Rising wage inequality and stagnant real wages have contributed to inequality in family incomes during the past three decades. While the expansion of the Earned Income Tax Credit (EITC) and the Supplemental Nutrition Assistance Program (SNAP) have helped mitigate the impact on low-income families (Bitler and Hoynes 2010), federal minimum wage policy has not contributed to the solution. The federal minimum wage has failed to keep pace with both the cost of living and the median wage in the labor market. As a consequence, working full-time at the minimum wage does not allow many families to escape poverty, or to attain economic self-sufficiency.

State and local governments can set minimum wages in excess of the statutory federal minimum wage. Indeed, state and local governments have played an important role in establishing minimum wages across the country; as a result, thirty-seven states had state minimum wages exceeding the federal level in 2007 prior to the most recent federal increase. Cities, too, have begun setting higher minimum wages, as evidenced by city-level wage minimums in Albuquerque, San Francisco, San Jose, Santa Fe, Seattle, and Washington, DC; other cities are actively exploring possibilities of raising minimum wages. 

In this policy memo, I propose a framework for effective state and local minimum wage policy. First, I propose using half the local-area median wage as an important gauge for setting an appropriate level of the minimum wage. Second, I propose that state and local governments take into account the local cost of living as a relevant consideration in setting a minimum wage, and I provide estimates of how state minimum wages would vary if they reflected cost-of-living differences. I also recommend the use of regional consumer price indexes (CPIs) to index the local minimum wage. Finally, I propose that cities and counties coordinate regional wage setting to mitigate possible negative effects of local mandates. 

The implementation of the state and local framework does not override the need for reform at the federal level. Thoughtful reforms to the federal minimum wage can help reduce poverty and mitigate inequality. The federal minimum wage has been the focus of substantial debate by academics and policymakers; this proposal focuses on state and local reforms that have received substantially less attention. These state and local reforms can be an important part of the policy portfolio for reducing the incidence of poverty and for helping low-income families support themselves as they strive toward the middle class. In particular, although the federal minimum wage serves as a floor in the labor market, there is some room for additional increases in higher-wage areas.

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• Designing Thoughtful Minimum Wage Policy at the State and Local Levels - Full Text

At 77 years of age, the federal minimum wage deserves a respite from the day-to-day combat of political life. Today, protestors around the country are demanding a $15 minimum. But few observers think this level is economically desirable: even fewer think that it is likely.

Democrats want a higher minimum, and say so loudly. Republicans of a free-market persuasion mostly do not—but tend to stay silent because they know that swing voters look positively at raising the wages of low-earners.

The minimum wage is lagging…

Congressional political stalemate has meant the U.S. wage floor has lagged behind median earnings. In contrast wage growth in other OECD countries has performed much better, as this graph produced by the Hamilton Project shows:

Advanced nations have de-politicized minimum wage decisions

The federal minimum wage is an established piece of the U.S. policy furniture—and one that is quite dated. It now makes sense to consider taking some of the power and responsibility for setting the wage rate out of the hands of politicians—just as interest rates are set by the Federal Reserve.

This is not a novel proposal in international terms. In most advanced economies, minimum wage decisions are not purely political. Out of 66 countries studied by Tito Boeri in 2009, 24 delegate the determination the minimum wage level to a tripartite body; 26 countries set the minimum wage after taking advice following formal consultation between the Government and representatives of employers and workers; and just 16 countries (including the U.S.) set the minimum wage through a simple legislative vote.

Over in the U.K., the Conservative Prime Minister David Cameron just jacked up the national minimum wage by 3% up to £6.70, with barely a squeak of protest from employers or the right wing of his own party. Why? Because, like his two predecessors, he simply followed the advice of the Low Pay Commission, which is comprised of nine commissioners—three each from trade unions, employer organizations and academia.

Two options for taking the political heat out of the U.S. minimum wage

Can the U.S. follow suit? And if it can, what might the new system look like? Two options at least are worth considering.

1. A Federal Minimum Wage Advisory Board. This could be made up (like the U.K. version) of nine members: three representatives of employer organizations, three from labor organizations, and three independent labor economists. The Board would recommend a rate for the national minimum wage each year, which would then be enacted by Congress in the usual manner. The Board would have a strong incentive to set a rate likely to be adopted by Congress, in order to establish and maintain its reputation: there is, after all, little point in sitting on a Board that is ignored. The Board’s recommendation would not be binding and would not become the legal ‘default’ level. But because the advice is likely to be sensible, Congress would likely be inclined to follow it.

2. Wage Indexation. An alternative—favored by my Brookings colleague Gary Burtless—would be to simultaneously raise the minimum wage and introduce automatic indexing, lifting the minimum wage at the same rate as either consumer prices or the median wage—preferably the latter. In effect, this would do for the minimum wage what President Nixon did for Social Security. Congress would have the power to suspend a rise—perhaps if unemployment reached a certain threshold—but the default position would be to link changes in the minimum wage to changes in the median wage or in the broader consumer economy.

Policy commitment devices in action

These are both examples of what I have called policy commitment devices—in a new paper, Ulysses Goes to Washington—that help to overcome political myopia in order to support longer-term policy objectives. In the first case, taking advice from an independent commission, the commitment is somewhat less binding, although as James Madison knew, ‘the counsels and checks of friends’ can carry plenty of weight. Indexation would be a tighter form of binding, since inaction on the part of politicians would lead to an uprating of minimum wage, rather than the current stasis.

