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Expansions in pass-through business activity have lowered the labor share of income  

The labor share of income in the U.S. corporate sector has been steadily declining in recent decades. Using administrative tax data, Matthew Smith of the U.S. Treasury and co-authors estimate that about a third of this decline has been driven by the rise in pass-through business activity over the 1978-2017 period. Pass-through businesses have tax incentives to classify owners’ labor income as profits or to form partnerships (for financial, legal, and consulting services, etc.) that move labor-intensive activities away from the corporate sector. The authors estimate that had the shift towards pass-through businesses since the 1980s not occurred, the labor share of income in the corporate sector would have been 1.6 percentage points larger in 2017. The authors’ adjustments are concentrated among mid-market firms in services, suggesting that the remaining decline in the labor share is driven by the manufacturing sector and by the rising importance of superstar firms, they conclude.  

Highly concentrated Bitcoin market susceptible to systemic risk  

By combining data from blockchain—the technology used to record transactions of Bitcoin and other cryptocurrencies—with information scraped from blogs and websites, Igor Makarov of the London School of Economics and Antoinette Schoar of MIT construct a dataset of real entities holding Bitcoin and use algorithms to analyze the behavior of Bitcoin market participants. They find that 90% of transactions are not related to substantial economic activity, and 75% of the transactions since 2015 involve buying and selling Bitcoin. In addition, the Bitcoin market is highly concentrated, with the top 10% of bitcoin miners controlling 90% of Bitcoin mining capacity and the top 50 miners (0.1%) controlling close to 50%. In addition, between 60% and 80% of mining capacity is in China. Finally, the top 1,000 investors own about one-fifth of all bitcoins, while the top 10,000 investors own about one-third. Overall, almost half of all bitcoins are owned by individual investors rather than banks and other intermediaries. Such a highly concentrated market, the authors conclude, makes the Bitcoin ecosystem susceptible to systemic risk and wider acceptance of Bitcoin will likely only benefit a small group of people.  

Labor force exits during the pandemic were larger for Black women, Latinas, and women living with children  

Examining differences in the labor force participation of women aged 25 to 54 in the U.S. during the COVID-19 pandemic, Katherine Lim and Mike Zabek from the Federal Reserve Board find that labor force participation of Black and Latina women declined by over 4 percentage points during the first few months of the pandemic. In the fall and winter of 2020, Black women’s labor force participation increased but participation among Latina women remained persistently lower. In addition, the authors show that women with young children were more likely to exit the labor force than women without children, reflecting the unique demands of raising children during the pandemic. Among women with primary-school-age children in the household, excess pandemic-era labor force exits were concentrated among lower-earning women. Moreover, the authors find that the presence of children explains roughly one-fourth of the labor force exits in excess of the pre-pandemic trend for Black and Latina women. The authors conclude that “the coincident increase in labor force exits among women living with children suggests that regular, reliable, and available childcare plays an important role in supporting women’s labor force participation”.

Chart of the week: Bond market investors expect elevated inflation rates to persist 

Quote of the week:  

“The fundamental dilemma that we face at the Fed right now is this: Demand, augmented by unprecedented fiscal stimulus, has been outstripping a temporarily disrupted supply, leading to high inflation. But the fundamental productive capacity of our economy as it existed just before COVID—and, thus, the ability to satisfy that demand without inflation—remains largely as it was, and the factors that are disrupting it appear to be transitory. Looked at purely in that light, constraining demand now, to bring it into line with a transiently interrupted supply, would be premature. Given the lags with which monetary policy acts, we could easily find that demand is damping just as supply is increasing, leading us to undershoot our inflation target—and, in the worst case, we could depress the incentives for supply to return, leading to an extended period of sluggish activity and unnecessarily low employment,” says Randal Quarles, Member, Federal Reserve Board of Governors. 

“I am among those who see a good chance that inflation will remain above 2% next year, but I am not quite ready to conclude that this ‘transitory’ period is already ‘too long.’ We haven’t yet met the more stringent tests for liftoff that we have laid out in forward guidance about the federal funds rate … Importantly, the level of uncertainty around the paths for inflation and employment are higher than normal as we navigate the unprecedented reopening of the world economy. Therefore, we will remain outcome based, waiting to see further improvements in employment and the evolution of inflation pressures in coming months. And, if the broadly held expectation that inflation will recede next year turns out to be wrong or if inflation expectations show signs of becoming unanchored to the upside, I am confident that the monetary policy tools at our disposal can bring inflation down toward our 2% goal.” 

The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation. 

      

What’s the latest thinking in fiscal and monetary policy? The Hutchins Roundup keeps you informed of the latest research, charts, and speeches. Want to receive the Hutchins Roundup as an email? Sign up here to get it in your inbox every Thursday.

