Friday, August 6, 2010
MV=PQ: A Resource for Economic Educators
I have recently added MV=PQ to my list of useful resources. Some good discussions, and a good place to look for links to academic research on topics relevant to your classes.
Monday, August 2, 2010
Financial Reform: What is Basel III and Why Should We Regulate Bank Capital?
The 2010 Dodd-Frank Act reformed bank regulation in several ways. It established a systemic risk council, set out a new resolution mechanism for failure of complex financial firms, improved consumer protection, limited risks from derivatives and private trading, and more. However, there were some big things that it did not do. The biggest of those was not to set rules for bank capital.
Establishing a minimum level of capital lies at the very heart of bank regulation. Banks with too little capital (excessive leverage) are at risk of insolvency if they suffer even small losses on loans or other assets. However, higher leverage also increases the rate of return on shareholder capital for banks that manage to remain solvent. Capital standards are thus is a key element of the trade-off between risk and rate of return for banks and other financial institutions.
Bank regulators, who are concerned about the spillover effects of bank failures on the rest of the economy, generally prefer lower risk and higher capital than do banks. (See this earlier post for a more detailed discussion of the risk-return preferences of banks and regulators.) The regulators of individual countries do not act alone in regulating bank capital. Instead, they coordinate their capital standards through the Basel Committee on Bank Supervision. The BCBS has issued a series of regulatory guidelines, beginning with Basel I (1988), later followed by Basel II (2004).
Unfortunately, the Basel II standards were a spectacular failure. They did not prevent the global financial crisis that began in 2007, and may even have facilitated it. The crisis devastated the nonfinancial economy and required costly rescue of dozens of the world's largest banks, including many that, on paper, fully met Basel II capital adequacy standards. The failures of Basel II can be traced, above all, to the fact that they allowed banks to overstate their true amount of capital and understate the risks to which they were exposed.
Many observers think that the simplest measure of capital, tangible common equity (TCE), is the best for gauging a bank's ability to withstand losses. Tangible common equity counts only assets, like loans, securities, or real property, that could be sold by a failing bank to help cover losses in an emergency. It counts as capital only the equity claims of common shareholders that are the first in line to absorb losses. Basel II instead used a more lenient measure of regulatory capital that differed from TCE in two ways. First, it allowed inclusion of certain intangible assets like goodwill and tax loss assets--accounting entries that could indicate future profits for a healthy firm but that offer no protection to one on the brink of insolvency. Second, they allowed inclusion of certain forms of hybrid capital, like preferred stock, that have properties midway between pure equity and debt. Hybrid capital has proved to be a less secure cushion against insolvency under conditions of stress.
In addition, Basel II allowed banks to hold less capital per dollar of safe assets than per dollar of risky assets. At the same time, it allowed understatement of risks, which in turn, allowed banks to get by with inadequate capital. Excessive reliance on ratings agencies, which exaggerated the safety of complex securities, was one problem. Inadequate attention to off-balance-sheet risks was another.
Now negotiations are underway for a new set of international capital standards that will be known as Basel III. Preliminary proposals show a clear recognition of the shortcomings of Basel II. They recommend tightening the definition of capital, relying less on ratings, and paying more attention to off-balance-sheet risks, among other things. Unfortunately, with finalization of Basel III still months away, the goal posts are already beginning to move. At a July 26 meeting, the BCBS announced an intention to water down some of its initial proposals. Some observers are beginning to worry that furious lobbying by banks is paying off, and that the final Basel III standards will again be inadequate. If so, another global crisis will be only a matter of time.
Follow this link to download a free set of classroom-ready slides discussing the meaning of bank capital, the need to regulate it, and the Basel Accords. You may find it helpful to use these new slides together with this earlier set, which discusses bank regulation and the risk-return trade-off in additional detail.
Establishing a minimum level of capital lies at the very heart of bank regulation. Banks with too little capital (excessive leverage) are at risk of insolvency if they suffer even small losses on loans or other assets. However, higher leverage also increases the rate of return on shareholder capital for banks that manage to remain solvent. Capital standards are thus is a key element of the trade-off between risk and rate of return for banks and other financial institutions.
