The GOP's Zombie Dodd-Frank Would Lose the Core Logic of Financial Reform

Sep 20, 2012Mike Konczal

Republicans might not repeal Dodd-Frank outright, but they'd eliminate the system of rules that make it work.

Republicans might not repeal Dodd-Frank outright, but they'd eliminate the system of rules that make it work.

It was just announced that Tim Pawlenty will become the head of the bank lobbying group Financial Services Roundtable. The powerful financial lobbying group, which represents groups like JP Morgan and Bank of America among other big financial sector players, appears to be aligning itself more closely with the Republican Party and betting on the idea that Republicans will control at least part of Congress. But what do they want? Earlier in the year, I argued in Washington Monthly that they'd like to repeal the core parts of financial reform.

Recently, Phil Mattingly had an article at Bloomberg Businessweek about how the GOP and Mitt Romney would approach Dodd-Frank. This is with a hat-tip to Reihan Salam who notes that this article "has confirmed something I’ve heard from well-informed insiders" and makes additional arguments [1]. So it seems well-sourced.

Mattingly's argument is that it is unlikely that the Republicans will outright repeal Dodd-Frank. "Instead, President Romney would likely try to give the financial industry something it wants more: a diluted financial reform law that would relax restrictions on some of its most profitable—and riskiest—investments but maintain enough government oversight to give the banks cover."

So what would the Republicans try to dilute and remove? Mattingly:

"Wall Street wants to loosen rules governing the swaps market, which generated $7 billion in revenue in the first quarter of 2012, according to government records. The banks would also get rid of restrictions on bank investment in private equity and hedge funds, pare back the power of the new federal consumer protection agency, and block the Volcker Rule, which bars banks from trading with money from their own accounts, a practice that can put customer deposits at risk. [...]

Wall Street doesn’t oppose everything in the law. Banks support the “resolution authority” that spells out how and when the government can seize and wind down struggling banks before they catastrophically fail."

So they want to go after derivatives rules (swaps), the Volcker Rule and the related law on restrictions on hedge fund investments, and also the CFPB. It's important to understand this isn't like removing random parts of the bill, as strict as they may be, but is instead gutting the core logic of the law. It's the equivalent of Republicans saying they'd keep the Obamacare bill, but stop the exchanges, remove the individual mandate, and lose the ban on pre-existing conditions while getting rid of the means-tested subsidies and Medicaid expansion. We'd understand that all of the parts of this system are interconnected and inseparable; the ban requires everyone to be in the market, which requires subsidies and well-developed markets.

Let's make sure we understand how derivatives, the Volcker Rule, and the CFPB all work together. Imagine that we're car engineers, and we want to design a car and road system so that if the car crashes, it does so as safely as possible. There are four things we can do. We can put airbags and seatbelts in the car and other cars so that when it does crash the damage is limited and controlled. We can design the car with things like a brake override system so that if it hits a rough patch the driver can keep control of it and make it less likely to crash.  We can put some speed limits on the road, as well as clear traffic signals to guide cars from running into each other. And we can have some protection for pedestrians, like cops watching for DUIs or barriers to prevent cars from driving into crowds of people. Easy, right?

Now let's think of Dodd-Frank. There are the legal powers that deploy to resolve a firm if it fails, like an airbag, which are called resolution authority. This allows the FDIC to take down a failed financial firm as if it were a bank, subject to serious rules and restrictions.  And, like requiring certain car features, there are specific policies for large, systemically risky financial firms, like enhanced capital requirements, limits to investments in risky hedge-funds, and the Volcker Rule, which are designed to make it less likely for a firm to crash.

Dodd-Frank also introduces speed limits and rules of the road in the financial sector, designed to make the system as a whole less likely to crash or spiral out of control when a panic does happen. One primary place it does that is through derivatives regulations. And "cops on the beat" is the metaphor for the Consumer Financial Protection Bureau.

So there's Dodd-Frank law to allow a firm to fail, law to make it less likely a financial firm fails, laws to prevent the interconnected financial markets from going into crisis if a firm does fail, and law to gives consumers a representative in dealing with the regulatory field. This is like thinking of Dodd-Frank as a system of deterrance, detection, and resolutiion, a related model we've developed elsewhere.

If Wall Street and the Republicans are looking to seriously gut the Volcker Rule, derivatives, and the CFPB, then they're looking to gut the entire logic of the bill. Interestingly, they are less interested in "resolution authority," the legal process to fail a financial firm. This is evidently no problem with everything else removed, perhaps because they believe congressional bailouts will then happen. This should remind us that resolution authority is strengthened and made more credible by other strong regulations, including things not in Dodd-Frank, like size caps or Glass-Steagall. Preventing these diluations is crucial to building a regulatory system for the financial sector that works in the 21st century.

[1] Reihan notes that banks "also understand that [Dodd-Frank] favors incumbents over new entrants, particularly incumbents with the legal acumen and lobbying resources to shape the emerging regulatory regime. My strong preference, very much in line with conservative and libertarian sensibilities, would be for a financial reform that would aim to facilitate rather than stymie entry."

I'd like to see more on how Dodd-Frank as blocking new firm entry works. While this is a generic complaint of regulations in general, I'm not sure in what ways it applies to Dodd-Frank. Parts of Dodd-Frank actually are designed to scale up with size and risk, e.g. Sec. 171 requires capital requirements to scale with "concentrations in market share for any activity that would substantially disrupt financial markets if the institution is forced to unexpectedly cease the activity," which is not for new entries. The idea is to hold larger and riskier firms to tougher standards and higher capital, which is regulation that scales with size.

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On the Occupy/Strike Debt "Debt Resistors'" Manual

Sep 14, 2012Mike Konczal

People have been talking a lot about the one-year anniversary of Occupy Wall Street. There is special interest with the movement's turn to organizing around the idea of debt as a "connective thread" for the 99%. The most recent issue of The Nation has two articles on the topic, with Astra Taylor witing "Occupy 2.0: Strike Debt" and David Graeber writing "Can Debt Spark a Revolution?"

People have been talking a lot about the one-year anniversary of Occupy Wall Street. There is special interest with the movement's turn to organizing around the idea of debt as a "connective thread" for the 99%. The most recent issue of The Nation has two articles on the topic, with Astra Taylor witing "Occupy 2.0: Strike Debt" and David Graeber writing "Can Debt Spark a Revolution?"

There's a Strike Debt/Occupy Wall Street group, and they have put out a Debt Resistors' Operations Manual, which is embedded here at the end of this post and available at that link as a pdf. You can pick up a hard copy of the document tomorrow, Saturday, in Washington Square Park from 10:30 a.m. till 7:30 p.m. and at Judson Church from 7:30 p.m. till 9:30 p.m.

Reading it, I agree with Yves Smith's assessment that it "achieves the difficult feat of giving people in various types of debt an overview of their situation, including political issues, and practical suggestions in clear, layperson-friendly language." You should read her review in its entirety, and check it out for yourself. I want to talk a little bit about it from a different angle, noting how each half of the book builds out a new direction for Occupy.
 
