Economist's View

December 31, 2009

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Posted 12/31/2009 11:59:00 PM by Mark Thoma

March 21, 2009

Economist's View - 4 new articles

Short-Run and Long-Run Deficits

Robert Frank says its important to separate the cyclical component of the budget from its long-run trajectory, and that when evaluating deficits, how the money is spent matters:

When 'Deficit' Isn't a Dirty Word, by Robert H. Frank, Commentary, NY Times: ...Because important policy decisions hinge on whether deficits matter, this is an opportune moment to take stock of what we know. The good news is that there is little disagreement among economists who have studied the issue. The consensus is that short-run deficits help end recessions, and that whether long-run deficits matter depends entirely on how government spends the borrowed money. If failure to borrow meant forgoing productive investments, bigger long-run deficits would actually be better than smaller ones. ...

When a downturn throws people out of work, they spend less, causing still others to be thrown out of work, and so on, in a downward spiral. Failure to use short-run deficits to stimulate spending amplifies that spiral, causing further declines in tax receipts and even bigger deficits. That this path makes no sense is a settled issue.

But what about long-run deficits? To think more clearly about them, we must recognize that carrying debt is costly. The ... money spent to service debt can't be spent for other things we value. But that doesn't mean we should always borrow less. The main issue is what we do with the borrowed money.

If we simply use the money to buy bigger houses and cars, deficits make us unambiguously worse off in the long run. That's why the explosive increase in the national debt during the Bush administration was a grave misstep.

Trillions of dollars, many of them borrowed from China, financed tax cuts for the wealthy, who spent much of their added wealth on things like bigger mansions. ... Much of the interest we'll pay on debt incurred during the Bush years is thus money down the drain.

In contrast, borrowing for well-chosen investments doesn't make us poorer. Road maintenance is a case in point. Failure to repair roads in a timely way could mean eventually spending two to four times as much for the work. ...

Once the downturn ends,... there are many ways to pay down debt without requiring painful sacrifices. A $2 tax on each gallon of gasoline, for example, would generate more than $100 billion in additional revenue a year. Europeans, who pay more than $2 a gallon in gasoline taxes, have adapted by choosing more efficient cars — and they appear no less satisfied with them.

We could also levy a progressive consumption surtax, which would ... also stimulate private savings...

Notwithstanding the neo-Hooverite talk from stimulus-program opponents, the current deficit isn't too large. If anything, it may need to be even larger to revive the economy. In the long run, new sources of tax revenue could keep deficits from growing and could even pay down existing debt. But if the political system cannot figure out how to pay for productive investments with tax revenue, we'd still end up richer, on balance, by making those investments with borrowed money.

Here are "Bogus Arguments about the Burden of the Debt".

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"Despair over Financial Policy"

Reactions to the leaked details of the administration's bank bailout plan. If I find any posts in support of the plan, I will add those in an update.

First, Paul Krugman:

Despair over financial policy, by Paul Krugman: The Geithner plan has now been leaked in detail. It's exactly the plan that was widely analyzed — and found wanting — a couple of weeks ago. The zombie ideas have won.

The Obama administration is now completely wedded to the idea that there's nothing fundamentally wrong with the financial system — that what we're facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

To this end the plan proposes to create funds in which private investors put in a small amount of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad — I mean misunderstood — assets. This is supposed to lead to fair prices because the funds will engage in competitive bidding.

But it's immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn't, that's someone else's problem. ...

This plan will produce big gains for banks that didn't actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized. And I fear that when the plan fails, as it almost surely will, the administration will have shot its bolt: it won't be able to come back to Congress for a plan that might actually work.

What an awful mess.

Calculated Risk:

Geithner's Toxic Asset Plan, Calculated Risk: The NY Times has some details ...

Toxic Asset Plan Foresees Big Subsidies for Investors: The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell. In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money. In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Secure Lending Facility, a joint venture with the Federal Reserve.

More approaches doesn't make a better plan. The FDIC plan involves almost no money down. The FDIC will provide a low interest non-recourse loan up to 85% of the value of the assets. ...

With almost no skin in the game, these investors can pay a higher than market price for the toxic assets (since there is little downside risk). This amounts to a direct subsidy from the taxpayers to the banks. Oh well, I'm sure Geithner will provide details this time ...

Yves Smith:

Private Public Partnership Details Emerging, Yves Smith: The New York Times seems to have the inside skinny on the emerging private public partnership ... program. And it appears to be consistent with (low) expectations: a lot of bells and whistles to finesse the fact that the government will wind up paying well above market for crappy paper. ...

If the money committed to this program is less than the book value of the assets the banks want to unload (or the banks are worried about that possibility), the banks have an incentive to try to ditch their worst dreck first. In addition, it has been said in comments more than once that the banks own some paper that is truly worthless. This program won't solve that problem. ... And notice the hint of skepticism from the Times regarding the Administration's supposition that the bidding will result in fair prices. Huh? First, the banks, as in normal auctions, will presumably set a reserve price equal to the value of the assets on their books. If the price does not meet the reserve (and the level of the reserve is not disclosed to the bidders), there is no sale; in this case, the bank would keep the toxic instruments. Having the banks realize a price at least equal to the value they hold it at on their books is a boundary condition. If the banks sell the assets as a lower level, it will result in a loss, which is a direct hit to equity. The whole point of this exercise is to get rid of the bad paper without further impairing the banks. So presumably, the point of a competitive process (assuming enough parties show up to produce that result at any particular auction) is to elicit a high enough price that it might reach the bank's reserve, which would be the value on the bank's books now. And notice the utter dishonesty: a competitive bidding process will protect taxpayers. Huh? A competitive bidding process will elicit a higher price which is BAD for taxpayers! ...

Paul Krugman again:

More on the bank plan, Paul Krugman: Why was I so quick to condemn the Geithner plan? Because it's not new; it's just another version of an idea that keeps coming up and keeps being refuted. It's basically a thinly disguised version of the same plan Henry Paulson announced way back in September. ...

[W]e have a bank crisis. Is it the result of fundamentally bad investment, or is it because of a self-fulfilling panic?

If you think it's just a panic, then the government can pull a magic trick: by stepping in to buy the assets banks are selling, it can make banks look solvent again, and end the run. Yippee! And sometimes that really does work.

But if you think that the banks really, really have made lousy investments, this won't work at all; it will simply be a waste of taxpayer money. To keep the banks operating, you need to provide a real backstop — you need to guarantee their debts, and seize ownership of those banks that don't have enough assets to cover their debts; that's the Swedish solution, it's what we eventually did with our own S&Ls.

Now, early on in this crisis, it was possible to argue that it was mainly a panic. But at this point, that's an indefensible position. Banks and other highly leveraged institutions collectively made a huge bet that the normal rules for house prices and sustainable levels of consumer debt no longer applied; they were wrong. Time for a Swedish solution.

But Treasury is still clinging to the idea that this is just a panic attack, and that all it needs to do is calm the markets by buying up a bunch of troubled assets. Actually, that's not quite it: the Obama administration has apparently made the judgment that there would be a public outcry if it announced a straightforward plan along these lines, so it has produced what Yves Smith calls "a lot of bells and whistles to finesse the fact that the government will wind up paying well above market..."

Why am I so vehement about this? Because I'm afraid that this will be the administration's only shot — that if the first bank plan is an abject failure, it won't have the political capital for a second. So it's just horrifying that Obama — and yes, the buck stops there — has decided to base his financial plan on the fantasy that a bit of financial hocus-pocus will turn the clock back to 2006.

Here is a Defense of Private Funds for Jump-Starting the Market for Troubled Assets by Lucian Bebchuk.

The main objection is that the government will (in essence) overpay for these assets, and that will cost the taxpayers money. In the meantime, the banks - which get a windfall from the overpayment for the assets - could recover and do just fine. If the administration insists on moving in this direction rather than adopting a version of the Swedish plan, why not require some insurance against future taxpayer losses, e.g. require firms participating in the bailout to sacrifice future equity shares equal to the value of any losses that fall on taxpayers? There are probably better ways to structure this, but having such insurance in place could help with the politics of the bailout which the administration does not seem to get. Taxpayers are in no mood to be giving away money to failed banks without assurances that it is justified, that there is no other plan that will well enough to provide a substitute and that they have been protected as much as possible in the process. This plan, at least what we know about it so far, does not meet those conditions. In particular, there are alternative plans such as the proposed derivatives of the Swedish plan that can be expected to work just as well, yet do not involve giveaways to failed banks.

Hoisted from comments:

I am SAC Capital. I get to be one of the bidders on bank assets covered by the program Citi holds $100mm of face-value securities, carried at $80mm. The market bid on these securities is $30mm. Say with perfect foresight the value of all cash flows is $50mm. I bid Citi $75mm. I put up $2.25mm or 3%, Treasury funds the rest. I then buy $10mm in CDS directly from Citi [or another participant (BOA, GS, etc)] on the bonds for a premium of $1mm. In the fullness of time, we get the final outcome, the bonds are worth $50mm SAC loses $2.25mm of principal, but gets $9mm net in CDS proceeds, so recovers $6.75mm on a $2.25mm investment. Profit is $4.5mm Citi writes down $5mm from the initial sale of the securities, and a $9mm CDS loss. Total loss, $14mm (against a potential $30mm loss without the program) U.S. Treasury loses $22.75mm Great program. It's just a scheme to transfer losses from the bank to the taxpayer with an egregious payout to a middleman (SAC) to effectively money launder the transaction. You've also transmuted a $30mm economic loss into a $36.75mm economic loss because of the laundering. So its incredibly inefficient. How did fraud and money laundering become the national economic policy of the US? One would have to be a criminal to participate in this.

Folks, this IS even worse than I thought, and you know I have a constitutional predisposition to take a dim view of things...

Update: Jamie Galbgraith responds to the plan.

I've just been reading the NYT report. The central Treasury assumption, at least for public consumption, seems to be that the underlying mortgage loans will largely pay off, so that if the PPIP buys and holds, at an above-present-market price governed by auction, the government's loan to finance the purchase will not go bad.

Recovery rates on sub-prime residential mortgage-backed securities (RMBS) so far appear to belie this assumption. ...

The way to find out who is right is ... examination of the underlying loan tapes -- and comparison to the IndyMac portfolio -- would help determine whether these loans or derivatives based on them have any right to be marketed in an open securities market, and any serious prospect of being paid over time at rates approaching 60 cents on the dollar, rather than 30 cents or less.

Note that even a small loss of capital, relative to the purchase price, completely wipes out the interest earnings on the Treasury's loans, putting the government in a loss position and giving the banks a windfall.

If I'm right and the mortgages are largely trash, then the Geithner plan is a Rube Goldberg device for shifting inevitable losses from the banks to the Treasury, preserving the big banks and their incumbent management in all their dysfunctional glory. The cost will be continued vast over-capacity in banking, and a consequent weakening of the remaining, smaller, better- managed banks who didn't participate in the garbage-loan frenzy. ...

If I were a member of Congress, I would offer a resolution blocking Treasury from making the low-cost loans it expects to offer the PPIPs, until GAO or the FDIC has conducted an INDEPENDENT EXAMINATION OF THE LOAN TAPES underlying each class of securitized assets, and reported on the prevalence of missing documentation, misrepresentation, and signs of fraud. In the absence of a credible rating, this is the minimum due diligence that any private investor would require.

I hope what I'm driving at, here, is clear...

Update: From James Kwak, This Time I'm Not the One Calling It a Subsidy.:

Instead of coming up with one plan to buy troubled assets, it looks like the government has come up with three. ... For now, I think the concerns I expressed last month still hold. If we take as given that the government will only negotiate at arm's length with the banks (meaning the banks can decide at what price they are willing to sell the assets), then the most important thing is for the plan to work. But it's not clear if the degree of subsidy offered will be enough to close the gap between what investors are willing to pay and what banks are willing to sell at. Having multiple buyers and using cheap Fed financing will increase the willingness-to-pay for these assets, but we won't know a priori if it will exceed the reserve price of the sellers.

In the best-case scenario: (a) the government's willingness to bear most of the risk encourages private investors to bid enough to get the banks to sell; (b) the economy recovers and the assets increase in price from the prices paid; (c) the investment funds pay back the Fed (which makes a small spread between the interest rate and the Fed's low cost of money); and (d) the government gets some of the upside through its capital investments. (I think the main purpose of that government capital is to deflect the criticism that all of the upside belongs to the private sector.) In the worst-case scenario, the market stays stuck because the banks have unrealistic reserve prices. Perhaps the idea is that, in that case, the TALF will allow the government to (over)pay whatever it takes to bail out the banks.

Most encouragingly, the headline in the Times was "Toxic Asset Plan Foresees Big Subsidies for Investors," indicating that the mainstream media have figured out the game. ...

Update: Brad DeLong in The Geithner Plan FAQ notes that having a large share of the downside also means having a large share of the upside, so if the downtrodden assets appreciate after the government gains control of them, the Geithener plan could make money:

Q: What is the Geithner Plan?

A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.

Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?

A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

Q: Where does the trillion dollars come from?

A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.

Q: Why is the government making hedge and pension fund managers kick in $30 billion?

A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.

Q: Why then should hedge and pension fund managers agree to run this?

A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.

Q: Why isn't this just a massive giveaway to yet another set of financiers?

A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.

Q: Why do we think that the government will get value from its hiring these hedge and pension fund managers to operate this program?

A: They do get 17% of the equity return. 17% of the return on equity on a $1 trillion portfolio that is leveraged 5-1 is incentive.

Q: So the Treasury is doing this to make money?

A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.

Q: How does having the U.S. government invest $1 trillion in the world's largest hedge fund operations reduce unemployment?

A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lousy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.

Q: So?

A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.

Q: And firms that ought to be expanding can then get financing on good terms again, and so they hire, and unemployment drops?

A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.

Q: Oh.

A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.

Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.

Q: This sounds very different from the headline of the Andrews, Dash, and Bowley article in the New York Times this morning: "Toxic Asset Plan Foresees Big Subsidies for Investors."

A: You are surprised, after the past decade, to see a New York Times story with a misleading headline?

Q: No.

A: The plan I have just described to you is the plan that was described to Andrews, Dash, and Bowley. They write of "coax[ing] investors to form partnerships with the government" and "taxpayers... would pay for the bulk of the purchases..."--that's the $30 billion from the private managers and the $150 billion from the TARP that makes up the equity tranche of the program. They write of "the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money..."--that's the debt slice of the program. They write that "the government will provide the overwhelming bulk of the money — possibly more than 95 percent..."--that is true, but they don't say that the government gets 80% of the equity profits and what it is owed the FDIC on the debt tranche. That what Andrews, Dash, and Bowley say sounds different is a big problem: they did not explain the plan very well. Deborah Solomon in the Wall Street Journal does, I think, much better. David Cho in tomorrow morning's Washington Post is in the middle.

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"Global Imbalances and the Crisis"

Michael Dooley and Peter Garber believe that most people have the source of the crisis wrong:

Global imbalances and the crisis: A solution in search of a problem, by Michael Dooley and Peter Garber, voxeu.org: The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda:

That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US.

That the crisis was caused by easy monetary policy in the US.

That the crisis was caused by financial innovation.

In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry.

When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds¹ that do not generate systemic risks.

International capital flows

One "lesson" that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.² The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance? If this were true, we would have to stop all capital flows, not just net imbalances. In the US context, we are unable to think of any plausible model for such behaviour.

If capital inflows did not directly cause the crisis perhaps they did so indirectly by depressing real interest rates in the US and other industrial countries. We have emphasised that capital inflows to the US from emerging markets associated with managed exchange rates caused persistently low long-term real interest rates in both the US and generally throughout the industrial world (Dooley, Folkerts-Landau and Garber 2004, 2009). Low real interest rates in turn drove asset prices up, particularly for long-duration assets such as equity and real estate.³ At the same time, low real interest rates temporarily reduced credit risks and a stable economic environment generated a marked decline in volatility of asset prices.

We have not argued that a "savings glut" in emerging markets is the fundamental driving force behind these capital flows. We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US. These official capital flows are not offset, but reinforced, by private capital flows because managed exchange rate pegs are credible for China and other Asian emerging markets.

Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future.

Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity. The hard landing predicted for Bretton Woods II was not to be caused by low real interest rates per se but by the sudden end to low interest rates as unsustainable capital inflows to the US were reversed. This is not the crisis that actually hit the global system.

But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.⁴ The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish.⁵ This could just as well have happened with stable or rising real interest rates, as it did, for example, during the lead up to the US S&L crisis in the 1980s, another government manufactured disaster. Falling real interest rates in themselves should make a financial system more stable and an economy more productive.

Imagine a global system with permanent 4% equilibrium real interest rates. Now imagine a system with permanent 2% real interest rates. Why is one obviously more prone to fraud and speculation than the other? The vague assumption seems to be that capital inflows were large and interest rates were low, and this encouraged "bad" behaviour.

The current conventional interpretation is that low interest rates and rising asset prices generated an environment in which reckless and even dishonest financial transactions flourished. One version of this story is that rising real estate prices led naïve investors to believe that prices would always rise so that households with little income or assets could always pay for a house with capital gains on that house. Moreover, households could borrow against these expected capital gains to maintain current consumption at artificially high levels. This pure bubble idea does not provide much guidance for reforming the international monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise?

Easy money and financial innovation

There is no sensible economic model that suggests that monetary policy can depress or elevate real long-term interest rates. The Fed could in theory target nominal asset prices (for example equity prices), but it would then lose control over the CPI. Would Alan Greenspan's critics have preferred a monetary contraction necessary to depress the CPI enough to allow the real value of equities to rise? The Fed could, and may still, inflate away the real value of financial assets but this requires inflation as conventionally measured. This may yet come, but it was not a part of the story in recent years, and it is still not expected by market participants.

