Bailouts and Systemic Insurance. By Giovanni Dell'Ariccia and Lev Ratnovski

Bailouts and Systemic Insurance. By Giovanni Dell'Ariccia and Lev Ratnovski
IMF Working Paper No. 13/233
November 12, 2013
http://www.imf.org/external/pubs/cat/longres.aspx?sk=41048.0

Summary: We revisit the link between bailouts and bank risk taking. The expectation of government support to failing banks creates moral hazard—increases bank risk taking. However, when a bank’s success depends on both its effort and the overall stability of the banking system, a government’s commitment to shield banks from contagion may increase their incentives to invest prudently and so reduce bank risk taking. This systemic insurance effect will be relatively more important when bailout rents are low and the risk of contagion (upon a bank failure) is high. The optimal policy may then be not to try to avoid bailouts, but to make them “effective”: associated with lower rents.

Excerpts

When banks expect to be supported in a crisis, they take more risk, because shareholders, managers, and other stakeholders believe they can shift negative risk realizations to the taxpayer. So the expectations of support increase the probability of bank failures that governments want to avoid in the first place.

This paper highlights that when there are risks beyond the control of individual banks, such as the risk of contagion, the expectation of government support, while creating moral hazard, also entails a virtuous “systemic insurance” effect on bank risk taking. The reason is that bailouts protect banks against contagion, removing an exogenous source of risk, and this may increase bank incentives to monitor loans. The interaction between the moral hazard and systemic insurance effects of expected bailouts is the focus of this paper.

The risk of contagion is one of the reasons that makes banks special. While a car company going bankrupt is an opportunity for its competitors, a bank going bankrupt is a potential threat to the industry, especially when the failing bank is large. Banks are exposed to each other directly through the interbank market, and indirectly through the real economy and …nancial markets. While banks have some control over direct exposures, the indirect links are largely beyond an individual bank’s control. The threat of contagion affects bank incentives. The key mechanism that we consider in this paper is that when a bank can fail due to exogenous circumstances, it does not invest as much to protect itself from idiosyncratic risk. Indeed, would you watch your cholesterol intake while eating on a plane that is likely to crash? Or save money for retirement when living in a war zone? Moreover, making the threat of contagion endogenous to the risk choices of all banks generates a strategic complementarity that ampli…es initial results: banks take more risk when other banks take more risk, because risk taking of other banks increases the threat of contagion. [While we focus on the risk that a bank failure imposes on other banks, other papers have focused on the potential bene…ts for competing banks that can buy assets of a distressed institution at …resale prices, possibly with government support to the buyer.]


Under these circumstances, when the government commits to stem the systemic effects of bank failure, it has two effects on bank incentives. The …rst is the classical moral hazard effect described in much of the literature. The second is a systemic insurance effect that increases banks’incentives to monitor loans (this is similar to the effect identi…ed for macro shocks by Cordella and Levy-Yeyati, 2003, and to that of IMF lending to sovereigns in Corsetti et al., 2006). The promise of bailout removes a risk outside the control of a bank and increases its return to monitoring. Going back to our risky ‡ight parable, how would your choice of meal change if you had a parachute?

Formally, we develop a model of financial intermediation where banks use deposits (or debt) and their own capital to fund a portfolio of risky loans. The bank portfolio is subject to two sources of risk. The fi…rst is idiosyncratic and under the control of the bank. Think about this risk as dependent on the quality of a bank’s borrowers, which the bank can control through costly monitoring or screening. The second source of risk is contagion. Think about this, for example, as a form of macro risk. When a bank of systemic importance fails, it has negative effects on the real economy, possibly triggering a recession. A deep enough recession can lead even the best borrowers into trouble and, as a consequence, can cause the failure of other banks independently of the quality of their own portfolio. The risk of contagion is exogenous to individual banks (it cannot be managed or diversi…ed), but it is endogenous to the …nancial system as a whole, since it depends on risk taking by all banks.

These two sources of risk are associated to two inefficiencies. First, banks are protected by limited liability and informational asymmetries prevent investors from pricing risk at the margin. As a result, in equilibrium banks will take excessive idiosyncratic risk. As in other models, this problem can be ameliorated through capital requirements. The second ine¢ ciency stems from externalities. When individual banks do not take into account the effect of their risk taking on other banks, they take too much risk relative to the coordinated solution. And since banks are also affected by the externality, this exogenous source of risk reduces the private return to portfolio monitoring/screening. Bank increase idiosyncratic risk, increasing also the contagion externality. Capital requirements cannot fully correct this problem: even a bank fully funded by capital will take excessive risk when exposed to risk externalities.

Against this background, government intervention in support of failing banks has two opposite effects on incentives. It exacerbates the moral hazard problem stemming from limited liability, but reduces the externality problem associated with contagion. The extent of moral hazard depends on the rents that the government leaves to bailed out banks, while the importance of the "systemic insurance" effect depends on the probability of contagion. Thus, there are parameter values .low bailout rents and a high risk of contagion -- for which the promise of government intervention leads to lower bank risk and better ex ante outcomes.

The "systemic insurance" effects continue to be present when we allow banks to correlate their investments. The threat of contagion may induce banks to excessively correlate their portfolios, because contagion discourages strategies that pay off when other banks fail. Such correlation may be undesirable for a number of reasons .ine¢ cient distribution of credit in the economy, lower bank profits, or an increased probability of simultaneous bank failures (which are socially costly; Acharya, 2009). We show that the expectations of government support may reduce banks'incentives to correlate their investments by decreasing the risk of contagion. It is important to interpret our results with caution. First, they should not be seen as downplaying the moral hazard implications of bailouts. Rather, we argue that such implications have to be balanced with systemic insurance effects. Systemic insurance may be important for some, but not all parameter values. The best illustration for the case where systemic insurance effects might dominate would be a financial system on the brink of the crisis (with weak banks and high probability of contagion) with well-designed bank resolution rules (which minimize bailout rents). Second, we focus on ex ante effects of policies. Ex post considerations may be different and depend e.g. on the difference between the economic costs of bank bankruptcy and that of the use of public funds. Third, and most critically, we assume that the government is able to commit to a given bailout strategy. In a richer model with potential time inconsistencies in the government reaction function, outcomes may be more complex. In particular, banks may find it optimal to take correlated risks if they believe that bailouts will be more likely when many of them fail simultaneously.

Several recent papers have explored the effects of expected government support on bank risk taking. In these papers, bailouts increase risk taking and generate a strategic complementarity among banks when the probability of bailouts increases with the share of the banking system that is in distress. We add to that literature by introducing a risk externality in the form of an undiversi…able contagion risk. This risk externality creates an additional strategic complementarity in risk taking, one that does not result from government policy. In contrast to the existing literature, by preventing contagion, bailouts can reduce the strategic externalities and bank risk taking. The paper relates to the literature on government intervention as a means of preventing contagion. The observation that by removing exogenous risk the government can improve banks’ monitoring incentives was …first made by Cordella and Levy-Yeyati (2003), in the context of macroeconomic shocks. Our model builds on their work by making these shocks endogenous to the banking system, thus offering a link between individual bank risk taking and systemic risk. [Orszag and Stiglitz (2002) use the creation of fire departments as a parable to describe how risk taking incentives are affected by externalities and public policy. In their model (like here), individuals do not take into account the effects of reproof houses on reducing the risk of fire damage to their neighbors’homes, and invest too little in fire safety. The introduction of a fire department reduces the risk of a fire, but further worsens individual incentives, as it reduces the probability that a fire spreads from one house to another. To extend their parable, our paper is more about condo buildings rather than single-family houses. If the rest of the building burns down and collapses, a condo owner gets little benefit from having …reproofed her own apartment. Then, the introduction of a fire department makes individual safety measures more valuable as it reduces the probability of total meltdown.]