Over the summer, Jodi Dean argued that debt would be a difficult connective thread to pull off for a political movement. It's too individualized, too prone to viewing people as failed market agents, too moralized, and it can mimic unhelpful reactionary arguments against the welfare state and the government. I know people involved in organizing homeowners, especially underwater and deliquent homeowners, and I can say that these are all very accurate problems. Beyond that, nobody likes their identity as a struggling debtor. People can take pride in their role as workers, as citizens, and as numerous other things organizers can build on, but debt is a real challenge. The failure part runs deep.
 
So there's a couple of interesting things in the Strike Debt booklet that I think are useful as a political statement. The first half of the book is about the major types of consumer debt -- medical, housing, education, and credit card -- as well as the credit scoring agencies. And the book places runaway consumer debt in the context of larger institutions that are failing to meet the needs of the population.
 
The medical debt chapter calls for universal health care, the student debt chapter calls for free public colleges, and the credit card chapter is titled "The Plastic Safety Net," directly alluding to weakness in income maintence and basic income support. The credit scoring chapter points out how these debts, and your ability to pay them, are tied to your ability to gain access to basic needs like utilities, phone lines, and health care.
 
These are all essential goods for our lives, and we choose the institutions that will deliver them. They can be publicly provided, based in principles of social insurance, decommodification, and access independent of wealth. Or they can be provided in individualized ways, ones that replace social insurance with self-insurance through individualized, large debt loads, while also working to the benefit of private agents.
 
But these are both choices. And this focus on debt is a way of understanding the wrong choices we've made as a society in providing for these goods, and who benefits and who loses from them. People should understand their debts as part of a system's design, rather than its failure. If developed, it could turn into a powerful statement for the commons and for a more progressive and social democratic approach to all of these topics.
 
It also approaches the 1 percent issue in a new way. Instead of a lot of arguments about the just deserts of the richest, the 1 percent and the "financialized" sectors of the economy are those who profit from inserting themselves between social goods and those who desperately need them. The second half of the book focuses not on individual debts but structures that benefit creditors. From municipal debt to the "expensive to be poor" areas of fringe finance to debt collection and bankruptcy, there's a whole series of institutions that work against debtors, the poor, and civic infrastructure.
 
Here the banks aren't just nefarious agents taking too much of the pie; they are the people overcharging the poor to be able to cash a check or otherwise engage in trade. They are the people ignoring the Fair Debt Collection Act, harassing your family on old debts they bought on the cheap. And they are the ones privatizing municipal structures, collecting the gains while socializing the losses. And that's a new way of understanding the 1 percent's power, and how to resist it, and ultimately overcome it in the kind of world we want to build, which is a major step forward.
 
As Astra Taylor wrote in her Nation piece, "As individuals, many of us are in debt because we have to borrow to secure basic social goods—education, healthcare, housing and retirement—that should be publicly provided. Meanwhile, around the world, debt is used to justify cutting these very services, even as the game is further rigged so that the 1 percent continues to profit, raking in money from tax cuts, privatization schemes and interest on municipal and treasury bonds."
 
Will it be enough to spark a genuine political movement? Who knows. But it is a document worth your time, and the issues it brings up will hopefully form a core narrative of all future political struggles.

Occupy Wall Street/Strike Debt: The Debt Resistors' Operations Manual

 

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The Problem of Committing Against Bailouts

Aug 22, 2012Mike Konczal

Economist Robert Stein had a recent post at the American Enterprise Institute about ending Too Big To Fail (h/t James Pethokoukis). His major advice, which frames the rest of his argument, is that "Ideally, the federal government would end Too Big To Fail (TBTF) by credibly pre-committing not to bailout large financial firms when they run into trouble."

Economist Robert Stein had a recent post at the American Enterprise Institute about ending Too Big To Fail (h/t James Pethokoukis). His major advice, which frames the rest of his argument, is that "Ideally, the federal government would end Too Big To Fail (TBTF) by credibly pre-committing not to bailout large financial firms when they run into trouble."

There's some other problems with the piece [1], but I want to run with this statement. The implication is that the Dodd-Frank financial reform act doesn't do such things. Let's take a second and document what Dodd-Frank does in terms of pre-committing to avoid bailing out a large financial firm, and where the problems with such a process could really occur.

Federal Reserve: Dodd-Frank strips out previous language from the Federal Reserve Act that was used to execute the (unpopular) emergency lending facilities (Sec. 1101). The Federal Reserve can no longer use its 13(3) powers to, in "unusual" circumstances, provide support for an "individual, partnership, or corporation." That language has been removed, and replaced with "program or facility with broad-based eligibility.” Dodd-Frank explicitly writes into the Federal Reserve Act that "any emergency lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company." Going further it writes "The Board shall establish procedures to prohibit borrowing from programs and facilities by borrowers that are insolvent."

Provided we want the Federal Reserve to act as a lender-of-last-resort, this is a proper way to do it. At one point, even Richard Shelby seemed to think these reforms were the right approach.

Activating Resolution Authority: Now let's look at what is required to activate an orderly-liquidation action, or what is often called resolution authority. This is the FDIC taking over a failing financial institution and winding it down. If you've seen movies where two people need to turn their key to activate a nuclear weapon, then you'll understand that there's a three-key mechanism for resolution authority (Sec. 203).

The Treasury Secretary, after consulting with the President, needs to determine whether resolution is an appropriate path for a firm, one where "the failure of the financial company and its resolution under otherwise applicable Federal or State law would have serious adverse effects on financial stability in the United States." The Treasury Secretary then needs the recommendation of 2/3rds of the Board of Governors, as well as 2/3rds of FDIC (with the SEC replacing the FDIC for brokers and dealers, and the Federal Insurance Office for insurance companies), to approve going forward with resolution. So you have three institutions who have to turn their keys for resolution to go, institutions including both independent regulators and people with politicial accountability.

What should guide the recommendation for the Board of Govenors and the FDIC? Their written recommendation requires "an evaluation of the likelihood of a private sector alternative to prevent the default of the financial company" as well as "an evaluation of why a case under the Bankruptcy Code is not appropriate for the financial company." The default setting in the law is that the private sector alternative is always better to government action, and that the Bankruptcy Code is always better than resolution. This is consistent with the logic of those who want the government to pre-commit to as little action as possible.

Executing Resolution Authority: If the FDIC starts to resolve a failing financial company using its liquidation powers, what strict, legal limitations does it have to follow? There's a section titled "Mandatory Terms and Conditions for all Orderly Liquidation Actions" (Sec. 206) that can give us a start. If there's a liquidation, the FDIC has to wipe out shareholders if necessary ("ensure that the shareholders of a covered financial company do not receive payment until after all other claims and the Fund are fully paid") and hit creditors ("ensure that unsecured creditors bear losses in accordance with the priority of claim provisions").  The government isn't allowed to redo TARP or AIG and buy equity in the firm to keep it alive ("not take an equity interest in or become a shareholder of any covered financial company or any covered subsidiary"). The FDIC can't act for "the purpose of preserving the covered financial company."

