Fiscal Studies

According to the intertemporal capital asset model... real consumption fluctuations are perfectly correlated across all individuals in the world. This result follows since with complete risk management any fluctuations in individual endowments are completely pooled, and only world risk remains. But, in fact, real consumption changes are not very correlated across individuals. As Backus, Kehoe, and Kydland (1992) have documented, the correlation of consumption changes across countries is far from perfect…Individuals do not succeed in insuring their individual consumption risks (Cochrane 1991). Moreover, individual consumption over the lifecycle tends to track individual income over the lifecycle (Carroll and Summers 1991)... The institutions we have tend to be directed towards managing some relatively small risks."

"An important milestone in the development of life insurance occurred in the 1880s when Henry Hyde of the Equitable Life Assurance Society conceived the idea of creating long-term life insurance policies with substantial cash values, and of marketing them as investments rather than as pure insurance. The concept was one of bundling, of bundling the life insurance policy together with an investment, so that no loss was immediately apparent if there was no death. This innovation was a powerful impetus to the public’s acceptance of life insurance. It changed the framing from one of losses to one of gains…It might also be noted that an educational campaign made by the life insurance industry has also enhanced public understanding of the concept of life insurance. Indeed, people can sometimes be educated out of some of the judgmental errors that Kahneman and Tversky have documented…In my book (2003) I discussed some important new forms that livelihood insurance can take in the twenty-first century, to manage risks that will be more important than death or disability in coming years. But, making such risk management happen will require the same kind of pervasive innovation that we saw with life insurance."

"According to a theoretical model developed by Stefano Athanasoulis and myself, the most important risks to be hedged first can be defined in terms of the eigenvectors of the variance matrix of deviations of individual incomes from world income, that is, of the matrix whose ijth element is the covariance of individual I’s income change deviation from per capita world income change with individual j’s income change deviation from per capita world income change. Moreover, the eigenvalue corresponding to each eigenvector provides a measure of the welfare gain that can be obtained by creating the corresponding risk management vehicle. So a market designer of a limited number N of new risk management instruments would pick the eigenvectors corresponding to the highest N eigenvalues."

"Helping the economy and raising incomes requires increasing productivity, and the saving rate is central to that objective. The initiative we are announcing today has the potential of raising our national saving rate as well as reducing the cost of capital to the federal government. Today we are announcing our intention to issue securities that will offer investors protection against inflation. Americans' retirement savings in their pension plans or their own IRAs can have inflation protection, which can help ensure their retirement security... 

We believe these bonds will offer savers value-added in the form of protection against inflation, plus a real rate of return backed by the full faith and credit of the United States, and in return for offering that value-added, over time the cost of financing to the federal government will be lower than it otherwise would be...This is a common sense approach to government and an excellent example of government reinvention -- protecting Americans from inflation with an innovative investment method, and saving them money as taxpayers by holding down borrowing costs."

"All assets have an expected return equal to the risk-free rate, plus a risk adjustment. Assets whose returns covary positively with consumption make consumption more volatile, and so must promise higher expected returns to induce investors to hold them. Conversely, assets that covary negatively with consumption, such as insurance, can offer expected rates of return that are lower than the risk-free rate...You might think that as asset with a volatile payoff is `risky' and thus should have a large risk correction. However, if the payoff is uncorrelated with the discount factor m, the asset receives no risk correction to its price, and pays an expected return equal to the risk-free rate!"

Source: Christensen and Gillan (2011)

Source: Dudley, Roush, and Steinberg Ezer (2009)

Survey Research at Work

A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Lets smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Lets assume that we have a can-opener..."

"First, while low rates might encourage spending if credit were easy, it is not at all clear that traditional savers today would go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside. 

Alternatively, low interest rates could push her (or her pension fund) to buy risky long-maturity bonds. Given that these bonds are already aggressively priced, such a move might thus set her up for a fall when interest rates eventually rise. Indeed, America may well be in the process of adding a pension crisis to the unemployment problem."

"In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small...

I have heard from various business contacts that the low interest rate environment is spurring institutional and individual investors to “search for yield.” This may entail taking on more credit risk than these investors are typically comfortable with in a reach for yields that may ultimately be illusive and result in losses they are ill-equipped to handle. Very low yields may also be distorting other investment decisions, inducing firms to undertake long-run investment projects that may prove to be unprofitable in a rising interest rate environment."

"Savers looking for a larger rate of return should... take their money out of low interest savings accounts and out of the failed financial intermediation industry and invest it into quality economic projects that create jobs and growth. This could involve buying the stock or debt of large companies that wish to expand, or it could involve starting your own business, or investing in a startup or a mixture of these things. The easiest way to return to growth — and thus higher interest rates, and higher returns for things like pension funds — is for today’s savers complaining about low interest rates to turn into tomorrow’s investors seeking out and pouring money into quality projects that increase incomes, create jobs and create products that people desire and want to use."

• Plosser: "The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner. As I said, I see little if any benefit from these purchases, and growing costs. The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds."
• Krugman: "Unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried)."
• Rajan: "We really don’t know. Given the dubious benefits of still lower real interest rates, placing central-bank credibility at risk would be irresponsible."

• Plosser wants removal of fiscal-policy-induced uncertainty: "There remains significant uncertainty about the choices that will be made. How much will tax rates rise? How much will government spending be cut? U.S. fiscal policy is clearly on an unsustainable path that must be corrected. Efforts by Congress and the administration at the end of last year reduced some of the near-term uncertainty over personal tax rates. But the impact of the sequester, the debate over the continuing resolution to fund the federal government beyond this month, and the debt ceiling, which will once again become binding in the spring, all have clouded the fiscal policy situation. So, the resultant uncertainty will likely be a drag on near-term growth. In my view, until uncertainty has been resolved, monetary policy accommodation that lowers interest rates is unlikely to stimulate firms to hire and invest."
• Krugman thinks the fiscal multiplier is large, and fiscal retrenchment would be destructive: "the logic for a biggish multiplier and the logic of the crisis itself are very closely linked: times like these, the aftermath of a credit bubble, are precisely when you expect fiscal multipliers to be large. And that in turn says, once again, that fatalism — or worse yet, demands for fiscal retrenchment — in the aftermath of such a bubble are deeply destructive."
• Rajan looks to helping households refinance, and (somehow) improving workforce capabilities: "We cannot ignore high unemployment. Clearly, improving indebted households’ ability to refinance at low current interest rates could help to reduce their debt burden, as would writing off some mortgage debt in cases where falling house prices have left borrowers deep underwater (that is, the outstanding mortgage exceeds the house’s value)... But it is also important to recognize that the path to a sustainable recovery does not lie in restoring irresponsible and unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance... Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes."

One way to think about the skill-biased technological change issue that I think is useful is to construct for yourself an exaggerated hypothetical in which SBTC is definitely driving a big increase in inequality...what would be the correct policy response? I say—higher taxes to finance more and better public services, the exact same thing that’s the correct policy response to the actual world.