Economix Meets the Gales of Change

Creative destruction, an economic theory credited to Joseph Schumpeter, posits that institutions are destroyed so that new institutions can grow and flourish.

This blog, Economix, is perhaps another example of Schumpeter’s gale. Its five-and-a-half-year run as the location for insights into everything economic has come to an end. But in its place will rise a new site, The Upshot, which will be a plain-spoken guide to politics, policy and, importantly, economics. The brainchild of David Leonhardt, one of the founders of Economix, it will carry on the best practices of Economix: “illuminate and distill a discussion, rather than muddy it.”

That is how Economix described its mission in its inaugural post in September 2008 in the depths of the Great Recession. The blog took the talents of the economic reporters of The New York Times and added prominent economists to the mix.

The Upshot will remain a prominent platform for writing on the science of everyday life. We have hired Neil Irwin, a Washington Post economics writer and author of “The Alchemists: Three Central Bankers and a World on Fire,” and Josh Barro, an MSNBC commentator and a former writer for Business Insider and Bloomberg View. Claire Cain Miller, formerly a Times technology reporter, will be a full-time presence. Annie Lowrey, Binyamin Appelbaum, Nelson Schwartz, Eduardo Porter, Shaila Dewan and Floyd Norris, The Times’s economic team, will frequently add their thoughts. Several regular contributors to Economix will continue: Jared Bernstein, Phillip Swagel and Uwe Reinhardt, who was with Economix from the beginning.

The Upshot will also feature the thoughts of several more provocative economists, including Sendhil Mullainathan, a Harvard economics professor, and Justin Wolfers, professor of economics and public policy at the University of Michigan.

Aaron Carroll and Austin Frakt â€" who write about health policy on the Incidental Economist blog â€" have also joined The Upshot. Dr. Carroll is a professor of pediatrics at the Indiana University School of Medicine whose research bridges information technology, medical decision making, medical ethics and health policy. Mr. Frakt is an economist with appointments at VA Boston Healthcare System, Boston University and the Leonard Davis Institute of the University of Pennsylvania.

It’s quite a team.

Thank you for reading Economix through the years, and for your comments and arguments. (Rest assured, everything will remained archived on the Times site.) And please follow us at The Upshot.

Mortgage Reform Is Worth the Small Extra Cost to Borrowers

Phillip Swagel is a professor at the School of Public Policy at the University of Maryland and was assistant secretary for economic policy at the Treasury Department from 2006 to 2009.

In the current housing financing system, shareholders and management of Fannie Mae and Freddie Mac got the considerable profits in good times, and when the housing market collapsed, taxpayers were stuck with the bill â€" a $190 billion tab in the recent crisis.

A Senate proposal for a new system would have private investors rather than taxpayers take on most of the risks and returns involved with mortgage lending â€" if a misguided obsession with the small additional cost to borrowers doesn’t sink the reforms.

The proposal put forward recently by Senators Tim Johnson, Democrat from South Dakota, and Michael Crapo, Republican from Idaho, who lead the Senate banking committee, would bring about a housing finance system driven first and foremost by market incentives rather than by government dictates.  There are many pieces to the proposal, including support for affordable housing and an innovative approach by which to reward financial firms that serve a broad range of customers and penalize those that do not.

But reducing the government involvement in housing finance and bringing back private capital is at the heart of the bill, which would end the anomalous situation in which the housing finance giants Fannie Mae and Freddie Mac are private companies that earn enormous profits but remain under the control of a government regulator.

Building on an earlier effort by Senators Bob Corker, Republican from Tennessee, and Mark R. Warner,  Democrat from Virginia, the Crapo-Johnson legislation reduces taxpayer exposure to housing risk by requiring private investors to risk their own capital in an amount equal to 10 percent of the value of the mortgages receiving a government guarantee. The government would then sell secondary insurance on mortgage-backed securities composed of qualifying home loans (with underwriting protections written into the legislation). As mortgages go bad (which they do even in good times), the private capital would take the first losses and provide a buffer against the need for the government to put out cash on its guarantee.