Bank regulators, who are concerned about the spillover effects of bank failures on the rest of the economy, generally prefer lower risk and higher capital than do banks. (See this earlier post for a more detailed discussion of the risk-return preferences of banks and regulators.) The regulators of individual countries do not act alone in regulating bank capital. Instead, they coordinate their capital standards through the Basel Committee on Bank Supervision. The BCBS has issued a series of regulatory guidelines, beginning with Basel I (1988), later followed by Basel II (2004).
Unfortunately, the Basel II standards were a spectacular failure. They did not prevent the global financial crisis that began in 2007, and may even have facilitated it. The crisis devastated the nonfinancial economy and required costly rescue of dozens of the world's largest banks, including many that, on paper, fully met Basel II capital adequacy standards. The failures of Basel II can be traced, above all, to the fact that they allowed banks to overstate their true amount of capital and understate the risks to which they were exposed.
Many observers think that the simplest measure of capital, tangible common equity (TCE), is the best for gauging a bank's ability to withstand losses. Tangible common equity counts only assets, like loans, securities, or real property, that could be sold by a failing bank to help cover losses in an emergency. It counts as capital only the equity claims of common shareholders that are the first in line to absorb losses. Basel II instead used a more lenient measure of regulatory capital that differed from TCE in two ways. First, it allowed inclusion of certain intangible assets like goodwill and tax loss assets--accounting entries that could indicate future profits for a healthy firm but that offer no protection to one on the brink of insolvency. Second, they allowed inclusion of certain forms of hybrid capital, like preferred stock, that have properties midway between pure equity and debt. Hybrid capital has proved to be a less secure cushion against insolvency under conditions of stress.
In addition, Basel II allowed banks to hold less capital per dollar of safe assets than per dollar of risky assets. At the same time, it allowed understatement of risks, which in turn, allowed banks to get by with inadequate capital. Excessive reliance on ratings agencies, which exaggerated the safety of complex securities, was one problem. Inadequate attention to off-balance-sheet risks was another.
Now negotiations are underway for a new set of international capital standards that will be known as Basel III. Preliminary proposals show a clear recognition of the shortcomings of Basel II. They recommend tightening the definition of capital, relying less on ratings, and paying more attention to off-balance-sheet risks, among other things. Unfortunately, with finalization of Basel III still months away, the goal posts are already beginning to move. At a July 26 meeting, the BCBS announced an intention to water down some of its initial proposals. Some observers are beginning to worry that furious lobbying by banks is paying off, and that the final Basel III standards will again be inadequate. If so, another global crisis will be only a matter of time.
Follow this link to download a free set of classroom-ready slides discussing the meaning of bank capital, the need to regulate it, and the Basel Accords. You may find it helpful to use these new slides together with this earlier set, which discusses bank regulation and the risk-return trade-off in additional detail.
Wednesday, July 28, 2010
Postmortem on Waxman-Markey: The Politics of Cap-and-Trade
As recently as 2008, the prospects for cap-and-trade climate change legislation looked good. Both major-party presidential candidates in that year's election supported the concept, and there was bi-partisan support in both houses of the U.S. Congress. Now, as of July 2010, cap-and-trade is dead. The Senate will not bring the House-passed Waxman-Markey cap-and-trade bill to a vote, nor will it propose a substitute. What has this experience taught us about the politics of cap-and-trade?
Textbook analysis tells us there are two market-based approaches to controlling carbon emissions. One is a tax of a fixed amount per ton of carbon emitted. The other is to impose a cap on emissions and then issue tradeable permits. Under proper conditions, the equilibrium price of permits would settle down to the same value as the optimal tax, and the environmental effects of the two approaches would be equivalent. If the permits were auctioned off, the budgetary effects of cap-and-trade would also be equivalent to those of a tax.
More advanced economic analysis reveals second-order effects that may break the equivalence in favor of carbon taxes. For example, some economists argue that permit prices would vary greatly from year to year, introducing an element of uncertainty that could discourage pollution control investments. The volatility of EU carbon permit prices lends support to this concern. However, if cap-and-trade were more attainable politically, many economists would accept it as a second best.
