(Corrects reference to banks financing with debt rather than equity in 10th paragraph)
The summer debate that has dominated Washington seems straightforward. Under what conditions should the U.S. government be allowed to borrow more money? The numbers that have been bandied about focus on reducing the cumulative deficit projection over the next 10 years, as measured by the Congressional Budget Office.
But there is a serious drawback to this measure because it ignores what will probably prove to be the U.S.’s single largest fiscal problem over the next decade: The lack of adequate capital buffers at banks.
The Congressional Budget Office was created in 1974 to provide nonpartisan analysis of budget issues. This was a major breakthrough. It’s hard to exaggerate the lack of serious and timely budget information that existed previously. The CBO still does great work, but it has a major blind spot. (Disclosure: I’m a member of the CBO’s panel of economic advisers; I don’t speak for them here or anywhere else.)
The CBO is very good at explaining how the U.S. got itself into a fiscal mess. The primary cause of the government debt surge in recent years was a huge recession. A big loss of gross domestic product and a fall in employment in any country will collapse tax revenue. To appreciate the magnitude of this disaster in the U.S., compare the CBO’s baseline forecasts immediately before and after the financial crisis.
In January 2008, before anyone thought the crisis would spin out of control, the CBO projected that total government debt in private hands -- the best measure of what the government really owes -- would reach only $5.1 trillion by 2018, which was then the end of its short-term forecast horizon. That represented a fall in real terms to just 23 percent of GDP. Some House Republicans might argue that even this level of debt relative to the size of the economy is too large, but there is no evidence that such debt levels by themselves stall growth or cause other ill effects. The U.S. carried government debt at or slightly above this level throughout the 1950s and the decades that followed.
As of January 2010, once the depth of the recession became clear, the CBO projected that over the next eight years debt would rise to $13.7 trillion, or more than 65 percent of GDP --a difference of $8.6 trillion. In January 2011, CBO moved the forecast for 2018 to $15.8 trillion, or 75 percent of GDP, primarily because the damage to growth had proved even more prolonged than anticipated.
Most of this fiscal impact is not due to the Troubled Asset Relief Program -- and definitely not to the part of TARP that injected capital into failing banks, most of which has been repaid. Of the change in the CBO baseline (comparing 2008 and 2010 versions), 57 percent is due to decreased tax revenue resulting from the financial crisis and recession, and 17 percent is due to increases in discretionary spending, including the stimulus package made necessary by the financial crisis (and because the “automatic stabilizers” in the U.S. are relatively weak). An additional 14 percent came from increased interest payments on the debt, and the rest from increases in mandatory spending, otherwise known as entitlements. Some of the entitlement spending, which includes food stamps, unemployment, and other support payments, is also due to the recession.
Why was the financial crisis so devastating to the real economy? The answer is that, in large part, financial firms had become so highly leveraged, meaning they had very little real equity relative to their assets. This was a great way to boost profits during the economic boom, but when the markets turned, high leverage meant either that firms failed or had to be bailed out. Many financial firms in trouble at the same time means systemic crisis and a deep recession. In effect, a financial system with dangerously low capital levels creates a nontransparent contingent liability for the U.S. budget through the fall in GDP and loss of tax revenue.
The single most important paper to read on future fiscal crises is actually about bank capital -- why the U.S. and other countries need to increase it and why arguments to the contrary are wrong. The paper was written last year and revised in March by Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer, and is called “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive.” The work by Admati and her colleagues is not partisan. In fact, her work has drawn support from finance experts across the political spectrum, including John Cochrane, a professor of macroeconomics and finance at the University of Chicago, who recently wrote an op-ed supporting the Admati approach.
Low levels of bank capital are just one way to measure the extent to which banks endanger the broader economy by financing themselves with debt rather than equity. Higher capital in any system means more equity and larger buffers against losses. In a brilliant speech recently, Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, connected the dots by showing the extent to which the U.S. Tax Code encourages dangerously excessive use of debt by households, companies and banks.
Kocherlakota argues persuasively that U.S. policy should aim to reduce the use of leverage -- and that there are much safer ways if the U.S. wants to subsidize first-time homebuyers or business investment. Tax reform that encourages financial firms to use equity instead of debt should be scored as lowering likely future government deficits.
Many House Republicans -- including some who say they are fiscal conservatives -- as well as some House Democrats remain strongly in favor of lowering capital requirements. But any true fiscal conservative should fight to strengthen the legislative and regulatory safeguards that aim to make the financial system less prone to collapse. Pushing for lower capital requirements in the financial system poses a major fiscal risk. It is unfortunate that fiscal risks arising from the financial sector are not currently scored as claims on the federal budget by the CBO. This introduces a false separation between financial and fiscal issues on Capitol Hill.
The CBO is only as good as Congress allows it to be. The CBO itself should push hard in this direction. The agency is good about scoring other contingent liabilities and implicit guarantees. Future health-care costs, for example, are assessed on the basis of probabilities. No one knows what the world will look like in 2050, but the CBO should be able to warn taxpayers and lawmakers what will probably happen in the future, based on the immediate past.
(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)
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