The 10 percent capital requirement is large enough to protect taxpayers. Fannie Mae and Freddie Mac together in the crisis suffered losses of about 4 percent of the value of their assets, meaning it would take an economic upheaval considerably worse than that of the last seven years to burn through the private capital protecting taxpayers. In exchange for the increased role of the private sector, the existence of the secondary government backstop would ensure that mortgages remained available to Americans across financial market ups and downs.

Adding this protection for taxpayers has a cost, since private investors require compensation to take on housing risk. This translates into higher mortgage interest rates for borrowers.

Before the financial crisis, advocates for reforms were sometimes attacked as “antihousing,” on the grounds that the higher interest rates from reduced government support would make it more difficult for Americans to become homeowners. This complaint is misguided, since the impact on interest rates from the Crapo-Johnson is the consequence of fixing the flaw in the old system that left taxpayers at risk: the higher cost for borrowers corresponds to the protection for taxpayers that was missing.

Moreover, Senators Crapo and Johnson address concerns over the impact of higher interest rates on low- and moderate-income families by including billions of dollars to subsidize affordable housing, both rental and owner-occupied.

Mortgage bankers argue alongside housing advocates for a private capital requirement of only 5 percent rather than 10. There is an irony in the apparent alliance, since groups that support affordable housing subsidies typically look skeptically at the role of large banks in the economy. Many left-leaning groups supported a past legislative proposal to impose a 15 percent capital requirement on megabanks, with the aim of protecting taxpayers against bailing out institutions that are too big to fail. Presumably their view is that the higher capital requirement would have only a modest negative impact on bank lending â€" the opposite of the argument that 10 percent capital would have a large impact on housing-related activity.

It would be hard to know the overall result for home buyers until the new system was in place, but the incremental impact on interest rates of having 10 percent private capital to protect taxpayers rather than 5 percent is likely to be modest. The first 5 percent of private capital slated to take losses would  be costly, because investors know their money is on the line in the event of another housing debacle. But this 5 percent private capital would be present under all legislative proposals.

The cost of the next 5 percent of private capital to take losses ahead of taxpayers is at issue. It takes only a moment’s reflection to recognize that the cost is likely to be modest once a new system with more capital is put into place over time.  The reasoning is that the sixth to tenth percentage points of private capital would be at risk only after the first 5 percent was wiped out. Or as I put it in testimony in October before the Senate Banking Committee, if 5 percent private capital is enough to protect taxpayers, then the next 5 percent private capital is safe and cannot be expensive. If the additional private capital is expensive, then it must be that 5 percent is not enough to protect taxpayers â€" it cannot be both ways.

The best estimates to date suggest that mortgage interest rates under the Crapo-Johnson proposal would rise less than half a percentage point compared to the current system.  By way of comparison, interest rates are likely to increase by multiple percentage points in the next two or three years as the Federal Reserve moves away from the zero interest rates in place since late 2008.  Just as Janet L. Yellen, the Fed chief, will be doing her job to return interest rates back to normal, so, too, will Congress by protecting taxpayers against another housing bailout.

One reasonable hesitation for undertaking any housing finance reform is that it would rearrange a sector of the economy central to the economic and social aspirations of American families. We have all seen the confusion created by the Affordable Care Act in forcing too many people to endure undesired changes in their insurance policies and choice of physicians, and setting the stage for galloping insurance premium increases in the future.

But the Crapo-Johnson bill is the opposite of Obamacare. It brings the private sector back into a housing finance system now dominated by the government. Market incentives rather than government officials would determine the availability of mortgage financing, allowing private investors to extend mortgage loans to potential home buyers who today are prevented from buying a home by the pendulum swing to overly strict post-crisis lending standards.  Indeed, bringing in considerable private capital will not just protect taxpayers, but also provide an incentive for prudence in lending on the part of investors whose money is at risk.

Without housing finance reform, the government will continue to dominate mortgage markets. The alternative to the Crapo-Johnson bill is not a fully private system but instead setting in concrete the current situation and thus effectively nationalizing the housing finance system.  A fully private mortgage market might seem attractive on paper, but it ignores the political and financial reality that any future Congress and President will act to stabilize mortgage markets if Americans cannot obtain home loans.