Third in the roundup of usual suspects in the blame game is financial innovation. There is no doubt that innovation has dramatically altered the incentives of financial institutions and other market participants in recent years. Securitisation of mortgages, for example, clearly reduces the incentives for those that originate credits to carefully screen applications. But securitisation also reduced the cost of mortgage credit and increased the value of housing as collateral. Private equity facilitated the dismantling of inefficient corporate structures. Venture capital has directed capital to high-risk but high-reward activities. Before we give up these benefits we need to ask if it is possible to retain the advantages of these innovations without the costs associated with the current crisis.

The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers.

Fraud is not a financial innovation. The unhappy fact is that any change in the financial environment can generate new ways to undertake dishonest and imprudent positions. The regulators in turn have to adapt their procedures for monitoring and discouraging such activities. If it is really the case that regulators cannot understand the risks associated with modern financial markets and instruments, then there is a strong case for trying to return to a simple and relatively inefficient system. But we do not believe the story that no one can understand these innovations. To the contrary, it seems clear to us that the bankers that used these innovations to exploit moral hazard knew very well what they were doing and why. The first-best response to this is to attract a few of the many quants who are now unemployed to help enforce the prudential regulations already on the books.

Conclusions

In this crisis, three macro-financial institutional arrangements remain to hold the financial system together. These are the dollar as the key reserve currency with US Treasury securities as the ultimate safe haven, the integrity of the euro, and the global monetary system as defined by the Bretton Woods II view. Attacking the latter as a major cause of the crisis and seeking its end is, at the end of the day, an attack on the basis of the international trading system. It is a sure way to metastasise the crisis in the global financial system further into a crisis of the global economic system.

References

Bernanke, Ben (2007) "Global Imbalances: Recent Developments and Prospects" speech delivered at Bundesbank Berlin September 11. BIS 78^th Annual Report (2008). Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2004) "The Revived Bretton Woods System," International Journal of Finance and Economics, 9:307-313. Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2009) "Bretton Woods II Still Defines the International Monetary System," NBER Working Paper 14731 (February). Dunaway, Steven, Global Imbalances and Financial Crisis, Council for Foreign Relations Press, March, 2009. Economic Report of the President (2008) Economist (2009) When a Flow Becomes a Flood," January 22. Paulson, Henry (2008) "Remarks by Secretary Henry M. Paulson, Jr., on the Financial Rescue Package and Economic Update," U.S. Treasury press release, November 12. Sester, Brad (2008) "Bretton Woods 2 and the Current Crisis: Any Link?", Council on Foreign Relations

Notes

1. Of course, a bank thinly disguised as a hedge fund should be regulated as a bank just as a hedge fund thinly disguised as a bank should be. 2. See Paulson (2008), Dunaway (2009). 3. This is arithmetic, not economics. A permanent fifty percent decline in the level of real interest rates, for example from 4% to 2%, is the same thing as a doubling of an infinite maturity financial asset's price, provided that the payout from that asset is unchanged. For practical purposes, thirty years is good enough to about double prices. 4. This view has taken hold in central banks see Bernanke (2007), Hunt (2008), BIS (2008). In the financial press, see Sester (2008) and Economist (2009). It should be noted for the record that these claims are always raw assertions, without theoretical, empirical, or even logical basis. 5. The financial system problems in many other countries are independent of regulatory problems in the US. The banking collapses in Iceland, the UK, and Ireland were home grown. The loans of the European banking system to Eastern Europe and to emerging markets in general were independent of US financial system behavior.

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links for 2009-03-21

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Posted 3/21/2009 11:04:00 PM by Mark Thoma

March 19, 2009

Economist's View - 7 new articles

Golden Geese

Becker and Murphy:

Do not let the 'cure' destroy capitalism, by Gary Becker and Kevin Murphy, Commentary, Financial Times: Capitalism has been wounded by the global recession, which unfortunately will get worse before it gets better. As governments continue to determine how many restrictions to place on markets, especially financial markets, the destruction of wealth from the recession should be placed in the context of the enormous creation of wealth and improved well-being during the past three decades. Financial and other reforms must not risk destroying the source of these gains in prosperity.

Consider the following extraordinary statistics... World real gross domestic product grew by about 145 per cent from 1980 to 2007, or by an average of roughly 3.4 per cent a year. ... Global health, as measured by life expectancy at different ages, has also risen rapidly, especially in lower-income countries.

Of course, the performance of capitalism must include this recession and other recessions along with the glory decades. Even if the recession is entirely blamed on capitalism, and it deserves a good share of the blame, the recession-induced losses pale in comparison with the great accomplishments of prior decades. ...

Governments should not so hamper markets that they are prevented from bringing rapid growth to the poor economies of Africa, Asia and elsewhere... New economic policies that try to speed up recovery should follow the first principle of medicine: do no harm. ...

The failure of financial innovations such as securities backed by subprime mortgages, problems caused by risk models that ignored the potential for steep falls in house prices and the overload of systemic risk represent clear market failures, although innovations in finance also contributed to the global boom over the past three decades.

The people who made mistakes lost, and many lost big. Institutions that made bad loans and investments had large declines in their wealth, while investors that funded these institutions without proper scrutiny have seen their wealth cut in half or much more. Households that overextended themselves have also been badly hurt.

Given the losses, actors in these markets have a strong incentive to correct their mistakes the next time. In this respect, many government actions have been counterproductive, shielding actors from the consequences of their actions and preventing private sector adjustments. ...

The claim that the crisis was due to insufficient regulation is also unconvincing. For example, commercial banks have been more regulated than most other financial institutions, yet they performed no better... Regulators got caught up in the same bubble mentality as investors and failed to use the regulatory authority available to them. ...

The Great Depression induced a massive worldwide retreat from capitalism, and an embrace of socialism and communism that continued into the 1960s. It also fostered a belief that the future lay in government management of the economy, not in freer markets. The result was generally slow growth during those decades in most of the undeveloped world, including China, the Soviet bloc nations, India and Africa.

Partly owing to the collapse of the housing and stock markets, hostility to business people and capitalism has grown sharply again. Yet a world that is mainly capitalistic is the "only game in town"... We hope our leaders do not deviate far from a market-oriented global economic system. To do so would risk damaging a system that has served us well for 30 years.

When the golden goose is too wild for its own good, you can clip its wings without killing it.

While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people like Kashyap and Mishkin arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

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Galbraith: No Return to Normal

Update: Speaking of Jamie Galbraith, he says to watch this Paul O'Neill video:

This is by Jamie Galbraith. There's much, much more in the actual article:

No Return to Normal, by James K. Galbraith, Commentary, Washington Monthly: ...CBO's model is based on the postwar experience,... if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don't capture the key feature of that crisis—which is, precisely, the collapse of the financial system. ... Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt's ambition exceeded anything yet seen in this crisis:

[Roosevelt's] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York's Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country's entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

The New Deal rebuilt America physically, providing a foundation (the TVA's power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. ... If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn't overcome until the war ended.

It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. ... But the relaunching of private finance took twenty years, and the war besides.

A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

That being so, what must now be done?

The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief,... except in cases of speculative investment and borrower fraud. ...

Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income... For an increasing number of the elderly, Social Security and Medicare wealth are all they have. That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. ...

This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. ... In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.

Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?

Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. ...

As these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced—it is a good thing that they will encourage those at the top to retire. ...

Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. ...

Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they've lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years. Today the largest problems we face are energy security and climate change... And here, obviously, we need a comprehensive national effort. ...

This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.

A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.

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"The Judgments of the Market are True and Righteous Altogether"

Christopher Carroll with an evidence based rebuttal to the "risk-is-holy view" advocating a free market, hands off approach to the financial crisis, and a call for the Fed to do what it always does in a crisis, manage the price of risk (which means going beyond measures such as the purchase of long-term government securities and taking risky assets onto the Fed's balance sheet):

Punter of last resort, Christopher D. Carroll, Vox EU: The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the "price of risk" is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that "If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether."

The deep origins of the cult, as always, are obscure; presumably they lie properly in the field of psychoanalysis. But to the extent that overt origins can be traced, the wellspring is the literature that attempts to explain the Mehra and Prescott (1985) 'equity premium puzzle.' The 'puzzle,' in a nutshell, is that asset prices have not, historically, exhibited a relationship between risk and return that is easy to reconcile with the rational behavior of a representative agent facing perfect markets. Many of the responses to this challenge start with the assumption that asset prices must be always and everywhere rational, and then proceed to work out the kind of preferences or environment that can rationalize observed prices. This game brings to mind Joan Robinson's comment that "utility maximization is a metaphysical concept of impregnable circularity," and Larry Summers's remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent's utility function was not a particularly good day for economic science. Oddly, even the failure of this literature to produce a widely agreed solution to the 'puzzle' does not seem to have weakened participants' belief in the soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect reflect the actual past practice of economic policymaking during crises. As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the "lender of last resort" role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today's terminology, 'an increase in the price of risk').¹

Some economists, of course, view narrative history in the DeLong and Kindleberger mode as irrelevant to the practice of their science; they prefer hard numbers to mere narrative. For the numerically inclined, however, Figures 1a and 1b should be persuasive; they show that controlling a market price of risk is something the Federal Reserve has done since it first opened up shop. The top figure depicts a measure of what we are now pleased to call the 'risk-free' rate of interest in the United States – essentially, the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed.² Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as 'risk-free' is that the Fed takes away the risk.³

Figure 1a

Figure 1b

Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last? It was, after all, the intolerable stresses caused by financial panics that ultimately led to the founding of the Federal Reserve, in the face of adamant opposition from people holding financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are eerily similar to dogmas that continue to be propounded today. The panic of 1907, in which J.P. Morgan effectively stepped in as a private lender of last resort, constituted the last straw for the unregulated financial system that preceded the managing of risky rates that we have had since the creation of the Fed.

A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all. But there is, at least, a perception that this way of operating is hallowed by time and practice: Since the Fed, the story goes, has spent most of its history ignoring risk, it shouldn't change that now.

But even this milder dogma does not match the facts. Recent work by Robert Barbera, Charles Weise, and David Krisch,⁴ shows that over the "Taylor Rule" era of systematic monetary policy (roughly since 1984), the Federal Reserve's choice of the short run interest rate has been powerfully correlated to market-based measures of risk such as the difference between the interest rates on corporate bonds and corresponding maturity Treasuries. When risk has been high, the Fed has felt the need to stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed's pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed's balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond perhaps some purchases of longer-dated Treasury securities, are not the voices of reason; they represent a howling dogma that was discredited in 1844 (when the Bank of England received its first implicit authority to intervene during panics; see DeLong (2008)), was discredited again in the panic of 1907, and again during the Great Depression (by being adopted in an extreme form), and is in the process of being discredited yet again today. (In fairness, during ordinary times it is probably wise for the authorities to avoid attempting systematic manipulation of the price of risk, for all the reasons Kindleberger (2005) and Robert Peel (1844) articulated. But this is no ordinary time).

Let's put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future.⁵ The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets. While I realize that some economists (and some politicians) might be willing even to undergo another Great Depression as the steep price of clinging to their faith, those of us who do not share that faith should not have to suffer such appalling consequences.

As the Economist magazine might put it, the problem is that the 'punters' (investors) who normally populate the financial marketplace and risk their fortunes for the prospect of return, have fled from the field in terror. Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the 'lender of last resort' to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed's appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks; it needs, in other words, to step up to the plate and become the punter of last resort.

References

Barbera, Robert J., and Charles L. Weise (2008): "Minsky Meets Wicksell: Using the Wicksellian Model to Understand the 21st Century Business Cycle," Manuscript, Gettysburg College.

DeLong, J. Bradford (2008): "Republic of the Central Banker," The American Prospect.

Holland, A. Steven, and Mark Toma (1991): "The Role of the Federal Reserve as "Lender of Last Resort" and the Seasonal Fluctuation of Interest Rates," Journal of Money, Credit and Banking, 23(4), 659–676.

Kindleberger, Charles P. (2005): Manias, Panics, and Crashes: A History of Financial Crises. Wiley, 5th Edition.

Macaulay, Frederick R. (1938): The Movements of Interest Rates, Bond Yields and Stock Prices in the United States Since 1856. National Bureau of Economic Research, New York.

Mehra, Rajnish, and Edward C. Prescott (1985): "The Equity Premium: A Puzzle," Journal of Monetary Economics, 15, 145–61.

Weise, Charles L., and David Krisch (2009): "The Monetary Response to Changes in Credit Spreads," Paper Presented at the Eastern Economic Meetings, March 1 2009.

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"People are Hanging Tight"

The end of the great migration:

U.S. Migration Falls Sharply, by Conor Dougherty, WSJ: Migration around the U.S. slowed to a crawl last year ... as a weak housing market and job insecurity forced many Americans to stay put.

Demographers say the dropoff in migration, shown in Census data to be released Thursday, is among the sharpest since the Great Depression. It marks the end of what Brookings Institution demographer William Frey calls a "migration bubble."

As asset values rose fairly steadily in the past decade, Americans young and old moved around the country in search of jobs or better weather. In many cases, people living in higher-cost housing markets such as San Francisco and New York cashed in their real-estate winnings and moved to outlying counties, or to states like Florida and Nevada, hoping to find a cheaper house and pocket the difference. Now, "people are hanging tight; they're too scared to do anything," said Mr. Frey. ...

Migration typically slows during recessions. But in past downturns, the slowdown has been more regional in scope, with workers fleeing weaker job markets for places where companies were still hiring. ... What's unique this time is migration has slowed almost everywhere. The sharpest year-to-year changes were among what demographers call "domestic migrants," people who moved within the U.S. ... The Census data show that the biggest falloffs were in the worst housing markets. ...

Having a key resource - labor - largely frozen in place doesn't help the economy at all. People are in no mood to take risks by moving to a new job, they probably can't find a job anyway, and if they do, will they be able to sell their house? And if all that goes right, they find a job, it's a good enough opportunity to be a risk they're willing to take, and they found a buyer for their house, will the loan be so far underwater that they can't afford to sell it?

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links for 2009-03-19

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"Selfish Punishment"

How does altruism survive?:

Thriving on Selfishness, by Marina Krakovsky, Scientific American: It's the altruism paradox: If everyone in a group helps fellow members, everyone is better off—yet as more work selflessly for the common good, cheating becomes tempting, because individuals can enjoy more personal gain if they do not chip in. But as freeloaders exploit the do-gooders, everybody's payoff from altruism shrinks.

All kinds of social creatures, from humans down to insects and germs, must cope with this problem; if they do not, cheaters take over and leech the group to death. So how does altruism flourish? Two answers have predominated...: kin selection, which explains altruism toward genetic relatives—and reciprocity— the tendency to help those who have helped us. Adding to these solutions, evolutionary biologist Omar Tonsi Eldakar came up with a clever new one: cheaters help to sustain altruism by punishing other cheaters, a strategy called selfish punishment.

"All the theories addressed how altruists keep the selfish guys out," explains Eldakar... Because selfishness undermines altruism, altruists certainly have an incentive to punish cheaters—a widespread behavior pattern known as altruistic punishment. But cheaters, Eldakar realized, also have reason to punish cheaters...: a group with too many cheaters does not have enough altruists to exploit. ... That is why, he points out, some of the harshest critics of sports doping, for example, turn out to be guilty of steroid use themselves: cheating gives athletes an edge only if their competitors aren't doing it, too. ...

In a colony of tree wasps..., a special caste of wasps sting other worker wasps that try to lay eggs, even as the vigilante wasps get away with laying eggs themselves. In a strange but mutually beneficial bargain, punishing other cheaters earns punishers the right to cheat. ...

[T]he idea of a division of labor between cooperators and policing defectors appeals to Pete Richerson, who studies the evolution of cooperation at the University of California, Davis. "It's nothing as complicated as a salary, but allowing the punishers to defect in effect does compensate them for their services in punishing other defectors...," he says. After all, policing often takes effort and personal risk, and not all altruists are willing to bear those costs.

Corrupt policing may evoke images of the mafia, and indeed Eldakar notes that when the mob monopolizes crime in a neighborhood, the community is essentially paying for protection from rival gangs—a deal that, done right, lowers crime and increases prosperity. But mob dynamics are not always so benign... "What starts out as a bunch of goons with guns willing to punish people [for breaching contracts] becomes a protection racket," Richerson says. The next question, therefore, is, What keeps the selfish punishers themselves from overexploiting the group?

Wilson readily acknowledges this limitation of the selfish punishment model..., "there's nothing telling us that that mix is an optimal mix," he explains. The answer to that problem, he says, is competition not between individuals in a group but between groups. That is because whereas selfishness beats altruism within groups, altruistic groups are more likely to survive...

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"China Toys With Biting Hand Feeding Its Surplus"

John Berry:

China Toys With Biting Hand Feeding Its Surplus, by John M. Berry, Bloomberg: If Chinese Premier Wen Jiabao is so worried about the safety of China's investment in U.S. Treasury securities, he can order the money be moved elsewhere.

Of course, that likely would drive down the value of the dollar, push up U.S. interest rates and cause huge losses in China's $700 billion portfolio of Treasuries.

The reality is that Wen and China are stuck. They have no viable alternative so long as China continues to accumulate large amounts of foreign currencies as a result of its big trade surplus. ... [C]ontinuation of a big trade surplus is ... critical to China -- something Wen conveniently forgets. ...

There will still be a large deficit to be financed, and China and the U.S. will still be intertwined both economically and financially. Wen must know that.

What he doesn't seem to accept is that anything he and other senior Chinese officials do to raise questions about U.S. creditworthiness or the value of the dollar could come back to haunt them.

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Posted 3/19/2009 10:55:00 PM by Mark Thoma

March 18, 2009

Economist's View - 4 new articles

FOMC: "Economic Conditions are Likely to Warrant Exceptionally Low Levels of the Federal Funds Rate for an Extended Period"

The news in this press release from the FOMC is the plan to purchase "up to an additional $750 billion of agency mortgage-backed securities," to buy "up to $300 billion of longer-term Treasury securities over the next six months" and other moves such as "increased purchases of agency debt this year by up to $100 billion" designed to bring down long-term interest rates:

Press Release, Release Date: March 18, 2009, For immediate release: Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.
In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

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Who's the Villain in the Crisis?

