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January 27, 2008

Economist's View - 5 new articles

Lawrence Summers: Beyond Fiscal Stimulus

Larry Summers says now that we have the ball rolling on fiscal policy (if only barely so), and interest rate cuts are in place, the time has come to take the next steps and begin to repair the financial system, to begin containing the damage caused by the housing sector, and to begin work on global coordination of policy. This addresses the first of these steps, repairing the financial system:

Beyond fiscal stimulus, further action is needed, by Lawrence Summers, Commentary, Financial Times: Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession... The debate about recession is now about how deep and global its impact will be.

There is enormous uncertainty... It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further...

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macroeconomic stimulus..., there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy. This column addresses the first of these imperatives...

Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan's did in the 1990s. ...

The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital. More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. ... A critical element of regulatory policy should be insisting on increased capital in existing financial institutions. ...

Efforts to infuse capital into existing institutions should be matched by a greater effort to ensure transparent and fair valuations. A capital market where the same loan is valued at one price in a bank, another in a different bank, another in a conduit and yet another as a hedge fund asset to be margined cannot be the basis for sound economic performance.

It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. ... It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. ...

While attention to date has focused on capital infusions into existing institutions, it would be desirable for capital to be injected into new institutions that do not have the legacy problems of existing ones and can meet the demand for new lending. Warren Buffett's recent entry into bond insurance is an example. There are grounds for concern about the adequacy of the flow of lending for student loans, automobiles, consumer credit and non-conforming mortgages. In each of these areas, there may be a need for collective private action or for government measures.

Normal economic performance will not return without a return to normality in the credit markets. The fear that pervades the markets will not abate of its own accord, nor is there a silver bullet. But consistent, determined approaches to doing what is needed to resolve each of the problems that arise will, in the end, re-establish confidence.

Martin Feldstein: The Stimulus Package is Not about Long-Term Growth

Martin Feldstein discusses the ability of monetary policy to impact the economy when there are problems in the financial and housing sectors, and the relationship between stimulus to aggregate demand and long-run growth (yesterday's post discussing Andrew Samwick's commentary comes to the same conclusion as Feldstein on whether aggregate demand changes can impact long-run growth):

Seven Questions: Martin Feldstein on the "R" Word, Foreign Policy: Foreign Policy: Everyone is anxiously discussing the possibility that the U.S. economy is in a recession or that it will be soon. You wrote in December that the probability of a recession in 2008 has now reached 50 percent. Where do you stand now?

Martin Feldstein: Well, I think it's higher. ...

FP: And how bad do you think it could get?

MF: It could get worse than the typical recession because the usual channels for turning something like this around through monetary policy are going to be less effective now due to the problems of the credit markets. The housing decline is really very serious this time. You put those two together, and I think we could end up with something that's deeper and longer than has traditionally been true. But it depends on the Fed, the White House, and Congress doing something to either prevent or dampen the magnitude of a downturn...

FP: U.S. President George W. Bush has proposed a roughly $140 billion stimulus package that centers on one-time tax rebates. But George Mason University economist Russell Roberts says the very idea of an economic stimulus package is "like taking a bucket of water from the deep end of a pool and dumping it into the shallow end." As he put it, "If you can make the economy grow, why wait for bad times?" So, is the idea of a stimulus package just political theater, or do you expect it to really help?

MF: I do expect it to help, but let me be clear about why it's not like moving water from one end of the pool to the other, or more accurately, why it is not a way of making the economy grow under all circumstances. If the economy is fully employed and growing at a normal pace, 3.5 percent, with unemployment under 5 percent and no expectation of a downturn, then aggregate demand is not the problem. Then, the only way to get the economy to grow more is to have more investment in capital equipment, people working harder, more innovation, and so on. And you can't do that by simply giving money back to taxpayers to spend more. So, the "spend more" approach to increasing economic activity is not about long-term growth. What it's about is offsetting the risk of an economic downturn. ...

Repeating from yesterday, which was in large part a follow-up to comments on the Landsburg article about fiscal policy:

I am less concerned with whether stabilization policy stimulates private consumption, private investment, or government investment than others seem to be, the important thing is to increase aggregate demand as fast as possible and get the economy moving again, and it doesn't much matter which component of aggregate demand, C, I, G, or NX is behind the stimulus. ... Real output growth is independent of demand changes in the long-run in most, but not all macro models. Demand shocks change short-run conditions, but the economy eventually finds its way back to the long-run path... Stabilization policy ... changes the speed at which you return to the long-run path, but its impact on the path itself is minor or non-existent. So the important thing is to get incentives or money to the people most likely to impact aggregate demand quickly which, fortuitously, is also happens to be the people most in need of help.

Restoring Confidence in Financial Markets

Robert Shiller says it's time to to update financial regulation to fit the modern financial world:

To Build Confidence, Try Better Bricks, by Robert Shiller, Economic View Commentary, NY Times: The key to maintaining economic stability is well-placed confidence in the markets. Bubbles, by contrast, result from misplaced confidence.

We are living in a post-bubble world, following the stock market bubble of the 1990s and the real estate bubble of the 2000s. ... We need to restore confidence in the markets' basic ability to function, not in their presumed tendency to make us all rich by always going up...

One main response to the Depression that helped prevent another from occurring was a set of tools that improved confidence by truly improving market security. One of these was the Federal Deposit Insurance Corporation, in 1933, but there were also a large number of others, especially the Securities and Exchange Commission the next year.