Much of the wealth held by the richest households is accrued from business ownership

Using administrative tax data over the 2001-2016 period, Matthew Smith of the U.S. Treasury, Eric Zwick of the University of Chicago, and Owen Zidar of Princeton estimate that the top 1% of households hold as much wealth as the bottom 90%. The share of wealth held by the top 0.1% increased from 12.9% in 2001 to 15% in 2016. Households in the top 0.1% hold over half of their wealth in public equity and pass-through businesses, the authors find. In contrast, pensions and home equity make up the majority of wealth accrued by the bottom 90%. The wealthiest households also have greater risk exposure and earn higher than average rates of return on their investments, the authors estimate. Taking this heterogeneity in returns into account results in lower estimates for the share of wealth held by the top 0.1%. “Given prominent wealth tax proposals focus on the extreme tail of the wealth distribution, our estimates would reduce mechanical wealth tax revenue estimates,” the authors conclude.

Simplicity of post-FOMC press conference language gives investors additional insight

In 2011, the Federal Reserve chair began holding press conferences after Federal Open Market Committee (FOMC) meetings. Michiel De Pooter of the Federal Reserve Board finds that press conferences generate financial market reactions, suggesting that they give investors information beyond that in the post-meeting statement and Summary of Economic Projections. On average, interest rates fluctuate between 1 and 3 basis points, the S&P 500 Index changes by ½ percent, and the dollar moves around 1/4 percent during the period beginning 10 minutes before and ending 20 minutes after the press conference. The authors find that the language of the press conference is more easily understood than the FOMC statement, and also find that Chair Jay Powell’s language in answering questions has been notably less complex than that of his two predecessors. While Powell’s answers are at an eighth-grade level, Ben Bernanke and Janet Yellen’s were at the college level, according to a commonly used readability standard.

Declining interest rates disproportionately benefit “superstar” firms

Using firm-level data from 1962-2019, Thomas Kroen, Ernest Liu, and Atif Mian from Princeton and Amir Sufi from the University of Chicago find that falling interest rates disproportionately benefit “superstar” firms—those with valuations in the top 5 percent for their industry. In particular, a decline in interest rates disproportionately lowers the cost of borrowing for superstar firms, perhaps because conditions that lead to ultra-low rates tend to make other firms relatively riskier. In turn, superstar firms raise additional debt financing, repurchase shares, boost capital investment, and conduct acquisitions more aggressively than other firms. All these effects increase as the level of the interest rate approaches zero. These results suggest that the low interest rates observed in recent years may partly explain the rise of superstar firms and increase in market concentration in the U.S.

Chart of the week: Consumer price of natural gas rising quickly as winter approaches

Source: The Wall Street Journal

Quote of the week:

“I continue to believe currently elevated inflation is episodic, driven by pandemic conditions such as disruptions in supply chains and labor markets. A major caveat, though, is that the severe and pervasive supply chain issues will probably last longer than most of us initially expected. Up to now, indicators do not suggest that long-run inflation expectations are dangerously untethered. But the episodic pressures could grind on long enough to unanchor expectations,” says Rafael Bostic, President of the Atlanta Federal Reserve Bank.

“In my view, then, the fate… of price stability could be on the line in coming months. I think inflation is likely to remain above 2 percent going forward. How far forward I cannot say. But upside risks are salient. I believe the conditions I’ve described argue for a removal of the Committee’s emergency monetary policy stance, starting with the reduction of monthly asset purchases, as we discussed in last month’s meeting.”

The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation.

      

Fiscal policy, including both automatic stabilizers and pandemic-related tax and spending legislation, played a significant role in cushioning the blows to the economy of COVID-19 in 2020 and 2021. The Hutchins Center Fiscal Impact Measure (FIM)—which measures how much federal, state, and local tax and spending policy adds to or subtracts from overall economic growth—shows that fiscal policy has boosted economic growth on average since the start of the pandemic, but will restrain growth going forward as the effects of the stimulus wane.

The FIM measures the direct impact of fiscal policy on the growth rate of GDP, but not on the level. In this post, we illustrate how fiscal policy has impacted the level of GDP over the course of the pandemic.  While waning spending from pandemic-related fiscal policy is currently reducing the growth rate of GDP, as seen in a negative reading of the FIM, fiscal policy is still boosting the level of GDP. In other words, total output has been, and will be for some time, higher than it would have been without fiscal policy.

How has pandemic-era fiscal policy affected the level of GDP?