Is there a single factor, or one predominant factor, that caused the crisis? I've been asked this a lot. Is there something we can point to and say that was the villain, that did it, that's who we should blame? Was it greedy CEOs, Greenspan and the Fed, lying homeowners, real estate agents with bad incentives, Chinese savers, the ratings agencies, the quants, the economists who didn't see it coming, the regulators who failed to regulate, is there a single, predominate cause?

I don't think so. For the crisis to have occurred, there must have been (1) a source of vast amounts of liquidity, (2) a reason for most of that liquidity to go to one sector, the housing sector, rather than being spread around to a variety of industries, and (3) a failure to detect and prevent the bubble from developing in the industry where the excess liquidity found a home.

The source of the excess liquidity is well known, it came from China, the oil producing countries, and low interest rate policy from the Fed. China could have accumulated less reserves, invested them at home, etc., and the US could have pursued a higher interest rate policy (but at what cost to the economy as it was trying to recover from the bursting of the tech stock bubble), that's true, and it might have made the bubble less severe, but were these things, and these things alone, the cause of the bubble?

There's no reason why the excess liquidity could not have been invested in a variety of industries rather than flowing mainly to housing. If that happens, the risks are spread far more broadly, and we don't have such a large bubble, one that endangers the broader economy when it pops. So we have to ask, why did the money flow almost entirely to one industry? It was the false perception that financial innovation could produce higher rewards without increasing risk, there were lots of complex mathematical models around to prove it, and there were ratings agencies to validate the claims. So the combination of excess liquidity with the false promise of higher returns without higher risk caused the money to flow into a particular industry rather than into a wide variety of investment opportunities. It was safe as houses.

But even that wasn't enough to produce a bubble by itself, we have to ask why the checks and balances within the housing sector, both from the market and from regulators, failed to stop the massive flow of money into these assets. The reason is that there were incentive problems all the way through the system. The homeowner gets a non-recourse loan which makes risks mostly one-sided, real estate agents are paid on commission giving them to incentive to maximize the number of houses sold at the highest price they can get, real estate appraisers were in the pocket of the real estate agents (that's obvious when you buy a house), if they don't give the values the agents are looking for, their phone stops ringing. The mortgage brokers were being paid, essentially, on commission and they were able to move these loans off their books - sell them as repackaged securities - so as to remove any long-run interest in the outcome of the loans (so they didn't care what the appraisers said). Their incentive was to sell as many loans as possible with no real concern for quality. Why did people buy these repackaged loans from banks and brokers? Here we come again to the ratings agencies and the poor risk assessment models, the culture within these institutions, moral hazard from implicit or explicit government guarantees, compensation structures, and so on. The incentives at just about every step of the process were to create as many loans as possible with little regard to quality, every check and balance that ought to be in place was missing. The market did not self correct, and regulators clearly fell down on the job, fixing any one of these incentives could have made a big difference by plugging up the pass-through of the excess liquidity from China and the Fed, but the regulators were absent. Whether this is due to incompetence, poorly structured regulatory procedures, or regulatory capture - money talks and nobody wanted to spoil the party - I don't know for sure. But the regulatory failures were clearly broad based.

So I can only narrow the villains down and place them into broad categories, I can't point fingers at any one of them and say you did it, you were the cause of this. The managers at places like AIG were part of the problem, and they surely don't deserve rewards for their performance, that is not the argument here, but they and others like them were only one part of the problems we now have, they didn't cause the problems by themselves. It was a combination of things working together that produced this crisis, that is, excess liquidity, very poorly structured incentives, and incorrect assessment of the risks all came together to produce the problems we are seeing. I wish I could point to a single villain, it would be easier in a many, many ways to be able to do that, but I don't think we can, and doing so runs the risk of delaying the reform that is needed by causing us to focus on only a small set of the larger set of "villains". There's plenty of blame - and reform - to spread around.

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"The Tipping Point?"

James Kwak hopes that the AIG scandal will compel the administration to take action:

The Tipping Point?, by James Kwak: $165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another. Yet it may turn out to be the $165 million that broke the camel's back.

The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.

The bonus contracts - which have still not been released to the public - reflect the instinct of Wall Street to favor its employees over any other stakeholders. ...

The failure of the Treasury Department and the Federal Reserve to review and renegotiate the bonus plans as a condition of federal assistance last fall...

The seeming inability of the government to do anything but throw up its hands reflects the failed strategy of the bailouts so far: provide as much cash as needed, but do everything you can to minimize the impact on the companies being bailed out. ...

The testaments to "the best and the brightest" - here, referring to the people of AIG Financial Products - reflect, I don't know, either absolute, brazen obscenity, or a world-historical example of making the mistake of believing your own hype. The fact that people on Wall Street believe that they are the best among us is bad enough. The fact that people in Washington are willing to accept it is worse.

However, this scandal may yet serve a purpose. ... The key issues throughout this crisis have been political as much as economic. In this case, the Obama administration has been taking a difficult political position - propping up financial institutions in their current form and insisting everything will be OK - when it would have been easier to play the populist card. This was by no means an inescapable choice; according to news reports in February, David Axelrod and Rahm Emmanuel were in favor of being tougher on the banks. Perhaps the AIG bonus scandal will force the administration's hand toward the decisive action that we need.

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links for 2009-03-18

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Posted 3/18/2009 10:46:00 PM by Mark Thoma

March 16, 2009

Economist's View - 6 new articles

"Grading Obama on the Economy"

I was asked about the grade of "F" the WSJ gave to the economic policies of Obama and Geithner:

Grading Obama on the economy, by Mark Thoma, Comment is Free, UK Guardian: Obama hasn't received high marks for his handling of the financial crisis. Does he deserve a failing grade?

The Obama administration's economic policies received a low average rating from 54 economists participating in a recent poll appearing in the Wall Street Journal, low enough to allow the paper to award an "F" grade to the president and US Treasury secretary Timothy Geithner. (Ben Bernanke fared a bit better.)

However, there was considerable variation across the 54 responses, perhaps because the question was too broad. In particular, when assessing the administration's policy successes or failures to date, it's important to separate the stimulus package from the bailout package, and to separate the economics from the politics.

Though they are often confused, the stimulus package is intended to jump-start the economy and is largely independent of Geithner and the Treasury, while the bailout policies are directed at repairing the financial sector and are, to a large extent, a direct product of the Treasury's efforts.

The economic policies underlying the stimulus package do not, in my opinion, deserve a failing grade, or anything close to that. The policies the administration would have liked to have implemented were based upon solid principles. But I was disappointed with the actual legislation.

The problem was the politics, not the economics. The administration did not get out in front and dominate the political message. Instead, the framing was left to the opposition, and that forced compromises in the stimulus legislation that limited its potential effectiveness, perhaps to the point of falling below the critical threshold needed to get the economy moving.

For example, the bill that actually emerged slanted too much toward tax cuts that are likely to be saved rather than spent, thus reducing the impact on aggregate demand. There was not enough help for state and local governments, and there was not enough help for struggling households who have taken big balance sheet and employment hits as the crisis has unfolded. So while I would give the policy design decent marks, the actual implementation has fallen short, largely due to a tendency to compromise instead of taking control of the political battlefield.

The financial bailout suffers from a similar problem, but here the economics have been problematic as well. The plan has been slow to develop, and does not seem to recognise the nature of the problem. However, this may be due to fear of the politics associated with nationalisation rather than a lack of understanding of the problem and then potential solutions to it. Or it could be from a genuine belief that nationalisation ought to be a last resort.

But all of the false steps, the hesitation, the lack of a firm commitment to a particular course of action look to me like they have been driven by a desire to find some way, any way, of avoiding the political consequences of doing what they know needs to be done in their heart of hearts: take temporary control of the banks, separate the good assets from the bad, recapitalise the banks as necessary, then sell the reconstituted banks back to the private sector.

But instead of leading the political argument, they have allowed the opposition to dominate the political landscape and that has forced the administration's hand in terms of the policies they are able to pursue. In the case of the financial sector, it's time to stop hoping that muddling along until the economy recovers will somehow solve the problem, and to get out in front and lead. As for the stimulus package, the message is the same. Given that the first package may not be enough due to the lack of a proper political foundation, and therefore that a second round may be needed, it would be helpful to begin paving the political path forward here as well.

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Tim Duy: The Oregon Employment Report

Tim Duy on today's employment report for Oregon. It's not good.

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"Should we Still Make Things?

There is a symposium on Should We Still Make Things? at Dissent Magazine. Here's part of Dean Baker's entry:

Should We Still Make Things?, by Dean Baker: I have often thought that economists should be required to have a better grasp of simple arithmetic. It would prevent them from repeating many silly comments that pass for conventional wisdom, such as that the United States will no longer be a manufacturing country in the future.

Those who know arithmetic can quickly detect the absurdity of this assertion. The implication of course is that the United States will import nearly all of its manufactured goods. The problem is that unless we can find some country that will give us manufactured goods for free forever, we have to find some mechanism to pay for our imports.

The end of manufacturing school argues that we will pay by exporting services. This is where arithmetic is so useful. The volume of U.S. trade in goods is approximately three and half times the volume of its trade in services. If the deficit in goods trade were to continue to expand, we would need an incredible growth rate in both the volume and surplus of service trade and our surplus on this trade in order to get to anything close to balanced trade.

For example, if we lose half of our manufacturing over the next twenty years, and imported services continue to rise at the same pace as the past decade, then we would have to see exports of services rise at an average annual rate of almost 15 percent over the next two decades if we are to have balanced trade in the year 2028. ... It would take a very creative story to explain how we can anticipate the doubling of the growth rate of service exports on a sustained basis. ...

[Also], the idea that U.S. workers are somehow too educated to be doing for manufacturing work, but instead will be making the beds, bussing the tables, and cleaning hotel toilets for foreign tourists is a bit laughable. Of course, with the right institutional structure (e.g. strong unions) these jobs can be well-paying jobs, but it is certainly not apparent that they require more skills than manufacturing. ...

In short, the idea that the United States can survive without manufacturing is implausible: It implies an absurdly rapid rate of growth of service exports for which there is no historical precedent. Many economists and economic pundits asserted that house prices could keep rising forever in spite of the blatant absurdity of this position. The claim that the U.S. economy can be sustained without a sizable manufacturing sector is an equally absurd proposition.

I thought that if you looked at the value of US manufacturing, it hasn't fallen nearly as much as manufacturing employment. Thus, much of the change that has affected workers is due to changes in technology, not the exporting of jobs (this comes from a study done by the Peterson Institutute, more here). But from a worker's perspective, it doesn't matter all that much whether it's technology or jobs moving to other countries, the job is gone either way. The key, then, is to have good jobs waiting for workers when they are displaced due to inevitable (and desirable) technological change or to jobs moving overseas, jobs that are every bit as good or better than the jobs they left. That is where we are falling short. The new jobs we are creating are not as good as the jobs we are losing, when workers are forced to find new jobs they don't tend to do as well as they did in their previous job, and that is the source some of the stagnation we have seen in middle class incomes over the last few decades.

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Clarida and DeLong on Fiscal Policy

Two views on fiscal policy from Brad DeLong and Richard Clarida. First, Clarida who has doubts about fiscal policy (and he isn't so sure about monetary policy either), then DeLong who, like me, is more supportive of fiscal policy efforts.

Richard Clarida:

A lot of bucks, but how much bang?, by Richard Clarida, Vox EU: "We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand" - John Maynard Keynes, "The Great Slump of 1930", published December 1930.

I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts to discuss the state of global markets, geopolitics, and the many and varied ways that Russia factors into these complex domains. The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me, from the two-and-half-hour session that included probing questions from a number of the audience members assembled for the event.

That theme suggests the title I've chosen for this column; there are, at last, a 'lot of bucks' now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much 'bang' we can expect from these bucks.

In the US, President Obama has just signed a nearly 800 billion dollar stimulus package and the Fed has cut the Federal Funds rate to zero. Monetary policy in the rest of the G7, while lagging behind the US, will follow the US lead and soon come close to zero. (In the case of the ECB, the policy rate may end up at 1%, but the effective interbank rate has been trading well below the official policy rate in recent weeks so a policy rate of 1% could translate into an effective interbank rate of nearly zero). Likewise for fiscal deficits – they are rising globally and headed higher, propelled by a combination of discretionary actions and automatic stabilisers.

To date, however, these traditional policies have been insufficient for the scale and scope of the task. Recall that the Obama stimulus package is actually the second such US effort in the last 12 months. The 2008 edition was deemed to be a failure because a big chunk of the rebate checks were saved or used to pay down debt and not spent. The Obama package includes tax cuts and credits that will provide a boost to disposable income, but how much of these will be spent rather than saved or used to pay down debt? The package also includes a substantial increase in infrastructure spending, as well as transfers to the states, but the infrastructure spending is back-loaded to 2010 and later, and the transfers to states will most likely just enable states to maintain public employment, not expand it appreciably.

Bucks without bang

What is the source of this concern that the US fiscal package will not deliver a lot of 'bang' for the 'bucks' committed? Because of the severe damage to the system of credit intermediation through banks and securitisation, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Recall the Econ 101 idea of the Keynesian multiplier – the impact traditional macro policies are 'multiplied' by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It important to remember why and how policy multipliers actually come about. Policy multipliers are greater than 1 to the extent the direct impact of the policy on GDP is multiplied as households and companies increase their spending from the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand from the initial round of stimulus.

Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001, the economy was in recession, but households took advantage of zero-rate financing promotions – as well as ready access to home equity withdrawal from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts and income earned from government spending on goods and services will not be leveraged by the financial system to nearly such an extent, resulting in (much) smaller multipliers.

There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates. Just in 2008 alone, I estimate that the net worth of US households fell by some 10 trillion dollars, with much of this concentrated in older demographic groups who, in our defined contribution world, must now be focused on building back up their wealth to finance retirement, which is not that far away. This means more saving, less consumption, and smaller multipliers.

Global challenges

Outside of the G7, many of the major countries (certainly including Russia) are commodity exporters. The global recession has triggered a collapse in commodity prices, turning 2007's fiscal surpluses into deficits and turning property and capital spending booms into busts in a matter of months. For example, as I am writing this, a headline has just popped up confirming that Dubai has received a "10 billion dollar bailout" from the UAE central bank to help provide financing for the rollover of debt backed by thousands of unfinished and unsold houses and apartment projects. Immense reserve stockpiles, which only months ago were criticised by some as excessive and without any purpose other than to manipulate national currencies so as to prevent appreciation are now, in Russia and some prominent other countries, being drawn down rapidly in a futile attempt to slow speculative depreciation of their currencies.

In Russia's case, Deputy Prime Minister Shuvalov spoke at the conference and made very clear that 2009 will be a year of hard choices for the Russian government. Most importantly, Shuvalov made clear that Russia is unwilling to spend more than the 200 billion (a third) of the reserves they have already spent in what has turned out to be a futile attempt to support the Ruble. This will mean that companies and some banks will be allowed to fail, and that fiscal outlays will be scaled back and not funded at previous levels through a further draw down of reserves. So in Russia's case, and I suspect some others, a lot of 'bucks' remain in reserve coffers, but they will be mostly saved, not spent to finance a major discretionary expansion in fiscal policy.

Will the Fed pull it off?

So where does this leave us? A LOT is riding on the efforts of the Fed and other central banks to stabilise the financial system and restore the flow of credit.

Officials recognising these challenges are now seriously considering "non-traditional" policies that combine monetary and fiscal elements. Cutting rates to (near) zero has not been a mistake, but it has been ineffective – really the most striking example of 'pushing on a string' I have witnessed in my lifetime. The reason, again, is the impaired credit intermediation system. The private securitisation channel, which at its peak was intermediating nearly 50% of household credit in the US, has been destroyed. Banks are hunkering down in the bunker, hoarding capital as a cushion against massive losses yet to be recognised on the trillions of dollars of 'legacy' assets that they have been unable or unwilling to sell at the deep discount required to attract private investors. For this reason, the Fed and Bank of England – with many other central banks likely to follow suit in some form or fashion – are filling the vacuum by directly lending to the private sector. The Fed aims to purchase 600 billion dollars worth of mortgage-backed and agency securities this year and, via the soon to be launched Term Asset-Backed Securities Loan Facility (TALF), to finance without recourse up to one trillion dollars worth of private purchases of credit cards, auto loans, and student loans. Since last fall, the Fed has also been supporting the commercial paper market via the Commercial Paper Funding Facility (CPFF).

Altogether, between the MBS, CPFF, and TALF programs, the Fed is committing nearly 2 trillion dollars of financing to the private sector. While these sums may be necessary to prevent an outright economic collapse that extends and deepens into 2011 and beyond, it is not clear to me that they are sufficient to turn the economy around so that it returns to robust growth. Moreover, based on the Fed's just released economic forecast and Chairman Bernanke's recent testimony to the Senate Banking committee, the Fed is also not convinced that these policies are sufficient to turn the economy around. On 24 February, knowing that an 800 billion stimulus had passed, that the Fed has committed nearly 2 trillion dollars of lending to the private sector, and that the Treasury's Public Private Investment Fund will aim to support up to one trillion dollars of private purchases of bank legacy assets, Chairman Ben Bernanke said,

If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability – and only if that is the case, in my view – there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,

As I said in my remarks at the conference, I think of myself as an optimist, and that outlook on life has served me well. However, the last nine months have severely tested that mindset, at least as it pertains to my professional endeavours. But old habits are hard to break, so I am casting aside the contrary evidence and putting my 'bucks' on the Fed. But it is a close call.

Next, Brad DeLong:

Why we need not fear that a bigger stimulus will be counterproductive, by Brad DeLong, Vox EU: My favourite line from Jaws is uttered police chief Martin Brody (Roy Scheider) when he finally sees the shark: "You are going to need a bigger boat."

