In the more optimistic case to which I subscribe, the productive capacity and potential wealth of the U.S. have not been permanently damaged and currently unused resources are still productive. Accordingly, in my opinion, monetary policy should be used more aggressively to increase aggregate demand. In time, a reduction in excessive risk aversion, supported by natural market forces would reestablish the fundamentals that previously supported stronger growth and full employment. In this way, large social losses would be mitigated. By stimulating aggregate demand, we can have “Morning in America, again” and our best days can still be ahead of us. 6  BIS central bankers’ speeches  But the clock is ticking – the longer we wait, the more likely it is that unutilized skills diminish to the point that more permanent damage takes hold. Challenge #3: monetary policy held back by zero lower bound By now, the third obstacle is quite well-known: the federal funds rate in the U.S. is currently constrained by the zero lower bound on interest rates. Given the economic scenario and inflation outlook I have discussed, were it possible, I would favor cutting the federal funds rate by several percentage points. But since the federal funds rate is already near zero now, that’s not an option. To date, the Fed’s policy-making committee, the FOMC, has used a number of nontraditional policy tools to impart greater financial accommodation. I have fully supported these policies. Today, however, I simply think we need to do more.
That estimate becomes very substantially smaller if we make less conservative assumptions and allow for several offsetting impacts from banks holding more capital. Specifically: 1. Allowing for a partial offset because as a bank holds more equity capital, its equity becomes less risky, and therefore requires a lower return. (A Modigliani-Miller effect – which I will assume is not zero but only 30% as big as it would be under perfect markets)  2. Allowing for the value to the government of the extra tax revenue received as a result of banks having more equity capital which is less tax sheltered than is debt. 10  BIS Review 133/2010  3. Allowing for a somewhat lower use of bank funding for investment than in the baseline. 4. Allowing for a lower sensitivity of investment and the capital stock to a rise in the cost of funds to non-financial firms. Table 2 shows how rapidly the estimated long-run economic cost of requiring higher bank capital falls as we sequentially allow for each of these offsets. I conclude from this that the long-run costs of having banks hold more capital is likely to be small – plausibly it is negligible. If that is so then the benefits of having much more robust banks would far exceed its costs. If it is right that the benefits of raising capital requirements to much higher levels far outweigh their economic cost, how we did we get into a situation that bank capital was so low relative to total assets?