Fed Chairman Bernanke Submits 70 Answers to His Take-Home Exam

A few weeks ago, Fed Chairman Ben Bernanke appeared before the Senate Banking Committee for his confirmation hearing. Following the normal ritual, Committee members made their statements and peppered Bernanke with questions about every economic topic under the sun. That much is well-known (and was closely followed on CNBC).

What’s less well-known is that Bernanke went back to his office to discover an enormous stack of homework, including a 70-question take-home exam from Senator Jim Bunning.

Senator Bunning’s questions cover a lot of territory: Fed policy, fiscal policy, AIG, the dollar, etc. Chairman Bernanke’s answers are worth a read, when you have time for a 34-page, single-spaced document.

Here’s one important excerpt, reiterating the Fed’s view that Lehman could not have been saved with then-existing authorities:

54. What was your rationale for letting Lehman fail?

Concerted government attempts to find a buyer for Lehman Brothers or to develop an industry solution proved unsuccessful. Moreover, providers of both secured and unsecured credit to the company were rapidly pulling away from the company and the company needed funding well above the amount that could be provided on a secured basis. As you know, the Federal Reserve cannot make an unsecured loan. Because the ability to provide capital to the institution had not yet been authorized under the Emergency Economic Stabilization Act, the firm’s failure was, unfortunately, unavoidable. The Lehman situation is a clear example of why the government needs the ability to wind down a large, interconnected firm in an orderly way that both mitigates the costs on society as whole and imposes losses on the shareholders and creditors of the failing firm.

P.S. Calculated Risk also posts some good excerpts.

Another Issue With Redirecting TARP Money

Last week I noted two challenges that Congress will face if it wants to use unused TARP money to “pay for” new spending efforts. The first is that each dollar of redirected TARP money generates only 50 cents in budget “savings” (because TARP budgeting uses credit principles that immediately recognize the potential for some money to be repaid in the future). The second is that the alleged budget “savings” are likely mythical (because the existing TARP program is on track to use much less than its full $699 billion authority).

A third issue, recently pointed out to me by a friend, is that the original TARP legislation includes language that’s intended to prevent TARP money from being redeployed to other uses. As I say in a new piece at e21:

When Congress created TARP, it specified that future TARP rescissions should not be used to pay for new spending. Section 204 of the Emergency Economic Stabilization Act indicates that the costs of TARP were being incurred because of an emergency (and therefore were exempt from certain congressional budget requirements) and that “rescissions of any amounts provided in this Act shall not be counted for purposes of budget enforcement.” In other words, Congress wanted to make sure that the emergency spending in TARP wouldn’t subsequently be rescinded to pay for new, non-emergency spending.

That limitation has not been a factor thus far when Congress has used TARP rescissions to pay for new legislation. In the spring, Congress used a $1.26 billion TARP rescission to help pay for legislation to help struggling homeowners. A few weeks ago, the House used a $34 million TARP rescission to pay for a new TARP database. In both cases, the resulting budget savings were relatively small ($630 million and $17 million, respectively) and were used to pay for programs related to TARP’s goals (housing and transparency). Looking ahead, a key question is whether Section 204 will play a bigger role now that Congress is considering larger TARP rescissions that would be used to fund programs well outside TARP’s scope.

I am not sure whether section 204 will have any practical relevance to today’s TARP debate (insights from folks close to the process would be appreciated). At a minimum, however, it is interesting that someone in Congress saw the potential for today’s TARP debate and tried to prevent it.

P.S. In case you’d like to check my interpretation, here’s the complete language of Section 204 of the Emergency Economic Stabilization Act:


All provisions of this Act are designated as an emergency requirement and necessary to meet emergency needs pursuant to section 204(a) of S. Con. Res 21 (110th Congress), the concurrent resolution on the budget for fiscal year 2008 and rescissions of any amounts provided in this Act shall not be counted for purposes of budget enforcement.

When Do Regulations Turn Private Insurance into Government Insurance?

Summary: A new Senate health proposal might turn private insurance into government insurance, at least from CBO’s perspective.

In the 1990s, the Congressional Budget Office dealt a key blow to President Clinton’s health legislation when it decided that the reforms would move large portions of the health care system into the government and thus onto the budget. In that case, CBO concluded that regulations on private insurance would be so intrusive that it would effectively become a governmental activity. That finding strengthened the hand of opponents who portrayed the proposal as a big government expansion.