In the chart below, we show actual and projected GDP versus what GDP might have been had fiscal policy failed to respond to the pandemic’s shock to the economy. The top (orange) line represents actual GDP—using the latest Congressional Budget Office projections of GDP from the third quarter of 2021 on. The bottom (blue) line is a counterfactual that provides our estimate of the path GDP would have taken if not for the substantial fiscal stimulus. For this counterfactual, we assume that government purchases, taxes, and transfers all would have increased at the rate of potential GDP from the first quarter of 2020 on; in reality, purchases and transfers far exceeded this counterfactual fiscal policy. Our projections of future fiscal policy make the same assumptions about spending responses to fiscal policy as those underlying the FIM. Unlike the FIM, which includes only direct effects of fiscal policy, this analysis also includes multipliers.^[1]

The distance between the two lines represents the effect of fiscal policy changes on economic activity. The chart shows, for example, the huge fiscal response in the spring of 2020 (which we estimate increased the level of real GDP by $607 billion in the second quarter of 2020, and about $900 billion in both the third and fourth quarters), and the big increase in the first quarter of 2021 representing the effects of legislation enacted in December 2020 and January 2021. As the money flowing from pandemic legislation slows and the economy recovers, reducing the automatic stabilizers, the boost to GDP from fiscal policy lessens. Assuming no additional legislation, we estimate that the real GDP will converge to its counterfactual level by early 2023. Of course, if Congress enacts new legislation—like the infrastructure or Build Back Better bills—that will boost actual GDP and the estimated effect of fiscal policy.

As noted above, the FIM estimates fiscal policy’s contribution to GDP growth rather than its level. Thus, when the effect of fiscal policy on the level of GDP gets smaller over time—as it does from the second quarter of 2021 on—fiscal policy is lowering GDP growth, and the FIM is negative.

How do the different components of fiscal policy affect the level of GDP?

The chart below decomposes the boost to GDP from fiscal policy (the distance between the two lines in the first chart) into its components.^[2] These represent the effects on GDP from the changes in policy, which depend on how much and how quickly households, businesses, and state and local governments change their spending in response to changes in fiscal policy over time (the marginal propensities to consume). We assume different spending responses for different types of policy. For example, we assume that Paycheck Protection Program (PPP) loans (in the subsidies category) have a much smaller and slower effect on private spending per dollar of government expenditure than do unemployment insurance benefits.

While the expansion of unemployment insurance and the three rounds of rebate checks have provided a considerable boost to GDP since the start of the pandemic, we expect their impact to diminish going forward as consumer spending from rebate checks and the now-expired expanded unemployment benefits wane. Other social benefits, which include programs like SNAP and the Child Tax Credit, are projected to follow a similar pattern.

Subsidies to businesses (a category that includes the PPP loans) increased more slowly but provide a steady stream of spending going forward. Although federal purchases and grants to state and local governments rose in response to the pandemic, state and local spending has been very weak, causing total purchases to be a drag on the level of GDP. We project that real government purchases will be roughly neutral, on average, during the projection period. Although we expect state and local governments to increase their spending out of the grants provided in the American Rescue Plan, federal purchases are projected to decline. Health outlays for Medicaid and Medicare have grown just a bit faster than potential while taxes have grown more slowly (boosting GDP a bit), although we project that both will rise steadily into 2023.

How do the components of fiscal policy impact GDP growth as measured by the FIM?

The counterfactual levels of fiscal policy used in the charts above assume taxes, purchases, and transfers grow at the rate of potential GDP from the beginning of 2020 onward. They show what would have happened to GDP had fiscal policy not expanded at all in response to the COVID-19 recession. The FIM, on the other hand, compares actual GDP in a quarter to a counterfactual in which the taxes, transfers, and spending from each previous quarter had grown with potential. And, as noted above, the FIM only measures the direct effects of fiscal policy and includes no multipliers. Still, the patterns in the FIM and those depicted above are very similar.

The chart below shows the headline FIM, broken down into the different components of fiscal policy. The largest boost to GDP growth in the early stages of the pandemic came from the large increases in spending on unemployment insurance and rebate checks. As the impetus from these programs lessens over time, these categories of spending become a negative for GDP growth.

^{[1] The concept of fiscal multipliers is explained in this related analysis: https://www.brookings.edu/blog/up-front/2021/01/28/the-macroeconomic-implications-of-bidens-1-9-trillion-fiscal-package/. We use the same multipliers as in that analysis.}

^{[2] Purchases are federal, state, and local government spending on goods and services, including employee compensation. Subsidies are payments by the government to private businesses and state-owned enterprises (like airports).}

      

The Hutchins Center on Fiscal & Monetary Policy at Brookings will host a discussion of these issues by Richard Clarida, vice chair of the Federal Reserve Board; Philip Lane, member of the ECB’s Executive Board; and Ben Bernanke, distinguished senior fellow at the Hutchins Center and former chair of the Federal Reserve. Following that discussion will be a panel of Fed watchers—Julia Coronado of Macro Policy Perspectives; William Dudley, former president of the Federal Reserve Bank of New York; and Tiffany Wilding of PIMCO.

