James Kwak on "the role of democratic politics in responding to the financial crisis":
Financial Crises and Democracy, James Kwak: Lorenzo Bini Smaghi, a member of the Executive Board of the European Central Bank, gave a thought-provoking speech in Milan last week. In particular, he focused on the role of democratic politics in responding to the financial crisis and, more broadly, in how governments manage their economies. Smaghi begins with the premise that it was a mistake to let Lehman fail in mid-September (not everyone agrees with this, but many people do), thereby triggering the acute phase of the credit crisis. He then asks why this happened.
As subsequent events have shown,... when the first rescue package was rejected by the US Congress, opposition to providing the financial sector with public funds came not only from within the government, but also from parliament. The Members of the US Congress, many of whom face voters at the beginning of November, feared that such a decision would compromise their re-election. There was opposition to rescuing Lehman Brothers, therefore, not only from within the Administration, but also from Congress and, more broadly, from public opinion. In other words, the decision was largely the result of a democratic process.
For Smaghi (and for many others), however, the systemic importance of the financial sector meant that it was actually in the interests of US citizens to bail out Lehman and, later, much of the financial sector. ...
Smaghi continues by investigating why the public is opposed to a rescue of the financial system that is actually in its own interests.
My opinion is that this doesn't require investigation, as there is little reason to expect people to vote in their own economic interests since, in most cases, thick screens of political rhetoric make it extremely difficult for them to identify where their interests lie. To take the most obvious example of the moment: According to the non-partisan Tax Policy Center, Barack Obama's tax plan will be better for the bottom four quintiles of the income distribution, and John McCain's plan will only be better for the top quintile (see the figure on page 41); yet more Americans think that Obama will raise their taxes than that McCain will (50% to 46%), thanks to the constant repetition of the "spreading the wealth" sound bite (note how the numbers have reversed in just the last two weeks). If governments make the right economic choices on occasion, it is sometimes in spite of popular opinion but, most often, because the public does not have a strong opinion on the topic. (How many people get worked up about the Fed Funds rate, at least in normal times?)
In some respects, it may actually be good that the economy is being overseen by a lame-duck administration that is largely free to ignore public sentiment, and therefore has been able to ditch its vocal anti-regulatory ideology in favor of a series of pragmatic steps that, collectively, constitute the largest direct government intervention into the economy in my lifetime. There are certainly aspects of the intervention that reflect the free-market instincts of the players concerned, such as the outsourcing of TARP to banks and asset management firms and the relatively gentle recapitalization program. But on the whole, it is an exercise of government power in the economy that until a few months ago was anathema to the conservatives in the administration. ...
We will need to decide how much of the power to respond to financial crises we want concentrated in the hands of an independent Federal Reserve who can react with less concern for the political consequences of their actions, and how much of the power we want in the hands of congress so that policy choices are subject to legislative debate and procedures, and there is accountability to voters. We've seen that too much concentration of power can be risky - the original Paulson bailout plan showed us that we shouldn't trust all that power in the hands of one person, and we were fortunate that checks and balances led to modification of the plan into something more acceptable. Even so, my own preference is to put quite a bit of the authority in the hands of the Fed even when it involves actions such as the purchase of risky securities that put taxpayer money at risk (but I should acknowledge that view does not appear to be a widely held).
Putting the power in the hands of a single individual gives us the ability to respond quickly to any financial crisis, but this represents too much concentration of power and is risky for that reason. But congress is overly deliberative and can be too slow to react to problems, it is subject to myopic political concerns that can come at the expense of the long-run health of the economy, and members of congress often lack the knowledge needed to understand the full implications of alternative policy choices. So perhaps the Fed represents a workable medium between these extremes that offers relatively speedy action, deliberation among the board memebers, bank presidents, and staff, implicit oversight from congress, and shared consent for policy choices that gives us, on average, better and less costly policy outcomes.
Jeff Sachs says that Greenspan's bubbles and the problems they have caused make clear that it's time to abandon "the economic model adopted since president Ronald Reagan came to office in 1981." I think Fed policy contributed to the housing bubble, but I am not convinced it was the primary cause. However, whatever the primary cause of the problems we are experiencing, I have no disagreement with Sach's call for "a new economic strategy":
Greenspan Folly makes room for a new New Deal, by Jeff Sachs, Project Syndicate: This global economic crisis will go down in history as Greenspan's Folly. This is a crisis made mainly by the US Federal Reserve Board during the period of easy money and financial deregulation from the mid-1990s until today. ...
At the core of the crisis was the run-up in housing and stock prices... Greenspan stoked two bubbles — the Internet bubble of 1998-2001 and the subsequent housing bubble that is now bursting. In both cases, increases in asset values led US households to think that they had become vastly wealthier, tempting them into a massive increase in their borrowing and spending — for houses, automobiles and other consumer durables.
Financial markets were eager to lend to these households, in part because the credit markets were deregulated... This has all come crashing down. ...
The challenge for policymakers is to restore enough confidence that companies can again obtain short-term credit to meet their payrolls and finance their inventories. The next challenge will be to push for a restoration of bank capital so that commercial banks can once again lend for longer-term investments.