We are at last seeing the shape of this downturn – and we are going to need a bigger fiscal stimulus than the deficit-spending package President Barack Obama pushed through the US Congress in February. We might get lucky; maybe the next four months will be months of unreserved good luck; maybe four months from now we will think that what we have collectively done to stabilise the North American and world economies is appropriate. That is not very likely; mixed news would mean that four months from now we are going to want to do another round of government spending boosts and tax cuts to try to keep the unemployment rate from rising too much higher and capacity utilisation from falling too much lower. (And the legislative calendar means that we should start thinking about laying the groundwork for such a second round of stimulus right now; in order to be in the budget reconciliation bill that will pass the congress in August, provision for fiscal stimulus must be in the budget resolution that will pass the congress in April.) Moreover, if the next four months are months of worse-than-expected bad news – well, let's not go there right now.

Getting another round of spending boosts and tax cuts will, however, be problematic. Partisan opposition is mounting. That there is partisan opposition is very strange. We know John McCain's chief economic advisers – people like Douglas Holtz-Eakin, who made an excellent reputation for himself as head of the Congressional Budget Office, like well-respected forecaster Mark Zandi, like AEI's Kevin "Dow 36000" Hassett. We know how they think. We know that had John McCain won last November's presidential election a very similar stimulus plan (but with fewer spending increases and more tax cuts) would just have moved through congress with solid Republican support. So the current 98% Republican opposition (except by governors who have to, you know, govern) leaves us scratching our heads.

So as we get ready to try to go and buy a bigger fiscal stimulus boat to deal with this Jaws recession, whose bite pushed the unemployment rate up to 8.1% in February, it is important to be clear why we ought to be doing this. And the first point that needs to be made is that the strange right-wing talking point that a government fiscal boost would not spur the economy because... because... well, it's not sure why... is badly mistaken at best and disingenuous at worst.

Four legitimate fears

But there are legitimate reasons to fear that deficit-spending fiscal boost programs would not work well enough and would have high enough longer-term costs to be not worth doing. I classify these legitimate fears into four groups.

Bottleneck-driven inflation. The fear is that although more deficit spending will increase total spending, and although businesses seeing increased demand for their products will indeed try to hire more workers to boost production, they will succeed only by offering their new workers higher wages – wages higher enough that they then have to boost their prices – and by snatching scarce commodities out of the supply chain by paying more and then having to boost their prices more as well. Thus rising inflation will make the increase in real demand an order of magnitude less than the increase in nominal demand. And if the inflation produces general expectations that prices will continue to rise – well, then we are back where we were in the 1970s, with everybody focusing on changes in the overall price level rather than whether their business plan made sense given individual goods and services prices. An inflationary economy is one in which the price system does not do a very good job of telling people and businesses where to focus their energy. It is likely, over the decades, to be a slow-growth economy. Breaking an inflationary spiral would require another recession on the order of 1979-1982. It is better not to go there, and a fiscal stimulus plan that takes us there is not worth doing.

Capital flight-driven inflation. The fear is that the stimulus package will cause foreign holders of domestic bonds to believe that inflation is on the way and trigger a mass sell-off of US Treasuries and other dollar-denominated assets that will push the value of the dollar down. And as the value of the dollar falls, the dollar prices of imported goods and services rise – and we are off to the inflation races once again.

Crowding-out of investment spending. The fear is that additional government borrowing may – not will, not must, but may, for this is a fear not a certainty – push up interest rates, make financing expansion even more expensive for businesses, and so discourage private investment. The boost to spending would thus come at a high cost-benefit ratio as much additional borrowing leaves us with only a little additional demand. Moreover, it would leave us with a low productivity-growth recovery that has too little productivity-boosting private investment and too much government spending in the mix.

Reaching the limits of debt capacity. The fear is that the long-term costs of additional fiscal boosts via deficit spending will be very large because those from whom the US government will have to borrow the money to finance spending will only loan it on lousy terms – high and unfavourable real interest rates that impose substantial amortisation burdens and associated deadweight losses from taxation on America's taxpayers.

All of these are legitimate fears when a government undertakes a deficit-spending plan. We can all recall historical episodes when they turned out to be not just fears but realities. We remember bottleneck-driven and wage-push inflation from the late 1960s and from the oil shock-ridden 1970s – those episodes were the first fear coming home to roost. Nobody today is happy with American fiscal policy in the late 1960s or American demand management policy in the 1970s.

The second fear became a reality in France in the early 1980s. Capital flight and anticipated-depreciation-driven inflation were the immediate result of Francois Mitterand's attempt to institute Keynesianism in one country and drive for full employment when he became president of France in 1981.

The third fear was perhaps not a reality but it certainly was greatly feared in the winter of 1992 and 1993, back when I carried spears for Lloyd Bentsen and his subordinates Roger Altman and Lawrence Summers in the Clinton Treasury. They argued that the Clinton-era economy could not afford the crowding-out of private investment that even the steady-course deficits then projected for the mid-1990s were threatening to produce through high and rising interest rates.

And the fourth fear is an even older legitimate fear yet. It goes back to Adam Smith and his Wealth of Nations, which contains pages warning that deficit spending on the imperial adventures of George III and his ministers would produce an unsustainable debt burden that would crack the British economy like an egg – as had been the consequences of debt-financed wars in Holland, France, Spain, and the Italian city-states over the previous three centuries.

Why we need not fear

These four fears are all legitimate fears, but I believe that we, here, now do not need to fear them.

In each of the cases in which these fears are legitimate, we can see in advance that the stimulus program is going wrong. Stimulus packages produce increases in nominal but not real demand when exchange rates fall and prices rise; we can watch the exchange rates fall and the prices rise, and we can watch as financial markets anticipate these events beforehand. Stimulus packages crowd-out private investment when the government's borrowing causes medium-term interest rates on corporate borrowings to rise. Stimulus packages impose a heavy financing burden on the government when they cause long-term interest rates on government securities to rise.

In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead.

Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds.

If any of these start to materialise, expect me and a number of other stimulus advocates to start backpedalling rapidly. But so far, so good.

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Paul Krugman: A Continent Adrift

Was European integration and the creation of a common currency a mistake?:

A Continent Adrift, by Paul Krugman, Commentary, NY Times: I'm concerned about Europe. Actually, I'm concerned about the whole world... But the situation in Europe worries me even more than the situation in America.

Just to be clear, I'm not about to rehash the standard American complaint that Europe's taxes are too high and its benefits too generous. Big welfare states aren't the cause of Europe's current crisis. In fact,... they're actually a mitigating factor.

The clear and present danger to Europe right now comes from ... the continent's failure to respond effectively to the financial crisis.

Europe has fallen short in terms of both fiscal and monetary policy... On the fiscal side, the comparison with the United States is striking. Many economists ... have argued that the Obama administration's stimulus plan is too small... But America's actions dwarf anything the Europeans are doing.

The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates..., and it has shied away from any strong measures to unfreeze credit markets.

The only thing working in Europe's favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.

This is no small matter. Guaranteed health insurance and generous unemployment benefits ensure that, at least so far, there isn't as much sheer human suffering in Europe as there is in America. And these programs will also help sustain spending in the slump.

But such "automatic stabilizers" are no substitute for positive action.Why is Europe falling short? Poor leadership is part of the story. European banking officials ... still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany's finance minister you have to listen to, well, Republicans.

But there's a deeper problem: Europe's economic and monetary integration has run too far ahead of its political institutions. The economies of Europe's many nations are almost as tightly linked as the economies of America's many states... But unlike America, Europe doesn't have the kind of continentwide institutions needed to deal with a continentwide crisis.

This is a major reason for the lack of fiscal action: there's no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to ... finance a stimulus that will convey many if not most of its benefits to voters in other countries.

You might expect monetary policy to be more forceful. After all, while there isn't a European government, there is a European Central Bank. But the E.C.B. isn't like the Fed, which can afford to be adventurous because it's backed by a unitary national government — a government that has already moved to share the risks of the Fed's boldness, and will surely cover the Fed's losses if its efforts to unfreeze financial markets go bad. The E.C.B., which must answer to 16 often-quarreling governments, can't count on the same level of support.

Europe, in other words, is turning out to be structurally weak in a time of crisis. ... Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe.

But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?

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links for 2009-03-16

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Posted 3/16/2009 10:49:00 PM by Mark Thoma

March 15, 2009

Economist's View - 3 new articles

Bernanke on 60 Minutes

[Ben Bernanke's Greatest Challenge]

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Animal Spirits

Some history of the phrase "animal spirits":

...Needed now, say today's contrarians, is an infusion of animal spirits. In a New York Times Op-Ed a few weeks ago ... Robert Shiller, the author with his fellow economist George Akerlof of a new book, ''Animal Spirits,'' which carries a depressingly lengthy subtitle about psychology, noted that... ''The attention paid to the Depression story ... is a cause of the current situation — because the Great Depression serves as a model for our expectations, damping what John Maynard Keynes called our 'animal spirits,' reducing consumers' willingness to spend and businesses' willingness to hire and expand. The Depression narrative could easily wind up as a self-fulfilling prophecy.''

Keynes was surely the popularizer of the phrase in his 1936 book ''The General Theory of Employment, Interest and Money.'' He held that economic instability..., often the result of speculation, was also caused partly by ''spontaneous optimism rather than mathematical expectations. Most, probably, of our decisions to do something positive can only be taken as the result of animal spirits — a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.''

In that passage, he was warning about overconfidence; in another, he encouraged risk-taking: ''If the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.'' I like that one more.

The phrase that Keynes made famous in economics has a long history. ''Physitions teache that there ben thre kindes of spirites,'' wrote Bartholomew Traheron in his 1543 translation of a text on surgery, ''animal, vital, and naturall. The animal spirite hath his seate in the brayne called animal, bycause it is the first instrument of the soule, which the Latins call animam.''

Novelists seized the expression's upbeat sense with enthusiasm. Daniel Defoe, in ''Robinson Crusoe'': ''That the surprise may not drive the Animal Spirits from the Heart.'' Jane Austen used it to mean ''ebullience'' in ''Pride and Prejudice'': ''She had high animal spirits.'' Benjamin Disraeli, a novelist in 1844, used it in that sense: ''He had great animal spirits, and a keen sense of enjoyment.'' Feel better?...

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links for 2009-03-15

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Posted 3/15/2009 10:51:00 PM by Mark Thoma

March 14, 2009

Economist's View - 4 new articles

"Blame Economists, Not Economics"

Dani Rodrik says economics is fine, but its practitioners are not (the full version points to macroeconomists in particular):

Blame economists, not economics, by Dani Rodrik, Project Syndicate: As the world economy tumbles off the edge of a precipice, critics of the economics profession are raising questions about its complicity in the current crisis. Rightly so: economists have plenty to answer for. ...

So is economics in need of a major shake-up? Should we burn our existing textbooks and rewrite them from scratch? Actually, no. Without recourse to the economist's toolkit, we cannot even begin to make sense of the current crisis.

Why, for example, did China's decision to accumulate foreign reserves result in a mortgage lender in Ohio taking excessive risks? If your answer does not use elements from behavioral economics, agency theory, information economics, and international economics, among others, it is likely to remain seriously incomplete.

The fault lies not with economics, but with economists. The problem is that economists (and those who listen to them) became over-confident in their preferred models of the moment: markets are efficient, financial innovation transfers risk to those best able to bear it, self-regulation works best, and government intervention is ineffective and harmful.

They forgot that there were many other models that led in radically different directions. Hubris creates blind spots. If anything needs fixing, it is the sociology of the profession. The textbooks -- at least those used in advanced courses -- are fine.

Non-economists tend to think of economics as a discipline that idolizes markets and a narrow concept of (allocative) efficiency. ... But ... spend some time in advanced seminar rooms, and you will get a different picture. ... Advanced training in economics requires learning about market failures in detail, and about the myriad ways in which governments can help markets work better. ...

Economics is really a toolkit with multiple models -- each a different, stylized representation of some aspect of reality. One's skill as an economist depends on the ability to pick and choose the right model for the situation.

Economics' richness has not been reflected in public debate because economists have taken far too much license.

Instead of presenting menus of options and listing the relevant trade-offs -- which is what economics is about -- economists have too often conveyed their own social and political preferences. Instead of being analysts, they have been ideologues, favoring one set of social arrangements over others.

Furthermore, economists have been reluctant to share their intellectual doubts with the public, lest they 'empower the barbarians.' ...

Paradoxically, then, the current disarray within the profession is perhaps a better reflection of the profession's true value added than its previous misleading consensus. Economics can at best clarify the choices for policymakers; it cannot make those choices for them.

When economists disagree, the world gets exposed to legitimate differences of views on how the economy operates. It is when they agree too much that the public should beware.

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Who's Responsible for the Budget Deficit?

Dean Baker:

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"The Agenda for 'Understanding Society' is an Old One"

Daniel Little:

Proto social inquiry, Understanding Society: We sometimes imagine that the current disciplines and methods of the social sciences represent a more or less inevitable set of approaches to the problem of understanding social phenomena. But really, the latter task is much larger than the specific sets of disciplines and methods we have currently developed. It is worth turning back the dial a bit and reflecting on the intellectual currents that led to contemporary programmes for the social sciences. Reflective people have been curious about the workings of the social world for as long as they have observed and commented upon the world of actions and institutions that they found around themselves. The Greeks were particularly interested in such things as the causes and outcomes of war (Thucydides), the properties of different kinds of states (Plato), the nature of the family (Aristotle), and so on. Often the focus was on the question of "justice"—the features of social arrangements that were justified on moral grounds. But there are also many examples of philosophers and writers who were interested in the question of the how and why of social life: how does it work, what sorts of causes are at work, and why do certain kinds of outcomes occur (poverty, war, violence)? These reflections often represented systematic thinking and observation, but they did not amount to what we would call "social science" today. Several important changes occurred in Europe in the eighteenth and nineteenth centuries that created a new impulse towards a different kind of study of the social world.

One was eighteenth-century globalization. There was more knowledge available from travelers and colonial administrators about exotic social and familial practices in non-European places. The fact of religious and moral diversity was itself a startling discovery. This set of discoveries demonstrated the unavoidable fact of human social diversity. In the eighteenth century European thinkers raised questions deriving from the observed differences in social orders around the globe; so thinkers such as Rousseau and Montesquieu considered the significance and causes of different patterns of social organization in Europe, the New World, Africa, and Asia. So the questions arose, how do these alternative social orders work, and why are there such wide differences in the first place? Second was an increasing recognition of the interconnectedness of economic and political life within European societies themselves. The physiocrats and the British political economists began to postulate causal connections between certain kinds of social facts—settlement, trade, extension of agriculture, and law—with certain kinds of outcomes—the creation of the wealth of nations. The physiocrats particularly highlighted the systematic relationships that exist between environment, land, food production, prices, rents, and other forms of economic development. And debates about economic policies in the nineteenth century -- debates over the Corn Laws, for example -- likewise pointed towards the discovery of previously unobserved causal connections among economic facts. A third major change carried over into the nineteenth century—the advance of modern industrial production, urbanization, bureaucratic states, class formation, migration, and a recognition of major social changes associated with urbanization and industrialization. These changes, associated with the industrial revolution, set urgent new intellectual challenges to thoughtful observers; why were these changes taking place, and where were they going? Even Hegel expressed theoretical interest in the rise of the bureaucratic state -- Shlomo Avineri's Hegel's Theory of the Modern State makes a very clear case for the historical and empirical interests that Hegel had, along with his abstract philosophical theory of Right. What would be the consequences for European (or French and English) civilization of these basic seismic shifts in the order of society? Thus, for example, Engels, Tocqueville, and Carlyle all reflected intensely on the meaning of Manchester for the new society (link, link, link). Fourth, a raft of novel and urgent social problems—destitution, factory safety, crime, widespread hunger, deracination of the majority population, and the creation of enormous cities—loomed large in the emerging interest in creating "sociology." How could a modern society cope with these problems? (Gareth Stedman Jones's book Outcast London is particularly interesting for the insights it shed on how nineteenth-century observers, including Alfred Marshall, attempted to understand the problems and changes associated with London's rapid development.) Parliamentary commissions on conditions of labor, public health, and other important social problems provided an empirical basis for more systematic study by theoretically minded thinkers. The systematic collection of social statistics in turn created an intellectual demand for analysis in the form of the mathematics of probability and statistics. (Ian Hacking's book, The Emergence of Probability: A Philosophical Study of Early Ideas about Probability, Induction and Statistical Inference, provides a nice account of some of these developments.) Finally was the rise of full-blown results in the natural sciences in the nineteenth century—chemistry, electromagnetism, mechanics, geology, and biology. So the idea of studying and explaining the patterns of the social world with the same kinds of "science" was a fairly natural next step. The sudden impact of Darwinian ideas about biological evolution and the origin of species at late century was also important for some early sociologists. Founding social scientists as diverse as Marx, Durkheim, Comte, and Spencer were influenced by the models of empirical and logical rigor associated with positive natural science -- sometimes to the detriment of the future development of the social sciences. (See earlier postings on positivism and naturalism for more about these shortcomings.) The point here is a simple one. The agenda for "understanding society" is an old one, predating the modern social sciences by centuries. And the needs that we have for understanding, explanation, and intervention in the area of complex social processes and problems inherently exceed the scope of the particular efforts we've made to date in constructing empirically rigorous social science. We need to keep our eyes open for new problems and new approaches in the social sciences, if we are to do a satisfactory job of understanding and coping with the social issues of the twenty-first century. (See earlier postings on world sociology , French sociology, and Chinese sociology for more thinking about the need for innovation in the social sciences.)

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links for 2009-03-14

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Posted 3/14/2009 10:52:00 PM by Mark Thoma

March 13, 2009

Economist's View - 8 new articles

Positive Trends in Economic Development

William Easterly:

When Will There Be Good News?, William Easterly: In the midst of the general doom and gloom, fears about how the crisis will affect poor countries, and fierce criticism of markets, states, and aid agencies, perhaps it's healthy to step back to the big picture, to recognize there has already been some very real good news. The graph below shows some overall statistics for the developing world:

This graph has a mixture of good news that all of the much-criticized triad of markets, states, and aid can take partial credit for. Markets obviously get at least some credit for the reduction in global poverty and increase of global average income. States supply public goods like education, water, and health, and there has been progress on all of these. Aid deserves some credit for successes in health, as already stressed in a previous blog post.