For both sides, there are political attractions to sub-contracting some decision-making power over the minimum wage. By accepting the advice of an independent body or allowing indexation to do its silent work, Republicans can keep their business donors and right-wing critics at bay; Democrats can do the same for unions and the political left. Sometimes the most powerful thing politicians can do is give some power away. The minimum wage is now perhaps a case in point.

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The U.S. government spends billions of dollars each year on computer hardware, software and file servers that may no longer be necessary. Currently, the public sector makes relatively little use of cloud computing, even though studies suggest substantial government savings from a migration to more Internet-based computing with shared resources.

On July 21, the Center for Technology Innovation at Brookings hosted a policy forum on steps to enhance public sector adoption of cloud computing innovations. Brookings Vice President Darrell West moderated a panel of experts, including David McClure of the General Services Administration, Dawn Leaf of the National Institute for Standards and Technology, and Katie Ratte of the Federal Trade Commission. West released a paper detailing the policy changes required to improve the efficiency and effectiveness of federal computing.

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• Moving to the Cloud: How the Public Sector Can Leverage the Power of Cloud Computing

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• Uncorrected Transcript (.pdf)
• Download Dawn Leaf's PowerPoint Presentation (.pdf)
• Download David McClure's PowerPoint Presentation (.pdf)

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Although research suggests that considerable efficiencies can be gained from cloud computing technology, concerns over privacy and security continue to deter government and private-sector firms from migrating to the cloud. By its very nature, storing information or accessing services through remote providers would seem to raise the level of privacy and security risks. But is such apprehension warranted? What are the real security threats posed to individuals, business and government by cloud computing technologies? Do the cost-saving benefits outweigh the dangers?

On October 26, the Brookings Institution hosted a policy forum on the privacy and security challenges raised by cloud computing. Governance Studies Director Darrell West moderated a panel of technology industry experts examining how cloud computing systems can generate innovation and cost savings without sacrificing privacy and security. West will also present findings from his forthcoming paper “Privacy, Security, and Innovation in Cloud Computing.”

After the program, panelists took audience questions.

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20101026_cloud_computing

Executive Summary

The move to the cloud is one of the defining information technology trends of the early 21st century. By providing businesses, universities, government agencies, and other entities with access to shared and often physically dispersed computing resources, cloud computing can simultaneously offer increased flexibility, reduced cost, and access to a wider array of services.

Cloud computing has also created a set of new challenges. For example, the issues of privacy and security in the cloud are well recognized and have been extensively discussed in the business and popular press. However, one critical issue that has received very little attention with respect to cloud computing is export control.

In the broadest sense, export control relates to regulations that the United States and many other countries have put in place to restrict the export of various sensitive items, information, and software.

There is an inherent tension between cloud computing and export control. While the concept of the cloud is centered on the premise of removing the need to track the details of data movement among various destinations, export control regulations are built largely around restrictions tied to those very movements.

If cloud computing is to reach its full potential, it is critical for providers and users of cloud services to address its implications with respect to export control. It is equally important to adapt the export control regulations to reflect the increasing prevalence of cloud computing in a manner that preserves the ability of American companies to benefit from the efficiencies of the cloud while also ensuring that American national security and foreign policy interests are adequately protected.

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• Download the Paper

No. We should exempt workers earning the lowest wages.

Social Security faces a serious funding problem. The program takes in too little money to pay all that has been promised to future beneficiaries. Government forecasters predict Social Security’s reserve fund will be depleted between 2030 and 2034. There are two basic ways we can eliminate the funding gap: cut benefits or increase contributions. A common proposal is to increase the age at which workers can claim full retirement benefits. For people nearing retirement today, the full retirement age is 66. As a result of a 1983 law, that age will rise to 67 for workers born after 1959.

When policymakers urge us to raise the retirement age, they are proposing to increase the full retirement age beyond 67, possibly to 70, for workers now in their 30s or 40s. This saves money, but it also cuts monthly retirement benefits by the same percentage for every worker, unless workers delay claiming benefits. The policy might seem fair if workers in future generations could all expect to share in gains in life expectancy. However, new research shows that gains in life expectancy have been very unequal, with the biggest improvements among workers who earn top incomes. Life expectancy gains for workers with the lowest incomes have been small or negligible.

If the full retirement age were raised, future retirees with high lifetime earnings can expect to receive some compensation when their monthly benefits are cut. Because they can expect to live longer than today’s retirees, they will receive benefits for a longer span of years after 65. For low-wage workers, there is no compensation. Since they are not living longer, their lifetime benefits will fall by the same proportion as their monthly benefits. Thus, “raising the retirement age” is a policy that cuts the lifetime benefits of future low-wage workers by a bigger percentage than it does of future high-wage workers.

The fact that low-wage workers have seen small or negligible gains in life expectancy signals that their health when they are past 60 is no better than that of low-wage workers born 20 or 30 years ago. This suggests their capacity to work past 60 is no better than it was for past generations. A sensible policy for cutting future benefits should therefore preserve current benefit levels for workers who have contributed to Social Security for many years but have earned low wages.

Editor's note: This piece originally appeared in CQ Researcher.

Health reform (aka Obamacare) is entering a new stage. The recent announcement by United Health Care that it will stop selling insurance to individuals and families through most health insurance exchanges marks the transition. In the next stage, federal and state policy makers must decide how to use broad regulatory powers they have under the Affordable Care Act (ACA) to stabilize, expand, and diversify risk pools, improve local market competition, encourage insurers to compete on product quality rather than premium alone, and promote effective risk management. In addition, insurance companies must master rate setting, plan design, and network management and effectively manage the health risk of their enrollees in order to stay profitable, and consumers must learn how to choose and use the best plan for their circumstances.