The government guarantee in housing is thus latent, even in a system that is ostensibly private. Pretending otherwise would inadvertently recreate a salient defect of the past: the implicit backstop under which shareholders and the management of Fannie and Freddie kept the upside in good times and taxpayers were stuck with the bill when the housing market collapsed â€" a $190 billion tab in the recent crisis. Rather than creating a system that is private only until the inevitable next crisis, it is thus preferable to make clear the government’s limited role and to ensure that an immense amount of private capital takes losses before another taxpayer bailout. Formalizing a taxpayer backstop on housing is anathema on the right, but it is the first and necessary step to shrinking the government’s role.

Democrats might hesitate at reducing the government role but applaud the innovative approach in the legislation under which mortgage companies have a financial incentive to serve all borrowers capable of sustaining a mortgage (and not just high-income families). This would be in addition to money for affordable housing activities through mechanisms created in the Housing and Economic Recovery Act of 2008 but that did not receive funds as a result of the financial difficulties at Fannie and Freddie.

A sticking point from the left is that many housing advocates expect Melvin L. Watt, the director of the Federal Housing Finance Agency, to put the money into affordable housing activities out of the now-considerable profits of Fannie and Freddie. Mr. Watt has the legal authority to do this now â€"  some would say that the 2008 law requires him to do so.  If the money for affordable housing flows ahead of broader reform, however, an important incentive for left-leaning stakeholders to support Crapo-Johnson would be removed.  It is ironic that action by Mr. Watt could actually undermine a measure supported by President Obama.

Reform of housing finance remains among the chief unaddressed legacies of the financial crisis. The Crapo-Johnson bill is truly a bipartisan compromise, satisfying neither side in whole but constituting a vast improvement over the current housing finance system in which taxpayers are at risk even while too many families cannot obtain mortgages.

 

In Europe, Auto Sales Are Still Low, But They Are Rising

European auto sales figures for March, reported today, show that slightly more new cars were sold in the euro zone during the most recent 12 months than had been sold a year earlier. The increase was a tiny one, just 0.4 percent.

Source: European Automobile Manufacturers Association

Monthly figures have been rising for some time, but this was the first year-over-year rise since early 2010, and another sign that economic growth is returning to Europe.

Some of the largest gains were in countries that have experienced severe recessions. Sales in Greece, Portugal, Spain and Ireland were all at least 10 percent higher than they had been during the previous 12 months.

Source: European Automobile Manufacturers Association

To some extent, however, that merely reflects how low sales had fallen. Even with the the gain, sales in Portugal during the 12 months through March were 43 percent lower than in the full year 2007, and sales in Greece, Spain and Ireland were down by more than half. For the euro area as a whole, the decline was 26 percent.

By contrast, United States auto sales over the past 12 months were up 6 percent from a year earlier, and were only 3 percent below the 2007 level. In Britain, sales were up 12 percent on a year-over-year basis, and 2 percent below the 2007 level.

Source: European Automobile Manufacturers Association

The End of Our Financial Illusions

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz professor of entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The global financial crisis that broke out following the collapse of Lehman Brothers in September 2008 was a big shock. This is literally true in terms of the impact on investors and market prices; a wide range of financial variables moved rapidly in unexpected and worrying directions. But what happened was also a shock to the realm of ideas about finance.

Before September 2008 â€" or at least before 2007, when some of the underlying problems first became more clearly manifest â€" the prevailing consensus among officials and specialists was that financial innovation was a good thing. In isolated instances, a particular new product might not work out as planned, as happens, for example, with medical innovation. But over all, the consensus went, financial innovation led by the private sector was making the system safer and more efficient.

This view was wrong.

In its day, this line of thinking justified the legal and regulatory changes that allowed some banks to become very large and to build up a much more complex range of activities in the 1990s and early 2000s, including through various kinds of opaque derivatives transactions.

In retrospect, much of the financial innovation in the previous decades built up risk for the financial system in ways that were not properly understood by regulators or, arguably, by management at some of the largest banks.

Of course, some bankers knew exactly what they were doing as their companies increased their debt relative to their equity. On average, large complex global banks had about 2 percent equity and 98 percent debt on the liability side of the balance sheet before the crisis, meaning they were leveraged 50:1 (the ratio of total assets to equity).

