Tuesday, January 7, 2014

Interview with John Cochrane: Regulation, Bailouts, Debt, and More

Aaron Steelman of the Richmond Fed conducted an "Interview" with John Cochrane that has been published in Econ Focus (Third Quarter 2013, pp. 34-38). It's full of Cochrane's characteristically crackling commentary. Here are some snippets:

On the Dodd-Frank financial regulation law
"I think Dodd-Frank repeats the same things we’ve been trying over and over again that have failed, in bigger and bigger ways. ... The deeper problem is the idea that we just need more regulation — as if regulation is something you pour into a glass like water — not smarter and better designed regulation. Dodd-Frank is pretty bad in that department. It is a long and vague law that spawns a mountain of vague rules, which give regulators huge discretion to tell banks what to do. It’s a recipe for cronyism and for banks to game the system to limit competition."
On how to stop bailing out large financial institutions

You have to set up the system ahead of time so that you either can’t or won’t need to conduct bailouts. Ideally, both. 
On the first, the only way to precommit to not conducting bailouts is to remove the legal authority to bail out. Ex post, policymakers will always want to clean up the damage from crises and worry about moral hazard another day. ... You also have to let people know, loudly. The worst possible system is one in which everyone thinks bailouts are coming, but the government in fact does not have the legal authority to bail out.
On the second, if we purge the system of run-prone financial contracts, essentially requiring anything risky to be financed by equity, long-term debt, or contracts that allow suspension of payment without forcing the issuer to bankruptcy, then we won’t have runs, which means we won’t have crises. People will still lose money, as they did in the tech stock crash, but they won’t react by running and forcing needless bankruptcies.
How large government debts affect monetary policy

Monetary policy will be different in the shadow of huge debts. For example, suppose the Fed wants to raise interest rates to 5 percent tomorrow. The Treasury would then have to start rolling over its debt at that higher interest rate, which means a net flow of about $800 billion of extra deficit that has to come from somewhere — more taxes or less spending eventually. Will Congress still say, “Sure, go ahead and tighten”? After World War II, we had a similarly huge debt and Congress simply instructed the Fed to keep interest rates low to finance the debt. That could happen again. How independent can monetary policy be in the shadow of huge debts?

The issue of time-varying risk premiums

One big unresolved issue in finance is why risk premiums are so big and why they vary so much over time. You can look at the spread between what you have to pay to borrow and
what the U.S. government pays in order to see that risk premiums are big and varying. ... For macroeconomics, the fact of time-varying risk premiums has to change how we think
about the fundamental nature of recessions. Time-varying risk premiums say business cycles are about changes in people’s ability and willingness to bear risk. ...

On tax-favored savings accounts

Medical savings accounts are a great idea, although the need for special savings accounts for medicine, retirement, college, and so on is a sign that the overall tax on saving is too high. Why tax saving heavily and then pass this smorgasbord of complex special deals for tax-free saving?  If we just stopped taxing saving, a single “savings account” would suffice for all purposes!