Rules of Thumb for Bank Solvency Stress Testing. By Daniel C. Hardy and Christian Schmieder

Rules of Thumb for Bank Solvency Stress Testing. By Daniel C. Hardy and Christian Schmieder
IMF Working Paper No. 13/232
November 11, 2013
http://www.imf.org/external/pubs/cat/longres.aspx?sk=41047.0

Summary: Rules of thumb can be useful in undertaking quick, robust, and readily interpretable bank stress tests. Such rules of thumb are proposed for the behavior of banks’ capital ratios and key drivers thereof—primarily credit losses, income, credit growth, and risk weights—in advanced and emerging economies, under more or less severe stress conditions. The proposed rules imply disproportionate responses to large shocks, and can be used to quantify the cyclical behaviour of capital ratios under various regulatory approaches.

Excerpts

Motivated by the usefulness of rules of thumb,

this paper concentrates on the formulation of rules of thumb for key factors affecting bank solvency, namely credit losses, pre-impairment income and credit growth during crises, and illustrates their use in the simulation of the evolution of capital ratios under stress. We thereby seek to provide answers to the following common questions in stress testing:

• How much do credit losses usually increase in case of a moderate, medium and severe macroeconomic downturn and/or financial stress event, e.g., if cumulative real GDP growth turns out to be, say, 4 or 8 percentage points below potential (or average or previous years') growth?

• How typically do other major factors that affect capital ratios, such as profitability, credit growth, and risk-weighted assets (RWA), react under these circumstances?

• Taking these considerations together, how does moderate, medium, or severe macro-financial stress translate into (a decrease in) bank capital, and thus, how much capital do banks need to cope with different levels of stress?

Conclusions

A variety of evidence is presented on the “average” pattern of behavior of financial aggregates relevant to solvency stress testing banks based in EMs [emerging market economies] and ACs [advanced economies], and, with some limitations, also for larger LIC banks. Table 10 provides an overview of some main results.



Typical levels of credit loss rates, pre-impairment income, and credit growth were estimated under moderate stress (a one-in-10/15-years shock), medium stress (worst-in-20-year), severe stress (a 1-in-40-years shock), and extreme stress (1-in-100 years). All three variables react in non-linear fashion to the severity of stress, which means that effects under severe conditions is manifold the effects under moderate conditions. Also, a substantial “tail” of poorly performing banks is likely to be much more affected than the median bank.

Comparing ACs on the one hand and EMs/LICs on the other, loss levels are found to be substantially higher in the latter, compensated for by higher returns. It was found that 1-in-20 year stress loss levels usually lead banks to report some net losses, especially in ECs, and thereby lose some capitalization (1 to 3 percentage points if they are under Basel I or the Basel II standardized approach), but only a macroeconomic crisis approaching severe intensity would normally bring down typical well-capitalized banks (unless there are other issues related to confidence and financial sector-generated sources of strain).

Further evidence is presented on macro-financial linkages, and specifically on defining rules of thumb of how a change in GDP growth triggers credit losses, income, and credit growth effects under different levels of stress. While such rough satellite models are more complex than the descriptive solvency rules, they allow the development of scenarios based on an explicit story. As such, the rules make allowance for national circumstances, such as the expected severity of shocks.

While the study has found general patterns, country-specific and/or bank-specific circumstances may differ widely from the average. Hence, the rules of thumb elaborated in this study serve as broad guidelines, particularly to understand benchmarks for worst-case scenarios, but do not fully substitute for detailed analysis when that is possible. The rules of thumb with explicit focus on macro-financial linkages cover only some of the main macroeconomic risk factors that may affect a banking system, namely those captured by GDP. It would be worthwhile to investigate whether analogous simple rules can be formulated that link specific elements of banks’ balance sheets and profitability to such other sources of vulnerability. Relevant macroeconomic variables could include (i) interest movements, including an overall shift in rates and a steepening or flattening of the yield curve. Effects are likely to depend crucially on how frequently rates on various assets and liabilities adjust; (ii) inflation and especially unexpected movements in the inflation rate. A rapid deceleration could strain borrowers’ ability to repay; (iii) exchange rate movement, especially where a large proportion of loans are denominated in foreign currency; and (iv) shocks affecting sectoral concentration of exposures or certain business lines.

The rules of thumb can be used to compute minimum levels of capitalization needed to withstand shocks of different severities—even those far from a country’s historical experience. Also, the regulatory approach used by banks matters: whether a bank adopts an IRB approach to estimating risk-weighted assets or relies on a standardized approach is shown to make a substantial difference to the magnitude and also the timing of when the effects of shocks are recognized, provided that banks’ risk models reflect changes in risk on a timely basis. Thus, the results are relevant to recent policy discussions centered on the robustness of regulatory capital ratios, especially on the computation of RWAs (e.g., BIS 2013, BCBS 2013, Haldane 2012, 2013) and the design of (countercyclical) capital buffers (e.g., Drehmann and other 2009). The results echo the call for (much) longer samples to be used in the calibration of models used for RWA computation and the “right” choice of the regulatory capital ratio (e.g., BCBS 2013, BIS 2013).

El cost de l'intervencionisme a Hong Kong

El cost de l'intervencionisme a Hong Kong. WSJ Editorial

En contra de les afirmacions del govern, les taxes dificulten més els negocis a les petites companyies.

Wall Street Journal, 5 nov 2013 11:16 a.m. ET

Translation of The Cost of Hong Kong's Interventionism to Catalan. By Un Liberal Recalcitrant

http://online.wsj.com/news/articles/SB10001424052702303482504579179251139447562

El govern de Hong Kong s'ha resistit fortament a acceptar els crítics que suggereixen que els seus esforços per frenar l'activitat del mercat immobiliari local perjudica la seva reputació de polítiques de lliure mercat i pro-creixement . Potser és hora que s'ho pensin de nou. Vegin el nou informe que mostra que la intromissió del govern en aquest mercat està danyant el clima dels negocis en el Territori .

Encara que Hong Kong figura en el segon lloc en l'informe Doing Business 2014 del Banc Mundial, publicat la setmana passada, la posició d’aquest territori a la categoria "facilitat per registrar propietat" es va desplomar del lloc 60 al 89. La caiguda reflecteix l'increment fins al 7,5% al febrer, un 100%, de les taxes aplicables a les transaccions immobiliàries comercials (no d'habitatges). El govern ha pres aquesta decisió després de diversos intents per refredar el mercat residencial amb impostos especials que simplement van desviar el capital al mercat no residencial.

