What Does John Makin Believe?

I was interested to read recently at the Huffington Post that John Makin, an economist at the American Enterprise Institute (“AEI”), a conservative Washington, DC think tank, had recently written that the U.S. was already on a deficit reduction path and that there should not be more deficit reduction at the current time. Of course, liberals like this message coming from a conservative, but, if one reads Makin’s paper, there is much in it for liberals to dislike. The paper does not appear, though, to be aimed at convincing liberals. It is aimed at a different audience.

Before turning to this recent paper, I note that Paul Krugman once praised John Makin in a post about an article Makin had written in 2010. The title of Krugman’s post was “John Makin’s Hair Is On Fire.”  Krugman wrote that even though Makin is a political conservative at a “right-wing think tank,” he had written “something I or Jan Hatzius (Goldman’s chief economist — never mind the Blankfein stuff, the econ group is very good, and very pessimistic) might have written. Except Makin is even more gloomy, warning that we might enter deflation this year.” 

The article to which Krugman was referring is a July 2010 Economic Outlook piece called “The Rising Threat of Deflation.”  It is worth reading, and it certainly does not toe the line that austerity (“fiscal consolidation”) is a good idea.  At the end of the article, Makin writes:

“The G20's shift toward rapid, global fiscal consolidation--a halving of deficits by 2013--threatens a public sector, Keynesian ‘paradox of thrift’ whereby because all governments are simultaneously tightening fiscal policy, growth is cut so much that revenues collapse and budget deficits actually rise. The underlying hope or expectation that easier money, a weaker currency, and higher exports can somehow compensate for the negative impact on growth from rapid, global fiscal consolidation cannot be realized everywhere at once. The combination of tighter fiscal policy, easy money, and a weaker currency, which can work for a small open economy, cannot work for the global economy.

“The link between volatile financial conditions and the real economy has been powerfully underscored by the events since mid-2007. Growth has suffered and subsequently recovered given powerful monetary and fiscal stimulus. And yet, the damaged financial sector, unable to supply credit; a jump in the precautionary demand for cash; and a persistent overhang of global production capacity have combined to leave deflation pressure intact. The G20's newfound embrace of fiscal stringency only adds to the extant deflation pressure.

“No wonder no country wants a strong currency anymore, as attested to by Europe's easy acceptance of a weaker euro. The acute phase of the financial crisis is over, but the chronic trend toward deflation that has followed it is not.”

One can criticize Makin’s 2010 article for being overly pessimistic; deflation has not happened. It was, though, a solid piece of analysis of the risks. Unfortunately, one cannot say the same about the analysis in his new Economic Outlook piece, “Austerity Undone” or his shorter Guardian article on the same subject.

In “Austerity Undone,” he writes that the now-famous Carmen Reinhart and Kenneth Rogoff article implying that a 90 percent debt-to-GDP ratio represents a danger point “has been shown to be seriously flawed.”  He states that there are now doubts about both “fiscal austerity” and “a resumption of Federal Reserve tightening.” After all, “U.S. inflation is slowing and bond yields are falling…” 

So far, so good. Makin, though, then begins to generate some confusion when he turns his attention to a recent IMF report. He writes:

“Underscoring the widespread confusion about the use of fiscal austerity, the IMF's Fiscal Monitor, after charging the United States with tightening fiscal policy too rapidly, singled it out as among the 10 countries with ‘the most severe fiscal problems,’ suggesting that it still needs to agree on medium-term deficit reduction targets.

“The IMF Fiscal Monitor prescriptions for the United States are badly muddled and ignore significant changes in its fiscal stance. The decried sequester does cut annual spending next year by about $120 billion if it is not rescinded by a nervous and confused-no thanks to the IMF-Congress. Let us hope the sequester is left in place, providing as it does a modest $1.2 trillion worth of spending cuts (only about 2.5 percent of federal spending over the next decade).”

Makin appears to be criticizing the IMF for saying that, while the U.S. has implemented too much austerity in the here and now, it is not doing enough about the deficit in the “medium term.” This view can be criticized, but Makin’s does not make entirely clear his reasons for disagreeing with the IMF. He does say that the IMF ignores the progress that has been made in cutting the budget deficit in the next few years, though Makin just assumes, with no explanation, that this is good policy.  He then turns his attention to the sequester, which he claims to be a “modest” budget cut, but one which he approves. Why? He does not say, but there seems to be an implicit assumption that his audience shares his view that cutting budget spending is usually good idea, even if done in a thoughtless way. Note that he has not prepared the ground for this, because his earlier discussion said there was doubt that austerity is a good idea. He does not give a reason why “modest” austerity is then a good idea; he just assumes it. Perhaps that is a given in the lunchroom at AEI, but it is not elsewhere. And his earlier statements about austerity might not meet with AEI lunchroom approval.

