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September 30, 2008

Economist's View - 4 new articles

House Votes against Bailout Package

The House voted against the bailout package. Brad DeLong says:

Bring Congress Back into Session After the Election...: ...and go for the Swedish plan: nationalize the insolvent large financial institutions: dare Bush to veto that after the election.

Vote Count:

Democrats: 141 Yea, 94 Nay
Republican: 66 Yea, 132 Nay.

This Republican Party needs to be burned, razed to the ground, and the furrows sown with salt...

Swamped today - quickly - and holding back the shrill reaction, this is irresponsible and needlessly puts our economy at risk. I'll update with more reactions as I find them.

Update: Initial market reaction:

The Dow Jones Industrial Average, which had posted a loss of less than 300 points heading into the House vote, posted a decline of nearly 700 points as the "nay" votes reached a majority.

The market has recovered slightly. We'll see how it goes. They can revote, so there's still hope, but don't know if that is planned, or if that would do any good. But it's not the stock market I care about, it's employment and growth. Even if this is not a catastrophe, you don't take this kind of risk with the economy. Even without a major crash, it's likely a lot of people just lost their jobs, though they don't know it yet. If the problems aren't addressed, it is likely to constrain credit, that in turn causes firms to cut back on new investment projects, and as they do, employment and growth taper off. You don't see the effects as a big drop off in employment all at once since investment projects can take years to complete and momentum from the past keeps the ball rolling. But as those projects end, if they are not replaced with new ones, employment and growth will suffer. And it's not just investment, people who sell cars, refrigerators, tractors, TVs, stereos, and so on, rely upon credit markets. If the credit isn't there, they aren't needed.

I'm worried, maybe for nothing, but why take this kind of a chance with people's lives?

Megan McArdle:

I didn't think it was possible to be more disgusted with politicians than I usually am, but I find it impossible to express the seething contempt that I feel at this kind of opportunism. I don't mind when they screw with the normal operation of the economy for venal personal gain. But risking a recession in order to get a cut in the capital gains tax? Letting it tank because you can always blame it on the Republicans? ...

The public doesn't quite grasp what's at stake, and there's no reason they should. But the representatives do. ... But anyone who tanks a bank bailout they think might be needed, in order to get a cut in the capital gains tax, deserves to be tried for treason.

Paul Krugman:

OK, we are a banana republic: House votes no. Rex Nutting has the best line: House to Wall Street: Drop Dead. He also correctly places the blame and/or credit with House Republicans. For reasons I've already explained, I don't think the Dem leadership was in a position to craft a bill that would have achieved overwhelming Democratic support, so make or break was whether enough GOPers would sign on. They didn't.

I assume Pelosi calls a new vote; but if it fails, then what? I guess write a bill that is actually, you know, a good plan, and try to pass it — though politically it might not make sense to try until after the election.

For now, I'm just going to quote myself:

So what we now have is non-functional government in the face of a major crisis, because Congress includes a quorum of crazies and nobody trusts the White House an inch. As a friend said last night, we've become a banana republic with nukes.

Republicans are admitting they nuked the vote. Why? They are saying it's because of Pelosi's speech during the vote (read it and judge for yourself):

Rep. Boehner and others say Pelosi's partisan floor speech is to blame for the financial rescue bill's defeat.

Barney Frank wonders why a speech would cause them to change their votes:

"Because somebody hurt their feelings they decided to punish the country."

Steve Benen adds:

But more important that than is the truly ridiculous frame Republicans are establishing for themselves by using Pelosi's speech as an excuse for their own failure. The House GOP, for reasons that defy comprehension, has decided to characterize itself as a caucus of cry babies. Worse, they're irresponsible cry babies who, according to their own argument, are more concerned with their precious hurt feelings than the nation's economic stability.

Willem Buiter:

What is likely to happen next? With a bit of luck, the House will be frightened by its own audacity and will reverse itself. If a substantively similar bill (or a better bill that addresses not just the problem of valuing toxic assets and getting them off the banks' books, but also the problem of recapitalising the US banking sector) is passed in the next day or so, the damage can remain limited. If the markets fear that the nays have thrown their toys out of the pram for the long term, the following scenario is quite likely:

  • The US stock market tanks. Bank shares collapse, as do the valuations of all highly leveraged financial institutions. Weaker versions of this occur in Europe, in Japan and in the emerging markets.
  • CDS spreads for banks explode, as will those of all highly leveraged financial institutions. Credits spreads generally take on loan-shark proportions, even for reputable borrowers. Again the rest of the world will experience a slightly milder version of this.
  • No US bank will lend to any other US bank or any other highly leveraged institution. The same will happen elsewhere. Remaining sources of external finance for banks, other than the facilities created by the central banks and the Treasuries, will dry up.
  • Banks and other highly leveraged institutions will try to unload assets at fire-sale prices in illiquid markets. Even assets not viewed as toxic before will become unsaleable at any price.
  • The interaction of a growing lack of funding liquidity and increasing market illiquidity will destroy the banks' business models.
  • Banks will stop providing credit to households and to non-financial enterprises.
  • Banks will collapse, both through balance sheet insolvency and through liquidity insolvency. No bank will be safe, not even the household names for whom the crisis has thus far brought more opportunities than disasters.
  • Other highly leveraged financial institutions collapse on a large scale.
  • Households and non-financial businesses revert to financial autarky, among wide-spread defaults and insolvencies.
  • Consumer demand and investment demand collapse. Unemployment shoots up.
  • The government suspends all trading in financial stocks until further notice.
  • The government nationalises all US banks and other highly leveraged financial institutions. The shareholders get nothing up front and have to wait for an eventual re-privatisation or liquididation to find out whether they are left with anything at all. Holders of bank debt get a sizeable haircut 'up front' on the face value of the debt and have part of the remainder converted into equity that shares the fate of the old equity.
  • We have the Great Depression of the 2010s.

None of this is unavoidable, provided the US Congress grows up and adopts forthwith something close to the Emergency Economic Stabilization Act as a first, modest but necessary step towards re-establishing functioning securitisation markets and restoring financial health to the banking sector. Cutting off your nose to spite your face is not a sensible alternative.

PS My remaining financial wealth is now kept in a (small) old sock in an undisclosed location.

PPS The conduct of both US Presidential candidates in this matter makes them unfit for purpose.

Washington Wire:

"I do believe that we could have gotten there today, had it not been for the partisan speech that the Speaker gave on the floor of the House," Boehner said. "We put everything we had into getting the vote to get there today." ...

Minority Whip Roy Blunt (R., Mo.) said he had 12 Republicans who would have voted for the bill but changed their minds, while Rep. Eric Cantor (R., Va.) holding up a copy of what he said was Pelosi's floor remarks - said the speaker "frankly struck the tone of partisanship." A senior aide to Pelosi rejected the Republican claims against the speaker, saying the suggestion that her speech motivated House Republicans to vote against the bailout plan was "absurd."

"You don't vote on the speech, you vote on the bill," said the aide.

Frank, speaking at a press conference, mocked the suggestion. "Give me those twelve people's names and I will talk uncharacteristically nicely to them," Frank said.

Jeff Frankel:

The Revised Troubled Asset Relief Plan Deserved to Pass: When the Treasury came out with its $750 bailout plan on September 22, I thought it lacked so many necessary ingredients that it deserved a thumbs down. ...

But in the negotiations between the Treasury and Congressional leaders over the course of last week, the missing ingredients were inserted. Starting with the additions that were most necessary on the merits, and moving toward the ones where the necessity was more political, they were...

The plan (TARP for Troubled Asset Recovery Program) would still be unprecedented in magnitude and in the discretion it gives the Treasury Secretary. Even if the congress had passed it today, it would not have guaranteed an end to the financial crisis, let alone averting the recession that is probably already inevitable at this point. Furthermore it does little to begin with the reforms in regulation that our financial system now clearly needs.

