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April 30, 2008

Economist's View - 6 new articles

The Fed Cuts the Target Rate to 2%

The Fed decided to cut rates to 2%. Here's the statement:

Press Release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 2-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Atlanta, and San Francisco.

More later (in a conference on financial innovation as I write this), but quickly note the intent to pause, though that depends upon what future incoming data tell them about inflation and output. Also note that only four banks submitted requests to lower the discount rate indicating some disagreement over today's policy move.

Slow First Quarter GDP Growth

The BEA announced today that growth in the first quarter is estimated to be .6%, though that figure could be (and probably will be) revised later.

There is a lot of discussion about whether this means we can say the economy is in a recession or not (Hamilton, Ritholtz, Krugman). Call it want you want - some people use the term growth recession to describe the current situation - but whatever we call it, a growth rate of .6% is slow (see Krugman's comments on employment as well).

The report was better than many people expected, but this isn't good news:

The U.S. economy didn't slump in the first quarter as some had feared it would, but its weak climb was the product of a likely unintended inventory buildup.

This isn't good news either:

Nonresidential fixed investment contributed -0.3%; a small factor in the total, but a development that worries Calculated Risk.

And a warning that there can be considerable lags in the adjustment process:

Four mega-dangers international financial markets face, by Dennis J Snower, Vox EU: Day after day new, alarming news emerges from the world's financial markets, and day after day the public is surprised by how bad it is. But instead of wringing our hands, let's ask ourselves an important, unconventional question: What is more surprising: that financial markets have turned from bad to worse, or that we continue to be surprised by each successive piece of adverse news?

I suggest that our repeated surprise should be more surprising. This issue is important, because if we were better at recognising the financial risks we face, we could do more to avoid them. If banks, investment houses, and American homeowners had done a better job in recognising the risks in the subprime mortgage market, we could have spared ourselves the current crisis.

Why does the public repeatedly underestimate the repercussions of the present financial crisis? The answer is simple: most of us are short-sighted; we can't imagine a future that is radically different from the present. In particular, most of us don't understand that economic events often unfold gradually due to the operation of important lagged adjustment processes embedded in the economy. The public, the media and politicians would do well to give them close attention. Lagged adjustment processes. After the Titanic's hull was punctured, it took hours for its hull to fill with water; thus the passengers couldn't imagine that it would sink.

In my judgment, there are currently four major dangers facing the world economy, and all of them are currently obscured by the fact they play themselves out slowly.

Four dangers The first danger we have witnessed since August 2007: The subprime mortgage crisis gave rise to a liquidity crisis in the international banking system, due to uncertainty about who holds the losses. This is leading to reduced lending to firms and households. But that is not the end of the story, because the reduced lending will lead to reduced consumption and investment. With a lag, reduced sales of goods and services will reduce stock market valuations. And, with another lag, the lower stock market prices will – in the absence of any favourable fortuitous events – intensify the banks' liquidity crisis.

The second danger lies in the dynamics of U.S. house prices. As more and more U.S. households find themselves unable to repay their mortgages, foreclosures are on the rise, more houses are put on the market, the price of houses falls further – with further lags – this leads to more foreclosures and declines in housing wealth. This dynamic process plays itself out only gradually, as households face progressively more stringent credit conditions and house sales gradually lead to lower house prices.

The third danger results from the interaction between wealth, spending and employment. As U.S. households' wealth – in the housing market and the stock market – falls, their consumption is beginning to fall and will continue to do so, again with a lag. This decline in consumption is leading to a decline in profits, of which more is on the way, which in turn will lead to a decline in investment. The combined decline in consumption and investment spending will eventually lead to a decline in employment, as firms begin to recognise that their labour is insufficiently utilised. The decline in employment, in turn, means a drop in labour income, which, with a lag, leads to a further drop in consumption.

And that leaves the fourth (and possibly the nastiest) of the dangers, one that concerns the latitude for monetary policy intervention. As the Fed reduces interest rates to combat the crisis, the dollar is falling. This is leading to higher import prices and oil prices in the United States, putting upward pressure on inflation. The greater this inflationary pressure – which is currently in excess of 4 percent – the more difficult it will be for the Fed to reduce interest rates in the future, without running a serious risk of inflaming inflationary expectations and starting a wage-price spiral. U.S. firms and households will gradually recognise this dilemma and the bleak prospect of little future interest rate relief will further dampen consumption and investment spending.

Eventually, of course, the decline in spending will lead to a decline in inflation, but this will only happen with a lag. The longer the lag turns out to be, the longer the period over which the U.S. economy will endure stagflation, that is, a cruel combination of rising prices and falling aggregate demand. Much hinges on how persistent U.S. inflation is. More persistent inflation will inevitably give rise to higher inflationary expectations, leading gradually to higher inflation, and so on. It took central banks over a decade, in the 1980s and early 1990s, to get inflationary expectations under control, and the fruits of this battle are now in danger of being lost.

Global implications The international financial crisis and the decline in the U.S. economy will inevitably have an adverse effect on the growth of the world economy. Europe and the emerging markets of Latin America and the Far East cannot fill the gap that the U.S. economy leaves. There exists no economic mechanism whereby a drop in the U.S. aggregate demand will be matched by a correspondingly large increase in aggregate demand elsewhere. Germany and other European economies highly exposed to the vagaries of international trade will certainly feel the pinch.

In the longer run, the prospects for the world economy look much brighter. Eventually U.S. house prices will stabilise, rising exports will help the U.S. economy recover, the fall in world demand for goods and services will reduce the price of raw materials, U.S. households will learn the importance of saving, and global imbalances will correct themselves. These rosy prospects lie in the mists of the future. Meanwhile, however, we are well advised to stay focused on the four dangers.

Brad DeLong: McCain and the Decline of US

Brad DeLong says America will be much poorer if John McCain is elected president:

McCain and the decline of US, by J Bradford DeLong, Project Syndicate: Back in 1981, America's Republican Party gave up all belief that the government's budget ought to be balanced. The idea took hold that tax cuts should be undertaken all the time, at every opportunity, because reducing taxes supposedly raised revenue. ...

John McCain – who once criticised George W Bush's tax cuts as imprudent and refused to vote for them – has succumbed to this potion. He appears to be proposing further tax cuts that promise to cost the US Treasury some $300bn a year, to "offset" them with cuts in earmarked spending accounted for at $3bn a year, and somehow to balance the budget.

We know the consequences: McCain's fiscal policy is likely to be standard Republican fiscal policy – and since 1981, standard Republican fiscal policy has increased the ratio of gross federal debt to GDP by nearly 2% per year. By contrast, a typical post-WWII Democratic administration has reduced the debt-to-GDP ratio by more than 1% per year. This is one of the issues at stake in this year's presidential election.

Policies that ignore the level of government debt lead to the currency's collapse, depression (due to the resulting disruption of the sectoral division of labour), and high inflation – perhaps hyperinflation. Often, the guilty blame the economic catastrophe on the sinister manipulations of foreigners like the "gnomes of Zurich" or the IMF. The US is far from that point. But even in the shorter run – over the next two presidential terms, say – the costs of a high deficit and rapid debt growth would be substantial.

A growing debt-to-GDP ratio would ... crowd out investment, as resources that would otherwise go to fund productive investment instead support private or public consumption.

Since 1981, the US has been lucky in that inflows of capital from abroad financed the growth of government debt. At some point, this will stop, and increases in deficits will trigger capital flight from the US.

Suppose that over the next eight years larger deficits trigger neither extra capital inflows nor capital outflows, and suppose that a lower-investment America is a poorer America, with a gross social return on investment of 15% per year.

By 2016, America's productive potential would be smaller by an amount that would reduce real GDP by 3.6%..., or roughly $3,000 per worker. In a poorer America, fewer businesses would find it worthwhile to entice ... workers ... into the labor force, and perhaps 500,000 net jobs would disappear.

In getting from here to there over the next eight years, a higher-debt America would see productivity growth slow by perhaps a third of a percentage point per year. Average unemployment would then ... rise... The gross correlations between productivity growth and average unemployment found in the 1970's, 1980's, 1990's, and 2000's would increase the economy's natural rate of unemployment by about one-fifth of a percentage point, costing an additional 500,000 jobs.

And a higher-debt America is one in which savers and lenders would have a justified greater fear that the government would resort to inflation in order to repudiate part of its outstanding debt.