Another Makin opinion that may not sit well in some Republican circles is his statement that “fiscal austerity has been moderate and probably, at the current pace of deficit reduction of about $300 billion per year over the next half decade, has proceeded far enough for now.” In fact, some liberals disagree with this too, believing that the current priority should be growth and that requires increased government spending in a time of lagging private sector demand. In this paper, Makin does not provide a rationale for his position. Why is some austerity called for now, but just the current amount? The reader has no way of knowing what type of economic model Makin is relying on for his judgments.

Makin does take pain, though, to burnish his conservative credibility by criticizing the President’s budget proposal. He claims “it does not advance the fiscal debate.” Really? One may agree or disagree with the Administration’s proposals – and plenty of liberals disagree with some parts of the Administration’s budget – but to say there is no debate to be had here makes no sense. Reading on, it becomes clear what Makin really means. According to his analysis, the Administration’s budget does not reduce the deficit – in his words, advance us on “the road to sustainable fiscal policy.” In other words, the Administration does not advance the fiscal debate because Makin does not agree with what the Administration has proposed. And, he still has not explained why deficit reduction right now is more important than growth-oriented policy. Unlike some fiscal hawks, Makin is not one who argues that deficit reduction is pro-growth. He writes:

“… It is necessary to remember that placing the United States on a sustainable fiscal path after four years of trillion-dollar deficits will have consequences in the short term. Coupled with a ‘tax’ of about $90 billion from higher oil prices, the total of fiscal and oil drag prior to sequester is about $270 billion, and $45 billion in 2013 sequester raised that to $315 billion, or nearly 2 percent of GDP. That drag needs to be contrasted with average fiscal thrust of nearly 3 percentage points of GDP over 2009-12.

“The ‘fiscal swing’ of 5 percentage points of average 2009-12 fiscal thrust of 3 percent of GDP to 2013's 2 percent of GDP drag means that a sharp US slowdown may occur in mid-2013, notwithstanding the heartening signs of growth in the housing sector and a strong push from rising stock prices, all occurring while interest rates remain remarkably low. Still, Congress should not try to reverse deficit reduction progress as the president's budget has in effect suggested. Sequestration will be blamed for any slowdown, but really the cause will be a swing from steady previous stimulus to about $225 billion of fiscal drag along with some bad luck supplied by about $90 billion in higher energy costs.”

This leaves the reader still puzzling why this “fiscal drag” is a good idea, even if factors other than the sequester contribute more to the drag. Why should the government (Congress and the Administration) not pursue in a slowing economy policies generating “fiscal thrust”? Makin assumes we know the answer to that, but readers who do not instinctively share this belief are left puzzled. One wonders how Makin would articulate his position on this if challenged, which I assume is not likely to happen at AEI’s offices in Washington, DC.

Finally, when it comes to deficit reduction, it is clear that Makin prefers spending cuts to tax increases. That is a defensible ideological position, especially if one’s political philosophy leads one to the conclusion that the government’s role is currently too large. But if you are going to contend that one is preferable to the other in terms of the impact on the economy, then one should have an economic argument to back up this assertion. Here is what Makin says:

“Republicans will decry the January 2013 tax increases as crippling the economy and vow to allow no more. Democrats will decry the sequester spending cuts and vow to allow no more spending cuts without tax increases. The president has already proposed rescinding the sequester. The reality the current weak economy is demonstrating is that further tax increases to replace the deficit reduction by the sequester as proposed by the president would weaken the economy even further.”

Makin gives no reason for the contention in the last sentence. Why is that? My guess is that this paper is not really meant as an objective view of the fiscal situation and economic outlook. The evidence is that Makin is perfectly capable of good economic analysis if that is what he wanted to do. Rather, the purpose of this article is to convince Republicans that budget austerity has gone far enough for now. The political reality is that Makin has no hope in convincing them to reverse course, and he knows that. He is worried, though, that additional austerity would be devastating and is trying to convince Republicans in Congress of that while making statements that preserve his conservative credibility. He does not have to justify these statements to his intended target audience.

We are left, though, wondering what Makin actually believes. He may well believe that the current amount of austerity is correct and that increasing taxes and cutting the amount of the sequester by equal amounts is bad policy. Since he gives no reasons, we are left to wonder.

Personal Note:   Early in my career I met John Makin, though I doubt he remembers me. He did some consulting work for the Treasury when I was working on U.S. balance of payment issues. He was trying to use a statistical methodology (Box-Jenkins) to predict the large statistical discrepancy that is put on the capital account side to make the capital and current account balances offset each other exactly, as they must from an accounting perspective. I also ran across him, I believe, in earlier jobs I had in international monetary research at Treasury and at the Federal Reserve Bank of San Francisco.