During the live event, the audience may submit questions at sli.do using the code #FedFramework, or join the conversation on Twitter using the hashtag #FedFramework.

      

Implementing robust macroprudential policy—addressing threats to financial stability beyond those that were the focus of safety and soundness on an institution-by-institution basis or of investor protection market-by-market—was a constructive outcome of the legislative and policy response to the global financial crisis of 2008-09.

In the U.S., the Dodd-Frank Act of 2010 strengthened the hand of the Federal Reserve as it addressed the systemic risks in banks and bank holding companies, including those emanating from institutions that were “too big” or “too systemic” to fail. It also created two new institutions to look across the fragmented regulatory landscape to drive macroprudential policy addressing risks outside of banks: the Financial Stability Oversight Council (FSOC), which is chaired by the secretary of the Treasury and includes the heads of federal regulatory bodies, is charged with identifying and responding to risks to the financial stability of the United States, and the Office of Financial Research (OFR), which was created to support the work of FSOC through research and data gathering. FSOC’s powers are limited—it can designate systemically important institutions, and it can make recommendations to constituent regulators—but even those authorities have been infrequently used. The structures set up by Dodd-Frank have not led to consistent and effective macroprudential policies in the U.S.

The Biden administration, under the leadership of Janet Yellen at Treasury, intends to drive more active macropru policies, but at this still early stage of the administration, results are not yet evident. It is urgent they get on with the job. First, the “dash for cash” of March 2020 as the pandemic shutdown set in revealed a number of weaknesses in market-driven financial intermediation that required unprecedented and massive central bank intervention to prevent a total breakdown of the financial system that would have made an already dire economic situation much worse. We had hints of those weaknesses before the pandemic, but they became considerably more visible under stress. Moreover, the actions of the Federal Reserve and other central banks to counter their effects raise the possibility that private risk taking will be distorted by the expectation of future interventions in stress situations. The authorities need to move while memories are fresh and political support for corrective steps is at its highest.

The second reason for urgency is the current economic and financial situation. If the economic and financial situation evolves as seems to be expected in financial markets, credit will flow, and financial markets will continue to serve the needs of the economy. But the current situation is replete with fat tails—unusually large risks of the unexpected which, if they come to pass, could result in the financial system amplifying shocks, putting the economy at risk. At a recent FOMC meeting, the Board of Governors staff characterized financial vulnerabilities as “notable,” reflecting some asset valuations, leverage in corners of the financial system, and persistent structural issues.^[1] Moreover, these vulnerabilities have arisen in the context of truly unprecedented circumstances, making it difficult, if not impossible, for policymakers or market participants to predict the future with confidence. There’s the virus, of course, and the public and private response to its evolution. In addition, fiscal policies are raising Federal debt-to-income to record peacetime levels and a new monetary policy framework has yet to play out in practice. Meanwhile, inflation has spiked to the highest levels in many years. Yet market participants appear to have priced in very low interest rates for a very long time even as the economy recovers and, judging from risk spreads and equity prices, are quite confident that higher debt levels can be serviced and sustained—even though a disproportionate increase in private debt has been among lower-rated business borrowers.^[2]

Well-functioning U.S. financial markets are essential for well-functioning global finance. We saw all too clearly in 2008 how disruptions in U.S. markets can trigger a global financial meltdown and recession. Building resilience in the U.S. to risks that could readily materialize is essential to building confidence in a sustained global recovery from the pandemic. New legislation would be helpful in a number of dimensions—especially in reworking how FSOC and OFR function and making sure they are supported by a more prominent financial stability focus and analytical capability in constituent agencies. But U.S. agencies already have the tools to address many of the vulnerabilities that have lingered since the GFC and became so evident in March of 2020, and some new ones that have emerged more recently.^[3]

Here’s a checklist of actions that do not require legislation. Notably, it is not a menu from which to pick a few “dishes” to make a macropru meal—all of these things should be addressed, and promptly.

Banking

The resilience of the banking sector was greatly strengthened after the Global Financial Crisis (GFC) by tightened and reformed capital requirements, stress tests of capital adequacy, liquidity requirements, and greater scrutiny of bank risk-management practices, with extra requirements in each area for systemically important banks whose failure would have significant knock-on effects. But more can be done to build resilience in banks and in securities markets where banks intersect with nonbank finance.

