Economics Lesson: The Difference Between Bank Liquidity and Capital

For the past year, and especially for the past few weeks, U.S Treasury and Federal Reserve officials have cautioned that a credit crunch (significant reductions in normal bank lending to companies and household that regularly depend on such credit for normal business activities and investment) threatened to turn a mild economic slow down into a more serious recession. Sometimes they pointed to a lack of liquidity as the problem and at other times to the lack of capital. What is the difference?

Banks and firms, like households, experience a mismatch of receipts and expenditures day by day, which they manage by investing temporary surpluses in liquid assets (those that can be sold and turned into cash quickly and easily) or by borrowing to cover temporary shortfalls. Problems can arise when normally liquid assets become hard to sell or usual sources of funds become hard or expensive to obtain. Its like maxing out your credit card. If depositors withdraw their funds or investors/lenders fail to renew their investments in a bank, the bank must find other depositors/investors, liquidate assets, or reduce lending. If their assets become hard to sell, requiring a discount, or if new depositors/investors become expensive (require higher interest rates) to attract, banks will reduce lending. If secondary markets for their normally liquid assets (e.g. Mortgage Backed Securities—MBSs) become thin, expensive, and unreliable, banks will tend to shift to more liquid assets such as treasury securities and reserve deposits with the Federal Reserve. In short, they will try to build up (horde) “liquidity” as a precaution. When all banks are trying to build up their liquidity at once, their reluctance to roll-over or extend loans squeezes businesses and households who then must cut back on inventories, employees, investments or purchases. Such credit crunches can cause or worsen recessions. Rather than force a bank to sell assets at a steep discount in an illiquid market to cover deposit withdraws, central banks traditionally accept such assets as collateral for loans to banks to satisfy their need for liquidity.

Normally banks borrow and lend from each other in an interbank money market as part of their day to day liquidity management. The interest rate for three month interbank credits (London Interbank Offer Rate—LIBOR) is normally about 0.1 or so percentage points above the Federal Reserve’s target for the interest rate on overnight interbank lending (the Fed funds rate). In the second half of September this spread (mark up over the Fed funds rate) jumped to 2.4 percentage points. This does not represent a liquidity shortage as banks can borrow large amounts from the Federal Reserve at 25 basis points about the Fed funds rate. Rather it is a risk premium for the risk banks see in lending to other banks (counterparty risk). This focuses attention on bank capital.

Capital means somewhat different things in different contexts. For economists, capital is net worth, the difference between the value of a bank’s (or anyone else’s) assets and its liabilities. There is a closely related but somewhat different concept of “regulatory capital” for banks. Capital absorbs limited losses in the value of assets so that banks are still able to honor all of their deposit and other liabilities. Prudential regulations limit the amount a bank can lend in relation to its capital. Thus even if a bank has all of the liquidity it wants, it can not lend if it does not have sufficient capital.

If a borrower defaults on its mortgage from a bank, the bank reduces the value of that loan on its books (it still expects to recover much of the value of the loan by foreclosing and selling the collateral) and its capital falls by that amount. If losses are larger than its capital it becomes insolvent and cannot pay off all of its liabilities. U.S. banking law requires the FDIC to take over banks when their capital reaches very low levels and to sell off the bank or its assets and operations in whatever manner maximizes their value to pay off the depositors and other creditors.

Before introducing deposit insurance (and sometimes still) when depositors suspected that their bank did not have the money to cover and return their deposits, depositors would run the bank (line up to withdraw their money). However, a bank might be solvent (have positive capital) but not be able at the moment to return deposits because it is temporarily illiquid (not enough cash in the faults). This is exactly when central banks are supposed to provide such liquidity by lending to banks. However, the bank might be insolvent as well as illiquid, in which case the central bank should not provide liquidity and the banks should be “closed” (taken over and resolved by the FDIC). A major challenge is that the ultimate value of assets (e.g., loans and mortgages) is not known and can be difficult to estimate. The value of a mortgage cannot be known for sure until it is fully paid off (or defaulted). Thus a bank’s capital can only be estimated. Experience suggests that when banks are seriously illiquid they are almost always also insolvent (negative capital) as well.

Treasury Secretary Paulson and Federal Reserve Board Chairman Bernanke asked for and got the Emergency Economic Stabilization Act, which included the $700 billion Troubled Asset Relief Program (TARP), in order to improve bank liquidity and capital. This act also increased the size of deposits covered by the FDIC’s deposit insurance while at the same time Ireland and some other European countries guaranteed all deposits in their banks (100% insurance coverage). Deposit insurance improves bank liquidity by removing the reason for bank runs, but it does nothing to improve bank capital. It has no effect on bank capital because it does not change the value of bank assets. Deposit insurance also reduces the incentive for depositors to monitor the soundness of their banks. The purchase of MBSs by the Treasury under TARP on the other hand can increase bank capital in two ways as well as improve bank liquidity by improving the marketability of MBSs. If the Treasury pays their actual value for the MBSs it buys, it will ultimately receive that value when they are paid off and these purchases will cost tax payers nothing (however, it is impossible to know for sure what the actual value will turn out to be). If as is suspected the market is currently undervaluing these MBSs because of its aversion to the risk and uncertainty about their “true” value, the higher price paid by the Treasury will allow banks holding them to mark up their value on their books. This will increase their capital at no cost to anyone because it comes from reduced uncertainty. Secondly the Treasury might pay more than their true value for the MBSs it buys. This would increase bank capital even more as a result of tax payers picking up the tab for the difference.

An obvious question is why not just let insolvent (or seriously undercapitalized) banks fail and accept the punishment free markets hand out for poor or overly risky behavior. After all, the FDIC has developed quite efficient ways of handling such failures. In systemic crisis like the one we are in the longer run costs to the economy can be far greater than the costs that fall on those in the financial markets who misbehaved and would be born by most of us. That cost can be limited with minimal damage to market discipline of economic actors by increasing bank capital generally until confidence returns to the market and its normal functioning can resume with market determined winners and losers. This would require that some existing losses be shifted to tax payers. A government (tax payer) recapitalization of banks should be offered only to those banks rated as generally sound by the banking supervisors and those that are not should be allowed to fail (using the FDIC’s normal bank resolution tools). Accounting tricks that merely hide losses (by abandoning honest mark to market accounting) will not do and are dangerous (a form of capital forbearance).

TARP is a rather roundabout way of improving bank capital. I have describe two better ways in "The Big Bailout–What Next?", CATO Institute, October 3, 2008 and in "The Subprime Crisis–Plan C".

The Subprime Crisis—Plan C

The just enacted $700 billion Plan B to put a floor on the market prices of mortgage related assets may not be enough to restore credit markets to normalcy, though the Treasury has yet to settle on just what Plan B is.  What should Plan C look like?

When the bursting of the real estate price bubble began to dramatically increase mortgage defaults and foreclosures in the spring of 2007 (especially for adjustable rate mortgage loans to subprime borrowers), banks began to horde liquidity and heavily indebted hedge funds and others began to deleverage. The three month LIBOR, the rate at which banks lend to each other, which normally averages between 0.1 and 0.2 percentage points above the overnight Federal funds rate, suddenly jumped starting in August 2007 to more than triple those spreads by mid September reflecting a lack of confidence in the borrowing banks.

In Plan A the Federal Reserve responded quickly to supply the increased liquidity demanded by the market and even introduced new facilities that extended the terms, increased the list of eligible collateral (all Federal Reserve Bank loans are collateralized), and broadened the institutions that could access these new facilities. The money supply (M2) grew above its normal rate throughout this period. Lenders were encouraged to renegotiate the terms of mortgages if foreclosure could be avoided and the lender incur a smaller loss. Plan A included bank by bank interventions and resolutions of failing commercial and investment banks starting with Northern Rock in the U.K, followed by Bears Stearns in the U.S. and later by Countrywide, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia to name the bigger ones. But still the three month LIBOR spread over the fed funds rate persisted in the 0.7 to 0.8 percentage point neighborhood.[1]

Following the September 15th bankruptcy of Lehman Brothers and the government take over of AIG the next day financial markets panicked and by the end of the month the LIBOR spread more than tripling again from its already extremely large value (to 2.4 percentage points) and credit markets largely froze up. Regrettably more radical intervention was needed. Having largely addressed the “liquidity” problem the Federal Reserve and U.S. Treasury began to focus on the “capital” problem. The write offs of mortgage losses and the prospects of more to come led banks to question the soundness of their counterparties (those other banks to whom they generally lend short term money) and limited what they could lend even if they had the liquidity with which to do it. Thus the rapidly conceived and still unspecified Plan B for Treasury to buy up and insure mortgage related assets held by banks in order to help improve their capital. Plan B seeks to free up the flow of credit to “Main Street” by bailing out “Wall Street.” Depending on the details of its implementation it might succeed, especially if intervention takes the form of direct capital assistance (preferred shares) to all but the weakest banks (which should be resolved in the traditional way if they are not able to come up with enough capital on their own). The best plan would be to immediately guarantee that the government will take a significant, specific share of any actual loss on any mortgage. This plan could be implemented immediately with an immediate increase in the value of all questionable mortgages and of the capital of the banks that hold them.[2] It would share the loss with, and thus reduce it to, lenders but would not eliminate it completely.