Nevertheless, as distasteful as it is to be "bailing out" Wall Street, or even bailing out those homeowners who took out loans that they shouldn't have, or bailing out policymakers who were asleep at the switch, my view is that the program is necessary. It is better than the alternatives:

  • better than the Treasury proposal of 9/22,
  • much better than the proposal we would have gotten from a pre-Paulson Bush Administration,
  • better than the alternative that the House Republicans were offering, and
  • (most important of all) better than the alternative of doing nothing, which would (will?) quite likely mean a severe recession.

I suppose it is not surprising that Congressmen facing elections in 5 weeks don't want to go on record supporting something so unpopular. What will happen now that the House rejected the deal in its vote today?

Most likely the stock market and real economy will plummet, until the pain gets so bad that a bailout package like this one accumulates more support.

Are people expecting soup lines?:

The S&P 500 retreated 106.59 points to 1,106.42, as only one company gained, Campbell Soup Co.

Paul Krugman: The 3 A.M. Call

Which of the two candidates should we trust with the economy?:

The 3 A.M. Call, by Paul Krugman, Commentary, NY Times: It's 3 a.m., a few months into 2009, and the phone in the White House rings. Several big hedge funds are about to fail, says the voice on the line, and there's likely to be chaos when the market opens. Whom do you trust to take that call?

I'm not being melodramatic. The bailout plan released yesterday is ... better than the proposal Henry Paulson first put out — sufficiently so to be worth passing. But ... it won't end the crisis. The odds are that the next president will have to deal with some major financial emergencies.

So what do we know about the readiness of the two men most likely to end up taking that call? Well, Barack Obama seems well informed and sensible... Mr. Obama and the Congressional Democrats are surrounded by very knowledgeable, clear-headed advisers, with experienced crisis managers like Paul Volcker and Robert Rubin always close at hand.

Then there's the frightening Mr. McCain... We've known for a long time ... that Mr. McCain doesn't know much about economics... That wouldn't matter too much if he had good taste in advisers — but he doesn't.

Remember, his chief mentor on economics is Phil Gramm, the arch-deregulator, who took special care in his Senate days to prevent oversight of financial derivatives — the very instruments that sank Lehman and A.I.G., and brought the credit markets to the edge of collapse. Mr. Gramm hasn't had an official role in the McCain campaign since he pronounced America a "nation of whiners," but he's still considered a likely choice as Treasury secretary.

And last year, when the McCain campaign announced ... "an impressive collection of economists..." to advise him..., who was prominently featured? Kevin Hassett, the co-author of "Dow 36,000." Enough said.

Now,... the poor quality of Mr. McCain's advisers reflects the tattered intellectual state of his party. Has there ever been a more pathetic economic proposal than the suggestion of House Republicans that we ... solve the financial crisis by eliminating capital gains taxes? (Troubled financial institutions, by definition, don't have capital gains to tax.)...

The real revelation of the last few weeks ... has been just how erratic Mr. McCain's views on economics are... Thus on Sept. 15 he declared — for at least the 18th time this year — that "the fundamentals of our economy are strong." This was the day after Lehman failed and Merrill Lynch was taken over, and the financial crisis entered a new, even more dangerous stage.

But three days later he declared that America's financial markets have become a "casino," and said that he'd fire the head of the Securities and Exchange Commission — which, by the way, isn't in the president's power.

And then he found a new set of villains — Fannie Mae and Freddie Mac... (...Fannie and Freddie ... played little role in causing the crisis...) And he moralistically accused other politicians, including Mr. Obama, of being under Fannie's and Freddie's financial influence; it turns out that a firm owned by his own campaign manager was being paid by Freddie until just last month.

Then Mr. Paulson released his plan, and Mr. McCain weighed vehemently into the debate. But he admitted, several days after the Paulson plan was released, that he hadn't actually read the plan, which was only three pages long.

O.K., I think you get the picture.

The modern economy, it turns out, is a dangerous place — and it's not the kind of danger you can deal with by talking tough and denouncing evildoers. Does Mr. McCain have the judgment and temperament to deal with that part of the job he seeks?

"A Government Hand In the Economy Is as Old as the Republic"

Robert Shiller says the crisis presents an opportunity to build a better system:

Everybody Calm Down. A Government Hand In the Economy Is as Old as the Republic, by Robert J. Shiller, Commentary, Washington Post: It has become fashionable to fret that the current crisis on Wall Street marks the end of American capitalism as we know it. "This massive bailout is not the solution," Sen. Jim Bunning (R-Ky.) warned.... "It is financial socialism, and it is un-American." It is neither. The ... bailout would represent a thoroughly American next step for our economic system -- and one that will probably lead to better times. ...

Whenever the public endures a crisis, ordinary citizens start to wonder how -- and whether -- our institutions really work. We no longer take things for granted. It is only then that real change becomes possible. ...

The current crisis offers us a singular opportunity to reevaluate fundamentally the safety and permanence of the master financial institutions that we have come to take for granted...

So we ... should be open to thinking about a new set of financial arrangements... Here are some key features:

1. Handle moral hazard better. The term "moral hazard" refers to the pernicious tendency some people have of failing deliberately if they think it's advantageous to do so. Moral hazard is used to justify teaching people a lesson for their failures... the meaning of a contract.

By rescuing Wall Street tycoons who succumbed to the lure of an irrationally exuberant housing bubble, the bailouts today do pose something of a moral-hazard problem. But we can more than repair it by defining a new generation of financial contracts ... reflecting greater enlightenment, greater understanding of human psychology and the means to deal with financial failure. ...

2. To limit risks to the system, build better derivatives. Some of today's derivatives ... turned out to be "financial weapons of mass destruction,"... The problem isn't derivatives per se but a certain kind... Some kinds of derivatives, such as those maintained by futures exchanges using procedures that effectively eliminate the risk that the other party in the agreement will default, are more useful -- and far safer -- than others. It is high time to redesign derivatives...

3. Trust markets, not Wall Street titans. If institutions can be said to have charisma, such giants as Lehman Brothers and Merrill Lynch certainly had it in spades. But these firms proved not to be the sole source of financial intelligence. They were merely meeting places for smart, financially savvy people -- and for some reckless folks besides. We need to learn to trust people and markets rather than institutions...

4. Ideas matter. Maybe next time, we will listen more closely to financial theorists who think in abstract, general terms. Consider the Long-Term Capital Management debacle in 1998... Lots of people hold that the moral of the LCTM story was the failed thinking of two of the firm's founders, Robert Merton and Myron Scholes, both of whom were Nobel Prize-winning financial theorists. In fact, the collapse of LTCM was largely due to the overconfidence of bond trader John Meriwether and some of his other LTCM colleagues, who were gambling in the markets. The disgraced Merton has been working for the last decade trying to build better risk-management systems, mostly to little avail. Maybe he will be heard now. People still seem to want to trust businessmen who have made bundles and have a huge investment bank behind them, rather than listen to experts who are thinking about the fundamentals of risk management. We would have been better off this month if we'd been ignoring the former and listening to the latter. ...

If we move smartly, Americans can have a better, more robust financial democracy.... The current crisis does not mean the end of American capitalism. But if we are lucky, it will mean an important step in its evolution.

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September 28, 2008

Economist's View - 4 new articles

Emergency Economic Stabilization Act of 2008

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Here's the full text: Emergency Economic Stabilization Act of 2008.

Here's the CBO analysis of the proposal.

I'm with everyone else. The proposal could be better, but as I've argued all along, the problems are real and if this is the best we can get - and it appears that's the case - then it will have to do.

Others: Krugman [2, 3], DeLong, Economists' for Obama, Interfluidity, Justin Fox, Adam Levitin.

Update: One section would:

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Allow the Federal Reserve System to pay interest on certain reserves of depository institutions that are held on deposit at the Federal Reserve, starting on October 1, 2008

That gives banks with reserves on deposit with the Fed an infusion of capital, but not sure how large and it's unlikely that's the reason for the change. I've written about this before (as far as I know, removing reserve requirements isn't part of the bailout proposal, this is from March 2006):

This (discussed previously here) brings up the possibility of a "channel" or "corridor" system for setting the federal funds rate as is currently in place in Canada, Australia, and New Zealand. A channel/corridor system makes open market operations unnecessary and allows the Fed, as proposed elsewhere on the proposed list of regulatory changes, to remove reserve requirements.