A very serious amplifier of stress in the March 2020 dash for cash was the counterintuitive and counterproductive behavior of Treasury securities prices, which fell, rather than rose, in the midst of a flight to liquidity and safety. Dysfunction in the Treasury market spills over in many ways to the broader financial markets and the economy since Treasuries are relied on for liquidity by market participants, for risk management, and as a pricing reference point. There were a number of contributors to this behavior, but one was the reluctance of private dealers, the largest of which are subsidiaries of systemically important bank holding companies, to flex their balance sheets to pick up the Treasury securities being offered in the market. The dealers were especially constrained by the risk-insensitive leverage ratio applied to systemically important bank holding companies, until the Federal Reserve temporarily exempted deposits at the Fed and Treasuries from its calculation. That exemption has lapsed, and with continuing Fed securities purchases, deposits at the Fed are a growing threat to making the leverage ratio salient again, which would constrain dealer market-making appetite. The Federal Reserve should permanently exempt deposits at the Fed from calculation of the leverage ratio.

This exemption, however, should not be allowed to reduce the capital required of banks, especially systemically important banks. There are a number of ways to keep this from happening, but one I favor is to raise risk-based requirements a bit on average through the cycle by activating the countercyclical capital buffer (CCyB).  The Fed’s current practice is to leave this at zero unless it has identified the risk environment as already elevated. In this, it differs from many other authorities globally, who have targeted a positive CCyB in a normal risk environment, which enabled them to release that capital to back lending when the Covid-related shut down hit.

The argument for an active CCyB has been strengthened by experience in the pandemic.  Evidence from both the U.S. and EU is that banks are reluctant to dip into their regulatory capital buffers to make loans under stress out of concern about market reactions and about supervisory constraints on earnings distributions. Studies have shown that banks with less headroom over buffers tended to lend less in the pandemic than banks with more headroom.^[4] The beauty of the CCyB is that once released, it is not part of a regulatory capital buffer and is more available for use. Moreover, the recent changes to the Fed’s stress tests and capital requirements, including substituting a “stress capital buffer” derived from stress test results for elements of the capital stack, are likely to make capital requirements procyclical; adding an actively managed CCyB would counter this adverse macroprudential outcome.

The evident reluctance of banks to dip into regulatory buffers under stress suggests a reasonably sizable CCyB in “normal times” to release under stress would be a helpful countercyclical measure from a macroprudential perspective. The Financial Policy Committee at the Bank of England has established two percent as its target CCyB in a standard risk environment, twice what many other macropru authorities have set, in part by shifting capital from other elements of the stack.

The Federal Reserve should make the CCyB positive in normal risk environments and then manage it actively as risks build or materialize. As it implements a CCyB, the Fed should consider the appropriate level in the context of sterilizing a potential release of capital from adjusting the leverage ratio and the composition of the overall capital stack that would best support the resilience of the financial system and the economy. 

Market-based finance

Credit has increasingly shifted to nonbank channels, especially to markets, responding to innovation and to regulatory arbitrage as bank regulation tightened. But elements in nonbank finance share the leverage and maturity and liquidity transformation characteristics of banks, making them also vulnerable to runs and fire sales that tighten credit and amplify business cycles. In many respects, however, vulnerabilities in market-based finance are harder to deal with than they are with banks. They are spread over many types of institutions and markets, subject to multiple regulators—and some parts are very lightly regulated, if at all. Market-based finance is global, facilitating arbitrage across borders and necessitating a globally agreed approach to regulation. And rapid technological change produces a constantly evolving set of instruments and players. Still, tools are available to address a number of vulnerabilities and the centrality of U.S. markets to global markets means that the U.S. should lead the effort.

As noted, well-functioning U.S. treasury markets are a critical element in keeping both bank and nonbank financing channels operating well. Leverage ratio reform is a necessary but not sufficient condition to bolstering Treasury market liquidity. In addition, the Treasury and the Fed should examine the costs and benefits of mandating central clearing for Treasuries and repos, which might free up dealer capital that would be available to be used for market making.^[5] And the agencies need to gather and publish more complete data on market transactions to help both regulators and market participants better understand and anticipate market dynamics.^[6]

Even with greater private-sector market making, circumstances could arise in which the Federal Reserve would need to step in to preserve well-functioning Treasury securities markets. To that end, backstop standing repo facilities for foreign official holders of Treasuries and for a wide variety of private market participants would put structures in place that could fill that role in a well-anticipated and transparent fashion. In that regard, the Federal Reserve’s recent announcement of two such facilities—one for foreign official institutions and another for dealers—was welcome.

But the repo facility for private parties is limited to the primary dealers and, over time, some depository institutions. To better guarantee Treasury market functioning, the Federal Reserve needs to design a repo facility that is available to a variety of large participants, like hedge funds and other leveraged investors that are playing an increasingly important role in the market. Such an extension would raise issues of counterparty risk and distortions to risk-taking incentives among lightly regulated entities; those can be dealt with through varying haircuts and by imposing a small ex ante fee on lightly regulated entities with access to the facility, but other approaches may also work.

