donald l kohn : monetary policy perspectives on risk premiums in financial markets remarks by mr donald l kohn, member of the board of governors of the us federal reserve system, at the financial market risk premiums conference, federal reserve board, washington dc, 21 july 2005. * * * i am pleased to have an opportunity to participate in this conference on the time variation and macroeconomic links of financial market risk premiums. steven sharpe, paul harrison, and hao zhou are to be congratulated for putting together an interesting program that should advance our understanding of this important topic. although your papers concentrate on the equity premium, i would like to take a few minutes today to broaden the discussion to encompass risk premiums in other markets and to highlight the connections between risk premiums and monetary policy. my goal is not to draw conclusions on recent movements in risk premiums but rather to give you a sense of how estimates of risk premiums may influence our policy decisionmaking, to note some of the difficulties that we face in interpreting their movements, and, i hope, to stimulate further research in this already fertile field. 1 at the federal reserve, we pay a lot of attention to financial market prices in the formulation of monetary policy. financial markets are the channel through which our policy affects the economy, and asset prices contain valuable information about investors'expectations for the course of policy, economic activity, and inflation, as well as about the risks around those expectations. an important element in interpreting financial market prices is the identification of the risk premiums they contain. to be clear, when i say " risk premium " i mean the additional compensation required by investors for holding a risky security - - that is, one with uncertain returns - - above the compensation that would be demanded by risk - neutral investors who care only about expected returns. for example, while a risk - neutral investor would demand a certain spread on a junk bond over a risk - free rate of the same maturity as compensation for expected losses, a risk - averse investor likely requires an even wider spread depending on the covariance characteristics of the bond's total return. in the treasury market, risk - - or term - - premiums are generally evident as maturities extend and reflect mostly the interaction of risk aversion and uncertainty about the future path of interest rates. when applied to credit markets, the term " risk premium " is sometimes used in a broader sense to include expected losses, but i am thinking of risk premium

dependence on sources of tax revenue such as stamp duties, capital gains tax and corporation profits tax made total tax revenues dependent to an exceptional degree on profitable economic conditions, high transactions in the property market and asset price appreciation ( chart 2 ). all tax systems tend to do better in such conditions, but the elasticity of tax revenue response to a return to more normal conditions was exceptionally high in ireland. of course tax revenues have slumped, and expenditure has soared in all of the countries affected by the global downturn of 2008 – 9 and the slow recovery that is now in process. ( the taxes and spending programmes that behave in this way are normally seen as stabilizing, and indeed are called the automatic stabilizers. ) but the deterioration in ireland ’ s fiscal position has been worse than almost any other country. partly of course this reflects the fact that ireland ’ s home - grown property bubble had risen further and so has fallen further than most ( chart 3 ). but it also reflects the heightened elasticity of the tax receipts. interestingly, when you plot tax and current expenditure as a percentage of gdp, you might miss this ( chart 4 ), masked as it is by the scale of the collapse in gdp – tax receipts fell even faster despite big increases in rates and base especially in income tax as the government tried to make up for the shortfalls elsewhere. that is one of the main reasons why ireland ’ s exposed fiscal position, with which the government has been struggling for the past two and a half years and which will be the subject of intensified corrective action to be set out in detail in the promised 4 year fiscal programme to be announced shortly, is so exceptional. chart 2 chart 3 chart 4 how could one use accounting numbers to improve the usefulness of the sgp for ensuring sustainable public finances? i have some ideas on this to which i will return after i speak a little about accounting and the irish banks. a full account of the government finances is not complete in ireland without considering the banks. over the past year or more there has been intense interest in figuring out what will be the total cost of the losses incurred in the property bubble. indeed this has been a focus of attention worldwide, with for example the imf ’ s world economic outlook report devoting attention to the issue in each of its five semi - annual reports between april 2008 and april 2010. interestingly, the estimated losses for the global financial system from this source have oscillated, growing from the first