Currently, the federal funds rate is capped by the discount rate. Since the Fed will lend to banks at the discount rate, no bank would pay a higher rate in the federal funds market so the federal funds rate cannot go any higher than the discount rate. Similarly, with the ability to pay interest on deposits, no bank would lend to another bank at less than the rate the Fed will pay on deposits, so the federal funds rate cannot be lower than this. These two bounds are shown in the figure below (copied from Mishkin's text). Notice that if these bounds are fairly tight, the federal funds rate will be controlled precisely (for more on this point, see Woodford). In addition, keeping the federal funds rate on target does not require open market operations, only discount window (lombard facility) borrowing and lending.

Larger version

The Woodford article explains some of the advantages of this system (though it's a bit technical).

Summers: Taxpayers Can Still Benefit from a Bail-Out

This is an argument I've been making too, i.e. that "we don't have to give up our aspirations for the future." So I'm in full agreement with the points made below that the expected cost of the bailout is far less than $700 billion and hence not as constraining in terms of out ability to address other problems as many pundits have implied, that countercycical measures are needed immediately, and that fiscal policy dominates monetary policy as a stimulus tool. (And with fiscal policy, I prefer government spending to tax cuts as a means of stimulating the economy since the effect on aggregate demand is more certain, and spending can be directed toward particular, high employment, high economic return projects such as rebuilding infrastructure and addressing environmental concerns). I also agree with the final point made below that as fiscal policy measures are undertaken to stimulate the economy in the short-run, it is best if they also help with long-run problems. But right now, the short-run is the biggest concern:

Taxpayers can still benefit from a bail-out, by Lawrence Summers, Commentary, Financial Times: Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. ...

The idea seems to have taken hold in recent days that because of the ... bail out..., the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. ...[T]he events of the last weeks suggest that for the near term, government should do more, not less.

First,.... No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. ... It is impossible to predict the ultimate cost to the Treasury of the bail-out... But it is very unlikely to approach $700bn and will be spread over a number of years.

Second, the usual concern about government budget deficits is that ... government bonds ... will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. ...[T]he US made a serious error in allowing deficits to rise over the last eight years. But it would be compounding this error to override ... "automatic stabilisers" by seeking to reduce deficits in the near term.

Indeed, in the current circumstances the case for fiscal stimulus ... is stronger than at any time in my professional lifetime. Unemployment is now almost certain to increase – probably to the highest levels observed in a generation. Monetary policy has very little scope to stimulate the economy... And ... economic downturns caused by financial distress ... ... are almost always of long duration. ...

The more people who are unemployed the more desirable it is that government ... put them back to work by investing in infrastructure, energy or simply through tax cuts that allow families to avoid cutting back on their spending.

Fourth, it must be emphasised that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the US is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.

From this perspective the ... best measures would be those that represent short-run investments that ... over time ... improve the budget. Examples would include investments in healthcare restructuring or steps to enable states and localities to accelerate, or at least not slow down, their investments.

A time when confidence is lagging in the household, financial and business sectors is not a time for government to step back. ...

"And Now the Great Depression"

The financial bailout plan looks more likely now that there has been a "breakthrough." Barry Eichengreen says even with a plan in place, the crisis won't end quickly and double digit unemployment is "not out of the question":

And Now the Great Depression, by Barry Eichengreen, Vox EU: A couple of months ago at lunch with a respected Fed watcher, I asked, "What are the odds are that US unemployment will reach 10% before the crisis is over?" "Zero," he responded, in an admirable display of confidence. Watchers tending to internalize the outlook of the watched, I took this as reflecting opinion within the US central bank. We may have been in the throes of the most serious credit crisis since the Great Depression, but nothing resembling the Depression itself, when US unemployment topped out at 25%, was even remotely possible. The Fed and Treasury were on the case. US economic fundamentals were strong. Comparisons with the 1930s were overdrawn.

The events of the last week have shattered such complacency. The 3 month treasury yield has fallen to "virtual zero" for the first time since the flight to safety following the outbreak of World War II. The Ted Spread, the difference between borrowing for 3 months on the interbank market and holding three month treasuries, ballooned at one point to five full percentage points. Interbank lending is dead in its tracks. The entire US investment banking industry has been vaporized.

And we are in for more turbulence. The Paulson Plan, whatever its final form, will not bring this upheaval to an early end. The consequences are clearly spreading from Wall Street to Main Street. The recent performance of nonfinancial stocks indicates that investors are well aware of the fact.

So comparisons with the Great Depression, which have been of academic interest but little practical relevance, take on new salience. Which ones have content, and which are mainly useful for headline writers?

First, the Fed now, like the Fed in the 1930s, is very much groping in the dark. Every financial crisis is different, and this one is no exception. It is hard to avoid concluding that the Fed erred disastrously when deciding that Lehman Bros. could safely be allowed to fail. It did not adequately understand the repercussions for other institutions of allowing a primary dealer to go under. It failed to fully appreciate the implications for AIG's credit default swaps. It failed to understand that its own actions were bringing us to the brink of financial Armageddon.

If there is a defence, it has been offered Rick Mishkin, the former Fed governor, who has asserted that the current shock to the financial system is even more complex than that of the Great Depression. There is something to his point. In the 1930s the shock to the financial system came from the fall in the general price level by a third and the consequent collapse of economic activity. The solution was correspondingly straightforward. Stabilize the price level, as FDR did by pumping up the money supply, and it was possible to stabilize the economy, in turn righting the banking system.

Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself. There has been a housing-market collapse, but in contrast to the 1930s there has been no general collapse of prices and economic activity. Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system. But this also makes resolving the problem more difficult. Since there has been no collapse of prices and economic activity, we are not now going to be able to grow or inflate our way out of the crisis, as we did after 1933.

In addition, the progress of securitization complicates the process of unravelling the current mess. In the 1930s the Federal Home Owners Loan Corporation bought individual mortgages to cleanse bank balance sheets and provide home owners with relief. This time the federal agency responsible for cleaning up the financial system will have to buy residential mortgage backed securities, collateralized debt obligations, and all manner of sliced, diced and repackaged paper. Strengthening bank balance sheets and providing homeowners with relief will be infinitely more complex. Achieving the transparency needed to restore confidence in the system will be immensely more difficult.

That said, we are not going to see 25% unemployment rates like those of the Great Depression. Then it took breathtaking negligence by the Fed, the Congress and the Hoover Administration to achieve them. This time the Fed will provide however much liquidity the economy needs. There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover's in 1930. Where last time it took the Congress three years to grasp the need to recapitalize the banking system and provide mortgage relief, this time it will take only perhaps half as long. Ben Bernanke, Hank Paulson and Barney Frank are all aware of that earlier history and anxious to avoid repeating it.

And what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analogue for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the US economy, notwithstanding the admirable flexibility of its labour markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10%.

Update: Brad Delong comments.

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September 27, 2008

Economist's View - 5 new articles

"In Defense of a Giant (and Growing) Health Care Industry"

Now I know who to blame:

Without health care as the economy's most powerful economic locomotive, economic growth during President George W. Bush's first term would have been so anemic that he most probably would have lost the election in 2004.

That is Uwe E. Reinhardt writing in the NY Times new Economix blog in defense of the health care industry:

In Defense of a Giant (and Growing) Health Care Industry, by Uwe E. Reinhardt, Economix: If a Martian landed on earth and followed our debate on health care, he or she ... would hear politicians, business people and the talking heads ... lament the burden that health care puts on the economy and over the prospect that health care will destroy America. ... Only an ignoramus or a fool could arrive at this conclusion.

Alas, Mother Earth is full of such people.

Think about it. When you last visited a physician's practice or stayed in a hospital, did you see people other than patients... [T]hese people call their work "jobs"... [T]heir care for you has economic value...? Did you consider that they postponed your death by many years, perhaps even decades? Would you really surmise that their work creates less value added than, say, the fast-food industry? ...