They also have to fire management ("ensure that management responsible for the failed condition of the covered financial company is removed") and fire board members ("ensure that the members of the board of directors...are removed") by law. There's explicit legal language to allows FDIC to claw back compensation (Sec. 210, "may recover from any current or former senior executive or director substantially responsible for the failed condition of the covered financial company any compensation received during the 2-year period preceding"). It's difficult to imagine a firm really excited about going through such a procedure.

The Problem: Dodd-Frank goes out of its way to pre-commit against further bailouts. The problem with pre-committing against bailouts isn't Dodd-Frank; it's that the financial sector broadly will be too unstable and that Dodd-Frank won't have sufficient reforms in place to keep that in check. Remember the bailouts of 2008 were the results of GOP-appointed Hank Paulson, GOP-appointed Sheila Bair and GOP-appointed Ben Bernanke, all with the support of a Bush White House-sponsored EESA, going to Congress and asking that an emergency bill be passed to allow for TARP. Dodd-Frank cannot prevent that from happening again no matter what its precommittments are. No law can prevent Congress from acting in such a way. The best that can be done is set up the basic legal structures of the financial industry to make it so it isn't prone to collapse and abuses, and when there is failure to make sure losses are allocated in a fair way.

[1] Stein also proposes that "One way to signal this intent would be phasing out deposit insurance, a cornerstone of the government’s involvement in 'safeguarding' the financial system." Mark Calabria at Cato has called for capping deposit insurance access from its current 10 percent to 5 percent as anti-TBTF policy; Tim Carney and Matt Yglesias like this idea as well.

Let's graph out the size of major financial institutions in both their deposit and non-deposit dimensions, using a chart I use to help explain the SAFE Banking Act that would Break Up the Banks:

If we had to place Lehman Brothers or Bear Stearns, the shadow banks that caused the market panic, the shadow banks that need to be folded under traditional banking regulations, on this graph, it would clock in more like Morgan Stanley than Wells Fargo. You could proceed with such a 5% cap on deposit liabilities - though Treasury would tell you that it just forces banks to go into the more prone-to-panic and poorly regulated non-deposit/repo market for funding, as you can see from Bank of America above - but it would regulate Wells Fargo more than it would regulate firms like Citigroup, Goldman Sachs or Morgan Stanley, or the firms where the focus should be.

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What's the Best Liberal Case Against Principal Reduction?

Aug 21, 2012Mike Konczal

Binyamin Appelbaum has an article in the New York Times about the administration’s terrible response to the housing crisis.

Binyamin Appelbaum has an article in the New York Times about the administration’s terrible response to the housing crisis. The administration “tried to finesse the cleanup of the housing crash, rejecting unpopular proposals for a broad bailout of homeowners facing foreclosure in favor of a limited aid program — and a bet that a recovering economy would take care of the rest.” This has several responses, including David Dayen at firedoglake, as well as Ezra Klein writing about the administration's response from a balance-sheet recession and housing point of view. That got a response from Dean Baker arguing that this balance-sheet recession point of view, and the subsequent focus on mortgage debt reduction, is a distraction from better policy.

With President Obama pushing for a wider refinancing plan and the debate over refinancing and principal reduction back in the headlines due to the book Bailout and the fight over the GSEs, it might be useful to formalize the best liberal case against principal reduction. It'll give us a set of arguments to wrestle with so that we can then work backwards toward better arguments. So what is the best case? I see three broad arguments.

1. Wealth Effect Means It Doesn't Matter

This is the approach Dean Baker takes, and I think it is influential among many liberal wonks. The housing crashed destroyed a lot of housing value, leaving us feeling poorer, which means we spend less. An important way to understand this argument is that if every house during the housing bubble was paid for with cash instead of a mortgage, and we had the same housing bubble and crash but no mortgage debt overhang, our recession and slow recovery would look virtually identical. Reducing housing debt in our situation won't help the economy as a whole (though it will help the individuals involved), because housing debt hanging on the economy isn't the drag.

Foreclosures are still bad in this argument (and Dean has been at the forefront of fighting against foreclosures), but they only need to be stopped in the sense that all bad things should be stopped; housing crisis policy will help some and hurt some, but it isn't a check on the recovery. It is not necessary and isn't effective in getting us back to full employment.

I think there are some empirical problems with this argument. The elasticities people are finding are an order of magnitude bigger than realistic expectations. Declines in housing prices are nonlinear against wealth distribution. Something else is in play. See this interview or this paper for more on these arguments. The administration seems to be moving in this balance-sheet direction. Let's say we reject this wealth effect argument -- should we change policy?

2. Fiscal and Monetary Uber Alles

Christina Romer would say no. She, like many, would argue that housing debt is probably a drag on demand, but we should respond to it with fiscal and monetary stimulus. She would stay out of the policy in the purple circle above, which is the mapping I use around here to approach how people think of the recession. Romer, from September 2011:

[One argument is that the] bubble and bust in house prices has left households burdened with too much debt. Until we deal with this problem — perhaps by providing principal relief to the 11 million households whose mortgages are larger than the current value of their homeswe’ll never get the economy going.

The premise of this argument is probably true: recent evidence suggests that high debt is holding back consumer demand. But it doesn’t follow that the government needs to directly lower debt burdens to stimulate job growth.

Recent research shows that government spending on infrastructure or other investments raises demand even in an economy beset by over-indebted consumers. Another effective approach is to aim tax cuts and government payments at households that would like to spend, but can’t borrow because of their debt loads (such as the poor and the unemployed).

History actually suggests that the “tackle housing first” crowd may have the direction of causation backwards. In the recovery from the Great Depression, economic growth, which raised incomes and asset prices, played a big role in lowering debt burdens. I strongly suspect that fiscal stimulus will be more cost effective at speeding deleveraging and recovery than government-paid policies aimed directly at reducing debt.

There's a general critique of the president's stimulus program that argues it was too focused on tax cuts instead of long-term investments, which have a better bang for the buck. The same critique can be used on spending money on principal reduction. It's money that by definition isn't spent (it was already spent), so you need second-order effects for it to go. We'd prefer just giving people money (tax cuts) over principal reduction in the same sense that we'd prefer infrastructure over tax cuts.

And one doesn't need to be a conservative worried about helping the "losers" or someone who is uncomfortable with the fairness of mortgage debt reduction to think there are better ways to spend this money. Consider having $250 billion dollars to spend, one benchmark put forward as the amount of money that could have been spent from TARP. You could hand it out in some manner to pay off underwater debts, perhaps a matching scheme with the banks. That wouldn't reduce overall mortgage debt that much because there is a lot of it.

