Social Risk, Fiscal Risk, and the Portfolio of Government Programs

Samuel G. Hanson; David S. Scharfstein; Adi   Sunderam

Article | Review of Financial Studies | June 2019

Social Risk, Fiscal Risk, and the Portfolio of Government Programs

by Samuel G. Hanson, David S. Scharfstein and Adi Sunderam

Abstract

We develop a model of government portfolio choice in which a benevolent government chooses the scale of risky projects in the presence of market failures and tax distortions. These two frictions generate motives to manage social risk and fiscal risk. Social risk management makes attractive programs that ameliorate market failures in bad economic times. Fiscal risk management makes unattractive programs that entail large government outlays at times when other programs in the government's portfolio also require large outlays. We characterize the determinants of social and fiscal risk and argue that these two risk management motives often conflict. Using the model, we explore how the attractiveness of different financial stability programs varies with the government's fiscal burden and with characteristics of the economy.

Keywords: Risk Management; Government and Politics; Programs;

Format: Print

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Hanson, Samuel G., David S. Scharfstein, and Adi Sunderam. "Social Risk, Fiscal Risk, and the Portfolio of Government Programs." Review of Financial Studies 32, no. 6 (June 2019): 2341–2382. (Internet Appendix Here.)

Using historical data on post-war financial crises around the world, we show that crises are substantially predictable. The combination of rapid credit and asset price growth over the prior three years, whether in the nonfinancial business or the household sector, is associated with about a 40% probability of entering a financial crisis within the next three years. This compares with a roughly 7% probability in normal times, when neither credit nor asset price growth has been elevated. Our evidence cuts against the view that financial crises are unpredictable “bolts from the sky” and points toward the Kindleberger-Minsky view that crises are the byproduct of predictable, boom-bust credit cycles. The predictability we document favors macro-financial policies that “lean against the wind” of credit market booms.

Drawing on lessons from the 2007–2009 Global Financial Crisis (GFC) and a simple conceptual framework, we examine the response of U.S. bank regulators to the COVID-19 pandemic. We argue that the current regulatory strategy of “watchful waiting”—the same strategy that was used during the early stages of the GFC—poses unnecessary risks to the financial system and broader U.S. economy. Instead, promoting an early recapitalization of the banking system, by stopping dividends and by encouraging new equity issues, would be a more prudent way to manage the vulnerabilities the pandemic has created. We close by suggesting additional measures that we believe regulators should take in both the short and long run.

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Social Risk, Fiscal Risk, and the Portfolio of Government Programs

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