Plan B does little to help homeowners unable to meet their mortgage payments. Reducing mortgage defaults is the most fundamental way to reduce Wall Street losses and increase bank capital. It is being called a “trickle up” rather than a “trickle down” approach. The administration and Congress have been rightly concerned not to tax those who borrowed prudently to bailout those who borrowed foolishly or who speculated on increasing housing prices, or to change lending rules in ways that increase the costs of mortgages in the future (such as court order debt restructuring). It has pressed for voluntary loan restructuring with HOPE and beefed up the FHAs assistance programs. However, we now need to carefully consider a radical Plan C that helps home owners with minimum unfairness and moral hazard of encouraging imprudent borrower behavior in the future.

Koppell and Goetzmann recommend that the government “pay off all the delinquent mortgages” by offering “to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent.” [3] McCain introduced a similar plan during the Presidential debates October 7. These proposals are bold but fail on many of the fairness, moral hazard criteria above. McCain’s plan spares the lenders any cost of their misjudgments and fully bails out borrows who can’t or won’t pay. A better plan, proposed by Henry Sanborn, is for the Federal government to offer to pay a share, say 30%, of the existing contractual mortgage payment in exchange for which the lender must pay (write off) a share, say 10% and the mortgagee the rest. The government’s payments would be a loan to struggling homeowners with attractive terms that encourage early repayment.[4] Replacing ARMs with Koppell and Goetzmann’s fixed rate mortgage could be usefully added to this plan. Actual and expected foreclosures should drop significantly to those levels that should not be prevented in any event and the market value of mortgages and mortgage backed securities would quickly increase, the associated losses to lenders decrease, and the capital of banks holding them increase.

To illustrate, a $200,000 30 year mortgage on a house valued at 220,000 with an initial teaser interest rate of 4% adjustable after two years, would require monthly principal and interest payments of $955 per month. After two years the remaining principle would be $192,812. If the interest rate on the adjustable rate mortgage (the category with the largest defaults) increased to 6% (most ARMs cap year to year adjustments at 2%), monthly payments would jump to $1,186 per month (or $1,440 per month at 8%), which might be more than the borrower could afford. Sanborn’s proposal is that if the lender can not agree on a voluntary restructuring satisfactory to the borrowing, the government would pay (as a loan) 30% of the monthly payments ($356) and the lender would eat (write off) 10% ($119) reducing the monthly payments for the borrower to $712. More likely that borrower would choose to borrow from the government the smaller amount needed to keep her payments at the affordable $955 per month. There is no firm data on the extent to which such measures would reduce mortgage defaults but it is likely to be considerable. Even if the market price of the house fell 20% to 180,000 (i.e. below the amount of the mortgage (serious home owners are not likely to walk away from their home as long as they can continue to make the monthly payments)

Let’s start discussing the details of Plan C before poorly designed versions are forced through a panicked Congress and before the unavoidable losses on other credits as the economy slows add to the erosion of capital.

[1] See Coats, “The D E Fs of the Financial Markets Crisis,” CATO Institute, September 26, 2008.

[2] See Coats,  "The Big Bailout–What Next?", CATO Institute, October 3, 2008.


[3] Jonathan G.S. Koppell and William N. Goetzmann, "The Trickle-Up Bailout", The Washington Post, October 1, 2008; Page A17

[4] Henry N. Sanborn, “A Different Solution to the Financial Mess” unpublished


Is America becoming Socialist?

I participate in an Internet discussion with a number of African free market thinkers who participated in the Mont Pelerin Society meetings in Nairobi last year. A number of them have commented on the financial crisis centered in the U.S. and whether the proposed Mortgage Backed Securities bailout was a surrender to Socialism. This morning I contributed the following to that discussion.

Stella, Rejoice, James, Leon and others raise a very important, fundamental, and difficult question about capitalism—what is the best relationship between individuals, enterprises, markets, and governments. Capitalism is not anarchy. Its incredible success in raising the standards of living of so many depends on an ever evolving set of rules and relationships within which we all interact. As James has said, “capitalism is about driving self interest…,” meaning directing self interest into serving the general welfare. Some market infrastructures are better than others, but the winners are generally sorted out Darwinian fashion over time. A critical corner stone in the foundation of capitalism is the efficient establishment and enforcement of property rights under the rule of law. These were not presented to the world on golden tablets but have evolved from experience. Capitalism is and always will be a work in process.

Some of capitalism’s infrastructure of practices, rules, and laws emerged from the private sector and some from government. America has been particularly successful because of the flexibility with which this infrastructure has adapted to new technology and knowledge and to experience. The unavoidable dark side of capitalism’s dynamism is that many fail along the way (the storms of the invisible hand). This may indeed raise moral questions but it certainly raises a practical one. The freest possible private market economy we believe in can not exist without very broad acceptance by our fellow citizens. Thus we offer safety nets to the losers to soften their fall in part to win their support for playing the game. Capitalism is prone to booms and busts and asset price bubbles and as with social safety nets for individuals we need to find that balance of government intervention that maximizes the freedom of the market that the public is prepared to accept.

With that background, yes, the government needs to help restore confidence and liquidity to American financial markets but with due regard for the potential moral hazards of how they do it. Doing so is not socialism. I addressed some of these issues in my blog posted here a few days ago. The FDIC assisted resolution of a very large U.S. bank (Wachovia) provides a good example of what in my view is the right balance. A major bank failed, wiping out its shareholders, with no damage to its depositors nor contagion to other banks. The FDIC’s interference in “pure” market solutions was in the best interest of the insurance fund (reducing the cost of an insurance pay out from bankruptcy) and the market more generally. Considerable (but not total) market discipline was preserved in a way acceptable to the market.

This does not mean that America is becoming socialist (I am not sure that such dichotomous terminology is useful). It means that it is forever searching for the right balance in the partnership between government and individuals in support of capitalism. It does not always get it right by any means but I am of the view that over time we learn from our mistakes more often than not and that we have thus generally enjoyed progress.

The Big Bailout: What Next?

The administration has told us that American financial markets are in a perilous state because of recent and prospective losses of financial institutions that threaten the adequacy of their capital[1] and because of the illiquidity and presumed market under pricing of Mortgage Backed Securities (MBSs). Both of these have increased banks’ demand for liquidity and tightened bank lending standards. A credit crunch, which would worsen an economic slow down, could result if markets for normally liquid assets such as MBSs and bank capital are not restored.

The root source of these problems is a higher than expected default rate on mortgages (mainly adjustable rate mortgages to subprime borrowers) AND uncertainty over how high default rates will go. The increase in defaults and foreclosures (the take over of the house collateral backing the defaulted loan) has followed closely the decline of grossly inflated housing prices, but they are not directly caused by falling housing prices. They are caused the inability of mortgage borrowers to meet their monthly payments or their decision that it is not economically advantageous for them to do so. Falling housing prices may affect the second of these, especially for flippers (those speculating that housing prices will rise).

A secondary source of these problems is the complexity of modern financial instruments, which has increased the interdependence of financial institutions on each other through credit default swaps (CDSs) and other forms of insurance and warrants and made it difficult to know who actually bears the losses from mortgage defaults.

A contributing factor in the excessive extension of mortgage loans to those now unable or unwilling to repay them (in addition to the government’s policy of promoting greater home ownership among low income households) was weak oversight of compliance with lending standards, which may also have been too low. The enforcement of these standards was made more difficult by the widespread securitization of mortgage loans (the sale of loans by their originators to other investors, which tends to reduce interest in loan soundness by the originator). These weaknesses will be corrected by loan originators and mortgage pool consolidators in order to protect their business and by, hopefully carefully focused, strengthening of the regulatory restrictions on lending. The market’s self corrects will be more complete the more heavily the costs of recently past weaknesses and mistakes are born by those who made them.

The administration faces the need to prevent an immediate credit crisis and to adjust the regulatory regime in order to reduce the prospects of similar problems in the future. Short run fixes, especially under the pressure of a crisis, always run the risk of undermining or weakening what is needed for the long run. Any short run help should be designed to minimize the “moral hazard” of bailing out the mistakes of those who took risks that have gone bad. Such accountability for our actions (accepting the consequences good or bad) is a cornerstone of the market’s regulation of economic activity.

The urgent, immediate need is to provide banks and the financial market with the liquidity they need in order to resume or maintain norm lending. The mystery of Secretary Paulson’s $700 billion proposal is that the Federal Reserve has been quick and imaginative in addressing the market’s liquidity problems. “Commercial banks and bond dealers borrowed $217.7 billion from the Federal Reserve as of yesterday [September 25, 2008], more than double the prior week….”[2]  In addition, AIG has drawn “down $44.6 billion on its $85 billion credit line from the Fed, up from $28 billion as of Sept. 17,…”[3] The use of MBSs as collateral for loans from the Fed has large advantages over their proposed purchase by the Treasury. The almost impossible task of pricing the very diverse MBSs correctly (near best estimates of their “true” value) for purchases by the Treasury is avoided by their use as collateral. The Fed’s lending facilities are in place and operating and do not require new legislation from Congress. While over pricing them would allow banks and other holders of comparable MBSs to reflect these higher values and thus improve reported capital in their financial statements, over valuation might discourage the revival of trading them in the market and hence market provided liquidity. Overpricing would be paid for by tax payers and underpricing by bank capital.

As noted above, the root cause of the crisis is the rising defaults on mortgages. Can and should these be prevented? The downward adjustment in housing prices from their severely inflated levels of two years ago should not be prevented. These are needed to make housing affordable again and to revive the housing market (both construction and resale). Though the pace of price decline has slowed[4] and sales of existing homes are recovering slightly from year end lows[5], prices will need to fall another 10% or so to return fully to the average affordability level of the 2000 to 2003 period.[6] Everything possible should be done to facilitate the restructuring of defaulting mortgages where borrowers are able and willing to pay reduced monthly charges if these adjustments preserve greater value to the lenders than they would receive for foreclosing on deflated homes. Lenders have every incentive to help borrowers avoid foreclosures in this way and hundreds of thousands of such loan restructurings have been undertaken voluntarily one by one. There is no conceivable way government bureaucrats could organize to perform this task better. Going beyond this to bailout borrowers will create a dangerous moral hazard that will encourage reckless borrowing in the future in the hopes of another bail out.

