Center for Financial Innovation and Stability

Notes from the Vault

Sovereign Debt and Default
Gerald P. Dwyer
November/December 2011

The United States has a debt problem, even if it is not as intensely scrutinized as European debt.
While market prices and markets are much maligned, the prices in markets provide information about underlying problems faced by governments.
Countries' responses to the sovereign debt crisis in Europe have been quite different, but the most successful ones to date involve radical, wrenching changes over a short period instead of long, drawn-out changes.

The Financial Crisis and Recovery: Why so Slow?
Gerald P. Dwyer and James R. Lothian
September/October 2011

The U.S. economy has recovered slowly from the recession of 2007 to 2009.
U.S. history provides no support for linking low employment and high unemployment in the current recovery with the financial crisis of 2007–2008.
The recent recovery and the recovery after the Great Depression are similar, both of which differ from other recoveries.
Current discussions about the recovery echo prominent interpretations of the Great Depression, focusing on low aggregate demand or government policies that increase uncertainty or decrease productivity.

Standard & Poor's (S&P) downgrade of the long-term credit rating of the United States has been criticized because the risk of default on U.S. government debt in dollars is zero.
U.S. Treasury debt is nominally risk free but not really risk free.
While S&P does include a monetary score in its assessment of creditworthiness, a higher inflation rate will earn a lower score, not a higher one.

The Federal Reserve now pays interest on reserves held by banks, but cannot by law pay interest on reserves held by the government sponsored enterprises (GSEs).
GSEs earn some interest on reserves by selling the reserves to banks, but the rates earned by the GSEs are far below rates received by the banks.
The result is that banks earn risk-free profits at the expense both of the GSEs and of the U.S Treasury, given the Treasury's relationship with Fannie Mae and Freddie Mac, the two largest GSEs.
A solution would be to allow the Federal Reserve to pay interest on reserves to GSEs so long as Treasury effectively owns the GSEs' marginal profits and losses.

Capital at Banks
Gerald P. Dwyer
April 2011

There have been numerous calls for banks to raise their capital and decrease the probability of failure.
Instead of merely increasing capital directly, bank owners could be required to post a bond—assets that generate income to the owners as long as the bank is open.
Such a bond has the potential to lower the risk that bank owners are willing to undertake and thereby reduce the number of failed banks.

Iceland and Ireland responded to the banking crises in their countries in quite different ways.
While the countries are similar in many respects, they have some significant differences, the most prominent being their exchange-rate regimes.
Iceland's combination of a flexible exchange rate and a policy of closing its failed banks appears to have served the country well in the aftermath of the financial crisis.

Municipal Bond Woes
Gerald P. Dwyer
February 2011

Interest rates on state and local government debt have exceeded rates on federal government debt since the onset of the financial crisis in 2007, presumably at least partly due to credit risk.
Decreases in tax revenue and increases in debt are informative, relatively simple measures of fiscal pressures faced by governments.
The available data do not support a forecast of widespread defaults and losses on municipal bonds.

The Center for Financial Innovation and Stability cosponsored a conference in December 2010 to examine international aspects of the financial crisis.
Faster growth of credit and higher leverage before the crisis were associated with larger decreases in projected output in 2009.
The evidence indicates that problems in Ireland, Spain, and the United Kingdom have similar causes as the U.S. crisis and are not effects of the U.S. crisis.

Notes from the Vault was on hiatus after the March/April 2012 post; it restarted in March 2013.

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