The good news is that the official consensus was shattered in 2008, and is not coming back. Systemic risk slapped everyone in the face with an undeniable wake-up call.

However, the process of reforming the financial system is still at an early stage. The Dodd-Frank financial reforms of 2010 represent a useful start â€" including the Volcker Rule‘s restrictions on excessive risk-taking â€" and the recently adopted Basel III framework for capital regulation nudges equity requirements higher.

But the world’s largest banks will, by one informed estimate, end up â€" as things currently stand â€" with about 3 percent equity and 97 percent debt as the average structure of their balance sheet liabilities. In the United States, if the latest leverage rule is implemented and enforced properly, this will become 5 percent equity and 95 percent debt for the biggest eight banks by 2018. While 20:1 is better than 50:1, this is still not enough equity to assure a reasonable degree of financial stability in the foreseeable future.

The argument about finance has now shifted and is much more about whether capital requirements for the largest banks should be increased further. Those opposed to such a move offer three reasons why big banks should not be required to fund themselves with much more equity.

First, some people contend that the crisis of 2008 was a rare accident and Dodd-Frank fixed whatever problems existed. This is completely unconvincing â€" particularly because many of the same people have spent much of the last four years opposing and delaying financial reform.

Most importantly, it ignores the ways in which incentives and rules have changed since the 1980s. As James Kwak and I asserted in “13 Bankers,” the structure of the financial system is quite different now from what it was in 1980. In particular, the largest banks have become much bigger and more able to take on (and mismanage) much more risk.

The second argument is that the costs of the crisis were not huge, so there is no reason to fear a repeat. This is the view sometimes associated with former Treasury Secretary Timothy Geithner. (Mr. Geithner has a book coming out soon, and it will be interesting to see his current position on this point).

But the impact of any financial crisis is not measured primarily in terms of whether the Treasury made or lost money on specific investments. The criteria instead should be what happened to output and jobs, as well as what the impact was on the country’s fiscal accounts. How much more public debt do we have now relative to what we had before â€" and what kind of lasting negative effects will that have?

Mr. Kwak and I took this on in “White House Burning,” putting the recent surge in public debt in the longer-run context of American fiscal policy. No matter how you look at it, the financial crisis was a complete disaster for the real economy and, given the way fiscal politics work in the modern United States, for the budget and for investments in any kind of physical infrastructure and education.

The third counterargument is that large complex financial institutions are needed because they provide some sort of magic for the broader economy. This still seems to be the view of some people at the Federal Reserve Bank of New York, which recently published a set of research papers on the topic.

But the benefits they find are small relative to the potential costs. Anat Admati and Martin Hellwig’s “The Bankers’ New Clothes” makes the vulnerability of modern banking abundantly clear.

A recent report from the International Monetary Fund finds that the United States and other governments are providing large implicit subsidies to these big banks: The prospect of potential government support lowers their funding costs by about 100 basis points (one percentage point).

Many people are involved in the official sector’s rethinking of finance. This is the lasting contribution from books such as Sheila Bair’s “Bull by the Horns,” Neil Barofsky’s “Bailout” and Jeff Connaughton’s “The Payoff.” In government circles, key decision makers were swayed by officials including Thomas Hoenig and Jeremiah Norton (both of the Federal Deposit Insurance Corporation) and Sarah Bloom Raskin (then on the Board of Governors of the Federal Reserve System; now at the Treasury Department). As chairman of the Commodity Futures Trading Commission, Gary Gensler had an immensely positive impact, both directly on the regulation of derivatives and also more broadly.

The Democratic senators Sherrod Brown of Ohio, Jeff Merkley of Oregon and Carl Levin of Michigan and Ted Kaufman of Delaware (who has since left the Senate), along with David Vitter, Republican of Louisiana, played key roles in shifting opinion. Elizabeth Warren’s work, both before and after her election to the Senate from Massachusetts, has also had great influence.

Of all the civil society organizations seeking to promote financial stability, Dennis Kelleher’s Better Markets stands out for its major impact through a relentless surge of arguments, comment letters and research. Its report on the cost of the crisis made clear beyond any reasonable doubt that the crisis had profound negative consequences for millions of people.