Unfortunately for supporters of climate change action, the Waxman-Markey experience raises doubts about the politics of cap-and-trade. The old argument was that cap-and-trade made it easier to put together a climate action coalition. The main idea was that by giving away a limited number of permits for free, some polluters could be won over to the cause of limiting emissions. A secondary political benefit is that a cap-and-trade scheme would not, strictly speaking, be a tax. In the past, that was enough to garner the support of at least a few Republican legislators who would never dream of voting for a tax increase.
The lesson of Waxman-Markey is that the coalition-building powers of cap-and-trade were greatly overrated. In order to assemble a winning coalition in the House, not just a few, but nearly all permits were handed out for free. (Recall that Candidate Obama's 2008 campaign platform on cap-and-trade had called for all permits to be auctioned.) Worse than this, some permits were to be squandered on a bizarre scheme that would have protected consumers from higher energy prices, thus undermining a crucial incentive for energy conservation. Finally, the bill was loaded up with a grab-bag of command-and-control provisions, for example, renewable energy mandates for utilities. What was left was a weak measure that departed widely from the market-based efficiency of a textbook cap-and-trade plan.
When the debate moved over the the Senate, the cap-and-trade coalition collapsed entirely. So much had been given away to win a House majority that there was little room left for maneuver. When the Republican leadership decided to re-brand cap-and-trade as "cap-and-tax," the few remaining Republican supporters dropped away.
The bottom line: The demise of Waxman-Markey seems to be more than a tactical setback for the cap-and-trade approach to climate change. Right now, there seems to be no political appetite at all for climate change legislation. If demand for action emerges again in the future, the case for a straight-up carbon tax seems stronger than before, and the case for cap-and-trade weaker.
Follow this link to download a free set of classroom-ready slides that explains the basic economics of both carbon taxes and cap-and-trade, and discusses the specifics of the Waxman-Markey bill.
Textbook analysis tells us there are two market-based approaches to controlling carbon emissions. One is a tax of a fixed amount per ton of carbon emitted. The other is to impose a cap on emissions and then issue tradeable permits. Under proper conditions, the equilibrium price of permits would settle down to the same value as the optimal tax, and the environmental effects of the two approaches would be equivalent. If the permits were auctioned off, the budgetary effects of cap-and-trade would also be equivalent to those of a tax.
More advanced economic analysis reveals second-order effects that may break the equivalence in favor of carbon taxes. For example, some economists argue that permit prices would vary greatly from year to year, introducing an element of uncertainty that could discourage pollution control investments. The volatility of EU carbon permit prices lends support to this concern. However, if cap-and-trade were more attainable politically, many economists would accept it as a second best.
Unfortunately for supporters of climate change action, the Waxman-Markey experience raises doubts about the politics of cap-and-trade. The old argument was that cap-and-trade made it easier to put together a climate action coalition. The main idea was that by giving away a limited number of permits for free, some polluters could be won over to the cause of limiting emissions. A secondary political benefit is that a cap-and-trade scheme would not, strictly speaking, be a tax. In the past, that was enough to garner the support of at least a few Republican legislators who would never dream of voting for a tax increase.
The lesson of Waxman-Markey is that the coalition-building powers of cap-and-trade were greatly overrated. In order to assemble a winning coalition in the House, not just a few, but nearly all permits were handed out for free. (Recall that Candidate Obama's 2008 campaign platform on cap-and-trade had called for all permits to be auctioned.) Worse than this, some permits were to be squandered on a bizarre scheme that would have protected consumers from higher energy prices, thus undermining a crucial incentive for energy conservation. Finally, the bill was loaded up with a grab-bag of command-and-control provisions, for example, renewable energy mandates for utilities. What was left was a weak measure that departed widely from the market-based efficiency of a textbook cap-and-trade plan.
When the debate moved over the the Senate, the cap-and-trade coalition collapsed entirely. So much had been given away to win a House majority that there was little room left for maneuver. When the Republican leadership decided to re-brand cap-and-trade as "cap-and-tax," the few remaining Republican supporters dropped away.
The bottom line: The demise of Waxman-Markey seems to be more than a tactical setback for the cap-and-trade approach to climate change. Right now, there seems to be no political appetite at all for climate change legislation. If demand for action emerges again in the future, the case for a straight-up carbon tax seems stronger than before, and the case for cap-and-trade weaker.
Follow this link to download a free set of classroom-ready slides that explains the basic economics of both carbon taxes and cap-and-trade, and discusses the specifics of the Waxman-Markey bill.
