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January 1, 2008

Economist's View - 4 new articles

Brad DeLong: Three Cures for Three Crises

Brad DeLong says the cure for a financial crisis depends upon why the crisis exists:

Three cures for three crises, by J. Bradford Delong, Project Syndicate: A full-scale financial crisis is triggered by a sharp fall in the prices of a large set of assets that banks and other financial institutions own, or that make up their borrowers' financial reserves. The cure depends on which of three modes define the fall in asset prices.

The first -- and "easiest" -- mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.

The cure for this mode -- a liquidity crisis caused by declining confidence in the financial system -- is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.

This is the rule set out by Walter Bagehot more than a century ago: Calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times.

Once everybody is sure that, no matter how much others panic, financial institutions won't have to dump illiquid assets at a loss, the panic will subside. And the penalty rate means that financial institutions can't profit from the investment behavior that left them illiquid -- and creates an incentive to take due care to guard against such contingencies in the future.

In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.

This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren't solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.

In this case, applying the Bagehot rule would be wrong.

The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away, while the Bagehot rule -- with its high lending rate for banks -- would make matters worse.

Of course, easy monetary policy can cause inflation, and the failure to "punish" financial institutions that exercised poor judgment in the past may lead to more of the same in the future. But as long as the degree of insolvency is small enough that a relatively minor degree of monetary easing can prevent a major depression and mass unemployment, this is a good option in an imperfect world.

The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger. Easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system's capacity to guide resource allocation. But even this is almost surely better than a depression.

Since late summer, the US Federal Reserve has been attempting to manage the slow-moving financial crisis triggered by the collapse of the US housing bubble.

At the start, the Fed assumed that it was facing a first-mode crisis -- a mere liquidity crisis -- and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis -- more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.

As Fed Vice Chair Don Kohn recently put it: "We should not hold the economy hostage to teach a small segment of the population a lesson."

No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.

And, as if on cue, from the WSJ Economics blog:

Liquidity Threat Eases; Solvency Threat Still Looms, WSJ Economics Blog: As 2007 winds down, the much-feared year-end liquidity crisis appears to have been averted thanks to aggressive action by central banks. ... [A]s 2008 begins, it's solvency, not liquidity, that threatens the economy and the financial system. And at the root of the solvency threat is a likely decline in housing prices that will further undermine credit quality. Making banks more confident of their own ability to raise funds is not going to resolve a generalized shrinkage of lending driven by declining collateral values. ...

Paul Krugman: The Great Divide

Almost all of the Republican presidential candidates have embraced discredited voodoo economic policies, sometimes in contradiction to their previous policy positions. What does this tell us?:

The Great Divide, by Paul Krugman, Commentary, NY Times: Yesterday The Times published a highly informative chart laying out the positions of the presidential candidates on major issues. It was, I'd argue, a useful reality check for those who believe that the next president can somehow usher in a new era of bipartisan cooperation...

On one side, the Democrats are all promising to get out of Iraq and offering strongly progressive policies on taxes, health care and the environment. That's understandable: the public hates the war, and public opinion seems to be running in a progressive direction.

What seems harder to understand is ... the degree to which almost all the Republicans have chosen to align themselves closely with the unpopular policies of an unpopular president. And I'm not just talking about ... the Iraq war. The G.O.P. candidates are equally supportive of Bush economic policies. ...

The "Bush boom," such as it was, bypassed most Americans... Meanwhile, insecurity has increased... And things seem likely to get worse as the election approaches... All in all, ... you'd expect Republican politicians ... to distance themselves from the current administration's economic policies and record...

In fact, however, ... Republican contenders ... assure voters that they will not deviate an inch from the Bush path. Why? Because the G.O.P. is still controlled by a conservative movement that does not tolerate deviations from tax-cutting, free-market, greed-is-good orthodoxy.

To see the extent to which Republican politicians still cower before the power of movement conservatism, consider the sad case of John McCain.

Mr. McCain's lingering reputation as a maverick straight talker comes largely from his opposition to the Bush tax cuts of 2001 and 2003, which he said at the time were too big and too skewed to the rich. Those objections would seem to have even more force now, with America facing the costs of an expensive war — which Mr. McCain fervently supports — and with income inequality reaching new heights.

But Mr. McCain now says that he supports making the Bush tax cuts permanent. Not only that: he's become a convert to crude supply-side economics, claiming that cutting taxes actually increases revenues. That's an assertion even Bush administration officials concede is false.

Oh, and what about his earlier opposition to tax cuts? Mr. McCain now says he opposed the Bush tax cuts only because they weren't offset by spending cuts.

Aside from the logical problem here — if tax cuts increase revenue, why do they need to be offset? — even a cursory look at what Mr. McCain said at the time shows that he's ... clearly decided that it's better to fib about his record than admit that he wasn't always a rock-solid economic conservative.