The Federal Reserve would then have to fight inflation – putting upward pressure on unemployment – in order to reassure savers and lenders of its willingness to guard price stability. There are not even crude gross correlation-based estimates of the size of this effect, but economists believe that it is very real. Would it cost a negligible number of jobs? A quarter-million? A million?

Add it all up, and you can reckon on an America that in 2016 that will be much poorer if McCain rather than Barack Obama or Hillary Rodham Clinton is elected president. ... [U]nder McCain, the wedge between public spending and taxes would be larger, Americans would feel richer, and they would spend more at the expense of "posterity" eight years down the road. Ronald Reagan might have approved. After all, as he put it: "Why should I do anything for posterity? What has posterity ever done for me?" Or was that Groucho Marx?

"What to Do About Gas Prices?"

Jonah Gelbach emails that he has signed on to post periodically at Economists for Obama:

What to Do About Gas Prices?, by Jonah Gelbach: As an economist, as a person who worries about climate change, and as someone who believes the Democratic Party's electoral success is very important, if only to spare us more of the damage that the GOP has done over the last quarter-century of its hammer lock on federal policy, I find political discussion of gas taxes to be extremely frustrating to watch.

Democratic politicians regularly use high gas prices as a club with which to beat Republicans. I understand that politicians use the issues they think will work. And the nexus between oil company profits and GOP officials whose policies have been awful for most people in the bottom four quintiles of the income distribution (and probably plenty in the top one) has got to be pretty tough for Democratic candidates and officials to resist.

But the fact of the matter is that gas prices should be high. They should be high for the very simple and now very obvious reason that the pressure on the world's climate needs to be reduced. Our country's foolish policy of keeping gas prices low while providing implicit (and sometimes explicit) subsidies to the vehicles that get the worst mileage should have ended many years ago. Demand-side pressure on gas prices is finally pushing gas prices into the range they should have been for many years.

But that last paragraph tells only part of the story. One effect of the low-gas price policies we've pursued for so long is that it's induced many people to buy very fuel-inefficient cars and trucks. These are the people who are getting nailed hardest in the wallets by today's high gas prices, and I don't blame them for being upset. If you drive a vehicle that gets 18 miles per gallon for 12,000 miles a year, then you use about 670 gallons of gas a year. Even a $1.00 per gallon increase in the price of gas over a period of one year alone therefore translates into more than the stimulus tax rebate that a single person with sufficient income will receive over the next month. A married couple each of whom drives such a car 12,000 miles a year will receive a smaller rebate than the one-year cost of a $1 per gallon gas price hike.

By any reasonable standard, the increase in gas prices translates into real money for a huge number of people in this country, especially under current economic conditions.

But since the reason this is true is that American consumers have been induced to buy inefficient gas guzzlers, with serious environmental consequences, policies that would reduce the price of gas should be the last thing we consider. (On this score, the gas tax holiday that Sens. McCain and Clinton have proposed at least has the virtue that it would likely do very little, leading to at most a very small change in the price of gas; McCain's proposal would add to the deficit by increasing windfall profits of oil companies, while Clinton at least has proposed a new windfall profits tax to undo her proposal's provision of windfall profits.)

So what to do?

I propose the following two-pronged policy:

  • Prong 1. No change in the gas tax until the economy improves. At that point, we would begin to increase the gas tax annually by some fixed amount that would be stated in advance, allowing people to make informed car-purchase decisions. Consumers would shift consumption toward more fuel-efficient vehicles, and automakers would see this coming, so they would shift R&D toward such vehicles. Over time, the efficiency of the U.S. auto fleet would improve, cutting emissions and making us less dependent on all that foreign oil over which everyone always frets.
  • Prong 2. Every person who owns a car and files a tax return would receive a Gas Price Rebate (GPR). The amount of the GPR could vary with income if means-testing is desired to keep the overall cost of this program lower than it would otherwise be. However, the GPR would not vary according to the type of car people own. It could be set at something like. (12,000/avg MPG of U.S. fleet) x (the 2002-2008 change in the per-gallon price of gas)

We could adjust any particular component of the GPR. The point isn't the exact formula, but rather the fact that the GPR does not vary with the type of car that a person drives but does provide relief to the millions of Americans who responded to the bad incentives created by the misguided/chicken*$@# representatives the people themselves elected. People who want to keep driving those H2 and Mustang monstrosities (Ok, I admit it -- I used to drive a Mustang) can do so if they want, but they'll have to pay for it.

Thus, the two prongs together move incentives in the right direction (prong 1) while helping alleviate the real suffering going on out there due to gas price increases (prong 2). What I hope makes such a policy politically viable is the combination of the two elements. Yes, opponents will slam prong 1, but prong 2 is there as a retort.

As for paying for prong 2, some headway can be made with the increase in gas taxes in prong 1. It's a truism of microeconomic theory, though, that a tax-induced price increase will reduce equilibrium quantity, so it's likely that any GPR big enough to make prong 1 politically feasible will require additional funding. To deal with this, I propose ... you guessed it, an increase in taxes on upper-income Americans. And while I think the best way to do this would be those who make even more than I do, if need be, I'd be happy to pay more in taxes to help make this plan a reality.

Update: Here's Obama talking about the McCain-Clinton proposal today.

Random Notes

A few quick notes from the Milken Institute Global Conference:

"The president would not understand dynamic evolutionary stochastic processes," From "A Discussion with Nobel Laureates in Economics," Gary Becker, Edmund Phelps, Myron Scholes, and Michael Spence, Moderator: Michael Milken.

As I was riding down the elevator this morning, the car stopped and Muhammad Yunus got on. I said hi. He said hi back.

In a lunchtime quiz, 45% of the people in the audience thought the very first Nobel prize in economics went to Hayek.

When Steve Forbes used the words "flat tax," some people in the audience began applauding. The also applauded every time he used the phrase "tax cut."

The session "Harnessing Growth to Break Poverty's Grip on the Developing World," with Ricardo Hausmann, Myron Scholes, and Maria Eitel, and moderated by Michael Spence, was very good. Part of it was about monkeys in trees. Maria Eitel, president of the Nike foundation, was also very persuasive in arguing for more aid to women. Currently, only about a nickel of every development dollar is devoted to improving the economic prospects for women in developing countries, but there can be huge payoffs from investment in this area (Michael Spence consulted on this work). The political and social problems surrounding investment in women were also interesting. Essentially, even though there are large long-term benefits to helping women, it is in nobody's short-term interest to take women out of their traditional role in the family and community where they provide water, firewood, food for the family, care for sick family members, are expected to provide insurance for the family by dropping out of school if the family needs help, and so on. The key has been to stop trying to attack this as a political or social issue, and instead show families that it is in their economic interest to allow their daughters to attend school, marry later, etc., and then use targeted aid programs that create the correct incentives (e.g. micro loans that provide more help to the family than the daughter can, and are only available if the daughter is in school).

The session "State of the State of Wall Street: Creating Opportunity Out of Chaos," with Bennett Goodman, Senior Managing Partner, GSO Capital Partners LP; Kenneth Griffin, Founder, President and CEO, Citadel Investment Group LLC; Kenneth Moelis, CEO, Moelis & Company; Charles Ward III, President, Lazard Ltd.; Chairman, Lazard Asset Management Group; Peter Weinberg, Partner, Perella Weinberg Partners; Moderator: Paul Calello, CEO, Investment Bank, Credit Suisse was interesting. The panelists clearly understand that some sort of increased regulation of the financial sector will be forthcoming, but they are very worried about the form that regulation will take (and issued the usual threats, e.g. we'll move to other countries). It was clear they plan to be proactive in trying to shape the regulatory changes. They were very supportive of the Fed's bailout of Bear Stearns and changes to the discount window (no surprise there), though one panelist who ran a hedge fund did complain about not having access to the newly designed discount window while other firms did. They were very grateful that sovereign wealth funds were available to provide needed capital, and they were much more optimistic about economic prospects on Main street where they believe there is only a minor contraction and chance of a quick recovery, than about the prospects on Wall street, where they see a depression and a much more drawn out process of recovery.

Update: The elevator keeps messing with me. I was waiting to go down for the dinner thing, the door opens, it's crowded, so I wave it off. But some guy says no, there's room, get on, and people scrunch to make space. I look up and it's Michael Milken. It's the Beverly Hilton, he's paying for the room, my dinner, etc., so I did what I was told and got on the elevator. I did say thanks. Weird.

