFriendly]

There are ways to include automatic inflation protection with a JG, which would be by far the most effective demand stabilization program out there.
http://econintersect.com/a/blogs/blog1.php/the-job-guarantee-wage-price
http://econintersect.com/a/blogs/blog1.php/more-on-the-job-guarantee

[Ralph Musgrave]

Dipper,

Banks did not insure against the risk I'm on about: damage to the wider economy. They just insured agains damage to themselves.

[James Peach]

Headline capital ratios may be well below the levels proposed by Admati and Hellwig but you overlook the fact that there are auto-stabilisers built into financial policy in the form of counter-cyclical capital buffers.

[Mike W]

Ok Chris, I just placed an order for the Admati Hellwig book. If I don't like it I will come done to Rutland water and throw it to the trout in front of you!

I hope it will clarify your comment:

'this means ensuring that banks are strong and well-capitalized, so that bad loans don’t deplete capital so much as to prevent lending to other companies.'

Banks don't lend reserves or do they? If you have a pulse, bleed, and equity in your house, they just don't give a fuck about their reserve status or risk. 'Reserves' and issues around them right now, are a made up number produced by NeoLib economists in Switzerland for banks to sit around the table and discuss with politicians in London to keep the show rolling.

Banks are not an 'Industry' or 'business' in any meaningful sense of the word (just because they have a 'balance sheet', do PAYE and have 'PLC' after their logo? Really?) Rather they are a part of government. They are the executive.This is how they manage 'risk' and systemic failure. We all understand this now. Hope my new book outlines this in more detail.

Banks rule in peace time. The military rule in wartime. Neither organisation care much about the state of the people - until one hands over to the over. 'Fucking hell, these undersized, boney workers from the industrial cities will never be good infantry soldier', says every surprised british General since about 1870.

However, if the state has a 'Gyro' type payment system in place that can credit and debit every citizens, 'cash' only debit account - then the banks can go fuck themselves, and they can go under as their 'masters of the universe' wish. Then Banks would indeed be just another industry/business model in the market accepting the rules imposed by the politicians and courts and the voters (one hopes, of course, ultimately the prison officers).

I'm assuming when my new book comes this will be in the conclusion; and it won't be just another two Neolib economists dicking me about for 300 pages with a fake new 'Golden Reserve Rule' set at x or y % at the end.

If banks go under their creditors own them. Not the tax payer. Debt for equity: normal business insolvency rules for those shareholders stupid enough to buy into them. Then, only then, will the capital ratios count for something to someone.

[James Peach]

Mike you are correct in one sense but not another - banks do not lend reserves but they do need reserves in order to lend.

When banks lend they credit their customers' accounts, in turn creating a new liability. If it had no reserves the bank would be unable to settle any payments that the new borrower wanted to make. It would be illiquid. In practice reserves aren't really a constraint because the bank can get reserves (as long as it is solvent) from the central bank or the inter-bank market.

Chris' comment: "this means ensuring that banks are strong and well-capitalized, so that bad loans don’t deplete capital so much as to prevent lending to other companies" - is referring to the tendency of banks to reduce lending in a crisis in order to restore their capital ratios. When banks face losses, capital ratios fall. They can either raise more capital or reduce assets to increase capital ratios (given that simple capital ratio = capital/assets). In crises raising capital is difficult so in practice there is a tendency for banks to shrink lending. This creates a powerfully pro-cyclical feedback loop which can push the economy further in to recession. Having higher capital ratios (steady state and time-varying) is therefore essential if we want to reduce the amplitude of the business cycle.

[Matthew Springall]

OK so headline capital numbers dont gwt to thw adamanti/hellwig levels. But factor in MREL and we're not that far off (and growong rapidly). MREL has the added advantage of allowing more anticyclicality in how we treat banks capital.

Resolution regiemes and supporting legislation are by far the biggest part of the post crisis regulatory response. It honestly baffles me how much allegedly informed commwntry is written that doesnt even mention them! Including the asi article linked.

[Peach]

I am not sure MREL is procyclical. It operates by writing down debt which would reduce net asset positions. If net assets are drivers of consumption and investment then MREL will surely dampen them.

[Mike W]

Professor Peach,

Thank you for the clarification.I suspected as much. I really do have a copy of the book on its way too. (I am not a disgruntled former student given a poor mark ten years ago by Professor Hellwig!)

I even take some interest in the accounting detail. However, as you can see from my polemic, my concern is not academic progress in this field.

Is there something I can look at that desribes the actions of the banks in 2008 (when these rules were also widely accepted). My interest is broadly: the status of economists 'market based rules for banks', when the economic actors (banks) collectively understand that they are the government; even if the government executive itself has not fully grasped this fact.