One group that doesn't deserve much credit is "development experts," because there is a terrible crisis of confidence in development economics now, where we all freely confess we don't really know what to advise governments on how to speed up development. ...

Yes, there is a terrible crisis now, not to mention that all of these indicators are still deeply unsatisfactory, so we all keep criticizing and holding accountable the market, state, and aid actors who fall so woefully short. But let none of us forget how much development already happened over the last half-century, which may inspire us with hope that more step-by-step improvements in markets, states, and aid could make even more development possible.

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Summers at Brookings

Economic Recovery [Transcript of Entire Speech] Fiscal Solvency Education Secretary Tim Geithner

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The Rodrik Roundtable

Dani Rodrik at The Economist:

A Plan B for Global Finance

My response at the Rodrik Roundtable (Other responses: Richard Baldwin, Adam Posen, Simon Johnson, Leo Tilman, The Economist: London, The Economist: New York):

Central Authority Necessary, by Mark Thoma: Dani Rodrik does not believe that global financial regulation is feasible, prudent, or desirable, and he argues for considerable regulatory autonomy for individual countries rather than a centralised regulatory authority. This is consistent with the one economics, many recipes theme he has been developing in recent years. I don't disagree with the idea of granting individual countries as much individual flexibility as possible, and most proposals recognise some role for a global institution, so the question is one of degree, i.e. how much power to give a central authority, and how much power to leave to each individual country.

There is often tension between moving quickly to resolve a crisis, and following democratic processes that allow all interests to be represented in the decision-making process. When power is concentrated, quick action is much easier, and we see this concept at work in the Federal Reserve system. The Fed, as initially conceived in 1913, was a decentralised institution with no dominant central authority. The vision was one of twelve cooperating banks, with each bank granted the power and the flexibility to respond to conditions within their districts. This is the vision Dani has for the world economy.

But the Great Depression made it clear that such an institution, while perhaps ideal for normal times, was severely limited when a crisis hits... [...continue reading...]

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Failing to Bailout Lehman Brothers was a Mistake

Lately, the idea that allowing Lehman Brothers to collapse was not the big disaster many have claimed it was has been heard with increasing frequency, especially among those opposed to government bailouts of the financial industry. For example, John Taylor recently said of the "bad turn" financial markets took after Lehman Brothers failed:

Many have argued that the reason for this bad turn was the government's decision not to prevent the bankruptcy of Lehman Brothers... A study of this event suggests that the answer is more complicated and lay elsewhere.

Here's a rebuttal of this idea, and of the evidence presented by Taylor:

Why letting Lehman go did crush the financial markets, by Sam Jones: For some time now, the folks over at Clusterstock - notably John Carney - have led a challenge to a particularly virulent piece of received wisdom: that the failure of Lehman was necessarily an inflection point that took the severity of the financial crisis to a whole new level.

And with that the implication that the government's decision to let Lehman fail was, in itself, a failure.

Until now, that kind of debate might have seemed a little academic - a question for historians. But day by day; bailout by bailout, its pertinence to current events and future policy is growing: politicians and regulators are going to find themselves increasingly under pressure to account for the growing number of expensive opportunities they are being occasioned with to Save The World.

Loath as we are to turn again to the "Japanese Scenario" for appropriate lessons, it's worth bearing in mind that in Japan, it was ultimately the weight of public opinion, as much as it was economic or financial considerations, that came to shape the way the crisis played out. Distaste for spending taxpayers' money grew extreme: bailouts became taboo. The way Japan's authorities consequently pussy-footed their way around problems rather than tackling them head on drew the crisis out for nigh on a decade - dare we now even say, two.

Back now, though, to the specifics of Lehman's collapse. ... [...continue reading...] ...

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links for 2009-03-12

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When to Take Cover

In 1999, John Kenneth Galbraith explained how to spot speculative excess:

Notable and Quotable, WSJ: From an address given by John Kenneth Galbraith at the London School of Economics in June 1999 called "The Unfinished Business of the Century":

We have far more people selling derivatives, index funds and mutual funds (as we call them) than there is intelligence for the task. I am cautious about prediction; I discovered years ago that my correct predictions are forgotten, the others meticulously remembered. But some things are definite; when you hear it being said that we have entered a new economy of permanent prosperity with prices of financial instruments reflecting that happy fact, you should take cover. This has been the standard justification of speculative excess for several centuries -- for a good part of the millennium. My one-time Harvard colleague Joseph Schumpeter thought inevitable and even beneficial what he called "creative destruction" -- the cyclical process by which the system eliminates the people and institutions which are mentally too vulnerable for useful economic service. Unfortunately the process has larger and less benign effects, including the possibility of painful recession or depression.

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Jim Cramer Interview

[Part 1]

[Part 2]

[Part 3]

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"The Ponzi Paradigm"

Paul Krugman on March 12, 2000:

The Ponzi Paradigm, by Paul Krugman, Commentary, NY Times, March 12, 2000: Charles Ponzi wasn't the first to try it, but he has joined Dr. Bowdler and Captain Boycott among those whose names will forever be terms of abuse. And the classic scam that bears his name -- using money from new investors to pay off old investors, creating the illusion of a successful business -- shows no sign of losing its effectiveness.

Robert Shiller's terrific new book, "Irrational Exuberance," contains a brief primer on how to concoct a Ponzi scheme. The first step is to come up with a plausible-sounding but complicated profit opportunity, one that is difficult to evaluate. Ponzi's purported business involved international postage reply coupons. In a more recent example, Albanian scammers convinced investors that they had a profitable money-laundering business.

From that point on it's all a matter of timing and publicity. An initial group of investors must be pulled in, large enough to attract attention but not too large; then a larger second group, whose investments can be used to pay off the first, a still larger third group, and so on. If all goes well, stories about how much early investors have made will spread, attracting ever more people, and the continuing success of the company will silence or drown out the skeptics.

In the United States, regulators -- who know very well just how effective such scams often are -- do their best to stop them before they get started. So you might think that Ponzi schemes are mainly a historical curiosity. But Mr. Shiller is not interested in history for its own sake; he uses Ponzi schemes as a model for something much more important.

Imagine, just hypothetically, that a new set of technologies -- technologies that are really, truly, deeply fabulous -- has just emerged. And suppose also that a number of companies have been created to exploit these new technologies, in the entirely honest -- but very hard to assess -- belief that they will eventually be able to earn huge profits. For the time being they earn little if any money; even if they make an accounting profit, they must continually raise more cash to pay for equipment, acquisitions and so on. Still, as the evidence for a true technological revolution mounts, the prices of their stocks keep rising, producing huge capital gains for early investors. And this attracts ever more investors, pushing the prices still higher.

If the process goes on long enough -- and there is no reason it cannot go on for years -- the doubters will start to look like fools, and the bears will go into hibernation. Everyone (well, almost everyone) may be completely sincere; nonetheless, in effect you get a Ponzi scheme without a Ponzi, a scam with no scammer.

Given the title of Mr. Shiller's book, you can guess the punch line. He makes a powerful case that the soaring stock market of recent years is a huge, accidental Ponzi scheme in progress, one that will come to a very bad end. The book actually focuses on the market broadly defined (most numbers are for the S.&P. 500), but it reads even better as a tale of the tech stocks. It's a book that I hope many people will read; but I doubt that many will be persuaded.

You see, right now bears have an extra credibility problem. Not long ago many people were skeptical not only about the prospects for today's technology companies but about the importance of the technology itself. (I plead guilty.) And every new statistic showing soaring productivity and earnings growth shows how wrong they were. As a matter of logic you can concede the reality of a technological revolution, even while asserting that the valuations of many technology companies are crazy; but who will listen?

It's also true that savvy investors (at least they seem savvy) are following the Levi Strauss strategy: Let others get caught up in the gold rush, we'll sell them the supplies. It is quite possible that the valuations of companies that sell Internet infrastructure make sense even if those of the dot-coms do not.

Still, as you watch those who missed out on the first few thousand points of the Nasdaq's rise feverishly try to make up for lost time, you have to wonder. Will people 80 years from now talk, without quite knowing where the term comes from, about being bezosified or qualcommed?
[Follow-up column: "When things are going well there is a strong tendency to suppose that financial markets can take care of themselves. Well, they can't."]

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Posted 3/13/2009 10:48:00 PM by Mark Thoma

March 12, 2009

Economist's View - 5 new articles

"Macroeconomic Imbalances and the Current Recession"

Antonio Fatás:

Macroeconomic imbalances and the current recession, by Antonio Fatás: While there is no doubt that the current recession is fundamentally linked to excesses in financial markets and asset prices, there were still some classic macroeconomic imbalances that preceded the crisis. For years we have been talking about global imbalances and how certain advanced economies (the US in particular) were building large deficits. A current account deficit is simply a measure of the difference between spending and income for a country. ... In the case of the US, consumption grew to levels that we had never seen before. The chart below displays household consumption as a ratio to GDP for the US and four other advanced economies.

This is a ratio that we expect to be fairly constant for a country with stable growth rates (as it is the case for these economies). In fact, in the cases of Germany, France and Japan, consumption remains fairly stable during the sample, as we expect. It is true that in the case of Japan we see the ratio increasing in the 70s but this has an explanation: as convergence in living standards materializes, the country's saving rate goes down...

The US, and to a much smaller extent the UK, have seen consumption increasing at rates much faster than GDP for the last two decades. ... How could this trend be justified? For this number to go up, a combination of these things should happen:

Lower taxes (current or future) that increase disposable income

Expectations of larger future income (through faster productivity growth

Related to the previous one, expectations of more productive investment which reduces the need to save and invest to generate the same amount of future income

A demographic transition that makes the future (income or wealth) look "better" than the present.

While one can always debate about whether some of these assumptions were reasonable during the last decades, overall one finds more arguments that go in the opposite direction and might have justified a lower consumption rate. An aging population and a growing government debt make the future look worse than the present. If anything, there is the need to increase saving... In terms of productivity growth.., there is no consistent signal that productivity growth is accelerating dramatically in the US or UK...

How can it be that in the light of such strong evidence of a macroeconomic imbalance very little was done about it? During those years asset and housing prices were booming and this was used as a justification for the consumption increase... Of course, for this to be true those asset prices had to be sustainable and this could only happen if one of the arguments above was true...

Today's perspective is, of course, very different as asset prices have collapsed and consumption looks also very high relative to wealth; it is clear that these imbalances need to be addressed. Unfortunately, this is the wrong time to address such an imbalance. In the middle of a deep recession, economic policies work to stimulate consumption, not depress it. ... No surprise that policy makers, such as Larry Summers today in an interview with the FT, are making the arguments that this is not the time to save. Point taken but let's make sure that when we are out of the recession we look back at this chart and make a conscious decision to avoid these growing imbalances reappear again in the future.

I don't think we can avoid higher savings no matter how much policymakers plead, and I'm not sure that's desirable since there are holes in household balance sheets that need to be filled, and we will see higher savings rates until that is accomplished. That's why it's up to government to create the necessary demand levels needed to stop the downward movement in the economy, it's unlikely to come from the household sector. But I do agree that once we get to the other side, the ratios will need to change, what we had before is demonstrably unsustainable.

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Using the Crisis as an Excuse

Andrew Leonard had a post entitled The silliest Republican economic proposal yet. He may want to reconsider that call:

Republicans Propose 'No Cost' Stimulus, Fox News: SEAN HANNITY, HOST: And in "Your America" tonight, another economic plan is also emerging tonight. The Republicans have proposed an alternative to the president's $787 billion stimulus package, and it costs a little bit less. Zero dollars. And it also promises to create two million new jobs without any of your money.

Joining us Congressman John Shadegg and Senator David Vitter. They're here to explain.

All right. Now we keep hearing from the Democrats well, the Republicans, they need to — they need an alternative proposal. You have an alternative proposal.

Congressman Shadegg, we'll start with you.

JOHN SHADEGG (R), ARIZONA CONGRESSMAN: We do have an alternative proposal. It looks at the fact that we spent billions of dollars on this stimulus package taxing the American people and burdening future generations with little to show for it. And many of us believe it will not produce Americans jobs.

With unemployment rates going up how can we produce American jobs? And the answer is we have had a non-energy policy in this country for a very long time. The reality is we are giving jobs to oil fieldworkers and natural gas fieldworkers in Russia and Saudi Arabia and Venezuela, when we should be putting those people to work here in the United States.

HANNITY: Right.

SHADEGG: Now Senator Vitter and I have drafted a bill that says let's put Americans to work, let's pursue the fight we had last summer of an all of the above energy strategy, let's clear the bureaucracy out of the way, and let's move forward with American jobs, producing American energy. ...

So opening ANWR and easing restrictions on offshore drilling is (a) free (never mind the potential environmental costs, those don't count if you're a Republican), and (b) will create 2 million jobs by taking them from other countries (the jobs will come from commies and terrorists, foreigners in any case, so no problem there, no need to count the costs to those workers).

This is, of course, silly and simply a way to use the crisis to push a favorite Republican proposal, something they do routinely (a terrorist threat? looks like we need another tax cut...). But I'm curious why the standard Republican objection to attempted job creation through changes in taxes or spending - that the jobs will simply be taken from other industries - doesn't apply here (if the jobs do come from other industries, it's not "costless" as claimed). Or are there, as Democrats claim, idle resources sitting around just waiting to be put back to work? [Note: Comments point out - correctly - that talking about short-run tradeoffs for this policy is silly since most estimates don't anticipate much job creation from relaxing these restrictions, and the jobs that would be created don't appear for several years. That is, this does nothing to stimulate the economy to use idel resources in the short-run.]

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Class Warfare?

John Berry:

If Tax-Cut Lapsing Is Class Warfare, Let's Fight, by John M. Berry, Commentary, Bloomberg: If letting top income-tax rates go back to where they were in 2000 is class warfare against the rich, I'm ready to snap to attention with my old M1 rifle on my shoulder.

What a ridiculous label, class warfare. It's hardly aggression against any class to have a progressive income-tax system in which fairness and ability to pay are important considerations in setting rates for different income groups.

As far as the top tax rates are concerned,... The law already calls for today's 33 percent rate to go to 36 percent and the 35 percent rate to rise to 39.6 percent, in 2011.

Why did a Republican Congress and President George W. Bush countenance the 2011 expiration dates in the 2001 tax-cut bill? It was one of several deceitful provisions that made rate reductions temporary to hold down estimates of revenue loss. Of course, the GOP intended all along to make the rate cuts permanent.

Obama would let the Bush rate cuts expire only for couples with incomes above $250,000 ... and raise the rates for them on capital gains and dividends to 20 percent from 15 percent.

Unfair? I don't think so, given these earners' relatively greater ability to bear the added burden. There's no doubt that a larger share of the nation's income has become concentrated at the very top of the distribution.

The extra revenue would be used to help finance the government's necessary role in dealing with the dangers of climate change and improving access to health care and control of its costs. ...

The Obama plan would give most taxpayers small reductions in tax liabilities...

When Clinton proposed raising the top rates to 36 percent and 39.6 percent in 1993, there were plenty of predictions that the higher marginal rates would hurt Americans' willingness to work and invest. Some economists argued that so many people would opt for leisure instead of work that the higher rates would raise no additional revenue.

Instead, a boom ensued in the latter 1990s... What did Bush's lower rates produce? Mediocre growth, very large deficits and financial-market manipulation.

The reality is that tax rates aren't nearly as powerful a force as some people think they are. ...

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Who Built the House of Cards?

Were chief executives at financial firms caught in "a financial tsunami" beyond their control, or are they partly responsible for what happened?:

A Tsunami of Excuses, by William Cohan, Commentary, NY Times: It's been a year since Bear Stearns collapsed, kicking off Wall Street's meltdown, and it's more than time to debunk the myths that many Wall Street executives have perpetrated about what has happened and why. These tall tales ... tend to take the form of how their firms were the "victims" of a "once-in-a-lifetime tsunami" that nothing could have prevented...

Take, for example, the myth that Alan Schwartz, the former chief executive of Bear Stearns, unleashed on the Senate Banking Committee... "Looking backwards and with hindsight, saying, 'If I'd have known exactly the forces that were coming, what actions could we have taken beforehand to have avoided this situation?' And I just simply have not been able to come up with anything ... that would have made a difference..." ...

Dick Fuld, the longtime chief executive of Lehman Brothers ... told Congress: "I wake up every single night thinking, 'What could I have done differently?'... And I have searched myself every single night. And I come back to this: at the time I made those decisions, I made those decisions with the information I had." Harvey Miller, the bankruptcy lawyer who is representing what remains of Lehman, has been working hard to absolve Mr. Fuld ... wrote, "The comptroller fails to recognize that Lehman was a victim of a financial tsunami that was beyond its control."

Now, wait just a minute here. Can it possibly be true that veteran Wall Street executives like Messrs. ... Schwartz and Fuld — who were paid an estimated ... $117 million and at least $350 million, respectively, in the five years before their businesses imploded — got all that money but were clueless about the risks they had exposed their firms to in the process?

In fact, although they have not chosen to admit it, many of these top bankers ... made decision after decision, year after year, that turned their firms into houses of cards. ...

Could these Wall Street executives have made other, less risky choices? Of course they could have, if they had been motivated by something other than absolute greed. Many smaller firms ... took one look at those risky securities and decided to steer clear. When I worked at Lazard in the 1990s, people tried to convince the firm's patriarchs ... that they must expand into riskier lines of business to keep pace with the big boys. The answer was always a firm no. ...

So enough already with the charade of Wall Street executives pretending not to know what really happened and why. They know precisely why their banks either crashed or are alive only thanks to taxpayer-provided life support. And at least one of them — John Mack, the chief executive of Morgan Stanley — seems willing to admit it. ... "The events of the past months have ... made clear the need for profound change to that system. At Morgan Stanley, we've dramatically brought down our leverage, increased transparency, reduced our level of risk and made changes to how we pay people." He continued: "We didn't do everything right. Far from it. And ... I take responsibility for our performance."