Several types of open-end funds faced very large redemptions in March, including both money market funds and corporate bond and loan funds; to meet those demands, funds turned in part to selling the Treasuries they held for liquidity purposes, so these redemptions disrupted Treasury, corporate bond, and commercial paper markets. The scale of the redemptions is not surprising. Many mutual funds offer their investors much greater liquidity—an ability to redeem by tomorrow at tonight’s closing price—than the liquidity of the underlying securities they hold, which often trade in illiquid markets or simply don’t trade at all, like commercial paper. This mismatch creates a first mover advantage—an incentive to get out while the fund has Treasuries to sell—before redemptions by other investors force fire sales of less liquid assets, depressing prices. The SEC must change regulations to align the liquidity offered investors with the liquidity of the underlying assets in the fund. There are a variety of ways to do this—and the choice for money market funds might differ from the best choice for bond funds. Swing pricing forces early redeemers to pay the price of the liquidity they are getting; where that isn’t possible, as is argued for money market funds, alternatives may work to properly price liquidity under stress, like penalizing redemptions under some circumstances or holding back a portion of the investment.

Another source of elevated demand for liquidity in March 2020 arose from initial margining at central counterparties in derivative and securities markets. According to users, a lack of transparency and predictability about margining methodologies contributed to unexpected demands for cash during the “dash for cash.” But in addition, margin requirements rose substantially as markets became much more volatile. From the perspective of the clearinghouses, this made good sense, and in fact central counterparties remained functioning and viable during an extremely stressful market episode. But here is a case of the micro and macroprudential impulses in conflict as the interest of each clearinghouse added to overall market stress. The CFTC and the SEC should draw on the systemic perspectives of the Fed and Treasury to make margins in CCPs less procyclical with more through-the-cycle methodologies.

This is a formidable list—and I could have added more. Much of it is already under consideration in the U.S. and in global groups, like the FSB. Each element will draw opposition from private parties fearing added costs and counting on intervention from the fiscal and monetary authorities to contain the next market crisis. All of it will require a careful balancing of costs and benefits—but most explicitly and importantly taking account of the costs to society, beyond the costs to market participants, of repeated episodes of financial instability.

Other jurisdictions

The risk environment in the financial markets of many other advanced economies is quite similar to that facing the U.S. Asset prices are elevated and leverage in some sectors has ballooned as market participants count on low interest rates persisting for a very long time. But uncertainties abound as the global economy emerges from a global pandemic after application of unprecedented monetary and fiscal policies. And, until the U.S. raises its macropru game, they are vulnerable to disruptions emanating from U.S. markets.

Many authorities outside the U.S. have utilized a wider array of macropru tools than has the U.S. Given the risk environment, now is the time to make sure domestic institutions and markets would be resilient to severe shocks. Where requirements were adjusted or eased in response to the onset of the pandemic, they should be restored to former settings now that economies are recovering and credit is flowing readily. For example, CCyBs cut in March 2020 to encourage bank lending should be raised as quickly as is consistent with the commitments and forward guidance given when the reductions were announced.  Where the “dash for cash” revealed new vulnerabilities that can be addressed in individual jurisdictions, actions should be taken to build resilience—for example, if the margining at CCPs and the behavior of highly leveraged investors in domestic sovereign bond markets amplified stress. Where effective remediation is not possible in global markets without the participation of the U.S., other authorities should work closely with U.S. authorities in international fora to build consensus around best practices that can be implemented globally, including in the United States.

^{[1] Darrell Duffie highlighted the potential for central clearing to economize on dealer capital.  https://www.brookings.edu/research/still-the-worlds-safe-haven/}

^{[2] Notably, the recommendations of the G-30 group on Treasury market functioning are broadly aligned with those of the Task Force. https://group30.org/publications/detail/4950}

^{[3] https://www.federalreserve.gov/econres/feds/un-used-bank-capital-buffers-credit-supply-shocks-at-SMEs-during-the-pandemic.htm. And for similar findings away from the U.S.: https://www.bis.org/bcbs/publ/d521.pdf.}

^{[4] https://www.federalreserve.gov/newsevents/pressreleases/monetary20210818a.htm}

^{[5] https://www.ft.com/content/32a57864-d983-46b0-bbfa-85fd2d2361e5}

^{[6] Much (though not all) of what follows is based on the recommendations of a Chicago Booth-Brookings Task Force on Financial Stability that I co-chaired.  https://www.brookings.edu/research/report-of-the-task-force-on-financial-stability/. I have also drawn on my talk to the Kansas City Fed’s Jackson Hole symposium.  https://www.brookings.edu/research/building-a-more-stable-financial-system-unfinished-business/}

      

