A Financial-Fiscal Trilemma

Financial crises and sovereign debt crises are, of course, not a new phenomenon. But the strong connection between fiscal crises and financial crises is relatively recent, primarily developing since the Great Depression and especially since the 1980s. In a new and ambitious NBER working paper, Michael Bordo and Chris Meissner survey the literature on financial and fiscal crises and their interconnections, providing both a history of thought and a catalog of open questions.

The key to the growing link between fiscal and financial crises, they explain, is the increased use of government guarantees of financial institutions. This means that banking crises are often followed by a rise in the debt-to-GDP ratio that can be partially attributed to costs of reconstructing the financial sector. Based on a synthesis of the research in this area and some preliminary empirical analysis, Bordo and Meissner posit that countries face a “financial/fiscal trilemma.” As they explain:

This financial/fiscal trilemma suggests 43 that countries have two of the following three choices: a large financial sector, a large bailout package, and a strong discretionary reaction to the downturn associated with financial crises. The logic is as follows by way of an example. Assume a country with a large financial sector faces a banking crisis. If so, then the government can provide a bailout package of a size that is commensurate with the size of the financial sector. If so it uses up its fiscal space. Otherwise it could lower the size of the bailout and devote its fiscal space to discretionary fiscal policy. With a smaller financial sector, and the same amount of fiscal space, since the size of the bailout would by definition be smaller, the size of the rise in debt due to expansionary policy could rise (p. 42-43). 

They use data from Laeven and Valencia (2012) on 19 systematic banking crises to estimate the equation:

Fiscal costs refer to the fiscal costs of bailouts in the three years following a crisis. Discretion is the change in debt not due to the fiscal costs of bailouts, also in the three years following a crisis. The estimation results, with standard errors in parentheses, are:

Notice that the estimated coefficients on the fiscal cost and discretion to GDP ratios sum to approximately 1, suggestive of a tradeoff. If the financial sector is smaller, or if the bailout package is smaller, then the change in fiscal costs to GDP ratio is likely to be smaller, which could allow a larger change in the discretion to GDP ratio, hence the "trilemma." The trilemma is illustrated by Figure 5, below. The discretion to GDP ratio is on the y-axis and the fiscal costs of bailout to GDP ratio is on the x-axis. For a given change in the debt to GDP ratio, the regression estimates imply an "iso-line" showing the fiscal costs of bailouts and discretion to GDP ratios that are possible.

Source: Bordo and Meissner (2015)

As further evidence of the trilemma, they present Figure 6, which illustrates that countries with a larger financial sector, as measured by the domestic credit to GDP ratio, tend to have a larger rise in the share of the debt to GDP ratio explained by bailouts.

Source: Bordo and Meissner (2015)

This evidence of a new "trilemma" certainly merits more rigorous empirical evaluation. As the authors note, however, empirical studies of financial and fiscal crises face the challenge of inconsistent classification and measurement. Alternative crisis chronologies lead to contradictory results. Bordo and Meissner thus propose the following:

If economists and policy makers truly believed that crises were an important phenomenon to understand and possibly avoid then it might be the case that an independent crisis dating committee could help set the standard in much the same way the NBER business cycle dating committee works. The advantage of following this model is that the NBER is a respected non-governmental, non-partisan organization. Other organizations such as the IMF are not sufficiently politically independent. If crises are becoming increasingly global and crisis fighting is a global public good, then the importance of such a reform should be obvious. 

Loving the Long Shot

The latest recipient of the 2012 Carolyn Shaw Bell Award is Professor Catherine Eckel of Texas A&M. This award is given annually by the American Economic Association Committee on the Status of Women in the Economics Profession (CSWEP) to recognize an individual who has furthered the status of women in economics. Eckel is an experimental economist who has studied the role of a wide range of social and psychological factors in economic exchange-- attitudes toward risk, gender differences, beauty, trust, corruption, and charitable giving, to name a few.