Politico Hypes Story about Congress and the Affordable Care Act

Politico has a story posted late yesterday with the headline, “Lawmakers, aides may get Obamacare exemption.” There is some real news in the story; leaders in Congress are looking for ways to change the provision of the Affordable Care Act (“ACA”) which denies members of Congress and their staff health insurance under the Federal Employees Health Benefit (“FEHB”) Program once the insurance exchanges mandated by the ACA become operational. Therefore, members and their staff under this provision will be denied employer-provided health insurance and will need to find coverage through the exchanges. (On the MSNBC cable show, Morning Joe, Mike Allen of Politico hyped this story and did not receive any questions that would have forced him to explain what this is really about. Mike Allen’s appearance can be viewed at the end of this clip.)

Politico’s presentation of this story is misleading and will provide fuel to the anger many feel about the ACA without really understanding it. In fact, the provision in question is in fact an exemption from the requirement that employers over a certain size provide health insurance to their employees. The provision, which was introduced by Senator Chuck Grassley (R., IA), reads as follows:

“(D) MEMBERS OF CONGRESS IN THE EXCHANGE.—

(i) REQUIREMENT.—Notwithstanding any other provision of law, after the effective date of this subtitle, the only health plans that the Federal Government may make available to Members of Congress and congressional staff with respect to their service as a Member of Congress or congressional staff shall be health plans that are—

(I) created under this Act (or an amendment made by this Act); or

(II) offered through an Exchange established under this Act (or an amendment made by this Act).

(ii) DEFINITIONS.—In this section:

(I) MEMBER OF CONGRESS.—The term ‘‘Member of Congress’’ means any member of the House of Representatives or the Senate.

(II) CONGRESSIONAL STAFF.—The term ‘‘congressional staff’’ means all full-time and part-time employees employed by the official office of a Member of Congress, whether in Washington, DC or outside of Washington, DC.”

The ACA (or “Obamacare”) is, of course, more than the exchanges, and U.S. residents are subject to and affected by provisions of the ACA whether or not they obtain health insurance through the ACA exchanges. Employers, such as corporations or the federal government, are supposed to offer their employees health insurance. The reason the ACA contains this provision removing most members and their staffs from the FEHBP was political. Now Congress realizes that this causes a problem for recruiting and retaining staff, since the rest of the federal government will continue to use the FEHBP. The FEHBP insurance plans are likely to be more attractive than what it is offered on the exchanges. It is a political problem for them to fix this, but to say that they are seeking an Obamacare exemption is misleading.

There is some confusion about the meaning of the Congressional provision. It appears generally accepted, as the Politico article states, that the provision does not cover the staff of Congressional committees. More subject to debate is whether the provision extends to the staffs of the Congressional leadership. The Politico article also says that it does not extend to members of Congress currently receiving Medicare benefits. I cannot find any support elsewhere for this contention and cannot say whether Politico is correct about this.

With regard to Medicare, it seems as if the provision could be read to deny some members and their staff Medicare benefits. It could be construed that their eligibility for Medicare is based on their service in Congress, if they had no significant employment elsewhere, and that Medicare is a health care plan offered by the federal government. That obviously was not the intent of the law, and I doubt that it will be interpreted that way. This may need to be clarified at some point. However, unless Politico is relying on some provision of the ACA that I am unable to locate, it would appear that under current law members of Congress and their staff eligible for Medicare will need to look elsewhere than the FEHB to supplement Medicare coverage.

It also appears that this provision will remove one benefit of federal employment, to continue to receive FEHB insurance as an annuitant. Congressional staff members who were planning on that for retirement will likely seek employment elsewhere in the federal government if the provision is not amended or repealed.

Politico is obviously trying to gain readers by hyping this story. It is a legitimate story; Congress has a political problem in amending or repealing this provision though there are persuasive arguments to do this. But in presenting the story in this misleading way, Politico is doing more than reporting; it is becoming a political actor inflaming opponents of the ACA with a false story line. That is not what one should expect from a news outlet founded by former Washington Post journalists that wants to be taken seriously.

More on the Chained CPI (April 18 House Ways and Means Subcommittee Hearing)

On April 18, the Subcommittee on Social Security of the House Ways and Means Committee held a hearing on the proposal to use the chained CPI-U to index Social Security payments. This index increases at a somewhat slower pace than the CPI-W, the index to which payments are currently indexed. 

The hearing was stacked in favor of the change. There were two proponents of the change, Charles Blahous and Ed Lorenzen; two government witnesses – Jeffrey Kling (Assistant Director for Economic Analysis, Congressional Budget Office) and Erica Groshen (Commissioner of the Bureau of Labor Statistics – who, while assuming a neutral stance, clearly believe that the chained CPI-U is a better index to measure the change in the “cost of living”; and one witness, Nancy Altman, who opposed the change and any other changes to Social Security at this time.

