The cost of moral hazard in banking
While I disagree with a good portion of Barro’s analysis
(especially in regards to fiscal and monetary policy… somehow I don’t agree
that the Keynesian multiplier is as low as Ricardian Equivalence would suggest:
http://www.washingtonpost.com/blogs/ezra-klein/wp/2012/08/08/the-romney-campaign-says-stimulus-doesnt-work-here-are-the-studies-they-left-out/),
I did appreciate his emphasis on central bank independence, his analysis of
bank regulation, and his explanation of credibility in macroeconomic policy.
One interesting part of Barro’s writing that jumped out at me was his support of the Bank of England’s (BoE) bailout, or lack there of, BCCI and Baring’s. I
was most struck by how well Barro’s theories rational expectation/adapted
Ricardian equivalence fit with the idea of moral hazard.
Much of Barro’s argument rests on the idea that rational
individuals will not be impacted by expected fiscal or monetary policy shifts,
due to the understanding that these policies will have to be reversed or
balanced over time. This yields the result that fiscal and monetary policy are
often ineffectual over time, and a transparent, static framework is preferable
to a volatile one. Individuals predict how the macroeconomic policy maker will
behave in the future based on past actions. That is, if the Fed allows higher
inflation for a period of time, individuals will come to expect higher
inflation in the future.
But why does this matter for bailouts and banking? It
matters tremendously, due to the fact that once banks are bailed out once, the
policy making body loses the credibility that this sort of behavior will come
again. Barro’s analysis astutely points out the dangers of allowing bailouts in
this way, and compliments the BoE for not participating in such policies when
Barring’s failed.
This is immensely applicable today given the recent string
of bailouts, support, and emphasis on ending “too big to fail.” The reason a
new emphasis on disallowing too big to fail in the future is just this problem
of moral hazard. Systemically important banks (think the big ones: JP, Goldman,
DB, etc.) are able to capitalize on upside returns, but distribute losses
amongst all taxpayers. This is because the government has bailed them out once
and has lost its credibility that it won’t do so again.
As part of the moral hazard aspect of the bailouts, the
government implicitly subsidizes these large banks a great deal. This subsidy
comes about because the government has been unable to established credibility
in changing the markets expectations. Namely, the market doesn’t believe major
governments will let these banks fail in the future, despite efforts such as
Dodd-Frank. Looking explicitly at how much these subsidies aid banks (this is
from 2009, but the data has remained consistent):
http://www.cepr.net/index.php/publications/reports/too-big-to-fail-subsidy/
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=5&ved=0CDkQFjAE&url=http%3A%2F%2Fwww.moodys.com%2Fmicrosites%2Fcrc2012%2Fpres%2FFrederic_Schweikhard.pdf&ei=VLl0UMaaDeKpiAKJ7oCoDA&usg=AFQjCNEIZxE97dvj71-utd4bNInz9zw4wA
(Banks would have higher credit default swaps, and with it
higher borrowing rates, if there was no implicit guarantee)
Banks are able not only to receive a higher credit rating,
in fact if one looks at a Moody’s or S&P report government backing
(Systemic Importance) explicitly raises credit ratings by one or two notches.
This makes it cheaper to run the bank in terms of financing, and is a cost born
by the average tax payer. Barro, in this case is right, there is a large cost
to bailing out banks.
While Barro does make it clear the costs of implicitly
insuring these banks due in the future due to prior explicit insurance, he is
less thorough in his discussion of the perhaps occasional need to insure the
banks in this way given the current financial structure. However, Barro’s use
of prior policies as indicators of future policy given rational expectations,
combined with the empirical evidence from the banking crisis, indicate that
continued action will likely need to be taken to demonstrate a firm commit to
ending this sort of subsidy.
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On an unrelated note, I thought the comments on the political independence of the Fed were extraordinarily timely given the recent calls by a number of politicians for greater Congressional oversight and audits of the Fed. Additionally, the timing of QE3 caused some to questions whether Bernanke was trying to stimulate the economy to help Obama win and save his own job (something I view as unlikely, but an interesting criticism nontheless). It does seem to me the Fed has become increasingly politicized.
For more:
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=13&ved=0CC0QFjACOAo&url=http%3A%2F%2Fnorthernfinance.org%2F2012%2Fopenconf%2Fmodules%2Frequest.php%3Fmodule%3Doc_program%26action%3Dview.php%26id%3D72&ei=pbt0UOARqc6LApmYgIgC&usg=AFQjCNHblSSF9lRxC6Gp57HUJDleeVd3uw
or
http://conversableeconomist.blogspot.com/2012/04/to-big-to-fail-how-to-end-it.html
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