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April 2, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View

Paul Krugman: Financial Reform 101

Posted: 02 Apr 2010 12:09 AM PDT

In order to prevent another financial crisis, should we limit the size of financial institutions, or would it be better to regulate what banks can do? Paul Krugman argues that limiting behavior is more important than limiting size, but I think both are needed. Limits on size are needed if for no other reason than to limit the political power these institutions have. For just one example, look how hard it's been to get the hard limits on leverage many of us have called for -- one of the key reforms Paul Krugman calls for below (the economic rationale for size limits is explained in a part I left out).

So while there are two groups, those who want to limit size and those who want to limit behavior, I guess I'm a member of a third group that believes both types of reform are necessary. But if I had to choose between size limits and behavioral limits, I'd start -- as I've said many times -- with limits on leverage even though such limits are difficult to sustain when banks have size and political power (assuming, as Paul Krugman does below, that the bank run problem has been addressed through implicit deposit insurance):

Financial Reform 101, by Paul Krugman, Commentary, NY Times: Let's face it: Financial reform is a hard issue... Reasonable people can and do disagree about exactly what we should do to avert another banking crisis.
So here's a brief guide to the debate — and an explanation of my own position.
Leave on one side those who don't really want any reform at all, a group that includes most Republican members of Congress. Whatever such people may say, they will always find reasons to say no to any actual proposal to rein in runaway bankers.
Even among those who really do want reform, however, there's a major debate about what's really essential. One side — exemplified by Paul Volcker, the redoubtable former Federal Reserve chairman — sees limiting the size and scope of the biggest banks as the core issue in reform. The other side — a group that includes yours truly — disagrees, and argues that the important thing is to regulate what banks do, not how big they get. ...
Here's how I see it. Breaking up big banks wouldn't really solve our problems, because it's perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that's precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.
The same would be true today. Breaking up big financial institutions wouldn't prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn't be concentrated on a few big companies — but it would be a bailout all the same. I don't have any love for financial giants, but I just don't believe that breaking them up solves the key problem.
So what's the alternative to breaking up big financial institutions? The answer, I'd argue, is to update and extend old-fashioned bank regulation.
After all, the U.S. banking system had a long period of stability after World War II, based on a combination of deposit insurance, which eliminated the threat of bank runs, and strict regulation of bank balance sheets, including both limits on risky lending and limits on leverage, the extent to which banks were allowed to finance investments with borrowed funds. ...
What ended the era of U.S. stability was the rise of "shadow banking": institutions that carried out banking functions but operated without a safety net and with minimal regulation. In particular, many businesses began parking their cash, not in bank deposits, but in "repo" — overnight loans to the likes of Lehman Brothers. Unfortunately, repo wasn't protected and regulated like old-fashioned banking, so it was vulnerable to a pre-1930s-type crisis of confidence. And that, in a nutshell, is what went wrong in 2007-2008.
So why not update traditional regulation to encompass the shadow banks? We already have an implicit form of deposit insurance: It's clear that creditors of shadow banks will be bailed out in time of crisis. What we need now are two things: (a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage.
Does the reform legislation currently on the table do what's needed? Well, it's a step in the right direction, — but it's not a big enough step. I'll explain why in a future column.

"The Consumption Response to Income Changes"

Posted: 02 Apr 2010 12:06 AM PDT

How does consumption respond to a change in income?:

The consumption response to income changes, by Tullio Jappelli and Luigi Pistaferri, Vox EU: With the recovery underway, the consumption-income link is back in the spotlight. While there is a long tradition of studying the connection, many questions lack definitive answers:

  • How does household consumption respond to changes in economic resources?
  • Does the response depend on the nature and duration of the changes?
  • Do anticipated income changes have a different consumption impact than unanticipated shocks?
  • Do transitory income shocks have a lower impact than permanent ones?
  • What about small changes compared with large ones?

These questions are crucial for understanding consumers' behavior and to evaluate fiscal policy changes that impacts households' resources. Indeed, in virtually all countries, consumption represents more than two thirds of GDP, and knowledge of how consumers respond to income shocks is crucial for evaluating the macroeconomic impact of fiscal packages implemented in response to the financial crisis.