Policymakers have taken great pains to avoid the same fate in their current efforts at health insurance reform. Early in the process, Congressional leaders asked CBO to detail how it would decide which proposed policies should be treated as part of the government — and thus be recorded on the budget for Congressional purposes — and which not. To provide some answers, CBO released a brief back in May that describes how it would draw the line between government and non-government in evaluating health insurance proposals.  In his blog, Director Doug Elmendorf summarized the key distinction as follows:

In CBO’s view, the key consideration is whether a proposal would be making health insurance an essentially governmental program, tightly controlled by the federal government with little choice available to those who offer and buy health insurance—or whether the system would provide significant flexibility in terms of the types, prices, and number of private-sector sellers of insurance available to people. The former—a governmental program—belongs in the federal budget (including all premiums paid by individuals and firms to private insurers), but the latter—a largely private-sector system—does not.

The health legislation being considered in Congress includes many new regulations on private insurance (e.g., to forbid screening based on pre-existing conditions and to require coverage for certain activities), but CBO has consistently found that they aren’t enough to bring private insurance into the federal budget. The regulations would certainly change insurance markets, but in CBO’s view would leave enough flexibility and choice for those markets to still be considered private.

Until last week, that is, when a new proposal emerged that might cross CBO’s line and bring significant portions of the private insurance market onto the federal budget. That proposal would require health insurers to achieve a “medical loss ratio” of at least 90%. [A medical loss ratio (MLR) is the amount that the insurer spends on health care divided by the premiums that it collects. The difference between premiums and health spending covers the insurer’s overhead and administrative costs and provides profits for its shareholders (if any; many insurers are non-profits).]

Some insurance companies have MLRs that are 85%, 80%, or lower. Critics believe those lower ratios reflect either wasteful administrative costs or unwarranted profits. Defenders, on the other hand, point to the high administrative costs of providing careful care and cost management, as well as the higher costs of serving some parts of the insurance market.

Whatever the relative merits of those arguments, the key question for CBO is whether limiting MLRs would fundamentally transform the private insurance market. Based on what I’ve heard from several reporters this afternoon, it appears that the answer is yes. CBO has apparently concluded that when combined with other regulations in the proposed health legislation, strict limits on MLRs (e.g., establishing a minimum of 90%) would cross the line and bring any affected insurance into the federal government and onto the federal budget. On the other hand, much less stringent requirements on MLRs (e.g., establishing a minimum of 80%) would not cross that line.

Given the painful memories of the Clinton effort, you can be sure that Senate leaders are working hard to make sure their new proposal won’t cross the line. But it might come really, really close.

Menu Engineering

Earlier in the semester, my students bravely endured the usual microeconomic approach to understanding consumer choice. You know: budget constraints, indifference curves, and tangencies. Very useful when deployed appropriately, but rather abstract.

To lighten things up—and illustrate some important truths about how consumers actually behave—we then spent a class on the psychology / behavioral economics of consumer choice.

For me, the most fun part was discussing menu engineering. In the usual economic model, people make choices based on prices and the attributes of the goods they can buy. Those things matter in the real world too, but consumers are also influenced by other information. For example, their purchase decisions can sometimes be steered by crafty decisions about what options to include on the menu.

One good example is Dan Ariely’s now-famous experiment with subscription rates for The Economist magazine. In one experiment, his students were offered the choice between paying $59 per year for an online subscription or $125 for print plus online. In a second experiment, they were offered three choices: $59 for an online subscription, $125 for a print subscription, or $125 for a print/online subscription.

Standard economic analysis suggests that the print-only option in the second experiment shouldn’t matter. No one should choose it since they could get print+online for the same price. In practical terms, then, the comparison is the same as the first experiment: online at $59 or print+online at $125. And so standard economics would predict that consumers would make the same choices in the two experiments.

That’s not the way it worked out. In the first experiment, 68% of his students chose the online edition of The Economist and 32% went for print+online. In the second experiment, however, 84% went for print+online, while only 16% went for the online. The good news for standard economics is that no one chose print only. The bad news is that including that option had a big effect on choices. Even though people didn’t want that option, it made the other $125 option look more attractive. In short, it established a reference from which people might decide that the $125 print+online choice was a bargain. So many more of them chose it.