Meanwhile, with $250 billion dollars, you could build 5,000 miles of high-speed rail. You could fund universal pre-K for a decade. You could take the 13 million people unemployed under the traditional unemployment measure and give them a basic income of almost $10,000 for two years. You could build infrastructure, create social goods designed to foster egalitarianism, or tackle poverty. These are all better investments for us to make, plus they build a better society and they get us to full employment faster. Tackling mortgage debt produces none of these benefits.

When Geithner's argued against principal reduction, saying that it would be "dramatically more expensive for the American taxpayer, harder to justify, [and] create much greater risk of unfairness," he followed it up by saying "The whole foreclosure crisis across the country now is really driven by what happened to unemployment and what happened to the income of Americans. The best things we can do now to help mitigate that risk is to help get the economy. growing again, bring unemployment down as quickly as we can, put people back to work." I view that as in line with Romer's argument.

By itself, I think this is correct. But one important response to that is that principal reduction can often pay for itself, especially in situations where a borrower is at risk. A lender will want a consistent, if lower, payment stream rather than to take ownership of an abandoned house in a depressed market. As Lew Ranieri said, "You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure." So it is good economics, especially in a distressed market. Another response is that few people propose just giving money away, but instead want to tie it to some sense of risk and reward, or reaccounting of the banks' balance sheets. So how does that play out?

3. Upsides and Downsides

One reason giving away money to pay off underwater debts is a bailout, and thus politically unpopular, is that there would be a disconnect between who absorbed the costs on the downside and who gains the potential value from the upside. If taxpayers just paid off mortgage debts, banks and homeowners would gain a windfall that isn't directly shared with taxpayers. One way to deal with this is either to force creditors to eat a cost upfront -- they absorb the downside and then can benefit from the upside. The other is for taxpayers to gain from the upside, usually through the mass purchase and/or refinancing of mortgages. Let's look at the first way.

Why aren't bank servicers doing writedowns? There's a mix of bad incentives and poor resources that result in bad practices. The administration hasn't been aggressive with using financial fraud, like the range of practices including robosigning and documentation fraud, to force reform here, instead focusing on removing legal liabilities from the banks. Maybe that task force will someday do something, but from my read even sympathetic observers think it was a wasted opportunity. 

But even if policy is centered on forcing servicers to clean up their fraud, there's a lot of creditor free-riding in ad hoc debt writedowns that becomes problematic. Is writing down first mortgages good policy even if junior mortgages, often held by the biggest banks, are untouched? If home equity lines of credit are acting as a last line of income maintenance and credit for households in this weak recovery, is it wise to push policy to extinguish them to adjust first mortgages? If you wipe out both, isn't that a giant transfer to other creditors like auto lenders, private student loans, and credit card companies? Should we be concerned about moral hazard from the debtor's side? You need some mechanism to coordinate and bind the collective behavior of creditors while preventing free riding and also bringing in impartial adjudication, which is a traditional function of bankruptcy. Bankruptcy reform was famously not pushed by the administration, and to me that was its biggest mistake.

The other approach to avoid a bailout is for the government to gain a share of the upside for taking on the downside. This is one reason writedowns for the GSEs make sense: we gain the upside, as we own the GSEs, and we're already on the hook for the downside, so the risk on the downside isn't a "bailout" but prudent policy.

When it comes to dealing with the broader housing market, a lot of the programs proposed, like revitalizing HOLC or Senator Merkley's plan on refinancing, would have taxpayers put up money but gain in the upside. Even the IMF is now encouraging the United States and other countries to investigate bringing back something like an HOLC. The two counter-arguments would be that HOLC still had a high redefault rate, a rate that would have a lot of people crying foul. The second is the problem of what to pay for the mortgages. Recent attempts to use eminent domain to purchase mortgages at below-market rate in order to compensate taxpayers for absorbing these risks in a terrible market also have a lot of people crying foul.

My general thought is that moral hazard can be a problem, but the misery and wasted lives of mass unemployment is a much bigger problem. That said, bankruptcy and these government programs eliminate most moral hazard concerns. Bankruptcy can be done in such a way to hit homeowners as well; for the government program you'd want people to be trying to take advantage of them. That's why so many people have been shocked that the administration hasn't pushed on either.

What I find interesting is that all these articles about what could have been done with housing take the way TARP played out as given. But starting a HOLC program, rebooting the broken servicing model, or otherwise writing down mortgage principal would have been significantly easier if the banks were put into a receivership in early 2009. TARP policy, which was to protect the banks' balance sheets at all costs, worked counter-productively, putting administration resistence to enacting even the lowest-hanging policy fruit. Receivership would have cost more upfront, but it would have been significantly easier to tackle these problems. There is a major debate to have on this topic.

 

Mike Konczal is a Fellow at the Roosevelt Institute. Follow or contact the Rortybomb blog:

  

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Paul Ryan Really Doesn't Like Dodd-Frank

Aug 13, 2012Mike Konczal

Beyond thinking Dodd-Frank generally was a bad bill, he's voted against most of its individual pieces.

The entirety of Romney's plan for financial reform in the wake of the 2008 crisis is contained in the following sentence: "Repeal Dodd-Frank and replace with streamlined, modern regulatory framework." One might argue that this is vague enough to cause some of the dreaded economic policy uncertainty, but either way it is very unclear about what exactly financial regulation should involve.

Beyond thinking Dodd-Frank generally was a bad bill, he's voted against most of its individual pieces.

The entirety of Romney's plan for financial reform in the wake of the 2008 crisis is contained in the following sentence: "Repeal Dodd-Frank and replace with streamlined, modern regulatory framework." One might argue that this is vague enough to cause some of the dreaded economic policy uncertainty, but either way it is very unclear about what exactly financial regulation should involve.

This might change with Paul Ryan. Not only is Ryan well known for his wonky style, but he voted for TARP, the Wall Street bailout. He also went to the floor of the House and asked his fellow Republicans to vote for TARP. One would imagine he would think that the status quo is flawed if he had to vote for TARP to save the economy. Alas, Paul Ryan voted against the Dodd-Frank Wall Street Reform and Consumer Protection Act, the major financial regulatory response to the crisis.

(It might be worth noting that Public Citizen did an analysis that found that House members who voted for TARP and against Dodd-Frank, a club Paul Ryan belongs to and consists mostly of Republicans, received three times as much campaign money from the financial industry as those that voted the opposite in both cases. As Zach Carter pointed out in an analysis back in 2010, of the 60 Republican House members who voted for TARP and against Dodd-Frank, Paul Ryan received the ninth highest donation from the financial industry in 2010, with a haul of at least $531,500 for the year.)

So Paul Ryan is against Dodd-Frank as an overall bill. He also seeks to repeal it in his budget. But what does Ryan think of the individual parts of Dodd-Frank? One could be opposed to Dodd-Frank as a whole while still thinking individual parts are good ideas. In order to isolate that question, we can look at a series of Dodd-Frank amendments Ryan voted on, as well as subsequent actions and statements.