As for the panels during dinner, I discovered that I don't like Bill Bennett any more in person than I do on TV. Jerry Brown was better, CNN's Bill Schneider was more entertaining than I expected, though from an entertainment perspective John cleese in the earlier panel was better yet. Nobody said anything particularly surprising, except, perhaps, the begrudging (and somewhat backhanded) respect Bennett gave to Clinton for her toughness and perseverance. Still, the consensus was it would be McCain versus Obama, and that the identity each carries into the election will be the determining factor (e.g. McCain as feeble old man or tough war hero, and the extent that Obama will continue to be identified with Wright, elitism, Ayers, etc. - Brown was more optimistic than Bennett that these issues would fade over time).

I have more business cards than I can ever remember having at one time. I didn't bring any (because I've never bothered to get any), so when I'm given one I just take it and say thanks. I always feel kind of awkward at that moment. Then again, I can't put faces with the cards I've been given, so maybe being a big business card dork actually helps with the longer-term memory imprinting.

Because I'm a blogger, they gave me a press pass. That's kind of cool I guess, or so I thought at first, but it doesn't give you any extra privileges except a separate work area I had no use for. It's like a cat bell that tells people you might report on what they say, and that makes some of them reluctant to answer questions. It took me awhile to realize that.

links for 2008-04-30

April 29, 2008

Economist's View - 6 new articles

Random Notes

A few quick notes from the Milken Institute Global Conference:

"The president would not understand dynamic evolutionary stochastic processes," From "A Discussion with Nobel Laureates in Economics," Gary Becker, Edmund Phelps, Myron Scholes, and Michael Spence, Moderator: Michael Milken.

As I was riding down the elevator this morning, the car stopped and Muhammad Yunus got on. I said hi. He said hi back.

In a lunchtime quiz, 45% of the people in the audience thought the very first Nobel prize went to Hayek.

When Steve Forbes used the words "flat tax," some people in the audience began applauding. The also applauded every time he used the phrase "tax cut."

The session "Harnessing Growth to Break Poverty's Grip on the Developing World," with Ricardo Hausmann, Myron Scholes, and Maria Eitel, and moderated by Michael Spence, was very good. Part of it was about monkeys in trees. Maria Eitel, president of the Nike foundation, was also very persuasive in arguing for more aid to women. Currently, only about a nickel of every development dollar is devoted to improving the economic prospects for women in developing countries, but there can be huge payoffs from investment in this area (Michael Spence consulted on this work). The political and social problems surrounding investment in women were also interesting. Essentially, even though there are large long-term benefits to helping women, it is in nobody's short-term interest to take women out of their traditional role in the family and community where they provide water, firewood, food for the family, care for sick family members, are expected to provide insurance for the family by dropping out of school if the family needs help, and so on. The key has been to stop trying to attack this as a political or social issue, and instead show families that it is in their economic interest to allow their daughters to attend school, marry later, etc., and then use targeted aid programs that create the correct incentives (e.g. micro loans that provide more help to the family than the daughter can, and are only available if the daughter is in school).

The session "State of the State of Wall Street: Creating Opportunity Out of Chaos," with Bennett Goodman, Senior Managing Partner, GSO Capital Partners LP; Kenneth Griffin, Founder, President and CEO, Citadel Investment Group LLC; Kenneth Moelis, CEO, Moelis & Company; Charles Ward III, President, Lazard Ltd.; Chairman, Lazard Asset Management Group; Peter Weinberg, Partner, Perella Weinberg Partners; Moderator: Paul Calello, CEO, Investment Bank, Credit Suisse was interesting. The panelists clearly understand that some sort of increased regulation of the financial sector will be forthcoming, but they are very worried about the form that regulation will take (and issued the usual threats, e.g. we'll move to other countries). It was clear they plan to be proactive in trying to shape the regulatory changes. They were very supportive of the Fed's bailout of Bear Stearns and changes to the discount window (no surprise there), though one panelist who ran a hedge fund did complain about not having access to the newly designed discount window while other firms did. They were very grateful that sovereign wealth funds were available to provide needed capital, and they were much more optimistic about economic prospects on Main street where they believe there is only a minor contraction and chance of a quick recovery, than about the prospects on Wall street, where they see a depression and a much more drawn out process of recovery.

Update: The elevator keeps messing with me. I was waiting to go down for the dinner thing, the door opens, it's crowded, so I wave it off. But some guy says no, there's room, get on, and people scrunch to make space. I look up and it's Michael Milken. It's the Beverly Hilton, he's paying for the room, my dinner, etc., so I did what I was told and got on the elevator. I did say thanks. Weird.

As for the panels during dinner, I discovered that I don't like Bill Bennett any more in person than I do on TV. Jerry Brown was better, CNN's Bill Schneider was more entertaining than I expected, though from an entertainment perspective John Kleese in the earlier panel was better yet. Nobody said anything particularly surprising, except, perhaps, the begrudging (and somewhat backhanded) respect Bennett gave to Clinton for her toughness and perseverance. Still, the consensus was it would be McCain versus Obama, and that the identity each carries into the election will be the determining factor (e.g. McCain as feeble old man or tough war hero, and the extent that Obama will continue to be identified with Wright, elitism, Ayers, etc. - Brown was more optimistic than Bennett that these issues would fade over time).

I have more business cards than I can ever remember having at one time. I didn't bring any (because I've never bothered to get any), so when I'm given one I just take it and say thanks. I always feel kind of awkward at that moment. Then again, I can't put faces with the cards I've been given, so maybe being a big business card dork actually helps with the longer-term memory imprinting.

Because I'm a blogger, they gave me a press pass. That's kind of cool I guess, but it doesn't give you any extra privileges except a separate work area I had no use for. It's like a cat bell that tells people you might report on what they say, and that makes some of them reluctant to answer questions. It took me awhile to realize that.

Brad DeLong: Twenty First-Century Banking

Brad DeLong on the moral hazard implications of recent Fed policy moves:

Twenty First-Century Central Banking, by Brad DeLong: The problem of dealing with moral hazard in twenty first-century central banking has taken an interesting twist. Twice in the past decade the Federal Reserve has intervened in cases in which specific institutions ... that the Federal Reserve ... has concluded are too big to be allowed to fail through standard processes. The two institutions are the hedge fund Long Term Capital Management--LTCM--in 1998, and the bank Bear-Stearns in 2008.

In 1998 LTCM had suffered major losses on a mark-to-current-market basis (although its long-term prospects in the event of global financial recovery from the crisis looked correspondingly good), and appeared both illiquid and--if forced to liquidate its positions at then-current values...--insolvent. Alan Greenspan and Peter Fisher at the New York Fed gathered all of the Federal Reserve's major creditors in a room, told them that they had a problem, and told them that they should solve it: that systemic risk would be created by an LTCM bankruptcy and liquidation and that the Fed did not want to go there. The creditors agreed to cooperate and split both the liability and the upside (with the exception of Bear Stearns, that declined)... The ... equity of LTCM's principals and investors was confiscated--to the dismay of LTCM's principals and investors, some of whom believe that they would have been able to get a much better split of the upside had they been allowed to play their creditors off against each other.

In 2008 Bear Stearns had suffered major losses on a mark-to-current-market basis (although its long-term prospects in the event of global financial recovery from the crisis looked correspondingly good), and appeared both illiquid and--if forced to liquidate its positions at then-current values...--insolvent. Ben Bernanke and Tim Geithner at the New York Fed declared that systemic risk would be created by a Bear Stearns bankruptcy and liquidation, that the Fed did not want to go there, and that the only deal they would fund and support would be a deal that sold Bear Stearns to J.P. MorganChase at $2 (later raised to $10) a share, and the Federal Reserve kicked into the deal a put on Bear Stearns assets that one might speculate had a full-information liquid-market value of perhaps $3 billion. Various speakers for principals and investors in Bear Stearns protested that this effective confiscation of their equity value was unfair and inappropriate...

We now have two precedents. If the Federal Reserve judges that a major financial institution:

  • is too big to fail in that its failure will generate systemic risk
  • has followed portfolio strategies that have produced inappropriate and excessive leverage
  • requires immediate action

then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero entity. Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table.

This is not the arms-length equal-treatment impersonal-rule-of-law ideal to which a government should aspire. This does, however, seem to get the incentives about right. ...

These two precedents suggest that the Federal Reserve is evolving a case-law-of-twenty-first-financial-crisis that is somewhat different: in a crisis the lender-of-last-resort will always show up, but investors and principals in individual institutions that need to be specially rescued will discover that the lender of last resort is not their friend.