The Hutchins Center on Fiscal & Monetary Policy and the Center on the U.S. and Europe hosted Paolo Gentiloni, Commissioner for the Economy in the European Union, for “Next Generation Atlanticism? A conversation about economics and geopolitics” on October 14. Brookings’ scholars Gian Maria Milesi-Ferretti and Thomas Wright led the conversation. David Wessel moderated.  This post summarizes the conversation, which focused on the key economic challenges facing Europe as it recovers from the COVID-19 pandemic (including the potential impact and uses of the Next Generation EU Fund)  as well as transatlantic and other foreign policy issues. *Event transcript can be accessed here»

Mr. Gentiloni stressed both the speed and the size of the policy response to the COVID crisis at the European Union level: the actions of the European Central Bank, the suspension of the restrictions imposed by the Stability and Growth Pact, which allowed national governments to undertake a strong fiscal response to the crisis, as well as the common issuance of European debt to finance short-term work schemes and subsequently the recovery program. The joint response to vaccine procurement,  after a difficult start, has now helped ensure that over 75 percent of EU citizens are vaccinated. This has allowed the re-opening of activity and underpinned a strong economic recovery. Real EU growth this year is forecast at around 5 percent by the IMF.

While risks and uncertainties remain —  linked to the evolution of the pandemic, supply-side bottlenecks, the spike in energy prices, and the large increase in public debt —  the challenge for the European Union is how to find ways not just to make up the ground lost because of the pandemic, but to yield more durable and sustainable growth, he said. Spending on public investment to support the greening of the economy and its digitalization are important tools, and so are the reforms that national governments committed to in their recovery plans.

Mr. Gentiloni also noted the importance of the recent agreement on international taxation, and the fact that all 27 member states of the Union signed the agreement, including some, like Ireland, for which the decision to accept a minimum corporate tax rate of 15 percent was difficult. Together with the other international tax agreement pillar–the re-allocation of taxing rights, based on where profits are generated — this was a turning point. The European Union has committed to achieving its implementation by 2023. He said the agreement, long discussed, reflects the change of administration in the U.S., and singled out Treasury Secretary Janet Yellen for her role in forging a consensus.

On the geopolitical front, Mr. Gentiloni highlighted the welcome shift of the new Biden administration towards multilateralism. The difficulties with the AUKUS developments and especially with the withdrawal of troops from Afghanistan reinforced an awareness in the European Union of the need to try to play a more important geopolitical role, he said.  This is particularly important in areas crucial for Europe such as the Mediterranean, North Africa, the Balkans, and can be good for NATO and for the US-EU partnership. The EU faces a challenge in achieving these objectives—for instance, progress on European defense has been very limited. At the same time, it is on the same page as the US on the need to address the China challenge, and strongly committed to NATO, which plays a crucial role vis-à-vis Russia.

In regard to China, Mr. Gentiloni said, the EU is fully aware of the challenge posed by an authoritarian model where economic success is not coupled with democracy as we know it. Europe has to face this challenge also in some aspects of its own  political landscape as well. It is trying to support an open economy, open trade, and to avoid the negative economic consequences of a decoupling or a closure of this international economic relations. This double track is challenging, not easy of course, as exemplified by the difficulties faced by supply chains during the crisis and the need to take care of European autonomy in some strategic supply chains without breaking international trade relations. The EU realizes that it needs to strengthen its political position vis-à-vis China and Russia if it wants to keep open the doors for trade and investment.

In regard to Brexit, Mr. Gentiloni mentioned that the problems should not be exaggerated. It was very difficult to reach the so-called Northern Ireland protocol, which came on the basis o f a UK proposal that the Commission accepted. Of course, things can be made more flexible, but this protocol cannot be attacked or cancelled without causing dangerous political consequences, even more so in Ireland than with the EU–and this is not the right thing to do.

On the availability of COVID vaccines for less developed countries, Mr. Gentiloni said the problem with the authorization of exports from the EU of 800 million doses is that these doses are not reaching especially the low-income countries, and here more effort is needed. The, next G-20 in Rome at the end of October could be a turning point and increase commitments from different advanced economies. Richer countries need to be more ambitious, and this can be done. The issue is very important—nobody is safe until everybody’s safe, and the costs are not that high. It is not only an issue of solidarity, but also of the well-being of advanced economies. On the COVID front, it is also important to ease traveling rules. The so-called Green Certificate in the EU has been a big success, allowing travel and access to indoor activities all over Europe with the same QR code. This is a good way to increase and facilitate exchanges and travel, and could be extended to developing countries.