Well, it's a start. But there can be no restoration of confidence in the banking system — and therefore no hope for an economic recovery — until Wall Street comes clean. If the executives responsible for what happened won't step forward on their own, perhaps a subpoena-wielding panel along the lines of the 9/11 commission can be created to administer a little truth serum.

Many people want more than just an admission of responsibility, but I don't think economic recovery depends upon that happening.

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links for 2009-03-12

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Posted 3/12/2009 10:46:00 PM by Mark Thoma

March 11, 2009

Economist's View - 5 new articles

You Make the Call

The voting is pretty one-sided so far:

Are we all Keynesians now?

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Tax Cuts and Work Effort across Income Levels

A revenue neutral change that makes taxes more progressive increases work effort. That is, when taxes on the middle class go down by a dollar and taxes on the wealthy go up by a dollar, the increase in work effort by middle class workers more than offsets and fall in work effort by the wealthy:

So, based on my research, if a need to raise some revenue means tax rates have to be increased for someone, raising them on the wealthiest will result in a smaller reduction in work effort than raising tax rates on the middle class.

That's Julie Hotchkiss reporting on her research in macroblog. There is a catch:

An additional relevant question remains: What is the implication of changing work effort for GDP growth? The relationship between work effort and value of output is not necessarily the same across income levels. In other words, one hour of high-income (higher education) labor is expected to yield a higher value of output in the economy than one hour of labor from a middle-income (lower education) worker. A complete analysis of the aggregate impact of the administration's tax plan would have to also take this into account.

However, the effect on growth is only one metric by which to judge this policy, e.g. the benefits to the household that come from one more hour of work may also differ across income levels, particularly if the additional money is used to buy necessities in one case, and luxuries in the other.

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Greenspan: The Fed Didn't Do It

Alan Greenspan takes on John Taylor's claim that the Fed caused the housing bubble, and he warns against "micromanagement by government" regulators. Greenspan says the Fed couldn't have caused the housing bubble because it lost control over long-term interest rates once financial markets became globalized, and those were the rates that caused the problem:

The Fed Didn't Cause the Housing Bubble, by Alan Greenspan, Commentary, WSJ: ...The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier...

[T]he presumptive cause of the world-wide decline in long-term rates was the ... surge in growth in China and a large number of other emerging market economies that led to an excess of global ... savings... That ... propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of ... the global housing price bubble. ... I would have thought that ... such evidence would lead to wide support for ... a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by ... John Taylor... Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust." This notion has ... taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical ... analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover,... the "Taylor Rule" ... parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight. Given the decoupling of monetary policy from long-term mortgage rates,... the Fed ... could not have "prevented" the housing bubble. ...

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not ... heavy regulation. That would stifle important advances in finance that enhance standards of living. ... The solutions for the financial-market failures ... are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities. ... Adequate capital and collateral requirements ... will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management..., while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

We seem to have a disagreement on the scope of regulation. Ben Bernanke:

Bernanke Calls for Broader Regulations, WSJ: Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets... Among his recommendations were tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily. ...

The recommendations were largely consistent with measures being pushed by House Financial Services Committee Chairman Barney Frank (D., Mass.), who is expected to be a key architect of the new financial regulation. ...

Mr. Bernanke ... also pushed for much tougher policies over ... big companies. "Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards," Mr. Bernanke said. ...

I'm in agreement with Greenspan's response to Taylor to the extent that following the Taylor rule wouldn't have stopped the crisis, but I think the low interest rate policy pursued by the Fed is part of the story and served to magnify other factors. As for regulation, relying mainly upon enhanced capital requirements as Greenspan proposes isn't enough, so I'm at least where Bernanke with respect to close supervisory oversight of firms who pose a systemic risk. But I'd go even further and - to the extent possible - break up the firms into smaller entities and sever their interconnections until they no longer posed a threat to begin with. This is harder than it sounds, or so I'm told, but I'd still pursue the option.

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"Equilibrium and Meltdown"

George Waters of Illinois State University on the economic crisis and the state of macroeconomics:

Equilibrium and Meltdown, by George A. Waters: Equilibrium in economics is such a ubiquitous concept some might be surprised to hear that it is also controversial. It is hard to imagine doing much economic analysis without examining the intersection of supply and demand, but whether we should focus exclusively on equilibrium outcomes is a critical question. Though the importance of equilibrium might seem like an esoteric debate, the attitude toward this question has deep implications for economists' views on the correct policy response to the current economic crisis.

Milton Friedman believed in equilibrium. An example of the intensity of his belief was his argument against requiring medical licenses for doctors on the grounds that more doctors would be allowed to practice, and market forces would weed out poor doctors and improve the quality of care. This argument makes perfect sense if we focus on the equilibrium outcome, but most people are instinctively repelled by this proposal. The concern arises from the consideration of how the world gets to such an equilibrium. To find out who the bad doctors are, some patients have to try them, get bad treatment and tell others about it. Since patients have little expertise in making judgments about doctors, a poor doctor could practice for many years without detection. I know this happens even with licensing requirements, but the situation could easily be worse without them. An equilibrium outcome cannot be divorced from the path to arrive at that state.

This issue arises in the labor market, with implications for macroeconomics. If labor supply always equals labor demand then there is no such thing as involuntary unemployment. Workers don't work because the wage offered is too low. While undoubtedly true for some, the picture of unemployment must be more complex. Real Business Cycle (RBC) models of the macro-economy focus on equilibrium in the labor market, leading to the remark that, in such a framework, the Great Depression was really the Great Vacation. There are other views of the labor market in macroeconomics. Traditional Keynesian approaches focus on sticky wages (and prices) and have a more natural explanation for unemployment. For example, in a recession firms prefer to use layoffs rather than lower wages. Labor search explicitly model the matching of unemployed workers and vacant positions.

Dynamic Stochastic General Equilibrium (DSGE) models are currently the dominant approach in macroeconomics. They are descendents of RBC models in that they are general equilibrium models with microfoundations, meaning they focus on household and firm behavior rather that make direct assumptions about the relationships between macro variables. However, the DSGE label applies to wide variety of models including monetary policy models with price and wage stickiness. However, the vast majority of DSGE models used for policy analysis still study fluctuations around a unique equilibrium[1].

The desirability of fiscal stimulus in response to the current crises has been a point of contention producing much debate and, unfortunately, a number of muddled arguments[2]. One notable exception comes from James Hamilton[3]who points out that the housing, financial and auto industries are going through necessary contractions, and the process of those workers finding new jobs, which could require retraining and relocating, will be a long, painful process that no fiscal or monetary stimulus can alleviate. He goes on to add that government spending that increases productivity, such as infrastructure improvements, or maintains services, such as block grants to states, could still be beneficial. I would add that spending to stimulate demand and prevent unnecessary contraction of healthy industries could help as well. Nevertheless, his point that the government should allow the labor market to adjust and not try to guarantee a certain level of employment at all times is very much on target.

Of course, fiscal policy should not be considered in isolation from other aspects of the economic crisis. The housing market continues to fall affecting households and putting the financial sector is in danger of collapse with serious effects on the economy, pushing real estate prices further still. Monetary policy has reached the zero lower bound for the Federal Funds rate, raising the possibility of a deflationary spiral. Whether to Fed can avoid such a liquidity trap with "quantitative easing," is another important issue. Targeting longer maturity rates, now that the fed funds rate is essentially fixed, is an untried idea, so far.

And what does macroeconomic theory have to tell us about the present situation? As a macroeconomist, I'm sorry to say, not enough to give confident answers to the policy questions, though we do have some helpful tools at our disposal. Labor search models have the potential to analyze the frictional unemployment that Hamilton says should be tolerated. Natural ways to describe the deflation that can arise in a liquidity trap include have been developed using a model with multiple equilibria or at least entertaining the possibility that the economy is not in equilibrium for significant periods of time[4]. Furthermore, one can think of recessions in general and financial crises in particular as shifts between multiple equilibria. However, standard DSGE models with monetary and fiscal policy are single equilibrium models and do not incorporate these possibilities. When Tom Sargent, one of the godfathers of the DSGE approach, says that "the calculations that I have seen supporting the stimulus package are back-of-the-envelope ones that ignore what we have learned in the last 60 years of macroeconomic research," he may be right in a narrow sense, but his comment is more indicative of how far macroeconomic theory has to go to properly analyze complex economic environments such as the one we face.

To be more specific, we would like to know what combination of fiscal and monetary policy can avoid deflation, maintain aggregate demand so that firms do not fail unnecessarily while allowing for necessary adjustments in the labor market. To analyze such questions, we need a model incorporating fiscal and monetary policy, a financial sector, labor search while allowing for alternate equilibria or out-or-equilibrium behavior that can be interpreted as a deflationary liquidity trap and/or a recessionary state. Many macroeconomists would disagree with the details of this prescription, but most know that a model with sufficient sophistication to give a confident policy recommendation does not exist. That back-of-the-envelope calculations are all we have should not be surprising. In Keynes' words, macroeconomists should be humble.

We can better understand economists' responses to the stimulus question through the lens of their preferred models. Those who have spent their careers working with single equilibrium RBC models tend to view the stimulus as wasteful, contributing only to debt and inflation but not productivity. Those who view unemployment as unused resources in an out of equilibrium labor market believe government spending could put those resources to work. Paul Krugman has advocated forcefully for the stimulus, which is unsurprising given the nature of his research. One of his major contributions is to show how multiple equilibria can arise in a model of international trade where industries have increasing returns to scale. The notion of an economy shifting to a better equilibrium with a push, like a stimulus, is natural for him.

One reason models with multiple equilibria are not standard parts of policy analysis is that their implications for data analysis are difficult to interpret. Interestingly, the most common macro-econometric methods that does allow for multiple equilibria is the regime shifting model of James Hamilton, which estimates a probability of switching in or out of a recessionary state in each time period. As noted above, he has expressed some skepticism about the stimulus. I suspect that he considers the current recession as a persistent change in our natural rate of growth or as necessary "creative destruction." Alternatively, the economy could be in the process of shifting to a new state with high saving, low consumption, investment and employment. Olivier Blanchard describes the crisis in these terms and advocates for policy to reinvigorate demand to help the economy to shift back[5]. Distinguishing between a temporary shift to a new equilibrium and a persistent change in productivity is hard, which points up the subtle issues arising when we take the idea of multiple states seriously.

Despite the difficulties, there is good reason to extend our understanding of models with multiple equilibria.[6] There has been some loose talk among economists that the current crisis is not a garden-variety recession. The language of multiple equilibria could help formalize this idea: Normal recessions are dips below trend for output growth that can be handled with monetary policy, but we are experiencing a potential shift to a bad state that should be avoided using all available policy tools. If the keys are not to be found under the streetlight of a unique equilibrium, we must look in the dark alley. The restriction to a unique equilibrium is not the only problematic feature of many macro models. Most micro-founded models have representative agents[7], such as a single household representing the consumption, saving and labor supply decisions for the whole economy. A quick glance out most windows reveals that not all households are the same. The vast majority also assume rational expectations, which assumes all economic actors use all available information to form forecasts, a rather strong assumption.

It is not necessary to resort to arguments based on multiple equilibria to argue for the stimulus. Standard Keynesian arguments support government expenditure to employ unused resources. Some argue against spending on the grounds that government debt will grow unsustainably. Rising national debt is a serious concern, but a temporary stimulus need not lead to an insoluble problem.

This essay is not an argument for throwing all of macroeconomic theory overboard. Understanding each of the models described above gives insights into particular issues. My primary point is that many of the arguments dismissing fiscal stimulus as a solution to the current crisis rely on strong underlying assumptions about equilibrium and the impact of government spending. Arguments against the stimulus due to concerns about the debt and the necessity of large labor and financial market adjustments are quite valid. The policy problem comes down to a difficult judgment weighing these costs against the ability of fiscal and/or monetary policy to halt a deepening of the crisis. Given the state of theory, it is not surprising that there are vast disagreements among our most eminent economists. Those who believe there is a clear answer to the question of whether fiscal stimulus will work (whatever that means) should recognize that macroeconomics needs to re-examine its most closely held beliefs.

References

1 In the discussion of macroeconomic models, "multiple steady states" is more accurate than "multiple equilibria" which could also encompass sunspot equilibria arising in indeterminate models. I refrain from using "steady state" to avoid excessive jargon.

2 The "treasury view" and complete crowding out arguments against the stimulus are prominent examples.

3 See his Econbrowser post "The Paradox of Thrift" of February 8, 2009. Unfortunately, he followed this with post titled "How Much is a Trillion" (March 3, 2009), which offers as much insight as the title suggests.

4 Bullard and Cho (Journal of Economic Dynamics and Control v. 29(11) and Evans, Guse and Honkapohja (European Economic Review v. 52(8) examine liquidity traps as distinct steady states. The latter argues for fiscal stimulus when monetary policy has reached the zero lower bound of its interest rate target.

5 See his Economic Focus column in The Economist (January 29, 2009). He does not explicitly talk about multiple states.

6 The idea of multiple equilibria or steady states is far from new. Cooper and John (Quarterly Journal of Economics 103 (August, 1988)) discuss a switch to an inferior steady state as a "coordination failure."

7 Peter Diamond, among others, has cautioned against relying on representative agent models for policy analysis.

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links for 2009-03-11

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Posted 3/11/2009 10:51:00 PM by Mark Thoma

March 10, 2009

Economist's View - 7 new articles

"Adam Smith's Market Never Stood Alone"

Amartya Sen explains how Adam Smith has been misinterpreted, and how the beliefs associated with that misinterpretation lead to a form of capitalism that Smith would not have approved of. In fact, Smith would not have been surprised that the type of capitalism we have seen in recent decades would lead to the difficulties we are having today:

Adam Smith's market never stood alone, by Amartya Sen, Commentary, Financial Times: ...[T]he market economy has been exceptionally dynamic, generating unprecedented expansion of the global economy over the past 60 years. Not any more, at least not right now. .... The question that arises most forcefully now is not so much about the end of capitalism as about the nature of capitalism and the need for change. ...

Do we really need a "new capitalism"...? ... What exactly is capitalism? The standard definition seems to take reliance on markets for economic transactions as a necessary qualification... In a similar way, dependence on the profit motive, and on ... private ownership, are seen as archetypal features of capitalism. However,... All the affluent countries in the world – those in Europe, as well as the US, Canada, Japan, Singapore, South Korea, Taiwan, Australia and others – have depended for some time on transactions that occur largely outside the markets, such as unemployment benefits, public pensions and other features of social security, and the public provision of school education and healthcare. The creditable performance of the allegedly capitalist systems in the days when there were real achievements drew on a combination of institutions that went much beyond relying only on a profit-maximising market economy. ...

Smith did not take the pure market mechanism to be a free-standing performer of excellence, nor did he take the profit motive to be all that is needed. ...[A]n economy needs other values and commitments such as mutual trust and confidence to work efficiently. ...

Even though the champions of the ... Smith enshrined in many economics books may be at a loss to understand the present crisis..., the far-reaching consequences of mistrust and lack of confidence in others which have contributed to ... this crisis ... would not have puzzled him. ... The need for supervision and regulation has become much stronger over recent years. And yet the supervisory role of the government in the US in particular has been ... sharply curtailed, fed by an increasing belief in the self-regulatory nature of the market economy. Precisely as the need for state surveillance has grown, the provision of the needed supervision has shrunk.

[There is] ... a tendency towards over-speculation that, as Smith argued, tends to grip many human beings in their breathless search for profits. Smith called these promoters of excessive risk in search of profits "prodigals and projectors" – which, by the way, is quite a good description of the entrepreneurs of subprime mortgages over the recent past. The implicit faith in the wisdom of the stand-alone market economy, which is largely responsible for the removal of the established regulations in the US, tended to assume away the activities of prodigals and projectors in a way that would have shocked the pioneering exponent of the rationale of the market economy.

Despite all Smith did to explain and defend the constructive role of the market, he was deeply concerned about the incidence of poverty, illiteracy and relative deprivation that might remain despite a well-functioning market economy. ... Smith was not only a defender of the role of the state in doing things that the market might fail to do, such as universal education and poverty relief ...; he argued, in general, for institutional choices to fit the problems that arise rather than ... leaving things to the market.

The economic difficulties of today do not ... call for some "new capitalism", but they do demand an open-minded understanding of older ideas about the reach and limits of the market economy. What is needed above all is a clear-headed appreciation of how different institutions work, along with an understanding of how a variety of organisations – from the market to the institutions of state – can together contribute to producing a more decent economic world.

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Quick Note

I'll be on the Mark and Dave show (KEX Portland) between 4:00 and 7:00 p.m. (PST) today (it's a recorded interview, so not sure of the exact time). It was 5-10 minutes long (streaming audio).

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The Shrinking Middle Class?

If the trends over the last 25 years continue, as is likely, when the economy finally starts to recover and create new jobs, many of those who lost jobs during the downturn will find that the jobs available to them are not as attractive as the jobs they left:

The middle-age, middle-income squeeze, by Stephanie Schorow, MIT News Office: ...Dramatic shifts in the U.S. labor market in the last 25 years are relegating older workers -- even those with a college education -- to lower-wage jobs... This trend appears likely to steepen in the current recession, as employers accelerate the rate at which they shed nonessential positions.

In a paper co-authored with graduate student David Dorn, "This Job is 'Getting Old'...,"... Autor analyzes a phenomenon that he refers to as the "hollowing out" of the U.S. job market from 1980 to 2005.

"One of the most remarkable developments in the U.S. labor market of the past two and a half decades has been the rapid, simultaneous growth of employment in both the highest- and lowest-skilled jobs," Autor says. European labor markets echo this shift.

Automation, computerization and offshoring are reducing the number of middle-wage, skilled occupations -- stock clerks, inspectors, telemarketers, payroll workers, sales agents and software programmers -- Autor finds. These jobs are particularly vulnerable to automation because their core tasks follow well-understood routines that can increasingly be codified in software and executed by machinery.