Econoblogger Panel

I am at the Milken Global Conference where I participated in a panel on "econoblogging" (though most of the people on the panel were more orientated toward finance issues than economics).

Calculated Risk attended the session:

Conference Comment, by Calculated Risk: I enjoyed attending the Milken conference yesterday. Thanks to Jennifer Manfre' of the Milken Institute for arranging a press pass.

I attended a couple of sessions on topics that I know little about (like Urbanization in India and China), and they were awesome. IMO this type of conference has two strengths: 1) you meet a number of interesting people, and 2) the sessions provide a great introduction to a variety of topics.

However when I was familiar with the topic (like "Real Estate: Where is the Bottom?"), I was disappointed with the depth of the analysis. Hopefully Tanta will have a chance to listen to the audio of "The Future of the Mortgage Market: Where Do We Go From Here?" - but I suspect she will be disappointed too.

On a personal note, it was great to finally meet several bloggers: Professor Mark Thoma of Economist's View, Felix Salmon of Market Movers, Yves Smith of Naked Capitalism, and Paul Kedrosky of Infectious Greed.

Mark and I are "internet friends" - we've corresponded for over 3 years - and it was fun to finally meet face to face. We seemed like old friends ... the internet is awesome!

The econblogger session was well attended. Personally I thought the moderator asked several wrong questions - and he kept focusing on the credibility of the bloggers and rumors being spread on the internet, as opposed to focusing on experts in specific fields bringing more in-depth analysis to a subject than a newspaper. The moderator worked previously at the WSJ, and he seemed to think blogs were a competing product to newspapers. Professor Thoma argued persuasively that blogs are complementary to newspapers and when written well (think Tanta!), provide more in-depth analysis on specific subjects.

I can't watch it, partly because I don't think I expressed myself very well (I never think I do...), but there is a video of the session here (Also, Felix says "If you're having trouble with the sound, it kicks in properly around the 8 minute mark").

"The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus"

It would be safe to say that Jamie Galbraith's view of modern monetary theory differs from mine:

The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus, by James K. Galbraith: Twenty-five years ago, on a brilliant winter day at Alta, I stepped off the top of the Sugarloaf lift and heard a familiar voice asking for directions. It was William F. Buckley, jr. I pulled off my hat and skied over to say hello. Buckley greeted me, then turned to a small man at his side, wrapped in a quilted green parka, matching green stocking cap, and wrap-around sunglasses in the punk style. "Of course," he said, "you know Milton Friedman."

Five months ago, I received from Professor Delemeester the invitation to deliver this lecture. My first act was to notify Buckley, already then quite ill. I warned that he couldn't publish on it or the invitation might be revoked. The email came back instantly, full of exclamation points, block caps and misspellings. "Congratulations! What a wonderful opportunity to REPENT!"

My other close encounter with Milton Friedman came around eighteen years ago, when he invited me to debate the themes of "Free to Choose" for an updated release of that late-seventies television series. Looking at it recently on the Internet after so many years, my main impression is that this format did not show Friedman at his best. Unlike Buckley on television he would simplify and condescend, and this left him vulnerable to easy lines of attack. When I suggested that his program plainly drew no distinctions between the big government of communist China and the big government of the United States, he had no reply. It was true: that's what he thought. If this were all there was to Friedman, he would not be worth talking about and you would not have endowed this lecture.

Truly I come to bury Milton, not to praise him. But I would like to do so on the terrain that he favored, where he was strong, and over which he ruled for many decades. This is monetary policy, monetarism, the natural rate of unemployment and the priority of fighting inflation over fighting unemployment. It is here that Friedman had his largest practical impact and also his greatest intellectual success. It was on this battleground that he beat out the entire Keynesian establishment of the 1960s, stuck as they were on a stable Phillips Curve. It was here that he set the stage for the counter-revolution that has dominated academic macroeconomics for a generation, and that – far more important – also dominated and continues to influence the way in which most people think about monetary policy and the fight against inflation.

What was monetarism?

Friedman famously defined it as the proposition that "inflation is everywhere and always a monetary phenomenon." This meant that money and prices were tied together. But more than that, Friedman believed that money was a policy variable – a quantity that the Central Bank could create or destroy at will. Create too much, there would be inflation. Create too little, and the economy might collapse. There followed from this that the right amount would generate the right result: stable prices at what Friedman came to call the natural rate of unemployment.

The intent and effect of this line of reasoning was to defend a core proposition about capitalism: that free and unfettered markets are intrinsically stable. In Friedman's gospels government is the lone serpent in Eden, while the task of policy is to stay out of the way. Just as this was the vulgar lesson of "Free to Choose" so it turns out it was also the deep lesson of the larger structure of Friedman's thought. Friedman and Schwartz's Monetary History for all its facts and statistics carried a simple message: the market did not fail; the government did.

Friedman succeeded because his work was complex enough to lend an aspect of scientific achievement to his ideas, and because the ideas played to the preconceptions of a particular circle. As Keynes wrote of Ricardo: "The completeness of [his] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely... to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority."

Friedman's success was similar to Ricardo's but not in all respects. Yes he also explained away injustice and supported authority. But the logical superstructure was not vast and consistent. Rather Friedman's argument was maddeningly simple, yet slippery. He would appeal to short run for some effects and to the long run for others, shifting between them as it suited him. Once at some American Economic Association meetings in San Francisco I encountered him at the end of a camera. "Professor Friedman," the reporter inquired, "how will the economy do next year?" "Well," Friedman replied, "because of the slow money growth last year, there will be a terrible recession." "And what is your outlook for prices?" "Because of the fast money growth over the past several years, there will be a terrible inflation." "Professor Friedman," the reporter continued, "will the average American family be better off next year, or worse off than they are today." "There is no such thing as the average American family. Some American families will be better off, and some will be worse off." As I said: he could be difficult to pin down. And while the practice resulting from the teachings was indeed austere and unpalatable, Friedman actually denied this. His money growth rules promised stable employment without inflation. Their promise was not austere, but happy. Ricardo was Scrooge. Friedman was more like the Pied Piper.

Friedman's success was consolidated in the late 1970s by facts: the strength of the monetarist regressions and the failure of the Keynesian Phillips Curve. Stagflation happened. Robert Lucas called this "as clear-cut an experimental discrimination as macroeconomics is ever likely to see." At the same time, I played a minor role in bringing monetarist ideas to the policy market. My responsibility was to design the Humphrey-Hawkins hearings on monetary policy from 1975 through their enactment into law in 1978. In a practical alliance with monetarists on the committee staff, we insisted that the Federal Reserve develop and report targets for monetary growth a year ahead. The point here was not to stabilize money growth as such: it was to force the Fed to be more candid about its plans. But the process certainly lent weight to monetarism.

It was on the policy battleground, shortly after, that monetarism collapsed. From1979, the Federal Reserve formally went over to short-term monetary targets. The results were a cascading disaster: twenty-percent interest rates, a sixty percent revaluation of the dollar, eleven percent unemployment, recession, deindustrialization through the Midwest including here in Ohio, and in Indiana, Illinois and Wisconsin, and ultimately the debt crisis of the Third World. In August 1982, faced with the Mexican default and also a revolt in Congress – which I engineered from my perch at the Joint Economic Committee – the Federal Reserve dumped monetary targeting and never returned to it.

By the mid-1980s, the rigorous monetarism Friedman had championed also faded from academic life. Money growth became high and variable, but inflation never came back. Perhaps inflation was "always and everywhere a monetary phenomenon." But monetary phenomena could happen without inflation. This vitiated the use of monetary aggregates as an instrument of policy control. At the Bank of England Charles Goodhart stated his law: when you try to use an econometric relationship for purposes of policy control, it changes. Friedman himself conceded to the Financial Times in 2003: "The use of quantity of money as a target has not been a success. I'm not sure I would as of today push it as hard as I once did."