There is a growing consensus among economists outside of government and Wall Street that a better approach is to help banks increase their capital directly.[7] Such help might take the form of mandating the suspension of dividend payments (adding the retained earnings to capital) for any banks whose capital is below, say, 6% of risked weighted assets and requiring recapitalization through new share issues if needed. But these tools are already in place and in use though bank shareholders would naturally rather be bailed out than have to pay up themselves.[8] There is also a good case for lowering capital adequacy requirements cyclically during business downturns as long as estimates of loan and other losses are properly made and provisioned (reserves set aside to cover them should they be realized). 

In fact, there is little evidence of widespread serious capital deficiencies among banks. Only a small number of banks have failed and the U.S. has reasonably good and efficient procedures for resolving insolvent or critically undercapitalized banks. These procedures should be used (as they have been) one case at a time. Bear Stearns and AGI are not banks and the legal resolution tools for banks are not available to the authorities for dealing with them. Under the circumstances the Federal Reserve did about the best it could to remove them from play as smoothly and efficiently as possible. Consideration should be given to enacting similar tools for any class of financial institution that might pose systemic risks should it fail.

The general view in the market is that banks have already written off all or most of their expected losses. Are depositors and other creditors really panicking to the extent that a massive government intervention is needed to restore confidence in the system? The run on money market mutual funds last week clearly unnerved the authorities, but Fed lending to banks has enable them to replace withdrawn funds (by buying fund commercial paper) and fund depositors will need to put their withdrawn money somewhere.

But what if depositors lose confidence in banks more generally, creating a truly systemic crisis? While weak and poorly managed banks should be allowed to fail for their mistakes, it would not serve the public interest to let a large proportion of the banking system go under for reasons largely outside of their control. The government should in this unlikely situation intervene more forcefully. The Swedish approach for dealing with its banking crises in the early 1990’s has been raised as a model that the U.S. should consider. Stefan Ingves, who has been the governor of Sweden’s central bank (Riksbank) since January 1, 2006, oversaw the formulation and implementation of Sweden’s banking crisis resolution first as Under-secretary for Financial Markets and Institutions at the Swedish Ministry of Finance and then as Director General of the Swedish Bank Support Authority in 1993-94. Stefan was also my direct boss at the IMF from 1999 until I retired in 2003 and the lessons of the Swedish experience played an important role in IMF advise to the many countries that experienced banking crisis over the last fifteen or sixteen years.

The end of Sweden’s property boom in 1991 and the collapse of real estate prices in 1991-2 put a large number of its banks underwater (negative capital). In September 1992 Prime Minister Carl Bildt announced that the government was guaranteeing all bank deposits and other creditor claims on all banks in Sweden, thus immediately ending bank runs. It also ended any market discipline of bank soundness on the depositor side. The government focused instead on maximizing the discipline and oversight of shareholders (bank owners). Banks were required to immediately and fully write off all losses in order to have an honest picture of their condition. Those needing government funds to recapitalize (if they chose to stay in business) were required to surrender shares first putting the regulators temporarily in charge of such banks. Sweden earned high marks for its skillful and principled approach to its banking crisis.[9]

The situations in Sweden in the early 1990s and the U.S. now have similarities and important differences. Sweden did not have the legal bank resolution tools available in the U.S. now and thus had to improvise. Because of these tools, the U.S. can take over and resolve a failing bank without fear of systemic consequences. We need to continue applying these tools and to extend them to investment banks and insurance companies and the Fed needs to continue supplying all of the liquidity needed. If public confidence in banks erodes, deposit insurance limits might be raised. I see little purpose in injecting government capital directly into undercapitalized banks outside of the existing bank resolution mechanisms, but it would seem preferable to Secretary Paulson’s $700 billion purchase of MBSs.

Another proposal worthy of further consideration is to insure non agency (privately issued) MBSs in the same way those issued by Fannie and Freddie are insured.[10] This would nationalize such insurance along the lines of the Federal Deposit Insurance Corporation (FDIC). The contracted mortgage payments would be assured but the return to those buying and holding them would be reduced by an insurance premium that would reflect the expected loss from defaults by the ultimate borrowers. If the market is currently underpricing these MBSs, as is assumed by many,[11] such insurance would increase their market price (and the capital of banks holding them). Of equal importance it would remove further uncertainty over the value of such MBSs, which should restore their liquidity in the market. If MBSs could be correctly categorized by default risks from the underlying mortgages (a challenging task) and insurance premiums assigned accordingly, there would be no cost to tax payers. The new MBS insurance agency would be responsible for monitoring compliance by mortgage originators of the underwriting standards applicable to each risk (insurance premium) group. It is also quite a challenge (but not necessarily impossible) to put such a scheme in place in a matter of weeks. Until the premiums for each MBSs are determined they are not likely to be traded.

            If Congress eventually adopts a version of the Administration’s $700 billion MBS bailout proposal the most important decision will be how to price MBSs purchased by the Treasury (or some entity created by the legislation for this purpose) and the insurance premiums paid to guarantee them. If each MBS is correctly priced, i.e., if it is purchased at a price that matches it’s ultimate yield to the holder (which is unknowable in advance), the operation will cost the taxpayers nothing. Such a price will be above what these MBSs can be sold for in the market today because it will remove uncertainty over the price and thus the risk premium attached to current trading. It will provide a better price for valuing comparable MBSs in financial institutions’ portfolios. Banks that are still seriously undercapitalize after these repricings should be dealt with in accordance with existing bank insolvency legislation. Failing institutions considered to big to fail should be recapitalized by the Treasury (under the systemic emergency provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 — FIDICIA) placing them under temporary government control. The draft legislation also authorizes “the Secretary to encourage the servicers of the underlying mortgages, considering net present value to the taxpayer, to take advantage of the HOPE for Home owners Program under section 257 of the National Housing Act or other available programs to minimize foreclosures.”[12]

            The use of reverse auctions to establish the Treasury’s purchase prices should break MBSs into the same risk classes as would be needed for setting premiums for an insurance program discussed above. This will be a challenging task as MBSs are very diverse. Banks will obviously offer their worst MBSs for sale in such auctions but if each auction pertains to a relatively narrow risk class, the range of actual expected values within each class will also be narrow. The auction price that clears supply and demand for that auction should then be relatively close to the best possible assessment of value given the information available at the time. Auctions should proceed quickly. Financial institutions that participate in sales to the Treasury will be subject to restrictions on executive compensation. “Troubled assets” may be guaranteed. These guarantees would be financed by premiums paid by issuers based on their risk class.

For best results all MBSs of each risk class purchased by the Treasury in reverse auctions should be insured using an insurance premium that matches the discount from face value of the auction price paid by the Treasury. To illustrate, if MBSs of risk class X with a face value of $100 are sold to the Treasury for $60, all such MBSs held by financial institutions subject to mark to market accounting would be valued at $60 per unit. All such MBSs would be guaranteed, i.e. the trusts or SPVs holding the mortgage pools backing this class of MBSs would be paid by the Treasury insurance fund any shortfalls or defaults in payments by the mortgagees. Thus the trusts would be guaranteed by the U.S. government to receive full value for their mortgage pools. The insurance premium they should pay for this guarantee should be exactly the $40 discount established by the reverse auction to the Treasury. Owners of this class of MBSs would receive the full value of the underlying mortgages less the insurance premium or $60 ($100 – $40). These combined measures will have accomplished several important things. MBSs that might have traded in a risk averse market at $50 or $45 per unit are now valued at $60 by all who hold them thus improving their capital. Furthermore that value is now guaranteed by the U.S. government and these MBSs can trade in the market at the price of $60 with the same risk as U.S government securities (i.e., no risk). This should ensure the marketability (liquidity) of these assets. If performance of the underlying mortgages improves or worsens over time the gain or cost accrues to the tax payers underwriting the guarantees. If mortgage performance deteriorates to $50 per $100 face value, for example, holders of the MBSs will still receive $60 and the insurance fund will incur costs of $50 or $10 more than the insurance premium of $40. Combining Treasury purchases of MBSs with guarantees for those MBSs remaining in the market should provide a substantial strengthening of market liquidity. The existing tools for providing liquidity to banks and for problem bank resolution will still be needed and should be sufficient.

            On Monday a majority of the House of Representatives rejected the Administrations proposals. No convincing evidence has been presented that existing liquidity and bank resolution tools are not up to the job of seeing us through the adjustments to earlier excesses now underway. As long as that remains the case the Federal Reserve and FDIC should continue to rely on them. Should fresh evidence indicate otherwise, the authorities should turn first to increasing deposit insurance limits, establishing a mortgage insurance agency (to replace Fannie Mae and Freddie Mac), and only as a last resort the injection of tax payer financed capital into (and thus government take over of) financial institutions judged too big to fail.


Warren Coats,  "The U.S. Mortgage Market: the Good, the Bad and the Ugly".