Economists have taken different empirical approaches to estimate these important policy parameters. To put matters in perspective, Figure 1 provides a roadmap to the main links between consumption and income changes. The main distinction that we draw is between the effect of anticipated and unanticipated income changes. The Modigliani and Brumberg (1954) and Friedman (1957) celebrated life-cycle and permanent income models posit that people use savings to smooth income fluctuations, and that they should respond little – if at all – to changes in income that are predictable.

Figure 1. A roadmap of the response of consumption to income changes


More recently, the literature has sought to gain further insights by distinguishing between situations in which consumers expect an income decline or an income increase. A further distinction that has proven to be useful is between large and small expected income changes, as consumers might may react mostly to the former and neglect the impact of the latter. The branch on the right-hand side of the figure focuses instead on the impact of unanticipated income shocks. The main distinction here is between transitory shocks, which should have a small impact on consumption, and permanent shocks, which should lead to major revisions in consumption. As with anticipated changes, the literature has sought to pin down the empirical estimates identifying positive and negative shocks.

Predictable income changes

A first group of researchers has tried to identify specific episodes in which predicted income changes are observable by both the consumer and the econometrician. Such episodes can also be classified into expected income increases and expected income declines.

For instance, Shapiro and Slemrod (2009) use survey data to measure individual responses to actual or hypothetical tax policies, reporting that temporary tax changes could be moderately effective in increasing household spending. Parker (1999) considers the effect on consumption of the anticipated income increase induced by reaching the US social security payroll cap ($106,800 in 2009), and Souleles (2002) how consumption responded to the widely pre-announced tax cuts of the Reagan administration era.

Further insights from tax refunds is provided by Johnson et al. (2006), who study the large income tax rebate program provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. The authors find that the average household spent 20% to 40% of their 2001 tax rebate on non-durable goods during the three-month period in which the rebate was received. The authors also find that the expenditure responses are largest for households with relatively low liquid wealth and low income, which is consistent with the presence of liquidity constraints.

Expected income declines

A second group of authors considers the effect of expected income declines on consumption. The most important predictable decline in one's income occurs at retirement. One of the first papers to look at this issue is Banks et al. (1998) who found a remarkable drop in consumption after retirement, a finding that has been challenged by subsequent research (Hurd and Rohwedder 2006, and Aguiar and Hurst 2007).

Unanticipated income shocks

The approach taken by economists studying the impact of unanticipated income shocks is to compare households that are exposed to shocks with households that are not (or the same households before and after the shock), and to assume that the difference in consumption arises from the realization of the shocks. The literature has looked at the economic consequences of illness, disability, unemployment, and, in the context of developing countries, weather shocks and crop losses. Some of these shocks are transitory (such as temporary job loss), and others are permanent (disability); some are positive (dividends pay-outs), others negative (illness).

A further approach to identify the consumption response to unanticipated income shocks makes specific statistical assumptions about the income process, and estimates the response of consumption to income shocks. Blundell et al. (2008) find that in the US consumption is nearly insensitive to transitory shocks, while the response of consumption to permanent shocks is about 0.65 (but lower for the college educated and those near retirement and higher for poor or less educated households). Jappelli and Pistaferri (2008) find a response to permanent shocks of about 1 in Italy.

Overall, there is by now considerable evidence that consumption appears to respond to anticipated income increases, over and above by what is implied by standard models of consumption smoothing. In Jappelli and Pistaferri (2010) we cite evidence from diverse sources, studies and countries. We find that, at least locally, financial markets' arrangements and liquidity constraints are an important culprit for this lack of consumption smoothing. Indeed, consumption appears much less responsive to anticipated income declines (for instance, after retirement), a case in which liquidity constraints have no bearing.

A second finding that emerges from the literature is that the consumption reaction to permanent shocks is much higher than that to transitory shocks. There is also evidence, at least in the US, that consumers do not revise their consumption fully in response to permanent shocks.

Concluding remarks

Taken together, these findings suggest that tax changes might have a considerable impact on consumption expenditures. However, the precise effect will depend on whether the policy is anticipated, whether taxes increase or decline, whether the change is perceived as temporary or permanent. The main challenge for empirical work evaluating fiscal packages is therefore to distinguish between different expectations and contexts in which tax programs and fiscal packages are implemented.


Aguiar Mark, Erik Hurst (2007), "Life-Cycle Prices and Production", American Economic Review, 97: 1533-59.