Can any straight-thinking person really conclude that, on balance, health care is a burden on our economy?

For starters, be advised that health care is a large part of a nation's gross domestic product. In the United States, it accounts for 16 percent of gross domestic product, now projected to go to 20 percent or so within a decade. Between 2001 and 2002, for example, growth in health spending represented over 50 percent of the growth in the entire United States G.D.P.

Some experts condemn these trends... To be sure, there is considerable waste in ... health care, just as there is in the ... defense industry and in many other sectors... But such waste at the margin does not vitiate the assertion that, on average, our health system is one of the finer sectors in the economy.

In a 2005 study,... Eric Topol and Kevin M. Murphy showed the American health care system to be one of the highest value-added sectors in the economy. And as the economist Michael Mandel of Business Week recently reported, health care contributed 50 percent of all new jobs over the most recent business cycle.

If that Martian were to land this week, in the middle of the bailout maelstrom, he'd probably tell Americans to thank their lucky stars that at least one sector of their economy is, well, still healthy.

My hope is that the bailout of the financial sector does not "starve" social programs, progress on health care reform, infrastructure spending, and other critical needs. One disappointment in the debate last night was to see so many questions assume this as an implicit truth, that the bailout will severely constrain our ability to do other things. So I'm not confident the hope will be realized.

Our economic system is in need of repair in a variety of ways. We need health care reform that gives everyone the care they need, and gives businesses a better competitive position on global markets, we need a "New New Deal" as it has been called to provide social insurance for workers and their families that works in the modern, global economy, we need to address crumbling infrastructure, and we need to go beyond replacing what has depreciated and make new investments in our future.

I see nothing wrong with asking the people who have benefited the most from our economic system in the past to play the largest role in helping to repair it. We don't have to give up our aspirations for the future, we just need those who have benefited so much from our economic system to step up to the plate and help us move forward.

"The Opposite of Moral Hazard"

John Hempton is upset over the the seizure of Washington Mutual. Justin Fox explains:

Australian money manager John Hempton owned Washington Mutual preferred shares and was thus wiped out when the bank was seized and flipped to JP Morgan Chase last week. But he's not mad about that. He's mad about what happened to owners of Wamu bonds. By also wiping out senior debt holders at Wamu, he argues, the government has now botched things in a profoundly serious way...

Hempton thinks that if the FDIC had simply liquidated Wamu, some money would have been left for the senior creditors. By choosing not to do that--presumably because it would have meant a big hit to the FDIC insurance fund--it has discouraged anybody else from providing that kind of credit to U.S. banks.

Here's (a short version of) John Hempton :

The reckless, irresponsible seizure of Washington Mutual: please read in Washington DC, by John Hempton: I lost money on this – so you can take my analysis with the caveat of a slightly angry grain of salt.

But I still think the seizure of Washington Mutual is the most capricious government action of this cycle and possibly the worst thing that has happened to American Capitalism this cycle. ...

Now what has the Government done here. It has confiscated the institution and sold everything except the liabilities marked equity, preferred, junior and senior. It confiscated the liquidation rights of the senior and junior debt. [It confiscated the liquidation rights of the preferreds too but that is an understood risk in owning preferreds. And whilst I lost money here I am far more angry about the other…]

If WaMu had been placed in liquidation I am pretty sure the seniors would have got something. If the senior debtors had been allowed to conduct an auction for WaMu (compromising all the junior stuff including the prefs I owned) then they would have got something.

Except that the liquation rights – well established order-of-creditor rights – were denied by a swift US Government action.

Now I understand that there is a strong policy presumption in favour of a quick government disposal of a failing institution – and that policy presumption might at some stage trump the rights of some holders of paper. However a pretty strong case must be made....

It would of course be more acceptable if there was a large body of evidence that the government put forward to justify their complete disregard for quite senior rights here. ... But in this case the Feds did very little to justify their decision. ...

The OTS/FDIC carried a risk – the risk being that the losses would be so large that would wind up costing the government money.

The government solved its problem – and it did it by taking away the rights of the senior debt holders to an orderly liquidation – when on the numbers given by the ultimate acquirer the senior debt was likely to be whole or near to whole.

The Government did this seemingly capriciously. It changed the order of creditors and the basis on which banks all across America raise wholesale funds.

Now there is not much raising of wholesale funds by banks at the moment. But after this deal there is likely to be less. It is simply the case that there is now a new risk for people who provide wholesale funding – and that risk is that the government will unilaterally abrogate their rights – without appeal, without due process and without accountability.

In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America. They will have put the fear-of-Government into such people globally. This is the opposite of moral hazard. In the Moral hazard case people take too many risks because they believe the government will reimburse their losses. But in this case people are going to take too few risks because they know that government might unilaterally remove their rights and property.

This was – by far – the least justified government action of this credit cycle. And it spells doom for any bank in America that is ultimately reliant senior (and hence well protected) but unsecured financing because it is so capricious.

Those banks are many – but we can start with Wachovia whose destiny (failure) is now nearly certain – and for whom the precedent is set. But after that we can go for all the banks including the champions such as Bank of America and Citigroup. Creditors now face confiscation of their rights by the US Government without oversight or audit or even process.

At that point there is no creditors and the economy collapses. The trust needed to make capitalism worked has been removed. I am not a conservative - but I will argue - along with many conservatives - that the most important function of government in a capitalist society is provision of a framework by which property rights can be defined and enforced as this is the key to making a capitalist society function. The Government is now acting as if the framework does not apply to them. That is bad whatever your political persuasion.

What next

The FDIC and OTS have won the battle with respect to WaMu. They got rid of WaMu without any cost to the taxpayer. The WSJ lauded that achievement. They really did get out of their WaMu risk quite neatly – and I will be the heads of those organisations went to bed feeling pretty pleased with themselves.

But in the process they have doomed about two thirds of the US banking system.

I am still a believer that government – whilst not stuck with great incentives will grope for right solutions. But that belief of this former (competent) public servant is being shaken to the core.

And whilst Wachovia and dozens of others will eventually hit the wall because of this decision, the Government will work out that it has a bad process before Bank of America fails.

But I think it is time that the process is short circuited. The heads of the OTS (John Reich) and of the FDIC (Sheila Bair) should be sacked now and for cause. Mr Paulson better get control of this process and let it be known that the US has a process for dealing with senior creditors and making sure that their rights are honoured.

Otherwise heaven help us.


Jeff Sachs says "current energy crisis will most likely worsen before it gets better":

Why the Oil Crisis Will Persist, by Jeffrey D. Sachs, SciAm: ...[F]undamental factors of supply and demand in the world economy will keep oil costly for years to come. ... Drilling in protected areas would provide little relief, and at horrendous environmental risks. Only a concerted move to new transport and energy technologies will relieve the pressures.

The greatest irony about the Bush Administration is that it correctly focused on energy needs at the start of its first term, but then got everything wrong in the strategy. Viewing the world through the eyes of Texas oilmen, it focused on gaining concessions to Iraqi oil fields and opening U.S. protected areas to drilling, while scorning fuel economy standards, renewable energy sources, and climate change mitigation. But the simple arithmetic of oil and carbon was always against the strategy.

World demand for conventional oil is outstripping world supply. ... There are few prospects for mega-discoveries that could keep up with fast-growing world demand. ...

The boom in global driving is likely to be relentless. ... If China attains just half of the U.S. per capita ownership of passenger vehicles, it would have ... roughly twice as many as the U.S. And that prospect is not a silly scenario. Vehicle production in China has already tripled... With ... massive house building on the spreading periphery of city centers, China seems intent on reproducing America's metropolitan sprawl and commuter-based society. A similar, though still less dramatic trend, is getting underway in India. ...

Conventional oil has little prospect of keeping up with this soaring demand.

What then will give? Of course a grave economic crisis—war, global depression, economic collapse of one or more major economies—would cut oil demand the hard way. There are two much better alternatives. The first is a redesigned, far more energy-efficient automobile that uses ... electricity or hydrogen. Several variants of plug-in-hybrid and all-battery cars have been promised by major auto producers as early as 2010...