What remained in the aftermath was a sequence of doctrines. All were far more vague and imprecise than monetarism but they carried a similar policy message: the Fed should place inflation control at the center of its operations, it should ignore unemployment except if that variable fell too low. Further, there was a sense that instability in the financial sector should be ignored by macroeconomic policymakers except when it could not be ignored any longer. The first of these doctrines, the "natural rate of unemployment" or "Non-Accelerating Inflation Rate of Unemployment," originated with Friedman and Edmund Phelps in 1968 and had the fatal attraction of incorporating expectations for the first time into a macroeconomic model. Macroeconomists fell for it wholesale. But it proved laughably defective in the late 1990s, Alan Greenspan, bless his heart, allowed unemployment to fall below successive NAIRU barriers – 6 percent, 5.5 percent, 5 percent, 4.5 percent, and finally even 4 percent. Nothing happened. No inflation resulted. This was good news for everyone except economists associated with the NAIRU who were, or ought to have been, embarrassed. Some retreated from Friedman to Knut Wicksell: there was a brief vogue of something called the "natural rate of interest" an idea unsupported by any actual research nor any theory since the demise of the gold standard.

And then we got Ben Bernanke and ostensible doctrine of "inflation targeting." This idea -- Dr. Bernankenstein's Monster – rests on something Professor Marvin Goodfriend of Carnegie- Mellon University calls the "new consensus monetary policy." This is a collection of ideas framed by the experience of the early 1980s but adapted, at least on the surface, to changing conditions since then. These are, first, that "the main monetarist message was vindicated: monetary policy alone...could reduce inflation permanently, at a cost to output and employment that, while substantial, was far less than in common Keynesian scenarios." Second, a determined independent central bank can acquire credibility for low inflation without an institutional mandate from the government...." and "Third, a well-timed aggressive interest-rate tightening can reduce inflation expectations and preempt a resurgence of inflation without creating a recession." Let us take up each of these alleged principles in turn.

First, is the proposition that monetary policy can reduce inflation permanently and at reasonable cost the "main monetarist message"? The idea is absurd. The main monetarist message was that the control of inflation was to be effected by the control of money growth. We have not even attempted this for a generation. Money growth has been allowed to do whatever it wanted. The Federal Reserve stopped paying attention, and even stopped publishing some of the statistics. Yet inflation has not returned. The main monetarist message is plainly false. As for the question of cost, no one ever doubted that a harsh recession could stop inflation. But in fact the monetarists' recession of 1981-82 was by far the deepest on the postwar record. It was far worse than any inflicted under Keynesian policy regimes. In misstating this history, Goodfriend also completely overlooks the catastrophe inflicted by the global debt crisis on the developing world.

Second, is the anti-inflation "credibility" of a "determined central bank" worth anything at all? This idea is often asserted as though it were self-evident: that workers will restrain their wage demands because they recognize that excessive demands will be punished by high interest rates. There is some evidence for such a mechanism in the very specific case of postwar Germany, where a powerful union, the Metallgesellschaft, implicitly bargained with the Bundesbank for a period of some years. But in that case, the Bundesbank held a powerful, targeted weapon: a rise in interest rates would appreciate the D-Mark and kill the export markets for German machinery and metal products. This was a credible threat. Such a situation does not exist in the United States, and there is no evidence whatever that American labor unions think at all about monetary policy in their day-to-day work. It would not be rational for them to do so: in a decentralized system, restraint in one set of wages just creates an advantage for someone else. Moreover, and still more telling, there of course never existed any oil company that ever failed to raise the price of petroleum, when it could, because it feared a rise in interest rates might afflict someone else later on.

Third, can we safely state that a "well-timed aggressive tightening" can avert inflation "without creating a recession"? That statement is surely the lynchpin of the new monetary consensus. It was published in the Journal of Economic Perspectives – a flagship journal of the American Economic Association, in the issue dated Fall 2007. The article, by Professor Goodfriend, is entitled, "How the World Achieved Consensus on Monetary Policy." It therefore represents a statement of the highest form of expression of economic groupthink we are ever likely to find. Let me quote further, just so the message is clear. Goodfriend writes: "According to this "inflation-targeting principle," monetary policy that targets inflation makes the best contribution to the stabilization of output. ... [T]argeting inflation thus makes actual output conform to potential output." Further: "This line of argument implies that inflation targeting yields the best cyclical behavior of employment and output that monetary policy alone can deliver. Thus, and here is the revolutionary point delivered by the modern theoretical consensus–even those who care mainly about the stabilization of the real economy can support a low-inflation objective for monetary policy. ...[M]onetary policy should [therefore] not try to counteract fluctuations in employment and output due to real business cycles."

This statement was published, hilariously, around August, 2007. It is the economists' equivalent of the proposition that the road to Baghdad would be strewn with flowers. For as of that moment, the Federal Reserve was at the crest of an "aggressive tightening" underway since late 2004, aimed precisely at "pre-empting inflationary expectations" while "averting recession." On July 19, 2006, Chairman Bernanke so testified: "The recent rise in inflation is of concern to the FOMC.... The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation." On February 14, 2007, he repeated and strengthened the message: "The FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected." On July 19, 2007, this is again repeated: "With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern."

Before the fall, Chairman Bernanke made occasional reference to developments in the financial sector. On May 23, 2006, these were actually enthusiastic. Bernanke testified: "Technological advances have dramatically transformed the provision of financial services in our economy. Notably, increasingly sophisticated information technologies enable lenders to collect and process data necessary to evaluate and price risk much more efficiently than in the past." And: "Market competition among financial providers for the business of informed consumers is, in my judgment, the best mechanism for promoting the provision of better, lowercost financial products." As for consumers, education was Bernanke's recommendation and caveat emptor was his rule: "...one study that analyzed nearly 40,000 affordable mortgage loans targeted to lower-income borrowers found that counseling before the purchase of a home reduced ninety-day delinquency rates by 19 percent on average."

On February 14, 2007, Bernanke was still optimistic: "Despite the ongoing adjustments in the housing sector, overall economic prospects remain good." And: "Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes." On March 28, 2007, he was less cheerful: "Delinquency rates on variable-interest loans to subprime borrowers, which account for a bit less than 10 percent of all mortgages outstanding, have climbed sharply in recent months." Still, "At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." Only on July 19, 2007, do we hear that previous assessments were a bit rosy. Only then do we hear that "in recent weeks, we have also seen increased concerns about credit risks on some other types of financial instruments." That was three weeks before all hell broke loose on August 11, 2007.

What in monetarism, and what in the "new monetary consensus," led to a correct or even remotely relevant anticipation of the extraordinary financial crisis that broke over the housing sector, the banking system and the world economy in August 2007 and that has continued to preoccupy central bankers ever since? The answer is, of course, absolutely nothing. You will not find a word about financial crises, lender-of-last-resort functions or the nationalization of banks like Britain's Northern Rock in papers dealing with monetary policy in the monetarist or the "new monetary consensus" traditions. What you will find, if you find anything at all, is a resolute, dogmatic, absolutist belief that monetary policy should not – should never – concern itself with such problems. That is partly why I say that monetarism has collapsed. And that is why I say that the so-called new monetary consensus is an irrelevance. Serious people should not concern themselves with these ideas any more. Meanwhile central bankers caught in the practical realities of a collapsing financial system have had to re-educate themselves quickly. To some degree and to their credit they have done so. What they have not done, is admit it.

What is the relevant economics? Plainly, as many commentators have hastily rediscovered, it is the economics of John Maynard Keynes, of John Kenneth Galbraith and of Hyman Minsky, that is relevant to the current economic crisis. Let say a word on each.

Here is Keynes, who wrote in 1931 that we live "in a community which is so organized that a veil of money is, as I have said, interposed over a wide field between the actual asset and the wealth owner. The ostensible proprietor of the actual asset has financed it by borrowing money from the actual owner of wealth. Furthermore, it is largely through the banking system that all this has been arranged. That is to say, the banks have, for a consideration, interposed their guarantee. They stand between the real borrower and the real lender. ... It is for this reason that a decline in money values so severe as that which we are now experiencing threatens the solidarity of the whole financial structure. Banks and bankers are by nature blind. They have not seen what was coming. Some of them have even welcomed the fall of prices towards what, in their innocence, they have deemed the just and 'natural' and inevitable level..., that is to say, to the level of prices to which their minds became accustomed in their formative years. In the United States, some of them employ so-called 'economists' who tell us even today that our troubles are due to the fact that the prices of some commodities and some services have not yet fallen enough... A 'sound banker,' alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him."