Retailers have understood this psychology for years, of course, while economists are just catching up. But growing interest in behavioral economics has also spawned further innovation in retail, and we are seeing the rise of a new species of consultant: the menu engineer.

Menu engineers advise restaurants and other retailers how to design their menus to encourage customers to buy more and to steer them to more profitable purchases. Consistent with The Economist example, one standard piece of advice is including high-priced items just to make everything else look like a bargain. Menu engineers also recommend that restaurants not use dollar signs; people spend more when they aren’t reminded it’s money. And then there’s a whole science to writing the mouth-watering prose describing each item.

If you have a few minutes, this Today Show interview with a menu engineer is quite amusing.

And for a guided tour of menu tricks, see this piece in New York magazine (ht: Tyler Cowen).

P.S. For completeness, I should note that, according to the Economist entry linked above, the Economist stopped using the three-part pricing system. So maybe it doesn’t work as well in the real world as Ariely’s experiments suggest.

Mythical Budget Savings from Cutting TARP

The TARP news continues fast and furious. This afternoon’s installment involves the House’s financial regulation bill, officially known as H.R. 4173, the Wall Street Reform and Consumer Protection Act of 2009. That bill would make many changes to financial regulation, one of which – enhanced dissolution authority for financial firms that run into severe trouble – would cost about $10 billion over the next five years, according to the Congressional Budget Office.

In order to pay for those costs, the bill would reduce TARP authority by $20.8 billion. Consistent with previous scoring decisions, CBO estimates that this provision would result in budget savings of $10.4 billion (because CBO assumes, for scoring purposes, that each dollar of reduced TARP authority translates into 50 cents of reduced outlays; for more explanation, see this earlier post.)

Why is this important? Because the alleged savings are mythical.

Earlier today, Secretary Geithner predicted that the maximum draw on TARP would be $550 billion out of the $699 billion currently authorized. Reducing TARP authority from $699 billion to $678 billion, as the bill would do, would thus have no effect on spending or the deficit.

Under congressional budget rules, CBO is required to score the House bill relative to the budget baseline developed back in March. That was during the depths of the financial crisis so CBO assumed that all TARP authority would eventually be used. Happily, conditions have since improved, and that assumption is no longer realistic. But it is still used in congressional scoring.

The “savings” attributed to the House bill thus exist because the financial world has improved, not because the House bill is actually doing anything new to pay for its costs.

I hasten to add that this isn’t just my opinion. CBO itself highlights this issue in its cost estimate for the House bill, saying (in its more measured tones):

That reduction in spending relative to the March baseline might occur even in the absence of this legislation because financial conditions have improved considerably since March. Indeed, the Secretary of the Treasury noted in his December 9, 2009, letter to the Congress that “beyond these limited new commitments, we will not use remaining [TARP] funds unless necessary to respond to an immediate and substantial threat to the economy stemming from financial instability.” Thus, if CBO were to estimate the impact of the TARP provision in this legislation taking into account current financial conditions, the agency would not expect that the TARP’s ceiling on outstanding investment would be fully utilized. Therefore, the savings estimated relative to the budget resolution baseline may be attributable to the improvement in financial conditions rather than enactment of H.R. 4173. (emphasis added)

P.S. I should emphasize that there are good reasons for the current congressional budget rules. Developing legislation takes time, and it would be disruptive if CBO were constantly updating cost estimates to reflect changes in the economy. Fixing a baseline in March, however, does open up the possibility of budget game playing, particularly in budget categories that are volatile (TARP spending is one; royalties on oil and gas leases are another).  The hard question is when Congress should decide to deviate from the March baseline to reflect new realities.

Treasury Extends, but Limits, TARP

Well that was quick. This morning Treasury Secretary Geithner laid out the administration’s vision for TARP, answering the questions I posed yesterday.

As expected, Secretary Geithner is using his authority to extend the TARP program to October 3, 2010 (it otherwise would have expired at the end of this month). As I’ve suggested in earlier posts, I don’t see how he could have chosen otherwise. The administration is committed to programs that aren’t complete yet, and it needs to worry about unpleasant surprises. In the words of his letter to House Speaker Pelosi:

This extension is necessary to assist American families and stabilize financial markets because it will, among other things, enable us to continue to implement programs that address housing markets and the needs of small businesses, and to maintain the capacity to respond to unforeseen threats.

