Tuesday, May 27, 2008

Assessing the Social Costs of Credit

As we now all know, a glut of lending over the last few years has resulted in a serious economic hangover. Perhaps a trillion dollars or more of losses overhang the U.S. financial system. We are, for all practical purposes, in a recession. Inflation is ticking upwards, the dollar is dropping and the rising cost of energy is making all of the foregoing even worse. A variety of government actions have been or will be taken. The cost to taxpayers is already many billions, and with many additional billions surely to be paid.

We should recognize that the recent credit orgy imposed significant social costs. Social cost is an economist's notion for costs of economic activity that aren't incorporated into market prices. For example, the infamous smog of the 1950s and 1960s in Los Angeles and other cities caused serious health problems that were not reflected in the cost of gasoline. In order to account for these costs and make market prices more realistic, pollution control requirements were imposed. Much of the computerization of today's automobiles is directed at minimizing pollution, not enhancing gas mileage. The cost of these computers is borne by car buyers, as it should be since their driving creates the pollution. But we have much cleaner air today, a direct result of government action to incorporate the social costs of automobiles into market prices.

The reckless over-extension of credit during the last few years has produced numerous foreclosures, declining neighborhoods, ruined credit histories, bankruptcies, Wall Street bailouts, massive layoffs, recession and decline in the dollar. These are social costs that were not reflected in the market price of credit. Indeed, the Federal Reserve's easy money policies of the 2000s took exactly the wrong approach.

Increased federal regulation of banks, and also securities firms, is under way. Congress and the new President will be considering ways to improve the regulation of the financial markets. One measure that has not been proposed, but which deserves consideration, is to impose financial assessments on banks and securities firms based on the riskiness of the loans they make or underwrite. In other words, the more risky the lending activity undertaken, the larger an assessment the bank or securities firm should pay.

These assessments should be paid to the U.S. Treasury. They should not go into the FDIC insurance fund because the U.S. taxpayer, not the FDIC, is the primary insurer of financial firms today. These assessments would, in effect, compensate the taxpayer for assuming the risks that the Federal Reserve unilaterally decided, in the Bear Stearns bailout, that taxpayers would bear; and for bearing the other costs the have been or will be imposed on taxpayers as a result of the current financial crisis.

Determining the amounts of such assessments could be based on insurance principles. Not all of the costs of the credit crisis are known yet (at least not publicly). But once a fair picture of the total costs emerges, amounts can be determined.

Such assessments would surely raise the cost of credit. That, of course, is the idea. Over-extension of credit has proven to have numerous costs not reflected in the current or past market prices of credit. This market dysfunction should be corrected, or we can be confident that future crises will arise.

Such a program of assessments wouldn't interfere with the functioning of a free market. The market for credit is government controlled to begin with. The Federal Reserve, as the central bank, sets the baseline price of credit with its discount rate and its fed funds target rate. Virtually all other interest rates, one way or another, key off the Fed's prescribed rates. A program of risk-based assessments would enhance the efficiency of the pricing of credit, such that all (or at least more) of the costs of extending credit would be reflected in the price.

It's Econ 101 that underpricing results in overconsumption. That's our credit crisis in a nutshell. If the credit markets are to function more efficiently in the future, they should reflect the true cost of credit.

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