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The radical proposition of Arrow and Lind (1970) – that governments should use risk-free rates instead of market rates to discount their risky investments – can best be understood by first considering the work in its historical context.... more
The radical proposition of Arrow and Lind (1970) – that governments should use risk-free rates instead of market rates to discount their risky investments – can best be understood by first considering the work in its historical context. During the late 1960s and early 1970s, a debate was raging between the leading economists of the time about the cost of risk to the government, and related, the identification of the social discount rate. Recent advances in general equilibrium theory (notably, Arrow & Debreu, 1954; Debreu, 1959) allowed for more general welfare analyses of policy than had been undertaken previously; underscored the benefits of risk-sharing as well as the aggregate limits on risk-sharing; and clarified the role of market prices in aggregating the risk preferences of society. Such analyses also highlighted the potentially salutary role for governments in improving risksharing when markets are incomplete. On one side of the debate were authors who took the position that governments should rely on market prices in evaluating the cost of investments. Diamond (1967) analyzed an economy with technology risk and a stock market. Perhaps not surprisingly, he concluded that if markets are sufficiently complete for stock prices to reflect the social cost of risk, then those prices are also relevant to the government in evaluating its investment policy. Hirshleifer (1964, 1966) reached similar conclusions and argued forcefully for the use of market prices by governments. Other leading economists of the time advocated the position that was subsequently formalized in Arrow and Lind. Samuelson and Vickrey (in Jorgenson et al., 1964) argued that because of the large and diversified portfolio held by the government, the marginal return from public investment overall is virtually risk-free, and hence should be evaluated at the risk-free rate rather than the higher market rate demanded by less diversified investors. (The government’s own borrowing rate is usually taken as a proxy for the risk-free rate.) The specialness of the assumptions required to formalize the idea that the cost of market risk is irrelevant to the government – in particular, that there is no aggregate uncertainty affecting the value of government investments – was acknowledged by Arrow and Lind: ‘The results...depend on returns from a given public investment being independent of other components of national income’ (p. 373). Arrow and Lind defended that assumption with the assertion that correlated risk is likely to be insignificant for many government investments.
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Defined benefit (DB) pension plans cover about 44 million U.S. workers and retirees, and represent a significant liability for many corporations. 1 The total number of participants in defined benefit plans has increased modestly in the... more
Defined benefit (DB) pension plans cover about 44 million U.S. workers and retirees, and represent a significant liability for many corporations. 1 The total number of participants in defined benefit plans has increased modestly in the last decade, although the number of singleand
The federal government explicitly guarantees a portion of deposit obli-gations of commercial banks and thrifts through deposit insurance, and is thought to provide protection beyond this legal obligation for institu-tions considered “too... more
The federal government explicitly guarantees a portion of deposit obli-gations of commercial banks and thrifts through deposit insurance, and is thought to provide protection beyond this legal obligation for institu-tions considered “too big to fail. ” Although not explicitly guaranteed until
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The federal government makes subsidized federal financing for higher education widely available. The extent of the subsidy varies over time with interest rate and credit market conditions. A loan provision that adds considerably to the... more
The federal government makes subsidized federal financing for higher education widely available. The extent of the subsidy varies over time with interest rate and credit market conditions. A loan provision that adds considerably to the size and volatility of the subsidy is the consolidation option, which allows students to convert floating-rate federal loans to a fixed rate equal to the average floating rate on their outstanding loans. We develop a model to estimate the option’s cost and to evaluate its sensitivity to changes in program rules, economic conditions, and borrower behavior. We
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Technical papers in this series are preliminary and are circulated to stimulate discussion and critical comment. These papers are not subject to CBO's formal review and editing processes. The analysis and conclusions expressed in... more
Technical papers in this series are preliminary and are circulated to stimulate discussion and critical comment. These papers are not subject to CBO's formal review and editing processes. The analysis and conclusions expressed in them are those of the authors and should not be interpreted as those of the Congressional Budget Office. References in publications should be cleared with the authors. Papers in this series can be obtained at www.cbo.gov/tech.cfm.