L'informe Doing Business ressalta el que aquests impostos signifiquen per a petites i mitjanes empreses en termes pràctics. De mitjana, la transferència d'una propietat comercial ara costa el 7.7% del seu valor després d'afegir impostos i taxes. Abans que entrés en vigor la nova taxa estava en el 4%, si bé només és aplicable a les transaccions de més quantia. Encara que altres aspectes de la política econòmica de HK són pro-creixement , això representa un innecessari cost afegit sobre les petites empreses , que solien ser les més beneficiades de la senyera política de Honk Kong de mínima interferència en l'economia .

Això hauria de ser una crida al govern, el qual ha intentat argumentar des del començament, en aquest assumpte de la nova taxa, que aquestes mesures eren excepcionals i afectarien només als immobles. Els crítics van advertir en aquell temps, 2010, que la primera taxa especial sobre propietats residencials posaria al Territori en una pendent relliscosa per l'abandonament del que un antic ministre d'economia anomenava "no intervencionisme decidit". Com a resposta, el portaveu del govern, Michael Wong, va escriure una carta al director d'aquest diari prometent que el nou impost "no tindria més implicacions per a les polítiques de baixos impostos pro-empreses", qualificant les crítiques com "clarament de magnitud incorrecta".

La relliscada del govern cap els impostos especials per a la propietat comercial ha demostrat que els crítics tenien raó i l'informe del Banc Mundial indica que les petites empreses estan pagant el preu d'aquesta ficada de pota. Per mor dels emprenedors del Territori, és hora que el govern de HK porti de nou les seves polítiques immobiliàries al decidit “no-intervencionisme” que funciona tan bé en altres sectors de l'economia.

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Original, etc.: http://www.bipartisanalliance.com/2013/11/el-coste-del-intervencionismo-en-hong.html  

El coste del intervencionismo en Hong Kong

El coste del intervencionismo en Hong Kong. WSJ Editorial

En contra de las afirmaciones del gobierno, las tasas dificultan más los negocios a las pequeñas compañías.
Wall Street Journal, Nov. 5, 2013 11:16 a.m. ET
Translation of  The Cost of Hong Kong's Interventionism to Spanish
http://online.wsj.com/news/articles/SB10001424052702303482504579179251139447562

El gobierno de Hong Kong se ha resistido fuertemente a aceptar a los críticos que sugieren que sus esfuerzos por frenar la actividad del mercado inmobiliario local perjudica su reputación de políticas de libre mercado y pro-crecimiento. Quizá es hora de que se lo piensen de nuevo. Vean el nuevo informe que muestra que la intromisión del gobierno en ese mercado está dañando el clima de los negocios en el Territorio.

Aunque Hong Kong figura en el segundo lugar en el informe Doing Business 2014 del Banco Mundial, publicado la semana pasada, la posición del Territorio en la categoría "facilidad para registrar propiedad" se desplomó del puesto 60 al 89. La caída refleja el incremento hasta el 7.5% en febrero, un 100%, de las tasas aplicables a las transacciones inmobiliarias comerciales (no de viviendas). El gobierno ha tomado esa decisión después de varios intentos por enfriar el mercado residencial con impuestos especiales que simplemente desviaron el capital al mercado no residencial.

El informe Doing Business resalta lo que esos impuestos significan para pequeñas y medianas empresas en términos prácticos. En promedio, la transferencia de una propiedad comercial ahora cuesta el 7.7% de su valor tras añadir impuestos y tasas. Antes de que entrase en vigor la nueva tasa estaba en el 4%, si bien solo es aplicable a las transacciones de mayor cuantía. Aunque otros aspectos de la política económica de HK son pro-crecimiento, esto representa un innecesario coste añadido sobre las pequeñas empresas, que solían ser las mayores beneficiadas de la señera política hongkonesa de mínima interferencia en la economía.

Esto debería ser un llamamiento al gobierno, que ha intentado argumentar desde el principio de sus escarceos en el asunto de la nueva tasa que estas medidas eran excepcionales y afectarían solo a los inmuebles. Los críticos advirtieron en aquel entonces, 2010, que la primera tasa especial sobre propiedades residenciales pondría al Territorio en una pendiente resbaladiza por el abandono de lo que un antiguo ministro de economía llamaba "no intervencionismo decidido". Como respuesta, el portavoz del gobierno, Michael Wong, escribió una carta al director de este periódico prometiendo que el nuevo impuesto "[no tendría más implicaciones para las políticas de bajos impuestos, pro-empresas]", calificando las críticas como "[claramente de magnitud incorrecta]".

El deslizamiento del gobierno hacia los impuestos especiales para la propiedad comercial ha demostrado que los críticos tenían razón y el informe del Banco Mundial indica que las pequeñas empresas están pagando el precio de esta metedura de pata. Por mor de los emprendedores del Territorio, es hora de que el gobierno de HK lleve de nuevo sus políticas inmobiliarias al decidido no intervencionismo que funciona tan bien para otros sectores de la economía.

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Translation to Catalonian: http://www.bipartisanalliance.com/2013/11/el-cost-de-lintervencionisme-hong-kong.html

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The Cost of Hong Kong's Interventionism
Contrary to the government's claims, stamp duties are making it harder for small firms to do business in the city.WSJ, Nov. 5, 2013 11:16 a.m. ET
http://online.wsj.com/news/articles/SB10001424052702303482504579179251139447562

Hong Kong's government has steadfastly resisted any suggestion that its efforts to curb the local property market dent its reputation for free-market, pro-growth policies. Maybe it's time they reconsidered. Witness a new report showing that government meddling in property is harming the territory's business climate.

Although Hong Kong ranked second in the World Bank's 2014 Doing Business study released last week, the territory's rank in the ease-of-registering-property category plummeted to 89th from 60th. The drop traces to Hong Kong's doubling of stamp duty on commercial property transactions to 7.5% in February. The government levied this after its earlier attempts to cool the residential market with special taxes merely shunted capital into the commercial real-estate market.

The Doing Business report highlights what these taxes mean to small- and medium-sized businesses in practical terms. On average it now costs 7.7% of a property's value to transfer a commercial property when you include fees and taxes. That's up from 4% before the special stamp duty was implemented, though the duty only applies to larger transactions. Even though other aspects of Hong Kong's economic policies are solidly pro-growth, this represents a needless cost on small firms. They used to be among the biggest beneficiaries of Hong Kong's longstanding policy of minimal interference in the economy.

This should be a wake-up call to the government, which has tried to argue since the beginning of its stamp-duty forays that the measures were unique and would affect only property. Critics warned at the time that the first special duty on residential properties in 2010 put the territory on a slippery slope from its history of what a former financial Secretary called "positive noninterventionism." In response, government spokesman Michael Wong wrote a Letter to the Editor of this paper promising that the new tax would not have "wider implications for the territory's low-tax and business-friendly policies," calling these suggestions "well wide of the mark."