Six months ago, United Health Care (UHC) announced that it was thinking about pulling out of the ACA exchanges. Now, they are pulling out of all but a “handful” of marketplaces. UHC is the largest private vendor of health insurance in the nation. Nonetheless, the impact on people who buy insurance through the ACA exchanges will be modest, according to careful analyses from the Kaiser Family Foundation and the Urban Institute. The effect is modest for three reasons. One is that in some states UHC focuses on group insurance, not on insurance sold to individuals, where they are not always a major presence. Secondly, premiums of UHC products in individual markets are relatively high. Third, in most states and counties ACA purchasers will still have a choice of two or more other options. In addition, UHC’s departure may coincide with or actually cause the entry of other insurers, as seems to be happening in Iowa.

The announcement by UHC is noteworthy, however. It signals the beginning for ACA exchanges of a new stage in their development, with challenges and opportunities different from and in many ways more important than those they faced during the first three years of operation, when the challenge was just to get up and running. From the time when HealthCare.Gov and the various state exchanges opened their doors until now, administrators grappled non-stop with administrative challenges—how to enroll people, helping them make an informed choice among insurance offerings, computing the right amount of assistance each individual or family should receive, modifying plans when income or family circumstances change, and performing various ‘back office’ tasks such as transferring data to and from insurance companies. The chaotic first weeks after the exchanges opened on October 1, 2013 have been well documented, not least by critics of the ACA. Less well known are the countless behind-the-scenes crises, patches, and work-arounds that harried exchange administrators used for years afterwards to keep the exchanges open and functioning.

The ACA forced not just exchange administrators but also insurers to cope with a new system and with new enrollees. Many new exchange customers were uninsured prior to signing up for marketplace coverage. Insurers had little or no information on what their use of health care would be. That meant that insurers could not be sure where to set premiums or how aggressively to try to control costs, for example by limiting networks of physicians and hospitals enrollees could use. Some did the job well or got lucky. Some didn’t. United seems to have fallen in the second category. United could have stayed in the 30 or so state markets they are leaving and tried to figure out ways to compete more effectively, but since their marketplace premiums were often not competitive and most of their business was with large groups, management decided to focus on that highly profitable segment of the insurance market. Some insurers, are seeking sizeable premium increases for insurance year 2017, in part because of unexpectedly high usage of health care by new exchange enrollees.

United is not alone in having a rough time in the exchanges. So did most of the cooperative plans that were set up under the ACA. Of the 23 cooperative plans that were established, more than half have gone out of business and more may follow. These developments do not signal the end of the ACA or even indicate a crisis. They do mark the end of an initial period when exchanges were learning how best to cope with clerical challenges posed by a quite complicated law and when insurance companies were breaking into new markets. In the next phase of ACA implementation, federal and state policy makers will face different challenges: how to stabilize, expand, and diversify marketplace risk pools, promote local market competition, and encourage insurers to compete on product quality rather than premium alone. Insurance company executives will have to figure out how to master rate setting, plan design, and network management and manage risk for customers with different characteristics than those to which they have become accustomed.

Achieving these goals will require state and federal authorities to go beyond the core implementation decisions that have absorbed most of their attention to date and exercise powers the ACA gives them. For example, section 1332 of the ACA authorizes states to apply for waivers starting in 2017 under which they can seek to achieve the goals of the 2010 law in ways different from those specified in the original legislation. Along quite different lines, efforts are already underway in many state-based marketplaces, such as the District of Columbia, to expand and diversify the individual market risk pool by expanding marketing efforts to enroll new consumers, especially young adults. Minnesota’s Health Care Task Force recently recommended options to stabilize marketplace premiums, including reinsurance, maximum limits on the excess capital reserves or surpluses of health plans, and the merger of individual and small group markets, as Massachusetts and Vermont have done.

In normal markets, prices must cover costs, and while some companies prosper, some do not. In that respect, ACA markets are quite normal. Some regional and national insurers, along with a number of new entrants, have experienced losses in their marketplace business in 2016. One reason seems to be that insurers priced their plans aggressively in 2014 and 2015 to gain customers and then held steady in 2016. Now, many are proposing significant premium hikes for 2017.

Others, like United, are withdrawing from some states. ACA exchange administrators and state insurance officials must now take steps to encourage continued or new insurer participation, including by new entrants such as Medicaid managed care organizations (MCOs). For example, in New Mexico, where in 2016 Blue Cross Blue Shield withdrew from the state exchange, state officials now need to work with that insurer to ensure a smooth transition as it re-enters the New Mexico marketplace and to encourage other insurers to join it. In addition, state insurance regulators can use their rate review authority to benefit enrollees by promoting fair and competitive pricing among marketplace insurers. During the rate review process, which sometimes evolves into a bargaining process, insurance regulators often have the ability to put downward pressure on rates, although they must be careful to avoid the risk of underpricing of marketplace plans which could compromise the financial viability of insurers and cause them to withdraw from the market. Exchanges have an important role in the affordability of marketplace plans too. For example ACA marketplace officials in the District of Columbia and Connecticut work closely with state regulators during the rate review process in an effort to keep rates affordable and adequate to assure insurers a fair rate of return.

