Columbia Economics Review: Spring 2012

Columbia Economics Review Vol. II, No. 2

Follow the Fed

Spring 2012

The International Spillovers of U.S. Monetary Policy

Capital Market Failure

Financial Intermediation in China

Bonds, European Safe Bonds

An Interview with Professor Ricardo Reis

Spring 2012

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Columbia Economics Review

Spring 2012

TABLE OF CONTENTS

Features 4

Rainy Day Politics Latin American Countercyclical Fiscal Policy and the 2008 Financial Crisis

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Betting with your Brain Behavioral Economics and Gambling Safeguards

Interviews 12

Bonds, European Safe Bonds An Interview with Professor Ricardo Reis

Theory & Policy 15

Follow the Fed The International Spillovers of U.S. Monetary Policy

21

Tragedy of the Cucumbers Sea Cucumber Overfishing in the Galรกpagos

Business & Finance 24

Capital Market Failure Financial Intermediation in China

28

Recasting the Model Speculation in the Housing Market

Columbia Economics Review

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Rainy Day Politics American Countercyclical Fiscal Policy and the 2008 Financial Crisis Matt Getz Columbia University

The recent global financial crisis hit the developing world in September 2008. For Latin America, a region all too familiar with rapid downturns, this new global slump presented a serious threat to economic, political and social stability. Yet at the onset of the crisis, many observers were enthusiastic about the region’s outlook. Of particular interest was a newfound capacity for crisis-averting countercyclical policy. In the past, Latin America’s

...have Latin American countries developed sufficient macroeconomic capacity to escape the pro-cyclical crises of their past? What circumstances mediate the ability to implement these stimulus programs? overdependence on foreign financing and fiscal profligacy meant that sudden stops would trigger severe contractions during downturns (Gavin & Perotti, 1997). But throughout the first decade of the 2000s,

many Latin American countries moved toward exchange rate flexibility, inflationtargeting policies, stronger central banks, fiscal balances and decreased public debt (IDB, 2008; Fernández-Arias & Montiel,

2009). These macroeconomic reforms led observers to a common conclusion: Latin America now enjoyed newfound “space” for countercyclical policy.

This paper examines fiscal space in Latin America in relation to the 2008 financial crisis and five-year economic boom that preceded it. It analyzes an important question: have Latin American countries developed sufficient macroeconomic capacity to escape the pro-cyclical crises of their past? What circumstances mediate the ability to implement these stimulus programs? Through a comparison of several countries, I attempt to elucidate the Columbia Economics Review

pathway through which Latin American governments have accumulated or depleted fiscal space.

As in many developing countries, 1998 marked a severe drought of capital inflows to Latin America, spawning debt crises, inflation, and slow or negative growth.

These years of downturn marked a watershed with respect to the political economy of the region; the crises and stagnation, along with dissatisfaction with the International Monetary Fund (IMF), would create fundamental changes to domestic politics and economic policy for years (Cardim de Carvalho, 2010).

The severity of the late 1990s was outpaced by the boom period that began in 2003, driven by an exceptional combination of abundant financing and high commodity prices across the agricultural, mineral and energy sectors (Ocampo, 2009).

Average annual growth rates jumped to 6% between 2003 and 2007 as Latin America rode the wave of exuberance (IDB,

Spring 2012 2008, p. 3).

But as of September 2008, all of the fac-

fiscal stimulus programs in response to the 2008 crisis was conditioned by each

tors formerly responsible for driving the boom had reversed severely. First, international trade contracted drastically in late 2008 after growing by 9.3% per year in 2003–06. Second, commodity prices plummeted across the board (Ocampo, 2009, pp. 706-7). Finally, capital inflows to the region ground to a halt by the end of 2008 (ECLAC, 2009a, p. 21). Time was up: the

government’s actions during the 2003-07 boom.

Governments can fund countercyclical fiscal packages if they have savings or if they can access loans. But for better or worse, conditional loaning practiced by the IMF in the 1990s led to hesitation toward accepting support from that body.

The challenge in the region therefore be-

boom had ended.

This paper works from the recognition that fiscal policy can play a stabilization role in an economy by stimulating aggregate demand during downturns (Alberola & Montero, 2006). By engaging in fiscal and monetary activism, governments can mitigate the impacts of a crisis, sustain the purchasing power of the middle class, and avert social backlash.

At the onset of the crisis, political leaders in Latin America shared a general incentive, on both symbolic and material grounds, to implement countercyclical fiscal policies. Politicians would want to demonstrate to voters that they took immediate action to the crisis. By attempting to stimulate aggregate demand, they could reduce he probability of a largerscale downturn, which would be punished later through retrospective voting.

Yet while I assume that all governments, to some extent, shared this baseline incentive to implement countercyclical policy, in practice each government differed in its capacity to do so. During the run-up to the crisis, each government made choices that either contributed to or limited its ability to respond with stimulus programs. My contention is that the size and extent of

came “to find ways to deal with the possibility of capital flows reversals other than appealing to the IMF for support” (Cardim de Carvalho, 2010). From 2003 Latin American governmentFrom 2003 to 2007, Latin American governments could have increased revenue streams from their export booms through taxes or state-owned companies (Ocampo, 2008). If governments could also reduce discretionary expenditures, then they could lower sovereign debt and run healthy fiscal balances that could fund stimulus programs or attract loans in the time of a crisis.

From 2003 to 2007, Latin American governments could have increased revenue streams from their export booms through taxes or state-owned companies.

Governments could also prepare for downturns by accumulating international reserves from foreign liquidity inflows Columbia Economics Review

5 generated by commodity exports (Cardim de Carvalho, 2010). These reserves could be used as an “alternate financing modality” to finance fiscal deficits (FernándezArias & Montiel, 2011, pp. 306-8). Latin America witnessed extensive accumulation of reserves into “rainy day funds,” sovereign stabilization funds designed to account for fluctuations in capital inflows or commodity prices (Cardim de Carvalho, 2010).

A critical distinction must be made with regard to international reserves. Both Cardim de Carvalho (2010) and Griffith-Jones and Ocampo (2008) argue that the current account balance should play a central role in considering the use value of international reserves. When reserve accumulation is driven by a current account surplus, these reserves represent an accumulation of wealth; these reserves are owned, ready to be put to use. During a current account deficit, the reserves merely reflect an increase in foreign loans; they are borrowed liabilities (Griffith-Jones and Ocampo, 2008, p. 16). For international reserves to be used as stabilization funds, they must be accumulated with a current account surplus as their impetus.

The use value of international reserves is also altered by fiscal sustainability. In the eyes of the governments that control them, these rainy day funds have a value that is relative and based on the perceived risks and benefits of their use. During an economic crisis, countries will have an incentive to tap into these funds to fight for electoral favor. Yet governments are also constrained by concerns with creditworthiness. If a government is running a fiscal deficit with high sovereign debt, its leaders will worry that by depleting the reserves today, they risk leaving themselves vulnerable to even worse crises in the future. In other words, countries might not spend their “rainy day funds” today if they fear a torrential downpour tomorrow. Past experiences with financial meltdowns have made many Latin American countries particularly debt intolerant in this regard. I expect that these “owned” international reserves will be used to finance fiscal deficits only insofar as the risk of using them is perceived to be lower than the risk of holding them.

Of course, governments in the region may very well not have saved during the boom. Sociopolitical pressures during times of plenty can create political economy distortions that prompt procyclical spending (Calvo & Talvi, 2005).

A government that gives into spending pressure during a boom may find that it has handicapped itself when a crisis hits,

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rendering it incapable of responding with countercyclical policy despite its incentive to protect vulnerable constituencies (Talvi & Végh, 2005).

I hypothesize that the size and extent of fiscal stimulus policies will be determined by the combination of two variables: the accumulation of owned international reserves and fiscal sustainability. Larger stockpiles of international reserves and favorable fiscal sustainability will result in the largest stimulus programs, as governments tap into their reserves with reasonable confidence. A country with reserves, but doubts about sustainability, may manage to produce some stimulus programs,

ment. Third, I include the fiscal balance of each government, recognizing that high deficits are especially troubling for the future. Fourth, I include Fernández-Arias and Montiel’s “required structural adjustment” that would be necessary for each country to maintain its current debt-toGDP ratio (2009, p. 27). Finally, I perform a basic calculation of total public expenditures over public revenues in each country, which roughly measures how much each government has saved or spent (values over 100 show greater expenditure than revenues). I have collected each of these measures into Table 1 below, which gives a broad overview of each country’s

but these are likely to be limited by concerns of long-term solvency and will be smaller. Lastly, countries with smaller pools of international reserves and greater concerns with debt sustainability are expected to enact little to no fiscal stimulus programs.

In selecting countries for this study, I have chosen the seven largest Latin American economies, or the LAC-7: Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Together, these countries account for over 90% of Latin America’s GDP (IDB, 2008, p. 2). These nations’ size and resources fundamentally separate them from the rest of Latin America in terms of history and tendencies.

long-term sustainability in 2007.

It is no surprise that Chile stands out for its fiscal sustainability in every measure, given Chile’s good reputation in international financial circles. Second place goes, without question, to Peru. Again, these favorable figures are not entirely surprising, considering Peru’s adoption of a Fiscal Responsibility and Transparency Law at the turn of the century. The clear advantage of Peru and Chile in these measures reflects Ocampo’s assessment that only Peru and Chile exercised countercyclical restraint throughout the boom.

Conversely, there is Chávez’s Venezuela. Over 80% of Venezuela’s total exports are oil products (Jiménez & Tromben,

The LAC-7’s fiscal space at the onset of the crisis is a multidimensional consideration dependent on many factors (Polito & Wickens, 2005). Rather than rely on one measure alone, I have collected a series of data that capture various components of a country’s long-term prospects for sustainability. The first is J.P. Morgan’s Emerging Market Bond Index (EMBI), which serves as a market-based indicator of available fiscal space. Second, I have included the gross public debt of each central govern-

2006, p. 62), and while exports led to an average growth rate of over 11% between 2004 and 2007, there was no improvement in fiscal management during that time. As Venezuela’s pro-cyclical government expenditure and enormous required structural adjustment indicate, Chávez’s government greatly spent beyond its means.

Venezuela should have the greatest concerns with debt sustainability.

Argentina is another country that should have serious doubts about access Columbia Economics Review

to foreign financing. Since its 2001 default, Argentina has been regarded with suspicion in EMBI risk spreads. Most troubling, it has by far the highest debt-to-GDP ratio of the LAC-7. Considering “recent upward trend in public spending” in anticipation of the 2007 elections (Ocampo, 2007, p.26), this trend calls the country’s sustainability further into doubt.

Mexico is a complex case. Its EMBI spreads and debt-to-GDP ratio would suggest that its leaders could afford to be optimistic, yet its required structural adjustment is the second most severe after Venezuela. One must remember that Mexico has the greatest single market overdependence among the LAC-7; it sent 82% of its total exports to the US in 2007 (RojasSuarez, 2010, p. 6). At the onset of the crisis, the Mexican economy should expect a more severe contraction than more diversified countries. So while some of the 2007 figures indicate room for optimism, in practice the Mexican government may have had reason to worry that foreign financing would be available as the downturn continued.

This leaves Colombia and Brazil, remarkably close in each measurement. Both countries had enacted fiscal responsibility laws to increase investor confidence (Singh, 2006, p. 9). Brazil and Colombia are two countries in which fiscal sustainability may not be of immediate concern, but policymakers in both can be expected to be mindful of these constraints.

I group the LAC-7 into three categories of fiscal sustainability. Peru and Chile should have been unconcerned with their creditworthiness at the onset of the crisis. Mexico, Brazil and Colombia should display reasonable concerns with sustainability. Lastly, the governments of Venezuela and Argentina likely felt highly constrained by creditworthiness.

Reserves held in foreign currencies can be measured in dollar amounts or as a percentage of total GDP. In Tables 2 and 3, I display both measures between 2003 and 2007.

As Table 2 shows, international reserves increased—to varying degrees—in every country between 2003 and 2007. These increases were frequently heralded as positive steps for countries in the region.

However, as previously mentioned, it is useful to distinguish between international reserve accumulations under current account surpluses and deficits. Table 4 shows each country’s annual current account balances between 2003 and 2007.

Estimating the effect of the current account on reserve accumulation is complex.

I propose a simple estimation by using the

Spring 2012 current account surplus as a multiplier effect on reserves. For each country and year, I multiply the international reserves (in dollar amounts) by the current account balance (as % of GDP). This index estimates an adjusted size of reserves as moderated by the current account; the larger the surplus, the more likely these reserves will reflect “owned” assets rather than increased foreign liabilities. I have included this index in Table 5.

A closer examination of the numbers may reveal the utility of the index, starting with Argentina and Venezuela. These countries enjoyed only the third- and

fourth-largest pools of international reserves in 2007, but their current account surpluses were spectacular. Of course, it should be noted that Venezuela’s 8.8% drop in reserves between 2006 and 2007 is indicative of pro-cyclical depletion of these funds, which calls Venezuela’s access to reserves into question. Yet both had unquestionably accumulated a good deal of these “owned” international reserves.

