In addition, the rise in longer-term rates constrains economic activity – making it even more difficult to sustain an economic recovery. Moreover, once confidence begins to erode, it can do so very quickly. Even if a country were willing to pay higher interest rates, this path is not viewed as credible given the implications such rates have for future debt service costs and deficits. Put simply, to wait and see ultimately is likely to necessitate an even bigger fiscal adjustment. In addition, waiting for the market to say “no more” may mean losing discretion as to the timing and magnitude of fiscal tightening. It is very unlikely that the time when market sentiment turns most adverse would also be the most attractive time to have to tighten fiscal policy. Thus, there is a balancing act between solving the longer-term problem of needed fiscal consolidation and, at the same time, not tightening fiscal policy too soon or too abruptly so as to derail the nascent expansion. So what should be done? I believe that moving ahead earlier with a credible plan is preferable to waiting. I am not going to enter a political debate about whether the restraint should be more in the form of higher taxes or lower spending. However, I do believe, like most other economists, that fiscal consolidation that has the least negative impact on investment in physical and human capital is bound to be most effective. That is because fiscal capacity depends on economic capacity.
These firms are able to obtain funding on more attractive terms because debt holders expect that the government will intervene rather than allow failure. This creates an incentive to get large to achieve such status, not because it facilitates greater efficiency, but instead because the implicit government backstop enables the too-big-to-fail firm to achieve lower funding costs. Although the United States has an effective resolution mechanism for commercial banks, we do not yet have a good resolution scheme for large non-banking institutions or bank holding companies with large international operations. To address the too-big-to-fail problem, we need to develop a truly robust and credible resolution mechanism that allows for the orderly wind-down of any institution – regardless of its size – and that limits the contagion to the broader financial system. This will require not only domestic legislation, but also extensive work internationally to address a range of legal issues involved in winding down a major global firm. I want to emphasize how important it is that the incentives we embed within the regulatory apparatus for financial intermediaries encourage the type of behavior we seek – behavior consistent with safety and soundness and financial stability. For example, consider the efforts underway to standardize OTC derivatives and move the clearing of such trades to central counterparties (CCPs). These are good and worthwhile efforts.