Consumer Protection: While the bill that became Dodd-Frank was going through the House, Ryan voted to scrap the Consumer Financial Protection Agency and replace it with a plan proposed by the Chamber of Commerce. Right before Dodd-Frank came up for a vote in the House, there was an amendment proposed by Rep. Walt Minnick (D-ID) to replace the CFPA with a council of existing regulators. According to reports from the time, this was modeled off suggestions from the Chamber of Commerce. The amendment failed, though Paul Ryan voted for it. Beyond concerns of accountability or funding of the CFPB, Paul Ryan would likely rather see the entire thing go.

Derivatives Regulation: Part of Dodd-Frank requires that derivative contracts trade through a clearinghouse. We don't have a clear vote from Ryan that shows what he thought of derivatives at the time, but he did vote against the Lynch amendment. Stephen Lynch (D-Mass) proposed a simple amendment stating that a financial firm can't own more than 20 percent of a derivatives clearinghouse to prevent conflicts of interest. Later, Ryan also voted to delay the implementation of derivative regulations for one year in June 2011, signaling he doesn't approve of the aggressive derivatives reforms people like Gensler are championing at the CFTC. This contrasts him sharply with someone like John Hunstman, who had very strong derivatives reform as part of his broad, serious financial reform ideas during the Republican primary.

Resolution Authority: Ryan voted for the repeal of resolution authority -- indeed, he sponsored the legsliation to repeal it. Resolution authority, or orderly liquidation authority, is a new set of legal abilities that allow the FDIC to take over and wind down a failing financial firm. When Barney Frank says that his bill actually has a death panel in it, he's referring to this part.

We can get a bit specific with why Ryan likely did this. In his Path to Prosperity, Ryan makes two points in argument against resolution authority. The first is that it "intensifies the problem of too-big-to-fail by giving large, interconnected financial institutions advantages that small firms will not enjoy." As Barney Frank and others point out, there's not evidence that banks are actively seeking to be designated as systemically risky. The general read is that business are going out of their way to avoid that designation, even restructuring away from risky activities. Which is the point.

The second critique is that "Federal Deposit Insurance Corporation (FDIC) now has the authority to access taxpayer dollars in order to bail out the creditors" and will presumably use it, preserving Too Big to Fail. Depending on who is talking, this usually refers to either the FDIC’s ability to provide “an immediate source of liquidity for an orderly liquidation, which allows continuation of essential functions and maintains asset values” or its ability to repay creditors.

Dodd-Frank requires that the FDIC's responsibilities include ensuring "that unsecured creditors bear losses in accordance with the priority of claim,” that shareholders receive nothing "until after all other claims and the Fund are fully paid" and that any losses remaining afterward that could impact Treasury are repaid through assesments on systemically risky financial institutions. In order to avoid situations like AIG, the FDIC is explicitly prohibited from taking "an equity interest in or become a shareholder of any covered financial company or any covered subsidiary" during resolution. Management has to be fired. Taxpayer money is recouped and bailouts avoided.

Title II is built to avoid looking like a bailout, self-consciously so. If the critique is about the powers to differentiate payments, those powers, as Douglas G. Baird and Edward R. Morrison noted about the powers, look like critical vendor orders or other parts of bankruptcy powers. By all accounts the FDIC rules are being written in this manner.

Bankruptcy: Speaking at a town hall, Ryan has seemingly proposed modifying the bankruptcy code, perhaps in line with plans from the Hoover Institute, in order to handle financial firms. (He also seemed to endorse the Volcker Rule in that town hall, but I haven't seen that from him anywhere else.) This would mean the FDIC would lose the special powers it has been given, which are believed to be important for resolution, including advance planning and living wills, debtor-in-possession financing and liquidity, making payments to creditors based on expected recoveries, keeping operations running, having graduated regulations based on size and riskiness, the ability to transfer qualified financial contracts without termination, and the ability to turn up or down regulations going into a potential resolution based on prompt corrective action. If that is the plan, and those powers are unnecessary to tackle TBTF, Ryan should spell it out more clearly.

At the same time, Ryan has proposed policies that were already in or based on Dodd-Frank. He has told CNBC and Ezra Klein that he was interested in using Luigi Zingales' approach to taking down a financial firm as outlined in a National Affairs article. This approach uses credit default swap measures, a financial derivative designed to gauge the risk of collapse, to judge when to take a financial firm into an orderly liquidation.

As I noted at the time, this is a form of resolution authority. It is specifically a form of prompt corrective action, which requires regulators to go ahead and collapse a firm based on market signals instead of regulator judgement. For it to work, you'd need legal powers to carry out a resolution, which Ryan has voted against, as well as sufficient regulation of dervatives to make sure the price signal is clear, which Ryan also voted against. And it seems to stand in contrast to the bankruptcy approach he has talked about elsewhere.

At this point there are some allusions to specifics in what Ryan talks about when it comes to taking down a large financial firm, though it often contradicts itself. But he hasn't offered anything specific on derivatives, consumer financial protection, insurance, securitization, ratings agencies, and the shadow-banking industry more broadly -- all of which would be up for grabs if Dodd-Frank was repealed under the Path to Prosperity.

Mike Konczal is a Fellow at the Roosevelt Institute. Follow or contact the Rortybomb blog:

  

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A Year After S&P's Rating Downgrade, US Treasuries Trade 1% Lower

Aug 5, 2012Mike Konczal

On August 5th, 2011, one year ago today, S&P downgraded the United States from AAA to AA+. This was four days after Congress voted to raise the debt ceiling. S&P did this because they didn't like the politics of the debt ceiling, implicitly blaming the Republicans' aggressive threat of a default on the national debt to obtain their political goals.

On August 5th, 2011, one year ago today, S&P downgraded the United States from AAA to AA+. This was four days after Congress voted to raise the debt ceiling. S&P did this because they didn't like the politics of the debt ceiling, implicitly blaming the Republicans' aggressive threat of a default on the national debt to obtain their political goals. "The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed." And they did this because they wanted to nudge Congress to make big, Grand Bargain type changes. S&P was worried that, in the aftermath of the debt ceiling agreement, "new revenues have dropped down on the menu of policy options" and "only minor policy changes on Medicare and little change in other entitlements" would potentially be achieved in the near future.

Analysts at Treasury quickly noted, after reviewing the numbers, that S&P made a $2 trillion dollar mistake, which dramatically overstated the medium-term debt levels of the United States that were their economic justification. S&P stood by their downgrade while admitting the error.

The United States losing its AAA rating was a political shock. The verdict was quick from the center and the right - this would be incredibly harmful to the United States' ability to deal with its national debt. When S&P first brought up the possibility of the downgrade in July, the centrist think tank Third Way highlighted that "S&P estimates that a downgrade would increase the interest rates on U.S. treasuries by 50-basis points," and urged "Congress and the Administration [to] come together and pass a 'grand bargain' that will put us on a sustainable path and avoid a credit downgrade."

After the downgrade Mitt Romney noted that “America’s creditworthiness just became the latest casualty in President Obama’s failed record of leadership on the economy. Standard & Poor’s rating downgrade is a deeply troubling indicator of our country’s decline under President Obama."