Many other officials have also shifted their views in important ways. We are not going back to the old ways of thinking about finance, and allowing for changes in these theories is an essential part of any modern economy. Finance needs to be regulated effectively, and large banks should fund themselves with much more equity than is currently the case.

On Tax Day: What’s Fair?

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Tax day is upon us and with it comes a lot of buzz about tax fairness.  That’s a broad concept, for sure, with many different meanings.  One of its meanings has been quantified as the share of taxes paid by various income groups. And that leads to claims of unfairness over the alleged disproportionate share of taxes paid by those at the top of the income scale.

For example, The Wall Street Journal cites the Tax Policy Center’s findings that “overall federal tax receipts from the top 1 percent of earners rose by 1.3 percentage points to 29.3 percent of all federal tax revenue.”  Meanwhile, the center’s data show that middle-income families’ tax share is around 10 percent.

If that sounds unfair, consider the following: The taxpayers whose liabilities and share of total taxes paid are going up also happen to be pretty much the only people whose incomes have been rising.  Certainly another dimension of fairness, especially in a progressive tax system within an increasingly unequal income distribution, is assigning the burden to those who’ve made the gains, especially when they’re such a small group.

There is considerable evidence to support this case.

- The inequality expert and Berkeley professor Emmanuel Saez recently wrote that from 2009 to 20012, the “top 1 percent incomes grew by 31.4 percent while bottom 99 percent incomes grew only by 0.4 percent.” He noted that “the top 1 percent captured 95 percent of the income gains in the first three years of the recovery.”

- As The New York Times pointed out Sunday, “the median compensation of a chief executive in 2013 was $13.9 million, up 9 percent from 2012.”  Bureau of Labor Statistics data show that median weekly earnings for regular old full-time workers â€" not those from the executive suites, but making around $40,000 a year â€" rose about 1 percent last year. After inflation â€" about 1.5 percent â€" they actually fell behind.

- Over the recovery, which began in mid-2009, G.D.P. is up 11 percent, corporate profits are up 50 percent, the S&P 500 is up almost 80 percent, and median household income is down 3 percent (all changes inflation adjusted).

Now, to be clear and fair, there are other factors to be considered.  First, while the rich appear to have largely recovered from the downturn and are once again speeding ahead of the rest, they did get severely whacked by it.  The most comprehensive data on this  â€" the Congressional Budget Office’s household data series â€" shows real, pretax losses by the top 1 percent of 26 percent from 2007 to 2010 (the most recent year for this series), as the financial implosion led to large capital losses.

But even in these data, from 2009 to 2010, the average income of the top 1 percent rose 16 percent, or about $200,000 (from $1.2 million to $1.4 million). Middle incomes rose a mere 0.3 percent, up $200, to $65,400.  So, in that year, the gain in pretax income to the wealthiest households was about three time the level of middle-class incomes.

Second, the only recent federal tax increases legislated, those from the fiscal cliff deal at the end of 2012, raised taxes solely on the wealthy.  That said, the tax deal also locked in 82 percent of the sweeping Bush tax cuts. That’s one reason we’re collecting less revenue than we will need to in order to meet our longer term fiscal challenges.

Like I said, there are lots of ways to measure fairness in the tax code, but one pretty intuitive measure, especially in a progressive system, is the share of taxes paid by each income group compared with their share of pretax income. Thankfully, the excellent analysts at Citizens for Tax Justice present that very comparison, and even better, they do so including all levels of taxation: federal, state, and local.

Most of the bars are about of equal height for each income group, implying all-in tax shares are about the same of income shares.  At least by this metric, one I think most would view as reasonable, tax shares seem broadly fair.  And given where all the growth has been going, along with stagnating middle and low pretax incomes, even more progressive tax changes may be fairly envisioned.

However, over the longer term, we cannot sustain our revenue needs solely by increasing the tax liabilities of those at the very top of the income scale. The United States remains a low-tax country and if incomes would only start growing more broadly, it would be reasonable, in the interest of meeting future fiscal challenges, to raise more revenue from more households.  The alternative, of course, would be large spending cuts in social insurance, public goods, defense, and nondefense programs across the board, cuts the majority of the public does not want, for good reason.