In The Great Crash, published in 1955, my father rejects the idea, later embraced by Friedman, that bankers and speculators were merely reflecting the previous course of monetary policy. As of summer 1929, "[t]here were no reasons for expecting disaster. No one could foresee that production, prices, incomes and all other indicators would continue to shrink for three long and dismal years. Only after the market crash were there plausible grounds to suppose that things might now for a long while get a lot worse." And, "There seems little question that in 1929, modifying a famous cliché, the economy was fundamentally unsound. ... Many things were wrong, [including] ...the bad distribution of income... the bad corporate structure... the bad banking structure... the dubious state of the foreign balance...[and] the poor state of economic intelligence." On the last, he also wrote, "To regard the people of any time as particularly obtuse seems vaguely improper, and it also establishes a precedent which members of this generation might regret. Yet it seems certain that the economists and those who offered economic counsel in the late twenties and early thirties were almost uniquely perverse." On this point, JKG is now disproved. I refer you back to the "new monetary consensus."

Finally Hyman Minsky taught that economic stability itself breeds instability. The logic is quite simple: apparently stable times encourage banks and others to take exceptional risks. Soon the internal instability they generate threatens the entire system. Hedge finance becomes speculative, then Ponzi. The system crumbles and must be rebuilt. Governments are not the only source of instability. Markets, typically, are much more unstable, much more destabilizing. This fact that is clear, in history, from the fundamental fact that market instability long predates the growth of government in the New Deal years and after, or even the existence of central banking. We had the crash of 1907 before, not after, we got the Federal Reserve Act.

On November 8, 2002, then-Fed Governor Ben S. Bernanke spoke in Chicago to honor Milton Friedman on his 90th birthday. Bernanke said, "As everyone here knows, in their Monetary History Friedman and Schwartz made the case that the economic collapse of 1929-33 was the product of the nation's monetary mechanism gone wrong. Contradicting the received wisdom at the time they wrote...Friedman and Schwartz argued that 'the contraction is in fact a tragic testimonial to the importance of monetary forces." In that era, Bernanke argued, the Fed tightened to thwart speculation. One would argue that in 2005-7 it tightened to pre-empt inflation. No matter. You can see the difficulty without my help. At the close of his speech, Bernanke stated, "Let me end my talk by slightly abusing my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Less than six years later, Chairman Ben Bernanke faces an intellectual dilemma. He can stick with Milton, in which case he must admit that the only possible cause of the present financial crisis and evolving recession is the tightening action of the Federal Reserve, against which, when it started back in 2004 only two voices were heard: that of Jude Wanniski, the original supply-sider, and my own, in a joint Op-Ed piece no one would publish except the Washington Times. Or he can stick with the so-called "new monetary consensus," which holds that the Fed should now return to its inflation targets, pursue a much tighter policy, and that no recession will result. If Bernanke chooses the first, he must of course assume responsibility for the unfolding disaster. He cannot, logically, stay with Friedman without admitting the error of the late Greenspan years and his own first months in office. If he chooses the second, he must repudiate Friedman, and hope for the best. The two courses are absolutely in conflict.

My own view is that Friedman and Schwartz were right on the broad principle -- monetary forces are powerful -- but wrong in its application. The Federal Reserve alone did not "cause" the Great Depression. Intrinsic flaws in the financial, corporate and social structure, combined with bad policy both before and after the crash, were jointly responsible for the disaster, while the crash itself played a precipitating role. The danger, today, is that something similar could again happen. Thus I do not think that rising interest rates alone caused the present collapse, and I do not think that cutting them alone will cure it. They did so in conjunction with the failure to regulate sub-prime loans, with the permissive attitude to securitization, with the repeal of Glass- Steagall, and with the general calamity of turning the work of government over to bankers.

But if Friedman was wrong, the "new monetary consensus" is even more wrong. That consensus, having nothing to say about abusive mortgage loans, speculative securitization and corporate fraud, is simply irrelevant to the problems faced by monetary policy today. Its prescriptions, were they actually followed, would lead to disaster. Its adherents, who of course never had a consensus on their side to begin with, have made themselves into figures of fun. There is, mercifully, no chance that Ben Bernanke will actually choose to follow their path.

And if both sides of Bernanke's dilemma are wrong, what is a beleaguered central banker to do? I have an answer to that. Let Ben Bernanke come over to our side. Let him acknowledge what is obvious: the instability of capitalism, the irresponsibility of speculators, the necessity of regulation, the imperative of intervention. Let him admit the intellectual victory of John Maynard Keynes, of John Kenneth Galbraith, of Hyman Minsky. Let him take those dusty tomes off the shelf, and broaden his reading. I could even send him a paper or two.

Thank you very much indeed.

Democrats and Health Care

Jacob Hacker on the Clinton and Obama health plans:

Are You Confused Yet?, by Jacob S. Hacker, Commentary, NY Times: Polls show that health care ranks near the top of voters' concerns, especially among Democrats. ... And yet, voters must be awfully confused about where the Democrats stand on health care. ...

So what's the main story: (1) a basic Democratic consensus about what should be done, or (2) a widening policy divide fueled by presidential ambitions? The answer is (1), but unfortunately, the reality of (2) is increasingly upstaging this welcome development. And, unfortunately, this unnecessary and self-defeating conflict could ultimately derail efforts at reform, confusing and turning off the very voters Democrats need to woo.

To see the basic consensus, we need to go back to its immediate source: John Edwards's campaign proposal. Mr. Edwards's plan, released in early 2008, had ... a requirement that employers either cover their workers or help pay to cover those workers through a public framework (an approach known as "play-or-pay"). The second core element ... would give workers whose employers didn't provide secure coverage a choice of public or private insurance. The third core element was a requirement that everyone have coverage (a so-called "individual mandate"). ...

.The cornerstone of both candidates' plans ... is the play-or-pay requirement: employers cover their workers, or their workers are automatically enrolled in a single insurance pool to which employers are required to make contributions. (Both candidates have said they would exempt small businesses from this requirement, which could pose a big hurdle to universal coverage, since most of the uninsured work for small firms.)

Done correctly ... a play-or-pay requirement makes covering people much less complicated. The more than 90 percent of non-elderly Americans (and more than 80 percent of the uninsured) who live in a family in which someone works would be enrolled automatically... Many of those missed are already covered through public programs, and aggressive outreach could reach those who still remain without coverage. Thus, Mr. Obama's plan could well cover almost everyone even without the individual mandate.

But, of course, that hasn't stopped the individual coverage requirement from becoming a flashpoint of disagreement. Hillary Clinton has savaged Barack Obama for leaving out an alleged 15 million Americans — an oft-repeated estimate, the precision of which belies the huge uncertainty about how an individual mandate would be enforced and how many people it would actually cover. ...

For his part, Mr. Obama has repeatedly charged that Mrs. Clinton will force some people to buy unaffordable coverage, an incendiary charge. ... But Senators Obama and Clinton's proposals are so similar it's hard to see how Mr. Obama can suggest that everyone will voluntarily sign up under his plan while Mrs. Clinton's will impose unbearable costs on middle-income folks.

The truth is that the overall costs of the two plans, their essential structure, and their overarching logic are all but identical. Neither would force people to give up employment-based plans they're happy with. Both would give people without coverage from their employer a menu of different plans, including a predictable, simple and attractive public plan modeled after Medicare. And both could cover all or virtually all Americans for a relatively modest cost. ...

But unfortunately, the fierce debate has pushed both candidates toward rigid positions and extreme pronouncements, elevating a modest disagreement into a confusing melee. .... Meanwhile, John McCain ... has gotten a free ride.

The overheated attacks serve neither Democratic candidate. Rather than impugning each other, they should be saying how they would ensure affordability and enrollment. Mrs. Clinton took an important step in this direction by committing to a limit on how much Americans will have to pay for insurance. Mr. Obama should make a similar commitment, and make clear he will automatically enroll employees and their dependents through the workforce...

Most important, Senators Clinton and Obama should be talking less about how they would cover the uninsured as an isolated group and more about how they would provide health security to all Americans, ensuring that everyone has affordable coverage that doesn't disappear if they are laid off or change jobs. That's, after all, what matters to most voters... Senators Obama and Clinton have a health care prescription for these folks that's much more attractive than John McCain's skimpy tax credits for coverage — if only they would speak about it in clear, simple and attractive terms.