Reading the prepared statements is dispiriting. This is a political fight that some pretend to be all about a technical fix. To the proponents of the chained CPI-U, the argument is that it is a better index, this is a technical fix, and using it helps shore up Social Security finances. Charles Blahous couches his recommendation by saying that the chained CPI should be used for all government programs if Congress is persuaded that it is a better index, though it is fairly clear that Mr. Blahous believes that Congress should be persuaded of that. He also says that if the chained CPI-U is adopted, there should be no exceptions. He does not mention that the Administration in its budget proposes that the chained CPI-U not be used for means-tested government programs. Also, he, like most everyone else, ignores the inflation indexation of some Treasury securities. For reasons mentioned in my previous post on this subject, it is not legal to use chained CPI-U for outstanding inflation-indexed securities and not practical to use it for forthcoming issues of these securities.

The proponents also brush aside the long delay (years, not months) in getting final numbers for the chained CPI-U. They just point out that CBO has come up with some ways to use initial numbers. This is still, though, a real problem, and would likely become more so in higher inflationary environments than we are currently experiencing.

For her part, Ms. Altman argues that using the chained CPI-U is a benefit cut which hits the most vulnerable and that it is a worse, not better, index for measuring the cost of living for seniors.  On the latter point, she points out that the CPI-E, the experimental inflation index for those 62 and over, generally shows more inflation than the CPI-W. Therefore, moving to an index that increases more slowly than the CPI-W is even less accurate.

The real disagreement between Ms. Altman, on one side, and Mr. Blahous and Mr. Lorenzen on the other, is on whether we need to cut Social Security benefits. Blahous and Lorenzen use graphs from the Social Security trustees to show that the Social Security trust funds will be running out of money. Lorenzen says using the chained CPI-U is an easy fix; Blahous argues that there is an urgent need for real reform of Social Security and he does not consider adopting the chained CPI-U reform of the system. Altman uses data from the Social Security trustees projecting that Social Security benefits will reach 6.1 percent of GDP and stay there in the future, a percentage she says we can easily afford.

The fight over the chained CPI is an opening skirmish in more fights about Social Security cuts.  The outcome of this opening skirmish on a highly technical subject will not be decided objectively, but politically. It is interesting, though, that Andrew Biggs, a former principal Deputy Commissioner of the Social Security Administration and currently a resident scholar at AEI, a conservative think tank, has recently written in opposition to the chained CPI:

“It's hard to see how chained CPI can be a win for conservatives. With congressional Democrats opposed, the narrative is already forming that President Obama only proposed using the chained CPI to appease congressional Republicans. But why should Republicans take the rap for a measure that weakens Social Security for the least well-off and institutes a large and regressive tax increase? Higher taxes and a less effective Social Security program - what's not to dislike?”

Some Comments on the Chained CPI Controversy

I have perhaps a unique perspective on the Administration’s proposal in its FY 2014 Budget to use the chained CPI-U (“C-CPI-U”) for “most” government programs indexed to an inflation measure, including Social Security, and for the indexation in the Internal Revenue Code (see last page of this link). As a Treasury official, I once had to decide what inflation measure would be used for a new security we were developing – inflation-indexed bonds and notes, which are now called Treasury Inflation-Protected Securities (“TIPS”). While various indices had been proposed, the choice was not all that difficult – the CPI-U (all urban consumers) was the most recognized measure of inflation, though Social Security is indexed to a somewhat narrower index, the CPI-W (urban wage earners and clerical workers.)  However, while the headline monthly inflation number uses the seasonally adjusted version of the CPI-U, TIPS use the non-seasonally adjusted number because it is not subject to revision.  In order for there to be a well-functioning market for these securities, there needs to be finality in the index numbers. On trade and settlement dates, the nominal values of the principal and accrued interest need to be known with certainty.

One concern those of us who worked on TIPS had was the possible perception that the U.S. government had a conflict of interest in indexing securities to an index the U.S. government produces. We hoped people would understand that the Bureau of Labor Statistics (“BLS”) was not under the influence of the Treasury and staffed by objective economists and statisticians not subject to political influence. It did not help matters, though, that the Federal Reserve was at the time trying to persuade the BLS that the CPI needed technical fixes. All the technical fixes the Federal Reserve was proposing would lower inflation as measured by the CPI. While at least some of the Fed's suggestions were likely justified and the BLS made some changes, I did find it peculiar that they all went in the same direction -- lowering reported inflation. Were there no arguably necessary technical fixes that went in the opposite direction? And didn't the Fed's lobbying of the BLS seem a little like a student complaining about his grade to his teacher?