Conversely, while Brazil had by far the most international reserves, this figure is less impressive when adjusted for the size of Brazil’s economy and considering Brazil’s explosive capital account surplus toward the latter half of the boom years.

Brazil’s capital account surpluses in 2006 and 2007 reflected a rapid inflow of external loans. These flows of “borrowed” assets explain the country’s leap in international reserves by 2007. Thus, there is great reason to believe that these funds would not have been readily available to finance countercyclical stimulus programs in Brazil.

Chile, on the other hand, features international reserves that look moderate in dollar amounts. Yet like Argentina, Chile ran a steady current account surplus after 2003. More importantly, the Chilean government had created two sovereign stabilization funds, together worth about $21.9 billion (Ocampo, 2008, p. 9). All factors considered, therefore, Chile falls with Argentina as having the greatest access to international reserves to fund countercy-

clical policy.

Peru is another country for which reserves levels are promising considering the current account and government prudence. Peru’s current account surpluses after 2003 suggest that reserves accumulation was set in motion by increases in commodity exports. Like Chile, the Peruvian government in 2003 created a Fiscal Stabilization Fund to use reserves accumulated by the government from capital inflows on exports (Jiménez & Tromben, p. 77).

Last, there are Colombia and Mexico.

Throughout the boom period, both accumulated their international reserves under a steady current account deficit. But both countries also established sovereign stabilization funds to accumulate reserves from oil exports.

These sovereign funds were considered to be less substantial and effective than those of Chile and Peru (Jiménez-Tromben, 2006, p. 81), but they could nevertheless account for some flexibility at the onset of the crisis. In general, both Colombia and Mexico had accumulated a fair amount of international reserves in sovereign funds, but under conditions that call into question their abilities to fund fiscal deficits during a sudden stop.

I group the countries into four categories based on the nature of their international reserves. Argentina and Chile lead the pack. Peru’s sovereign fund greatly contributes to its capacity to use international reserves; I place it in the second-highest category. Venezuela joins Peru in this second category. In the third category are Colombia and Mexico; while their reserve accumulation was modest, both countries had sovereign stabilization funds, indicating that the governments have some immediately deployable reserves. Lastly, I place Brazil alone in the last category.

Unlike Colombia and Mexico, the Brazilian government had not established sovereign stabilization funds in preparation for a downturn. I judge Brazil to have the least immediate access to international reserves for deficit financing.

Large pools of international reserves will result in large fiscal stimulus programs only insofar as concerns with longterm solvency do not limit governments’ willingness to tap into these funds. I visually express this hypothesis by arranging Columbia Economics Review

7 both variables along separate axes and populating the field with countries based on my analysis (see Figure 1).

Moving up and to the right, the size of fiscal stimulus programs in reaction to the crisis should increase. This predicts that Chile will enact the largest stimulus program, with Peru having the second largest. With regard to the remaining countries, I believe that concerns with debt sustainability change a government’s perception of the risks of using the rainy day funds. In other words, while international reserves are the financing source for countercyclical spending programs, debt sustainability is the condition that allows or restrains the use of those funds.

Consider Argentina. I predict that Argentina’s aversion to debt and debt concerns fundamentally alter the use value of reserve pools by increasing the perceived risk in using them today rather than saving them. The same goes for Venezuela: despite large international reserves, I expect concerns with debt sustainability to incentivize saving the funds rather than using them. Argentina and Venezuela are expected to have the smallest fiscal responses to the crisis.

While Brazil, Colombia and Mexico each should have similar expectations of debt sustainability, the latter two had established sovereign stabilization funds by the time of the crisis, whereas Brazil did not.

These stabilization funds offer procedures for countercyclical spending and could be expected to have a significant effect. Colombia and Mexico should have larger fiscal stimuli than Brazil.

To review, I predict that the LAC-7 fiscal stimulus programs in response to the 2008 crisis should fall, from largest to smallest, as follows: Chile, Peru, Colombia and Mexico, Brazil, Argentina, and Venezuela.

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For each country, I include only programs enacted through 2009, thereby isolating the initial fiscal responses to the crisis. Figure 2 shows that, in order from largest to smallest countercyclical fiscal

spending. Colombia, Mexico and Brazil accumulated their reserves under lowto-negative current account balances, but while Colombia and Mexico saved sovereign stabilization funds, Brazil lacked

programs, the LAC-7 are: Chile, Peru, Colombia, Argentina, Mexico, Brazil, and Venezuela.

Despite Chávez’s populist rhetoric, Venezuela was forced to resort to blatantly procyclical cutbacks during the crisis. The severity of concerns with long-term debt sustainability made countercyclical policy untenable. Venezuela provides a strong anecdotal case that spending during upturns will limit a government’s ability to enact countercyclical fiscal policy during downturns.

At first glance, the size of Argentina’s stimulus programs seems to refute my hypothesis. But there is a crucial missing piece of information. Argentina was, in fact, hesitant to tap into its funds; its international reserve holdings slightly increased by the end of 2009. Instead, to finance its fiscal deficit, the Argentine government instituted a forced nationalization of private pension savings (ECLAC, 2010b). The risk of using these funds was judged to be too high, and the Kirchner government sought another heterodox way to finance its deficit.

The puny size of Brazil’s stimulus packages may have shocked those who argued that international reserves were the determinative factor of Latin America’s progress. But as this paper has argued, both the type of reserves accumulated and a country’s concerns with sustainability can alter these reserves’ readiness for

a similar institution. The disparity in fiscal stimulus programs implemented by Brazil on one hand and Colombia and Mexico on the other suggests that, all else being equal, sovereign wealth funds with stabilization as an institutionalized motivation may motivate policy action where the mere accumulation of reserves does not. Interestingly enough, the Brazilian government in 2009 began accumulating government revenue in the multi-billion dollar Sovereign Fund of Brazil (FSB), designed explicitly for stabilization during financial crises. Brazil may have learned a lesson from its neighbors in the region: a sovereign wealth fund, funded by commodities, can be of great use for enacting stabilizing countercyclical policy.

Colombia and Mexico, as predicted, both enacted moderate countercyclical fiscal policies. Likewise, in Chile and Peru, sovereign stabilization funds of international reserves were accessed to finance spending increases and tax cuts (ECLAC, 2010b). As predicted, Chile’s programs were slightly larger than Peru’s. Thanks to fiscal surpluses and manageable debt, policymakers in both countries were able to tap into these funds without fearing disproportionately worse credit crunches in the future.

My findings suggest that some of Latin America’s countries may have indeed gained some critical fiscal space. By limiting the impulse to spend during booms, Columbia Economics Review

Latin America as a region has avoided a large-scale economic collapse. Indeed, after a precipitous drop in 2009, growth rates for the LAC-7 countries (excluding Venezuela) rose to an average of 6.7% for 2010. Nevertheless, this macroeconomic improvement is limited and contingent.

More importantly, countries must learn the correct lesson from 2008: it was not public spending in general, but rather countercyclical public spending (and the improvement of external conditions) that enabled growth to return. As Cárdenas and Levy-Yeyati (2011) discuss, it takes less political maneuvering to tap into rainy day funds than to renew countercyclical saving as conditions improve.

As much as the 2003–2007 boom was an important test of restraint, the upcoming years will likely be even more important, as countries must cool off spending programs and replenish their reserves. Countries may have earned fiscal stability in 2008; but will they fight to keep it?

While international reserves provide a vehicle for financing stimulus in downturns, these pools should not be the only means to procure financing; many of the regional and international financial institutions were designed to stabilize the global economy by providing funds in a crisis. Given the IMF’s ruined reputation, the role of other intermediaries—the Inter-American Development Bank and the World Bank—could be increased to provide credit lines at reasonable interest rates to smooth sudden stops. If organizations could commit to providing credit to emerging markets, then concerns with debt sustainability would play less of a prohibitive role with respect to international reserves.

Lastly, Latin America has the potential to provide for stability in the face of the business cycle, but only if its countries can consolidate the fiscal restraint displayed in bits and spurts between 2003 and 2007.

As Rojas-Suarez (2010) argues, public savings rates in Latin America are still too low, and governments in the region must find a way to sell renewed countercyclical restraint to their populations in anticipation of the next downturn. But even with a healthy dose of skepticism, it is difficult to deny that Latin America has significant prospects for growth and stability in the foreseeable future. As fiscal space, trade diversification, and sovereign stabilization funds grow throughout the region, Latin America may be headed straight for stability.

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Betting with your Brain Behavioral Economics and Gambling Safeguards Jun Liang Yap New York University

The debate over casino legalization in Singapore was dominated by questions considering the potential social costs that the city-state could incur. In particular, many were worried about the implications of problem and pathological gambling given a locally situated casino. In a statement

In a statement at Parliament in 2005, Prime Minister Lee Hsien Loong framed the main issue behind casino legislation in Singapore: “Are the economic benefits worth the social and law and order fallout?” at Parliament in 2005, Prime Minister Lee Hsien Loong framed the main issue behind casino legislation in Singapore: “Are the economic benefits worth the social and law and order fallout?”

The answer to the question was a difficult “yes” for the government of Singapore as a significant proportion of the population remained unconvinced. Prime Minister

Lee did not expect unanimous support, recognizing the lack of a clear general consensus. It was decided that mandating casinos would do more good than harm in Singapore’s efforts to maintain itself as a world-class city. The casinos would provide added attractions that drive tourism.

Moreover, they represent an additional source of tax revenue. Currently, casinos are subject to a 15% tax on gaming revenue from regular players and a 5% tax on gaming revenue from premium players. Premium players are those who maintain at least $100,000 in Singapore Dollars in a deposit account with the casino. The gap in tax rates between premium and normal players leads to an effective tax rate of approximately 12%. Despite its benefits, the social costs of casinos still have to be addressed.

To mitigate potential social costs, the legalization of casinos under the Casino Control Act came with a host of mandatory social safeguards such as a controversial levy exclusive to citizens and permanent residents (PRs) of Singapore. The motivation behind these safeguards is relatively easy to grasp; the implication of a locally situated casino is that Singaporeans “will gamble more, more people will get into trouble, and more families will suffer.”

The economics behind such safeguards is also straightforward. Casinos create social Columbia Economics Review

costs that remain unaccounted for in an unfettered market. The imposition of social safeguards is meant to reduce these social costs. More specifically, these safeguards primarily aim to prevent existing problem and pathological gamblers from further destructive behavior and the development of new problem and pathological gamblers Broadly speaking, the policy instruments that can be used to limit problem gambling fall under three categories: command safeguards, pricing safeguards, and behavioral safeguards. Command safeguards, such as age restrictions and exclusion programs directly restrict entry to gambling venues.

Pricing safeguards, such as the casino levy for Singaporeans and PRs, indirectly restrict gambling by placing pricing barriers and disincentives. Behavioral and social safeguards such as patron education and media campaigns attempt to influence the decision making process of gamblers.

Since the opening of both casinos, there is almost no doubt that Singapore has incurred additional social costs. H2 Gambling Capital, a British consultancy firm, has estimated that gambling losses in Singapore have risen 53% from $924 to $1,413.

Moreover, the firm expects this figure to increase to $1849 by the end of this year.

Credit Counseling Singapore, a debt advisory center, has seen a significant increase

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Spring 2012 people find it difficult or impossible to gamble within controlled and reasonable limits.”

Behavioral economics offers important insight into this topic. Gambling behavior is not rational in the economic sense of the word: rationality in economics implies that people behave in ways that maximize their own welfare and it would be a mistake to assume that all gamblers do so. Uncontrolled gambling routinely ruins lives. Behavioral economics, the study of “economic behavior beyond the traditional simple economic models of constrained maximization with purely economic objectives (consumption / profits),” offers a useful inroad to the explanation of gambling behavior.

What follows is an explanation of how behavioral economics could possibly have an impact on crafting more effective social safeguards. It first provides a behavioral economics interpretation of patron education before highlighting exactly how behavioral economics could help create better policies. It then describes one promising way behavioral economics can enhance patron education. Lastly, it discusses very briefly further applications of behavioral economics on the social safeguards.

Under the CCA 106-(1)-(b)-1, all casinos must display prominently “the advice or

in the number of people seeking help for gambling debts. The local chapter of Crime Library, an international volunteer group, has reported a large increase in the number of people seeking help to locate their spouses who have disappeared as a result of large gambling debts. In light of these increasing social costs, it is important that we reconsider how best to regulate the casino industry.

Of the three types of safeguards, behavioral safeguards are the least understood and the least explored. The field of decision making, especially with regards to gambling, is relatively new. Casino industries throughout the world are currently subject to limited behavioral safeguards and those in Singapore are no exception. Currently Singapore casinos are required to comply with only two behavioral safeguards under the Casino Control Act (CCA). Under the CCA 109-(1), casinos are prohibited from installing automatic teller machines (ATMs) within their premises. Doing so helps to reduce the destructiveness of gamblers’ dynamically inconsistent behaviors.