  Association of Banks in Jordan, June 22, 2008

"Fannie and Freddie: More Good, Bad and Ugly" July 31, 2008 

"The D E Fs of the Financial Markets Crisis", Cato Institute, September 26, 2008

and Aarno Liuksila, "Institutional and Legal Impediments to Efficient Insolvent Bank  Resolution And Ways to Overcome Them" USAID Conference, Banking Supervision in a Global Environment “Meeting International Standards” Sofia, Bulgaria, July 7-9, 1999

[1] According to Scott Lanman in "Federal Reserve Doubles Lending as Crisis Worsens", “The subprime-mortgage collapse has led to $522 billion of writedowns and losses at major financial institutions since the start of 2007.”, (September 26,2008)

[2] Ibid.

[3] Ibid.

[4] Laurie Goodman, “MBS: Update on the Crises”, UBS September 23, 2008 and S&P/Case Shiller Composite-20 Home Price Index.

[5] National Association of Realtors, "Existing Home Sales" 

[6] Deutsche Bank, “MBS Special Reports; Update: Projecting Mortgage Losses” September 22, 2008


[7] See the interesting contributions to Martin Wolf’s blog at the Financial Times "Economists’ Forum"

[8] Good bank supervisory practice and FIDICIA (designed to overcome supervisors’ reluctance to act as capital becomes weak) mandate that as capital falls below prudent levels supervisors MUST take increasingly sever actions before it has fallen to critically low levels (2%) at which point the FDIC MUST take the bank over. This puts great weigh on having adequate capital (shareholder stake in the successful management of a bank) as the basis of leaving most of the rest to market regulation.

[9] For a highly summarized account see Carter Dougherty, "Stopping a Financial Crisis, the Swedish Way", The New York Times, September 22, 2008.

[10] Over 60% of all MBSs outstanding were issued by the GSEs and are thus guaranteed already (now with the full backing of the government). The serious weaknesses of the GSEs and their contribution to the existing subprime crisis are discussed in "Fannie and Freddie: More Good, Bad and Ugly" July 31, 2008. Any insurance program contains potential moral hazard and requires careful monitoring of compliance with appropriately priced underwriting standards. A properly charted insurance fund is much more likely to be successful at this than was the mixed mandated, private GSEs. The FDIC provides a good example.


[11] Goodman, Op cit,

[12] Discussion Draft of ‘‘Emergency Economic Stabilization Act of 2008,” Section 109 (a).

The D E Fs of the Financial Markets Crisis

Treasury Secretary Paulson has asked Congress to authorize the government to buy up to $700 billion dollars worth of Mortgage Back Securities (MBS) in order to stabilize their market price, which reflects the underlying value of the mortgages that back them, and to improve the financial health of the banks and other financial institutions that own them. The proposal has raised more questions than it has answered. After a false start of forbearance in which insolvent Savings and Loan associations were artificially kept alive in the 1980, the elimination of 747 S&L with efficient bank resolution tools left the American banking section in much stronger condition in the 1990s, which helped drive the rapid economy growth of the last decade. Financial institutions that have made too many mistakes should be resolved (efficiently liquidated) not bailed out. Until last week the government’s measures in this area (Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac) where broadly appropriate. The as yet to be fully defined massive bail out of the MBS market is a much more questionable undertaking. I discussed the background to the current situation in "The ABCs of the Housing Crisis" and more extensively in "The U.S. Mortgage Market: the Good, the Bad and the Ugly".

The background to our current financial problems is that the United States as a whole is over leveraged. There is too much debt and too little saving. Efficient borrowing/lending can be very beneficial, but too little saving for the whole country and for individuals during their working years reduces productive investment and the income growth it produces and increases the economy’s vulnerability to shocks. As a nation our net savings rate became negative in 2005 and remained near zero until this year. This has been possible because of high savings rates in the rest of the world and the ability of foreign governments, firms and individuals to invest large amounts of these savings in the United States. Foreigners were willing to invest in the U.S. (largely in government and private sector debt and to a much lesser extent in equity) for only modest yields because of their confidence in the safety of U.S. investments and they were able to do so because our (previously) overvalued currency (the so called “strong dollar”) created a large current account deficit (excess of imports over exports) that foreign investments in the U.S. helped finance.[1]

The inflow of foreign savings has kept interest rates low in the U.S. in recent years. This is a so called “real” rather than a “monetary” phenomenon. During the period from December of 2001 until November of 2004 the Federal Reserve’s overnight interest rate (fed funds rate) target was below 2% and the unusually low interest rates of this period are thought to have feed the housing price bubble. Many have claimed that these low rates were the result of excessively easy monetary policy, but this claim is somewhat contradicted by the evidence. During this period of low interest rates the broad measure of the money supply (currency plus the publics’ deposits with banks—M2) grew on average at 6.2%, exactly the same average rate as between 1980 and now.[2] During the shorter period between December 2002 and June 2004, when the fed funds rate was below 1.25%, M2 grew on average at 6.1% per year. However, when the fed funds rate was above 5% from November 1994 through March of 2001 the average growth rate of M2 was 6.4%.[3] The Federal Reserve’s adjustments in its interest rate target were largely stabilizing the growth in the money supply. A significantly higher fed funds rate during the 2002 to 2004 period would have resulted in much lower if not negative M2 growth. Interest rates were determined largely by the inflow of foreign saving. None the less, interest rates were negative in real terms (less than the inflation rate) and contributed to market exuberance. A slower than trend M2 growth (and thus higher fed funds rate) might have been more appropriate. Furthermore, M2 began growing in March of 2004 and the Fed should have begun increasing its Fed funds target rate sooner than it did.

During this period of low interest rates housing prices rose dramatically and financial market innovations exploded. Among the most important innovations were the growth and heavy reliance on securitization of debt (reselling it) and the reliance on collateral rather than expected cash flow when approving loans. In the case of mortgages, mortgage originators often sold the mortgages they issued to Fannie Mae or Freddie Mac or to private sector consolidators who packaged them together as collateral for a type of bond called a mortgage backed security (see "The U.S. Mortgage Market: the Good, the Bad and the Ugly"). These MBSs were then sold far and wide around the world to investors whose funds financed the growth in home ownership and rising home prices.

With the inevitable bursting of the real estate bubble, the estimated mortgage delinquency and foreclosure rates priced into mortgage lending rates and the privately issued MBSs proved optimistic and the value of these MBS began to decline.[4] This, and uncertainty over how far housing prices will fall and foreclosures will rise, are core features of the financial crisis we are now in. The losses in value to investors in mortgages and mortgage backed securities, though very large, should be absorbable by the widely disbursed holders of such securities without too much difficulty. However, the considerable uncertainty over the ultimate magnitude of these losses and increased concern over the status of other complex financial assets as economic activity slows have reduced the ability to trade these instruments (reduced their liquidity) resulting in a scramble among commercial and investment banks to replace their lost liquidity and to replenish their reduced capital. Not knowing who held these risky MBSs, banks also became reluctant to lend to each other. The continued flow of normal bank lending has been tightened and a credit crunch threatened.

A number of factors have been assigned some blame for the unexpectedly high losses in value and liquidity of some MBSs. Lenders were pressured into expanding sub prime loans by government policy that wished to increase home ownership for lower income families. However, even the reduced standards for qualifying for a mortgage loan were sometimes exceeded or ignored by lax or negligent underwriters eager to collect commissions. As long as housing prices were rising the risks of default seemed small. Over reliance on collateralized rather than cash flow lending contributed to weakened underwriting standards or the monitoring of compliance with those standards. MBSs issued by Fannie Mae and Freddie Mac are guaranteed by them (ultimately by tax payers) while private issue MBSs were generally divided into risk tranches and rated by rating agencies.[5] The rating agencies grossly under estimated the risks of subprime and Alt-A mortgages, which had only a limited history in a rising market on which to base expected default rates.

Unregulated or lightly regulated capital markets have many advantages. Regulations impose restrictions and compliance costs on financial dealings. If these costs exceed the benefits to the market in the form of safer loans, the costs of raising and allocating capital are increased to the detriment of investment and growth. In unregulated markets financial engineers are limited in the instruments they can create only by the willingness of investors to buy them. But this is a serious and important limitation common to most all products and their markets. The contracts by which mortgage back securities are packaged and sold were carefully developed to reassure potential investors that their risks were carefully controlled and understood. Underwriting standards are clearly stated and their enforcement is generally guaranteed or insured by the issuer or by third party insurers (by Fannie Mae and Freddie Mac in the case of MBS issued by them). It is hard to imagine that better contracts could be designed by regulators and they facilitated the flow of large amounts of money into mortgages, most of which are sound and beneficial. Yet things went wrong.

Peter Fisher, former Treasury Undersecretary for Domestic Finance, has argued that over reliance on collateral (for a mortgage, the house itself is the collateral) rather than cash flow (an assessment of the ability of the borrower to pay) lending has contributed both to lax underwriting standards (e.g. no doc or liars loans) and lax monitoring of the enforcement of those standards. He anticipates the reduction of securitization (collateralized borrowing) either as a result of regulation or market forces.[6]

Heavy reliance on collateral leaves borrowers to decide whether they can afford the loan or not. Borrows have a knowledge advantage in making the assessment. Whether they use that knowledge wisely will depend in part on whether they expect to suffer negative consequences from wrong judgments. With rapidly rising housing prices both borrowers and lenders assigned low risks to default. In fact, many borrowers fully intended to resell homes they knew they could not afford at higher prices before being forced to default (flipping). A critical feature of keeping borrowers honest and thus of relying on borrower’s assessments of their own ability to meet their payment obligations is to insure that they have enough of their own money at risk. Thus a reasonable down payment is critical. The traditional norm was 20% but government sponsored FHA loans require as little at 3%. When borrows have little or no financial stake in the loan, stricter regulation and scrutiny of their income and credit worthiness is needed.