This brings out two concerns about the Administration’s proposal. First, it is not clear how the Administration plans to handle revisions in the chained CPI. The revisions are necessary because the calculations are based on expenditure data which are only available with a lag. According to the BLS, the initial data for the current calendar year is subject to two revisions. The next calendar year, interim data will be published for the previous calendar year, and, the year after that, final values will be published. If Congress and the Administration decide to use the C-CPI-U, they will have to decide whether or not they will ignore revisions to the initial data.

While this first concern is a technical problem, the second concern is more political. The Administration and supporters can protest all they want that using the C-CPI-U is justified on the grounds that it is a more accurate measure of inflation. No one will believe it. Even the Administration seems to contradict this premise, because it has proposed “protections” from the effects of indexing Social Security to the C-CPI-U for the elderly (starting at age 76). Also, means-tested benefit programs would not be indexed to the C-CPI-U.

Patrick Brennan, who writes for the National Review, also argues that the real reason to use the C-CPI-U is not because it may be a more accurate measure of inflation. In a recent article, he states that those who argue over which index to use for Social Security, perhaps a chained CPI for older consumers, are “missing the point: Chained CPI has been proposed because it is expected to slow one of the ways in which Social Security benefits are scheduled to increase, though it also happens to reflect that those increases were probably more generous than intended. Debating the most accurate measure of inflation is merely the most politically palatable way of limiting how much we are willing to promise in retirement benefits to every American. That kind of limitation has to happen somehow, unless Americans would prefer significantly higher taxes, much less spending on other federal priorities, or permanently higher levels of debt.” (Of course, as many of pointed out, there are other ways to improve Social Security finances, such as raising or eliminating the ceiling on the amount of salaries or wages to which it is applied.)

A perhaps somewhat more objective observer, Peter Coy, the economics editor of Bloomberg Businessweek, writes in another recent article that the chained CPI proposal is “presented as a technical, politically neutral fix, but make no mistake: The Obama administration’s proposal to change the basis for Social Security raises to ‘chained CPI’ is all about saving money by slowing the growth rate of benefits. Whether you think that’s a good thing or a bad thing depends on whether you believe workers have been paying too much to support their elders.”

I would also point out that there are people who feel that the current CPI under reports inflation. Many of the people who think this are probably not liberals and generally distrust the government. It is true, though, as anyone who has been involved in creating or calculating economic indices knows, there is no perfect index, whether it be an inflation, foreign exchange, stock market, or other index. In producing a general inflation measure, there will always be an element of judgment about how to do it.

Also, choosing the right index is a judgment call. If the purpose of indexing Social Security benefits is  to protect those receiving them from increases in prices, an argument can be made that a chained CPI based on the basket of goods and services older people consume would be justified. This might, though, mean indexing different parts of Social Security differently, as the Administration already proposes to some extent, since not all who receive Social Security benefits are elderly.

While liberals’ problems with the chained CPI proposal are obvious, it also poses a dilemma for Republicans. Since tax brackets would be indexed to an inflation measure, this would serve to increase taxes over time. Contrary to some commentary I have seen, this would even apply to those in the top marginal bracket. While these high income taxpayers would not see an increase in their marginal tax rate over time because of the chained CPI proposal, their average tax rates would increase as the lower brackets moved up more slowly than they would under current law. It is not politically possible for Social Security to be indexed to the C-CPI-U without doing the same to tax brackets.

While a grand budget bargain seems unlikely, those who are concerned about the chained CPI proposal because of its effect on Social Security benefits, taxes, or both, should not be entirely complacent.  There could be a smaller budget bargain that includes this.

Finally, with respect to TIPS, the index for the existing securities cannot be changed, since this is part of the terms and conditions for these securities. Also, as I indicated above, there would be problems with indexing new securities to an index subject to revision. The Treasury Department, though, might have a bit of a public relations problem if the chained CPI proposal were to become law. It might have to justify indexing securities designed to “protect” investors from inflation to an index that indicates higher inflation than that used by the government to calculate Social Security benefits or tax brackets.

Book Review: "Bull by the Horns" by Sheila Bair

Sheila Bair’s book, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, recounts her view of the financial crisis from her perspective as chairman of the FDIC during and in the aftermath of the crisis. For those interested in the bureaucratic political and policy disputes, this book provides a trove of information. It should not, though, be read in isolation. There are other books which provide different perspectives, such as former Secretary of the Treasury Henry Paulson’s well written book, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System. 

The most notable aspect of the book is the portrayal of former Treasury Secretary Tim Geithner, which is savage. It is clear that these two do not like each other. Geithner apparently plans to write his own book. We’ll see what he has to say about his disagreements with Bair, if anything.