Many unresolved problems of cost, performance and infrastructure face these technologies, of course. Public funding for technological research, development and demonstration, and for supporting infrastructure, should certainly be deployed... Any electric or hydrogen option will require large-scale deployment of new low-emission electricity generation, such as solar, wind, nuclear, and coal plants that capture and sequester carbon dioxide.

The second alternative, equally important, is a gradual reconfiguration of city life, to reduce our dependence on automobiles... We've learned that sprawl is not good for energy dependence, air quality, biodiversity, human health or quality of life, including commuting time. ...

The current energy crisis will most likely worsen before it gets better. ... Yet it could also be the critical spur to action, prompting vital changes in technologies and lifestyles. It's not too late to take the more productive path, but time is running out.

The Great Depression

What was it like during the Great Depression? The first interview talks about economic policy, the rest of the interviews talk about the economic and social conditions:

  • Interview with Gardner C. Means, an economic advisor, on the New Deal and the difference between the Hoover and Roosevelt administrations. [terkel-a0a0p2-b.rm]
  • Interview with Peggy Terry, a migrant farm worker, on being unemployed, bread lines, soup kitchens, and homeless camps. [terkel-a0a0l6-b.rm]
  • Interview with Virginia Durr on shame and the fact that people blamed themselves and not the system. [terkel-a0a0r3-b.rm]
  • Interview with Ed Paulsen, a dayworker, on unemployment and the search for jobs (part 1). [terkel-a0a0k3-b.rm]
  • Interview with Emma Tiller, a cook who discusses how African Americans fed tramps when white people didn't. [terkel-a0a0k8-b.rm]
  • Interview with Pauline Kael, a film critic, on anger, violence, and the general strike in San Francisco. [terkel-a0a0k5-b.rm]
  • Interview with Mary Owsley on company stores. [terkel-a0a0o3-b.rm]

More here.

links for 2008-09-27


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September 26, 2008

Economist's View - 8 new articles

Bebchuk: A Plan For Addressing the Financial Crisis

Via email, an alternative plan:

A Plan For Addressing the Financial Crisis, by Lucian A. Bebchuk: Executive Summary This paper critiques the proposed emergency legislation for spending $700 billion on purchasing financial firms' troubled assets to address the 2008 financial crisis. It also puts forward a superior alternative for advancing the two goals of the proposed legislation – restoring stability to the financial markets and protecting taxpayers.

I show that the proposed legislation can be redesigned to limit greatly the cost to taxpayers while doing much better in terms of restoring stability to the financial markets. The proposed redesign is based on four interrelated elements:

  1. No overpaying for troubled assets: The Treasury's authority to purchase troubled assets should be limited to doing so at fair market value.
  2. Addressing undercapitalization problems directly: Because the purchase of troubled assets at fair market value may leave financial firms severely under-capitalized, the Treasury's authority should be expanded to allow purchasing, again at fair market value, new securities issued by financial institutions in need of additional capital.
  3. Market-based discipline: to ensure that purchases are made at fair market value, the Treasury should conduct them through multi-buyer competitive processes with appropriate incentives.
  4. Inducing infusion of private capital: to further expand the capital available to the financial sector, and to reduce the use of public funds for this purpose, financial firms should be required or induced to raise capital through right offerings to their existing shareholders.

Compared with the Treasury's proposed legislation, the alternative proposal put forward in this paper would provide a far better way to use taxpayers' funds to address the financial crisis. [link to plan]

Dani Rodrik and Ian Ayres at Freakonomics discuss this proposal, and both highlight the following:

Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5% of the profit its fund generates – that is, the excess of the fund's final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers' profit incentives would prevent the price from exceeding fair value.

There are good ideas in this proposal, but I think we need to get something done as soon as possible. So there's a tension between implementing the perfect proposal, and implementing something that is politically feasible, provides the needed stability, contains the appropriate safeguards, and can be agreed upon in a relatively short timeframe.

Update: Brad DeLong says, now that "John McCain and the House Republicans have blown up the Paulson-Dodd-Frank compromise," we have three options:

  • Do nothing.
  • Bailout (a la Paulson)
  • Nationalization (a la Sweden 1992)

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

It might work like this. Congress:

  • grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship
  • requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent (paying off in full or not paying off in full the liabilities of the firm at its discretion), unless
  • the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress
  • grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury
  • requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

In addition, Congress:

  • grants the Treasury the power to issue up to $500 billion of troubled asset redemption bonds, the proceeds of which are then to be loaned to the Federal Reserve to be used to cover the liabilities of those liquidated firms that the Federal Reserve judges it is in the interest of the taxpayer to have their liabilities paid off in full.

Paulson had his shot. It's time for the Democrats to pass a nationalization in the taxpayers' interest bill and dare Bush to veto it. If he does, then announce that the congress will pass it again the day after the election. And if he vetoes it again, announce that congress will pass it yet again on January 21, 2009.

Update: I'm assuming Greenspan won' have much credibility around here, but he's not alone in signing this letter:

Economists' Statement on the Federal Role in Relieving the Financial Crisis, Alan Greenspan, Robert Hall, and George Schultz: The U.S. economy is in the grip of the most severe financial crisis since the Great Depression. Even highly credit-worthy businesses are paying unprecedented premiums for borrowing. A large fraction of businesses are shut out of the credit market altogether. Past experience with financial crises shows that overall economic activity contracts soon after the crisis unless swift corrective action alleviates the crisis. Unemployment rises, employment falls, the nation's production of goods and services declines, and consumers' purchasing power diminishes. At worst, as in the Depression, the economy collapses.

Economists often disagree about the causes of financial crises, including the present one... But there is near-universal agreement that the federal government must take aggressive steps to protect workers and businesses from the harmful effects of a financial crisis. The great majority of those deserving this protection had no role in causing the crisis.

Experience has shown that the essential first step in heading off a crisis is to maintain the functions of critical financial institutions—banks and others performing bank-like functions. ... As a practical matter, at the current stage of the crisis, the only way that financial institutions can continue to function is for the government to provide financial support. The traditional form of that support calls for the government to buy assets from the institutions, swapping questionable assets for obligations of the government that are universally regarded as sound.

We endorse all plans that would preserve the key functions of the threatened financial institutions. As a group, we do not advocate any particular program for restoring confidence in those institutions, but we are aware that the traditional approach has succeeded in heading off crises in the U.S. and other advanced countries. We do not take a stand on the choice of institutions eligible for emergency assistance. Rather, we urgently advocate immediate, extensive action that would maintain the functions of credit markets and prevent a serious economic contraction.

We are deeply concerned about instituting reforms for the longer run that will prevent similar crises in the future. We applaud the increases in capital requirements for the institutions that have elected to become subject to the Federal Reserve's capital requirements. But we do not believe that action to deal with the immediate crisis can wait until a comprehensive program for financial stability in the long run is developed and put in place.

Update: For yet another view, that of Robert Shimer, see here.

Dear Greg:

...I opposed the Paulson plan. I thought I would ... explain my reasoning.

Before doing so, let me be clear that I agree with your comments about Ben Bernanke. I too know him well from the seven years I spent with him on the faculty at Princeton and I share your respect for his intelligence. I also recognize that he is far better informed about the current situation than I am. This does not, however, mean that he is perfectly informed. Indeed, looking back over the last 13 months, it should be clear that the Fed and Treasury have repeatedly underestimated the extent of the problem. In such an environment, the distributed knowledge of professional economists and other imperfectly-informed observers may be superior to the knowledge of the Fed staff. In other words, you write, "In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could." That may be correct, but I am not convinced that he understands the situation better than the collective wisdom of all professors.

Next, let me explain what I think is happening in credit markets. ...

"Do Demand and Supply Still Drive Oil Prices?"