Context has an effect on behavior; prohibit-

ing ATMs within casino premises reduces the temptation to withdraw money and gamble more. Also, under the CCA 106-(1), all casinos must engage in patron education, the act of helping gamblers make better decisions. This may include displaying problem gambling help services or even interventions by casino staff who are trained to recognize problem gambling behavior.

Given the limited knowledge of gambling behavior, an obvious question hangs in the air: Can anything be done to make these behavioral safeguards more effective, or should new ones be introduced?

The first step towards the implementation of effective behavioral safeguards is a solid understanding of gambling behavior.

A recent report for the South African Responsible Gambling Foundation makes a bold but insightful claim: “There is only one general way to try to make progress with respect to confused and conflicted intuitions on the proper goals and norms of policy around problem gambling. This is to conduct scientific research that attempts to understand what motivates people to gamble, and why some Columbia Economics Review

Gamblers routinely face probabilistic decisions and recent studies have shown that gamblers tend to discount rewards less steeply, and thus at a lower rate, than nongamblers. information concerning those rules (casino game rules), the mode of payment of winning wagers and the odds of winning each wager.” These requirements attempt to reduce the social costs associated with this market failure by increasing the amount of information available. Patron education facilitates greater transparency throughout casinos and helps patrons make better gambling decisions. In terms of behavioral economics, patron education is perhaps best understood as an attempt to make gamblers more cognizant of and more responsive to the expected losses of wagering money in a casino.

Probabilistic discounting refers to the rate at which a person’s valuation of a certain game of chance falls relative to the rate at

Spring 2012 which the probability of winning that game decreases. All else equal, all people would value a 90% chance of attaining $100 more than a 70% chance of attaining the same amount. As the probability of attaining the $100 falls, the value an individual ascribes to this game will decrease hyperbolically.

Hyperbolic decrease is a graphical term, describing an accelerating fall in one variable, in this case the valuation of a game, as another variable, the probability of attaining the reward, decreases. The more a person’s valuation of a game of chance falls relative to the falling probability of attaining its reward, the higher the probabilistic discount rate. Thus the higher a person’s discount rate, the more sensitive the person is to risk. Of course not everyone discounts at the same rate and not everyone is equally sensitive to risk.

Compared to research available on temporal discounting, the rate at which a person’s valuation of a reward falls relative to the time horizon of attaining that reward, there is a dearth in research on probabilistic discounting. However, the concept of probabilistic discounting could improve our understanding of gambling behavior.

Gamblers routinely face probabilistic decisions and recent studies have shown that gamblers tend to discount rewards less steeply, and thus at a lower rate, than nongamblers. This means that as the probability of attaining a reward falls, a gambler’s valuation of that potential reward falls at a slower rate than that of a non-gambler, though there is not yet an established consensus on this conclusion. A 2009 study found that clinically defined pathological gamblers have significantly lower probabilistic discount rates than their matched controls. Another study published in 2003 found that undergraduate students who were gamblers discounted probabilistic rewards less steeply than their controlled counterparts. These and other studies do more than point towards the intuitive idea that pathological and frequent gamblers (and perhaps potential pathological gamblers) are less sensitive to risk. Having a method of quantifying risk sensitivity is valuable. It may allow for controlled experiments on gambling behavior to inform new behavioral safeguards.

One question for policymakers, then, is whether patron education helps gamblers to discount probabilistic rewards (in casino games) more steeply. This is a precise question that can be answered through experiments in behavioral economics measuring the effects of different information on probabilistic discount rates.

Though essential, odds displays alone at casinos do not do enough to help patrons

make better decisions. Currently casinos are not required to display any information on the probability of winning a particular round of wagering. Rather, they are required to display the “odds of winning” which refers only to the payout of winning a specific wager. For example, the roulette table will display an offer of 1-1 odds for the color black. This means that a gambler would receive a payout of $2 for every $1 wagered should he happen to place a winning bet on the color black. Displays of the odds of winning are ambiguous and can confuse patrons without a basic grasp of the mathematics behind gambling. The odds of winning can be mistaken for the probability of winning a particular round of wagering in a particular game. For the most part, though, patrons of casinos are given information on how much they stand to win but not how often they stand to win.

This gap in information between payout and probability could encourage more harmful gambling decisions as it enhances the saliency of rewards. Gamblers could actually be making decision after decision that lead them to financial ruin without a sense of how often they stand to lose each bet.

To its credit the casino at Marina Bay Sands does offer information on the house advantage, the advantage that casinos have over players expressed as a percentage. Yet this information is not prominently displayed – rather, it is only available at scattered kiosks throughout the casino.

It is clear that displaying some form of probabilistic information should be required of casinos. With more salient information on how much they stand to lose in the long run, gamblers may behave less destructively.

Given the current literature on the probabilistic discount rates of pathological gamblers, it would be reasonable to conduct experiments on the effect of different types of displayed probabilistic information on the discount rates of frequent gamblers.

The results of such experiments could inform the process of crafting more effective behavioral safeguards in the form of patron education.

Apart from probabilistic discounting and odds displays, there is a host of other ways behavioral economics can inform the creation of fairer and more effective casino policies. These policies do not necessarily have to be behavioral safeguards. A thorough consideration of behavioral economics issues can benefit the design of pricing and command safeguards.

Concepts in behavioral economics suggest that the one hundred dollar levy for citizens and permanent residents could Columbia Economics Review

11 actually be doing more harm to the people it is intended to protect. Having paid the levy, a person may feel obliged to win it back by gambling more than he or she otherwise would. This tendency is described by the loss-averse nature of humans and their vulnerability to the sunk-cost fallacy.

Certain practices by casinos prey on the “gambler’s fallacy,” the irrational tendencies to see patterns where there are none.

When it comes to casino games, each round of wagering is a statistically independent event. Yet many gamblers misunderstand statistical independence and tend to feel that past outcomes have an effect on future ones. Upon seeing seven outcomes of black on a roulette table, a gambler may feel the chances of red increases for the eighth outcome. Such irrational dispositions are encouraged by the practice of prominently displaying recent histories of roulette outcomes. The same can be said for games such as Sic bo where displaying the historical results of dice rolls is common in casinos. The gambler’s fallacy encourages a false sense of empowerment. Certain practices in casinos encourage this fallacy which in turn may cause a person to gamble more than he otherwise would.

The implementation of behavioral safeguards in casinos can be seen as an extension of Richard Thaler and Cass Sunstein’s idea of “libertarian paternalism.” Behavioral safeguards are liberty preserving in that they allow individuals the freedom to choose or reject certain courses of action. Yet they are paternalistic in that they influence people to make better decisions.

We may find that when dealing with gamblers, egging them on to make better decisions is more effective than commanding them to do so, or setting a higher price on worse decisions. Better gambling decisions would undoubtedly mean lower revenues for casinos. Yet it could be argued that this tradeoff is less pronounced in Singapore given that the effective tax rate on casinos is much lower than in most other countries. A discussion on this issue however, is beyond the scope of this piece.

The battle to minimize social costs should not end with the creation and enforcement of the current set of social safeguards. It is very clear that behavioral economics has much to offer the policymaking process of mitigating these social costs. Voluntary experiments should be conducted to test hypotheses regarding the decision making processes of gamblers and their responses to various types of information about odds and expected earnings. In doing so, there is not much to lose but plenty to gain, a gamble surely worth taking.

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INTERVIEW

Bonds, European Safe Bonds An Interview with Ricardo Reis Ricardo A. M. R. Reis is a professor of economics at Columbia University.

His main area of research is macroeconomics, both theoretical and applied, and some of his past work has focused on understanding why people are inattentive, why information spreads slowly, inflation dynamics, building better measures of inflation, unconventional monetary policy, and the evaluation of fiscal stimulus programs. He is a founding member of the blog The Portuguese Economy, and writes weekly in Portuguese for Dinheiro Vivo, which comes out with Jornal de Notícias and Diário de Notícias.

Q: You are part of a group of European economists called the Euro-nomics Group and this group has been a vocal advocate for solutions to the crisis. Can you briefly relate how the team came together?

Sure, the reason it came together was that several of us had been going to conferences a little bit everywhere to talk about problems of particular countries and the eurozone as a whole. So as we noticed that we were bumping into each other giving talks, and as we had some debates in this conference, we thought, wouldn’t it be fun if we started having this regularly and talking regularly? And so we had an initial meeting at Columbia by the Program for Economic Research (PER), where we met for a Sunday. We chatted for a little bit about what were the problems and how the situation in Europe was evolving. Then we started meeting regularly via Skype and discussing the situation, and from that, we wondered ‘Why don’t we propose some solutions, since we know we have a sense of what’s going on?’ So we merged that way, somewhat spontaneous insofar as just the few people that kept on meeting each other in conferences and discussing the problems of Europe with each one of us understanding one particular country well and then wanting to understand what’s going on in the other countries. Then going from there to, if we think we know what the problem is here, can we create solutions to them?

large hit in 2008 and which have quite a few institutions in trouble.

So what it is that makes it so special that Europe is in trouble, especially once you realize that, when you look at the aggregate indicators of the eurozone as a whole, they don’t really look bad compared to the U.S.—if anything, in most of them, Europe, up until just a few months ago, was growing faster, had lower unemployment than the

Q: You proposed “European Safe Bonds” as part of a possible solution to the current eurozone crisis on the editorial pages of the Wall Street Journal. Can you explain what they are and how they would ameliorate the crisis in Europe?

So the difficulty with most of the things you read on the headlines is that they sound right, then you find yourself asking, yes, but if that’s right, then why not in the U.S.?

So we tried to think of the crisis beyond the easy diagnostics that you can read in most of the newspapers, and I think our starting point was: you can point to the fact that some regions in Europe have competitiveness problems; you can point to some regions of Europe which have public finance problems; you can point to the weakness of some of the banking sectors in Europe. The problem when you point to them is that regions in the U.S. suffer from exactly the same problems. There are quite a few states in the U.S. – West Virginia, Michigan – which have been in clear slumps that have lasted for a decade or more. You have regions in the U.S. that have clear public finance problems, with pensions about to blow up, not to mention of course California, whose public finances look absolutely dreadful. You have certainly a banking system in the U.S. that took a very

U.S., and had a trade balance unlike the massive deficit that is in the U.S. So the difficulty with most of the things you read on the headlines is that they sound right, then you find yourself asking, yes, but if that’s right, then why not in the U.S.?

We started looking for what was unique about Europe that led to the current problems. One of the main things that is unique is that banks, European banks, are much more fragmented than U.S. banks, not just in terms of their domain of operations but especially in terms of their portfolio holdings. What I mean by that is that we see European banks hold a tremendous amount of their particular country’s debt on their books. We do not see California banks holding a lot of California municipal debt, yet when you look at the typical Portu-

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guese or Greek bank, a very large portion of their balance sheet was committed to government bonds of Portugal or Greece respectively.

And so why is that? The reason is threefold. The reasons are, one, inadequate banking regulations that encouraged this, in particular when it came to establishing capital ratios – that is, requiring that against some assets or capital set aside because of risk. Well, sovereign debt was treated as all being equally riskless. Even if the markets were saying that the probability of default was close to 99%, it would still be the case that for purposes of setting capital aside for banking regulations, Greek banks had to set zero capital aside against Greek debt, because they were treated as 100% riskless – when in fact they were 99% sure to default. So that was an immediate problem. Second, the European Central Bank (ECB) was treating all of the sovereign debt as being equal when it came to accepting collateral for its loans. And then thirdly, of course, individual countries had a lot of sway because of the fragmented regulation over pressuring the banks of their countries to hold their bonds.

America. Again, we wanted to have a structure such that these flows, which are fairly natural over some time when markets freeze and investors run for safe assets, did not have the regional component that they did with the current European financial architecture.

So what was the answer to all of these challenges? The answer we thought was the creation of European Safe Bonds. European Safe Bonds are not guaranteed by the joint taxation power, one. Two, European Safe Bonds come with a closely related cousin in their creation, which is what we call European Junior Bonds, which are much riskier than European Safety Bonds in that they don’t have any nationality attached to them. Whenever there are big switches in what risk investors want to have, they can switch between European Safe Bonds and these junior bonds, which are both European bonds, and therefore do not lead to any geographic movements in capital and capital flow imbalances.