The government's slide into special duties on commercial property proved the critics right, and the World Bank report suggests small businesses are paying the price for this property fumble. For the sake of the territory's entrepreneurs, it's time Hong Kong's government returned its real-estate policies to the positive noninterventionism that works so well in other corners of the economy. 

When he was in power, he was unreasonable and arrogant and considered citizens' rights and the law to be nothing

Rejection of Bo Xilai's Appeal Concludes Chinese Drama. By Jeremy Page
'This Is the Final Verdict,' Court Says om Widely Expected RulingWall Street Journal, Oct. 25, 2013 9:51 a.m. ET
http://online.wsj.com/news/articles/SB10001424052702304799404579157354280260862



Edited:

Mr. Bo burnished his political reputation there by presiding over a sweeping campaign against organized crime that many lawyers and rights activists say disregarded legal norms and [other things we won't mention in this blog.]

"When he was in power, he was unreasonable and arrogant and considered citizens' rights and the law to be nothing," wrote Zhou Yongkun, a professor at Suzhou University's law school, on his microblog.

"As soon as he became a prisoner, he realized the importance of rights, and that the law was his umbrella. But it was too late."

Liquidity stress testing: a survey of theory, empirics and current industry and supervisory practices

Liquidity stress testing: a survey of theory, empirics and current industry and supervisory practices
BCBS Working Papers No 24

October 2013

http://www.bis.org/publ/bcbs_wp24.htm

Stress-testing is an important tool in developing a complete picture of an institution's liquidity risk profile. What constitutes a good stress test is, however, not universally clear. Practices still differ widely, not only in the supervisory community, but also in the banking industry. The Research Task Force's Workgroup on Liquidity Stress-Testing was mandated to draft a survey on current practices, identify gaps and - where possible - suggest ways forward.

This survey has been written with the broader supervisory community in mind. The Workgroup believes this would include a wide range of functions: for example, micro-prudential line supervisors, staff of supervisory institutions involved with liquidity stress tests, macroprudential regulators and supervisors. Many of the findings are, however, also relevant for risk managers in banks, given their role in measuring their institution's liquidity risk profile and enforcing risk limits. The key messages could also be helpful in future efforts to develop more guidance with regard to liquidity stress-testing.

Hong Kong's Policies of Impoverishment - A poverty line is another step on Hong Kong's road to serfdom

Hong Kong's Policies of Impoverishment. WSJ Editorial
A poverty line is another step on Hong Kong's road to serfdom.WSJ, Oct. 14, 2013 1:02 p.m. ET
http://online.wsj.com/news/articles/SB10001424052702304106704579134973249439240

Hong Kong's decision to create a poverty line puts us in mind of John Cowperthwaite, financial secretary from 1961-71 and one of the chief architects of the territory's free-market system. Sir John famously refused to collect basic economic data on the grounds that statistics only increased the temptation for government to meddle. An arbitrary measure of poverty is a perfect example, since it encourages policies that will undermine the social mobility and economic growth needed to reduce poverty.

Hong Kong's new poverty line was set at one half the median income, which means that 20% of the population is considered poor. The most obvious objection to such a cut-off is that the number of poor will remain relatively stable regardless of their real conditions. If the government gives out money, this will tend to raise the median income and hence the poverty line, necessitating yet more handouts.

Then there's the problem of using income to measure poverty, since many residents, especially the elderly, live on their savings. Those without savings may rely on help from family members. So while poverty is a real problem in Hong Kong that deserves attention, this poverty line is a crude attempt to quantify it.

Nevertheless, many politicians in both the pro-Beijing and pro-democracy camps are eager to expand Hong Kong's small welfare state, and they will no doubt use this new tool to lobby for more benefits. Also, in 2011 a minimum wage came into effect, with the reassurance that it was set low enough to minimize job losses. Now the poverty line is a talking point for raising the minimum wage.

Those in favor of tempering Hong Kong's capitalism with socialist institutions common in the West often argue that they will do less harm since the territory's population has a strong work ethic and the government budget is in surplus. They little consider that these are the results of Sir John's laissez faire framework.

Ironically, the Chinese Communist Party appreciates Hong Kong's capitalist strengths more than local leaders. In the 1990s, after the last British Governor Chris Patten increased social welfare spending 88% in five years, Chinese diplomats warned that "Eurosocialist" policies were like "putting people on a F1 racing car which runs so fast it crashes and kills all its passengers."

Zhou Nan, Beijing's representative in the territory, complained, "The price of the future Special Administrative Region government being forced to live beyond its means would be budgetary imbalance, tax hikes, reduced financial market liquidity which will result in eroded foreign investors' confidence." Sir John couldn't have said it better himself.

Mustafa Alani: "We are learning from our enemies now how to treat the United States."

Our Former Friends the Saudis. WSJ Editorial
So how is that vow to repair America's frayed alliances working out?
Oct. 22, 2013 7:13 p.m. ET
http://online.wsj.com/news/articles/SB10001424052702303902404579151573907253280

President Obama likes to boast that he has repaired U.S. alliances supposedly frayed and battered by the Bush Administration. He should try using that line with our former allies in Saudi Arabia.

As the Journal's Ellen Knickmeyer has reported from Riyadh in recent weeks, the Kingdom is no longer making any secret of its disgust with the Administration's policy drift in the Middle East. Last month, Prince Turki al Faisal, the former Saudi ambassador in Washington, offered his view on the deal Washington struck with Moscow over Syria's chemical weapons.

"The current charade of international control over Bashar's chemical arsenal," the Prince told a London audience, "would be funny if it were not so blatantly perfidious, and designed not only to give Mr. Obama an opportunity to back down, but also to help Assad butcher his people." It's a rare occasion when a Saudi royal has the moral standing to lecture an American President, but this was one of them.

On Monday, Ms. Knickmeyer reported that Saudi intelligence chief Prince Bandar has decided to downgrade ties with the CIA in training Syrian rebels, preferring instead to work with the French and Jordanians. It's a rare day, too, when those two countries make for better security partners than the U.S. But even French Socialists are made of sterner stuff than this Administration.

Bandar's decision means the Saudis will not be inclined to bow any longer to U.S. demands to limit the arms they provide the rebels, including surface-to-air missiles that could potentially be used by terrorists to bring down civilian planes. The Saudis have also told the U.S. they will no longer favor U.S. defense contractors in future arms deals—no minor matter coming from a country that in 2011 bought $33.4 billion of American weapons.

Riyadh's dismay has been building for some time. In the aborted build-up to a U.S. strike on Syria, the Saudis asked the U.S. to beef up its naval presence in the Persian Gulf against a potential Iranian counter-strike, only to be told the U.S. didn't have the ships. In last year's foreign policy debate with Mitt Romney, Mr. Obama was nonchalant about America's shrinking Navy, but this is one of the consequences of our diminishing military footprint: U.S. security guarantees are no longer credible.

Then there is Iran. Even more than Israel, the Saudis have been pressing the Administration to strike Iran's nuclear targets while there's still time. Now Riyadh is realizing that Mr. Obama's diplomacy is a journey with no destination, that there are no real red lines, and that any foreign adversary can call his bluff. Nobody should be surprised if the Saudis conclude they need nukes of their own—probably purchased from Pakistan—as pre-emptive deterrence against the inevitability of a nuclear Tehran.