Environmental Economics takes up the question of what drives movements in oil prices, fundamentals or something else:

Do demand and supply still drive oil prices?, by Gernot Wagner: Amid all of Wall Street's woes, one bit of significant economic news almost fell through the cracks this week: oil prices increased $16 on Monday, temporarily trading as high as $25 over the previous closing price. This is an all-time record high. Surely, it can't just be demand and supply that determined the price - not on a day when the Dow just happens to fall 370 points. Or can it? [ more...]

Would the Cantor Plan Solve the Crisis?

From Brad DeLong:

**Sigh:** House Republicans and the Press, Brad DeLong: Hoisted from Comments: anonymiss:

Grasping Reality with Both Hands: You gotta comment on the current House Republican insurance plan. Time Magazine seems to think it's a real plan, not a Potemkin plan. I have no idea, but I think the people at Time are morons, so you MUST let us know if this is real or more nonsense from the guys who brought you "get rid of the capital gains tax! That'll fix everything!"

Anonymiss is citing Karen Tumulty:

Politically at least, the [Republican Deputy Whip Eric] Cantor plan has a lot of appeal. By insuring these junky mortgage-backed securities, rather than buying them, the government presumably wouldn't be spending nearly as much money. In fact, it would be getting money from Wall Street, in the form of premiums for this insurance. This scheme would function sort of like GNMA. The very process of insuring these assets would help solve one of the biggest problems: Nobody knows what they are worth.

The problem, at least in the eyes of Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, is that, while it would help the situation, it wouldn't work to stabilize the markets as well as their plan would.

Here's how it has been explained to me: Last winter and spring, when Treasury and the Fed analyzed a lot of options out there for what to do, they considered this insurance option. They decided that because the insurance option would leave the bad stuff on the bank balance sheets, it wouldn't give the banks the additional liquidity they need. They also believe it wouldn't create a market price that can stimulate trading, the way a purchase program would.

I'm not any kind of an expert on this stuff, so I don't know who is right here...

Let us see. On the one hand, the Treasury Secretary, the Federal Reserve Chair, and their staffs. On the other hand, an unstaffed Republican Chief Deputy Whip Eric Cantor who has not a plan but a plan to have a plan to ask the Treasury to design a different plan than the plan the Treasury thinks is best.

Cantor calls for "the Treasury to design a system to charge premiums to [mortgage-backed security] holders to finance [government-provided] insurance" against defaults.

The Fed and the Treasury have been looking at these issues since at least last winter. I suspect that the Treasury and Federal Reserve staff have decided that such federal government-provided insurance is indeed something we want to try to work toward as part of our financial system after the crisis is over--the "commitment fee" due in 2010 in the Fannie/Freddie nationalization makes no sense otherwise, for it is such a fee for the insurance on mortgages and mortgage-backed securities that Fannie/Freddie have gotten for free in the past but that Treasury wants to charge them for and also offer to others staring in 2010. But my belief is that Treasury and Federal Reserve staff have also judged that it won't work well enough to be a useful tool in handling the current crisis for speed-of-implementation reasons: we need to move to asset purchases--that banks need liquidity now, and we need functioning markets where securities are priced now, and you can buy assets a lot faster than you can set up insurance schemes.

Confronted with these two sets of opinions--a single unstaffed guy who is an expert in rounding up and feeding Republican House members on the one hand, and the Treasury Secretary, Federal Reserve Chair, and their staffs on the other, Karen Tumulty says "I don't know who is right here" because "I'm not any kind of an expert on this stuff."

So why doesn't she give her space at Time to somebody who is an expert, and does know who is right here? This is he said-she said journalism as self-parody.

Why oh why can't we have a better press corps?

And, beyond the fact that the proposal can't be implemented fast enough, I don't see the big savings either. The losses will still be there (assuming whatever confidence effect that would occur with this proposal wouldn't be substantially different from the confidence effect from a direct purchase of distressed assets, and I don' see why it would be), and there would be revenue from the equity warrants just like there is revenue from the insurance premiums, so where are the big savings? There are also higher administrative costs under the insurance proposal (and all the usual market failure worries such as adverse selection to worry about in the program design).

It can't be accomplished fast enough to help with the current crisis, there are no big cost savings associated with using this program to solve the crisis (even if it worked), so what's so attractive about it as a solution to our immediate problems?

Ah, I just found more from Justin Fox:

More on the Cantor plan to insure everybody's mortgage, Curious Capitalist: I've been doing a little checking around on Eric Cantor's idea to insure everybody's mortgage, which ... is now generating some talk ... of a blended plan that would combine increased insurance with purchases of mortgage securities. ...

The government already insures half the mortgage debt out there, Cantor & Co. argue, so why not just insure the rest?

It turns out that people at Treasury and the Fed actually did discuss expanding mortgage insurance when they were tossing around ideas earlier this year for halting the mortgage meltdown, but decided it wouldn't have nearly the impact on getting markets moving again that buying mortgage securities outright would.

When I emailed Mark Zandi ... of Moody's ... he responded with that same worry plus some others:

Seems to me it doesn't address the fundamental problem that there is no market for these securities. How can you write insurance on these securities unless you know the risks you are taking and you can't know that unless you have a market. Reminds of that pink floyd song. Anyway, this is a much less effective way of addressing the problem and would very likely cost taxpayers more than the tarp. Perhaps most importantly most immediately is that since it is not clear how and if it will work it won't stabilize financial markets.

When I emailed back to ask which Pink Floyd song, Zandi was unresponsive. Anybody got any ideas?

Then I talked to Lou Pizante, a veteran of the mortgage-securitization business who now runs Mavent, a maker of compliance software for mortgage lenders. He pointed out the only way for the Cantor plan to work actuarily was for every last one of those $6 trillion in mortgage securities to be insured. Otherwise you'd just get the financial institutions with the crappiest loans on their books choosing to participate--which would amount to a giant bailout of the bad guys by taxpayers. So I'm not sure how you could do a blended plan of insurance and purchases, since you've got to insure everybody.

Finally, even if you do get every last mortgage in the country covered by insurance, there's the issue, mentioned in my earlier post, of figuring out to price it. Too cheap and it's a bailout, too steep and you make banks' problems worse. Which is true of the original Paulson plan as well, of course. But that plan is much more upfront about being a bailout.

Paul Krugman: Where Are the Grown-Ups?

Will congress do "the grown-up thing"?:

Where Are the Grown-Ups?, by Paul Krugman, Commentary, NY Times: Many people on both the right and the left are outraged at the idea of using taxpayer money to bail out America's financial system. They're right to be outraged, but doing nothing isn't a serious option...— this collapse of credit reminds many economists of the run on the banks that brought on the Great Depression.

It's true that we don't know for sure... Maybe we can let Wall Street implode and Main Street would escape largely unscathed. But that's not a chance we want to take.

So the grown-up thing is to do something to rescue the financial system. The big question is, are there any grown-ups around — and will they be able to take charge?

Earlier this week, Henry Paulson, the Treasury secretary, tried to convince Congress that he was the grown-up in the room, come to protect us from danger. And he demanded total authority...: $700 billion to be used at his discretion, with immunity from future review.

Congress balked. No government official should be entrusted with that kind of monarchical privilege, least of all an official belonging to the administration that misled America into war. Furthermore, Mr. Paulson's track record is anything but reassuring...

Besides, Mr. Paulson never offered a convincing explanation of how his plan was supposed to work — and the judgment of many economists was ... that it wouldn't work unless it amounted to a huge welfare program for the financial industry.

But if Mr. Paulson isn't the grown-up we need, are Congressional leaders ... able to fill the role?

Well, the bipartisan "agreement on principles" released on Thursday looks a lot better than the original Paulson plan. In fact, it puts Mr. Paulson himself under much-needed adult supervision, calling for an oversight board..." It also limits Mr. Paulson's allowance: he only (only!) gets to use $250 billion right away.

Meanwhile, the agreement calls for limits on executive pay at firms that get federal money. Most important, it "requires that any transaction include equity sharing."

Why is that so important? The fundamental problem with our financial system is that ... the housing bust has left financial institutions with too little capital....