While their plans may be very close overall, there may be a key difference - their willingness to make implementation of a health care plan a top priority after taking office.

links for 2008-04-29

Economist's View - 6 new articles

Trade Policy and Market Power

A colleague, Bruce Blonigen, says we should pay more attention to the anti-trust implications of trade policy, something that is almost always ignored in trade policy discussions:

Market power and the (non-)application of competition laws to trade policies, by Bruce Blonigen, Vox EU: The main premise of antitrust (or competition) laws is to proscribe practices that allow firms to limit competition in the marketplace. As is well known, limiting competition allows firms to raise prices above their marginal costs (something we call market power). Market power creates profits for firms, but the profits are more than offset by losses in consumer surplus. This translates into net (or deadweight) losses for society, and such losses are, obviously, something to be avoided.

The problems associated with market power are generally well recognised by the public when the topic of discussion is domestic competition and anti-trust policies. However, when the topic is trade policy, public discussion of how it might affect market power is often confused or nonexistent. For example, one virtually never hears any worry about the potential anti-competitive effects from applying traditional forms of trade policies, such as import tariffs and quotas.

The only place that one finds competition policies mentioned with trade policies is with respect to antidumping laws. And here the application of these principles is one-sided. It is recognised (and likely overemphasised) that there can be anti-competitive effects when a foreign firm uses low prices to eliminate competitors; i.e., predatory pricing practices. However, it is clear that the actual implementation of antidumping laws applies remedies for a whole range of pricing behaviours that any competition agency would find perfectly consistent with a competitive marketplace (for example, see "Why we need antidumping reforms").1 Indeed, the danger of antidumping remedies is that they could actually promote anti-competitive effects by helping firms collude (actively or tacitly) to achieve joint monopoly/cartel prices and profits. Most directly, this can be seen in the case of "undertakings," whereby government agencies coordinate arrangements with foreign firms (and in consultation with domestic firms) to keep the foreign firms' prices at predictably high levels in lieu of antidumping duties! Even a quick scan of an introductory industrial organisation text would suggest to you that this could be quite an effective mechanism for firms to coordinate tacit collusion.

Trade policy and market power in theory…

Though largely ignored in public discussions of trade policy, economists have been reasonably good at showing theoretically how various trade policies may affect market power. In general, the theoretical literature finds large market power effects from quantitative restrictions and none with tariff-based import protection.2 There is also a literature indicating that antidumping measures can raise firms' market power for similar reasons as quantitative restrictions; namely, that such policies can allow firms to tacitly coordinate higher prices to their benefit, but to the detriment of consumers and overall welfare (for example, see Prusa 1992).

Why does the issue of market power rarely enter public discussion of trade policies? There are a number of possible explanations, but let's discuss two where at least some of the responsibility can be placed on the economics profession. First, economists have simply not laid out these arguments very often. For example, the standard models used to illustrate trade policies in today's typical undergraduate textbook assume perfect competition. In such a setting, import protection increases employment in the protected sector, as well as infra-marginal rents of producers, but does not lead to market power for firms by assumption. Economists need to do a better job in presenting the conceptual reasons for why trade protection programs can raise market power and lead to the same sort of welfare losses that arise in more familiar cases where monopoly power leads to undesirable outcomes.

The second explanation is that the economics profession has not provided any empirical evidence for these market power effects. These effects may exist in theory under the right sets of assumptions, but do these effects really occur?

… and in practice

Empirical evidence on this issue is beginning to emerge, and the results of a couple of recent studies suggest that we ignore the potential anti-competitive effects of trade policies at our peril. In a recent paper I co-authored with Benjamin Liebman and Wesley Wilson, we undertake a systematic investigation of the market power effects of the wide variety of trade protection programs afforded to the U.S. steel industry over the last three decades (Blonigen, Liebman, and Wilson, 2007). The U.S. steel industry has been the main industrial sector receiving trade protection during this time period, accounting for more than a third of all antidumping and countervailing duty cases, as well as enjoying periods with quantitative restrictions and safeguard remedies on imports. Our statistical results are strongly consistent with the theoretical literature described in footnote 1 in that we find large market power effects from quantitative restrictions and none with tariff-based import protection. In fact, our estimates cannot reject the hypothesis that the U.S. steel industry was able to perfectly collude during the main quota period in the late 1980s.

Surprisingly, our estimates find no market power effects from antidumping protection in the US steel industry, which the theoretical literature suggests could be significant. These results contrast with recent evidence from Jozef Konings and Hylke Vandenbussche (2005) that antidumping duties in the European Union did raise market power significantly for many domestic firms that received antidumping duties against their import rivals. However, Konings and Vandenbussche note that market power effects are much lower or even nonexistent for products where antidumping protection leads to significant import diversion – market share gets diverted to import sources not targeted by the antidumping protection, rather than the domestic firms. The is a likely explanation for our finding of little market power effects for U.S. steel antidumping cases, as Prusa (1997) found significant trade diversion in U.S. antidumping cases.

Conclusions

What does this all mean in light of trade policy developments over the past decade? There is both good news and bad news. The good news is that the Uruguay Round made substantial progress in eliminating quantitative restrictions, which theory and empirics suggest are by far the most harmful trade policies in terms of raising market power. The bad news is that antidumping measures are acceptable under WTO agreements and have proliferated across member countries substantially in the past decade. While the initial evidence on market power effects of antidumping measures is mixed, the theory is clear in suggesting many ways in which such protection can raise market power.

While there may be political reasons to keep trade measures such as antidumping in place, as a profession, economics needs to continue to bring more evidence to bear about the market power effects of these programs. At the same time, we need to also continue to press policymakers more about the need for competition laws to apply equally to domestic and foreign firms. If policymakers can see the logic of having national treatment laws with respect to things such as tax policies towards firms in a market, then perhaps they can also be engaged to think about national treatment with respect to application of competition laws. As it stands, antidumping policies are a completely different (and wrongheaded) set of competition laws applied only to foreign firms exporting to a market.

References

Bhagwati, Jagdish N. (1965). "On the Equivalence of Tariffs and Quotas," in R.E. Baldwin et al., eds., Trade, Growth and the Balance of Payments: Essays in Honor of Gottfried Haberler, Amsterdam: North-Holland.

Blonigen, Bruce A., Benjamin H. Liebman, and Wesley W. Wilson (2007). "Trade Policy and Market Power: The Case of the US Steel Industry," NBER Working Paper No. 13671.

Konings, Jozef, Hylke Vandenbussche, and Linda Springael (2001). "Import Diversion Under European Antidumping Policy," Journal of Industry, Competition and Trade, Vol. 1(3): 283-299.

Konings, Jozef, and Hylke Vandenbussche (2005). "Antidumping Protection and Markups of Domestic Firms," Journal of International Economics, Vol. 65(1): 151-65.

Krishna, Kala. (1989). "Trade Restrictions as Facilitating Practices," Journal of International Economics. Vol. 26: 251-270.

Prusa, Thomas J. (1992). "Why Are So Many Antidumping Petitions Withdrawn?" Journal of International Economics. Vol. 33: 1-20.

Prusa, Thomas J. (1997). "The Trade Effects of US Antidumping Actions," in Robert C. Feenstra, ed., Effects of US Trade Protection and Promotion Policies, NBER Project Report Series. Chicago,IL: University of Chicago Press.

Footnotes

[1] Hylke Vandenbussche and Maurizio Zanardi, "Antidumping in the EU: the time of missed opportunities," VoxEU, 8 February 2008.

[2] Perhaps the first formal treatment dates back to Bhagwati (1965), who showed that a binding quota would allow a domestic monopolist to continue to wield market power in the face of lower international prices, whereas a standard import tariff would drive the domestic monopolist price to the competitive international price (plus tariff). Game theoretic analysis of oligopoly games also indicate that quantitative restrictions on imports allowed firms to increase market power, while import tariffs do not change existing market power (for example, see Krishna 1989).

Paul Krugman: Bush Made Permanent

The Pander Bear Express:

Bush Made Permanent, by Paul Krugman, Commentary, NY Times: As the designated political heir of a deeply unpopular president — according to Gallup, President Bush has the highest disapproval rating recorded in 70 years of polling — John McCain should have little hope of winning in November. In fact, however, current polls show him roughly tied with either Democrat.

In part this may reflect the Democrats' problems. For the most part, however, it probably reflects the perception, eagerly propagated by Mr. McCain's many admirers in the news media, that he's very different from Mr. Bush — a responsible guy, a straight talker.

But is this perception at all true? During the 2000 campaign people said much the same thing about Mr. Bush; those of us who looked hard at his policy proposals, especially on taxes, saw the shape of things to come.

And a look at what Mr. McCain says about taxes shows the same combination of irresponsibility and double-talk that, back in 2000, foreshadowed the character of the Bush administration. ...

