Taxing Debt to Curb Irrationality Without Reducing Economic GrowthBOCCONI STUDENTS ON THE ECONOMICS SEMINARS ORGANIZED BY IGIER. IN THE FIFTH ARTICLE OF THE SERIES, DANIELE GOFFI REPORTS ON THE WORK OF IVAN WERNING, MIT
Leading international scholars present their cutting-edge research at Bocconi every year, in front of faculty and students. In order to make this work accessible to a larger audience, Bocconi Knowledge publishes the summaries of the scientific and policy seminars organized by the IGIER research center, written by the students participating in the IGIER-BIDSA Visiting Students Initiative
As much as the Great Recession of 2009 challenged our economies and policymakers, it also raised an intellectual puzzle: how could the apparently healthy financial system of the mid 2000s experience a sudden collapse and an economic recession of such historic proportions? An overlooked hypothesis put forth in the 1970s by economists Hyman Minsky and Charles Kindleberger suggested that beliefs play a central role: during large economic expansions, investors tend to neglect the risk of a subsequent crash, so they overinvest in risky assets. When these neglected risks materialize (a so called “Minsky moment”), an apparently calm financial system is blown by a panic in which asset prices collapse, debt shrinks, and output falls.
At the IGIER Seminar of 30 November, Iván Werning from MIT presented his paper “Taming a Minsky Cycle” (joint with Emmanuel Farhi), which asks: how should macroeconomic policy behave in a world in which this kind of belief-driven instability can occur? To answer this question, the authors depart from the rational expectations assumption, which has dominated macroeconomics and finance in the last fifty years.
When people are rational, they do not make systematic mistakes in predicting the future. For instance, if they plan to purchase a house, they are of course not sure what the exact future price will be, but they can form an expectation that is on average accurate. This implies that they are aware that reality may differ from their average prediction and they understand that bad things may happen. As a result, rational people also behave in a cautious way. Matters are different if people are not rational and, in particular, if they think that the future will be similar to the past, consistent with the data on people’s expectations. In this case, people living through improving conditions become too optimistic about the future, for they are too confident that the improvement will last. For instance, people seeing increasing house prices become excessively optimistic about future house price increases. As a result, not only their predictions are on average inaccurate, but also and crucially they may behave in a reckless way, for instance by taking excessively large mortgages. In this case, when the “Minsky moment” occurs and people realize that their optimism was excessive, they also realize that they are overly indebted. The level of debt in the system is unsustainable and a financial crisis erupts.
To see the role of policy in this world, Werning and Farhi consider two types of interventions: 1) an interest rate policy whereby the Central bank increases interest rates to discourage excessive indebtedness, and 2) a macroprudential policy setting direct taxes or quantity restrictions on the amount of debt.
Consider first the interest rate policy. When the Central Bank raises the interest rate, borrowing becomes more expensive, so debtors will naturally borrow less. This curbs their proclivity to over-borrow. The rise in the policy rate is however not without costs: higher interest rates also reduce the current price of houses and of other assets. As a result, the owners of these assets feel “poorer” and cut consumption, which reduces economic growth. In this respect, if monetary policy was the only policy instrument, the choice of how much to raise interest rate should balance two opposite consideration: the benefit of discouraging excessive borrowing, and the recession induced by low asset prices. Standard analyses of monetary policy working under the rational expectation assumption only consider the latter aspect. However, neglecting the first “financial stability” effect of higher interest rates may be misleading.
It is here that macroprudential policy becomes critical. Werning and Farhi view macroprudential policy as a tax on debt. By directly taxing debt, the Central Bank could be free to set a relatively low interest rate so as not to reduce economic growth. The direct taxation of debt would itself reduce the incentive of people to over-borrow, avoiding the need to raise interest rates. In this respect, the combination of monetary and macroprudential policy achieved the best possible outcome: economic growth without financial instability.
The work by Werning and Fahri is a call to action for policy makers. In fact, even in a world with pervasive irrational beliefs, the right policy mix can achieve a lot: it can stabilize economic conditions but also preempt the onset of irrational exuberance, taming the Minsky cycle.
by Daniele Goffi