The Saudis are hardly the first U.S. ally to be burned by an American President more eager to court enemies than reassure friends. The Poles and Czechs found that out when Mr. Obama withdrew ballistic-missile defense sites from their country in 2009 as a way of appeasing the Russians.

The Syrian people have learned the hard way that Mr. Obama does not mean what he says about punishing the use of chemical weapons or supplying moderate rebel factions with promised military equipment. And the Israelis are gradually realizing that their self-advertised "best friend" in the White House will jump into any diplomatic foxhole rather than act in time to stop an Iranian bomb.

Now the Saudis have figured it out, too, and at least they're not afraid to say it publicly. "They [the Americans] are going to be upset—and we can live with that," Saudi security analyst Mustafa Alani told Ms. Knickmeyer last month. "We are learning from our enemies now how to treat the United States."

Arab Countries in Transition - Economic Outlook and Key Challenges - Deauville Partnership Ministerial Meeting

Arab Countries in Transition - Economic Outlook and Key Challenges - Deauville Partnership Ministerial Meeting
IMF Policy Paper, October 10, 2013
http://www.imf.org/external/pp/longres.aspx?id=4818

Summary: In an environment of heightened socio-economic tensions, regional insecurity, and strained public finances, the Arab Countries in Transition (ACTs) 1 face the difficult task of delivering on the expectations for jobs and growth. Despite patchy improvements in some countries, economic growth remains subdued, private investment is weak, and external and fiscal buffers are running low. Fostering social cohesion and avoiding a downward spiral of economic and political malaise calls for urgent implementation of economic reforms and coordinated support from the international community.


Regional economic outlook and key challenges (edited)
In an environment of heightened socio-economic tensions, regional insecurity, and strained public finances, the Arab Countries in Transition (ACTs, Egypt, Jordan, Libya, Morocco, Tunisia, and Yemen) face the difficult task of delivering on the expectations for jobs and growth. Despite patchy improvements in some countries, economic growth remains subdued, private investment is weak, and external and fiscal buffers are running low. Fostering social cohesion and avoiding a downward spiral of economic and political malaise calls for urgent implementation of economic reforms and coordinated support from the international community.

A. Background and recent developments
Three shocks undermine sentiment. The economic situation in the ACTs has become increasingly difficult amid a still weak external environment, rising regional tensions stemming largely from the civil war in Syria, and heightened domestic political uncertainty in many countries, at times accompanied by violence. As a result, private sector sentiment has worsened, private sector activity remains subdued, and private investment, particularly foreign direct investment, has slowed.

Growth is low and unemployment is rising. Average growth (excluding Libya) is expected to inch up to 3 percent in 2013 from 2½ percent in 2012, with the marginal pick-up reflecting a nascent recovery of tourism and exports, increased post-crisis capacity utilization, and a post-drought rebound of agriculture in Morocco. This moderate growth is not generating the jobs needed to stem the rise in the number of unemployed, which has increased by more than 1 million people since early 2010.

Progress with reforms has been uneven, further straining public finances. Budget deficits remain elevated, averaging 9 percent of GDP in 2012(excluding Libya) owing to weak revenue collection and weaker-than-expected fiscal consolidation efforts. In Egypt and Jordan, high levels of public debt (more than 80 percent of GDP) further limit fiscal space. Meanwhile, inflation pressures have begun to ease in most ACTs helped by lower food and energy prices and weak demand. Foreign exchange reserves have stabilized for now, reflecting a gradual narrowing of current account deficits and, notably in Egypt, external financial support. Nevertheless, reserve buffers remain low relative to the underlying vulnerabilities.


B. Short-term outlook
Private investment and growth are anemic. The current challenges faced by the ACTs are likely to persist over the near term. Revitalizing private sector activity will require political stability and strong policy efforts to improve the business climate. This will take time. Meanwhile, we expect only a gradual recovery in 2013–14, with average GDP growth at about 3 percent. Inflation is expected to stabilize in the upper single digits and the current account and fiscal deficits could begin to narrow gradually, but will remain elevated. Consequently, public debt and unemployment in most countries are likely to continue creeping up.

Significant downside risks. Risks to this already sobering outlook are significant, and mostly to the downside. The Syrian crisis, recent domestic political tensions, and incidences of increasing violence have the potential to intensify further and bring growth to a halt. This would have strongly negative consequences for labor markets in the region. First, an increased flow of refugees could overburden budgets of Syria’s neighboring countries, while damaging trade, confidence, and growth in the region more broadly. Equally damaging could be setbacks to the political transitions as well as an escalation of violence in Libya, Tunisia, Egypt, or Iraq, which would further delay economic reforms and deter investment. In some countries, new disruptions to energy supplies (for example, oil production in Libya or Jordan’s gas imports from Egypt) would take a toll on fiscal and external positions. Finally, and with somewhat lower probability, weaker global—notably European—growth could slow recovery of exports and foreign inflows.

Maurice Greenberg: State and federal agencies are hurting shareholders and undermining confidence in the banking system

The Regulatory Attack on J.P. Morgan Feels Familiar. By Maurice Greenberg
State and federal agencies are hurting shareholders and undermining confidence in the banking system.http://online.wsj.com/article/SB10001424052702303464504579109563311240116.
The Wall Street Journal, October 3, 2013, on page A13

A thriving financial-services sector requires a delicate balance of regulation and risk management. Realizing how vital this industry's health is to the economy, regulators and private businesses have spent the past century trying to create a system that ensures stability while encouraging investment. Responsible regulators understand just how difficult this is to accomplish. Others who ignore that reality often keep markets from functioning properly.

Regulators can help minimize risk to the investing public by learning from past regulatory mistakes. But it doesn't appear that they have. Now they're after J.P. Morgan Chase Co., a great American company led by arguably the best chief executive on Wall Street.

I experienced regulatory overreach first-hand at AIG. For nearly four decades, I led a team that included some of the most honorable and competent professionals in the insurance industry. We built the world's largest and most respected insurer, employing more than 90,000 people and opening markets across the world. That made AIG an attractive target for Eliot Spitzer, then New York's attorney general, in 2005.

Displaying an astonishing lack of knowledge of the insurance industry, Mr. Spitzer, by threatening to criminally indict the company, succeeded in separating the industry's most accomplished group of executives from a company that insured virtually every business sector across 130 countries. The replacement management took steps that made AIG vulnerable to the world-wide financial collapse of 2008. That provided a set of federal regulators with the opportunity to seize tens of billions of dollars from AIG's shareholders.

Nearly all of Mr. Spitzer's original allegations of accounting irregularities have been discarded or quietly dismissed by him and his successors. The remaining claims—on which no damages are sought—involve the accounting for reinsurance transactions that were not material to AIG. The real scandal, of course, is the fact that the attorney general brought this lawsuit and continues to prosecute it even today.

