Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”
The Clearing House, an association of banks, is at the forefront of efforts to prevent further potential restrictions on how large financial firms operate. One piece of the Clearing House-led pushback is a report recently commissioned from Oxford Economics, which purports to show that higher capital requirements would depress economic growth. (The report appeared on the Clearing House Web site last week.)
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Oxford Economics is a well-known economic forecasting firm with corporate and government clients and some prominent economists on its board. Presumably the Clearing House commissioned the report in order to add credibility to what would otherwise be seen as self-serving claims. Should we take this Oxford Economics report seriously and use it to guide policy? No.
There are three major conceptual and factual problems with the Oxford Economics report. Taken together, these issues are serious enough that the report should be given precisely zero weight in thinking about policy.
First, Oxford Economics fails to engage with the central analytical question: why exactly would higher capital requirements be bad for the economy? We know that banks like to borrow a great deal relative to their equity funding — excessive leverage, as it is known, means that the people running banks get the upside when things go well and someone else gets the downside when everything goes badly. Why is it good for the rest of us to allow global megabanks, for example, to generate a high level of systemic risk and a high probability of economic meltdown? This is a form of economic pollution that we could do without. There is no serious discussion of these issues in the report.
Higher capital requirements address this by requiring that banks fund themselves more with equity and less with debt. This creates a bigger buffer that can absorb losses, making banks less likely to fail and less likely to become any kind of zombie. In effect, requiring higher equity makes both their equity and their debt safer. The properly measured funding costs of banks should not increase, although bankers will scream and shout as their subsidies are withdrawn. (We allow tax deductibility of interest payments but not payments to equity holders, so debt is subsidized relative to equity through the tax code. When banks receive a government backstop because they are too big to fail, this is an additional form of implicit subsidy; you cannot see it in the government’s budget but it may be huge.)
In contrast, the Oxford Economics report assumes the answer that the Clearing House has long offered — that funding costs for banks would increase and by a significant amount (see the equation Oxford Economics uses on Page 8). This is not just a questionable assumption; this approach has been refuted at length in the new book, “The Bankers’ New Clothes,” by Anat Admati and Martin Hellwig.
The Oxford Economics report ignores Professors Admati and Hellwig completely, and consequently appears ill-informed about the current state of the policy debate. Professors Admati and Hellwig are central to all the serious discussions I have witnessed recently. The failure to even acknowledge the presence of leading critics of banking industry hardly helps convince the reader that Oxford Economics really wants to evaluate the available arguments and relevant evidence.
Second, the Oxford Economics report almost completely ignores the costs of financial crises, such as the deep recession that followed the downturn in fall 2008. Highly leveraged banks are more likely to collapse and to bring down the economy; avoiding this is the central rationale for capital requirements. (There is some mention in passing on Page 17 and again on Page 18, but in the context of downplaying potential permanent effects of crises.)
As Oxford Economics says says of one study (see Page 17):
A further key assumption is that financial crises have permanent effects on GDP. If this assumption is discarded and only temporary effects are allowed, the estimated net benefits from reform are dramatically lower — and low enough that further alterations to other assumptions might remove them altogether.
To the extent that Oxford Economics is willing to acknowledge there was a big crisis, it plays down the idea that such catastrophes have persistent negative effects (see Page 17-18). This is news to the millions of people who have struggled to find new employment — and to their children, many of whom will suffer long-term consequences in their schooling and later lives. The economic and social damage from deep financial crises and the aftermath is profound.
More broadly, the Oxford Economics team seems blissfully unaware that we subsidize debt through the tax code and through implicit government guarantees. Again, these points are not really mentioned (I don’t even find the words “subsidy” or “guarantee” in the text). In effect, we are subsidizing the production of financial-system pollution. If we cut back on that subsidy, there will be less pollution, which is precisely the point of the policy. In effect, the report provides cost-benefit analysis without acknowledging any benefits. Why would a serious research firm want to take such a position?
Third, the central mechanism for the negative effect of higher capital requirements does not make sense on Oxford Economics’ macroeconomic framework. It assumes that the interest rates charged on loans will go up (see Page 8). However, they are also aware that monetary policy can offset this effect (for example, see Page 33). They assume that the offset is only partial, but why? If monetary policy wants to offset fully, that can be achieved by some combination of conventional tools (like cutting policy-controlled interest rates) and quantitative easing.
Of course, permanently low interest rates are not a goal. Even the Clearing House, in other materials on its Web site, asserts that low rates were a contributing factor in the crisis of 2007 (see Page 13 in this presentation).
So what exactly is the problem? Is Oxford Economics seriously suggesting that higher capital requirements would reduce the effectiveness of countercyclical monetary policy, or make it harder to recover given precisely where we are in the cycle? I find no coherent macroeconomic discussion along these lines in the report, presumably because such a position would make no sense.
The Clearing House is apparently pleased with the report (see this news release and what is prominent on its Web site). But the Clearing House can produce the level of analysis itself with this simple approach on any policy that removes subsidies enjoyed by its members: ignore the relevant literature, assume the costs of removing subsidies are big and pretend there are no benefits to making the financial system safer.
This kind of work would undermine the reputation of any serious consulting firm.
Let me note also that in the context of my exchanges with Oxford Economics, I looked further into how it cites an International Monetary Fund working paper by Douglas Elliott and some co-authors. The Oxford Economics paper refers extensively to this work as an “I.M.F. study” (e.g., on Pages 7, 8 and 38), creating the impression that this is official work somehow representing the view of that institution (at the staff, management or board level).
It is no such thing. A working paper is no more than a paper written by someone with some affiliation to the I.M.F. (and Mr. Elliott was only loosely affiliated; he was not an employee). It in no way represents the views of anyone other than Mr. Elliott and his co-authors. I was chief economist at the I.M.F. in 2007-8) and I’ve checked this point carefully. In fact, I could not find anyone at the I.M.F. who wanted to be associated with Mr. Elliott’s methodology or findings (perhaps I did not look hard enough). Oxford Economics should withdraw the term “I.M.F. study” from its published paper; it is entirely misleading.
Oxford Economics feels that my assessment of its report does not accurately reflect its views. It states that its terms of reference for the report were narrowly limited to comparing the sensitivity of results to assumptions in particular studies and did not constitute a full cost-benefit analysis. This precluded Oxford Economics from considering the issues that I raise above. It does not deny that financial crises can have substantial economic and social costs. Its critique of raising capital requirements apparently should not be construed as opposition to raising these capital requirements. And its read of macroeconomic realities would preclude monetary policy from fully offsetting the effects of increasing loan rates, in part because quantitative easing may not be effective in the future.
I expect that the Clearing House will use this report as part of its campaign to oppose higher capital requirements. If Oxford Economics wishes to distance itself from that campaign, I would welcome the move. But I expect no such development.
Article source: http://economix.blogs.nytimes.com/2013/04/18/the-impact-of-higher-capital-requirements-for-banks/?partner=rss&emc=rss