Over the past 10 years I have participated in the debate regarding the amount of capital needed to insure the solvency of large financial institutions. This debate about “capital adequacy” concerns the amount of capital needed by institutions that invest in mortgages to survive severe downturns in house prices. My own conclusion is that the system in place at the start of the financial crisis allowed institutions to hold far too little capital to protect against the sharp drop in housing prices that has occurred in recent years. As a result, Freddie Mac, Fannie Mae and other institutions were overwhelmed by mortgage losses in much the same way that New Orleans, my home town, was inundated by floods in 2005 when its levee system proved unprepared to withstand the aftermath of Hurricane Katrina.

I have been struck recently by two major similarities in the capital adequacy debate and the debate about raising the federal debt ceiling. One relates to how we make policies that are reasonable over the long run when faced with much uncertainty. The second involves the reliance upon simplistic paradigms to buttress arguments on both sides of the debate. Since the debate over the debt ceiling and, more generally, the burden of the federal debt are far from over, consideration of some lessons from the capital adequacy debate may be instructive.

The first major similarity between the two debates is the inherent complexity of the problems being considered and the numerous assumptions underlying any proposed solution. In the capital adequacy debate, attention often focused on what would be a worst-case — or “stress” — scenario for house prices. A recent paper I co-authored with Seth Giertz highlights a variety of scenarios for Fannie and Freddie in the early 1990s and various assumptions and methods used to define a stress scenario. While we offer our best opinions on these scenarios, we readily acknowledge the role of subjective judgments in determining how to justify a particular choice.

A similar problem applies to the debate about the debt ceiling. Consider the Congressional Budget Office’s June 21, 2011 report as an example (Figure 1.1 from the report is replicated below). CBO presents 10-year forecasts of future federal tax revenues and expenditures for two different scenarios. One, the Extended-Baseline Scenario, assumes that federal tax rates currently in place will, as the current law is written, increase in 2013. The other, the Alternative Fiscal Scenario, assumes that existing tax rates will be extended beyond 2012 just as they were last year. This latter scenario, plus other assumptions based on how Congress will act in the next few years, leads to a much higher estimate of the debt as a percentage of gross domestic product in 10 years. (The gap between the line for total primary spending and revenues shows how much the nation’s accumulated debt would grow each year.)

CBO’s 2011 Long-Term Budget Outlook
Figure 1.1

Primary Spending and Revenues, by Category, Under CBO’s Long-Term Budget Scenarios
(Percentage of gross domestic product)

Arguments can be made in support of either scenario, and no one can say definitively what will happen at the end of 2012 and after the 2012 elections. What we can say is that the forecasts for 2012-2021 are highly sensitive to these and other assumptions about the future, such as the costs of wars and inflation in health care services. Reasonable and well-informed people would readily acknowledge the complexity surrounding long-term forecasts of this type and their sensitivity to assumptions that cannot be confirmed with certainty.

This does not mean that we can use the words of Sgt. Schultz from the old TV show “Hogan’s Heroes”: “We know nothing!” In particular, there is much wider agreement today than at the beginning of the most recent debate that the “budget outlook, for both the coming decade and beyond, is daunting,” as CBO acknowledges at the beginning of its June 21 report. Nonetheless, long-term forecasts of this nature are predicated upon meaningful assumptions that even the experts will debate.

A second major similarity between the two debates is the frequent use and reliance upon simplified paradigms or analogies to capture what are inherently very complex problems marked by a web of uncertainty, where such simplification is hard to justify. For example, failing to increase the debt limit was described by some as financial or political “suicide” and people on both sides of the debate were described as playing a “game of chicken.” Seventy-seven percent of Americans in a recent survey labeled the combatants in the debate “spoiled children.”

The capital adequacy debate featured its own simplistic paradigms, often used by those resisting the adoption of more realistic stress tests.[1] One of these included the claim that prospective home buyers based decisions primarily on rational expectations about future house price growth. The possibility of “irrational exuberance,” an idea championed by Robert Shiller and his colleagues, was often dismissed. Another had to do with the ability of statistical models largely based upon the performance of prime mortgages to predict the credit risk of subprime and other exotic mortgages created during the house price boom of the early and mid-2000s. These and other simplistic paradigms hindered the ability of many very community-minded people, as well as many self-serving folks, to see the potential of the serious house price bust that emerged.

One of my favorite simplified paradigms often used in the debt ceiling debate was the frequent reference to views “widely held by economists,” based upon the notion that trained experts will have well-informed and similar positions. If the experts agree, then allegiance to the paradigm says widely held views must be true or at least likely. In my experience as a card-carrying Ph.D. economist with over 35 years in academia, government and business, my “opinion” is that the opinions of economists are widely diffuse. While most would acknowledge that a “daunting” fiscal crisis is on the horizon, opinions are quite varied regarding the impact of extending or not extending the debt ceiling and, most importantly, specific tactics to combat the federal fiscal crisis that our country faces.