History seems to be repeating itself with the case of J.P. Morgan. The global bank is now under siege by federal and state regulators. The most ironic claim against J.P. Morgan is an allegation from current New York Attorney General Eric Schneiderman of mortgage fraud at Bear Stearns that allegedly took place prior to J.P. Morgan's acquisition of that firm. J.P. Morgan acquired Bear Stearns at the urging of federal officials who feared that fallout from Bear's collapse would damage the entire economy.

Like AIG, J.P. Morgan plays a central role in both the U.S. and world economies. There are no more than a handful of executives with the requisite experience, talent and intelligence to lead that bank. Its chief executive, James Dimon, is one of those rare individuals. By diverting his attention from his responsibilities, government officials are hurting shareholders, pension funds, countless employees, the City of New York, and the national and global economy—not to mention undermining confidence in our banking system.

Those regulators have pushed their dubious claims to the point of requiring the bank to pay over $11 billion in fines. I hope the board of directors at J.P. Morgan will have the wisdom and courage to support their CEO and not cave to demands from regulators that can only harm the company and its stakeholders. That would send a strong message to the nation's business community and allow J.P. Morgan to continue to benefit from Mr. Dimon's leadership.

I have spent my entire career opening markets in China, Eastern Europe and across the world. When we took AIG public in 1969, we chose New York as the company's place of business because the state offered a predictable regulatory environment. And yet what I see in New York and Washington is a regulatory culture that seems manifestly determined to make this state and nation the last places where any responsible CEO would want to do business. Incredible as it seems, federal and state regulators are now negotiating for their share of the "credit"—their cut of the cash—for the damage they are currently inflicting on J.P. Morgan, competing with one another to inherit Spitzer's "Sheriff of Wall Street" title. Some people never learn.

Mr. Greenberg is chairman and CEO of C.V. Starr & Co.

IMF: Key Aspects of Macroprudential Policy + Implementing Macroprudential Policy/Selected Legal Issues

Key Aspects of Macroprudential Policy - Background Paper
IMF, June 10, 2013
http://www.imf.org/external/pp/longres.aspx?id=4804

Summary

The countercyclical capital buffer (CCB) was proposed by the Basel committee to increase the resilience of the banking sector to negative shocks. The interactions between banking sector losses and the real economy highlight the importance of building a capital buffer in periods when systemic risks are rising. Basel III introduces a framework for a time-varying capital buffer on top of the minimum capital requirement and another time-invariant buffer (the conservation buffer). The CCB aims to make banks more resilient against imbalances in credit markets and thereby enhance medium-term prospects of the economy—in good times when system-wide risks are growing, the regulators could impose the CCB which would help the banks to withstand losses in bad times.


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IMF: Implementing Macroprudential Policy - Selected Legal Issues
IMF, June 10, 2013
http://www.imf.org/external/pp/longres.aspx?id=4802

Summary
As countries design and implement macroprudential policies, they face the challenge of determining what—if any—changes need to be made to their legal and institutional framework to ensure that these policies are effective. Based on a review of experience, it is clear that there are a variety of approaches that can be taken by members, in light of the legal constraints and institutional preferences of each country. Whichever approach is followed, a number of issues need to be addressed when designing legislation in this area, both with respect to the substantive legal provisions and the allocation of institutional responsibilities. As background to ”Key Aspects of Macroprudential Policy“, this paper provides an overview of these legal and institutional issues, while recognizing that macroprudential policy is an area that is still evolving.

Financial Inclusion for Financial Stability: Improving Access to Deposits and Bank Resilience in Sync

Financial Inclusion for Financial Stability: Improving Access to Deposits and Bank Resilience in Sync. By Martin Melecky
World Bank Blogs
Tue, Sep 10, 2013
http://blogs.worldbank.org/allaboutfinance/financial-inclusion-financial-stability-improving-access-deposits-and-bank-resilience-sync

From 2006 to 2009, growth of bank deposits dropped by over 12 percentage points globally. The most affected by the 2008 global crisis were upper middle income countries that experienced a drop of 15 percentage points on average. Individual countries such as Azerbaijan, Botswana, Iceland, and Montenegro switched from deposit growth of 58 percent, 31 percent, 57 percent, and 94 percent in 2007 to deposit declines (or a complete stop in deposit growth) of -2 percent, 1 percent, -1 percent, -8 percent in 2009, respectively.

In times of financial stress, depositors get anxious, can run on banks, and withdraw their deposits (Diamond and Dybvig, 1983). Large depositors are usually the first ones to run (Huang and Ratnovski, 2011). By the law of large numbers, correlated deposit withdrawals could be mitigated if bank deposits are more diversified. Greater diversification of deposits could be achieved by enabling a broader access to and use of bank deposits, i.e. involving a greater share of adult population in the use of bank deposits (financial inclusion). Based on this assumption, broader financial inclusion in bank deposits could significantly improve resilience of banking sector funding and thus overall financial stability (Cull et al., 2012).

In the recent background paper for the World Development Report 2014 (Han and Melecky, 2013), we investigate the implications of a broader access to deposits for the dynamics of bank deposits during the global financial crisis. Namely, we analyze whether access to bank deposits by a larger share of a country’s population can help explain differences in the drop of deposit growth over 2007-2010 across our sample of 95 countries. We also separately estimate the differences in the relationship between the drop in deposit growth and access to deposits for low-income (LIC), middle-income (MIC), and high-income (HIC) countries.

Our paper responds to an existing gap in the empirical literature linking greater access to deposits with greater financial (banking sector) stability. While the literature postulates that an inclusive financial sector will have a more diversified, stable retail deposit base that can increase systemic stability, empirical research confirming existence of such a relationship, especially at the level of the financial system, is largely absent in the literature (Cull et al., 2012; Prasad, 2010).

We find that a broader access to and use of bank deposits can significantly mitigate bank deposit withdrawals or growth slowdowns in times of financial stress. Specifically, the estimated coefficient on the variables measuring access to deposits indicates that a 10 percent increase in the share of people that have access to bank deposits can mitigate the deposit growth drops (or deposit withdrawal rates) by about three to eight percentage points. While this finding holds for the entire sample of HICs, MICs, and LICs, it could be particularly strong in MICs, where a large share of population still lacks access to bank deposits, trust in banks is yet to be firmly established, and the integration in global financial flows is growing.

Our findings have important policy implications. Policy makers face tradeoffs when deciding whether to focus on reforms to promote financial development (financial inclusion, innovation, competition, etc.) or whether to focus on further improvements in financial stability (microprudential, macroprudential, business conduct supervision, etc.). However, synergies between promoting financial development and financial stability can also exist as shown in our paper.

We recommend that policy makers focus first on taking advantage of such synergies in their framework for financial sector policy. This framework is typically formulated in a national financial sector strategy which sets the development goals in finance, in view of systemic risk associated with achieving these goals and the risk preference of the country government. Namely, we argue that involving more people in the use of bank deposits could be beneficial for people, economic development, and stability of the financial system alike.

Drawing on our paper, the World Development Report 2014, in its chapter on the financial system, makes similar recommendations; namely, that countries should strive to promote a broader and responsible use of financial tools not only to aid economic development and poverty alleviation, but also to complement the mainstream (macroprudential) policies to enhance financial stability and prevent financial crises.