...we see European banks hold a tremendous amount of their particular country’s debt on their books. We do not see California banks holding a lot of California municipal debt, yet when you look at the typical Portuguese or Greek bank, a very large portion of their balance sheet was committed to government bonds of Portugal or Greece

A European debt agency of a type could simply buy the debt of different countries up to a certain amount—not all of their debt, but some amounts, say 10, 20 or 30% of GDP, following some very strict rules in terms of how much they can buy of each country—and then it can package them in the following way: the first x-percent of dollars paid go to pay for the senior bonds, the European Safe Bonds, and only the remaining go to pay for the junior bonds. On top of that, some money can be set aside so that even if there’s enough on the first payments of the bonds to pay for the European Safe Bonds, then there would be some capital there to ensure that the safe bonds are safe. What this means is that the European Safe Bonds would be extremely safe for three reasons. They’d be safe because there would be a diversified pool of sovereign debt of different European countries, that is, sometimes Greek bonds would be doing poorly when German bonds are doing well, and so just by pooling them together, you’d lower the risk of the whole pool. Second, because they are the first to get paid, that is, that they’re senior, on account of that, it would require a collapse of Portugal, Greece, Spain, and part of Italy for the European Safe Bonds not to pay in full its investors.

And third, because of the capital set aside, even that’s very unlikely to happen. By our calculations, the European Safe Bonds would not pay their investors in full about once every thousand years, which of course you should take with a tremendous amount of skepticism.

You can divide that by ten if you want, but that still seems pretty safe to us. The junior claim is the junior bond I talked about earlier.

Having realized that this was a big part of why European banks looked so different, we then saw that this was, in some ways, at the heart or the root of the crisis. What has happened in the crisis is that if you have doubts about the solvency of a sovereign, as you see that it’s very likely that Greece is going to default, then you realize immediately that if Greece defaults then the Greek banks are going to default, because they’re holding so much Greek debt. Well if the Greek banks go bust, we know of course that, because of explicit deposit insurance or just because it is the norm for sovereigns to bail out the banks instead of letting the whole banking system collapse, the collapse of the Greek banks comes with a lot of extra public spending from the Greek government. But that of course leads to or confirms the initial fears that the Greek sovereign will be insolvent, and so you’re stuck in what we called the “diabolic loop” where fears about the solvency of the state becomes self-fulfilling because of this high concentration in the banking sector. So how does one break from the loop? What one needs to do is to move the portfolios of these banks away from their local sovereigns and to do so, one needs to remove the inadequate regulations. What we especially need to do is supply these banks with another asset they can hold which is deemed safe.

Second, another feature of the crisis that was important was that, when Spanish bonds were perceived as safe as German bonds, there was a big capital outflow from Germany toward Spain, because investment opportunities in Spain were good, and a lot of Germans wanted to buy their retirement homes in Spain. However, whenever you have a crisis like this, even if the crisis is somewhat unrelated to what’s going on in Europe but leads to an increase in risk aversion, what you’re going to have is a massive capital outflow, and these very large movements of capital between regions lead to current account imbalances and precipitate crises as we’ve learned to appreciate over the last twenty to thirty years of experience with Latin

Q: How are European Safe Bonds and European Junior Bonds created?

Q: Some have controversially suggested that the European Union member states ought to issue their own super-bonds – Eurobonds – as a way to support distressed eurozone countries. Are “European Safe Bonds” similar to Eurobonds? How are they different?

The big difference is that Eurobonds are about issuing debt at the European level that the European taxpayers have to collect the taxes to pay, like in the U.S. If the U.S. government issues federal debt for a billion dollars and decides to give the results to the residents of Dallas, Texas, all of the citizens in the U.S., through their taxes, are going to pay off this debt. With the European Safe Bonds, instead, all the European debt agency is doing is buying these debts, that is, when the citizens of Dallas, Texas decide to spend some money there, they have to borrow and the citizens of Dallas, Texas, and their taxation is accountable for paying the bonds. It’s through pooling, capital guaranteeing, and the junior/senior structure that the European Safe Bonds work, not through taxation power over other citizens.

We thought that this was much more realistic in terms of what the European citizens are willing to take, and it is as or more safe, be-

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cause, with Eurobonds, while in principle the sovereign can always tax and pay them, by experience, sovereigns do not do that. And two, and more importantly, given the lack of political unity in Europe, if the Eurobond was issued, and tomorrow, it was discovered that the Greeks or Italians or whoever had spent a lot of money and issued a lot of these bonds inappropriately, I wonder indeed whether the other Europeans would be willing to pay the extra taxes. So that type of political maneuvering is not required for the European Safe Bonds.

Q: Would these “European Safe Bonds” alone avert a steep economic contraction in Europe? If not, what other actions should governments and international institutions take to avoid deepening the crisis?

The European Safe Bonds are not a magical potion to solve all the problems of Europe. They’re one part of a strategy to set European institutions on safer ground. I think the most important lesson is that it’s certainly the case that the European Economic Area, by stopping solely at monetary union, was severely incomplete in a way that has led to the crisis. Many have argued that what’s needed there is a fiscal union, and once you have a full monetary and fiscal union, you’ve in fact created a new state, which is where Eurobonds would lead to. Our argument has been that what’s missing in Europe is not a fiscal union. What’s missing is a financial union. What’s missing is a European-wide bond. What’s missing is European-wide regulation

It’s through pooling, capital guaranteeing, and the junior/senior structure that the European Safe Bonds work, not through taxation power over other citizens. and deposit insurance. What’s missing is a European mechanism to deal with sovereign difficulties, as there are in countries that have to do with institutions of their localities. We think that if all of those are provided, the crisis would very quickly be averted, because you’d be de facto removing these individual problems in Europe. It is important to realize that, for the European Union as a whole, it doesn’t look that bad; it looks better than the U.S. It’s really about these regional imbalances. And the reason that these regional differences are causing such havoc in Europe and not in the U.S. is that there’s an element of integration missing, and we think it’s financial. European Safe Bonds are just one of the few things, which we are working on, and are about to propose.

Q: Do you think major public institutions such as the European Central Bank and the International Monetary Fund (IMF) have responded adequately to the crisis in Europe thus far?

These have been extremely challenging times but not difficult now, ex post, to point to mistakes in the last year. Ex ante, they had to make difficult choices. The most egregious mistake is on the part of the European ministers, especially at the level of the European Council, at the level of prime ministers. Whenever I see a picture of Angela Merkel or Nicolas Sarkozy or other European leaders meeting, I tremble in fear because each one of those meetings has been more disastrous than the previous one. In the midst of this, the ECB has been, relatively, the sane voice when it comes to the European debate. The IMF likewise has been extremely useful in the debate and has been producing the most prescient, as well as sensible, voices.

But the European Council has been disastrous.

Q: Many have criticized the European Central Bank for its unaccommodating monetary policy decisions during this crisis. Why do you think the bank has been so cautious in its response?

One, I think the ECB deserves the criticism for still not having driven interest rates down to zero. The ECB has been a little too focused on its inflation target and not enough with the amount of trouble that has happened in the economy. Having said that, the criticism that the ECB has not intervened in asset markets is misplaced. The balance sheet of the ECB has increased as much as that of the Federal Reserve. The ECB has bought a ton of sovereign debt of different countries or accepted [sovereign debt] as collateral for loans. To be providing loans to firms at the duration of three months is something the Fed has never done. The ECB has done a lot in this narrative that has the ECB as this shy, timid [institution] versus the Fed being this bold brave institution; this is simply not true. Having said that, the ECB has not been able to go as far as it should; that would have been desirable at different points in time. I think a very important distinction that people need to realize is that the ECB is a much less potent institution than the Fed in two ways. One way is that when the Fed, every time it intervened in 2009, in doing so, by intervening, had to take on a lot of risks. The Fed has a guarantee from the Treasury that if the Fed lost money, then the Treasury would back it up (would recapitalize the Fed). The ECB does not have it, has never had it, and institutionally does not have it at all. If the ECB does interventions to try to save the financial system or the economy and loses money, the ECB has no one to turn to for providing it with those resources.

The only thing one can do when one loses money is to print money, which would rapidly lead to extremely high inflation. So the ECB simply does not have this capital backstop. Secondly, the regulations of the ECB are much stricter than the Fed in terms of what the ECB can achieve, in part because it was created with a series of provisions to make sure the ECB did not interfere too much in the domains that the Europeans do not have a lot of political direction. So one, the ECB as an institution can do less, and two, it has no capital backing relative to its obligations.

Q: What do you think were the major design flaws of the European Monetary Union that have contributed to the current crisis?

The lack of a financial union, lack of common deposit insurance, lack of a European-wide safe bond, lack of European regulation, lack of a mechanism to deal with sovereign and public finance problems.

Q: Commentators have voiced several worst-case scenarios for the eurozone crisis, ranging from the mild to the bizarrely apocalyptic. What do you think is the realistic worst case scenario for the current crisis?

It really depends on what you mean by realistic. A scenario where the euro disappears as a currency is highly unlikely, but that unlikelihood, which should have been 0.00001% a few years ago, is something like 1% or 2% or maybe even as high as five or ten. I don’t know if 5% is something that comes across as realistic, but it sounds scarily high relative to the consequences of that. So a scenario where the euro collapses, while it’s not certainly the likely scenario, is one that has a probability that is higher than 1%, which qualifies as a worst case without going into Godzilla 8.

Q: Lastly for your current students, can you tell us when you’ll be coming back to teach at Columbia?

This summer. I’m back in the fall teaching Intermediate Macro as I always do.

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Follow the Fed The International Spillovers of U.S. Monetary Policy Colin Gray Stanford University

In 1993, John Taylor’s paper “Discretion versus Policy Rules in Practice” argued for a simple monetary policy rule on the basis of dynamic stochastic general equilibrium (DSGE) models, and found a strong fit of that rule to recent policy rates used by the Federal Reserve. The rule is specified in Equation (1), where r is the federal funds rate, π is the average quarterly rate of inflation over the past year using the GDP deflator, and y is the percent deviation of GDP from its trend, also called the “output gap”. The simplified “Taylor rule” is noted in Equation (2). Since its introduction, the Taylor rule has widely been regarded as the most flexible and simple monetary rule that exists.

Beginning in the early 2000s, the United States Federal Reserve deviated significantly from this Taylor rule (see Figure 1). Taylor (2007, 2010) argues that this deviation played a significant role in fueling asset bubbles, particularly in the housing market. The link between deviations from the Taylor rule and buoyancy in housing markets is further established by Ahrend et al (2008), who link departures from the Taylor rule to changes in home loan volumes, house prices, housing invest-

ment, and construction investment.

Admittedly, the magnitude of this effect remains controversial.

While deviations from the Taylor rule may affect domestic markets in signifi-

there exists a significant literature on international monetary policy and the role of fixed versus flexible exchange rates, there is a surprisingly sparse literature on how the decisions of cen-

Figure 1: Federal Funds Rate and Rate Implied By Taylor Rule (below)

cant ways, a natural follow-up question is how domestic monetary policy affects other countries. Even though Columbia Economics Review

tral banks influence the decisions of other central banks. Perhaps the most recent and powerful theory to address

Spring 2012

16 the issue is the “monetary superpower hypothesis” of Beckworth & Crowe (2011), which argues that the U.S. Federal Reserve has the unique ability to move the direction of international

are the VAR models of Kim (2000) and related models that focus on the interplay between the Federal Reserve and the ECB. While Belke & Gross (2005) argue that there exists “little support”

Figure 2: Deviation from the Taylor Rule for the United States (see below)

monetary policy due to its size and the importance of the U.S. dollar as a worldwide reserve currency. The fol-

for a “systematic asymmetric leaderfollower relationship between the ECB and the Fed” (921), they point out that

and ECB interest rates, respectively, to Federal Reserve announcements, and argue that Federal Reserve announcements affect both markets.

Perhaps most relevant, Beckworth & Crowe (2011) expands upon the “monetary superpower hypothesis” first introduced in a working paper by Grilli & Roubini (1995), which expounds the unique position of the Federal Reserve as a world leader in monetary policy.

Their data show that a number of developed countries also lowered policy rates when the Federal Reserve did, and find a positive correlation between the deviation from the Taylor rate by the U.S. and the eurozone. Finally, they establish “a close relationship between the stance of U.S. monetary policy and the growth of foreign exchange reserves” (15).

This research studies the “monetary superpower hypothesis” using an alternative methodology. My data and methodology corroborate their findings.

Equation 1: r=π+0.5y+0.5(π-2)+2 Equation 2: r=1+0.5*y+1.5*π

Deviations from the Taylor Rule for Large Economies (Figure 3.)

lowing paper investigates the spillover effects of U.S. monetary policy using panel data from 12 large countries with relatively developed central banks.

A number of researchers have addressed the question of how U.S. monetary policy may affect other countries.

Among the most widely cited models

since the creation of the Euro in 1999, innovations in the federal funds rate have Granger-caused innovations in the ECB main refinancing operations (MRO) rate and not the other way around. Ehrmann & Fratzcher (2005) and Monticini et al (2011) analyze the responses of international markets’ Columbia Economics Review

While the extended form of this research specifies a rational expectations DSGE model off of which to base my hypothesis, the tenants of my hypothesis are basic results of standard twocountry Mundell-Fleming models. In the interest of brevity, I qualitatively state the expectations and intuition that these models share.