Some in Congress have proposed to give courts the authority to force a loan restructuring if in the judgment of the court the resulting loan could be serviced by the borrower and the lender would be better off then foreclosing. Lenders are already free to renegotiate loans under these conditions. Giving the courts such authority would add an additional risk to lenders that they would need to reflect in either higher interest rates or higher eligibility standards (as are now applied to second homes where the courts already have such authority).[7] The proposal would create a moral hazard among borrowers to enter into mortgages they cannot service in the expectation of a court ordered renegotiation.

The timely servicing of mortgages with low down payments or that are sold to or through Fannie Mae and Freddie Mac are insured. The insurer has its money at risk and thus has a financial incentive to carefully evaluate the borrower’s capacity to pay. Much of the mortgage insurance was provided by Fannie and Freddie, who gambled with taxpayers’ money and lost more often than they would have if they had been risking their own money. Privately issued MBS also accepted unrealistically low borrower standards gambling that home prices would continue to rise. Fraud played a role as well. While carefully targeting regulations to improve transparency and capital charges against contingent liabilities (credit lines and guarantees/insurance) might be helpful, the market losses of careless lenders is the strongest guarantee of more prudent behavior in the future. Thus short term measures to help borrowers or lenders that reduce the consequences to them of their actions run the risk of promoting such behavior again in the future (moral hazard). Successful market regulation of financial markets depends heavily on the participants bearing the consequences of their actions.

If banks have over exposed themselves to risky mortgages and mortgage related assets to the point of insolvency, the United States has a relatively good and efficient bank insolvency regime. The process of liquidation is orderly and minimizes any secondary disruptions to financial markets. Shareholder owners bear the losses of their mistakes providing a very important market discipline for the future. The same legal tools are not available for investment banks and thus the Federal Reserve was more constrained in its options for resolving the financial problems of Bear Stearns. While Bear Stearns shareholders should probably have been totally wiped out, the arranged sale to JPMorgan Chase, with the help of some Federal Reserve guarantees came about as close to a typical FDIC failed bank resolution as the law permitted. Whether the existing bankruptcy regime would have worked as well is an important question for investigation, but it was a risk the Federal Reserve considered too great to take at the time. The government’s take over of Fannie Mae and Freddie Mac is (hopefully) the necessary first step in correcting the government’s folly in creating them in the first place and perpetuating them as semi private entities with both private profit and social/public mandates. The subsequent hands off approach to Lehman Brothers and Merrill Lynch were a welcome return to full market disciple. This was followed by the Federal Reserve’s take over of AIG insurance potentially wiping out the existing shareholders equity.[8] AIG had extended its traditional insurance business into insuring bank credits through “credit default swaps”, upon which market confidence in credit instruments has increasingly depended. No one really knows what the knock-on effects of a failure of an insurer of trillion’s of dollars in bank credits would be and the Fed was not willing to risk finding out the hard way.

Treasury Secretary Paulson has now urged Congress to authorize the Treasury to buy up to $700 billion of MBS “from any financial institution having its headquarters in the United States”[9] under terms and conditions determined by the Treasury. The Treasury would be required to “take into consideration means for…protecting the tax payer.”[10] The motivation for this staggering program seems to be to replace now illiquid assets of unknown value on bank balance sheets with cash (or government securities) and to stabilize the secondary market for MBSs thus restoring their liquidity. As yet unanswered questions include which MBSs the Treasury will buy and what they will pay for them. Presumably they wish to buy those MBSs banks have the most trouble valuing or selling. George Will called the scheme “Lemon Socialism.”[11] If the Treasury pays more for MBS than they are subsequently worth, they will have subsidized the investors’ mistakes with tax payer money with potentially very serious moral hazard consequences. If they pay fair value somehow determined, this will shift any remaining uncertainty and risk from the investor (banks and other financial firms) to tax payers, which is indeed the intent. This should free up bank liquidity to continue normal lending. It would also lock in a potentially large profit for those sellers who bought the MBS at a steep discount.

If the intent is really to restore liquidity to MBSs rather than to raise their value and thus the capital of those institutions holding them, the scheme is unnecessary because the Federal Reserve can lend banks any amount against these MBSs as collateral and has already introduced new lending facilities with longer maturities. There are many advantages to the Fed’s lending against MBS collateral over the proposed Treasury purchase of them. Their valuation (or misevaluation) is much less important unless the borrowing bank fails because the MBSs remain the property of the borrowing banks and are returned to them when the Fed loan is repaid. The proposed Treasury scheme would exchange MBSs for treasury securities and thus would not increase base money and the money supply. Fed loans can also be extended without unwanted increases in the money supply by matching such loans to particular banks with open market sales of treasury securities owned by the Fed to other banks.[12] If the proposed Treasury scheme is not necessary as a means of increasing liquidity, the Treasury’s purpose must really be to raise bank capital by increasing the value of the MBS in their portfolios. This would be a tax payer subsidy of investor mistakes with serious moral hazard consiquences.

Sebastian Mallaby argues convincingly that the Treasury plan only superficial resembles the highly successful Resolution Trust Corporation (RTC) set up in 1989 to maximize the recoverable value of bad S&L loans. The RTC expedited the liquidation via purchase and assumptions or otherwise of failed S&Ls. It had no real choice over the problem loans it had to sell for which it paid the best estimate of a fair market price.[13] More importantly, the creation of the RTC was part of a broader strategy of resolving failed S&Ls via take over and bankruptcy that ended several years of forbearance. It is worth remembering that because of inadequate funds in the reserves of the deposit insurers insolvent S&Ls were artificially kept alive for several years with disastrous results that greatly increased the ultimate $150 billion or so cost to tax payers. This weekend’s Treasury proposals smell more like the banking forbearance that preceded the RTC than their resolution of which the RTC was a part. The Treasury would be choosing what MBSs to buy from still operating financial institutions. As noted above, these institutions are already able to borrow very large amounts from the Fed using these same MBSs as collateral. From the proposed law and what little the Treasury has said about how it would implement it, it is hard to see how it would contribute much beyond a huge injection of tax payer money to save those institutions that made bad investment decisions. Market discipline could suffer for many years virtually requiring a significant increase in supervision to take its place. According to Mallaby, “Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans.”[14]

It is appropriate for the government to intervene to restore or preserve stable financial market if doing so saves tax payers money in the long run. However, such interventions should be well targeted and should minimize to the extent possible creating moral hazard incentives for financial institutions to take risks with tax payers’ money. We are rapidly reaching the point where the credit worthiness of the United States government itself is coming into question as a result of the growing list of unfunded commitments it has made.

Both private sector and government debt has skyrocketed in recent years. Credit market debt stood at 2.3 trillion dollars in 1990, 6.4 trillion in 2000 and 12.9 trillion at the end of 2007. U.S. government debt (leaving aside state and municipal debt) was 3 trillion in 1990 (51% of total national output that year), 5.8 trillion in 2000 (59% of GDP), and 9.5 trillion (69% of GDP) at the end of June this year. Twenty eight percent of its (2.6 trillion) is foreign owned. The Treasury and Federal Reserve have just added a potential additional trillion dollars to this debt with their various rescue actions and proposals.[15] Annual interest on this debt at the 3.8% currently paid for 10 year government bonds (while below the average interest on the debt) would be almost 400 billion dollars or about 14% of the total Federal budget. This seems quit manageable until the true deficit including the unfunded liabilities of Medicare/Medicaid and Social Security are added. According to Richard Fischer, President of the Federal Reserve Bank of Dallas, these are ten times the existing debt.[16] Interest payments on the full true debt would exceed total Federal tax revenue. Existing government spending promises simply cannot be met. Some mix of reductions is existing entitlements and increases in tax revenue will be required. Our goal should be to minimize the negative impact on economic growth of that mix in order to maximize the additional government revenue arising from a higher tax base.[17]

[1] This suggests that foreign savings were pulled into the U.S., but an equally convincing case can be made that China’s and Japan’s desires to prevent or moderate the appreciation of their currencies against the U.S. dollar resulted in huge accumulations of dollars in the reserves of their central banks, which could only be invested in the U.S.

[2] Within this average, the year on year percent change varied considerably from zero to 13%.

[3] Federal Reserve Bank of St. Louis

[4] Payment of interest and principle on mortgages underlying MBS issued by Fannie Mae and Freddie Mac are guaranteed by them so the risk of delinquencies or defaults falls on them rather than on the investors in their MBSs.

[5] The role played by Fannie Mae and Freddie Mac in encouraging excessive mortgage lending are discussed in "Fannie and Freddie, More Good, Bad, and Ugly"

[6] Peter Fisher, "Lending’s Blind Spot" The Washington Post, September 20, 2008, P A19

[7] Appling this authority retroactively to established contracts would violate the constitution’s ex post facto restrictions in Article I Section 9.

[8] The Fed has yet to clearly explain the details of this operation.

[9] Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets, Sec. 2.

[10] Ibid.

[11] George F. Will, "Bailout on Wheels", The Washington Post, September 21, 2008 Page B07

[12] The Fed has already run out of treasury securities that it could sell but it is already achieving the same effect via the sale of treasury securities by the Treasury (at the request of the Fed) in excess of what the Treasury needs to sell for government financing. The proceeds of these extra sales are deposited in a special frozen treasury account at the Fed. The monetary effect is the same as if the Fed had treasury securities in its portfolio and sold them in the same amount.

[13] Sebastian Mallaby, "A Bad Bank Rescue" The Washington Post, September 21, 2008 Page B07

[14] Ibid.

