Comment on Lucas & Phaup: The Cost of Risk to the Government and Its Implications for Federal Budgeting

Transcription

1 Comment on Lucas & Phaup: The Cost of Risk to the Government and Its Implications for Federal Budgeting Henning Bohn Department of Economics UC Santa Barbara

2 Summary: Excellent Paper. Roadmap to the Key Issues. Theory: How to think about risk. Benchmark: State-contingent claims pricing. Lessons: Risk has a cost. Options are valuable. Adapt to incomplete markets. Good survey. Lesson: Policy has potential to improve risk sharing. Applied: Budget Accounting Benchmark: Market values & opportunity cost. Lessons: Recognize cost when accrued. Distinguish economic cost/benefits from social welfare. Does risk matter? Yes, shown in applications. Concern: measuring systematic risks.

3 Broad Comments Two issues: #1 Pricing Risks Easy answers when market prices are available: Use them! No economic dispute. Perhaps political resistance. See the paper. Pricing risks when markets are incomplete: A list of special cases? Are there general answers? Two suggestions: 1. Distinguish micro and macro sources of inefficiency Moral hazard & adverse selection vs. intergenerational risk sharing. 2. Ask: Where is the government s comparative advantage? Micro level: Powers of the Internal Revenue Service. At the micro level, government production does matter. Macro level: Risk sharing with future generations

4 Broad Comments #2 Accounting Implications Are we missing the Elephants in the Room? Government debt: Safe for bond holders - Risky for future tax payers. Public employee and VA pensions (and health coverage) Social security & Medicare: No legal obligations, but economic cost. Accounting is about accountability. Two proposals: 1. Use G.A.A.P. whenever possible. Reject cash accounting. Should settle most micro issues. Special scrutiny if not. Example: Treasury s Financial Report of the U.S. Government 2. Pick ONE accounting system for intergenerational promises. Main choices: Unified budgeting or trust fund accounting. Abolish the other system. (Two sets of books = fraudulent.) Financial Reports use unified budget with footnotes. Concern: Lucas&Phaup too accepting of cash-accounting.

5 Thinking about incomplete markets In the paper: General categories. Here: Consider leading examples. Government holdings of risky securities 1. Example: Equity securities for railroad retirement Government credit 2. Example: Student Loans Government insurance 3. Example: Flood insurance

6 Accounting Issues [Examine which of them matter in each of the examples] 1. Opportunity cost vs. production cost. Lucas&Phaup: Use opportunity cost. 2. Timing: When are cost & benefits incurred? Tension: Accountability vs. Accuracy. Case for simplicity in a political setting: Sophisticated rules more accurate vs. manipulation. Cash accounting = extreme simplicity (too primitive) Benchmark: Balance sheets & income statements. Bohn (1992); Treasury s Financial Reports. 3. Systematic vs. diversifiable risks. Risk premium only if systematic. Estimation needed.

7 Example 1: Holding risky securities No micro issues: No Production. No asymmetric information. Market prices are observed. Key issues: Systematic risk. Optimal policy. What is the government s optimal portfolio? Optimal asset-liability management Optimal debt management Optimal funding of pension liabilities. Macro/accounting question: If intergenerational risk sharing is improved, should risk reduction be recognized ex ante as a cost reduction? [No] Case for using market prices: mark to market.

8 Example 2: Student Loans Microeconomic problems: Adverse selection & moral hazard. Market prices reflect private lenders cost. Key issue: Production Is the government better in collecting debt than private lenders? Perhaps yes, with IRS as collection agency. Then possible welfare-improvement. Accounting question: When is the government s comparative advantage recognized? Discourage loans if differential ability to collect is ignored. Case for using production cost, not opportunity cost as measured by private loan rates. Negative subsidy rates are not implausible.

9 Digression on Discounting: 1. Measurement: spreads vs. premiums A credit spread does NOT imply a risk premium. Specifics: distinguish Promised payment X* (say, student loan) Actual payment X, distributed [0,X*] Expected payment E[X]=(X*)*(1 default rate) Two ways to express present values: Spreads: V = X*/(1+r+spread) Risk premiums: V = E[X]/(1+r+premium) where r = safe interest rate. Typically spread>0. If risk is diversifiable, premium = 0, but spread>0 whenever the default rate is non-zero.

10 Digression on Discounting: 2. Systematic risk Value: V = E[u*X] with pricing kernel u where E[u]=1/(1+r) = safe discount factor Riskfree: V=E[u]*E[X] = E[X]/(1+r) Risky: V = E[X]/(1+r) + cov(u,x) Or Or V=E[X]/(1+r+premium) V=E*[X]/(1+r) with E* using risk-adjusted probabilities. Diversifiable risk: cov=0 => V = E[X]/(1+r) Applied question: What s the systematic risk? Is it important for student loans? Need evidence. Bigger issue: Discounting social security taxes/benefits.

11 Example 3: Flood Insurance Again microeconomic problems: Adverse selection No production issue (Assuming governments have no better information). Key issue: Subsidies How much? Redistribution => Incentives for political distortion [Also aggregate risks & optimal risk sharing, but secondary.] Ideal Accounting: When is a subsidy recognized? Case for accrual accounting: Recognizing subsidies when insurance is issued; using private insurance prices. Practical Accounting: Avoiding manipulation Avoiding hidden subsidies.

12 How can one ensure Accountability? Suggested Principles 1. Avoid special rules for the government. Rely mostly on corporate accounting principles. If special rules, then standardize (FASAB). 2. Distinguish reporting & analysis Inside reporting: Rules needed. GAAP. Outside analysis: Flexible interpretation. Analogy: Audited corporate accounts vs. analysis by investment banks

13 Quantitative Quibbles Table 1 shows New Loans only. Exposure = Outstanding Outstanding Balances in $Billion Outstanding Estimated Cost/ Program 2006 Future Cost Outstanding Direct Lending - Total % Federal Student Loans % Farm Service/Rural Development/Housing % Rural Utilities/Telephone % Other % Guaranteed Loans - Total % FHA Mortgage insurance fund % VA Mortgage % Federal Student Loans % Other % TOTAL %

14 Conclusions Excellent analysis good economics. Concerns: Calibration of systematic risk. Lack of accountability without systematic balance sheet framework. Need more general rules (GAAP). Need more analysis of macro risks.