Suppose there exist a domestic and a foreign country that international investors see as roughly comparable.

Consider an unexpected fall in the monetary policy rate of the domestic country. The foreign country expects to see a movement of investments from the domestic country with low interest rates into their own country, and an accompanying appreciation of the foreign currency that may have deleterious economic effects. To counter these effects, the foreign central bank can take a combination of the following three actions: 1. Lower the domestic monetary policy rate.

2. Build up stocks of the domestic country’s currency to induce relative depreciation of their own currency by expanding foreign currency reserve

Spring 2012 holdings.

3. Institute capital controls.

Because the period I use in my sample (1980Q1-2008Q2) is known to be

mat and frequency available (quarterly, monthly, or daily) and take quarterly averages. This dataset of quarterly averages contains data on published

Deviations of Large Countries from U.S. Taylor Rule (Figure 4.)

a period of few to no capital controls among developed countries, I do not consider option [3]. With regards to [1] and [2], testable hypotheses exist. All

All else fixed, I expect the foreign country to lower monetary policy rates and/or build up foreign currency reserves when the domestic country lowers its monetary policy rate below a “standard” value for economic conditions, such as the Taylor rule. If the foreign country does not take these, I expect foreign currency to appreciate. else fixed, I expect the foreign country to lower monetary policy rates and/ or build up foreign currency reserves when the domestic country lowers its monetary policy rate below a “standard” value for economic conditions, such as the Taylor rule. If the foreign country does not take these The majority of the data I use comes from Datastream. I pull data in the for-

policy rate targets, GDP gaps, inflation, Taylor rule rates (calculated using GDP gaps and inflation), deviations from the Taylor rule (called “gaps” in my dataset), the level of foreign currency reserves measured in U.S. dollar value, and the exchange rate. As mentioned before, the exchange rate is measured as the amount of foreign currency worth one U.S. dollar on in-

17 countries: Canada, the United Kingdom, Australia, China, Indonesia, South Korea, Norway, Brazil, Denmark, Israel, New Zealand, and the eurozone. I use all available data for each country, going as far back as 1980.

(1) Do foreign countries lower monetary policy rates, expand foreign currency reserve volumes, and/or observe currency appreciation when the U.S. Federal Reserve sets rates “too low”?

Figure 2 shows a graph of U.S. deviations from the Taylor rule since 1980.

A value of zero indicates no deviation from the Taylor rule, while a negative value indicates the policy rate is lower than the Taylor rule suggests, and a positive value indicates the opposite.

As we see, the U.S. Federal Reserve went “too low” in the early 1990’s and between 2002 and 2006.

Figure 3 shows the same deviation from the standard Taylor rule of the countries for which data are available.

Dotted vertical lines indicate the periods in which the U.S. Federal Reserve went “too low”. Out of 12 countries, 8 go “too low” in the 2002-2006 period, and most countries show significant reductions in Taylor rule deviations over this period even if policy rates were not below the Taylor rule.

Scatter plots of the U.S. deviation from the Taylor rule (vertical axis) against each country’s deviation from the Taylor rule (horizontal axis) tend

Foreign Currency Reserves versus U.S. Deviations from the Taylor Rule (Figure 5.)

ternational markets such that a reduction in this value signals currency appreciation and vice versa.

I have full data for the following Columbia Economics Review

to show a strong positive correlation, suggesting that countries are indeed deviating from the Taylor rule in the same direction as the Federal Reserve

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18 (see Figure 4).

As an important aside, the addition of the U.S. deviation from the Taylor

cance for both coefficients. Regardless of whether policy rate levels or deviations from the Taylor rule are more im-

cally significant at the 5% level, even when controlling for worldwide monetary policy trends. Furthermore, a onepercentage point shift of U.S. policy has almost the same magnitude of effect as a one-percentage point shift in the average policy rate of worldwide trends. On average, a one-percentage point deviation in the U.S. monetary policy rate causes a similar 0.4-percentage point deviation in the policy rate of another developed country.

These results suggest strong spillover effects of U.S. monetary policy on other central banks’ monetary policies in the expected direction. Indeed, it appears that the U.S. Federal Reserve going “too low” causes other central banks to do the same.

(2) Do foreign reserves increase with U.S. policy rate reductions (and vice versa)?

In order to counteract expected appreciation from a negative U.S. monetary policy deviation, a central bank

portant in influencing other countries’ interest rate decisions, we can study the effect of U.S. monetary policy on other countries’ monetary policy in broader terms.

Regression 1 confirms the importance of the U.S. policy rate in international monetary policy decisions. The dependent variable is the country’s monetary policy interest rate. The variable of interest is the U.S. federal funds rate.

In order to control for global trends, I create a policy control variable consisting of the average policy rate of the 11 other countries in my dataset, excluding the U.S. and the country of interest. I control for the GDP gap, inflation, and foreign currency reserves.

Due to the delayed effects of monetary policy and the relative unimportance of currency reserves relative to the policy rate, any added endogeneity bias should be overwhelmed by the prevention of omitted variable bias for these variables. Using country fixed effects and heteroskedasticity-robust standard errors, the resulting regression model is Regression 1.

Because of the existence of first order serial correlation in this regression, I use a General Least Squares (GLS) method. My findings are robust to an Ordinary Least Squares (OLS) fixed effects regression and a panel data Prais-Winsten regression.

The coefficient on the U.S. policy rate is positive, as expected, and statisti-

Overall, there certainly exists evidence that central banks change reserve volumes in response to U.S. policy rate movements.

Figure 6:

rule to a given country’s deviation from the Taylor rule generally adds 10-25% explanatory power (judging by the adjusted R-squared) and is statistically significant in the positive direction at the 5% level, according to t and F statistics. That is, we see added empirical accuracy and significance if we assume countries follow the modified Taylor rule in Equation (3), instead of the same rule without the U.S. Taylor rule deviation term. In contrast, the addition of an exchange rate term to these countries’ Taylor rules adds little to no explanatory power and is either not statistically significant at the 5% level, or is less so than the U.S. Taylor rule deviation. This finding suggests that central banks may be consistently considering how U.S. monetary policy is deviating from trends when making policy rate decisions.

The effect of the U.S. policy rate on other countries’ policy rates is evident in a fixed effects panel regression. Unfortunately, the relative importance of the U.S. deviation from the Taylor rule versus the policy rate level is difficult to establish. The reason behind this is the strong positive correlation between the U.S. policy rate level and the U.S. deviation from the Taylor rule. Statistically, then, it is difficult to determine which variable has the most significant effect, as regressions including both variables result in high standard errors and therefore lack statistical signifi-

Columbia Economics Review

may accumulate foreign currency reserves for the purpose of targeted depreciation relative to the U.S. dollar.

This hypothesis would appear in the data as a negative relationship between the U.S. deviation from the Taylor rule and the level of foreign currency reserves for that country. Scatter plots of reserve volumes (y-axis) against U.S. deviations from the Taylor rule (x-axis) suggest that this may be the case for many countries (see Figure 5).

This hypothesis can be more rigorously tested with a familiar 12-country panel regression. The dependent variable is the level of foreign currency reserves, measured in U.S. dollars. The independent variable of interest is the U.S. deviation from the Taylor rule.

Since errors seem to be autocorrelated according to a Drukker (2002) test, I use a heteroskedasticity and autocorrelation robust GLS panel regression similar to that of the last section (see Regression 2).

The data reveal that a U.S. deviation from the Taylor rule has a strong and statistically significant negative effect

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This finding suggests that central banks may be consistently considering how U.S. monetary policy is deviating from trends when making policy rate decisions.

on foreign currency reserve volumes among large countries with developed central banks. These results are robust to OLS fixed effects and Prais-Winsten specifications. The significance of the U.S. Taylor rule deviation in the regression vanishes when we control for the country’s Taylor rule deviation, probably because of high correlation between countries’ Taylor rule devia-

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tions and high standard errors. Overall, there certainly exists evidence that central banks change reserve volumes in response to U.S. policy rate movements.

(3) Do foreign currencies appreciate against the dollar along with U.S. policy rate reductions (and vice versa)?

Using the same technique as above, I test in Regression 3 whether exchange rate appreciation coincides with a negative deviation of the federal funds rate from the Taylor rule, holding constant the country’s monetary policy, reserve levels, and relevant macroeconomic conditions.

I expect a positive coefficient B1, which preciates relative to the U.S. dollar as the U.S. goes “too low”. There is no statistically significant effect in either direction.

Indeed, it appears that a “too low” rate in the U.S. supports a depreciation of foreign currency relative to the U.S. dollar.

The result does not coincide with our original hypothesis, and so it seems that a change in the U.S. policy rate does not lead to the expected contemporaneous change in nominal exchange rates.

In summary, fixed effect panel regression techniques suggest the following for the 12 countries considered:

20 A movement in the U.S. policy rate generally leads to a movement of the country’s policy rate in the same direction. The U.S. lowering policy rates thus causes other countries to lower policy rates, as well.

Spring 2012 A movement in the U.S. deviation from the Taylor rule generally leads to a change in foreign currency reserves in the opposite direction. The U.S. going “too low” thus causes other countries

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to build up foreign currency reserves, presumably as a means of currency intervention to prevent exchange rate appreciation.

All else equal, a movement in the U.S. deviation from the Taylor rule has no measurable effect on exchange rates under some regression models. Correcting for serial autocorrelation suggests that a “too low” U.S. policy rate may actually cause depreciation in the foreign currency.

Using the framework provided by Taylor (1993), Beckworth & Crowe (2011), and Walsh (2010), I expand upon the existing literature by showing the average contemporaneous effects of monetary policy changes on large countries using panel data. Namely, I find that changes in U.S. policy rates affect other countries’ monetary policy rates in the same direction, so a foreign central bank is likely to respond to a “too low” federal funds rate by setting its own policy interest rate “too low”.

A central bank is also likely to respond to a “too low” U.S. rate by accumulating foreign reserves, probably to prevent significant currency appreciation, in line with the “monetary superpower” hypothesis of Beckworth & Crowe (2011). My study finds no positive, statistically significant effects of U.S. deviations from the Taylor rule on exchange rates abroad, and possibly even a negative effect, suggesting the puzzling result that a “too low” federal funds rate may lead to disinflation abroad.

As an illustration of how these findings may be applied, consider the ECB during the period 2002-2006. When the U.S. Federal Reserve set policy rates lower than the Taylor rule, the ECB did the same. From my various regression techniques, it seems that a standard reaction to a -1.0-percentage point innovation in the U.S. monetary policy rate is on average a 0.5-percentage point negative innovation in the monetary policy rate for that country. Including this term in a modified Taylor rule for the ECB may explain a large amount of the ECB’s deviation from the Taylor rule during the 2002-2006 period (see Figure 6). As further application, this study, when viewed in the context of the link between “too low” interest rates and housing bubbles established by Taylor (2007) and Ahrend et al (2008) suggests that U.S. monetary policy spillovers are extremely important in the function of international markets and the prevention of the next economic crisis.

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Tragedy of the Cucumbers Sea Cucumber Overfisihing in the Galapagos Andrew Schein Stanford University

This paper examines the efficiency itoday, about 20 years after fishermen began extracting sea cucumbers and examines whether fishermen may be extracting I. fuscus at a rate that is on the inefficient side of the basic catch/stock function. We then evaluate whether the participatory management model used in the Galápagos encourages good community commons governance. Lastly, we consider the practical feasibility of individual transferable quotas (ITQs) as a potential means to regulate sea cucumber extraction.

The Galápagos Marine Reserve, extending 40 nautical miles around the archipelago, has been a UNESCO world heritage site since 2001. After sea cucumber fisheries off the coast of Ecuador collapsed in early 1990, many fishermen migrated to the Galápagos Islands to meet the continued demand for these underwater invertebrates.

At the same time, Galápagos fishermen also began extracting sea cucumbers. Corruption stymied early conservation efforts.

For instance, in October 1994, Galápagos officials opened an experimental fishing season with 420 authorized divers and a total allowable catch of 550,000 sea cucumbers.

Two months later, over 900 divers were fishing, and 8-12 million sea cucumbers had been caught. Currently, the Galápagos Islands presents a classic case of the tragedy

of the commons as well as the challenges of commons governance.

Galápagos sea cucumber data is imperfect for two main reasons. First, different zones on various islands have high degrees of variation in catch levels. Second, biologists did not do full surveys of sea cucumber densities and population before or even during the first years of the sea cucumber “gold rush” extraction in the 1990s. For this reason, we must extrapolate from a very small set of data in order to measure the effects of inefficient overfishing. Nevertheless, a basic stock/catch function indicates that the sea cucumber fisheries are dwindling and endangered. At the end of this section, we discuss anecdotal evidence that indicate unsustainable fishing practices.