Saturday, July 24, 2010
Will Extension of Unemployment Benefits Help or Hurt the Economy?
On July 22, President Obama signed an extension of unemployment benefits. Benefits averaging $300 per week, normally available for a maximum of 26 weeks, can now be paid for up to 99 weeks. Such an extension had been in force previously during the recession, but it had lapsed. Benefits will be paid retroactively for the 7 weeks during which the extension was not in force.
Politically, the extension was highly controversial, passing the Senate by a single vote. The close vote reflects the likelihood that extended unemployment benefits will have both good and bad effects on the economy.
The case favoring extension begins from the fact that long-term unemployment is now at a post-World War II high. Some 45% of all unemployed workers have been out of work for 26 weeks or more. The long-term unemployment rate always rises during a recession, but the previous peak number of long-term unemployed, in the early 1980s, was less than half of the current number. If we add the fact that unemployment disproportionately affects the lowest-paid and least educated workers, it is not surprising that many people see the extension as good social policy.
In terms of its effects on the labor market, the extension of unemployment benefits can be expected to have both positive and negative effects. Unemployment benefits lower the opportunity cost of job search. Other things being equal, that will tend to increase the average duration and rate of unemployment. (It should be pointed out that that is not entirely bad--lowering the cost of job search can potentially improve matching of workers to jobs and thereby improve labor market efficiency.) At the same time, the extension of benefits will stimulate aggregate demand. To the extent doing so speeds the recovery of real output, unemployment will fall.
Critics of the extension pointed out that any short-term benefits must be offset against the fact that more current spending will complicate the job of bringing the federal deficit and debt under control over the medium term. The rapid rise in the debt during the recession has limited the government's room for undertaking additional short-term stimulus. Several spending and tax-relief provisions were stripped out of the recent bill before passage.
Follow this link to download a free set of classroom-ready slides that include both current unemployment data and a simple presentation of a job-search model of unemployment.
Politically, the extension was highly controversial, passing the Senate by a single vote. The close vote reflects the likelihood that extended unemployment benefits will have both good and bad effects on the economy.
The case favoring extension begins from the fact that long-term unemployment is now at a post-World War II high. Some 45% of all unemployed workers have been out of work for 26 weeks or more. The long-term unemployment rate always rises during a recession, but the previous peak number of long-term unemployed, in the early 1980s, was less than half of the current number. If we add the fact that unemployment disproportionately affects the lowest-paid and least educated workers, it is not surprising that many people see the extension as good social policy.
In terms of its effects on the labor market, the extension of unemployment benefits can be expected to have both positive and negative effects. Unemployment benefits lower the opportunity cost of job search. Other things being equal, that will tend to increase the average duration and rate of unemployment. (It should be pointed out that that is not entirely bad--lowering the cost of job search can potentially improve matching of workers to jobs and thereby improve labor market efficiency.) At the same time, the extension of benefits will stimulate aggregate demand. To the extent doing so speeds the recovery of real output, unemployment will fall.
Critics of the extension pointed out that any short-term benefits must be offset against the fact that more current spending will complicate the job of bringing the federal deficit and debt under control over the medium term. The rapid rise in the debt during the recession has limited the government's room for undertaking additional short-term stimulus. Several spending and tax-relief provisions were stripped out of the recent bill before passage.
Follow this link to download a free set of classroom-ready slides that include both current unemployment data and a simple presentation of a job-search model of unemployment.
Saturday, July 17, 2010
Financial Reform: Why We Need It, and Why It Might Not Work
The Dodd-Frank financial reform act makes fundamental changes in the way the US financial industry will be regulated. It sets up a new oversight mechanism to spot early warnings of systemic risk, creates new resolution authority for complex financial firms, creates a new consumer protection agency, and introduces restrictions on several specific kinds of risky activity, including use of derivatives, proprietary trading, and ownership of hedge funds.
We can judge the likelihood that the Dodd-Frank Act will have its intended outcome by viewing the financial system in terms of the interaction of a risk-return frontier, shaped by market conditions and the regulatory regime, and the risk-return preferences of financial managers and regulators. Because of contagion, moral hazard, and agency problems, regulators tend to prefer a lower-risk point along the frontier than do managers.