Again, these policy efforts, their synergetic effects, and the plan for their implementation, including the resulting responsibilities of different government agencies, should be clearly described in the national financial sector strategy. With proper regulation and oversight in place, initiatives such as Kenya’s M-PESA and M-KESHO projects (Demombynes and Thegeya, 2012) or South Africa’s Mzansi accounts (Bankable Frontier Associates, 2009) could serve as good examples of promoting a broader use of bank accounts (deposits) and enhancing the reliability of bank deposit funding at the same time.

References

• Bankable Frontier Associates. 2009. "The Mzansi Bank Account Initiative in South Africa." Report commissioned by FinMark Trust. Bankable Frontier Associates, Somerville, MA.
• Cull, Robert, Asli Demirguc-Kunt and Timothy Lyman. 2012. "Financial Inclusion and Stability: What Does Research Show?" CGAP Brief 71305, CGAP, Washington, DC.
• Demombynes, Gabriel and Aaron Thegeya. 2012. "Kenya's Mobile Revolution and the Promise of Mobile Savings." Policy Research Working Paper 5988. World Bank, Washington, DC.
• Diamond, Douglas W. and Philip H. Dybvig. 1983. "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy 91(3): 401­–19.
• Huang, Rocco, and Lev Ratnovski. 2011. "The Dark Side of Bank Wholesale Funding." Journal of Financial Intermediation 20: 248–263.
• Prasad, Eswar S. 2010. "Financial Sector Regulation and Reforms in Emerging Markets: An Overview." NBER Working Paper 16428, Cambridge, MA.

Margin requirements for non-centrally cleared derivatives - final report issued by the Basel Committee and IOSCO

Margin requirements for non-centrally cleared derivatives - final report issued by the Basel Committee and IOSCO
September 2, 2013

The Basel Committee on Banking Supervision and the International Organization of Securities Commissions (IOSCO) released today the final framework for margin requirements for non-centrally cleared derivatives. The framework is available on the websites of the Bank for International Settlements and IOSCO.

Under the globally agreed standards published today, all financial firms and systemically important non-financial entities that engage in non-centrally cleared derivatives will have to exchange initial and variation margin commensurate with the counterparty risks arising from such transactions. The framework has been designed to reduce systemic risks related to over-the-counter (OTC) derivatives markets, as well as to provide firms with appropriate incentives for central clearing while managing the overall liquidity impact of the requirements.

The final requirements have been developed taking into account feedback from two rounds of consultation (a July 2012 consultative paper and a February 2013 near-final proposal) as well as a quantitative impact study that helped inform the policy deliberations.

Compared with the near-final framework proposed earlier this year, the final set of requirements includes the following modifications:

• The framework exempts physically settled foreign exchange (FX) forwards and swaps from initial margin requirements. Variation margin on these derivatives should be exchanged in accordance with standards developed after considering the Basel Committee supervisory guidance for managing settlement risk in FX transactions.
• The framework also exempts from initial margin requirements the fixed, physically settled FX transactions that are associated with the exchange of principal of cross-currency swaps. However, the variation margin requirements that are described in the framework apply to all components of cross-currency swaps.
• "One-time" re-hypothecation of initial margin collateral is permitted subject to a number of strict conditions. This should help to mitigate the liquidity impact associated with the requirements.

A number of other features of the framework are also intended to manage the liquidity impact of the margin requirements on financial market participants. In particular, the requirements allow for the introduction of a universal initial margin threshold of €50 million below which a firm would have the option of not collecting initial margin. The framework also allows for a broad array of eligible collateral to satisfy initial margin requirements, thus further reducing the liquidity impact.

Finally, the framework published today envisages a gradual phase-in period to provide market participants with sufficient time to adjust to the requirements. The requirement to collect and post initial margin on non-centrally cleared trades will be phased in over a four-year period, beginning in December 2015 with the largest, most active and most systemically important derivatives market participants.

The Basel Committee and IOSCO acknowledge that the margin requirements are new to the market and that their precise impact will depend on a number of factors and market conditions that will only be realised over time as the requirements are put into practice. Accordingly, the Basel Committee and IOSCO will monitor and assess the impact of the requirements as they are implemented globally.

Review of Thomas Healy's The Great Dissent

What Democracy Requires. By Joshua
Review of Thomas Healy's The Great Dissent
Justice Holmes changed his mind about free speech—and rediscovered the original intent of the First Amendment.
The Wall Street Journal, August 23, 2013, on page C5
http://online.wsj.com/article/SB10001424127887324108204579022881137648134.html

In the working sections of the Supreme Court building in Washington, D.C., the quiet places where the justices have their chambers and the staffs go about their work, portraits of the former members of the court peer out from almost every room and hallway. I used to find myself, when I worked there some years ago, pausing beneath the past luminaries and wondering what they might have to say about the court's current cases.

I never got very far with Oliver Wendell Holmes (1841-1935). His portrait didn't invite inquiry. He sat straight-backed in his judicial robes, his lips pursed beneath a virile white mustache, eyes boring directly ahead. He conveyed simultaneously grandeur and skepticism, as if he might interrupt you at any moment to say, "That's nonsense." This is Holmes in his Solomonic pose, the man hailed as the "Master of Sentences," lionized in an early biography as the "Yankee from Olympus," his life made the subject of a 1950s Hollywood film. It was an image that Holmes spent nearly the whole of his adult life cultivating, driven on by his galloping ambition. "I should like to be admitted," he told a correspondent in 1912, "as the greatest jurist in the world."

Holmes would surely have approved of Thomas Healy's "The Great Dissent." The subtitle conveys the narrative's gist: "How Oliver Wendell Holmes Changed His Mind—and Changed the History of Free Speech in America." Mr. Healy recounts Holmes's emergence late in his career as a champion of free speech and tells the story of the coterie of young intellectuals, led by Felix Frankfurter and Harold Laski, who worked assiduously to shape Holmes's views. It is a fascinating tale—and a charming one, of an aging and childless Holmes befriended by a rising generation of legal thinkers, surrogate sons who persuade him over time to take up their cause.

Mr. Healy, a professor of law at Seton Hall, is at his best detailing the younger men's campaign to win Holmes to their view of the First Amendment. In March 1919, Holmes still believed that the government could punish "disloyal" speech and wrote an opinion supporting the 1917 Espionage Act, which made it illegal to criticize the draft or American involvement in World War I. In Debs v. United States, the Supreme Court unanimously upheld the prosecution of Socialist Party leader Eugene Debs for his critical statements about the war. Less than nine months later, Holmes had changed his mind, dramatically. In Abrams v. United States, he broke with his colleagues and with his own earlier views and argued that the Constitution didn't permit the government to punish speech unless it posed a "clear and present danger" of public harm. Laws penalizing any other type of public speech were unconstitutional. Holmes's Abrams opinion is the "great dissent" of Mr. Healy's title.