How Working Women Help the Economy

If someone asked you to name the most important economic trends of the last 30 years, you would probably respond with rising inequality, increasing globalization and fast-paced technological change.

But there’s another trend that has led to sharply higher economic output, and one that goes largely overlooked. That is the flood of women into the full-time workforce: Since 1979, the proportion of working-age women with a full-time job has surged to 40.7 percent from 28.6 percent. For mothers, the effect is even more striking: The proportion has climbed to 44.1 percent from 27.3 percent.

Those statistics come from a new report from the Center for American Progress, a left-of-center Washington-based research group. It finds that if women’s employment patterns had remained unchanged for the last three decades, the economy would be about 11 percent smaller, translating into $1.7 trillion in lost economic output in 2012, roughly equivalent to government spending on Social Security, Medicare and Medicaid.

The report also looks at the hours women worked, regardless of whether they were in full-time or part-time jobs. The median number of hours worked by women has climbed by 739 hours a year, to 1,664 hours; for mothers, hours worked has increased by 960 hours to 1,560.

The ultimate effects are richer families and a larger economy. Compare the United States to Japan, for instance. Tokyo has failed to jolt the Japanese economy out a generation-long slump, and the failure of the country to integrate women into the workforce is a major cause, according to researchers at institutions including the International Monetary Fund.

For cultural and economic reasons - Japan has a yawning gender pay gap - many Japanese women choose not to work. The female employment rate is 25 percentage points lower than the male employment rate, versus 14 percentage points in the United States and 5.7 percentage points in Sweden.

The United States could be yet stronger if more women worked, the authors of the Center for American Progress paper say. But there remain structural reasons that so many women stay home. Right now, about a third of all women and one quarter of all mothers do not work, they said.

Policies that would help women include regulations to foster greater flexibility in hours, mandatory paid family and medical leave and mandatory paid sick days that could be used to care for a child, they argue. “Even as mothers and women are making significant contributions to the U.S. economy, they continue to do so within a set of institutions that too often do not provide them with the kind of support that they need to do this successfully both at work and at home,” the authors write.

Equal Opportunity and Social Innovation: Obama’s Policy Agenda

Laura D’Andrea Tyson is a professor at the Haas School of Business at the University of California, Berkeley, and headed the Council of Economic Advisers and the National Economic Council under President Bill Clinton. Jonathan Greenblatt is a special assistant to President Obama and director of the Office of Social Innovation and Civic Participation at the White House.

As Thomas Piketty reminds us in his new book, “Capital in the 21st Century,” we are living in an era of rising inequality of income and wealth and of eroding equality of opportunity. In the United States, income and wealth inequality have reached levels not seen since the 1920s.  Perhaps the most glaring signs of the pernicious effects of inequality are the large and increasing gaps in educational attainment between the children of middle-income and low-income families. Demographic trends and job-displacing technological change are aggravating the social and economic maladies rooted in widening inequality.

President Obama has set forth an ambitious agenda to expand opportunity for all Americans, including health care reform, investment in education, an expansion of the earned-income tax credit and an increase in the minimum wage. However, as a result of budgetary constraints, federal  government financing for nonmilitary discretionary programs â€" a category that includes most federal support for research and for kindergarten through 12th grade and early childhood education â€" is on course to be lower in real terms than before the Great Recession.

Despite the long-term fiscal challenges, the federal government is still seeking to achieve better outcomes from policies designed to address social challenges. But it will have to provide stronger incentives for the private sector to develop and expand programs with the same objectives.  And it will need to create conditions to support the nonprofit organizations that increasingly are asked to deliver essential human services as the government pulls back even as their resources fail to keep pace with growing demand.

In response to these challenges, President Obama created the White House Office of Social Innovation and Civic Participation in early 2009.  He recognized that to deliver on the promise of opportunity for all Americans, the government must identify and invest in innovative solutions to social challenges and work with the private sector â€" nonprofits, the business community and investors seeking both social and financial goals â€" to develop and finance these solutions. The office set out to bring different groups into the policy making process to determine which programs get the best bang for taxpayers’ bucks, to tap new resources and scale what works and to develop market-based models to sustain successful programs.

