Since the Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against all risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges.
The buffer may encompass expensive building materials whose earthquake flexibility is needed only for a minute or two every century. Any excess bank equity capital also would constitute a buffer that is not available to finance productivity-enhancing capital investment.
The choice of funding buffers is one of the most important decisions that societies must make. If policymakers choose to buffer their populations against every conceivable risk, their standards of living would almost certainly decline. It is no accident that earthquake protection of the extent employed in Japan has not been chosen by less prosperous countries at similar risk of a serious earthquake. Buffers are largely a luxury of rich nations. It does not matter whether we perceive an increased buffer as part of a nation’s capital stock, or as part of the net equity of the country. They are the same magnitude from different perspectives. Consolidated, the net capital stock of a nation must equal the sum of the equity of households, businesses and governments, adjusted for the nation’snet international investment position.
How much of its output should a society wish to devote to fending off once in 50 or 100-year crises? How is such a decision reached, and by whom? In the 19th century, when caveat emptor ruled, such risk judgments were not separable from the overall price, interest rate and other capital-allocating decisions struck in the marketplace.
Today, while the decisions of what risks to take remain predominantly with private decision-makers, the responses to the global financial and Japanese earthquakes have been largely government scripted. In the immediate aftermath of such crises, it is difficult to convince people that the wrenching events are not likely to recur any time soon, because, with a (very) low probability, they might. This is especially the case having just been through the brunt of a financial crisis that is likely to be judged the most virulent ever.
In the wake of the Lehman bankruptcy in 2008, private markets and regulators are requiring much larger capital, ie buffers, to support liabilities of financial institutions. Had banks and other financial entities maintained adequate equity capital-to-asset ratios before the 2008 crash, then by definition no defaults or contagion would have occurred as the housing bubble deflated. A resulting recession, though possibly severe, would almost certainly not have been as prolonged or have required bail-outs.
Bank managements, currently repairing their flawed risk management paradigm, have been moving aggressively to build adequate capital to enable them to lend. For the moment they are expanding their loan portfolios only marginally. Most of the new capital appears to have buffer status. Deep uncertainty about our economic future, as well as the potential level of regulatory capital, has unsettled bank lending. More than $1,600bn in deposits at Federal Reserve banks are lying largely dormant despite available commercial and industrial loans that, according to the Fed, entail “minimal risk” and are yielding far more than the 25 basis points reserve banks pay on such deposits. The excess reserves thus seem to have taken on the status of a buffer, rather than actively participating in, and engendering, lending and economic activity.