The odds are ... that the U.S. government will end up having to do what governments always do in financial crises: use taxpayers' money to pump capital into the financial system. Under the original Paulson plan, the Treasury would probably have done this by buying toxic waste for much more than it was worth — and gotten nothing in return. What taxpayers should get is what people who provide capital are entitled to: a share in ownership. And that's what the equity sharing is about.

The Congressional plan, then, looks a lot better — a lot more adult — than the Paulson plan... That said..., it seems that we don't have a deal.

This has to be a bipartisan plan... Democrats won't pass the plan without votes from rank-and-file Republicans — and as of Thursday night, those rank-and-file Republicans were balking.

Furthermore, one non-rank-and-file Republican, Senator John McCain, is apparently playing spoiler. Earlier this week, while refusing to say whether he supported the Paulson plan, he claimed not to have had a chance to read it; the plan is all of three pages long. Then he inserted himself into the delicate negotiations over the Congressional plan, insisting on a White House meeting at which he reportedly said little — but during which consensus collapsed.

The bottom line, then, is that there do seem to be some adults in Congress, ready to do something to help us get through this crisis. But the adults are not yet in charge.

Fed Watch: Regardless of Bailout, US Economy Decelerating

Tim Duy:

Regardless of Bailout, US Economy Decelerating, by Tim Duy: The US economy is limping through the second half of the year as the impact of this summer's stimulus checks fades. The continued weakness, I suspect, will come as a shock to the public, who have now been essentially promised that their problems will be solved with a bailout package they really don't understand to begin with for the financial sector they view as arrogant aggregators of wealth. But any bailout will only prevent a financial meltdown that threatens to deepen the credit crunch and worsen the ongoing slowdown, not reverse the current weakness. I doubt, however, the general public sees that distinction. And they are not likely to be convinced; this Administration sacrificed its credibility long ago. Instead, the public will see billions channeled into Wall Street as the unemployment rate climbs. And climb it will.

The flow of data this week, for those paying attention, is decidedly negative in tone. The housing market continues to deteriorate, with a precipitous decline in new home sales reported today. By definition, we must be closer to a bottom on new construction – but, to say the least, that bottom remains elusive. Initial unemployment claims, reached nearly 500,000 last week, although the Department of Labor attributes roughly 50k to the impact of recent hurricanes. Still, initial claims hovering around 450k foreshadows another weak employment report next week. Perhaps the most discouraging report this week was the advance durable goods release, which revealed a 2% decline in new orders for nondefence, nonaircraft capital goods. As Spencer at Angry Bear notes, the report is a negative for third quarter GDP.

In my opinion, the stimulus package revealed the staggering importance of US households on debt supported spending. Cash funneled to households via the mortgage markets fueled the recovery from the 2001 recession, but at the cost of driving housing prices to unsustainable levels. This financing channel broke down when it became evident the household income was fundamentally incapable of supporting the debt loads necessary to sustain elevated housing prices. Credit markets contracted as underwriting conditions returned to traditional standards. I see this as permanent shift to a more sustainable equilibrium; credit needs to be extended on the basis of ability to pay, which ultimately reflects household cash flow (income). Housing prices need to adjust accordingly. Hoping for a rebound in housing prices to reverse current trends is, in my opinion, naïve.

To compensate for reduced access to capital markets, policymakers initiated a fiscal stimulus package to put cash in the hands of households. The debt necessary to support the package was floated onto financial markets and absorbed by foreign central banks. Households traded one debt-financed cash infusion for another. Because, as should have been expected, housing markets did not recover over the summer, the government stimulus provided only temporary relief. Households need a steady source of cash beyond their incomes to support their consumptive proclivities; without some artificial support, consumer spending will contract as a percentage of overall economic activity. I tend to believe this process is inexorable. Economic growth needs to become less dependent on consumer spending to be sustainable in the long run. Policymakers can cushion the blow, but policy should avoid entirely resisting the adjustment.

The fall in housing prices, and outright mortgage defaults, crumbled the base of Wall Street's financial pyramid. A collapse of that pyramid threatens to spread and deepen the credit contraction beyond that already seen in housing. To be sure, a certain amount of additional contraction is almost certain as financial firms deleverage to more sustainable balance sheets. But this process threatens to turn disorderly quickly, which would generate a more significant credit crunch than is either necessary or desirable. The implications for Main Street are severe. Consequently, some sort of bailout for the financial sector is justified, in my opinion. I think the collapse of credit markets is something to be avoided if possible. I remember emerging Asia. We are not that different.

Congressional leaders were pulling together the final details of a bailout package to stem the bloodletting on Wall Street. The details may have been less than desirable. Indeed, it remains an extremely difficult sell to the public, especially when those who benefit are impolitic enough to suggest the following:

There also is the human cost to the financial floods, the collective psychological breakdown that occurs when Greenwich's billionaires become mere millionaires.

"It's the human toll that is frightening," said State Rep. Livvy Floren, a friend of Mr. Fuld. "Dick Fuld has spent 39 years of his life doing this. It's more than just money. They're not going to be in the streets starving….I think the man worked 24/7. His family and Lehman are his life."

A deeper analysis was offered by local Democrat Ned Lamont, who in one fell swoop compared Greenwich's money woes to the Japan malaise, Asian tsunami and the New Orleans flood.

"It really is a financial tsunami, and it could go either way," said the multimillionaire telecommunications mogul who ran for the U.S. Senate in 2006. "It took Japan 20 years to recover from their buying binge. How long does it take us to work through excessive leverage? That could take years not months. This is our Katrina."

I have yet to meet a soul on the street who accepts that it is necessary to move forward on a fix to the nation's financial underpinnings. With comments like these, is it any wonder?

Tonight we learned, however, that Republicans sabotaged a pivotal meeting today at the White House; the details are very distressing – see MarketWatch, Paul Krugman and Brad DeLong. The Republicans are playing with fire; the lack of leadership is on this issue is mind numbing. While I disagreed with certain elements of the initial proposal – nonexistent oversight is not a privilege this administration has earned – I believe there is a clear need for a comprehensive solution. And it is naïve to believe that the solution will come without a cost to taxpayers. No bailout is ever a free lunch. It is equally naïve, however, to believe that failure to act will be costless.

My hope is that a bailout is coming. But it will not change the path the economy is already on, it will only prevent activity from shifting to a new, less desirable path. I don't quite see how the billions of dollars plowed into this program will be funneled to households. I see instead it will only cushion the process of deleveraging, and thus minimize the quantity of resources stripped from the economy. This is important and necessary, but will not provide a miracle cure for the economy's travails.

Assuming a bailout comes to fruition, my attention will turn to the following:

1. What is the course of monetary policy? Increasingly, expectations are building for additional rate cuts, as much as 50bp as early as Monday. Federal Reserve Chairman Ben Bernanke's shift to a more dovish tone from Tuesday to Wednesday appears to open the door to additional rate cuts. I think, however, that was not Bernanke's intention. Instead, he felt it necessary to more forcefully press his case to Congress. That said, economic activity is decelerating, which, combined with the recent credit tightening, would typically prompt a rate cut – if the Fed had not already cut interest rates well ahead of their usual timing. And I suspect that Bernanke & Co. are more disposed to turn their attention to fixing the financial system, seeing that, rather than additional rate cuts, as the key to reinvigorating (or at least stabilizing) economic growth. Overall, I doubt they are interested in an intermeeting cut, and would prefer to wait until the December meeting.

If you are a cynic, however, and you believe there was a quid pro quo between Bernanke and Congressional leaders, then the Fed will cut rates next week. If so, the Fed would be openly abandoning its independence. Maybe it has come to that point. Nothing surprises me anymore when it comes to rate policy.

2. Will Congress step up to support Main Street? After the billions for billionaires bailout, it will be almost impossible to justified not taking further action to support Main Street, especially as labor markets deteriorate. It is not "if," but "when," with only the nature and size of stimulus to be decided.