Ironically, many jobs that require less formal education -- such as construction workers, janitors, truck drivers, auto mechanics, home health workers and wait staff -- are more difficult to automate than these white-collar positions because they demand physical flexibility and rapid adaptation to unpredictable circumstances (e.g., oncoming traffic, unhappy customers). Humans excel at this form of flexibility while current technology falls short. Demand also remains high for high-wage, high-skill jobs, such as attorneys, physicians, engineers and top managers -- all of which perform analytic, interpersonal and problem-solving tasks requiring both expertise and intellectual flexibility.

As the labor market "hollows out," workers who in a previous generation would have occupied middle-skill, white-collar positions must increasingly find their fortunes elsewhere -- either in high-skill, high-education professional, technical and managerial positions, or in less-educated manual labor and in-person service jobs. Autor's data indicate that since 1980, older workers with at least some college education are increasingly doing what was once thought of as "non-college" work, i.e. non-routine, but not highly skilled jobs.

According to data compiled by Autor and Dorn, the share of college-educated workers found in low-wage, non-routine occupations rose from 19.9 percent to 23.6 percent from 1980 to 2005. Moreover, the average age of those with college education working in such jobs rose by 6.7 years during this time. ... And as computers and offshore sourcing continue to reduce jobs in areas such as accounting and sales, this trend has accelerated. ...

Autor also suspects employers facing rising health costs and falling profit margins are more likely to hire young people because of the higher health care costs associated with older workers.

Thus, Autor's findings underscore the importance of both career retraining and, potentially, public assistance with health coverage in softening the brunt of the economic downturn on older workers. But they also challenge assumptions about the long-term value of a college education.

Higher education, particularly an advanced degree, is still the best way of ensuring future income, Autor says. However, "the degree to which a college education insulates you from downturns and from loss of prestige and earning power of your occupation is unfortunately smaller than it used to be."

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Optimism Abounds at the White House

Tim Duy doesn't see the light at the end of the tunnel that the administration says may be there:

Optimism Abounds at the White House, by Tim Duy: With the ink barely dry on the recent stimulus package, commentators are already calling for a fresh round of stimulus. But will these calls be heeded, or fall on deaf ears? For now, it looks like the Obama Administration is standing firm. And, really, what else could we expect? A call for more stimulus at this juncture is only a signal that the first package was destined to be a failure from the beginning, an admission that this Administration could not afford so early in the term. Christina Romer, chair of the Council of Economic Advisers, delivered a clear message today:

"We absolutely need to let this one work," Christina Romer, chair of the White House's Council of Economic Advisers, said Monday at the Brookings Institution. Tax withholding tables are just now being changed to get more money into consumers' pockets, she said, and many forecasters are saying the recent uptick in consumption may mean the economy is approaching bottom. "I think people are perhaps seeing some light at the end of the tunnel," Ms. Romer said.

Light at the end of the tunnel...what information exactly is flowing into the Oval Office? Did the White House get the same jobs report the rest of us saw last Friday? Not so much light in that report as pitch black. Another 651k employees cut from payrolls, unemployment pushed to 8.1%, and the U6 rate pushed to a whopping 14.8%. These numbers are all expected to deteriorate in the months ahead. What else did we see last week? Perhaps the light was the in the ISM reports? Manufacturing barely budged, and remains mired deep in recession territory; nonmanufacturing tells a similar tale. Initial claims fell, but at 639k still signalscontinued sharp deterioration in the labor market, and the 4-week moving average still edged up. Maybe she is referring to the downward revision to 4Q08 productivity, which suggests firms still have more work to do in reducing labor costs.

Recent data shows little light, in my opinion. It describes an economy in virtual free fall. Romer appears to be holding onto the hope that the relative stabilization in real consumption expenditures signals a bottom of activity. I hope she is correct, but I remain cautious - households are getting a significant boost right now from declining energy prices, but with oil prices settling out in the $35 to $50 zone, future gains are less likely. Moreover, the confidence numbers are not supportive of a bounce back in consumer spending:

Most irritating is that Romer knows all this; she is much too smart to not appreciate the severity of the data. But once you go are in the Administration - whatever Administration - you heed to the party line. Romer continues the line:

The White House is betting that addressing the root cause of the economic downturn — the housing and financial-sector trouble — will be enough (along with the stimulus spending) to return the U.S. to growth. Tim Geithner, the Treasury secretary, "loves to say, 'There's more stimulus in financial rescue than in stimulus,'" Ms. Romer said. "By getting our financial markets back, getting lending going again, that's incredibly important for aggregate demand and for spending."

Sometimes I feel like I am in Oz. And I want to go home, so badly do I want to go home. To a time that credit flowed like water from a spring, and the answer to all life's problems could be found in a home equity line of credit. And Geithner is whispering to me, "just click your heels, and say 'I want to go home.'" Yet for months I have been clicking my heels - since Fall of 2007 - and still I am stuck in Oz.

Efforts to unglue the financial system are important, but I sense that the Administration's expectations of what will by delivered by a fix will fall far short of what is necessary to fill the growing hole in the US economy. Even BOA CEO Ken Lewis, in a self-serving WSJ oped, admits as much:

Second, one of our greatest challenges is balancing the need to extend credit with the need of households to pay down excessive debt. In an economy that became too dependent on debt-driven consumption to create growth, the prospect of household deleveraging is sobering. The answer, in my view, is to let competitive forces lead us back to responsible lending practices, not the type of indiscriminate lending that has created so many problems.

Even if households suddenly rediscover their love affair with credit, a big if given the destruction of wealth in recent months, they will find themselves stymied by tighter credit conditions. A healthy, well functioning financial system simply will not extend credit on the scale seen in recent years. Without a replacement for that demand, economic activity will slide into a sub par equilibrium, and would likely remain sub par for an extended period of time as structural imbalances are corrected. David Altig at macroblog summarizes:

When I look ahead, I envision the U.S. economy over the next several years in terms of a simultaneous process of recovery and reformation: Recovery in the sense that the actual contraction of GDP will end, but reformation in the sense of structural transformation in financial markets, consumer behavior, and perhaps an adjustment of the global imbalances that are arguably at the root of much of the financial instability that has characterized the past decade.

Additionally, what is the time line for a financial market fix? One month, or one year? Will TALF jump start the securitization market overnight? How much damage will be done to the US economy while we wait? This Administration appears willing to find out.

In short, I grow increasingly fearful that the pace of economic deterioration will leave the US economy in a much deeper hole than this Administration expected, swallowing the stimulus package. Moreover, that even with a functional financial market, crawling out of that hole will be difficult at best. I see little but fiscal stimulus that could fill that hole. You might not like it, you might worry about the long term budgetary consequences, but we all might soon fall back on the old battlefield adage: There are no atheists in foxholes.

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Tent City

Along the American River, near Sacramento, California:

[Slide Show] [Same Location during Great Depression]

The small town I grew up in is not too far from there. Here's a story from the local paper:

Jobless rate hits 26.7%, by Susan Meeker, Colusa Sun Herald: ...State labor officials estimate more than 2,900 of Colusa County's 11,000 workers are unemployed, a significant increase in just two months.

But good news is on the way, as ... job seekers will soon benefit from federal stimulus money... "We don't know exactly how much we will receive from the federal stimulus package, but money is on the way," said Luis Moreno, deputy director of Colusa County Economic Development Department ...

Colusa County's unemployment rate was 26.7 percent in January – an increase of 8.7 percent since November...Mid-Valley counties traditionally have higher unemployment rates during the winter – due to the slowdown in seasonal agriculture work – it's the recession driving the latest figures.

"We are seeing a lot more people with a higher level of education lose their jobs," Moreno said. "That also includes people with a long work history. Many have been in jobs 10, 20 and 30 years. ... But Moreno said the EDD will move aggressively to jump start job creation once the stimulus money is in hand. ...

"We are going to spend this money very quickly," Moreno said. "The last thing we want to do is send it back to the federal government. After that, we just have to hang on and hope the recession will end soon." ...

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Mr. Freeze

David Brooks:

The Democratic response to the economic crisis has its problems, but let's face it, the current Republican response is totally misguided. The House minority leader, John Boehner, has called for a federal spending freeze for the rest of the year. In other words, after a decade of profligacy, the Republicans have decided to demand a rigid fiscal straitjacket at the one moment in the past 70 years when it is completely inappropriate.

The real goal, I think, is to protect the Bush tax cuts. The tax cuts are scheduled to expire soon due to budget games the Republicans played to get the tax cuts in place, but they never intended to actually let the tax cuts be reversed. Now that they are out of power, something they didn't expect would happen, there is a possibility that the increase in taxes Bush scheduled to game the budget figures will be allowed to happen after all. However, if the political winds move against more spending - something Boehner is trying to facilitate - and the economy remains weak, the case for allowing the scheduled Bush tax hikes to occur is harder to make.

Update: Paul Krugman:

Can America be saved?: So I read this:

Boehner said Americans want government to practice the same financial restraint they have been forced to exercise: "It's time for government to tighten their belts and show the American people that we 'get' it."

and I wonder if this country can handle the crisis we're in. Remember, John Boehner is, in effect, the second-most influential member of the GDP...

What's insane about Boehner's remark? He's talking about the current economic crisis as if it were a harvest failure — as if we faced a shortage of goods, so that the more you consume the less is left for me. In reality — even most conservatives understand this, when they think about it — we're in a world desperately short of demand. If you consume more, that's GOOD for me, because it helps create jobs and raise incomes. It's in my personal disinterest to have you tighten your belt — and that's just as true if you're "the government" as if you're my neighbor.

Plus, who is "the government"? It's basically us, you know — the government spends money providing services to the public. Demanding that the government tighten its belt means demanding that we, the taxpayers, get less of those services. Why is this a good thing, even aside from the state of the economy?

Again, this is what the leaders of a powerful, if minority, party think. Can this country be saved?

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links for 2009-03-10

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Posted 3/10/2009 11:44:00 PM by Mark Thoma

March 9, 2009

Economist's View - 4 new articles

"Did Lehman Brothers's Failure Matter?"

James Surowiecki takes on John Taylor:

Did Lehman Brothers's Failure Matter?, The Financial Page: By this point, it's become conventional wisdom that the failure of Lehman Brothers last September was the catalyst for a massive selloff in the credit and stock markets and a general flight to safety from which the markets have yet to recover. ...

In the past few days, though, a new meme has started circulating through the economics blogosphere, suggesting that Lehman's failure actually did not wreak the havoc that everyone who lived through last September thought it wreaked. This argument ... is based on a paper ... by the Stanford economist John Taylor, which purports to show (pdf) that the credit markets actually did not react all that badly to Lehman going under, and that the crisis was really the product of market uncertainty about the effects of government action. Taylor's conclusion is based on one piece of evidence: a graph of the 3-Month LIBOR...

The problem is that the graph that Taylor relies on as his only piece of evidence (it's on p. 16 of his paper) doesn't demonstrate what he thinks it does. In fact, LIBOR rose sharply in the days just before Lehman failed—evidence that even the prospect of Lehman going under had people worried. It then dropped a little when AIG was rescued, but then went straight up again, so that in the seven days leading up to and just after Lehman's failure, LIBOR nearly doubled. That's hardly a sign of the market shrugging off the incident.

More important, Taylor's assumption in his paper is that investors would have known right away how severe the repercussions of Lehman's bankruptcy would be. But this is simply untrue—for whatever reasons (some suggest fraud, others panic), the hole in Lehman's balance sheet was much bigger than people initially thought... As the magnitude of the losses became clearer, so too did banks' risk aversion, since Lehman's failure seemed to demonstrate starkly the risks of lending to any other big financial institution.

In any case, no one is arguing that Lehman's failure alone was responsible for investors' flight from risk... But it was the first, and crucial, moment in last fall's market panic... In this case, then, conventional wisdom seems to be right. And in thinking about what Lehman's failure tells us about how we should deal with tottering financial institutions today, I think Paul Krugman put it well a couple of weeks ago: "The collapse of Lehman Brothers almost destroyed the world financial system, and we can't risk letting much bigger institutions like Citigroup or Bank of America implode."

This may seem like an academic debate. But it's not, because those who want to convince us that Lehman's failure was not a big deal are doing so in order to shape future policy. In other words, they are arguing that when it comes to institutions like, say, Citigroup, the government can, in fact, let them implode ... without any disastrous effects. Maybe they're right, but it's an awful big gamble to take on the basis of a single, dubiously-interpreted graph.

I'm with those who believe that letting Lehman fail was a big mistake.

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Paul Krugman: Behind the Curve

[Behind the Curve, by Paul Krugman, Commentary, NY Times]

I've heard people say the debate over the size of the stimulus package was misrepresented in the media, that the media rarely presented the view that the plan was too small.

President Obama's plan to stimulate the economy was "massive," "giant," "enormous." So the American people were told... Watching the news, you might have thought that the only question was whether the plan was too big, too ambitious.

Yet many economists, myself included, actually argued that the plan was too small and too cautious. The latest data confirm those worries — and suggest that the Obama administration's economic policies are already falling behind the curve.

Why do you say that? Won't his plan create millions of jobs?

Mr. Obama's promise that his plan will create or save 3.5 million jobs by the end of 2010 looks underwhelming, to say the least. It's a credible promise... But 3.5 million jobs almost two years from now isn't enough in the face of an economy that has already lost 4.4 million jobs, and is losing 600,000 more each month.

Ah, I see. Even though it's likely to create 3.5 million jobs as promised, it's still millions short of what is needed. So how do we improve the plan?

There are now three big questions about economic policy. First, does the administration realize that it isn't doing enough? Second, is it prepared to do more? Third, will Congress go along with stronger policies?

What are the answers?

On the first two questions, I found Mr. Obama's latest interview with The Times anything but reassuring.

"Our belief and expectation is that we will get all the pillars in place for recovery this year," the president declared — a belief and expectation that isn't backed by any data or model I'm aware of. ... And there was no hint in the interview of readiness to do more.

Do you mean he doesn't seem ready to do more in terms of fiscal policy, or that he's not ready to do more of anything, in particular, more to help the banking system recover?

A real fix for the troubles of the banking system might help make up for the inadequate size of the stimulus plan... But he went on to dismiss calls for decisive action... As I read it, this dismissal — together with the continuing failure to announce any broad plans for bank restructuring — means that the White House has decided to muddle through on the financial front, relying on economic recovery to rescue the banks rather than the other way around. And with the stimulus plan too small to deliver an economic recovery ... well, you get the picture.

Yep. It's like one of those bad dreams where your feet won't move fast enough to get away from the impending doom closing in on you. Will the administration wake up and get moving?

Sooner or later the administration will realize that more must be done. But when it comes back for more money, will Congress go along?

One side won't, that's pretty clear, and I'm not so sure about the Democratic side of the aisle either.

Republicans are now firmly committed to the view that we should do nothing to respond to the economic crisis, except cut taxes — which they always want to do... If Mr. Obama comes back for a second round of stimulus, they'll respond not by being helpful, but by claiming that his policies have failed.

And if there are any small successes to point to Republicans will, of course, insist it was because of the tax cuts in the first round of stimulus. Where does the public stand at this point?

The broader public ... favors strong action. ... But will that support still be there, say, six months from now?

I wouldn't count on it.

Also, an overwhelming majority believes that the government is spending too much to help large financial institutions. This suggests that the administration's money-for-nothing financial policy will eventually deplete its political capital.

I don't suppose we can borrow political capital from China?

So here's the picture that scares me: It's September 2009, the unemployment rate has passed 9 percent, and despite the early round of stimulus spending it's still headed up. Mr. Obama finally concedes that a bigger stimulus is needed.

And at that point, he begins pushing a new plan?

But he can't get his new plan through Congress because approval for his economic policies has plummeted, partly because his policies are seen to have failed, partly because job-creation policies are conflated in the public mind with deeply unpopular bank bailouts. And as a result, the recession rages on, unchecked.

Would you bet some of your Nobel money on that prediction?

O.K., that's a warning, not a prediction. But economic policy is falling behind the curve, and there's a real, growing danger that it will never catch up.

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"Seeds of its Own Destruction"

Martin Wolf looks at some of the ways the world may change in response to the crisis:

Seeds of its own destruction, by Martin Wolf , Commentary, Financial Times: ...In the west, the pro-market ideology of the past three decades was a reaction to the perceived failure of the mixed-economy, Keynesian model of the 1950s, 1960s and 1970s. The move to the market was associated with the election of Reagan ... in 1980 and the ascent to the British prime ministership of Margaret Thatcher the year before. ...

Today, with a huge global financial crisis and a synchronised slump in economic activity, the world is changing again. ... If the financial system has failed, what remains of confidence in markets? It is impossible at such a turning point to know where we are going. ... We are witnessing the deepest, broadest and most dangerous financial crisis since the 1930s. ...

Among the possible outcomes of this shock are: massive and prolonged fiscal deficits...; a prolonged world recession; a brutal adjustment of the global balance of payments; a collapse of the dollar; soaring inflation; and a resort to protectionism. The transformation will surely go deepest in the financial sector itself. ... After the crisis, we will surely "see finance less proud", as Winston Churchill desired back in 1925. Markets will impose a brutal, if temporary, discipline. Regulation will also tighten. ...

No less likely are big changes in monetary policy. ... Yet a huge financial crisis, together with a deep global recession, if not something far worse, is going to have much wider effects than just these. ...

One transformation that can already be seen ... is a ... shift in attitudes towards inequality: vast rewards were acceptable in return for exceptional competence; as compensation for costly incompetence, they are intolerable. Marginal tax rates on the wealthier are on the way back up.

Yet another impact will be on the sense of insecurity. ... The search for security will strengthen political control over markets. A shift towards politics entails a shift towards the national, away from the global. ... protectionist intervention is likely...

The impact of the crisis will be particularly hard on emerging countries: the number of people in extreme poverty will rise, the size of the new middle class will fall and governments of some indebted emerging countries will surely default. ... Helping emerging economies through a crisis for which most have no responsibility whatsoever is a necessity.