Among its first efforts to invest in what works, the office established the Social Innovation Fund. The fund embodies the administration’s approach to addressing escalating social challenges at a time of inadequate federal financing. It works through intermediaries and partners with the private sector to amplify the impact of federal resources. The fund makes grants to social sector intermediaries like foundations, nonprofits and social enterprises on a competitive basis. It requires up to a three-to-one match of private money with government dollars.

The intermediaries are responsible for investing in nonprofits that try to create and expand effective programs. Funding over the life of a grant largely depends on evidence of success, much as venture capitalists invest in the early round of a start-up but maintain financing in further rounds only if the start-up shows success. To date, the fund has awarded over $175 million in grants, catalyzing more than $420 million in additional private philanthropic capital. More than 200 organizations have received money. The fund and its financing model enjoy bipartisan support in the Senate. The 2014 omnibus budget increased financing for the fund to $70 million, the highest level in its five-year history, from $47 million.

While the fund focuses on building capacity and financing nonprofits’ efforts, the $1 billion Small Business Investment Company Impact Fund, created by the Small Business Administration in 2010, focuses on fostering new venture funds whose investors seek both financial and social returns. The Small Business Administration provides up to a two-to-one match to private capital raised by these funds to invest in new businesses in underserved communities and areas like education and clean energy. To date, the small business fund has funneled $176 million in investment toward a dozen companies in California and Michigan. Applications for new investment money are pending as private sector interest in this kind of investing is gaining momentum.

Consistent with the goal of investing in what works, the administration has also pioneered Pay for Success financing to promote and expand social innovation. In a Pay for Success contract, sometimes called a social impact bond, the government sets a specific measurable target for a program to address a particular social goal â€" for example, reducing recidivism among juvenile offenders or providing early childhood education for vulnerable populations â€" and attracts an investor to pay for the program. The investor does so, lured by the promise of repayment of principal if the program meets the target and a higher return if the program exceeds the target. The investor gets no payback if the program fails to deliver results.

These contracts offer a win-win approach to their participants:  The nonprofit secures a new source of money for a program to address a social challenge; the investor can earn a return but bears the risk; and the government pays only for success. Moreover, payment by the government is intended to come from the savings generated by the program’s success.

In fall 2011, President Obama gathered state and city officials to brainstorm about the most promising applications of the pay for success model in the United States. Since then, nearly $50 million has been invested in these kinds of  transactions in Massachusetts, New York and Utah, and there is rising bipartisan interest in this model at all levels of government across the country.

At the federal level, the Obama administration proposed more than $80 million in its fiscal 2015 federal budget for these kinds of pilot programs in several federal agencies to encourage policy innovations in areas like juvenile justice, work force development and educational achievement.

More significantly, the administration has proposed a $300 million Pay for Success Incentive Fund to be housed in the Treasury Department. This fund would provide state and local governments with federal matching money for programs that produce federal budget savings. This fund would also offer a way to reduce the risk of these transactions to state and local governments, nonprofits and investors to encourage them to experiment with this approach and attract private capital for the upfront financing.

The hope is that this fund could do for “outcome financing” what the Community Development Financial Institutions Fund did for community finance 20 years ago. At that time, poor communities lacked access to private capital from both nonprofit institutions and banks. Yet, by 2013, the C.D.F.I. Fund supported more than 800 such certified financial institutions that made over 24,000 loans and investments, totaling almost $2 billion. In aggregate, these institutions manage more than $50 billion in assets and provide loans to nonprofits and small businesses that serve low-income populations and communities. If the Pay for Success Incentive Fund had a similar impact, it would mobilize private capital to finance and expand effective social programs, with benefits for vulnerable populations, risk-taking investors and the general public.

The United States is not alone in this approach. For example, Britain established a global Task Force on Social Impact Investing before the 2013 meeting of the Group of 8 industrialized countries in London. The United States is a member of the task force, which is expected to make recommendations this fall. Such initiatives offer considerable promise for addressing social challenges at a time of constrained government budgets and rising inequality.