3. How will the bailout and fiscal stimulus be financed? If it is not deficit spending, it will not be stimulative. My preference is for policy to focus on restructuring, not stimulus. Accept that we cannot deficit spend out way to prosperity, and support the bailout and additional stimulus via a tax increase on top income earners, those who have benefited most from Wall Street's orgy of debt. I recognize, however, that it would be silly of me to actually expect that Americans would stand for self-financing their problems, and instead foreign central banks will be called upon to finance the bailout and future stimulus.

4. What will be the consequences of flooding global financial markets with more US Treasury debt? We will get another lesson in the world's tolerance for absorbing low-yielding US assets. As long as foreign central banks continue to buy US debt no question asked, the lesson of the Reagan years hold true – deficits don't matter (unless of course, we set off another burst of global liquidity that fuels commodity prices). If global financiers balk at acquiring the debt, then deficit will matter, and domestic interest rates would rise quickly. Place your bets, but realize that betting against the Bank of China has been a losers bet.

With the bailout package currently in doubt, however, my worry is that credit markets will collapse Friday morning. Under these circumstances, the Fed would likely be forced into cutting interest rates in an intermeeting move. With Congress nipping at their heels over their handling of the crisis to date, and Republicans undermining the bailout package, monetary policymakers may simply be out of other tricks.

Good luck Friday…these are treacherous times.

Equity Warrants and Asymmetric Information

Jonah Gelbach an Economist for Obama, explains why an argument against including equity warrants as part of the bailout proposal doesn't hold in the presence of the type of asymmetric information present in these markets:

"Smart Friend" vs. Asymmetric Information, Economists for Obama: Earlier today, Greg Maniw posted a three-point defense of the Paulson bailout plan from someone to whom he referred only as "a smart friend". I want to address point 2 of Mankiw's friend's argument:

2. "Taxpayers will be better off if Treasury gets warrants."

This is essentially the assertion made in David Leonhart's column in the NY Times on Wednesday. And it again illustrates that we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again, assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.

For a smart guy, Mankiw's friend is making a pretty dumb argument. Sure, if everyone has the same information, then an asset with a value of $10 will cost $12 if it's required that a $2 warrant comes with it. But that totally misses the point. Based on what I've read, it appears that if everyone understood what these assets were worth, there wouldn't be any need for a bailout: the bailout is necessary because people with capital are scared witless that anything they buy will just be crud. Folks like Mankiw are constantly reminding us (and they're often right) that there's no reason to think government has better information than private parties. So how will Hank Paulson or his agents know any better than folks risking their own money?

In more concrete terms, the right way to think about the equity issue is as follows. (I'll abstract from debt-deflation spiral issues, which are no doubt important but are beside the point for this discussion.) Suppose a bailee has two assets, each of which has face value of one unit. However, actual value and face value diverge, say because the underlying security may default. The first asset is actually worth $10, and the other is actually worth $9. The Treasury can't tell the difference, but the bailee can.

Now suppose the Treasury declares that it is willing to pay $10 for one asset with a one-unit face value, with no equity transfer required. The bailee will certainly prefer to sell Treasury the $8 asset, as it will profit by $2. The bailee now has $10 in liquid capital, and Treasury books a real, long-term loss of $2.

Now suppose that Treasury insists on getting warrants whose value is an increasing function of the loss Treasury books when it sells off the bailee's assets. Let's suppose for simplicity that the warrants' value have expected value equal to the difference between the price Treasury pays the bailee and the price for which Treasury sells the asset. Now if the bailee hands Treasury the $8 asset for $10, the bailee will expect to pay $2 later in warrants, so the bailee and Treasury each break even, though the bailee gets liquidity in the short run, which is the point. On the other hand, if the bailee hands over the $10 asset, then there will be no warrants issued later, since Treasury won't lose anything on the deal.

In this example, the use of warrants has (1) gotten liquidity to the bailee, (2) made the bailee indifferent between transferring the two types of assets, and (3) ensured that Treasury doesn't get stuck with an adverse selection-induced loss. The moral of the story is that the use of equity claims makes truth-telling incentive compatible.

This is an example of simple mechanism design, a topic that is well understood by many microeconomists, no doubt including many smart friends of Greg Mankiw's. Obviously the real world is much more complicated than the simple example here (which I emphasize I took from Mankiw's smart friend). But the idea that the MM-type argument Mankiw's smart friend makes is at all relevant to a world full of informational asymmetries strikes me as bankrupt, tough to credit, and more than a little deflating.

links for 2008-09-26

House Republicans Obstruct Bailout Plan

House Republicans are attempting to stop the Paulson bailout plan and replace it with a proposal they've developed. Here's one of their alternative plans:

RSC pitches 'market-based' alternative to bailout, by Jackie Kucinich, The Hill: The House Republican Study Committee is set Tuesday to officially unveil its proposal to address the financial crisis through a "market-based" approach.

The conservative group ... is touting its plan as a "true alternative" to Treasury Secretary Henry Paulson's plan to rescue the financial markets.

The RSC plan, which will be unveiled at noon, calls for a two-year suspension of the capital gains tax.

"By encouraging corporations to sell unwanted assets, this provision would unleash funds and materials with which to create jobs and grow the economy," an outline of the proposal said. "After the two-year suspension, capital gains rates would return to present levels but assets would be indexed permanently for any inflationary gains."

The group's plan would also transition Fannie Mae and Freddie Mac to private companies "in a reasonable time," seeks to stabilize the dollar, and would "suspend the mark-to-market regulatory rules for long-term assets." ...

Obviously, selling off Fannie and Freddie to cronies in the private sector won't do anything to solve the immediate crisis, so let's focus on their main proposal for getting out of the danger we are in, a tax cut for the wealthy through a cut in the capital gains tax. Justin Fox:

[Do] Republican counterproposals floating around make any sense...

One, that of the House Republican Study Committee, seems to be a joke. It calls for a two-year suspension of the capital gains tax to "encourag[e] corporations to sell unwanted assets." But the toxic mortgage securities clogging up bank balance sheets are worth less now than when they were acquired. Meaning that no capital gains tax would be owed on them anyway. If you repealed the tax, banks would have even less incentive to sell them because they wouldn't be able use the losses to offset capital gains elsewhere. Seriously, where do these people come up with this stuff?

And even if there was a gain, a 15% cut in the tax rate for two years is not enough of a benefit to offset the high degree of risk in these markets. So this wouldn't unfreeze money markets even if there were gains instead of losses (and it wouldn't inflate asset values enough to provide much capitalization). Additionally, since it's a tax cut on all capital gains, people could benefit from transactions that didn't do a thing to help the banking sector. This is a giveaway of taxpayer dollars that uses the crisis as cover (and the tax cuts will increase the deficit, so the tax cut will have to be paid for in the future).

The economy is facing serious problems, as I've said before, peoples' livelihoods are at risk (see today's economic news). There's no excuse for holding the process hostage in an attempt to implement political agendas.

Update: Menzie Chinn discusses another proposal being floated by Republicans:

From the Justin Fox, regarding House Republicans' plan:

Eric Cantor, the Republican chief deputy whip, has a more reasonable-sounding if still pretty vague plan to insure more mortgages rather than buy mortgage securities. ....

I'm in agreement with Justin that guaranteeing even more mortgages won't be any better than the original Paulson plan.

My observation here is that the obstructionism of this group is either a manifestion of denial of reality, or a sheer indifference to the needs of their constituents -- to the extent that House Republicans purport to represent small business Main Street.

Menzie goes on to document the troubles facing small businesses - one of the few bright spots for job growth in recent years, - and concludes:

So if we end up delaying until households and small firms individually experience the credit crunch directly for the sake of ideology, well, we'll know where to locate the responsibility.

Update: Washington Monthly:

"Let The Markets Crash": Politico:

"According to one GOP lawmaker, some House Republicans are saying privately that they'd rather "let the markets crash" than sign on to a massive bailout.

"For the sake of the altar of the free market system, do you accept a Great Depression?" the member asked."

Think about that statement, and the callousness, lack of imagination, and sheer lack of concern for their country that it shows.

It staggers me.


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