The intended consequence of Dodd-Frank is to move the financial system downward along the risk-return frontier from management's preferred point to that of regulators. Provisions of Dodd-Frank that might help accomplish this include better oversight to avoid buildup of unnoticed systemic risks and the new authority to take over complex, at-risk financial institutions and wind them up if needed. Improvements to corporate governance and compensation practices could also have helped, although there is little of this in Dodd-Frank as finally passed.
On the other hand, provisions of Dodd-Frank that prohibit specific risk practices like proprietary trading or hedge-fund ownership carry a risk of unintended consequences. Such measures act by changing the shape of the risk-return frontier without changing management's underlying risk preferences. In response, managers will develop new strategies to reach their preferred risk-return point on the new frontier. Unfortunately, the new equilibrium is likely to be worse than the status quo ante from the point of view of both managers' and regulators' preferences.
Click here to download a free set of classroom-ready slides that develop the above points in greater detail, including a graphical analysis in terms of the risk-return frontier.
We can judge the likelihood that the Dodd-Frank Act will have its intended outcome by viewing the financial system in terms of the interaction of a risk-return frontier, shaped by market conditions and the regulatory regime, and the risk-return preferences of financial managers and regulators. Because of contagion, moral hazard, and agency problems, regulators tend to prefer a lower-risk point along the frontier than do managers.
The intended consequence of Dodd-Frank is to move the financial system downward along the risk-return frontier from management's preferred point to that of regulators. Provisions of Dodd-Frank that might help accomplish this include better oversight to avoid buildup of unnoticed systemic risks and the new authority to take over complex, at-risk financial institutions and wind them up if needed. Improvements to corporate governance and compensation practices could also have helped, although there is little of this in Dodd-Frank as finally passed.
On the other hand, provisions of Dodd-Frank that prohibit specific risk practices like proprietary trading or hedge-fund ownership carry a risk of unintended consequences. Such measures act by changing the shape of the risk-return frontier without changing management's underlying risk preferences. In response, managers will develop new strategies to reach their preferred risk-return point on the new frontier. Unfortunately, the new equilibrium is likely to be worse than the status quo ante from the point of view of both managers' and regulators' preferences.
Click here to download a free set of classroom-ready slides that develop the above points in greater detail, including a graphical analysis in terms of the risk-return frontier.
Thursday, July 15, 2010
New Feature: Tutorials
As part of my ongoing effort to make this blog as useful as possible to teachers of economics, I have decided from time to time to post short tutorials on economic concepts that I find useful in explaining current policy issues.
My first post in this series is a short tutorial on consumer and producer surplus. I have used these concepts in my recent post dealing with initiatives toward trade liberalization and the proposed US-Korea Free Trade Agreement. If you use the trade liberalization slide show in your classes, you may want to preface it with the tutorial, or assign the tutorial to your students as background.
You might also find the consumer and producer surplus tutorial to be useful in conjunction with some past posts on this site, including The Economics of a Soda Tax and The Gulf Oil Spill and the Myth of Affordable Energy.
My first post in this series is a short tutorial on consumer and producer surplus. I have used these concepts in my recent post dealing with initiatives toward trade liberalization and the proposed US-Korea Free Trade Agreement. If you use the trade liberalization slide show in your classes, you may want to preface it with the tutorial, or assign the tutorial to your students as background.
You might also find the consumer and producer surplus tutorial to be useful in conjunction with some past posts on this site, including The Economics of a Soda Tax and The Gulf Oil Spill and the Myth of Affordable Energy.
Recent US Moves toward Trade Liberalization : Economics vs. Politics
The Obama administration has recently announced several initiatives to promote US international trade. One is a National Export Initiative aimed at doubling US exports over 10 years. Another is a renewed effort to revive stalled bilateral trade agreements with Korea, Columbia, and Panama.
Economists, with relatively few exceptions, tend to favor free trade. They are at home in a world of economic models where the interests of consumers, firms, and workers are balanced against one another in a neutral, unbiased manner. Using familiar conceptual tools like producer and consumer surplus, economists tally up the net gains and losses to trade liberalization and almost always find that lifting trade restrictions benefits both importing and exporting countries.