Several studies now indicate that in selecting among health insurance plans people tend to give disproportionate weight to premium price, and insufficient attention to other cost provisions—deductibles and cost sharing—and to quality of service and care. A core objective of the ACA is to encourage insurance customers to evaluate plans comprehensively. This objective will be hard to achieve, as health insurance is perhaps the most complicated product most people buy. But it will be next to impossible unless customers have tools that help them take account of the cost implications of all plan features and report accurately and understandably on plan quality and service. HealthCare.gov and state-based marketplaces, to varying degrees, are already offering consumers access to a number of decision support tools, such as total cost calculators, integrated provider directories, and formulary look-ups, along with tools that indicate provider network size. These should be refined over time. In addition, efforts are now underway at the federal and state level to provide more data to consumers so that they can make quality-driven plan choices. In 2018, the marketplaces will be required to display federally developed quality ratings and enrollee satisfaction information. The District of Columbia is examining the possibility of adding additional measures. California has proposed that starting in 2018 plans may only contract with providers and hospitals that have met state-specified metrics of quality care and promote safety of enrollees at a reasonable price. Such efforts will proliferate, even if not all succeed.

Beyond regulatory efforts noted above, insurance companies themselves have a critical role to play in contributing to the continued success of the ACA. As insurers come to understand the risk profiles of marketplace enrollees, they will be better able to set rates, design plans, and manage networks and thereby stay profitable. In addition, insurers are best positioned to maintain the stability of their individual market risk pools by developing and financing marketing plans to increase the volume and diversity of their exchange enrollments. It is important, in addition, that insurers, such as UHC, stop creaming off good risks from the ACA marketplaces by marketing limited coverage insurance products, such as dread disease policies and short term plans. If they do not do so voluntarily, state insurance regulators and the exchanges should join in stopping them from doing so.

Most of the attention paid to the ACA to date has focused on efforts to extend health coverage to the previously uninsured and to the administrative stumbles associated with that effort. While insurance coverage will broaden further, the period of rapid growth in coverage is at an end. And while administrative challenges remain, the basics are now in place. Now, the exchanges face the hard work of promoting vigorous and sustainable competition among insurers and of providing their customers with information so that insurers compete on what matters: cost, service, and quality of health care.

Editor's note: This piece originally appeared in Real Clear Markets. Kevin Lucia and Justin Giovannelli contributed to this article with generous support from The Commonwealth Fund.

Event Information

The Building Bridges Coalition was launched at the Brookings Institution in June 2006 to promote the role of volunteer service in achieving development goals and to highlight research and policy issues across the field in the United States and abroad. Among other efforts, the coalition promotes innovation, scaling up, and best practices for international volunteers working in development.

On June 14, the Brookings Institution and the Building Bridges Coalition co-hosted a 10th anniversary forum on the role of volunteers in achieving the United Nation’s Sustainable Development Goals for 2030 and on the coalition’s impact research. General Stanley McChrystal was the keynote speaker and discussed initiatives to make a year of civilian service as much a part of growing up in America as going to high school.

Afterwards, three consecutive panels discussed how to provide a multi-stakeholder platform for the advancement of innovative U.S.-global alliances with nongovernmental organizations, faith-based entities, university consortia, and the private sector in conjunction with the launch of the global track of Service Year Alliance.

For more information on the forum and the Building Bridges Coalition, click here.

Video

• Welcoming remarks and featured speaker
• Panel 1 — Role of volunteer service in achieving the 2030 Sustainable Development Goals
• Panel 2 — Policy perspective: National and international service in the next administration
• Panel 3 — One million Americans in global service: The role of faith-based service

Audio

• International volunteer service and the 2030 development agenda

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20160614_volunteering_development_transcript

I’m late to the conversation about whether or not Republican efforts to insist on sixty votes for cloture on Chuck Hagel’s nomination as Secretary of Defense constitutes a filibuster. Bernstein’s earlier piece ("This is what a filibuster looks like") and Fallows’ recent contribution provide good, nuanced accounts of why Republican tactics amount to a filibuster, even if some GOP senators insist otherwise. In short, the duck test applies: If it looks like a duck, swims like a duck and quacks like a duck, then …. it’s a filibuster!

Still, I think there’s more to be said about the politics and implications of the Hagel nomination. A few brief thoughts:

First, let’s put to rest the debate about whether insisting on sixty votes to cut off debate on a nomination is a filibuster or, at a minimum, a threatened filibuster. It is. Even if both parties have moved over the past decade(s) to more regularly insist on sixty votes to secure passage of major (and often minor) legislative measures and confirmation of Courts of Appeals nominees, we shouldn’t be fooled by the institutionalization—and the apparent normalization—of the 60-vote Senate. Refusing to consent to a majority’s effort to take a vote means (by definition) that a minority of the Senate has flexed its parliamentary muscles to block Senate action. I think it’s fair to characterize such behavior as evidence of at least a threatened filibuster—even if senators insist that they are holding up a nomination only until their informational demands are met.

Second, there’s been a bit of confusion in the reporting about whether filibusters of Cabinet appointees are unprecedented. There appears to have been no successful filibusters of Cabinet appointees, even if there have been at least two unsuccessful filibusters against such nominees. (On two occasions, Cabinet appointees faced cloture votes when minority party senators placed holds on their nominations—William Verity in 1987 and Kempthorne in 2006. An EPA appointee has also faced cloture, but EPA is not technically cabinet-level, even if it is now Cabinet-status). Of course, there have been other Cabinet nominees who have withdrawn; presumably they withdrew, though, because they lacked even majority support for confirmation. Hagel’s situation will be unprecedented only if the filibuster succeeds in keeping him from securing a confirmation vote.