[15] In fact the tax payer cost will be much smaller than this. In the latest proposal the Treasury will issue up to $700 billion in treasury securities to exchange for MBSs (an asset swap). Tax payers loose only to the extent that the MBSs are ultimately resold for less than the Treasury paid for them.

[16] "Storms on the Horizon" Speech to the Commonwealth Club of California, May 28, 2008

[17] Brice Bartlett, "Back to Square One" The Washington Post, September 21, 2008, Page B07

Is the Fed Running Out of Money?

“The Federal Reserve has requested that the Treasury Department deposit $40 billion with the central bank in an effort to help the Fed continue to stabilize the financial markets and address concerns about whether it is overstretched.”[1]

David Cho goes on to give a correct explanation of the above somewhat misleading statement. But another commentator pronounced that the money was needed to bolster the Fed’s balance sheet. Bolster the Fed’s balance sheet? The Fed prints money. It can lend any amount that it decides to without help from the Treasury. So what is going on?

For the past year banks and other financial institutions have had difficulty managing the inflow and outflow of funds through their balance sheets because their usual tools for balancing the two (liquidity management) stopped working (a slight exaggeration). An insurance company, for example, collects premiums from policy holders on a regular basis and disperses money when insurance claims are made at unpredictable irregular times. Over the long term these inflows and outflows largely balance (with a margin for operating expenses and profits). But over the short term they do not. Insurance companies invest premiums in assets that can be sold easily when they must pay claims. Carefully managing their liquidity in this way reduces the cost of providing insurance and thus lowers premium payments. This is but one type of liquidity management.

This past year many normally quite liquid assets (i.e. those that can be easily sold for cash at a reasonable price like high grade corporate bonds, treasury bills, and various collateralize securities) became illiquid (difficult to sell except at a steep discount) because markets lost confidence in the underlying value of these assets (especially mortgage back securities). It is one thing for the value of an asset to fall by a known amount (e.g. bond prices falls by well know amounts when interest rates in the market increase). It can only be sold in the market at the lower price but it remains liquid in the sense that it can be sold quickly and without difficulty at that lower price. But in current market conditions the underlying loss or potential loss in value is uncertain, making the sale of such assets much more difficult. An insurance company needing to sell assets to pay for claims arising from damage from Hurricane Ike can only do so be selling them well below their probable (but uncertain) future value. Their option of holding on to these assets and borrowing the money needed to satisfy claims is unattractive as well because borrowing from other financial firms or from the market (e.g., by issuing bonds or commercial paper) has become very expensive because firms are holding on to their cash to bolster their own liquidity or are adding larger risk premiums to lend to other financial firms.

In this environment the Federal Reserve has taken a number of steps to unblock the flow of funds in the market and to satisfy the increased demand for liquidity. Normally when the “market” needs liquidity the Fed buys treasury bills from some 25 or so primary dealers who then on lend the funds to other banks and financial firms needing it (or replenish their t-bill holdings by buying them from other sellers). When the market has too much liquidity, which pushing short term interest rates down, the Fed sells back some to the t-bills from its holdings to prevent inflation. Because of the large increase in uncertainty over the value of many financial assets and the soundness of financial firms, this “interbank” market for liquidity is not working well to spread adjustments in liquidity throughout the entire country (the Fed’s open market operations all take place in New York City). Thus the Fed has opened new lending facilities to a broader range of financial firms that can borrow directly from it in order to help the liquidity get to where it is needed. All Fed lending is collateralized so the risk of not being repaid is negligible.

The enormous amounts that the Fed is lending through these new facilities, while needed by the specific borrowers, provides more liquidity than is needed by the market as a whole given the Fed’s target for inflation. Thus the Fed reabsorbs some of it through its normal open market operations in New York (the sale of t-bills to its primary dealers in daily auctions). These operations keep the federal funds rate at the level targeted by the Federal Reserve in light of its inflation target. So the Fed is lending through one window and reabsorbing some but not all of that liquidity through another (open market sales of t-bills).

Normally the Fed can inject all the liquidity it wants to by buying t-bills or by lending through one “window” (facility) or another. It has no balance sheet limit on the amount of liquidity it can provide because as the central bank it can “print” all of the money it needs to. However, its ability to round trip (lend through one window while buying back some liquidity through another) is limited to the amount of t-bills it owns and can sell. The Fed as run out of t-bills to sell and unlike the money it can create (print) it cannot create t-bills. Some central banks in the world in this situation, issue their own bills (central bank bills).

A better solution, however, is for the Treasury to issue more of its own bills to the market than it needs for financing the government and to deposit the extra money with the central bank. Normally when the Treasury raises money by issuing t-bills and bonds, the money it receives is deposited in banks and thus remains in the private economy. Treasury borrowing of this sort does not effect bank liquidity (the money moves from the accounts of those buying the bills to the account of the Treasury. But if the money is deposited with the central bank it is taken out of the system (reduces liquidity). That money is not for the use of the central bank but rather to reduce liquidity in the market just as if the central bank sold t-bills it already owned or issued its own bills. The money deposited by the Treasury is impounded and not used just as the money collected by the Fed when it sells t-bills is impounded (it is wiped off the books). This is exactly what the U.S Treasury has just done at the request of the Fed. Its effect is identical to the liquidity reducing effect of a sale of t-bills by the Fed in a traditional “open market operation.” It does not reflect any financial weakness of the Federal Reserve. It reflects good cooperation between the Treasury and the central bank.

[1] David Cho, "Fed Asks Treasury Dept. for Funds to Backstop Intervention Efforts", The Washington Post, September 17, 2008

The Russian Bear

My generation grew up thinking of Russian/Soviet behavior and motives as reflections of an ideological commitment to communism. With acceptance within Russia and most of the rest of the world that communism and economic central planning are deeply flawed and failed systems, we looked forward to better relations with a better behaved Russia that could finally take its proper place in the world commensurate with the highly respected cultural contributions of its people. Thus Russia’s behavior in recent years is a deep disappointment.

In reality, Russia’s international behavior has always tended to reflect admiration of “the West” and a strong desire to participate in and be respected by the West, despite the continuation of repressive feudal social structures within Russia. This contradiction aggravated an inferiority complex Russia seemed predisposed to anyway. These forces fed Russia’s century’s old impetus toward geographical expansion as the solution to its insecurities with regard to its “near abroad.”

Scott Thompson relates that “In 1980 just after Ronald Reagan’s election, a think tank in Philadelphia held a semi-official meeting with Moscow’s foreign policy elite, starting with Yuri Arbatov, the head of the USA Institute. Mr. Arbatov responded to our challenge—that Moscow was acquiring a vastly greater strategic military force than what America possessed—by saying that Moscow faced hostility along all its borders.  China bristled with might along that border, all the European states disliked it, and on its southern border there were hostile regimes. He contrasted this with the unarmed and peaceful boundaries the USA had with Canada on its north and Mexico on its south. One of us responded, ‘if you treated your neighbors the way we do, you wouldn’t be facing enemies on your borders.’”

With its outrageous attack on Georgia last month, Russia has reverted to earlier form. Tragically, it seems not to understand how respect in the West is earned, starting with the rule of law. One of the speakers at the Mont Pelerin Society meetings I am attending in Tokyo,[1] Andrei Illarionov, chronicled for us Russia’s multi-year preparations for this invasion. Andrei was the chief economic adviser of then Russian President Vladimir Putin from 2000 to December 2005. At lunch he told me that the U.S. invasion of Iraq provided Putin with the example of how great nations behave and he emulated it. Russia’s behavior cannot be easily explained he said. “Putin and his advisors are acting like confused teenagers wanting to be treated like adults. Who can understand it or make sense of it. It makes no sense either economically or politically.”

Andrie, and me,

When Russia sends its fleet into the Caribbean to visit Venezuela’s President Chavez, it will see itself as following the example of the United States Navy steaming into the Black Sea to the coast of Georgia. In many respects they are the same. A Russian visit to our near abroad is no more threatening to our security than our fleet’s visit to the Black Sea and the ports of Georgia is to Russia’s. Yet we are sensitive to such demonstrations, as are they. We should try to understand and respect Russia’s demand for greater influence in its own back yard, but we should insist that it behave in a civilized manner if it wishes to be apart of the civilized world. I would not support going to war to defend Georgia, but I do believe we need to strongly express our strong support of its democratically elected government and its right to its sovereignty and to raise the price to Russia or any other nation that violates broadly accepted international norms of behavior for such behavior. We also need to insure that we observe those norms ourselves.

[1] Other speakers included Vaclav Klaus, President of the Czech Republic, Edward Lazear, Chairman of the U.S. President’s Council of Economic Advisers, Myron Scholes, Nobel Prize in Economics recipient in 1997, Gary Becker, Nobel Prize in Economics recipient in 1992, Junichi Ujiie, Chairman of Nomura Holdings, and William Niskanen, Chairman of the Cato Institute.

How to measure the size of government

What is the right size of government? Obviously our answers vary depending on our understanding of the facts and the value we each place on different activities. It should be possible, however, to narrow the range of answers to differences in individual preferences (values). A good starting place is to agree on how to measure the size of government. My real interest in this note, however, is in how best to finance whatever government we wind up having.

The size of government should be measured by the resources it commands. This is obvious with regard to the government buying goods and services and employing people. These resources are taken from the private sector and employed for government purposes. If these purposes have greater value to us than their alternative value in private use (what economists call their “opportunity cost”), society as a whole is better off as a result. This is the economist’s famous cost benefit test.