This point can be highlighted using another simplified paradigm. About 40 years ago, President Richard Nixon made this statement: “We are all Keynesians now.” He was referring to the paradigm built upon some ideas of economist John Maynard Keynes in his famous book The General Theory of Employment, Interest and Money and the policies adopted during the Kennedy-Johnson administration in the early 1960s, which called for an active fiscal and monetary policy during a recession. My own sense now is that economists do not all believe or profess the Keynesian paradigm as many did then. Instead, they seem to fall within a couple of major camps. The Keynesian camp, perhaps best championed by Federal Reserve Chairman Ben Bernanke, sees a strong analogy between the current Great Recession and the Great Depression, about which Mr. Bernanke is a recognized and widely published scholar. This view leads him to champion various monetary and fiscal stimulus policies built upon this paradigm, such as quantitative easing and keeping the short-term interest rate near zero. Many other economists fall into a second camp and view our current problems as more distinct to the current environment. These problems include structural changes in the economy brought about by information technology, the increasing complexity and interconnectedness of the international economy and financial markets, and the consequences of excess borrowing or leverage during much of the 2000s. This camp believes that traditional Keynesian fiscal and monetary policies may be of more limited value in today’s economy than in the past. More fundamentally, this camp suggests that we are wise to perceive the heightened uncertainty surrounding our current economic environment and its long-run future as worthy of new remedies.

I put myself in the second camp. I emphasize in my research that house prices have declined by dramatic amounts in the past five years in many parts of the country and wiped out massive amounts of wealth among home owners and lenders. For those areas particularly hard hit by the crisis, which I call “emerging declining cities,” these may well be justifiable declines; full recovery will take many years since house price levels at their peak reflected wildly exaggerated expectations of future growth. Treating the declines as largely driven by shortages of liquidity and readily offset by stimulus spending and other government programs — policies championed by the Keynesians — is an erroneous and outdated prescription that may do more harm than good. The issue is whether advocates of the Keynesian model, including advisors to President Obama, are too locked into an old paradigm to notice that the world has changed in dramatic ways since the Great Depression and that the old remedies no longer apply.

These two similarities in the debates over the debt ceiling and capital adequacy suggest ways that the discussion about the debt limit and the policies adopted to reduce the deficit might be improved.

First, let’s do more research to help reduce the uncertainty regarding the fiscal situation we face and the new, modern and more complex economy in which we live. This step will involve de-emphasizing a number of metrics underlying macroeconomics built around national totals, such as national income, GDP and the aggregate unemployment rate. Instead, we are wise to take a more geographically granular view of our economy that measures regional, state and local economic activity and adapts policies specific to these areas. Focusing upon the national aggregate or the national average masks the extraordinary variation among markets in this country and, indeed, can even make it harder to identify seriously stressful events until it’s too late. This is difficult to do, but c’est la vie.

Second, and at least as difficult to implement, we need to challenge those who base their policy prescriptions on overly simplistic paradigms and do more “stress testing” of the plans being put forward using multiple potential scenarios. This approach is at the heart of the debate about capital adequacy for financial institutions, but it is virtually absent from the debate about the debt ceiling. CBO, for example, is just beginning to incorporate a wide variety of future economic scenarios into its calculations for Social Security. I encourage CBO and its ultimate boss, Congress, to build upon this approach for its federal debt analysis instead of focusing on the “expected” paths. For example, what would the CBO forecast be if real annual economic growth remained around 1 percent over the rest of the decade instead of its assumption of about 2.8 percent? This would clearly show an even more daunting fiscal problem, but there is surely no guarantee from CBO or anyone else that a 2.8 percent rate of growth, though reasonable based upon US history, will come to pass. Would it not be helpful to acknowledge such risks rather than to take no precautions for such an outcome?

Third, let’s include more “contingent” budgeting, incorporating explicit connections between future spending and how the economy evolves. One of my favorite examples of this point is a 1999 agreement between the State of California and one of its major pension plans for state employees.[2] An assumption underlying the agreement was that “the Dow Jones Industrial Average would reach 25,000 in 2009 …” The Dow is currently about half of that. The type of contingency budgeting I have in mind would call for adjustments to the pension plan in light of such an erroneous assumption underlying the agreement.

Let me end on an upbeat note that highlights a major difference in the two debates. The debt ceiling debate drew much more attention than the capital adequacy debate did. In the short run, this may lead to heightened uncertainty and reduced confidence in the political system to bring about a speedy and comprehensive solution. But political leaders could use this as an opportunity to help people better understand the stakes and to themselves be open to what good empirical research has to say about the best ways out of the conundrum in which we find ourselves. The broad options include a healthy mix of revenue increases and expenditure cuts, expenditure cuts only, or hoping for strong economic growth to make the problem go away. Choosing among these is an inherently difficult decision that will reflect a variety of potentially valid and subjective judgments. However, the quality of those judgments will be enhanced by getting more people paying attention to the debate, accepting the complexity of the situation, critically examining simplistic paradigms, considering more contingent budgeting, and being open to a wide variety of well-informed perspectives about our new and modern economy.