Third, using cloture votes as an indicator of a filibuster underestimates the Senate’s seeping super-majoritarianism. (Seeping super-majoritarianism?! Egads.) At least two other recent Cabinet nominations have been subjected to 60-vote requirements: Kathleen Sebelius in 2009 (HHS) and John Bryson (Commerce) in 2011. Both nominees faced threatened filibusters by Republican senators, preventing majority leader Reid from securing the chamber’s consent to schedule a confirmation vote—until Reid agreed to require sixty votes for confirmation. The Bryson unanimous consent agreement (UCA) appears on the right, an agreement that circumvented the need for cloture. Embedding a 60-vote requirement in a UCA counts as evidence of an attempted filibuster, albeit an unsuccessful one. After all, other Obama nominees (such as Tim Geithner) were confirmed after Reid negotiated UCAs that required only 51 votes for confirmation, an agreement secured because no Republicans were threatening to filibuster.

Finally, what are the implications for the Hagel nomination? If Republicans were insisting on sixty votes on Senator Cornyn’s grounds that “There is a 60-vote threshold for every nomination,” then I bet Reid would have been able to negotiate a UCA similar to Sebelius’s and Bryson’s. But Hagel’s opponents see the time delay imposed by cloture as instrumental to their efforts to sow colleagues’ doubts about whether Hagel can be confirmed (or at a minimum to turn this afternoon’s cloture vote into a party stand to make their point about Benghazi). Of course, it’s possible that the time delay will work to Democrats’ benefit if they can make headlines that GOP obstruction puts national security at risk. (Maybe Leon Panetta should have jetted to his walnut farm to make the point before the cloture vote.) Whatever the outcome, the Hagel case reminds us that little of the Senate’s business is protected from the intense ideological and partisan polarization that permeates the chamber and is amplified by the chamber’s lax rules of debate and senators’ lack of restraint. Filibustering of controversial Cabinet nominees seems to be on the road to normalization—even if Hagel is ultimately confirmed.

Executive Summary

If the main purpose of the Emergency Economic Stabilization Act of 2008 is to give banks confidence in each other, then enabling Treasury directly to bolster the capital positions of banks that need more capital may be an even more effective way to restoring confidence to the inter-bank market than the purchased of troubled assets. Whatever Congress may have intended about the pricing of the distressed assets, it also authorized a much more direct way to recapitalize the financial system and weak banks in particular: direct purchases by Treasury of securities that individual institutions may wish to issue to bolster their capital. At this writing, Treasury reportedly is considering ways do this. In this essay, we outline a specific bank recapitalization plan for Treasury to consider.

In particular, Treasury could announce its willingness to entertain applications for capital injections, using a set pricing formula. For publicly traded banks, Treasury could buy at the price as of a given date, such as the price one or more days before its plan was announced. For privately-owned banks, Treasury could use a price based on the average price-to-book value for publicly traded banks as of that date. To prevent government intrusion into the affairs of the banks, the stock should be non-voting. Treasury would make clear that it only would take minority positions. There should be no takeovers of more companies—AIG, Fannie and Freddie are quite enough. Treasury also should announce that it will dispose (or sell back to the bank) any stock acquired through these actions as soon as the financial system has stabilized and the bank is in sound financial condition (perhaps a time limit, such as three years, should be a working presumption).

We believe Treasury can accommodate a systematic recapitalization plan within the funding it has been given – initially $350 billion and another $350 billion later upon request to Congress (unless it disapproves) – by using the required disclosures about its asset purchases as a way of jump starting private sector pricing and trading of these securities. This should conserve Treasury’s resources it might otherwise use for asset purchases, and thus free up funds to recapitalize weak banks directly, but in an orderly fashion.

Treasury will have to be careful when it buys distressed assets to guard against the possibility that banks will just dump their worst stuff on taxpayers. The Department will also have to be careful when buying equity in banks. There cannot be an open invitation for bank owners to move assets out of the bank and then, in effect, say: “We don’t want this bank, you buy it.” To avoid this problem, Treasury should work closely with the FDIC and other regulators to determine whether or not a particular bank is eligible for an equity injection. The Department also may need to limit the scope of the recapitalization program to larger national banks, if it becomes infeasible to allow smaller banks to participate.

Making the Rescue Package Work: Asset and Equity Purchases [1]

The unprecedented financial rescue plan – technically the Emergency Economic Stabilization Act of 2008 (“EESA,” the “Act”, or the “plan”) -- has now been enacted by the Congress. One of the goals of the plan is to end the immediate panic in inter-bank lending markets, and on this basis several omens are not encouraging.

The Dow Jones stock index has been dropping daily, by large amounts, since EESA was enacted. The TED spread measures the difference between the interest rate on short term Treasury bills and the interest rate banks pay to borrow from each other (the LIBOR) and is a widely accepted measure of perceived risk in the financial sector. For several years this spread had hovered around 50 basis points or half a percentage point, reflecting the fact that lending to other financial institutions was considered almost as safe as buying Treasury bills. However, the spread shot up to 2.4 percentage points in July 2007 as the financial crisis hit, and it fluctuated widely in subsequent months. Following passage of the plan it remains even more elevated than it was last July—it was 3.8 percentage points as of October 7 and broke 4 percent on October 8. Financial institutions simply do not trust each other’s credit worthiness. Some of the market worries, of course, reflect the fragile state of the U.S. and global economies, but clearly the passage of the rescue plan itself has not calmed markets.