Those are two empirical predictions. Did the downgrade increase interest rates on U.S. Treasuries 50-basis points? Would you go further and describe our creditworthiness itself as a casualty?

Here's FRED data on Treasury 10 years:

They are down a little over 1 full percentage point, from 2.58 percent to 1.51 percent. If you want to consider the baseline the 3 percent interest rates from right before the downgrade, or the 2 percent interest rates that happened afterwards, then rates are down either 1.5 or 0.5 percentage points. That's a major decline in the borrowing cost of the United States. One can't find the increase in rates in this market. Counterfactuals are difficult - perhaps S&P is correct, and 10-year Treasuries would be closer to 1 percent had there been no downgrade.

But that seems unlikely. Here's a previous link discussing ratings agencies' internal research finding that they consistently overstate the default risk of government debt. The ratings agencies can add value in thin markets with little history, or as a means of a coordinating research and action among market participants. But the United States' debt market is one of the most liquid, traded, researched and transparent markets in the world, and it seemed doubtful the ratings agencies were going to add much information with their downgrade. A year later the downgrade appeared to have been irrelevant to United States' borrowing costs. To the extent that they were relevant they signaled and reinforced a further move away from potential stimulus for the economy, which collapsed demand and drove even more money into government bonds and the interest rate down to 2 percent almost right away. But either way, low interest rates on US debt continues their downward march. Contrary to S&P, the financial markets are calling for a larger deficit, not a smaller one.

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Can We Start the Merkley Plan Now Using TARP (And Bypass a Dysfunctional Congress)?

Jul 30, 2012Mike Konczal

Senator Jeff Merkley (D-OR) has just released a new housing plan for dealing with the mortgage crisis by refinancing underwater mortgages titled "The 4% Mortgage: Rebuilding American Homeownership." This plan would create a Rebuilding American Homeownership (RAH) Trust, modeled after the HOLC plan in the Great Depression. It would buy out underwater mortgages for three years, then wind down while managing its mortgage portfolio.

Senator Jeff Merkley (D-OR) has just released a new housing plan for dealing with the mortgage crisis by refinancing underwater mortgages titled "The 4% Mortgage: Rebuilding American Homeownership." This plan would create a Rebuilding American Homeownership (RAH) Trust, modeled after the HOLC plan in the Great Depression. It would buy out underwater mortgages for three years, then wind down while managing its mortgage portfolio. Underwater mortgages would have three payment options, including a 15-year 4 percent interest rate plan to help rebuild equity, a 30-year 5 percent plan like a standard mortgage, and a two-part plan that splits the loan into a first mortgage equal to 95 percent of the home's current value and a "soft second" for the rest. Here are links to the summarythe full plan and a YouTube video introduction.

I think it is a great plan. Felix Salmon is also a "huge fan" of the plan and has a description of several of the positive features. Many will probably react to it like Matt Yglesias, who, after discussing the positive parts of the plan, notes that the "chances of Congress actually doing this are slim to none."

But what if this plan didn't need Congress? What if the Executive Branch could do this right now, on its own?

There is interest is moving forward. Senator Merkley told David Dayen that he was hoping that "pilot programs for RAH operating in several states between now and the end of the year." Treasury Secretary Timothy Geithner said that he'd be willing to try to "find legal authority and resources to -- to test [the RAH] on a pilot basis."

The report notes three potential homes for the plan: (1) FHA, (2) Federal Home Loan Banks system, or (3) the Federal Reserve. Of those, FHA seems like a potential place to launch the plan immediately. As the report mentions, "FHA already implements the FHA Short Refi program as one of the government's foreclosure prevention programs." What if the administration took the FHA Short Refi program and replaced it with what is needed to run the RAH? To launch this right away by replacing FHA Short Refi with the Merkley plan you'd need authority and cash, and FHA Short Refi has both.

Why does FHA Short Refi have the authority to implement this plan? FHA Short Refi plan is a part of TARP designed to deal with the housing crisis by modifying underwater mortgages. When Dodd-Frank passed in July 2010, special language was put in to limit the creation of new programs or initiatives under TARP. However, this project exists as part of that already-existing housing priority, and those programs can be modified. These programs are modified all the time to try to make them work better. HAMP, for instance, was modified earlier this year.

FHA Short Refi was designed to "enable lenders to provide additional refinancing options to homeowners who owe more than their home is worth." So it looks like it has the authority to act and change its mission structure from Short Refi to the Merkley plan, provided that Treasury's lawyers (I believe) approve of the changes.

FHA Short Refi also has moneyAccording to SIGTARP's quarterly report to Congress from July 2012, Treasury had allocated $8.1 billion for FHA Short Refinance.

How many mortgages have been modified under the FHA Short Refi program since it started? "As of June 30, 2012, there have been 1,437 refinancings under the program." Less than 1,500 mortgages in the country have gone through this program. How much money has been spent? "Treasury has pre-funded a reserve account with $50 million to pay future claims and spent $6.6 million on administrative expenses." Less than $57 million dollars. Given $8.1 billion dollars to spend on helping the housing market, less than 0.7 percent of it has been allocated, impacting less than 1,500 people.

That's a bit mind-boggling, but the failure of FHA Short Refi to either impact homeowners, help the economy or use its resources could be the genesis for the success of the RAH. FHA can provide the baseline funding for the part of the mortgage that isn't underwater, while the additional resources necessary to ensure the additional funding for the underwater part of the mortgage can come from this FHA Short Refi. That $8 billion could be used to insure the other part of the mortgages involved, which would then be sold off in a new bond. Amplified in this way, that $8 billion dollars could be used to backstop tens of billions of dollars of new mortgages.

At that point funding would end, but we'd have a sense if it was working or not. And if that $8 billion can insure $100 billion dollars worth of underwater debt, between 10 and 18 percent of underwater debt could be refinanced. If it is successful, there will both be a good empirical argument for continuing with additional funding and a political coalition of other underwater homeowners who would want to participate. If it is a failure, then it is a good opportunity to end it right there.

With that in mind, it might be useful to remind ourselves why this plan is important as an economic matter. Most of the recent research finds that underwater mortgage debt is strongly linked with weak consumption, high unemployment, and sluggish wage growth - our economy is stuck in a "balance-sheet recession." The blockage of prepayment has created a windfall for creditors in a weak economy with low interest rates; as Felix Salmon notes "the CBO is saying that if we paid off current bondholders at 100 cents on the dollar, they would lose as much as $15 billion...They’re basically taking unfair advantage of the fact that homeowners are locked into above-market mortgage rates" and can't prepay or refinance their mortgages.

Beyond creating a hangover effect on aggregate demand and basic unfairness, underwater mortgages also blunt the ability of monetary policy to do its full job. Even Federal Reserve Chairman Ben Bernanke believes this is happening. Here's Bernanke at a press conference from last November:

One area where monetary policy has been blunted, the effects have been blunted, has been the mortgage market where very tight credit standards have prevented many people from purchasing or refinancing their homes and therefore the low mortgage rates that we’ve achieved have not been as effective as we had hoped. So, monetary policy maybe is somewhat less powerful in the current context than it has been in the past but nevertheless it is affecting economic growth and job creation.