Banks, James, Richard Blundell, Sarah Tanner (1998), "Is There a Retirement Savings-Puzzle?", American Economic Review, 88:769-88.

Blundell, Richard, Luigi Pistaferri, Ian P Preston (2008), "Consumption inequality and partial insurance", American Economic Review, 98:1887-1921.

Friedman, Milton (1957), A Theory of the Consumption Function, Princeton: Princeton University Press.

Gruber Jonathan (1997), "The Consumption Smoothing Benefits of Unemployment Insurance", American Economic Review, 87(1):192-205.

Hurd Michael D, Rohwedder Susann (2006), "Some answers to the Retirement Consumption Puzzle", NBER Working Paper 242.

Jappelli Tullio, Luigi Pistaferri (2008), "Financial Integration and Consumption Smoothing", CSEF Working Paper 200.

Jappelli Tullio, Luigi Pistaferri (2010), "The Response of Consumption to Income Changes", Annual Review of Economics, forthcoming.

Johnson David S, Jonathan A Parker, Nicholas S Souleles (2006), "Household Expenditure and the Income Tax Rebates of 2001", American Economic Review, 96: 1589-1610.

Modigliani Franco, Ricahrd Brumberg (1954), "Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data", in Kenneth Kurihara (eds), Post-Keynesians Economics, New Brunswick: Rutgers University Press.

Parker Jonathan A (1999), "The Reaction of Household Consumption to Predictable Changes in Social Security Taxes", American Economic Review, 89:959-7.

Souleles Nicholas S (2002), "Consumer Response to the Reagan Tax Cuts", Journal of Public Economics, 85(1):99-120.

Shapiro Mathew D, Joel Slemrod (2009), "Did the 2008 Tax Rebates Stimulate Spending?", American Economic Review, Papers and Proceedings 99:374-79.

links for 2010-04-01

Posted: 01 Apr 2010 11:04 PM PDT

Corporations, Social Insurance, and Unchecked Power

Posted: 01 Apr 2010 11:34 AM PDT

James Madison was not a fan of corporations:

Early Americans had a far more comprehensive and nuanced understanding of corporations than the Court gives them credit for. They were much more comfortable with retaining pre-Revolutionary city or school charters than with creating new corporations that would concentrate economic and political power in potentially unaccountable institutions. When you read Madison in particular, you see that he wasn't blindly hostile to banks during his fight with Alexander Hamilton over the Bank of the United States. Instead, he's worried about the unchecked power of accumulations of capital that come with creating a class of bankers.

More here: What the Founding Fathers Really Thought About Corporations, by Justin Fox. [See also: The Founders were deeply skeptical of corporations, by Michael Giberson.]

When thinking about corporations, I think it's useful to keep this in mind:

David A. Moss, a Harvard Business School professor ... explains that the first application of social insurance in our latitudes actually was aimed ... at ... supporting the growth of modern capitalism. Its main instrument to that end was the legal sanction of the principle of limited liability of the owners of corporations.
Prior to this form of social insurance, the owners of a business were legally liable with their personal wealth for damages the business might have inflicted on others. With limited liability, the corporation's shareholders are liable only up to their equity stake in the company. ... Beyond that, someone else in society — often the taxpayer — bears the financial risk for damages attributable to the corporation.
One wonders how many business executives and members of chambers of commerce ... realize that the limited liability of shareholders is social insurance.

In return for this protection, it's not unreasonable to impose regulation on corporations that, should they fail, impose large damages on society that do not have to be paid be the owners and managers. (As is the case with too big too fail financial institutions, e.g. do you think the behavior of banks might have been different if the bank managers' personal assets were at stake in a bank failure, with a high likelihood that bank failure would leave the managers penniless? In the current financial meltdown that was so costly to society, many managers paid little penalty when the firms they managed failed.)

For a managers and owners, if failure in the future is likely, the game here is simple. Transfer as much wealth as possible as fast as possible from the corporation to managers/owners where it will be safe from creditors and others who face costs if and when the corporation fails.

I'm not suggesting an end to limited liability -- though clawback provisions that return assets to the corporation are needed to give managers an incentive to maximize long-run rather than short-run gains and to prevent the looting of troubled firms. Only that the regulation of firms that benefit from substantial amounts of implicit social insurance is needed to align the incentives of managers with stockholders and, more generally, society at large.

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