A second and related goal for the plan, according to media accounts, is to facilitate the recapitalization of the financial system, but the language of the bill is surprisingly coy about this. While the Act aims to “restore liquidity and stability to the financial system” it also directs the Treasury Secretary to prevent “unjust enrichment of financial institutions participating” in the asset purchase program. It is not yet clear whether Treasury will choose to recapitalize banks through its asset purchases – by buying them at prices above the values to which banks and other sellers have already written them down – or whether Treasury will simply use its purchases to stabilize prices for these securities and thus provide liquidity to the market, even if it may result in additional write-downs of their values (and thus additional reductions in capital).

Whatever Congress may have intended about the pricing of the distressed assets, it also authorized a much more direct way to recapitalize the financial system and weak banks in particular: direct purchases by Treasury of securities that individual institutions may wish to issue to bolster their capital. Of course, in normal times, such authority would be unnecessary because financial institutions would seek to tap private sources of capital first. But these are not normal times, to say the least.

If the main purpose of the plan is to give banks confidence in each other, then enabling Treasury directly to bolster the capital positions of banks that need more capital may be an even more effective way to restoring confidence to the inter-bank market. Accordingly, we outline here a possible supplementary bank recapitalization plan that we believe Treasury should pursue, at the same time it purchases distressed assets. As this paper is being completed on October 9, 2008, The New York Times reports that the Treasury is now considering such a move. We are encouraged by this and in this essay we provide both a rationale for doing so and some concrete suggestions for how such a direct recapitalization program might work. We do not support further nationalization of the banking system beyond what has already been done but we believe that the crisis has become so severe that the asset purchase plan on its own will not be enough to turn the current situation around. Additional capital is urgently needed and could be supplied by Treasury purchases of minority, non-voting equity stakes, or by warrants.

We believe Treasury can accommodate a systematic recapitalization plan within the funding it has been given – initially $350 billion and another $350 billion later upon request to Congress (unless it disapproves) – by using the required disclosures about its asset purchases as a way of jump starting private sector pricing and trading of these securities. This should conserve Treasury’s resources it might otherwise use for asset purchases, and thus free up funds to recapitalize weak banks directly, but in an orderly fashion, as we describe below.

Why Do Banks Need More Capital?

Financial institutions make money by borrowing money on favorable terms, that is, at low interest rates, and then lending it out at higher rates or by buying assets that yield higher returns. They may make money in other ways too, but the state of their balance sheets of assets and liabilities is crucial. In order to create a viable financial institution that can accommodate requests by depositors to take money out, someone has to put up capital and typically this comes from the equity in the company. The owners of the company have an incentive to keep this equity capital low and to build a large volume of borrowing and lending off a small base of capital—to increase leverage. This is because the profits earned are divided among the equity owners and the less capital there is, the higher the return on equity.

Governments for many years and in almost all countries have regulations in place setting capital requirements for banks in particular to stop them from taking too much risk in the pursuit of high returns and also protect any fund that insures their deposits against loss (the FDIC in this country). But some of our larger banks in recent years found a way around these rules by establishing “off-balance sheet” entities – Structured Investment Vehicles (“SIVs”) – to purchase mortgage-related and other asset-backed securities that the banks were issuing. In addition, large investment banks significantly increased their leverage in the years running up to the recent crisis, and were able to do so without mandated capital requirements. As a result, when the mortgage crisis hit, our financial system was weaker than was widely believed, and in the case of large banks in particular, than was officially reported.[2]

The mortgage crisis, which first surfaced in 2006 and has escalated rapidly since then, has hit bank balance sheets severely. As banks were forced to recognize losses on the mortgages they held in their portfolio, and especially to write down the values of their mortgage securities to their “market values” (even though the prices in those “markets” reflected relatively few “fire-sale” trades), they suffered reductions of their capital. Furthermore, the large banks that had created SIVs to escape such events found they could not hide from them when the SIVs could no longer roll over the commercial paper they had issued to finance their holdings of mortgage securities. To avoid dumping these securities on the market to satisfy their creditors, the banks took the SIVs back on their balance sheets, only to suffer further losses to their capital.

As we have seen, some of our largest banks – Washington Mutual and Wachovia, to name two – have not been able to survive all of this, and have been forced or are or being forced into the hands of stronger survivors. Other banks have been doing their best to shore up their capital bases by issuing new equity to replace the losses they have absorbed on delinquent loans and declining prices of their asset-backed securities. According to media reports, financial institutions (largely banks) worldwide have suffered over $700 billion in such losses to date, of which they replaced approximately $500 billion by issuing new equity.

But more losses are sure to come; indeed Secretary Paulson has said to expect further bank failures. Earlier this year, the International Monetary Fund projected that losses due to the credit crisis worldwide could hit $1 trillion. The IMF has recently upped that forecast to $1.4 trillion. If anything close to this latest forecast is realized, then many banks – here and abroad – will need to raise even more equity, but in a capital market that is now highly more risk averse than only a few months ago.