I use these data to consider fishermen’s aggregate effort. Certain events occurred in 2000 and 2002 that exogenously increased sea cucumber stock. First, an El Niño year in 1997-1998 warmed surface water temperatures and created optimal conditions for reproduction, and the following La Niña year caused cold surface water temperatures, which fostered juvenile sea cucumbers development. Second, a system of individual transferable quotas (ITQs) implemented in 2001 led to dramatic reductions in catch, partly because fishing vessels mistakenly bought more quota holding rights than they Columbia Economics Review

could use. Both occurrences exogenously increased sea cucumber fishery stocks in the Galápagos Marine Reserve.

I extrapolate from catch (in millions of individual extracted sea cucumbers) and

catch per unit effort (individual cucumbers caught per fisherman per day) to find total effort (catch/CPUE) from 1999 to 2005. For 2002, I use a catch/effort function to model whether current sea cucumber extraction is grossly inefficient. In Figure 3, we see an effort level above the sea cucumber stock replenishment rates. Effort level refers to the amount of effort expended by fishermen in

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optimal.

In the Galápagos Islands, increased short-run profits from high effort levels were unsustainable.

Fishermen extracted sea cucumbers faster than sea cucumbers could reproduce and replenish their stock, leading to “stock collapse.” In Figure 4, we see that while the effort level of 2002 probably increased total short-run profits, excessive effort level led to subsequent economic losses and exit of many fishermen from the sea cucumber industry. In fact, decreasing total effort level in 2003 is key evidence for this exit. In other words, the “long-run” effects of overfishing only took two to three years to materialize.

The stock loss predicted by our model can be seen in empirical studies of later years’ sea cucumber density levels and catch per unit effort (CPUE). One indicator of the quickly declining stock is the diminishing catch per unit effort in each year after 2002 as evidenced by 2005 surveys.

The consistently declining returns to effort from 2002 onward suggest that the decline indicates inefficiency. Another indicator of stock loss is that sea cucumber density levels plummeted in pre-2003-fishing-season surveys. This alone does not show unsus-

Figure 1: Catch (in millions of individuals) and catch per unit effort (individuals caught per diver per hour) of sea cucumber Isostichopus fuscus 1999–2005

catching cucumbers; it is important in modeling resource extraction, because fishermen who expend more effort will generally catch more sea cucumbers. Thus effort level is a good proxy for the rate of individual cucumbers caught per fisherman per day.

In the short run of this model, increasing effort yields greater catches and larger profits than lower effort levels do. This individual incentive to overfish is the crux of the classic “tragedy of the commons” problem: private incentives lead fishermen to fish at a much higher level than what is socially optimal. The tragedy of the commons is a special case of an externality; in the case of fisheries, the externalized cost is the damage done to the reproductive capacity of the common sea cucumber stock. Essentially, since future profits derived from

In the short run of this model, increasing effort yields greater catches and larger profits than lower effort levels do. This individual incentive to overfish is the crux of the classic “tragedy of the commons” problems: private incentives lead fishermen to fish at a much higher level than what is socially optimal.

a fisherman restraining his fishing effort do not accrue to that prudent fisherman, all fishermen fish at a higher effort level than is collectively profit-maximizing or socially

Figure 3

tainable fishing levels; in fact, sustainable extraction may decrease stock density temporarily but creates conditions where the Columbia Economics Review

stock grows more quickly than with no extraction at all. However, data suggest that density loss was much greater than could be considered sustainable. In the early 1990s, a preliminary survey of the western stretch of the Galápagos Islands found density estimates of over 600 individual sea cucumbers per 100 m2. In late 2000s, surveys indicated density levels of about six individuals per 100 m2.

To put this low density in perspective, one should consider minimum average densities before the Galápagos National Park allowed fishermen to undertake any extraction in the area. Sea cucumbers need high density to reproduce, as males eject sperm into the ocean, where currents carry it to nearby females. Estimates of density levels, at which fishermen can sustainably extract sea cucumbers, range from 40 individuals per 100 m2, to 20 individuals per 100 m2, to 11 individuals per 100 m2. These lev-

els, when multiplied by the area in 100 m2 of the fisheries, are close to point “J” in Figure 3. In calculating density levels, biologists attempt to find minimum sea cucumber densities necessary for stock replenishment.

In the 2009 pre-fishing-season surveys, of all macrozones sampled, none reached the minimum reference point of 11 individuals per 100m2 necessary to open the fishery. In other words, current sea cucumber numbers are below even liberal estimates of a safe minimum stock level. Therefore, the stock is at a critical point, near or at commercial collapse.

A stable equilibrium would be represented in Figure 3 by a lower slope of the catch function G(effort, stock), so that it intersected the stock replenishment function between SMSY and K. Those levels of sustainable yields are shaded on Figure 1. In such a situation, we would expect sta-

Spring 2012 ble CPUE and sea cucumber density levels after a few years; however, we do not see this stability.

overfishing.” However, the depleted sea cucumber stock has somewhat changed the local attitude toward regulation; fishermen

Figure 4

Anecdotal evidence reinforces our view that current fishing levels are inefficient.

In 2004, fishermen moved to no-take zones (such movement was illegal) to find sea cucumbers. They dove deeper, with average diving depth jumping from 14 meters in 2001 to 25 meters in 2004. Moreover, they began extracting imperfect and illegal substitutes for I. fuscus, such as the less valuable sea cucumber species Stichopus horrens.

The Galápagos Islands has a system that could lead to efficient fishing harvests levels, in principle. The Participatory Management Board composed of scientists, fishermen, tourism representatives, and National Park employees helps set a fishing calendar to promote sustainable fishing harvests. The fishing calendar can close fisheries and set Total Allowable Catch levels to avoid fishery collapse. Fishery sustainability is also a matter of efficiency, because fishermen can achieve higher catches at lower levels in the long term if the fisheries do not collapse.

In practice, regulations are not always effective, because fishermen have minimal respect for the regulating body. Fishermen feel that “it is the tourism sector that reaps the benefits of conservation and participatory management,” and this sentiment engenders active hostility towards regulation.

Limits on catches have led to violent unrest, including the kidnapping of scientists and Galápagos Giant Tortoises as hostages.

Fishermen are also politically powerful. According to a report by the Charles Darwin Foundation, fishermen have historically vetoed “any measure designed to reduce

now view regulation with more openness.

Unfortunately, the Galápagos lacks shared norms where politics line up by sector with little shared vision for sustainable development, accountability of officials to users, and clearly defined boundaries between resource zones, which complicate effective management systems.

The Galápagos Islands can take some much-needed steps towards better commons management. “The low probability of detection, low rates of sanctions, and inappropriate penalties all contribute to undermine locally devised rules,” according to a Charles Darwin Foundation report on sea cucumber management history. As for commons governance expert Elinor Ostrom’s claim that compliance levels increase when the stakeholder group being monitored is included in the group doing the monitoring, fishermen could help the Galápagos National Park Service and Ecuadorian Navy patrol Galápagos National Park waters. Indeed, one study found that fishermen’s participation in enforcement increased compliance behavior and the perception of a regulation’s legitimacy.

In 2009 the Galápagos National Park did not open even one fishery to extraction, due to the low mean densities in sea cucumber fishing zones. Even without a stock recruitment, it is unclear how long fishermen will hold out before fishing, despite densities of sea cucumbers near critical “J” level in Figure 3. Practices that further align the interests of individual fishermen with the fishing community’s collective long-term interests would both forestall fishermen Columbia Economics Review

23 rebellion against the current constrictive co-management process and increase the likelihood that a new recruitment might be better managed. That realignment may take the form of transferable individual quotas, which were tried in 2001 but stopped after that year.

Currently, the fishing sector opposes the use of individual transferrable quotas on the grounds that ITQs will “never yield enough” to cover cash advances that fishermen receive before the fishing season to buy equipment. A close reading of this line of logic shows that it is an argument against any TAC that individual fishermen deem too low. In fact, ITQs might take some of the sting out of a TAC that enforced low short-term catch levels. After all, if individual ITQs did not represent enough catch to cover upfront costs, various fishermen could engage in old-fashioned “Coaseian” trading, where fishermen buy and sell their ITQs to other fishermen. One possible measure to increase the attractiveness of ITQs is for the cooperatives to remove “opportunistic” fishermen. These “opportunistic” fishermen are Galápagos men who work as construction workers, as captains on tour boats, or in other primary jobs, and who fish only during the sea cucumber fishing season. Removing them in this way would increase fishermen’s individual allowable catch. Individual transferrable quotas may seem impractical to enforce, but the style of sea cucumber fishing presents possible solutions to counting and implementation difficulties. The fishing fleet is made up of 446 registered vessels, 85% of which are small wooden or fiberglass boats called “pangas” and “fibras” with outboard engines. Larger vessels serve as mother-boats, towing the pangas and fibras to distant fishing grounds, storing the catch, and serving as living quarters. Perhaps much of the enforcement and cucumber counting could occur on the mother ships.

Excessively high effort levels appear to have been grossly inefficient, bringing Galápagos I. fuscus fisheries close to collapse and robbing many Ecuadorians of what could otherwise have been a long-term means of employment. Galápagos cannot rely on good community commons governance as a substitute for well-enforced regulation. Individual Transferable Quotas (ITQ) is one regulatory instrument that Galápagos National Park could use to restrain effort levels at more efficient levels.

If the option of using ITQs could overcome enforcement worries and opposition from fishermen, it could in theory represent an important precedent in the usage of a flexible regulatory tool that benefits locals without subsidizing migration.

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Spring 2012

Capital Market Failure Financial Intermediation in China Laura Fried Brown University

Financial intermediation is an essential process for achieving healthy growth in any economy. The concept refers to the markets and institutions that pool capital from savers in search of return on assets and allocate it to viable business opportunities in search of financing. Financial intermediation in China is of particular interest because there is a huge pool of savings to invest, approximately $5 trillion. However, effectively pooling and allocating a society’s savings requires a robust and developed financial sector that can attract savings and evaluate investment opportunities to determine which should receive financing. Since transitioning to a market economy in 1978, China has been highly successful at aggregating savings—primarily in the form of savings deposits in its four stateowned banks—but largely unsuccessful at assessing business opportunities and allocating capital to growth-enhancing investments. As a result, investors with free capital miss out on high rates of return on savings, and businesses with great ideas are strained for the financial resources necessary to grow and develop.

If not to high-return business opportunities, where is all of China’s capital going? The majority of China’s capital is

flowing to the state via the financing of large and inefficient State Owned Enterprises (SOEs) at the expense of Small to Medium Sized Enterprises (SMEs) in the private sector—a component of the Chinese economy which has been the front-

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runner contributor to growth over the last decade and has maintained productivity levels double that of the state sector. As a result of SOE restructurings in the 1990s, many smaller state firms were closed down or privatized, leaving only

Spring 2012 the largest as SOEs. Alternatively, 80% of SMEs are privately owned. Therefore, SOEs tend to be extremely large firms, while private sector firms are comparatively much smaller.

As a result of mismanaged financial intermediation, China is experiencing a decline in investment efficiency; banks and capital markets continue to invest in cash-losing state-run businesses. According to 2005 state figures, 40% of SOEs reported negative earnings. On the other hand, investment efficiency could increase substantially if capital flowed to high-growth business opportunities in the private sector on a competitive basis.

Increasing investment efficiency could allow China to sustain high growth, while devoting less of its national resources to saving and investment—freeing those resources for consumption and allowing for improvements in standards of living.

Banks are the mainstay of the Chinese

So where is all of China’s capital going, if it is not going to high-return business opportunities? financial system because the vast majority of financial assets are bank deposits.

The preponderance of bank deposits results from the fact that households, enterprises, and institutions store the majority of their savings as deposits, instead of other investment vehicles. Data from a 2006 McKinsey report suggests households save about 25% of their income, and over the last two decades have kept 70-80% of their savings in savings deposits and cash, while keeping much smaller amounts in bonds, equity, or insurance.

Firms are similarly dependent on banks since the predominant source of external finance for businesses is commercial loans. Therefore, banks are the gatekeepers of China’s saving and investment: they determine which firms can get financing and which cannot. Despite their dominant role in the financial system, China’s state-owned banks have failed to effectively lend to healthy firms, which in turn would maximize bank profitability and broader economic growth.

Chinese banks have not developed the appropriate mechanisms for screening and selecting good firms, nor have they developed the capacity to generate more revenue by charging appropriately higher rates to riskier borrowers. However,

this problem is not entirely the result of incompetence. Part of the problem is that Chinese banks are accustomed to operating in a planned economy in which interest rates, spreads, and term structures were configured by the central bank. It was only in 2004 that the government relaxed mandates on interest rates and gave banks more discretion to set these on their own. Therefore banks never developed experience and know-how in structuring loans and assessing risks.

Banks encounter further difficulty in assessing firms due to a lack of reliable information that results from discrepancies in accounting practices and a dearth of information-producing firms like credit rating agencies.