As way of background, I first met Sheila Bair when she was a commissioner of the Commodity Futures Trading Commission (“CFTC”). I was then an office director in the Domestic Finance section of the Treasury Department. I was impressed with her knowledge of the details of various issues. She eventually became the acting chairman of the CFTC. The meetings we had with her at Treasury on various issues involving the CFTC were always cordial. In particular, on one occasion, I was impressed with her diplomatic skills when discussing futures markets with a new high level Treasury political appointee whose knowledge of the mechanics of futures markets at the time appeared to be limited.

In the George W. Bush Administration, Sheila Bair was appointed Treasury Assistant Secretary for Financial Institutions. I did not report to her but to another Assistant Secretary (Financial Markets). There were some disagreements between my boss and Bair on issues in which I was involved (I forget the details), but, as I recall, they were amicably resolved.

While I was at Treasury, I saw a somewhat different side of her. She could be quite tenacious when she thought she was right.  I am consequently not surprised that, when she was head of the FDIC, others did not view her as a team player. Bair knows that this is how some people perceive her, and on more than one occasion in her book, she makes a statement to the effect that she did something in an effort to be a team player or a good soldier. 

Sheila Bair is a bit of an odd duck for a Republican policy official. She is hardly adverse to financial regulation if she believes it is necessary and is an advocate for strong consumer protection measures. One Republican policy official once remarked to me that discussing policy issues with Sheila Bair was like talking to a liberal Democrat. In fact, on some regulatory issues, she was more pro regulation than some of her Treasury Department predecessors in the Clinton Administration. (This now may not be that surprising to some liberals who make sport of attacking former Secretary of the Treasury Robert Rubin. Readers of this blog know that I think some of the criticisms of Rubin are not based on a full knowledge of the complexity of some issues.)

It was somewhat strange that the George W. Bush nominated her for two significant policy positions – Treasury Assistant Secretary and FDIC Chairman. Her replacement at Treasury was Wayne Abernathy, who had previously worked for Senator Phil Gramm. He was about as anti-regulatory as one could be and still be confirmable by the Senate. His ideology was immediately apparent upon entering his office. He had a sign which read: “Who is John Galt?” (For those who don’t know, this is a reference to Ayn Rand’s Atlas Shrugged.) Given the vast difference between Bair and Abernathy on regulatory issues, it left me wondering why the Bush Administration would nominate two such different people. As is sometimes remarked, personnel choices are policy.

While Sheila Bair obviously is not a good fit with the dominant factions of today’s Republican party, a hint of why she is a Republican can be found at the end of the book where she argues that the current budget deficits are “a source of systemic risk” (p. 353). She provides little in the way of analysis. She does contend that once there are some attractive alternatives to Treasury securities, investors will lose their appetite for Treasuries and interest rates will “skyrocket.”  She treats this as self-evident, though the dangers of the current fiscal situation are highly debatable. There is an argument that the stimulus was too small and withdrawn too soon, and there are prominent economists who disagree with her about the dangers of the current deficits, though some share her concern about the long-term outlook. Be that as it may, her thinking is in line with current Republican orthodoxy on this issue and with the opinions of some Democrats.   

For a press account of what motivates her, Bair points readers to a New Yorker article by Ryan Lizza, “The Contrarian: Sheila Bair and the White House Financial Debate.”  She writes: “I felt that Lizza ‘got me’…” (p. 306). The article, which I highly recommend to those curious about Sheila Bair, indicates that she aligns herself with the “trust-busting” Republican president, Teddy Roosevelt. Left unmentioned is that there was a schism in the Republican Party after his presidency, and Roosevelt, along with others, created the Progressive or “Bull Moose” party. Many former adherents of this party eventually became part of Franklin Roosevelt’s New Deal Democratic coalition.

One of the issues which Sheila Bair discusses but needs to think about more is the problem of regulatory capture. To be fair, this is an incredibly difficult issue, and no one really has any good answers. She is, though, somewhat inconsistent in her discussion of the proper regulatory structure to deal with this.

On the one hand, she argues that a single financial regulator for all banks would in effect be just a larger Office of the Comptroller of the Currency (“OCC”) and would be captured in the same way as she contends the OCC has been. This is the reason she says she opposed Senator Dodd’s proposal for a single bank regulator during the legislative process that led to the enactment of the Dodd-Frank legislation. 

On the other hand, at the end of the book, Bair proposes that the OCC be abolished and bank regulation be consolidated in the FDIC and that bank holding company regulation be the responsibility of the Fed. If this were to happen, which is unlikely, it would significantly transform the FDIC.  Existing staff of the OCC, including those current OCC staff that previously worked for the now-defunct Office of Thrift Supervision, would end up working for the FDIC. The FDIC would then be the primary federal agency responsible for the supervision of all the banks in the U.S. including the largest. This would radically change the agency’s focus on a day-to-day basis. The banks with their lobbyists would then try to capture the new agency intellectually. It is not clear why Bair is in favor of this but was against Dodd’s proposal. After all, putting the name FDIC on what effectively would be a new agency does not by itself guard against regulatory capture.