According to the nonpartisan Tax Policy Center, the overall effect of the McCain tax plan would ... reduce federal revenue by more than $5 trillion over 10 years. That's ... enough to pose big problems for the government's solvency.

But before I get to that, let's look at what I found truly revealing: the McCain campaign's response to the Tax Policy Center's assessment. The response, written by Douglas Holtz-Eakin,... former head of the Congressional Budget Office, criticizes the center for adopting "unrealistic Congressional budgeting conventions." What's that about?

Well, Congress "scores" tax legislation by comparing estimates of the revenue that would be collected if the legislation passed with estimates of the revenue that would be collected under current law. In this case that means comparing the McCain plan with what would happen if the Bush tax cuts expired on schedule.

Mr. Holtz-Eakin wants the McCain plan compared, instead, with "current policy" — which he says means maintaining tax rates at today's levels.

But here's the thing: ...the Bush administration engaged in a game of deception. It put an expiration date on the tax cuts, which it never intended to honor,... to hide those tax cuts' true cost. ... Mr. Holtz-Eakin is saying, in effect, "We're not engaged in any new irresponsibility — we're just perpetuating the Bush administration's irresponsibility. That doesn't count."

It's the sort of fiscal double-talk that has been a Bush administration hallmark. ...

And Mr. McCain has said nothing realistic about how he would close the giant budget gap his tax cuts would produce — a gap so large that eliminating it would require cutting Social Security benefits by three-quarters, eliminating Medicare, or something equivalently drastic. Talking, as Mr. Holtz-Eakin does, about fighting waste and reforming procurement doesn't cut it.

Now, Mr. McCain isn't unique in making promises he has no way to pay for — the same can be said, to some extent, of the Democratic candidates. But Mr. McCain's plan is far more irresponsible... Mr. McCain's budget talk simply doesn't make sense.

So what are Mr. McCain's real intentions?

If truth be told, the McCain tax plan doesn't seem to embody any coherent policy agenda. Instead, it looks like a giant exercise in pandering — an attempt to mollify the G.O.P.'s right wing, and never mind if it makes any sense.

The impression that Mr. McCain's tax talk is all about pandering is reinforced by his proposal for a summer gas tax holiday — a measure that would, in fact, do little to help consumers, although it would boost oil industry profits.

More and more, Mr. McCain sounds like a man who will say anything to become president.

Fading Power at the Fed?

In many popular models of the economy, monetary policy works by exploiting the existence of prices that cannot adjust quickly in response to shocks. If all prices are perfectly flexible so that all markets clear at all points in time, and there are no other problems, then monetary policy has no effect on real variables such as output, and this is true in virtually all reasonable models of the economy.

When prices aren't perfectly flexible, when they adjust sluggishly, inflation can impose costs on some agents in the economy. For example, when wages are fixed, an increase in the price level lowers the purchasing power labor income. The same thing happens to people on fixed incomes, e.g. retirement payments.

But economic agents do not stand by idly while shocks to the price level impose costs on them. Wages can be indexed for inflation, and often have been since the 1970s. Fixed income payments can become unfixed with cost of living adjustments that keep their real values constant. If fixed interest rates on loan contracts are causing unanticipated redistribution of income from lenders to borrowers, then create variable interest rate contracts that move with the inflation rate and offer insurance against this problem. Is committing to prices in catalog's that are printed months in advance a problem? Exploit technology and put the prices online where they can be easily adjusted. Whenever agents experience large costs from inflexible prices, they do what they can to increase their flexibility.

So I wonder if monetary policy will slowly run out of rigidities to exploit as, one by one, agents who have been hurt by price rigidities use technology or other means to to overcome them (and this is also true for other types of market imperfections, e.g. incomplete information).

Should we worry that monetary policy may lose effectiveness over time? Not if our models are correct. In fact, this would be desirable. If all prices are perfectly flexible, markets will behave optimally on their own and there would be no need for the Fed to intervene to stabilize the economy. Presumably, there would also be less chance for error when entire markets rather than a vote of twelve people determines the course of the economy.

Of course, as the current crisis shows, price rigidities aren't the only possible problem the economy can have, so there would still be a role for the Fed to play, but I do wonder if the power of monetary policy to impact the economy will diminish over time.

"America Needs to Make a New Case for Trade"

Larry Summers says that if we want people to support free trade, we are going to have to explain why it is in their interests to do so:

America needs to make a new case for trade, by Lawrence Summers, Commentary, Financial Times: ...Since the end of the second world war, American economic policy has supported an integrated global economy, stimulating development in poor countries... Yet America's commitment to internationalist economic policy is ever more in doubt. ...

To [the trade sceptic] the conventional wisdom has a well developed response, with four standard elements. First, the sceptic ... is educated around the many benefits of trade, not just for exporters but also for consumers and the economy more generally.

Second, the sceptic is assured that ... trade ... is not just good classical economics that reaps the gains available from comparative advantage – it is also good mercantilism. This is because the US already has low trade barriers, which it will typically not need to reduce as much as its trading partner. Sometimes the argument is added that we are in competition with other major economic powers and will be at a disadvantage if a developing country has a free-trade agreement with them but not us.

Third, the sceptic is also told that most of the observed increases in income inequality in the American economy are due to new technology rather than increased trade...

Fourth, it is acknowledged that while trade agreements are good for the economy overall, not everyone wins. And so it is increasingly recognised that they must be complemented by more ambitious efforts to reduce income inequality and income insecurity. ...

All of these points have the very considerable virtue of being correct economic arguments. Taken together, they make a compelling case...

But I suspect that the policy debate ... will need to confront a deeper and broader issue: the gnawing suspicion of many that the very object of internationalist economic policy – the growing prosperity of the global economy – may not be in their interests. ...

When other countries develop, American producers benefit from having larger markets to sell into but are challenged by more formidable competition. Which effect predominates cannot be judged a priori. But there are reasons to think that economic success abroad will be more problematic for American workers in the future.

First, developing countries increasingly export goods ... that the US produces on a significant scale, putting pressure on wages. ... Second, the growth of countries such as China raises competition for energy and environmental resources, raising the price for Americans.

Third and most fundamentally, growth in the global economy encourages the development of stateless elites whose allegiance is to global economic success and their own prosperity rather than the interests of the nation where they are headquartered. ...

Even as globalisation increases inequality and insecurity, it is constantly and often legitimately invoked as an argument against the viability of progressive taxation, support for labour unions, strong regulation and substantial production of public goods that mitigate its adverse impacts.

In a world where Americans can legitimately doubt whether the success of the global economy is good for them, it will be increasingly difficult to mobilise support for economic internationalism. The focus must shift ... to designing an internationalism that more successfully aligns the interests of working people and the middle class in rich countries...

"The Cost of Rising Inequality"

If the gains from economic growth since 19779 had been shared equally instead of flowing disproportionately toward the top of the income distribution, how would more income would the bottom 80% of the distribution have had?:

The Cost of Rising Inequality, by Lane Kenworthy: Income inequality in the U.S. has increased sharply in the past generation. Those who worry about this development do so partly on grounds of fairness and partly because inequality may have adverse effects on politics, health, and crime. Sometimes overlooked is a more immediate cost: slow income growth for a large chunk of the population.

The following chart shows average inflation-adjusted incomes in 1979 and 2005 for various groups of households: the bottom 20%, the lower-middle 20%, the middle 20%, the upper-middle 20%, the next 10%, the next 9%, and the top 1%. The incomes include government transfers and subtract taxes. The data, from the Congressional Budget Office (here), are the best available for this purpose.

The average income among all households rose at a rate of 1.5% per year over these two and a half decades. But as the chart makes plain, much of that increase went to households at the top of the distribution, especially those at the very top. Households in the bottom three quintiles experienced very slow income growth — 0.2% per year for the poorest quintile, 0.6% for the next, and 0.7% for the middle.

What would 2005 incomes have looked like if income growth had been proportionate rather than heavily skewed in favor of the top — in other words, if all incomes had increased at a pace of 1.5% per year? The dashed line in the next chart shows the answer. To make it easier to see the effect, I include only the bottom 80% of households here. All of them would have been a good bit better off.

It's often said that progressives focus too much on the distribution of income and don't pay enough attention to absolute income levels. In fact, its impact on absolute incomes is one of the chief reasons to be concerned about rising inequality.

links for 2008-04-28