So what does the conversion of Mr. McCain into an avowed believer in voodoo economics — and the comparable conversions of Mitt Romney and Rudy Giuliani — tell us? That bitter partisanship and political polarization aren't going away anytime soon.

There's a fantasy, widely held inside the Beltway, that men and women of good will from both parties can be brought together to hammer out bipartisan solutions to the nation's problems.

If such a thing were possible, Mr. McCain, Mr. Romney and Mr. Giuliani — a self-proclaimed maverick, the former governor of a liberal state and the former mayor of an equally liberal city — would seem like the kind of men Democrats could deal with. (O.K., maybe not Mr. Giuliani.) In fact, however, it's not possible, not given the nature of today's Republican Party, which has turned men like Mr. McCain and Mr. Romney into hard-line ideologues. On economics, and on much else, there is no common ground between the parties.

"Why Do People Support Economic Systems That Seem To Be Against Their Self-Interest?"

When are people most likely to voluntarily redistribute income?:

The Thinkers: Playing fair, even when it hurts in the pocketbook, by Mark Roth, Pittsburgh Post-Gazette: ...Why do people support economic systems that seem to be against their self-interest? ... "Why do we see ... poor people ... who don't buy into an egalitarian system and ... rich people... who support it?" [Christina Fong of Carnegie Mellon University] asked. "That's a big puzzle in economics."...

"If only income mattered and beliefs about fairness didn't matter at all, then you should expect to see ... poor people demand redistribution [of tax revenue] and rich people oppose it. "The fact that we don't see that requires some explanation, and a big part of the explanation is that these beliefs about fairness matter a lot. So if you're poor but you think that the rich people really deserve to be rich, then you'll accept having less."

Much of Americans' beliefs revolve around whether they think the free-market economy is fair -- "in other words, people who work hard get more and people who don't get less" -- or whether they think it is basically unfair, so that "people are working really hard and not getting enough compensation."

In one recent study, Dr. Fong and Giacomo Corneo at the Free University of Berlin ... calculate that ... people who think the free market is unjust would give up a fifth of their income to switch from a laissez-faire economy to one where the government reduces the gap between the rich and poor. But those who feel that private enterprise is fair would give up an equal amount ... to switch from an economy where the government redistributes money to the poor, to one where the free market rules.

Other studies show that people will spend real money to ensure fairness.

In one unpublished experiment she has just finished with Felix Oberholzer at Harvard Business School, Dr. Fong gave people $10 each and said they could split it any way they wanted between themselves and public housing residents they were paired with.

But then she added a twist. All the public housing residents in the study had indicated they were held back in life either by drug abuse or by a disability, and the experimental subjects were offered the chance to spend $1 to find out which reason had been cited by the residents they were matched with.

About a third of the subjects spent the dollar, Dr. Fong said. And while you might think such curiosity would make them the less generous group, the opposite was true.

On average, she said, people who didn't seek information about their public housing residents gave them about $2 and kept about $8. Those who paid to find out about their residents gave them about $2.60 and kept the remaining $6.40.

The averages obscured a more intriguing finding, though. Those who discovered they had "worthy" residents, who said a disability had held them back, gave the residents about $4.55, and kept just $4.45 for themselves. Those who found that their residents cited drug abuse as an impediment kept $8.38 and gave the residents only 62 cents.

It turned out, then, that the people who were more generous on average also were extremely interested in finding out whether their charity recipients deserved to be helped, while those who were more selfish on average didn't care as much about how worthy the recipients were.

"Selfish people don't need the information" about recipients, she said, "because they're just not going to give [as much], but the people who want to give are only going to give if the person is deemed worthy."

While feelings about fairness influence charitable giving, another study Dr. Fong published earlier this year with Erzo Luttmer of Harvard University shows that racial and ethnic identity also plays a role in the United States.

In that study, people were shown a video about victims of Hurricane Katrina and then could decide how to split $100 between themselves and Habitat for Humanity chapters in the communities they had learned about.

Some of the videos people watched showed mostly white residents and some showed mostly black residents. ... The bottom line: Whites who said they felt "close" or "very close" to their ethnic or racial group on average gave $17 less to blacks than whites, but whites who said they were "not very close" or "not close at all" to their group gave $13 more to blacks than to whites.

The lessons from this experiment are not just about race, Dr. Fong said, but about the importance of our opinions about the people receiving any kind of assistance.

While many people still have negative attitudes toward welfare, despite the reforms made over the past decade, they generally have positive feelings toward Social Security. ...[W]ith welfare, many people feel the recipients aren't deserving, but have opposite opinions about Social Security because most recipients paid into the system when they worked.

In America, she said, one way to tap into this basic sense of fairness is to bring up the subject of the working poor.

"If they're perceived as being really hard-working and having reached that state despite their hard work, that's the point at which people are willing to step in and say either I as an individual or we as a society have to do something for this person.

"People don't necessarily think a low-income worker should be as rich as Bill Gates, even though he might be working as hard as Bill Gates, but they do have some sense of when things have gone too far."

links for 2007-12-31

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