It is in this environment that banks have grown much less comfortable dealing with each other, even though they must to keep the financial system running. Every day, some banks have more cash on hand, or reserves, than they need to meet reserve requirements and ordinary demands for liquidity, while others are short of such funds. In the United States, banks thus trade with each other in the Federal Funds market while global banks borrow and lend to each other through the London Interbank market using the LIBOR rate of interest. The Federal Reserve’s main objective of monetary policy is to stabilize the “Fed funds” rate around a target, now just lowered to 1.5%, down from 2% where it has been for some months (and down from 5.25% before subprime mortgage crisis). To do so, the Fed has added a huge amount of liquidity to the financial system, even going so far this week as to buy up commercial paper issued by corporations, an unprecedented step. But the Fed does not and probably cannot control the longer term inter-bank market, in which banks lend to each other typically over a 3-month period.

The steep jump in the 3-month inter-bank lending rate – well over 4 percent – reflects two fundamental facts that EESA is designed to address. One is that banks don’t trust each others’ valuations of the mortgage and possibly other asset-backed securities they are all holding, precisely because the “markets” in those securities are so thin and thus not generating reliable prices. The second problem is that banks either are short of capital themselves, or fear that their counterparties are. No wonder that banks are so unwilling to lend to each other for a period even as short as three months – which in this environment, can seem like an eternity.

The capital shortage in the banking system, in particular, has severe implications for the rest of the economy. An institution that is short of capital is forced to cut back on its lending and this shows up in denials of lines of credit to companies and reductions in credit limits for consumers. Households cut back on spending; it is difficult to get a mortgage or a car loan; and companies reduce investment and curtail operations. And as we learn in any college course on banking, the impact of a loss of capital on bank lending can be multiplied. Each dollar of bank capital supports roughly ten dollars of overall lending in the economy. Each dollar of lost capital thus can result in ten dollars of lending contraction. The impact of an economy-wide bank contraction can be devastating for Main Street. The Great Depression was greatly exacerbated by the collapse of banks. The long stagnation in Japan was in large part the result of a failure to recapitalize the banks.

How bad is the current problem? We do not know how many banks, insurance companies or other financial institutions are in a weakened state, or perhaps even more important, may become weakened as the overall economy deteriorates. The official data published so far don’t really help on this score. The FDIC compiles information on the number and collective assets held by “problem banks,” or those in danger in failing. As of the second quarter of 2008, there were 117 such banks with assets of $78 billion up from 90 in the second quarter with assets of $28 billion., These figures did not include Washington Mutual, which would have failed had it not been bought by J.P. Morgan, or Wachovia, which at this writing, looks like it will be acquired by Wells Fargo (but also was in danger of failing without being acquired by someone). Together these banks hold more than $500 billion in customer deposits. Furthermore, according to recent media reports, even some large insurance companies (beyond AIG) may be having capital problems, having suffered large losses on the securities they hold in reserve to meet future claims.

Can the Asset Purchase Plan Succeed in Recapitalizing the Banks?

In principle, there are two ways in which the original Treasury asset purchase plan would recapitalize the banks. The first method is premised on the view that private markets are unwilling to supply capital to the banks because investors do not know how much their assets are worth. The Treasury, it is argued, would use its asset purchase plan as a way of revealing the prices of the assets and once that information is known, the banks will be able to raise new capital again from private markets. But better pricing will only attract capital if there are investors out there who are willing to supply it. Given the dramatic downturn in equities markets, finding such willing investors will be difficult, to say the least. Those investors that provided capital to banks early on in the crisis have been hit hard by the subsequent decline in equity prices and are reluctant to get burned again. When Bank of America said it would raise $10 billion from the markets, for example, its stock price fell sharply, suggesting there is a lot of market resistance to be overcome before private investors are willing to recapitalize the banking system.

Second, in principle, Treasury could recapitalize the banks by buying distressed assets at prices above those at which the securities are currently carried on the books of the institutions that sell them (original book or purchase value minus any write-offs).[3] In this case, the bank would be able to report a capital gain from its sale to the Treasury, a gain that would reverse, at least in part, the capital losses it had taken in the past and thereby add to its capital.

Treasury has said it will use reverse auctions[4] when it buys assets, and it is possible that the Department will be able to construct some auctions that will enable some holders of troubled assets to sell them to the Treasury at prices that earn a capital gain. But we are somewhat skeptical how many securities will fall into this category. For one thing, asset-backed securities are not homogenous, like traditional equity or bonds. In addition, it would be surprising in the current environment if reverse auctions would reveal prices that are above the written-down values of many of these securities. After all, an auction does not necessarily produce valuations that reflect the “hold to maturity” price rather than the “liquidation” price for the securities, as Fed Chairman Ben Bernanke suggested the purchase plan would accomplish.

Accordingly, we strongly suspect that Treasury will have to purchase many securities in one-on-one deals rather than through auctions. But in doing this, it may be both legally and politically difficult for the Treasury to pay prices in negotiations that are above the valuations banks or other sellers already have given them. Section 101 (e) of EESA specifically requires the Treasury Secretary “to take such steps as may be necessary to prevent unjust enrichment” of participating financial institutions, and Congress could construe such language to preclude such sales.[5] Furthermore, even if there were not a specific prohibition in the EESA, Treasury may wish to avoid the public criticism it would face if it purchased assets at prices that would allow participating institutions to book gains. And, in the case of sales at prices below the explicit or implicit price of the securities carried on an institution’s books, the sales will trigger further accounting losses and thus additional deductions from reported capital.