Moreover, Bair does not discuss the pros and cons of merging the current mission of the FDIC of insuring bank deposits and resolving failed institutions with greatly enhanced supervisory responsibilities. One could argue, as she does in other places, that the FDIC’s focus on insurance made it more conservative about banks taking on leverage and risk than the other regulators, and, without the FDIC at the table, things might have been worse.

There is, in fact, a good case that the current U.S. financial regulatory structure should be simplified. It is the result of historical events and not a rational design. On one particular regulatory structure issue, the nonsensical division of responsibilities for various derivative markets between the SEC and the CFTC, many agree, as do I, with Bair. At a minimum, the two agencies should be merged, though this is unlikely any time soon for political reasons.

As for the banking regulators, along with the regulators for government-sponsored enterprises, I would argue that there are way too many of them. Many people agree with Bair that the OCC is too sympathetic to the concerns of big banks, and, if it can, acts as an advocate for them. That does not mean, though, that a single regulator would be captured and weak, as Bair argues in dismissing Senator Dodd’s proposal. In fact, one could make the opposite argument that competition between the Federal Reserve and the OCC for banks leads to a certain laxness in regulation. In the case of the OCC, there is an obvious additional conflict that it relies on fee income for its budget, not appropriated funds. If it loses a bank to another regulator, it has less money to spend.

There are, however, other factors at play. The U.K. consolidated its multiple regulators into the Financial Services Authority (“FSA”).  The performance of the FSA leading up to the financial crisis was not better than that of U.S. regulators. Many observers did not see this, though. In fact, prior to the financial crisis hitting in full force, Secretary Paulson was trying to import its “light-touch,” “principles-based” regulation to the U.S., because he felt that stricter regulation was hurting New York in favor of London. Once the financial crisis hit, that idea of course had to be dropped.

Both the U.S. fractionated financial regulatory structure and the U.K.’s unified regulator failed in the years leading up to the financial crisis. The David Cameron government has been restructuring financial regulation in the U.K., and the FSA is in the process of being abolished.

In the U.S., unfortunately, barring another financial crisis, nothing is likely to happen legislatively anytime soon to restructure the U.S. regulatory system. Dodd-Frank was a missed opportunity. The financial regulators will have to work together to make the current unwieldy system work.

More thought needs to be given to the problem of regulatory capture. Regulatory capture not only involves the implicit promise of jobs in the private sector; it can also be intellectual and social. Regulators by necessity have to rely on information about business and market practices and developments from the institutions they regulate but have to be discerning enough to know when information is provided in a self-serving and selective fashion. This is not easy. There are outside groups who do research on regulatory issues and lobby on them from a pro-regulatory perspective. While I am sympathetic with the motivations of such groups, their knowledge about the details of the financial industry is of course inferior to that of the participants, and it is also sometimes presented in a selective and biased way.

As for Sheila Bair, she obviously was a very capable leader of the FDIC and led it through an incredibly difficult and challenging period. She has been a dedicated public servant, and we are all the better for it. Her main criticism of Tim Geithner is that he was too inclined to favor large financial institutions is not unique to her, and it is a legitimate point. Her ideas on forcing the restructuring the largest financial institutions into a manageable number of distinct subsidiaries should be considered by current government officials, senior bank officials, and others.    

Now that she is out of government, perhaps she will have the time to give more thought to regulatory structure and ways to mitigate the problem of regulatory capture.  After all, the regulatory failure that contributed to the financial crisis was not primarily the result of a lack of regulatory authority but the failure of regulatory agencies – and with respect to mortgage lending practices, the refusal of the Federal Reserve – to use existing authority. In the case of derivatives, while Bair contends that the regulatory problem was that the Commodity Futures Modernization Act of 2000 prohibited the CFTC and the SEC to regulate over the counter contracts such as credit default swaps (“CDS”), the financial regulatory agencies did have authority over many of the financial institutions who made markets in these instruments and could have taken action.  For example, does anyone think that some of the activities of financial institutions with respect to CDS and synthetic collateralized debt obligations were safe and sound banking practices?  And why did the banking regulators not notice the buildup of risk at AIG, since it was in effect acting as an insurance company for commercial and investment banks they regulated or supervised?

Bull by the Horns is worth reading for those interested in financial regulatory issues. It gives the perspective of one major participant in developing the government’s response to the financial crisis. While there are somewhat more passages that are sharply critical of her colleagues than I would have expected, I should warn though that this does not make the book a page-turner. The book does not assume that readers have a lot of knowledge about the subjects covered, but it will probably be primarily of interest mainly to those who have studied and thought about these issues.