That’s Fed speak for underwater mortgage refinancing being a major boom to boosting demand, which helps the economy as a whole, even people who have no mortgage or debt but are stuck in a terrible jobs market. Given how interested the Federal Reserve is in this blocked channel for the efficiency of monetary policy, I hope they are considering how they can play a role in this.

All in all, Merkley has put together an excellent plan and I believe we have the means to do it. It provides new stimulus while amplifying already existing monetary stimulus, plus it contains a measure of fairness between creditors and everyone else. When can we start?

 

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A Big Banker’s Belated Apology

Jul 30, 2012Jeff Madrick

This op-ed originally appeared at NYTimes.com.

This op-ed originally appeared at NYTimes.com.

Last week, in a CNBC interviewSanford I. Weill, the former chairman of Citigroup, said that America should separate investment banking from commercial banking. This separation, of course, was the prime purpose of the Glass-Steagall Act of 1933, a piece of legislation that Mr. Weill and other bankers had successfully watered down, with Alan Greenspan’s support, before Mr. Weill helped engineer its official demise in 1999. Now, Mr. Weill, the creator of what was once the largest financial conglomerate in the world, suggests that Citigroup and others should be broken up. Banks can no longer “be too big to fail,” he told CNBC.

But what was most eye-catching was Mr. Weill’s claim that the conglomerate model “was right for that time.” Nothing could be further from the truth.

Mr. Weill’s original business concept — the justification of financial conglomeration — was to provide one-stop shopping to any and all customers. This could now include clients for investment banking, stock research, brokerage and insurance. Then, with the 1998 merger of his Travelers Group with Citicorp, it could include savers, business borrowers and credit card users, too. But few, even among his own executives, ever believed the strategy would work.

Rather, conglomeration bred conflicts of interest in Mr. Weill’s firms, and others — the very conflicts that the original Glass-Steagall Act was designed to prevent. This inevitably led to investment in and promotion of risky, poorly run and, in some cases, deceitful companies that brought us the high-technology and telecommunications bubble of the late 1990s.

Indeed, Mr. Weill’s Citigroup was a primary underwriter of and one of the two largest lenders to the oil and futures trading firm Enron, whose accounting charade resulted in what was in 2001 the biggest bankruptcy of its time. Citigroup was a major underwriter for the telecommunications giants Global Crossing and WorldCom, which would later go bankrupt as a result of flagrant accounting deceptions. There were many other, if less visible, debacles.

Read the full article here.

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On Nickels, Bulldozers, JP Morgan's Now $5.8 Billion Dollar Loss, and the Volcker Rule

Jul 19, 2012Mike Konczal

One of the best metaphors for understanding how hedge funds and other elaborate trading strategies work is that they are "picking up nickels in front of a bulldozer." This contrasts nicely with the view within economics that there can never be $100 bills just lying on the street. There is free money, but it is both dangerous and difficult to go after. And while it is profitable to go after the nickels, when the bulldozer crushes you the losses can be spectacular.

One of the best metaphors for understanding how hedge funds and other elaborate trading strategies work is that they are "picking up nickels in front of a bulldozer." This contrasts nicely with the view within economics that there can never be $100 bills just lying on the street. There is free money, but it is both dangerous and difficult to go after. And while it is profitable to go after the nickels, when the bulldozer crushes you the losses can be spectacular. Like getting run over by a steamroller (another vehicle used for this metaphor), the losses are huge, painful, and immediate, yet they manage to continue coming.

The metaphoric bulldozer continues to crush JP Morgan's balance sheet in light of its disastrous credit derivatives trading (remember that?). The losses were originally supposed to be around $2 billion dollars. The losses have now tripled to $5.8 billion dollar, as reported last week in their quarterly losses. According to the New York Times a few weeks ago, some estimate that it will be more like $8 or $9 billion. $9 billion is a lot more than the original $2 billion. And it is a significantly more than the handful of nickles they were looking to pick up if the strategy had worked.

It's worth looking at this in light of the Volcker Rule. There's an argument that this kind of propritary trading is entirely fine and good for the economy, but it does not need to be done by institutions that have taxpayer money on the line or function as a systemically important part of the financial infrastructure of the economy. It will be both well provided and well compensated on its own through hedge funds and smaller players in the financial markets. If anything, taxpayer subsidizes could crowd out smaller players, distorting the way that the financial market works.

But there's also the question of what to do if a large, systemically risky firm fails. Here the Dodd-Frank policy regime involves prompt corrective action to begin prepping a firm that looks like it will fail for failure, much like how the FDIC currently does with commercial banks. This system works better if there is adequate time and if there are no gigantic surprises.

Contrast that with Bear Sterns and its hedge funds. Bear Sterns put up $40 million of its own money into two internal hedge funds between 2004 and 2006, and in June 2007, Bear had to bail out these two funds with a line of credit worth $3.2 billion dollars. $40 million dollars upfront got crushed under the steamroller to the tune of $3 billion. Such a large loss absorbed so quickly put significant pressures on the firm; it later collapsed.

Given this asymmetric payout, prop trading makes a certain type of failure more likely - one that is quick, out of nowhere, and large. This type of collapse strains our system for resolving large, systematically risky financial firms. This system is what we need in order for financial firms to collapse in a fair way, one that allocates losses to those who gained the most while also preventing huge spillovers to third parties. The Volcker Rule is an essential part of this.

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Four Issues with Miles Kimball's “Federal Lines of Credit” Policy Proposal

Jul 18, 2012Mike Konczal

Economics professor Miles Kimball has a new blog, Confessions of a Supply-Side Liberal. In one of his first posts, he outlines a plan for stimulus that he calls “Federal Lines of Credit” (FLOC).

Economics professor Miles Kimball has a new blog, Confessions of a Supply-Side Liberal. In one of his first posts, he outlines a plan for stimulus that he calls “Federal Lines of Credit” (FLOC). It's presented in a longer policy paper, “Getting the Biggest Bang for the Buck in Fiscal Policy." This has gotten interest across the political spectrum. Bill Greider has written about it in The Nation, as has Reihan Salam in the National Review.

What's the idea? Under normal fiscal stimulus policy in a recession, we often send people checks so that they'll spend money and boost aggregate demand. Let's say we are going to, as a result of this current recession, send everyone $200. Kimball writes, "What if instead of giving each taxpayer a $200 tax rebate, each taxpayer is mailed a government-issued credit card with a $2,000 line of credit?" What's the advantage here, especially over, say, giving people $2,000? "[B]ecause taxpayers have to pay back whatever they borrow in their monthly withholding taxes, the cost to the government in the end—and therefore the ultimate addition to the national debt—should be smaller. Since the main thing holding back the size of fiscal stimulus in our current situation has been concerns about adding to the national debt, getting more stimulus per dollar added to the national debt is getting more bang for the buck."