In short, we are not at all confident that the Treasury’s planned purchases of troubled securities, by themselves, will do much to recapitalize the banking system. This does not mean that the planned asset purchases will not deliver some needed help. Although at this writing the inter-bank lending market remains frozen even though EESA has been enacted and signed into law, one reason why banks and others may not yet have confidence that it will lead to a thaw in credit markets is that the guidelines for the asset purchases have not yet been issued. Once these guidelines are announced and the purchases begin, and the markets start to see real results, it is possible that some of the missing trust in the banking system will come back.[6]

However, Treasury may not need to spend, and for reasons elaborated below we do not believe it should spend, anywhere near the full $700 billion, or perhaps even most of the initial $350 billion tranche in borrowing authority, to liquefy the markets for mortgage and other asset-backed securities. EESA requires Treasury to publish (within two days) information about each of these purchases. We urge the Department to include in such publications (presumably on its website) regular data on the defaults and delinquencies to date of the loans underlying each batch of securities it purchases. Such information should enable financial institutions that are still holding similar securities not only to price them more accurately, but also to give market participants enough confidence to begin trading these securities without further Treasury purchases.

Husbanding its resources should be a prime objective for Treasury. In conducting its purchases of troubled assets, it should target first those asset categories that are the most illiquid. The main objective always should be jump-starting private sector activity or at least bringing greater clarity to the pricing of particular classes of securities. There is no need for Treasury, therefore, to make repeat purchases of similar securities (such as collateralized debt obligations issued within several months of each other, structured in roughly a similar way). Rather, the aim should be to make a market in as many different asset categories as are reasonably necessary to provide guidance to market participants, no more, no less.

Yet no one can be confident at this point that asset purchases alone will give banks sufficient confidence to begin dealing with each other at much lower interest rates. If the asset purchases do the trick, fine. But if they don’t, Treasury should make sure it has enough financial ammunition to pursue a second, more direct, strategy for restoring banks’ confidence – the direct bank recapitalization strategy to which we now turn.

Recapitalizing the Financial System Directly

Having the government put capital into financial institutions directly is not a new idea. It is the approach followed in this crisis for Fannie and Freddie and has been used in other countries. Sweden recapitalized its banks by adding capital to them during its crisis in the 1980s. Most recently, the British government has announced a sweeping bank recapitalization amidst the current crisis. And of more relevance to the U.S. situation, Congress specifically added authority in EESA for Treasury to make direct capital injections into banks.

In recent days, Treasury Secretary Paulson has acknowledged that the Department may take advantage of this authority and thus use some of its funds to buy equity in troubled banks. This is a welcome development. Even if Treasury’s asset purchase program restores confidence in the pricing of troubled securities, many banks still believe that many other banks lack sufficient capital, and thus can still be reluctant to lend to them. The fact that the FDIC stands ready (especially with its new unlimited line of credit at the Treasury) to assist acquiring banks in taking over failing banks is probably not sufficient, even with a successful Treasury asset purchase program, to provide this confidence. Bank lenders to failed banks can still lose money in such transactions, or at the very least may have difficulty accessing their funds for some period, at times when all banks seem to want or need as much liquidity as they can get.

How might such a capital injection program work? Treasury could announce its willingness to entertain applications for capital injections, using a set pricing formula. For publicly traded banks, Treasury could buy at the price as of a given date, such as the price one or more days before its plan was announced, as has been suggested by former St. Louis Federal Reserve Bank President William Poole.[7] For privately-owned banks, Treasury could use a price based on the average price-to-book value for publicly traded banks as of that date. To prevent government intrusion into the affairs of the banks, the stock should be non-voting. Treasury would make clear that it only would take minority positions. There should be no takeovers of more companies—AIG, Fannie and Freddie are quite enough. Treasury also should announce that it will dispose (or sell back to the bank) any stock acquired through these actions as soon as the financial system has stabilized and the bank is in sound financial condition (perhaps a time limit, such as three years, should be a working presumption).

The Treasury will have to be careful when it buys distressed assets to guard against the possibility that banks will just dump their worst stuff on the taxpayers. The Department also will have to be careful when buying equity in banks, especially if it decides to go for a broad, nationwide program. There cannot be an open invitation for owners to move assets out of the bank and then, in effect, say: “We don’t want this bank, you buy it.” This problem suggests that Treasury would need to work closely with the FDIC and other regulators to determine whether or not a particular bank is eligible for an equity injection. Treasury also may need to limit the scope of the program to larger banks, if it becomes infeasible to allow smaller banks to participate.

We presume that Treasury did not initially embrace the idea of a more systematic recapitalization of the banking system out of concern not to have any further government involvement in the banking system, especially on the heels of the Fannie/Freddie conservatorship and the Fed’s rescue of AIG. That Treasury is now considering direct capital injections indicates that this may no longer be a concern. In our view, limiting Treasury’s purchases to non-voting stock in any event would address this concern directly.

Conclusion

Ben Bernanke has compared the current financial crisis to a heart attack in the economy. For some heart attacks, it is enough to administer drugs and change diet and exercise habits. But in acute cases, major surgery is needed and the current crisis is in the acute phase. Direct surgery in the form of capital injected into financial institutions, along with direct asset purchases, should help calm the inter-banking lending market.

Based on recent monthly data it appears that GDP started to fall in mid-year and the economy is moving into recession so the proposals made here will not change that. Nor can the proposals compel banks to make loans to their traditional customers – consumers and businesses – in the current climate of fear. But Treasury can do something to mitigate that fear and thus, along with the recent further easing of monetary policy, likely additional fiscal stimulus and further homeowner relief, the Department will help reduce the severity of the current recession if it uses all the tools in its financial arsenal.

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