Because banks are not adept at assessing credit quality of borrowers, banks by default will lend to SOEs, since the consequences of making a bad loan to an SOE are less severe on the individual level of the loan officer and the firm level of the bank. A Chinese bank branch manager raised this point in an interview when he described the mentality of bank employees: “If I lend to an SOE and it defaults, I will not be blamed. But if I make a loan to a privately-owned shoe factory, and it defaults, I will be blamed.” Moreover, if loans to SOEs default or become non-performing, recent history suggests that the national government will not hesitate to purchase bad loans off state bank balance sheets. By contrast, when the privately-owned Guangdong International Trust and Investment Corporation (GITIC) was no longer able to meet debt obligations in excess of $5 billion due to its speculative involvement in private sector real estate development, securities trading, and silk manufacturing, the state let the trust fail. The bankruptcy left debt-holders with only 12.5% of their original investment. The risk of lending an SOE is effectively zero—regardless of the firm’s fundamentals—because of an implicit government safety net that supports banks lending to the state sector.

The GITIC case shows that taking bets on private sector enterprises does not come with the same safety net, and therefore, banks perceive it to be much riskier. Because banks cannot adequately assess private sector firms and will suffer losses if private sector investments go bad, banks choose to lend to these firms less.

A crowding out effect resulting from underdeveloped capital markets further drives disproportionate lending to SOEs. 85% of all formal external finance raised by firms in China comes from bank loans and only 15% is raised on debt or equity Columbia Economics Review

25 markets. In developed economies, the largest and most established firms have the luxury of obtaining their external financing via capital markets, not bank loans, because investors trust public companies enough to finance them directly despite the existence of informational asymmetries between the firm and the public. These firms can thus raise greater amounts of capital with lower overhead because they can forego the fees that banks charge to structure loans and monitor borrowers. In developed markets, large and established firms largely do not compete for bank financing, so commercial loans finance small and medium sized enterprises. However, because capital markets are limited in China, large state-owned firms go to banks for financing and effectively crowd out less established small and medium sized enterprises in the private sector.

As a result of ineffective credit assessment capabilities and non-competitive lending practices, China’s banking system has experienced significant financial difficulties over the last two decades.

These problems have imposed large costs on society, evidenced by the large government sponsored bailouts and bank recapitalizations that have taken place. Bloomberg estimates the total cost of these interventions has been $650 billion. On numerous occasions, the Chinese government has stepped in to prevent non-performing loans (NPLs) from eroding bank asset values and deteriorating bank net worth. NPLs ratios peaked in 2000; 30% of total loans issued by the four largest state-owned banks were considered non-performing, and their total face value was equivalent to 17% of GDP. Commercial banks are the mainstay of the Chinese financial system: they control the largest pool of capital, and they serve as the primary source of financing for corporations. Despite their size and predominance in the system, they have been highly effective at accumulating savings, but they have failed to allocate these savings efficiently to high-growth business opportunities via lending activities. These failures of financial intermediation have resulted in banks squandering China’s mobile capital by lending to poorly performing state firms, which frequently default. These non-performing loans end up being purchased en masse by the government to keep the banking system intact and well-capitalized. This cost to the government and the society at large may be avoided if banks intermediate capital to healthier firms that can use debt financing to grow and develop.

26 Equity markets are a relatively recent phenomenon in China, yet China’s two domestic exchanges in Shenzhen and Shanghai have grown rapidly since their creation in 1990. As of 2005, they have a combined market capitalization that ranks China’s equity market as the 11th largest in the world. Equity finance provides about 14% of all external corporate finance. However, equity markets—like commercial loan markets—have not been effective at awarding capital to firms on a competitive basis. Rather, they have served as another tool to funnel the nation’s capital to poorly performing state firms.

Most listing regulations favor state firms and public officials at the expense of private firms and their shareholders.

SOEs make up 90% of the approximately 1,500 listed companies, even though SOEs only account for 10% of all industrial enterprises. The equity market disproportionately finances SOEs because of extensive government involvement in the IPO selection process.

Unlike in the United States, where market forces determine which firms and how many firms go public, in Chi-

Part of the problem is that Chinese banks are accustomed to operating in a planned economy in which interest rates, spreads, and term structures were configured by the central bank. It was only in 2004 that the government relaxed mandates on interest rates and gave banks more disna, these variables are controlled by the Central Bank, the State Planning Commission, and the State Council Securities Policy Committee. Once the number of IPOs and number of shares are determined, they are divided up amongst provinces. Then provincial authorities are responsible for allocating shares and IPOs to interested firms, which are evaluated on their abilities to meet listing requirements and their contributions to regional economic objectives. According to Zhiwu Chen’s “Capital Markets and Development” (2003), once a firm is selected to receive an IPO permit—often

Spring 2012 through a process of lobbying and bribing—local officials are highly complicit with firms in committing accounting fraud to ensure that firms meet listing requirements. Local officials are willing to commit fraud so that their area SOEs can get access to funding to prop up employment. Successfully bringing firms public also helps the local party establishment to obtain promotions. Local authorities then appoint underwriters to form a syndicate, price, and issue the IPO, instead of allowing for a competitive bidding process between multiple underwriters, as in the United States.

Restricting the number of IPOs not only enables SOEs to extract more capital from investors, but also enables local governments to engage in rent-seeking activities. Keeping IPO flow artificially low is designed to push IPO prices artificially high through oversubscription, creating an impression of high demand.

This primes SOEs for raising large sums of capital through future seasoned equity offerings (SEOs) at inflated valuations. IPO data from the 1990s shows that share prices skyrocketed 732% on average on their first trading day. In this scenario, underwriters make a commitment to purchase equity from firms at cheap prices, which means that the firm does not generate as much cash from the IPO as it could if it were priced more accurately. However, excitement in the market bids up the price to absurd multiples, which enables the firm to generate massive amounts of capital when it issues additional shares in the future. Limits on the supply of IPO permits creates an environment ideal for rent seeking. Each province is annually extended an average of only three IPO permits per year.

Frequently, local officials hold informal auctions, accept bribes, and issue permits to the highest bidder. Many of the strongest firms sidestep this highly politicized and inefficient process altogether, choosing to list on the Hong Kong Stock Exchange or another foreign exchange.

Similar to the way in which preferential commercial lending to state firms has resulted in poor loan performance, preferential treatment of SOEs in the IPO selection process has resulted in weak stock market performance, as measured by the relationship between returns and volatility. In the period from 1995-2005, the Shanghai stock market yielded an annual rate of return of 2.5% and experienced volatility levels of 25%. Thus, Chinese equity markets are an anomaly in that they have low returns and high volatility. To put these figures in perspective, Columbia Economics Review

the S&P 500 during the same time period yielded annualized returns of 10.7%, and had an average standard deviation of 13.5%, equivalent to more than four times the return and only slightly more than half the risk of the Shanghai stock market. Overall market value has been another poorly performing indicator.

From 2001-2005, the Shanghai index lost half of its value, in spite of national average growth rates of 9%. Such poor stock market performance in a climate of high economic growth indicates that the listed companies do not reflect sectors of the economy that are driving growth. In fact, it indicates the existence of an adverse selection problem: cash-losing, staterun companies are more likely to list on an exchange to gain access to external finance than healthy companies with strong fundamentals and robust cash flows. Chinese equity markets therefore are similar to commercial loan markets in that the parties most adversely affected are investors earning low rates of return on savings and private firms that are capital constrained because of institutional bias against them. Beneficiaries are poorly performing state owned firms that obtain capital at an artificially low cost.

Debt capital markets emerge in developed economies as another channel for firms with track records of performance, reputations for being risky or safe, and credit histories based on commercial loans to raise capital directly from the public. They enable firms to forego the costs that come along with bank borrowing. However, unlike commercial loan and equity markets, China’s corporate debt market, including commercial paper, is ostensibly nonexistent. Corporate bonds represent only 1% of overall GDP, compared to 145% of GDP in the United States. Firms that do issue corporate debt, while small in number, tend to be large state owned firms. Corporate bond issuances only account for 1.4% of external corporate finance raised by Chinese firms, making bank loans and equity the dominant sources of finance by a large margin.

A number of regulatory frameworks designed by the state have made corporate bond issuance difficult for firms.

Regulation has made the corporate bond approval process extremely lengthy and cumbersome. On average, it takes fourteen to seventeen months for a firm to take a bond to the public. This affects strategic planning for firms, and necessitates that firms make decisions with longer time horizons if they hope to use debt financ-

Spring 2012 ing. Furthermore, the Chinese Securities Regulatory Commission (CSRC) has put limits on interest rates that firms can set on corporate debt to no more than 1.4 times nominal bank deposit rates. Since bank rates have been so low, this highly restricts the interest rates that firms can use to price their debt, effectively limiting the corporate debt market to well established firms who can issue debt at such a low rate. Lastly, from the investor perspective, government debt is more attractive than corporate debt since interest income on government bonds is taxexempt while corporate bond interest is taxed at 20%.

The equity market disproportionately finances SOEs because of extensive government involvement in the IPO selection process.

The most significant obstacles to developing an efficient corporate debt market are large informational asymmetries between firms and the public and the lack of a robust institutional investor community. In countries with developed financial markets, retail investors rarely purchase corporate bonds directly due to inaccessibility (corporate bonds are usually traded over the counter), denominational barriers, and the need for skilled firm monitoring and credit assessment.

However, most retail investors hold them indirectly through investments in mutual funds, insurance funds, and pensions. Because there are few institutional investors in China, and those that exist are not large, corporate bonds have had a difficult time generating enough demand to be a viable financial instrument.

Moreover, China’s small institutional investors are wary of purchasing corporate bonds due to problems of transparency and accounting fraud, which is most common amongst large and state-owned firms. Credit assessment capabilities are the necessary foundation of a thriving debt market, and China continues to lag behind in this area of financial sector development. In developed markets, investors rely on credit rating agencies and credit history to evaluate whether or not to lend to a firm, and at what cost.

Chinese banks have had serious issues in pricing and structuring bank loans, and have tended to issue loans at interest

rates clustered around benchmark rates rather than issuing loans at interest rates on a wide spectrum reflecting differences in ability to repay, time to maturity, and collateral posted. Beyond issuing loans at imprecisely determined rates, Chinese banks have done a poor job of storing and disseminating information about borrowers: the rates they were charged, their types of business, and the timeliness of repayment. Without this information, bond instruments are extremely difficult to market. As a result of these informational problems, corporate bond defaults were highly widespread in the 1980s and 1990s, further discouraging the expansion of this market.

While informational asymmetry and transparency problems also affect equity markets, they are not as pronounced as in debt markets since equity holders are willing to accept risk in the hope that they will reap upside benefits. Debt holders do not enjoy the same upside regardless of firm growth, since they receive income streams in fixed amounts. However, debt holders are exposed to downside risks and suffer losses if a firm can no longer cover its liabilities.

China’s inability to intermediate its massive pool of free capital has farreaching consequences for its broader economic growth and development. The first problem is a decline in investment efficiency. According to the 2006 McKinsey report, since the 1990s, China has experienced more than a 50% decline in investment productivity as measured by the units of investment required to produce one unit of output growth. Declining investment efficiency implies that a society must devote a greater share of resources to saving and investment, at the cost of higher consumption and standards of living, in order to maintain a certain level of growth. The second implication of poor financial intermediation is a higher cost of capital for China’s strongest firms. Effectively, poor financial intermediation is subsidizing China’s weakest firms while adding additional barriers to growth for its strongest players. Despite these hurdles, private firms have managed to grow, but they would likely grow even more if they had fair access to the nation’s financial markets. Third, ineffectively allocating bank credit to cash-losing firms has put enormous pressure on the nation’s banking system as manifested in the high share of non-performing loans. These costs become real to society when the national government is forced to devote billions of dollars to supporting ailing banks instead of other social, Columbia Economics Review

27 economic, and military objectives. Similarly, granting IPOs to mismanaged state firms has resulted in poorly performing equity markets, which manage to lose value even when the aggregate economy is growing at 8-9% per year. Fourth, the distorted returns on investment caused by poor financial intermediation have adversely affected savers and their ability to earn income on their wealth and save for retirement. Most Chinese savers are left with very few options aside from investments in real estate or near-zero return bank deposits. Equity markets are erratic; debt markets are small; and there are very few financial intermediaries like mutual funds, pension funds, and insurance companies. As a result, financial income as a share of total income in China remains one of the lowest in the world.

The inability to earn capital gains on investments triggers even higher rates of saving as workers fear that they will not be able to grow their savings for retirement. Fifth, the overabundance of financial support to SOEs has the implicit effect of devoting more financial resources to antiquated sectors of the economy— primarily in low-tech, low value-added manufacturing industries—at the expense of supporting developments in the high-tech or services sector.