These were not obvious innovations and, in fact, were highly controversial at the time. Indeed, it is never obvious how the government should foster well-functioning markets. The fundamental role of governments in promoting markets is clear, but the design of their instruments must make creative use of a great deal of information about financial theory, human psychology and existing institutions and practices. The successful markets we have are a result of considerable inventive effort.

The F.D.I.C. was controversial because it was established amid the ruins of various state-level deposit insurance plans that had just gone bankrupt. Critics at the time also argued that federal deposit insurance would encourage unsound banking. But it turns out that the F.D.I.C. was a very good idea. It restored confidence in the banking system during the Depression, and with hardly any cost.

The S.E.C. was similarly controversial. Critics said it would hamstring or straitjacket the markets. But it is now the model for securities regulation around the world.

We need ... to set up a national study commission and to pay for serious creative research on how to adapt important ideas, like deposit insurance and securities regulation, to a modern financial world. ...

The ... problems ... need urgent attention. The very fact that many people feel they can no longer rely on some of our financial institutions may bring a self-fulfilling prophecy, which could then fundamentally harm economic activity.

The mortgage market is suffering. ... The commercial paper market is suffering, too. ... Other credit markets are also having problems...

Confidence in our brokerage firms is suffering. With every announcement of major losses, some people start to wonder whether they can rely on these companies.

Improvements in the deposit insurance system... [are needed. The] very least we can do is to raise the F.D.I.C.'s limits on insured deposits. The limit of $5,000 in 1934 was 12 years' worth of per capita personal income at the time. The limit was last raised in 1980, to $100,000, which was then 10 years' income. But because of inflation and economic growth, that limit is less than three years' income today. ... We have allowed deposit insurance to go three-quarters of the way to extinction.

The insurance limits of the Securities Investor Protection Corporation, which protects customers when brokerage firms fail, were also last raised in 1980 — to $100,000 in cash accounts and $500,000 in securities — and thus have suffered an equally drastic erosion in real value. Such erosion could suddenly matter if the crisis, or even just the psychology of the crisis, were to worsen.

But far beyond this, at a time when so many problems have arisen outside the limits of existing federal insurance programs, we need to do more than update the programs for inflation. We need to consider the fundamental principles on which they were based, stress-test them for today's environment and consider extending them in creative ways.

Is Unity the Answer?

Ezra Klein on calls for unity:

Unity isn't all it's cracked up to be, by Ezra Klein, Commentary, LA Times: ...I've got unity fatigue. That seems to be one of the chief buzzwords of this election. Unity. Barack Obama invokes it more frequently than John Edwards mentions "mills." My in-box, meanwhile, has only recently recovered from the torrent of messages sent by "Unity '08,"...

What accounts for all this talk of unity and bipartisanship and non-ideological problem solving? ... The short answer is that the candidates have no other choice. Washington these days is rived by partisanship, but that's not necessarily anything new or even particularly worrisome. In Washington, partisanship is like the San Francisco fog; it rolls in, hangs out for a while, and everyone goes about their business. The problem is, in this case, it's created total, impenetrable gridlock.

So, though elections are usually about what is to be done, this campaign has been unusually focused on whether it is in fact possible to get anything done. ...

The problem is that hearing all these presidential hopefuls pledge to end gridlock is a bit like having a friend promise to fix my toilet by checking under the hood of my car. Analytically, it's misguided. Now, ... candidates have to over-promise, so let's grant that they may not believe all their own hype. But at the same time, we shouldn't ignore the essential incoherence at the heart of these arguments:

Gridlock is not something the president of the United States can solve. Political gridlock begins in the U.S. Senate, but we keep trying to end it in the White House. There is no potential executive in either party who would not like to manifest his or her agenda by sheer force of will. But in reality, ... you don't get a doctor's note exempting you from the legislative process just because you ran, or even govern, as an independent. If you don't believe me, ask Arnold Schwarzenegger, the classic post-partisan unifier who couldn't attract a single Republican vote for his centrist health plan when it went before the Assembly.

Gridlock isn't a mystery. ... It's a function of the rules of the Senate, where 40 senators can refuse to end debate on legislation and thus doom its chances of passage. ...

This is the power of the filibuster, and it used to be a rarely invoked power, as the culture of the Senate prized compromise and consensus. In the 1977-78 congressional term, for instance, there were only 13 filibusters. Ten years later, there were 43. Ten years after that, there were 53. The Democrats used the tactic plenty when they were in the opposition a couple of years ago, but now that they're in power, it is the Republicans who are having a filibuster party. If they maintain their current pace, they'll have filibustered a full 134 times this term, more than doubling any other year on record. It's obstructionism on a truly historic scale.

Add to that obstructionist minority a divided government (the White House controlled by one party, Congress by another), the tensions of an ongoing war and a lame-duck president with no chosen successor and thus little concern for his plummeting popularity, and you have a moment that laughs at legislative progress. That's why the presidential campaign has become so focused on "getting things done."

But it's not up to the president. There are a variety of fixes for a filibuster-happy minority. The media, for example, could start accurately reporting the cause of the gridlock, shaming the relevant senators and increasing political pressure to compromise. The voters could eject politicians who refuse to compromise, laying down an electorally enforced preference for a functioning government. The Senate majority could change the rules, essentially eliminating the filibuster. ...

But the president can't do this, not on his or her own. Unity means nothing in the face of obstructionism, and problems can't be solved if legislators refuse to solve them.

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