The ability of the west in general and the US in particular to influence the course of events will also be damaged. The collapse of the western financial system, while China's flourishes, marks a humiliating end to the "uni-polar moment". As western policymakers struggle, their credibility lies broken. Who still trusts the teachers?

These changes will endanger the ability of the world not just to manage the global economy but also to cope with strategic challenges: fragile states, terrorism, climate change and the rise of new great powers. ...

On June 19 2007, I concluded an article on the "new capitalism" with the observation that it remained "untested". The test has come: it failed. The era of financial liberalisation has ended. Yet, unlike in the 1930s, no credible alternative to the market economy exists and the habits of international co-operation are deep. ... The world of the past three decades has gone. Where we end up, after this financial tornado, is for us to seek to determine.

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links for 2009-03-09

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Posted 3/09/2009 10:54:00 PM by Mark Thoma

March 8, 2009

Economist's View - 3 new articles

"Snake-Oil Assets"

Robert Shiller:

A failure to control the animal spirits, by Robert Shiller, Commentary, FT: ...We are seeing, in this financial crisis, a rebirth of Keynesian economics. We are talking again of ... the Great Depression. This era, like the present, saw many calls to end capitalism as we know it. The 1930s have been called the heyday of communism in western countries. ... The General Theory became the most important economics book of the 20th century because of its sensible balanced message.

In times of high unemployment,... governments should expand demand by deficit spending. Then, in times of low unemployment, governments should pay down the resultant debt. With that seemingly minor change in procedures, a capitalist system can be stable. There is no need for radical surgery on capitalism. ...

[T]he General Theory also ... explained why capitalist economies,... without the balancing of governments, were essentially unstable. ... The key to this insight was the role Keynes gave to people's psychological motivations. These are usually ignored by macroeconomists. Keynes called them animal spirits, and he thought they were especially important in determining people's willingness to take risks. ...

There are times when people are especially adventuresome – indeed, too much so. ... These are the upswing of the business cycle. But then the animal spirits also veer in the other direction, and then people are too wary. ...

To a remarkable extent we have got into the current economic and financial crisis because of a wrong economic theory ... that ... denied the role of the animal spirits in getting us into manias and panics.

According to the standard "classical" theory,... the economy is essentially stable. ... What this theory neglects is that there are times when people are too trusting. And it also fails to take into account that if it can do so profitably, capitalism will produce not only what people really want, but also what ... people mistakenly want.

It will produce snake oil. ... [W]hen confidence is high, and since financial assets are hard to evaluate by those who are buying them, people will and do buy snake oil. And when that is discovered, as it invariably must be, the confidence disappears and the economy goes sour.

It is the role of the government at two levels to see that these events do not occur. First, it has a duty to regulate asset markets so that people are not falsely lured into buying snake-oil assets. Such standards ... make as much common sense as the standards for the food we eat, or the purchase medicine... But we do not want to throw out the good parts of capitalism... To take advantage of the good parts of capitalism, when fluctuations occur it is the role of the government..., through its counterbalancing fiscal and monetary policy, to maintain full employment.

The principles behind such an economy are not the principles behind a socialist economy. The government insofar as possible is only creating the macroeconomic conditions that will allow the economy to function well. ... Its role is to ensure a "wise laisser faire". ...

I'm not sure that confidence and too much trust on the upside and the pessimism and fear we see on the downside are the causes rather than the effects of cycles (and I'm also not sure that Shiller is making that claim). That doesn't mean that psychological factors don't have important feedback effects that help reinforce booms and busts, or that these reinforcing effects can't produce volatile swings in the economy that need to be prevented or dampened through government action, only that the changes in mood seem to be more a part of the process than a primary cause of it. But I don't want to close my mind to the possibility.

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Rogoff: Countries Risk Drowning in Red Ink

Ken Rogoff with lots of gloom and doom:

Countries are so deep in debt, they risk drowning in red ink, by Kenneth Rogoff, Project Syndicate: No one yet has any real idea about when the global financial crisis will end, but one thing is certain: Government budget deficits are headed into the stratosphere. ...

Although governments may try to cram public debt down the throats of local savers (by using, for example, rising influence over banks to force them to hold a disproportionate quantity of government paper), they eventually will find themselves having to pay much higher interest rates as well. Within a couple of years, interest rates on long-term U.S. Treasury notes could easily rise 3 per cent to 4 per cent, with interest rates on other governments' paper rising as much, or more. ...

With the credit crisis still making it difficult for many small-and medium-sized businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. A real possibility exists that global growth will register its first contraction since the Second World War. ...

Worse, unless financial systems spring back, growth could disappoint for years to come, especially in "ground zero" countries such as the United States, Britain, Ireland and Spain. U.S. long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution.

Countries with European-style growth rates could handle debt obligations of 60 per cent of GDP when interest rates were low. But with debts in many countries rising to 80 per cent or 90 per cent of GDP, and with today's low interest rates clearly a temporary phenomenon, trouble is brewing. ...

Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium-term growth prospects, raising real questions of solvency and sustainability. Italy, for example... Other countries, such as Ireland, Britain and the U.S., started with a much stronger fiscal position but may not be much better off when the smoke clears.

Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the U.S. printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road – if the euro is still around, that is.

As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combination of all three. Unfortunately, the endgame to the great recession of the early 2000s will not be a pretty picture.

That's why I wrote this. As I noted, there are plenty of people who are anxious to pin our economic problems on the deficit, and going one step further, the welfare state (e.g. the "growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution" statement above). But government intervention is not going to make things worse for, say, the typical unemployed worker, it will make things better by improving job prospects and providing an enhanced level of support while unemployed (health care, unemployment insurance, food stamps, and similar programs). The stimulus package won't prolong the recovery period, it will shorten it by jump starting the economy in important areas and keeping it going until the private sector can take over (think of the government spending and tax cuts as a bridge over troubled assets).

So I want to emphasize one more time that stabilization policy does not have to change the size of government in the long-run (and see pgl for a debunking of some of the claims about the size of government. i.e. he notess that "Federal spending as a share of GDP was about as high in 1985 as it is projected to be for 2019"). Fiscal policy can increase the size of government, but it can also shrink the size of government (lower taxes in the downturn, then cut spending when things are better to eliminate the deficit and government will shrink). So the criticism is not about the use of stabilization policy to help people during the downturn and to give the economy a boost, instead it's a claim about the long-term political aims of the administration with respect to the size of government. However, according to pgl's calculations, the projections are that the size won't exceed what we had under that well known socialist sympathizer Ronald Reagan.

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links for 2009-03-08

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Posted 3/08/2009 11:10:00 PM by Mark Thoma

March 7, 2009

Economist's View - 6 new articles

Blinder: Nationalize?

Alan Blinder is not a fan of nationalization:

Nationalize? Hey, Not So Fast, by Alan S. Blinder, Commentary, NY Times: ...When philosophical conservatives like Alan Greenspan start talking about nationalizing banks, you know you've passed into some kind of parallel universe. ... Like Ben Bernanke ... and Timothy Geithner,... I am not convinced that nationalization is the only, or even the best, way out. ...

[D]idn't Sweden pull this off with great success in the early 1990s? Yes... But this is not Sweden. Let's think about some of the downsides to nationalizing banks in America.

Where to draw the line? First and foremost, the Swedish government had to deal with only a handful of banks; we have more than 8,300. ... Presumably, no one wants to nationalize all the banks, thousands of which are healthy. But where do you stop, once you start?

Suppose we nationalized four banks. Bank Five would then find itself at a severe disadvantage in competing for funds... Forced to pay higher interest rates... Bank Five might start looking like a candidate for nationalization, too — followed by Banks Six, Seven and so on. ...

The Management Challenge The Swedes ... never had to deal with institutions of the size and complexity of our banking behemoths. Mr. Geithner has emphasized that governments are ill-suited to manage businesses. I'd take the point a step further: Overseeing the management of dozens, or hundreds, or maybe even thousands of nationalized banks is a daunting task.

Political Obstacles The process of nationalization and reprivatization ... in Sweden ... was remarkably free of political interference. Would that happen here? You decide. My bet is no.

The Confidence Question Finally, because nationalization runs counter to deeply ingrained American traditions and attitudes,... it might undermine rather than bolster confidence. ... The Treasury, of course, would never use "nationalization" in public; it would invent some nice euphemism. But the commentariat would not be so constrained.

All of that said, there are arguments in favor of nationalization. Or are there?

One is that financial firms are careening off track, thereby costing taxpayers more and more bailout money. (Think A.I.G.) That's a ... major reason to seek quick closure. But ... the government already owns shares in many banks, and ... the Fed can pretty much dictate to the banks right now, what additional powers would nationalization bring?

Another argument is that banks' dodgy assets are hard to value, making it impossible to know how much capital they need — and probably very expensive to provide it. True again. But nationalization doesn't make these problems disappear.

If the government takes over a bank, the taxpayers ... inherit... all the uncertainties over valuation. And if a bank has negative net worth when it is nationalized, who do you think fills the hole? ...

Worse yet, even talk about nationalization can be harmful if it puts bank stocks under further selling pressure. After all, who wants to own a stock whose value is heading toward zero? Which is why Mr. Bernanke and Mr. Geithner have taken pains to beat down rumors that nationalization is coming.

Unfortunately, their denials can never be categorical. If worst really does come to worst, the other options may evaporate, leaving the government no choice but to nationalize some banks. ... But, please, let's not rush there. Let's first at least explore what is called the "good bank, bad bank" approach.

What's that? While there are many variants, the basic idea is to break each sick institution into two. The "good bank" gets the good assets... As a healthy institution, it can presumably raise fresh capital and go on its merry way as a private company.

The "bad bank" inherits the bad assets and the rest of the capital — which, after appropriate markdowns of the assets, will not be enough. So, again, someone must fill the hole. And, realistically, given the mess we're in, much of that new capital would likely come from the taxpayers.

Here's a prediction: We will get to the good-bank, bad-bank solution sooner or later. Wouldn't it be nice if it was sooner?

Blinder's colleague at Princeton, Paul Krugman:

How many banks?, by Paul Krugman: One objection you keep hearing to ~~nationalization~~ pre-privatization as part of a bank restructuring effort is that the US financial system is just too big and complex. ... But are we really thinking about thousands of banks? Here's Martin Wolf, today:

The four biggest US commercial banks – JPMorgan Chase, Citigroup, Bank of America and Wells Fargo – possess 64 per cent of the assets of US commercial banks (see chart) [chart not available online]. If creditors of these businesses cannot suffer significant losses, this is not much of a market economy.

So as far as this discussion is concerned, we've got, like, four banks. The "thousands of banks" line is just a diversion.

And:

The truth is that the Bernanke-Geithner plan — the plan the administration keeps floating, in slightly different versions — isn't going to fly. ...

Think of it this way: by using taxpayer funds to subsidize the prices of toxic waste, the administration would shower benefits on everyone who made the mistake of buying the stuff. Some of those benefits would trickle down to where they're needed, shoring up the balance sheets of key financial institutions. But most of the benefit would go to people who don't need or deserve to be rescued.

And this means that the government would have to lay out trillions of dollars to bring the financial system back to health, which would, in turn, both ensure a fierce public outcry and add to already serious concerns about the deficit. (Yes, even strong advocates of fiscal stimulus like yours truly worry about red ink.) Realistically, it's just not going to happen.

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Quick Note

I will be on the Mark Martinez radio show today at 3:00 p.m. PST (streaming audio). The call-in number is 661 631-1230.

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Will Fiscal Policy Pass the Test?

This won't be the last downturn in the history of the world, I'm pretty sure of that, and how monetary and fiscal policymakers react and the difference it makes - if any - will be studied carefully and used to guide our response the next time something like this happens.

So we need to do this right. With respect to monetary policy, I think we have learned that monetary policy loses its punch as interest rates get stuck at or near zero. Not everyone agrees - some people argue that unconventional monetary policy can still be used effectively - but even if that's true, I don't think that monetary policy alone can stop the downturn and turn things around.

That leaves fiscal policy. I believe that fiscal policy can help people during downturns like we are in now. I could be wrong about that, the evidence just isn't there to say for sure. But of the two errors, not helping people when help would have mattered, and trying to help but failing to do any good, I'd rather make the second mistake.

But as we try to help, there are two ways in which we could make fiscal policy less attractive as a stabilization tool in the future.

First, the political process could render fiscal policy too weak to be effective. If tax cuts and government spending are directed mostly toward political goals, that could water the policy down so much that it does little good.

In the stimulus package just enacted, politicians did direct tax cuts and spending towards political ends, and they had enough success to make the policy far less effective than it might have been. But let's hope there's enough useful policy measures left to make a difference, and I think there are, and that the evidence is clear enough so that we are able to learn what works and what doesn't. That way, the lesson going forward will be about how to do fiscal policy better next time - which mix of policies works best - rather than that politicians can't be trusted to do it at all.

Second, we could fail to reduce the budget deficit once the economy turns around. Done correctly, stabilization policy does not add to the long-term budget problems of an economy. During the bad times, the troughs of the business cycle are filled by running deficits (either tax cuts or increased government spending), and during the good times the peaks of the cycle are shaved as these policies are reversed. By filling the troughs during the bad times with the shaved peaks from the good times, the economy is more stable since we are moving resources from times when the economy is overheated to times when it is running cold. And since the peak to trough transfers are one-to-one, there is no net change overall in the size of the government debt (the size of government could go up or down in the process, or it could stay the same, that depends upon the particular mix of tax and government spending changes that politicians choose, it has nothing to do with stabilization).

We're pretty good at giving away the goodies when things get bad, and I'm glad we are generous enough to do that, but we haven't been as good at paying the bills when times get better. If we are going to try fiscal policy, and as I said above I don't think we have any choice but to run a budget deficit right now, we have to find a way to pay the deficit off once things improve (but not before). If we don't, if this ends up adding substantially to our long-run debt, then the lesson will be that changes in taxes or government spending are too sticky to be used effectively as a stabilization tool. Taxes can be cut easily, but raising them again later is a lot harder, and the same goes for spending - it's easier to add to spending than to cut it back. If the lesson is that we cannot overcome this resistance to paying for stabilization policy, and there are plenty of people who cannot wait to make that point - in many cases the same people who are all too ready to argue that the increased debt necessitates cuts in key social programs - then fiscal policy will not look very attractive the next time the economy goes into a recession so deep that monetary policy alone is not enough to save the day.

In the short-run, the first problem is the worry, i.e. that the bill that was enacted is too watered down to be effective (and that another round won't be possible if things don't turn around), but over the longer run it's the second problem that is of concern. If it was up to me - and many of you will be happy it isn't - I'd put parts of fiscal policy in the hands of an independent Fed like structure and charge it with stabilizing fluctuations in the economy over the business cycle while retaining a long-run balanced budget (perhaps even implementing Andrew Samwick's idea of having a predetermined list of infrastructure projects on the shelf and ready to go if a recession hits). But that's not going to happen, so it's up to the political process to make fiscal policy work as a stabilization tool and, while there have been some good signs from the administration along these lines, I can't say I'm overly confident that politicians are up to the task.

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"Put Earmarks in Perspective"

Thomas Mann of the Brookings Institution says that "hyperbolic attacks on earmarks do a disservice to the public":

Put Earmarks in Perspective, by Thomas E. Mann, Senior Fellow, Brookings: It is hard to take seriously a political opposition whose major antidote to the most serious and frightening financial and economic crisis since the Great Depression is a rhetorical crusade against congressional earmarks.

Sen. John McCain took to the Senate floor Monday to unleash his fury at the 9,000 earmarks — "wasteful, disgraceful, corrupting ... pork barrel spending" — that are included in a $410 billion omnibus spending bill for the current budget year. ... But dramatic calls for an abolition of earmarks, by law or presidential veto, are futile and counterproductive. Congress has the constitutional power of the purse and legitimately defends its authority to allocate public resources. Given the enormity of the economic and financial problems facing the country, Obama would be foolish to engage Congress in a battle over earmarks.

Earmarks constitute less than 1 percent of the federal budget. In most cases, they don't add to federal expenditures but merely allow Congress to direct a small fraction of program funding that would otherwise be allocated by formula or grant competition. Abolishing all earmarks would therefore have a trivial effect on the level of spending and budget deficits. While earmark reform and reduction is a worthy cause, it is a relatively minor one. It would do nothing to slow the rate of federal spending or improve our long-term budget outlook. Moreover, hyperbolic attacks on earmarks do a disservice to the public, encouraging people to concentrate way too much attention and energy on a largely symbolic issue and ignore the critical decisions that we face in the months and years ahead. In an effort to stimulate an economy threatened by deflation and severe recession, federal spending will increase dramatically over the next several years. The challenge is to see that these new funds are expended in the most responsible way possible. Beefing up our public management capacity — in contracting, financial accountability, program evaluation — and developing oversight systems are the highest priorities. Same with efforts under way to stabilize the financial markets. Then there are the daunting challenges of designing and implementing new systems to restrain the cost and increase the coverage of health care and to shift to a low-carbon economy, to say nothing of grappling with a huge, long-term fiscal imbalance. In this most threatening and challenging policy environment, it is time for earmarks to be put in their proper perspective and for politicians in both parties to get serious with the public about what really lies ahead.

Here's a graph I made during the election illustrating the same point.

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Fractured Fairy Tales

The M1 multiplier is less than one:

The Demise of Fractional Reserve Banking, by Athenian Abroad: Fractional reserve banking -- the system under which banks hold only a fraction of their deposits in reserve, and lend the rest -- is a bête noire of a certain segment of the economic and political blogosphere. There's something about it that seems dizzyingly insubstantial, self-referential, unnatural, unearthly, and unholy: it's the Financial System from Yuggoth! I don't get it myself, but the metaphysical loathing can be quite intense. So, for these folks: good news! We don't have fractional reserve banking anymore. In statistics-speak, since last November, the monetary base has exceeded M1, which means, more or less, that bank reserves (plus surplus vault cash) exceed liquid deposits. So everything's OK now, right?

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links for 2009-03-07

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Posted 3/07/2009 10:58:00 PM by Mark Thoma