The youthful acolytes had made the difference. As Mr. Healy elaborates, Holmes had developed a knack for collecting young admirers in his years on the Supreme Court (1902-32). In 1919, Holmes's circle included Frankfurter, a junior professor at Harvard Law School serving in the Wilson administration, and the Englishman Harold Laski, just 25 and like Frankfurter a Jew and a teacher at Harvard. Both men would go on to illustrious careers—Frankfurter on the Supreme Court and Laski as a political theorist and chairman of the British Labour Party. Both admired Holmes for his modernist intellectual outlook: for his skepticism about moral absolutes and dislike of formal legal doctrine; and for what they believed (mistakenly) to be Holmes's progressive political views.

Even before the Debs case, Laski had been plying Holmes with arguments about free speech. After Holmes's disappointing opinion in that case, Laski redoubled his efforts, assisted by letters from Frankfurter and well-timed essays from the pair's allies at the New Republic magazine. As it happened, both Laski and Frankfurter suffered professionally in 1919 for their sometimes outspoken political views—both were briefly in danger of being dismissed from Harvard. Mr. Healy implies that their ordeal may have heightened Holmes's appreciation for free speech. But the more likely turning point came in the summer of 1919, when Laski forwarded to Holmes an article defending freedom of speech for its social value and then introduced Holmes to its author, another young Harvard law professor named Zechariah Chafee Jr.

Chafee, who was no sort of progressive and whose specialty was business law, argued that free speech advanced a vital social interest by promoting the discovery and spread of truth, which in turn allowed democracy to function. Holmes had never been much of a proponent of individual liberty, but he was profoundly committed to majoritarian democracy. Free speech as a social good was a rationale he could buy. And in his Abrams dissent a few months later, he did. He would eventually conclude that the First Amendment shielded speech from both federal and state interference.

Mr. Healy tells this conversion story well, bringing the reader into Holmes's confidence and into the uneasy, war-weary milieu of 1919 America. "The Great Dissent" is compelling, too, for the glimpses it gives of the human Holmes rather than the Olympian public figure. Here is Holmes standing at his writing desk to compose his court opinions, keeping them brief lest his legs tire; waxing rhapsodic each spring about the bloodroot flowers in Rock Creek Park. He was unfailingly decorous to his colleagues—even as he was indifferent to his wife—but quivered and fumed at the merest hint of criticism, unable to acknowledge that he had ever been mistaken about anything of importance.

All too often, however, Mr. Healy lapses into hagiography and an annoyingly Whiggish mode of storytelling, in which our modern free-speech doctrine —which protects the right of individuals and corporations to speak on most any topic at most any time—is portrayed as the Inevitable Truth toward which constitutional history has been marching all along. In this story, Holmes's embrace of free speech emerges as the very culmination of his life's work and its linchpin. "It was almost as if Holmes had been working toward this moment his entire career," Mr. Healy says triumphantly.

Not quite. Holmes's endorsement of free speech as a constitutional principle was far more ambivalent than Mr. Healy lets on and in considerable tension with the rest of his jurisprudence. This is precisely what makes it so interesting. Holmes's struggle to reconcile freedom of speech with his other legal ideas helped him to see connections that contemporary Americans are apt to miss.

Holmes made his name on the court as an advocate of judicial restraint. He thought courts should overturn the judgment of democratic legislatures in only the most extraordinary of circumstances. He was a skeptic. He believed law didn't have much to do with morality—"absolute truth is a mirage," he once said—or even logic. As he saw it, law was nothing more than "the dominant opinion of society." The Constitution placed no firm bounds on the right of the majority to do as it pleased. It was "made for people of fundamentally differing views," he said. The majority could choose the view and pursue the policies it wanted, for the reasons it wanted.

All this being true, the judiciary had no business substituting its views for those of the public. If law was based merely on opinion and raw preference, the people's preferences should count, not judges'.

How then did Holmes come to hold that the First Amendment could be used to strike down laws of Congress and even of the states? The answer is that Holmes came to see the principle of free speech as an essential part of majority rule; it was valuable because it helped majorities get their way.

Mr. Healy notes the influence on Holmes of Chafee's "social argument" for free speech but fails to explain just how central it was to his conversion experience. In his dissenting opinion in Abrams, Holmes wrote: "The best test of truth is the power of the thought to get itself accepted in the competition of the market." Truth was whatever the majority thought it was, but if the majority was going to make up its mind in a sensible way, it needed to have as many options before it as possible. Then too, majorities changed their minds, and protecting speech that was unpopular now preserved opinions that the majority might come to favor in the future. "The only meaning of free speech," Holmes wrote in 1925, is that every idea "be given a chance" to become in time the majority creed.

Such reasoning tethered free speech to majority rule, but it was less than perfectly consistent. Even as he valorized the right to speak, Holmes continued to insist that "the dominant forces in the community" must get what they wanted. Yet if free speech were to mean anything at all as a constitutional right, it would mean that majorities could not get their way in all circumstances. From time to time, Holmes recognized as much; in one of his last opinions he wrote that the "principle of free thought" means at bottom "freedom for the thought we hate." How forcing the majority to tolerate speech it hated facilitated that same majority's right to have its way is a formula Holmes never quite explained.

Mr. Healy suggests that with Holmes's dissent in Abrams, the modern era of First Amendment law had arrived. But Holmes's majoritarianism didn't prevail as the principal rationale for free speech at the Supreme Court, which has instead emphasized individuals' right to speak regardless of the social interests involved. Still, for all its internal tensions, Holmes's unfinished view—he continued to puzzle over the problem right through his retirement from the court in 1932—captures something that the contemporary adulation of free speech has hidden.

Holmes saw that the Constitution's commitment to freedom of speech is inextricably bound up with the project of self-government that the Constitution was designed to make possible. That project depends on an open exchange of ideas, on discussion between citizens and their representatives, on the ability of everyday Americans to talk and reason together.

This sort of government is a way of life, and the First Amendment helps makes it possible by prohibiting the state from censoring the organs of social communication. The government may not control newspapers or printing presses or stop citizens from stating their views. Government may not halt the dissemination of ideas.

In the past half-century, however, the Supreme Court has increasingly spoken of the right to free speech as a right to free expression. Under that rubric, it has expanded the First Amendment to cover all manner of things unconnected to public life, be it art or pornography or commercial advertising. This trend has been even more pronounced in popular culture, where the right to express oneself is now widely regarded as the essence of the freedom to speak.

And to be sure, individual expression is a valuable thing. The danger is in coming to think of free speech as merely expression. That reductionism encourages Americans to see freedom of speech, and freedom generally, as mainly about the pursuit of private aims. But in the end, such thinking represents a loss of confidence, or worse, a loss of interest in the way of living that is self-government—in the shared decisions and mutual persuasion that is how a free people makes a life together. Ours is a country saturated with talk and shouted opinions and personal exhibitionism but one less and less interested in the shared civil discourse that democracy requires.

Holmes wouldn't have described free speech or self-government in such elevated terms. He was too much the skeptic for that. But he came to understand, in his own way, the profound value of free speech to a free people. The story of this discovery is worth revisiting.

—Mr. Hawley, an associate professor of law at the University of Missouri and former judicial clerk to Chief Justice of the United States John G. Roberts Jr., is the author of "Theodore Roosevelt: Preacher of Righteousness" (2008).