Clearly, inadequate allocation of capital has major repercussions for China as it approaches the complex transition from a high-saving, high-investment, export-oriented economy to a developed economy whose growth is driven by domestic demand and consumption. Improving financial intermediation is a key part of this transition. In particular, Chinese banks and capital markets should adopt a more market-oriented attitude towards the allocation of capital, which uses empirical estimates of risk and return to determine which firms have access to financing. These reforms would improve the efficiency of financial markets, enable cash-strapped private firms to more easily access capital, and allow Chinese savers to earn higher returns on their investments. All the while, more household income can be made available for consumption. Successfully improving financial intermediation is integral to facilitating China’s emergence as a developed economy on the world stage.

28

Spring 2012

Recasting the Model Speculation in the Housing Market Benjamin Ehrlich Columbia University

The housing asset price bubble between 2005 and 2007 that culminated in the financial crisis of 2008 has resulted in renewed focus on the importance of the housing market in the overall economy. Before the crisis, the securitization of home loans allowed banks to decrease their risk in issuing mortgages by selling them off their balance sheets. Once sold, the loans were repackaged and resold in the form of mortgage-backed collateralized debt obligations (CDOs), which were engineered to carry high credit ratings and spread default risk to all holders. A majority of the owners of CDOs were major financial institutions.

With the demise of firms like Bear Stearns and Lehman Brothers, which sent shockwaves through the economy and signaled the beginning of the recession, many people became outraged by the amount of risk these CDOs actually carried. Much has been made of the securitization process, which turned risky assets into AAA-rated CDOs. Scrutiny has also been focused on predatory lending practices, which included offering low teaser rates on adjustable rate mortgages that were issued particularly to those individuals who probably could not afford mortgages of the size they took. Scholarship has also examined the moral hazard problems arising when the risks of issuing mortgages are no longer borne by the issuing bank. Additionally, short-term

investors, who sought to resell houses within a few months of purchasing and thus capitalize on the rapidity at which home prices were rising, have come under intense criticism.

Such buyers, termed “flippers,” might have exacerbated the sustained growth in housing prices and the eventual bust that followed declines in demand.

Many people hurt by the recession have

been outraged at the issuing banks’ seeming lack of risk management and screening in the origination of bad loans. When housing prices began to fall, mortgage debtors faced obligations that exceeded the market value of the collateral (i.e. their home). This situation, termed being ‘underwater,’ led to a higher Columbia Economics Review

than expected rate of defaults, including many ‘strategic defaults’ undertaken voluntarily for economic reasons, thereby creating a positive feedback loop that increased the downward pressure on housing prices. Far from just being a financial problem related to the loss in value of CDOs, the fall in housing prices especially affected those whose home equity depreciated substantially.

Yet looking at this situation only from the perspective of bad risk management in loan granting presents an incomplete picture. Although more regulation may be advisable in terms of mortgage origination and credit ratings, perhaps policymakers ought to pay more attention to the incentive structure that households consider when deciding whether or not to take mortgages.

I will outline the dynamics of housing investment in the US economy, summarize the assumptions and input variables that precipitated these dynamics, analyze current models being used to explain these dynamics, and examine whether and how the outcomes predicted by the models are supported by the empirical data.

To understand the housing price bubble it is necessary to review the theory of speculation bubbles in general. In his 1982 paper Hyman Minsky posited that asset price bubbles begin with a period of increased optimism in a specific sector, leading to high profitability

Spring 2012 forecasts, which are confirmed by rising asset prices as investors scramble to invest. This “euphoria,” leads to overtrading, a situation in which: (1) whole groups invest for a speculative purpose; (2) excessive optimism continues to grow; and (3) banks show a greater willingness to lend money, given the increasing profitability of investments. Only when the optimism decreases, generally due to a

reduction in profitability forecasts, does the bubble burst and asset prices fall (Bochenek, 2011).

In the housing market, increasing profitability is realized through escalating home prices. During the period between 2000 and 2006, housing prices were rising nationally at an extremely fast pace. Indeed, from January 2000 to April 2006, when the Case-Shiller 20City Home Price Index (see Figure 1) peaked, the average monthly growth in home prices

was an astronomical 97 basis points. This equates to an average yearly growth of 11.64%. For a homeowner this meant that the value of a home effectively doubled from 2000 to year end 2005. Compared with the period between 1987 and 2000 the average monthly increase in home prices was 30 basis points. This sharp surge in the growth rate of home prices led to the increased optimism predicted by Minsky’s theory.

Optimism needs to be matched by an increased availability of credit that allows for increased investment in the sector that is now perceived as profitable. To find evidence of

the increased availability of credit, one can examine the declining interest rate on 30-Year Conventional Mortgages. Over the period from the 1st Quarter of 2000 to the 2nd Quarter of 2006, when housing prices were peaking, the average interest rate on a 30-Year Conventional Mortgage in the US fell nearly 20% to a rate of 6.6%. This was matched by a peak-to-peak decline in the 1-Year Adjustable Rate Mortgage Average in the US. This demonstrates a secular decline in the cost of borrowing over this period of time which allowed for increased loan origination.

One factor that Bayar and Neilson (2010c) identify in their microeconomic model as being equally important to an increase in housing investment is the availability of high loan-to-value (LTV) mortgages. LTV serves as a limit on how much of a home’s price can be borrowed through a mortgage and how much money needs to be paid as a down payment. By 1970, the standards first set out by the Federal Reserve Act of 1913 had been relaxed from 50% to a 90% LTV ratio. In other words, one could now borrow up to 90% of a home’s value. By 1997, the ratio had actually risen to 125%, which meant that a homebuyer could use multiple mortgages to borrow not only the full current price of the home, but also its expected future value. Coupled with rising home prices, the increase in availability of high LTV mortgages resulted in an increase in the total value of credit given and invested in housing (Bayar & Neilson, 2010c).

One question arising from this discussion is how the availability of high LTV ratio mortgages is linked to speculation. The less money one needs to put down to buy a house, the more expensive a house one can afford, assuming one can meet the monthly mortgage payments. The ability to buy a larger house meant that a homeowner could effectively invest more in the housing sector which, given the housing asset price bubble, would yield larger profits when the house was sold. In other words, high LTV mortgages allow for increased exposure to housing, which one Columbia Economics Review

29 would pursue when driven by the expectation of above-average returns.

To demonstrate how this would affect the preferences of a household in spending their earnings, Bayar and Neilson created a two good model. The two goods they chose were housing investment (h) and consumption spending (c). Housing investment refers to the money put into buying, renting, renovating, or even buying a second house.

Consumption spending refers to the basket of goods a household might purchase, which is consumed over the period of the model. In this model, a household aims to maximize a normal utility function, u(h, c), over the period of the model. To simplify the model, two other assumptions must be made: that the model covers one period; and that no savings or bequests are considered, so that all income is spent. This makes the model static, which simplifies the mathematics behind it.

The theory of the model is based on the ability to borrow against the future value of a house and not, as had been the situation in the past, the current value of the house. This ability only exists where high LTV mortgages are available, as was the case during the runup to the financial crisis.

In a situation in which the future values of homes are rising and households have the ability to borrow against those future values, the budget constraint can shift outward, as previously discussed, which allows households to consume more of both goods than originally possible. This ability to borrow against the future value of homes makes housing investment relatively cheaper at the margin. However, once the outer borrowing constraint becomes binding, this is no longer the case.

At this point further increases in the future value of homes cannot increase borrowing (as consumers are already constrained by their outer budget constraint), leading to lower demand for housing and increased demand for consumption goods. The reason this result is so important is that it illustrates the decrease in demand that precedes the burst of the housing bubble. Rather than demand for housing continuing as home values continue to rise, at some point demand for housing investment is curtailed by this borrowing limit The reduction in housing demand that comes once the outer budget constraint is binding, despite continuing increases in future value of the house, pf, is one of the most important conclusions of the model. There are two main “regions” of expansion that have differing outcomes in terms of the behavior of households. In the first, increases in the growth of rf lead to a reduction in the effective price of housing, so demand increases.

This continues until the household reaches its limit on borrowing.

30 At this poin, the second region of expansion begins. In this region as pf continues to increase, which reduces the effective price of housing, consumers curtail their demand for housing and begin to demand more consumption goods, because on the margin both products are relatively the same price. The reason for this is that once a household has obtained the maximum amount of credit it could possibly get given its income level, increases in pf actually allow for a household to

need less housing investment to achieve the maximum amount of borrowing.

One requirement for this expansion is that the future value of homes rises faster than the interest rate, such that pf > p0 (1 + i) is true. p0 (1 + i) is the current price of the home multiplied by the interest rate over the period, i.e. the amount of return one gets on saving all the money they spend on housing investment. If the future value of a home is greater than this, then one is incentivized to invest in housing. Once that outer budget constraint becomes binding, households would begin to downsize their housing investments and consume more consumption goods. They cannot pay off their debts if the future value of their home begins to decrease. In a situation like this, the household is consuming more consumer goods than their income would normally allow (i.e. c > y).

The reduction in housing demand while the future value of houses continues to rise can be corroborated empirically by examining the quarterly changes in the Case-Shiller 20-City Home Price Index and the changes taking place in Real Private Residential Fixed Investment (RPRFI) (see Figure 3). Despite

Spring 2012 having a strong positive correlation between 2000 and 2011 (Corr=0.796), in the period beginning in 4th Quarter of 2005, RPRFI begins to decline before housing prices. It was not until the 3rd Quarter of 2006 that the CaseShiller Index began to experience declines.

By this time, the RPRFI had already declined by 11% from its 3rd Quarter 2005 high. What this shows is that demand for housing investment was decreasing over this period of time, while housing prices continued to rise by 2.1% nationally.

The importance of this data is that it links to the eventual bust of the housing bubble.

Once demand begins to decline, housing starts began to reflect the lack of demand, with peak-to-peak declines beginning in the 2nd Quarter of 2005. These factors combine to put downward pressure on housing prices, which then leads to systemic shocks throughout the economy since the future value of homes reflects the trend of decay in home prices.

When home prices began to decline and consequently the forecasted future price of homes began to fall, those people with high LTV ratio mortgages were more likely to go “underwater,” which incentivizes strategic defaulting. Unsurprisingly, as more people default, the downward pressures on housing prices are compounded, resulting in a positive feedback loop. This makes the problem more and more pervasive, affecting first the households with the highest leverage to income ratios.

All of the foregoing raises the question of whether there was an increase in leverage assumed by households in the time leading up to the financial crisis. With the future value of houses increasing at a higher rate than interest rates, housing was seen as a good investment. Thus it makes sense that households would want to take on more leverage to gain increased exposure to the higher returns in the housing market, a result predicted by asset bubble theory.

One way to show this is by plotting data on Debt Outstanding in the Nonfinancial Sectors against mortgage rates. A clear negative correlation between the decay in mortgage rates and increases in the debt taken on by households is clear. The intuition is that a reduction in mortgage rate lowers the cost of funds, which therefore allows for more borrowing.

Still, does this increase in borrowing necessarily mean that excessive risk was being taken? According to John B. Taylor’s evaluation Columbia Economics Review

of sub-prime lending, “The use of sub-prime mortgages, especially the adjustable rate variety…led to excessive risk taking.” The evidence Taylor relies upon to substantiate his claim is the fact that as housing prices rose, delinquency and foreclosure rates decreased.

However, as housing prices began to decline the reverse became true, and foreclosure and delinquency rates began to rise as the model explained by Bayar and Neilson would suggest. The “excessive risk” was in the assumption of continued growth in housing market.

As scholars including Taylor, Ben Bernanke, and Karl E. Case have noted, in the time leading up to the financial crisis, the Government pursued monetary policy aimed at incentivizing housing investment. Private residential fixed investment sharply increased during Alan Greenspan’s tenure. Interest rates throughout the economy decreased, and more loans were originated. Still, this causality does not fully explain how monetary policies regarding the Federal Funds Rate alone could affect the Bayar and Neilson model.

When the overinvestment in housing assets cooled off, one way the Fed could have continued to incentivize housing investment, in order to keep up demand for housing, was to decrease the interest rate. As long as the interest rate is increasing less than the rate at which future home prices are increasing, housing investment continues to be incentivized. However, this points to one of the major shortcomings of monetary policy during the financial crisis. In a situation in which future housing prices are negative, i.e. the future value of a home is expected to be less than the current value of the home, reductions in interest rates do not incentivize housing investment because pf < p0 (1 + i). Thus, during the period of time in which the Fed was not following the Taylor Rule (Taylor, 2009) and keeping interest rates lower than the rule would have predicted, one of the desired effects, i.e. stabilization of the housing market, did not happen.

Rather than trying to curtail a problem within the greater economy, a more effective solution would be limiting high LTV mortgages and reforming the incentive structure that affects how households invest. Gunther (2009) writes that a law such as a federally mandated maximum LTV ratio would “create a cushion of borrower equity” which might go “a long way toward avoiding a repeat” of the financial crisis. The standards that once guarded against such high LTV mortgages need to be reinstated.

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