One of her recent papers is particularly interesting from a macroeconomics and finance perspective: "Loving the Long Shot: Risk Taking with Skewed Lotteries" (2012, with coauthor Philip Grossman). The study addresses a widely noted conundrum, that risk-averse individuals voluntarily play the lottery. The expected payoff of a lottery ticket is less than the price of the ticket. Lotteries are positively skewed, since the vast majority of tickets have low payoff but there is a very small probability of a very large prize. Eckel and Grossman use a laboratory protocol to elicit the skewness preferences of 93 test subjects. They can isolate the effect of positive skewness on subjects' willingness to take risky gambles. If you haven't read an experimental economics paper before, I highly recommend reading Section 3 (pages 7-9) of their paper for an idea of how experimental design works in this field. From the conclusions:

We find that, controlling for risk preferences, individuals are overwhelmingly skewness-seeking in their lottery choices; lotteries with skewed payoffs are more attractive than lotteries with the same expected earnings and risk (variance) but lacking skewness.  Given equal expected earnings and risk, 84.9 percent of our subjects select a lottery with skewness = 1 over a lottery with skewness = 0 and 88.2 percent also prefer a lottery with skewness = 1 or 2 to a lottery with skewness = 0... More importantly, we find that increased skewness in the payoff structure entices a sizeable share of our sample (37.6 percent) to take on greater risk in their choice of lotteries. The change in lottery choices resulting from the skewing of payoffs increases the risk subjects face more than three times as much as it increases their expected payoffs.

The first thing that came to mind when I read this paper was the remarkable lottery loan governemnt fundraising scheme in England in the late 17th and early 18th century, shortly before the South Sea Bubble. An unprecedentedly large lottery was called the "Two Million Adventure." Tickets cost £100 and guaranteed a 6% yield annuity. In addition, tickets won prizes. The maximum prize was £20,000 and every ticket won a prize of at least £10. Prizes were paid in the form of a fixed sum annuity over a period of years, meaning the government held the prize money as a loan until it was paid out to the winners. Investors went crazy for tickets, and all tickets were sold within 9 days. Lottery payoffs were positively skewed. Including the prizes, the great mass of investors earned around a 6.5% yield, but a few lucky winners won much larger amounts, including one grand prize winner. Overall, the average yield was 8%, but the vast majority earned less and a few earned much more. Standard risk preferences suggest that investors would have preferred to buy annuities that simply guaranteed 8% yield, but Eckel's findings explain why investors so loved the lottery tickets. Richard Dale's book "The First Crash: Lessons from the South Sea Bubble" explains how the lottery loans were related to the notorious South Sea Bubble.

Lottery loans were hugely popular in other countries too. The New York Times in 1889 noted that "The new lottery loan has caused a perfect mania among the public of St. Petersburg... At least one hundred times the amount of the 172,000,000 rubles required have already been offered."

Today in the U.S., 42 states and the District of Colombia have lotteries, but positively-skewed payoffs in finance are much more pervasive than explicit lotteries. Most data on stock prices or asset returns has positive or negative skew (unlike normally-distributed data which has zero skew.) For large banks, an implicit or explicit bailout guarantee can put a lower bound on the payoff of risky investments without imposing an upper bound, a widely recognized source of moral hazard which has frequently been blamed for the financial crisis. Prevalent and strong skewness-seeking preferences could make the moral hazard problem stronger than standard models would predict. 

I am glad that CSWEP recognized Eckel's contributions to women in economics and hope the wider economic community will spend some time reviewing and discussing her very interesting research.

International Lending with Moral Hazard and Risk of Repudiation

Yesterday I presented the paper "International Lending with Moral Hazard and Risk of Repudiation" by Andrew Atkeson (1991 Econometrica) at the Berkeley Macroeconomics Lunch. My slides are here.

The paper presents a model to explain why countries sometimes face capital outflows when they suffer an adverse macroeconomic shock. With complete markets and perfect insurance, we wouldn't see such a situation. But in the model, the markets aren't complete. The borrower is a sovereign nation, and hence can repudiate the loan. Moreover, the lender cannot observe whether the borrower invests the loaned funds productively or uses them for consumption. The only way to incentivize the borrower to invest some of the funds in equilibrium is if insurance is incomplete, so that the borrower's future utility has some dependence on their investment choice. Thus, moral hazard imposes an insurance-incentives tradeoff.

While preparing for the presentation, I came across an interesting paper by Drelichman and Voth (2011) called "Lending to the Borrower from Hell: Debt and Default in the Age of Philip II.” Here's the abstract:

What sustained borrowing without third-party enforcement in the early days of sovereign lending? Philip II of Spain accumulated towering debts while stopping all payments to his lenders four times. How could the sovereign borrow much and default often? We argue that bankers’ ability to cut off Philip II’s access to smoothing services was key. A form of syndicated lending created cohesion among his Genoese bankers. As a result, lending moratoria were sustained through a ‘cheat-the-cheater’ mechanism. Our article thus lends empirical support to a recent literature that emphasises the role of bankers’ incentives for continued sovereign borrowing.