Second, Geithner announced that henceforth TARP will be used for only four programs: to mitigate home foreclosures, provide capital to small and community banks, additional efforts to facilitate small business lending, and, possibly, to expand the TALF program that supports securitization markets for loans to small businesses, commercial real estate, etc. Notably (and correctly) absent from this list are some of the ideas — funding for new infrastructure, assistance to state and local governments — that have been floated in recent days.

Geithner is right to draw a moat around TARP and to limit its use to specific activities, except in emergencies:

Beyond these limited new commitments, we will not use remaining EESA funds unless necessary to respond to an immediate and substantial threat to the economy stemming from financial instability.

Third, Geithner provided a new forecast of how much TARP money will eventually be used:

While we are extending the $700 billion program, we do not expect to deploy more than $550 billion.  We also expect up to $175 billion in repayments by the end of next year, and substantial additional repayments thereafter.  The combination of the reduced scale of TARP commitments and substantial repayments should allow us to commit significant resources to pay down the federal debt over time and slow its growth rate.

In short, the administration believes that at least $150 billion of TARP money will never be used. That’s great news. But now attention will turn to Congress to see whether it tries to use that $150 billion to “pay for” new initiatives. As I noted the other day, current budget rules would give Congress credit for 50 cents of savings for each dollar that’s removed from overall TARP authority. But such savings are an accounting fiction, not real, if the TARP authority never would have been used anyway.

Some Questions about TARP’s Future

As I discussed the other day, using TARP to pay for new jobs programs faces some serious practical issues. First, the administration is limited in how it can deploy existing TARP funds. It should be straightforward to use more funds to support lending to small businesses (which TARP already does to some extent), but it would take great legal ingenuity to use it to fund infrastructure projects or aid to state and local governments.  Indeed, in an article titled “Use of Cash from TARP Hits Hurdle“, the Wall Street Journal reports that top Democrats have concluded that TARP money can’t be used for either of those ideas.

Second, legislative use of TARP money are limited by budget scoring rules, which currently would attribute only 50 cents of budget savings to each dollar by which TARP’s authority might be reduced. And even then, careful budgeteers would realize that such savings are make-believe if, as seems likely, any such limits would apply only to TARP authority that was unlikely to be used anyway.

In short, the rhetoric about using TARP to finance various proposals seems to have gotten ahead of reality.

The President’s speech at the Brookings Institution today provided some additional insight into the Administration’s plans for TARP, but some important questions still remain.

Here are the President’s three forward-looking statements about TARP (he also made some comments about TARP’s origin and history, but that’s a topic for another day):

I’m asking my Treasury Secretary to continue mobilizing the remaining TARP funds to facilitate lending to small businesses. …

[W]ith a fiscal crisis to match our economic crisis, we also must be prudent about how we fund [initiatives to accelerate the pace of private hiring].  So to help support these efforts, we are going to wind down the Troubled Asset Relief Program — or TARP — the fund created to stabilize the financial system so banks would lend again. …

TARP is expected to cost the taxpayers at least $200 billion less than what was anticipated just this past summer.  And the assistance to banks, once thought to cost taxpayers untold billions, is on track to actually reap billions in profits for the taxpaying public.  So this gives us a chance to pay down the deficit faster than we thought possible and to shift funds that would have gone to help the banks on Wall Street to help create jobs on Main Street.

If I am reading that right, the President would like to (a) continue Treasury’s existing effort to support small business lending through TARP, (b) wind down the TARP program, and (c) shift funds to other purposes. That leaves me with some important questions, including:

  • Does the administration plan to expand TARP’s small business lending support or just execute the one that’s already been announced? (NB: The President also endorsed several other steps to help small businesses, including easier access to SBA loans.)
  • Does “wind down the TARP program” mean that Secretary Geithner won’t use his authority to extend the program beyond December 31, 2009? If I were him I would sleep much better at night if I had some “dry powder” in an extended TARP, just in case we have another September-October of 2008. Such a replay seems highly unlikely (knock on wood), but if that exceedingly remote event did happen, I wouldn’t want to be the Treasury Secretary who went up to Capitol Hill to ask for a TARP II.