The political game unfolds on a different playing field, for two reasons. First, although economists tend to focus on the net gains from trade, politics is very sensitive to the fact that any change in trade policy produces some losers along with the winners. Second, the political influence of winners and losers is not necessarily proportional to the magnitude of their economic gains or losses. Instead, well-organized groups, like corporations, farm groups, and unionized workers, have disproportionate political power compared to poorly organized groups like consumers and non-unionized workers.
As a case in point, consider the Korea-US Free Trade Agreement (KORUS FTA). It was originally negotiated in 2006 and signed by both governments in 2007, but it is not yet ratified. In the United States, the main opposition has come from the Big Three automakers and their unions. These control enough Democratic votes in Congress to have blocked ratification up to this point.
Ratification opponents claim that US-Korean automobile trade is inherently unfair because Korea exports 700,000 cars a year to the US, but imports more than 100 times fewer US cars. They less often emphasize the fact that KORUS FTA would lower Korean auto tariffs by more than US tariffs would be lowered, or that Korean and US automakers each produce many cars in the others' country, which do not show up in import figures, or that trade in auto parts is less unbalanced than trade in finished cars.
Will KORUS FTA be ratified? At the recent G20 summit in Canada, the presidents of the US and South Korea pledged a renewed push for ratification. A group of Republic senators has offered to help the ratification push. Still, as of mid-2010, the outcome is far from certain.
The bottom line: There is a big gap between the politics and the economics of trade liberalization. In Washington, lobbyists for corporations and unions battle one another in a zero-sum game. Consumer interests and non-unionized workers are rarely heard from. In contrast, economic analysis tells us that when the interests of all groups are taken into account, trade liberalization leads to net gains for both importing and exporting countries.
Follow this link to download a set of free, classroom-ready slides with a more detailed analysis of trade liberalization and KORUS. The slides make use of the concepts of consumer and producer surplus. Click here if you think your students would benefit from a quick tutorial on producer and consumer surplus.
Economists, with relatively few exceptions, tend to favor free trade. They are at home in a world of economic models where the interests of consumers, firms, and workers are balanced against one another in a neutral, unbiased manner. Using familiar conceptual tools like producer and consumer surplus, economists tally up the net gains and losses to trade liberalization and almost always find that lifting trade restrictions benefits both importing and exporting countries.
The political game unfolds on a different playing field, for two reasons. First, although economists tend to focus on the net gains from trade, politics is very sensitive to the fact that any change in trade policy produces some losers along with the winners. Second, the political influence of winners and losers is not necessarily proportional to the magnitude of their economic gains or losses. Instead, well-organized groups, like corporations, farm groups, and unionized workers, have disproportionate political power compared to poorly organized groups like consumers and non-unionized workers.
As a case in point, consider the Korea-US Free Trade Agreement (KORUS FTA). It was originally negotiated in 2006 and signed by both governments in 2007, but it is not yet ratified. In the United States, the main opposition has come from the Big Three automakers and their unions. These control enough Democratic votes in Congress to have blocked ratification up to this point.
Ratification opponents claim that US-Korean automobile trade is inherently unfair because Korea exports 700,000 cars a year to the US, but imports more than 100 times fewer US cars. They less often emphasize the fact that KORUS FTA would lower Korean auto tariffs by more than US tariffs would be lowered, or that Korean and US automakers each produce many cars in the others' country, which do not show up in import figures, or that trade in auto parts is less unbalanced than trade in finished cars.
Will KORUS FTA be ratified? At the recent G20 summit in Canada, the presidents of the US and South Korea pledged a renewed push for ratification. A group of Republic senators has offered to help the ratification push. Still, as of mid-2010, the outcome is far from certain.
The bottom line: There is a big gap between the politics and the economics of trade liberalization. In Washington, lobbyists for corporations and unions battle one another in a zero-sum game. Consumer interests and non-unionized workers are rarely heard from. In contrast, economic analysis tells us that when the interests of all groups are taken into account, trade liberalization leads to net gains for both importing and exporting countries.
Follow this link to download a set of free, classroom-ready slides with a more detailed analysis of trade liberalization and KORUS. The slides make use of the concepts of consumer and producer surplus. Click here if you think your students would benefit from a quick tutorial on producer and consumer surplus.
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