Let's kick the tires of this policy. There's a lot to like about the proposal, particularly how it could be used after a recession is over to provide high-quality government services to the under-banked or those who find financial services yet another way in which it is expensive to be poor (modified, it turns right into Steve Waldman's Treasury Express idea). It's not clear whether this is meant to supplement or replace normal demand-based fiscal policy - at one point he proposes it could balance out a "relatively-quickly-phased-in austerity program."

As a supplement it has promise, but I think there are some major problems with this proposal, which can be grouped under four categories.

I: Isn't deleveraging the issue? Is this a solution looking for a problem? From the policy description, you'd think that a big is credit access holding the economy in check.

But taking a look at the latest Federal Reserve credit market growth by sector, you can see that credit demand has collapsed in this recession. Consumer credit drops throughout the beginning of the recession, particularly in 2009. This is true even for consumer credit by itself, which rebounds in 2011. It's not clear that these lines of credit would be used to expand demand at the macro-level; likely, given what we see, it would be used to replace other, higher-interest forms of debt (see III), a giant transfer of credit risk from credit card companies to taxpayers. But certainly some people will benefit, so let's examine why this policy is supposed to work.

II: This policy is like giving a Rorschach test to a vigilante. No, not that vigilante. I mean the bond vigilantes. Because to assume this plan would work, you need to make some curious assumptions about how bond vigilantes think, as it increases the debt by a significant amount.

Let's say our country has a balanced budget with a debt-to-GDP ratio of 50 percent and we hit a recession while at the zero-bound. As a result of less tax revenue coming in and more automatic stabilizers going out, debt-to-GDP will be 60 percent at the end of the year. We want to stimulate the economy further using fiscal stimulus.

Let's say our default is that we take three percent of GDP, divide it among the population, and mail it out. At the end of the year, the debt-to-GDP ratio will be 63 percent (I am ignoring that fiscal stimulus at the zero-bound can be largely self-financing for this example).

In Kimball's FLOC, we instead take 9 percent of GDP, divide it evenly among the population, and mail out lines of credit that add up to that 9 percent of GDP. Let's also say that perfect forecasting tells us that within the year, 6 percent of it will be utilized as a loan not yet paid back, and 3 percent is still available as credit.

What's the government's debt-to-GDP ratio at the end of the year in Kimball's example? I'm not sure how he'd account for it. I imagine it should be 69 percent (60 + 9). Perhaps it is 66 percent (60 + 6)? Either way, it is more than the 63 percent of just giving people money. His plan requires a larger debt-to-GDP ratio. If his accounting ends up with just 60 percent, I'm not sure I understand how he is doing it.

Now Kimball will say that bond vigilantes will be happy with this. Why? Because there's a built-in plan for repaying it. "[T]he fact that much of the money would ultimately be repaid would dramatically reduce the ultimate addition to the national debt...(though at a relatively attractive ratio of additional aggregate demand to addition to national debt)."

If we are guessing as to what the bond vigilantes want, it is clear they want more U.S. government debt. Ten-year Treasuries are selling at 1.5 percent, while real interest rates are negative! But for the purposes of the FOLC, we need a few assumptions about what the bond vigilantes think, which aren't clear.

First (i) it assumes that the bond market will only care about the government's long-run debt ratio instead of the short-term. I think that's correct. But much of the bond vigilante argument is predicated on the opposite, that no matter what the long-term is, the capital markets will freak on short-term deficits.

It also assumes (ii) that the repayments of these FOLC will be made easier through debt collection than just collecting the equivalent amount of money through taxation. I see no reason why that's the case, and many reasons to believe the opposite.

III: This policy will involve trying to get blood from a turnip. I very much distrust it when economists waive away bankruptcy protection. Especially for experimental, controversial debts that have never been tried in known human history.

As the paper admits, this is a machine for generating adverse selection, as the people most likely to use it are people whose credit access is cut due to the recession. High-risk users will likely transfer their balances from higher rate credit cards to their FOLC (either explicitly or implicitly over time if barred) - transferring a nice chunk of credit risk from the financial industry to taxpayers.

It's also not clear what happens a few years later when consumers start to pay off the FOLC. Could that trigger another recession, especially if the creditor (the United States) doesn't increase spending to compensate?

The issue isn't whether or not the government will be able to collect these debts at some point. It has a long time-horizon, the ability to jail debtors and use bail to pay debts, the ability to seize income, old-age pensions and a wide variety of income, and the more general ability to deploy its monopoly on violence. The question is whether this will be smoother, easier, and more predictable than just collecting the money in taxes. We have a really smooth system for collecting taxes, one at least as good as whatever debt collection agencies are out there. If that is the case, there's no reason to believe that this will satisfy the bond vigilantes or bring down our debt-to-GDP ratio in a more satisfactory way.

IV: Since we've very quickly gotten to the idea that we'll need to jettison legal protections under bankruptcy for this plan to work, it is important to emphasize that this policy is the opposite of social insurance.

I don't see a macroeconomic difference between the government borrowing 3 percent of GDP and giving it away and collecting it through taxes later versus the government borrowing 3 percent of GDP, loaning it to individuals, and collecting it later through debt collectors except in the efficiency and the distribution.

The distributional consequences of this proposal aren't addressed, but they are quite radical. Normally taxes in this country are progressive. Some people call for a flat tax. This proposal would be the equivalent of the most regressive taxation, a head tax. And it also undermines the whole idea of social insurance.

Let's assume the poorest would be the people most likely to use this to boost or maintain their spending. I think that's largely fair - certainly the top 10 percent are less likely to use this (they'll prefer to use high-end credit cards that give them money back). This means that as the bottom 50 percent of Americans borrow and pay it off themselves, they would bear all the burden for macroeconomic stability through fiscal policy. Given that the top 1 percent captured 93 percent of the income growth in the first year of this recovery, that's a pretty major transfer of wealth. One nice thing about tax policy, especially progressive tax policy, is that those who benefit the most from the economy provide more of the resources. This would be the opposite of that, especially in the context of a ""relatively-quickly-phased-in austerity program."

Efficiency is also relevant - as the economy grows, the debt-to-GDP ratio declines, making the debt easier to bear. The most likely borrowers under FOLC, the bottom 50 percent, have seen stagnant or declining wages overall, especially in recessions. A growing economy would keep their wages from falling in the medium term, but this is still a problematic issue - their income is not more likely to grow to balance out the payment burdens than if we did this at a national level, like normal tax policy.

The policy also ignores social insurance's role in macroeconomic stability, and that's insurance against low incomes. Making sure incomes don't fall below a certain threshold when times are tough makes good macroeconomic sense and also happens to be quite humane. This is not that. As friend-of-the-blog JW Mason said, when discussing this proposal, the FOLC is like "if your fire insurance simply consisted of a right to borrow money to rebuild your house if it burned down."

What else am I missing about this proposal?

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