      

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Fluctuations in the unemployment rate have a lasting effect on the labor market  

Using data on 29 advanced economies over the 2002-2019 period, Laurence Ball of Johns Hopkins University and Joern Onken of University College London find that transitory changes in the unemployment rate shift the natural rate of unemployment (the rate that is consistent with full employment and stable inflation). The authors estimate that, on average, there is a 0.16 percentage point increase (or decrease) in the natural rate of unemployment if the unemployment rate runs 1 percentage point higher (or lower) than its natural rate over a year. The authors also find that the natural rate is more sensitive to transitory decreases in the unemployment rate than increases. The results imply that shifts in aggregate demand have long-lived responses in the labor market and that “a ‘high pressure’ economy has permanent benefits,” the authors conclude.    

Fintech lenders are more likely than traditional banks to issue PPP loans to Black-owned businesses   

The Paycheck Protection Program (PPP) was introduced during the pandemic to provide government-backed loans to small businesses. Sabrina Howell of New York University and co-authors find that, controlling for business characteristics, Black-owned businesses were about 12 percentage points more likely to receive a PPP loan from a fintech lender than a traditional bank. The authors find that this disparity is not primarily explained by differences in pre-existing relationships between borrowers and banks or by borrower application behavior. Instead, they find that the gap in lending is larger in areas with larger racial animus, such as the South, suggesting that the disparity may have been driven by racial discrimination. When small banks increase automation, reducing human involvement in the lending decisions, their rate of PPP lending to Black-owned businesses increases, they find. Fintech lenders and larger banks already implement automated underwriting processes, which may account for the discrepancy.  

Increases in federal highway grants lead to small decreases in state-financed highway spending  

Using state-level data from 1994-2015, Sheila Campbell and Chad Shirley from the Congressional Budget Office find that, for every dollar in annual federal highway grants, state and local governments spent 26 cents less of their own funds on highways than they would have otherwise. This finding suggests a smaller degree of crowd-out than in much of the literature. Furthermore, for each dollar of ARRA highway grants—temporary federal grants provided during the Great Recession—state and local governments increased their own highway spending by 13 cents, although the response was smaller for state and local governments with larger deficits. The authors note that the response to ARRA grants might have been different because states had to spend the grants much more quickly and were required to maintain their previously planned level of spending for highways.   

Chart of the week: Labor force participation declined sharply over the COVID-19 recession and remains far below pre-pandemic levels 

Source: The Wall Street Journal 

Quote of the week: 

“Amid the prolonged and painful pandemic, financial stability risks have been contained so far. Financial conditions have eased since the start of the pandemic. This reflects the continuing monetary and fiscal support for the economy which helped spur a rebound from 2020. Yet the sense of optimism which had propelled markets in the first half of the year has faded somewhat. Uneven vaccine access along with the mutations of the virus have led to a resurgence of infections. Investors are increasingly worried about the economic outlook amid greater uncertainty about the strength of the recovery. Anxiety about the inflationary pressures has recently pushed yields higher. A sudden and sustained repricing of risk could interact with underlying vulnerabilities that could lead to tightening of financial conditions which could put growth at risk in the medium term,” says Tobias Adrian, Financial Counsellor of the International Monetary Fund. 

“Policymakers are now confronted with a difficult tradeoff. They must continue to provide near-term support to the global economy, yet they must simultaneously try to avoid the buildup of medium-term financial stability risks. After more than a year, complacency appears as a real risk. Asset valuations remain stretched and risk-taking persists. If left unchecked, such vulnerabilities could become structural legacy issues. Policymakers should formulate action plans that would guard against unintended consequences. Monetary and fiscal policy support should be more targeted and tailored to country-specific circumstances given the varying pace of the recoveries across countries. Central banks should provide clear guidance about the future approach to monetary policy and remain vigilant to avoid an unwarranted and abrupt tightening of financial conditions. If price pressures turn out to be more persistent than anticipated, they should act decisively to avoid an unmooring of inflation expectations. Policymakers should take early action and tighten select macroprudential tools to target pockets of elevated vulnerabilities.”  

The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation. 

      

David Wessel, a senior fellow and director of the Hutchins Center on Fiscal and Monetary Policy at Brookings, is author of the new book “Only the Rich Can Play: How Washington Works in the New Gilded Age,” published by Public Affairs, which tells the story of how a Silicon Valley entrepreneur developed an idea intended to help poor people that will save rich people money on their taxes. Wessel relates in his book how the tax break, passed into law in the Tax Cuts and Jobs Act of 2017, led to the creation of over eight thousand tax havens across the U.S. called Opportunity Zones.

This episode of the Brookings Cafeteria presents part of a recent Brookings live event during which Wessel and other experts discussed the book and the Opportunity Zone experience on the ground. Here, Wessel is interviewed by New York Times White House correspondent Jim Tankersley about “Only the Rich Can Play.” Listen and watch the entire event here, or also subscribe to the Brookings events podcast channel.

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