People sometime confuse the size of government with the taxes leveled to finance it. Reducing taxes without reducing the government’s command over resources does not reduce the size of government. Rather it shifts how the resources commanded by government are paid for. But how the government gets and pays for these resources is important too because it can impose additional costs over and above the cost of just taking command of them. So what are the options? Here are the Good, the Bad and the Ugly choices. I have been indulging in a Clint Eastwood retrospective, if you haven’t noticed, and I am impressed by how many things can be conveniently partitioned this way.

When it comes to paying for government it is a bit of a stretch to talk of the Good. Almost all ways of paying for government distort private decisions and thus resource allocations to some extent, but some methods are clearly better than others. The goal should be to share the burden of government fairly and with the least disturbance and distortion to the private economy as possible. The view that the free market is generally the best allocator of resources is now so widely accepted that Democratic Presidential candidate Barak Obama said “The market is the best mechanism ever invented for efficiently allocating resources to maximize production. And I also think that there is a connection between the freedom of the marketplace and freedom more generally.”[1] I start at the top and descend to the ugly.

User fees

If the government is providing goods and services to specific individuals, they should generally be willing to pay for them especially since they value them. If the government provides a passport for an American or an entry visa for a visitor, it is both economically more efficient and fairer for those getting these services to pay for them rather than for someone else to. This mirrors the resource allocation efficiency of the private sector where prices reflect supply and demand. The same principle applies to highways, airports, schools and medical facilities. Why should those without cars pay to build highways for those who have them? And if drivers are willing to pay more than the cost of building a highway, it should be built. Taxes on gasoline are an attempt to charge user of roads for the cost of building them as are tolls on highways.

Institutions such as colleges and hospitals present a mixed case. They mix the provision of services for those who benefit individually from them and can pay for them with income transfers to those who can’t. But these two aspects can and should be separated by charging for these services and subsidizing the payments from those who can’t afford them. A different argument is generally made for primary and secondary education where the argument is that all of society benefits from this level of general education and thus everyone should help pay for it and thus a user charge is not appropriate. People without children sometimes object to this argument. Applying wage taxes on workers to pay for their social security is another example of mixing things up. Social Security is not a pension from saving while working. It is a pay-as-you go tax on the currently working to pay the pension of those already retired. My thoughts on Social Security are here: "Saving Social Security"

General taxation

Government command of resources for the general benefit of the whole country should be paid for with taxes on the whole country that are fair and that distort economic decisions of the public as little as possible. User fees are infeasible and inappropriate in these cases. A properly designed comprehensive income or consumption tax (no exemptions for favored activities) at a flat marginal rate fits these criteria. Views differ on the fairness of progressivity. For me, it is “fair” that someone with twice the income pays twice the tax, which is what a flat tax rate does. A flat tax is actually modestly progressive because the tax rate is actually zero up to the level of income from which the flat marginal rate applies. I prefer the consumption version (VAT) because it does not distort saving and consumption decisions by taxing saving but not consumption. Business income taxes found in most countries are very hard to justify (other than relative ease of collection for companies that do not operate across borders) as such income is taxed twice, once at the company level and again as income to this shareholders. For example, Moldova recently reduced its business income tax rate to zero. My slightly more developed thoughts can be found in: "The Ideal Tax System"

Debt finance

Here we descend to the “bad.” Governments can finance their activities by borrowing from the public. This has the “virtue” that those lending to the government (buying is bills and bonds) do so voluntarily because of attractive interest rates and low risk (I leave aside the now thoroughly discredited practice of some earlier governments of mandating purchases of government securities in one way or another). However, this financing tool falls almost fully on capital. The diversion of saving from financing capital to financing government “crowds out” and thus reduces private capital formation. While it is possible in principle that the resulting increase in interest rates increases saving and thus takes some of the government financing out of consumption, empirical evidence suggests that this effect is very small.

Cyclically balanced budgets are much more defensible. When the budget is balanced over the business cycle, governments save (spend less than their tax revenue) during the boom phase of the cycle and dis-save (or borrow) during the recession phase. Such behavior results from maintaining constant government spending over the cycle and has an automatic stabilizing effect on output.

Discriminatory taxes

Some taxes look a bit like user fees but are not actually linked to the provision or use of a government services to those paying these taxes. They simply fall on particular economic activities and thus increase the cost and reduce the supply of those activities. These clearly distort resource allocation. Examples are import duties and excise taxes.

If, however, an activity is taxed (or subsidized) that has social costs (or benefits) not paid for (or received) by those undertaking the activity, the tax (or subsidy) can actually improve resource allocation. In other words, to the extent a tax reduces any gap between private and social costs of an activity it will bring private decisions with regard to the activity more in line with the true cost to the economy, which will improve the efficiency of resource allocation. The classic example is a pollution tax. If, for example, activities that add carbon dioxide to the atmosphere contribute to global warming (a scientific assertion that is still under some debate), such as burning coal or gasoline (when driving a car), are taxed by the amount of that damage, the public’s decisions about whether and how much carbon fuels to use will better reflect the true cost to society of its use. This would improve the efficiency of resource allocation. Simply prohibiting the use of carbon fuels runs the strong risk of imposing a cost (in the form of the next best alternative energy sources) far greater than the benefit.


I am not sure whether to categorize lotteries as “ugly” or “merely “bad.” They are voluntary, which is a virtue. However, they might be said to exploit human weakness for gambling. Gambling can be an acceptable entertainment for those with the money to pay for it, but can become the desperate effort to get ahead by those who cannot. Most jurisdictions restrict or even forbid lotteries except when offered by the tax authority. This is morally odd indeed. The state grants itself a monopoly in an activity considered generally inappropriate and thus forbidden to private enterprise, on the grounds that the state puts the money to good us. Lotteries are generally regressive (raising money disproportionately from lower income families).

Mandates (outsourcing)

This is a seductive form of financing the government’s command of resources. Government regulations from banking supervision to product safety and much more reflect government command of resources a bit more indirectly. The costs of these regulations are as real as if the government bore them directly, but they are generally paid for by the regulated entities. They should be subjected to the same cost benefit assessment as any other government program. The danger of mandates is that because the costs do not appear in the government budget it is too easy and thus tempting for the government to undertake such regulations and mandates as if they had no cost at all.


Inflation is clearing in the “ugly” category. First it is the easiest of all taxes to administer. The central bank just prints the extra money to lend to the government to cover the cost of its activities (not covered otherwise). The government spends the money thus taking the resources away from the private sector. The private sector reduces its own spending as a result of the fall in the real value (purchasing power) of the cash held by the public. Thus economists refer to inflation as a tax on the holding of central bank money (currency and bank deposits with the central bank). While seductively easy to administer, the inflation tax has two serious shortcomings. First, it is generally hard to anticipate accurately and unfolds unevenly and thus tends to distort relative prices. Distorted relative prices distort resource allocation and thus slow the pace and quality of economic growth. Second, the inflation tax is regressive and thus fails the fairness test. Cash is held disproportionately by lower income families and thus the loss of purchasing power is born regressively.

The pernicious effects of inflation and the tempting ease with which government can “borrow” from its central bank have led to a world wide movement to protect central banks and their monetary policy from government by making them “independent.” Most central bank laws now prohibit or tightly limit central bank lending to government.

The health and well being of society and the economy depend in part on getting the size and nature of government right. But it also depends on financing those activities in the fairest and least distorting ways.

[1] Quoted in David Leonhardt, "How Obama Reconciles Dueling Views on Economy," The New York Times Magazine, August 20, 2008

Sarah Palin

I asked my UC Berkeley ATO fraternity brother, Steve Paliwoda, who now lives in Alaska, for his thoughts on McCain’s choice for his running mate. Here is his reply:


I think McCain’s selection of Sarah Palin as his Vice Presidential running mate could well prove to be the most savvy Vice Presidential choice in a very long time. Certainly the timing of the announcement of such an unexpected and interesting choice, coming as it did the morning after the end of the Democratic Convention did much to divert the public’s attention from Barak Obama. Thus, such well-known Friday evening news programs as "Washington Week" and "Bill Moyer’s Journal" spent a goodly amount of their air time discussing Sarah Palin, instead of talking about nothing else but Obama and Biden. Chalk one up for the Republican campaign.

Sarah Palin is arguably more of a political novice than Obama. Before being elected Governor of Alaska a year ago last November, she had served one — maybe two — terms as the Mayor of the town of Wasilla (pronounced just like it’s spelled: wah-SILL-ah — that is, I think it was Wasilla, which is a sizable strip-mall town about 40 miles north of Anchorage, and is the major town of that area, which is known as the Matanuska-Susitna (mat’n-NUS-ka soo-SIT-ka) Borough. Sarah is not new to the public eye, for I think that soon after she graduated from High School in the early 1980’s she won a local or regional beauty contest. She may have served on the MatSu Borough or Wasilla City Council for a term or two before being elected Mayor — I’m not sure about that.

I did not vote for Sarah in her run the Alaska Governorship; I voted instead for the Democratic candidate, Tony Knowles, who I felt was far more qualified. Tony is a Yale grad, originally from Oklahoma, and had served two 4-year terms at Mayor of Anchorage in the 1980’s, and two 4-year terms as Alaska’s Governor in the 1990’s. He then ran unsuccessfully for Senator, but was defeated by previous Senator Frank Murkowski’s daughter Lisa (that’s a long story). Tony then ran again for governor against an "unknown" Sarah Palin, who had defeated the corrupt incumbent Frank Murkowski in the Republican Primary, but it seemed that the Alaska voters were tired of the "old guard" of politicians, and welcomed someone new and fresh, like Sara (BTW, Tony served in all his offices with honor and distinction; however years before starting his political career, he worked for an oil company; and, however unjustly, that was what undid him in the last election).