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thank two anonymous referees whose comments greatly improved the paper. A detailed technical appendix is available at
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We analyze a stylized large-scale mortgage refinancing program that would relax current income and loan-to-value restrictions for borrowers who wish to refinance and whose mortgages are currently insured by Fannie Mae, Freddie Mac, or the... more
We analyze a stylized large-scale mortgage refinancing program that would relax current income and loan-to-value restrictions for borrowers who wish to refinance and whose mortgages are currently insured by Fannie Mae, Freddie Mac, or the Federal Housing Administration. The analysis relies on an estimate of the volume of incremental refinancing that would occur and an estimate of how future default and prepayment behavior would be affected by such refinancing. Relative to the status quo, the specific program analyzed here is estimated to cause an additional 2.9 million mortgages to be refinanced, resulting in 111,000 fewer defaults on those loans and estimated savings for the GSEs and FHA of $3.9 billion on their credit guarantee exposure, measured on a fair-value basis. Offsetting those savings, federal investors in MBSs, including the Federal Reserve, the GSEs, and the Treasury, would experience an estimated fair-value loss of $4.5 billion. Therefore, on a fair-value basis, the sp...
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This review develops a theoretical framework that highlights the principles governing economically meaningful estimates of the cost of bailouts. Drawing selectively on existing cost estimates and augmenting them with new calculations... more
This review develops a theoretical framework that highlights the principles governing economically meaningful estimates of the cost of bailouts. Drawing selectively on existing cost estimates and augmenting them with new calculations consistent with this framework, I conclude that the total direct cost of the 2008 crisis-related bailouts in the United States was on the order of $500 billion, or 3.5% of GDP in 2009. The largest direct beneficiaries of the bailouts were the unsecured creditors of financial institutions. The estimated cost stands in sharp contrast to popular accounts that claim there was no cost because the money was repaid, and with claims of costs in the trillions of dollars. The cost is large enough to suggest the importance of revisiting whether there might have been less expensive ways to intervene to stabilize markets. At the same time, it is small enough to call into question whether the benefits of ending bailouts permanently exceed the regulatory burden of pol...
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Governments play a central role in the allocation of capital and risk in the economy. Evaluating the cost to taxpayers of government investments requires an assumption about the government's cost of capital. Governments often take... more
Governments play a central role in the allocation of capital and risk in the economy. Evaluating the cost to taxpayers of government investments requires an assumption about the government's cost of capital. Governments often take their borrowing rate to be their cost of capital, which implicitly treats the market risk associated with their activities as having no cost to taxpayers. This article reviews the theoretical and practical rationale for treating market risk as a cost to governments, presents an interpretive review of the growing literature that applies the concepts and tools of modern finance to evaluating the costs of government policies and projects, and suggests directions for future research. Examples considered include deposit insurance, Fannie Mae and Freddie Mac, the Federal Reserve's emergency lending facilities, student loans, real infrastructure investments, and public pension plans.
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We examine a decision theoretic model of portfolio choice in which investors face income risk that is not directly insurable. We consider the sensitivity of savings and portfolio allocation rules to different assumptions about utility,... more
We examine a decision theoretic model of portfolio choice in which investors face income risk that is not directly insurable. We consider the sensitivity of savings and portfolio allocation rules to different assumptions about utility, the stochastic process for income and asset returns, and market frictions (transactions costs and short-sale constraints). Under CRRA time additive utility, habit persistence utility, and for a broad range of parameterizations, the model predicts that investors wish to borrow and invest all of their savings in stocks. This qualitative implication is robust to the introduction of significant transaction costs in the stock market, and contrasts sharply with portfolio allocation models in which there is no labor income.
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Capital Structure, Hurdle Rates, and Portfolio Choice Interactions in an Entrepreneurial Firm Professor John Heaton Booth School, University of Chicago Deborah Lucas Sloan School of Management, MIT Household Finance and Macroeconomics... more
Capital Structure, Hurdle Rates, and Portfolio Choice Interactions in an Entrepreneurial Firm Professor John Heaton Booth School, University of Chicago Deborah Lucas Sloan School of Management, MIT Household Finance and Macroeconomics Autumn 2009 1 / 32 Page 2. ...