A Brief Remark about the State of the Union Address

This is a small point, but one thing I noticed about the State of the Union address  which has not seemed to have received much, if any comment, is President Obama's statement: “Together, we have cleared away the rubble of crisis, and can say with renewed confidence that the state of our union is stronger." Usually, presidents say that the state of the union is strong.

I am sure that President Obama and his speechwriters and advisors chose this phrasing deliberately. There is a difference between saying that the state of the union is strong and saying that it is stronger than it was.

The most pessimistic assessment of the state of the union by a president that I can recall is in President Ford's 1975 State of the Union address. He said then:

“Today, that freshman Member from Michigan stands where Mr. Truman stood, and I must say to you that the state of the Union is not good: Millions of Americans are out of work. Recession and inflation are eroding the money of millions more. Prices are too high, and sales are too slow. This year's Federal deficit will be about $30 billion; next year's probably $45 billion. The national debt will rise to over $500 billion. Our plant capacity and productivity are not increasing fast enough. We depend on others for essential energy. Some people question their Government's ability to make hard decisions and stick with them; they expect Washington politics as usual.”

He was being honest.

More on H.R. 325 and Determining the Debt Limit on May 19

As I mentioned in my previous post on H.R. 325, it is not precisely clear how the new level of debt limit would be determined, and by whom, on May 19, assuming no intervening legislation and assuming H.R. 325 is enacted into law as passed by the House.  The language of the bill on this point reads:

“Effective May 19, 2013, the limitation in section 3101(b) of title 31, United States Code, as increased by section 3101A of such title, is increased to the extent that--

“(1) the face amount of obligations issued under chapter 31 of such title and the face amount of obligations whose principal and interest are guaranteed by the United States Government (except guaranteed obligations held by the Secretary of the Treasury) outstanding on May 19, 2013, exceeds

“(2) the face amount of such obligations outstanding on the date of the enactment of this Act.

“An obligation shall not be taken into account under paragraph (1) unless the issuance of such obligation was necessary to fund a commitment incurred by the Federal Government that required payment before May 19, 2013.”

Given fluctuating cash balances due to the mismatch in the timing of federal government receipts and expenditures, one possible way to determine the debt limit on May 19 is to take the net of the receipts and expenditures during the period beginning on the effective date of the legislation and ending on May 18 and adding that to the debt subject to limit at the beginning of the period. 

That may end up being what is done, if no new debt limit legislation is enacted before that date.  Another complication, though, has to do with trust fund transactions, such as Social Security. 

When Social Security payments are made at the beginning of each month, non-marketable Treasury securities in the appropriate trust fund are redeemed.  Those securities are subject to the debt limit, and the redemption lowers the amount of debt subject to limit. While Treasury does not match its security issuances to match particular expenditures, Treasury issuance of securities to the public is increased by the need to make Social Security payments. This increases the debt subject to limit. In addition, as Social Security tax receipts are received and invested in new non-marketable Treasury securities, the debt subject to limit also increases.   

It would seem that the most reasonable interpretation of H.R. 325 is that the redemption of Social Security trust fund securities would be offset by Treasury’s need to issue new debt to fund Social Security payments. The issuance of new securities to the Social Security trust funds as tax receipts and interest are reinvested would not count for purposes of determining the new debt limit, since these securities would not be issued to “fund a commitment…that required payment before May 19.”  

Since the trust funds in total are increasing the amount of Treasury securities that they hold, it would seem that the issuance of securities to all the trust funds during the period from the enactment of H.R. 325 and May 18 will be greater than redemptions.  In other words, this factor would contribute to Treasury exceeding the statutory debt limit on May 19 before Treasury takes “extraordinary measures” lowering the debt subject to limit. Treasury would need to take extraordinary measures to rollover existing debt as it matures and to raise new funds.

There would seem to be a more straightforward way to accomplish the apparent goals of H.R. 325. If the intent is to prevent Treasury from excessive borrowing during the period prior to May 19, it might have been simpler for H.R. 325 to state that Treasury could only borrow funds necessary to meet existing expenditures and to maintain a prudent cash balance. Then the new debt limit could be determined on May 19 by reference to the debt subject to limit but for the suspension on May 18.  One way to enforce the prudent cash balance requirement would be to subtract from the debt subject to limit on May 18 the amount Treasury cash exceeded a certain amount on that date for purposes of determining the new debt limit on May 19.  If Congress wants to net out the effect of the extraordinary measures in effect prior to the enactment of the law, they could add a provision to do that. The only reason for that, though, would be to lessen the amount of time Congress would have to raise the debt limit after May 19.