…And BTW, I don’t know whether I ever communicated this to you before, but in August and September of 1982, I served in then-Senator Frank Murkowki’s Washington D.C. office (in the Dirkson Building) as a temporary volunteer "intern". Believe it or not, they assigned me to perform initial research into the legislative background of what was then an unknown subject: "Wetlands". (That’s another long story.)
Getting back to Sarah: She has impressed people since taking office with practically everything she’s done. She knows how not to tread on people’s toes. She is not owned by anybody. The women lover her. She dresses and carries herself like many of the women voters who like her so much. She is a "natural" when it comes to public speaking, and yet does not come across as overblown or affected. She has a good public presence, without the political bombast. Now, it will be a challenge to her to be able to present herself well to reporters during the campaign on such subjects as international relations — but she is not easily fazed, has a quick mind, and is very "believable" when she speaks. She has a couple young kids, and recently gave birth to a Down-Syndrome son — which was expected early in her pregnancy, but which she chose to have anyway. ….The debate between her and Joe Biden could conceivably be more interesting to watch than the debate between McCain and Obama. Certainly, the audience for the vice-presidential debate (I presume there will be one) will draw an enormous audience, for the public has had such a steady diet of McCain and/or Obama over the past several months that they’ll dying to watch somebody new.

She has some conservative leanings when it comes to religion, and if memory serves, has made anti-abortion statements, and (I’m not sure about this next one) is tolerant toward the idea of teaching "Creationism" in public schools. Even so, she has enough brains to know such subjects are controversial, and is not one to go around trumpeting publicly such beliefs.

This summer, her office has been the center of attention regarding a couple mini-scandals, whereby (1) The guy she selected as head of Alaska’s State Troopers (a local police chief) had previously been chastised for supposedly being too "familiar" with one of his female subordinates. The letter that was put in his file was eventually expunged. His "slip-up"? — He failed to tell Sarah about that letter when she interviewed him for the job. Sarah didn’t appreciate the "surprise" when reporters dug that one up, so about a week later, the newly-hired Troopers Chief resigned. He’s now trying to get his old Police Chief job back. …and (2) One or two of her aides made pointed remarks to the previous Chief of State Troopers that he should consider firing a particular Trooper who had been chastised in the past for a variety of misconducts. The interesting point here is that the guy is currently involved with Palin’s sister in a nasty divorce-and-child-custody lawsuit. Sarah claims she never knew about the suggestion made to the Trooper Chief, and has temporarily "suspended" (i.e., put on leave with pay) the person who had the discussion(s) with the Chief.

Bottom Line: Sarah Palin is a very interesting choice for McCain’s Vice President, and will be the subject of much attention and discussion — which is just what the Republican want, I’ll bet. Her ability to be President of the U.S., Commander-in-Chief of the U.S. armed forces, and leader of the free world, in case McCain’s cancer snuffs him out — well, that’s another matter.

Steve Paliwoda

Saving Social Security?

Without changes, the Social Security payroll tax will stop raising enough money to meet the system’s pension payment obligations in 2018, just 13 years from now. This funding shortfall can be corrected with only modest adjustments, if action is taken now. Indexing retirement benefits on the consumer price index rather than the average wage increases would eliminate most of the shortfall and modestly and gradually increasing the retirement age a few years would reduce the rest. Other adjustments are also being discussed. The change in the benefit index would reduce the planned increase in benefits and leave the real value of current benefits unchanged. Choose which ever way of saying it that sounds best to you. Both are correct.

The issue of privatizing or otherwise reforming the nature of the system is another matter all together. Evaluating such reforms calls for a clear understanding of the purposes we wish Social Security to achieve. Before we can intelligently debate whether SS should be a fully funded insurance program (whether with a defined benefit or a defined contribution) or continue as a pay-as-you-go entitlement, we need to debate the role we want it to play in our overall system of retirement income.

Traditionally most Americans’ retirement incomes come from employer based pensions and individual savings (home ownership, whole life insurance, and other investments). Schools taught the need for proper preparations. On August 14, 1935, when the country was still struggling to overcome the Great Depression, President Franklin D Roosevelt added a mandatory government pension when he signed the Social Security Act. In addition to old age pensions, the Act established unemployment compensation, and aid to children and to the ill.

Roosevelt intended for the old age pension provided by Social Security to be a mandatory, defined benefit pension financed by the contributions of the pensioner and his employers over his working life. The system provided a guaranteed minimum pension for those who worked and paid into it. However, the relationship between what a person paid in and ultimately received was never close. Those at or near retirement when the system started were allowed benefits that were financed by young workers who would not draw their own benefits for many years. Pay-as –you-go financing is the cause of the upcoming financing problem as baby boomers swell the ranks of the retired. “As a result, the ratio of workers paying Social Security taxes to people collecting benefits will fall from 3.3 to 1 today to 2.1 to 1 by 2031.”[1] It was over 8 in 1955. The tax burden on those currently working is raising fast.

In its current form, Social Security’s old age pension is a complicated structure that is neither a sound insurance or pension scheme nor a well-designed and targeted safety net. The payroll taxes that finance it “account for more than 25% of all federal revenue; its payments represent more than 20% of all federal spending. For almost two-thirds of American’s pensioners, Social Security payments make up over half their income.”[2] As a social safety net, it does not target benefits or redistribute income in a clear and defensible way. As a compulsory, government administered pension, it is not financially sound and is considered by many to be an inappropriate and unnecessary government intrusion into private life.

How the system should be reformed, if at all (rather than merely fixing its demographic based financing problems), depends on how as a nation we answer the following questions: “Is Social Security a planning vehicle that an individual uses for his or her own retirement, or is it a pooling of resources so that all of society can meet the needs of its older members? Is it about each person saving for himself, or is it a matter of young helping old and rich helping poor?”[3] Should Social Security be part of the social safety net that Ronald Reagan spoke of for a society in which individuals and families are basically responsible for their own lives, or should it be an instrument of collective social responsibility for public welfare? The attitudes behind different answers to these questions reflect the great divide that has always separated (in varying degrees) Republicans and Democrats. But there may be a proper place for each view.

World Bank research found “that financial security for the old—and economic growth—would be better served if governments develop three instruments, or ”pillars,” of old age security: a publicly managed pillar with mandatory participation and the primary goal of reducing poverty among the old; a privately managed, mandatory saving system; and voluntary savings. The first covers redistribution, the second and third cover savings, and all three coinsure against the many risks of old age. By separating the redistributive function from the saving function, the amount of spending in the public pillar—and the tax rate needed to support it—can be kept relatively small. Spreading the insurance function across all three pillars offers greater income security to the old than reliance on any single system.”[4]

“A central recommendation of the [World Bank] report is that countries should separate the saving function from the redistributive function and place them under different financing and managerial arrangements in two different mandatory pillars—one publicly managed and tax-financed, the other privately managed and fully funded—supplemented by a voluntary pillar for those who want more.

“The public pillar would have the limited object of alleviating old age poverty and coinsuring against a multitude of risks. Backed by the government’s power of taxation, this pillar has the unique ability to pay benefits to people growing old shortly after the plan is introduced, to redistribute income toward the poor, and to coinsure against long spells of low investment returns, recession, inflation, and private market failures.”[5]

For the United States, the World Bank’s advice suggests a much smaller public pillar (the existing Social Security system), targeted on the poor (means tested) whether they had worked and contributed to retirement income or not. It would be financed from the government’s general revenues, not from wages if there were any. This social safety net would be supplemented by the second, mandatory savings pillar, which should sharply limit the need to resort to the first pillar. This mandatory, defined contribution, second pillar would be satisfied by qualifying (and regulated as now) company pension funds, 401K plans, or social security tax contributions to private mutual funds. Reasonable, but not excessive, restrictions and safeguards would be required. Recent experiences with pensioner losses with defined benefit pensions when their employer goes bankrupt indicate that further reforms of the private pension system are still needed as well.

The system would insure that those who could, i.e. those with jobs, would save enough for minimally acceptable levels of retirement income, but would still protect those who had not adequately protected themselves, whether from inability, short sightedness, or bad luck. Allowing workers to manage more of their retirement savings has several advantages. More would be invested in stocks and private bonds, which historically have yielded more on average than government bonds. Such savings would be part of the pensioner’s estate and any unused part would be passed on to his/her heirs. Both the reduction in wage taxes and the real savings of private pensions would tend to increase the supply of labor and national savings and investment, and thus economic growth. Fully funded benefits from saving would be free of the demographic problems now besetting our pay as you go system. Benefits from the second tier would be closely related to contributions, which would tend to increase saving (and economic growth) and to be seen as fair. Workers would become capitalists and thus potentially more sensitive to the health of the economy. Those who could not contribute enough, or experience poor returns on their investments would be protected by the first, public pillar.

President George W. Bush’s current proposals for Social Security combine both financial fixes for the existing system and substantive reform of the system by introducing “personal accounts.” His recent proposals may be seen as transitional steps to the above system. However, like the existing system, current proposals constitute a mixed and rather incoherent collection of ideas. The final result will be more satisfactory to everyone if the details now being debated contribute to a coherent overall three pillar plan for the provision of retirement income and medical care.

[1] “Fast Facts and Figures About Social Security, 2004,” U.S. Social Security Administration.

[2] “How to mend Social Security,” The Economist, February 12 2005 p 10.

[3] Steven Mufson, “FDR’s Deal, In Bush’s Terms,” The Washington Post, February 20, 2005, page B3

[4] “Averting the age old crisis for the old,” World Bank Policy Research Bulletin, August – October 2004, Volume 5, Number 4.

[5] Ibid.