But these steps, urgent as they are, will not prevent a recession... The US will be hardest hit, but other countries with recent housing and consumption booms (and now busts) — particularly the UK, Ireland, Australia, Canada and Spain — will be hit as well. Iceland ... now faces national bankruptcy...
It is no coincidence that, with the exception of Spain, all of these countries explicitly adhered to the US philosophy of "free market" and under-regulated financial systems.
Whatever the pain felt in the deregulated Anglo-Saxon-style economies, none of this must inevitably cause a global calamity. I do not see any reason for a global depression, or even a global recession.
Yes, the US will experience a decline..., lowering the rest of the world's exports to the US. But many other parts of the world will still grow. Many large economies, including China, Germany, Japan and Saudi Arabia, have very large export surpluses and so have been lending to the rest of the world — especially to the US — rather than borrowing.
These countries are flush with cash and not burdened by the collapse of a housing bubble. Although their households have suffered to some extent from the fall in equity prices, they not only can continue to grow, but can also increase their internal demand to offset the decline in exports to the US.
They should now cut taxes, ease domestic credit conditions and increase government investments in roads, power and public housing. They have enough foreign-exchange reserves to avoid the risk of financial instability from increasing their domestic spending — as long as they do it prudently.
As for the US, the current undeniable pain for millions of people, which will grow..., is an opportunity to rethink the economic model adopted since president Ronald Reagan came to office in 1981. Low taxes and deregulation produced a consumer binge that felt good while it lasted, but also produced vast income inequality, a large underclass, heavy foreign borrowing, neglect of the environment and infrastructure, and now a huge financial mess.
The time has come for a new economic strategy — in essence, a new New Deal.
It's time for "a major fiscal stimulus":
When Consumers Capitulate, by Paul Krugman, Commentary, NY Times: The long-feared capitulation of American consumers has arrived. According to Thursday's G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent.
To appreciate the significance of these numbers, you need to know that American consumers almost never cut spending...; the last time it fell even for a single quarter was in 1991, and there hasn't been a decline this steep since 1980...
So this looks like the beginning of a very big change in consumer behavior. And it couldn't have come at a worse time.
It's true that American consumers have long been living beyond their means... Lately,... the savings rate has generally been below 2 percent — sometimes it has even been negative — and consumer debt has risen to 98 percent of G.D.P., twice its level a quarter-century ago.
Some economists told us not to worry because Americans were offsetting their growing debt with the ever-rising values of their homes and stock portfolios. Somehow, though, we're not hearing that argument much lately.
Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. ...
Some background: one of the high points of the semester, if you're a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone's income.
In fact, consumers' income may actually fall more than their spending, so that their attempt to save more backfires — a possibility known as the paradox of thrift.
At this point, however, the instructor hastens to explain that virtue isn't really vice: in practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would ... lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can't offset the fall in consumer spending.
I'll bet you can guess what's coming next.
For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It's true that Ben Bernanke hasn't yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it's hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. ...
The capitulation of the American consumer, then, is coming at a particularly bad time. But it's no use whining. What we need is a policy response.
The ongoing efforts to bail out the financial system, even if they work, won't do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we've seen, Americans were overextended even before banks started cutting them off.
No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn't spend.
Let's hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let's also hope that the lame-duck Bush administration doesn't get in the way.
Why hasn't the increased availability of information reduced the demand for labor market intermediaries?
The economics of labour market intermediation, by David Autor, Vox EU: The labour market depicted by undergraduate textbooks (e.g. Mankiw 2006) is a pure spot market with complete information and atomistic price-taking. Labour economists have long understood that this model is highly incomplete. Search is costly, information is typically imperfect and often asymmetric, firms are not always price takers, and atomistic actors are typically unable to resolve coordination and collective action failures.
In this 'second-best of all worlds,' numerous third parties inevitably arise to respond to, and profit from, market imperfections. I refer to these third parties as Labour Market Intermediaries – entities or institutions that interpose themselves between workers and firms to influence who is matched to whom, how work is accomplished, and how conflicts are resolved.
Labour market intermediaries have been around in various guises for centuries, as labour unions, craft guilds, and occupational licensing boards. But they have also gained prominence in contemporary incarnations as temporary help agencies, Internet job search boards, and centralised job-matching institutions like the 'medical match' that allocates physicians completing medical school to medical residencies. The venerable history and continued re-emergence of intermediaries in various forms raises the question: what precise economic function do these institutions serve? And are they likely to improve labour market operation or merely tax it?
Though heterogeneous, it is my contention that labour market intermediaries serve a common role. They address – and in some case exploit – a set of endemic departures of labour market operation from the first-best benchmark of full information, perfect competition, and decentralised price taking. Three labour market deficiencies, in particular, appear to 'call forth' the involvement of intermediaries: costly information, adverse selection, and (failures of) coordination or collective action. I give examples of each below. A unifying observation that ties these examples together is that participation in the activities of a given labour market intermediary is typically voluntary for one side of the market and compulsory for the other; workers cannot, for example, elect to suppress their criminal records and firms cannot opt out of collective bargaining. I argue below that the nature of participation in an intermediary's activities – voluntary or compulsory, and for which parties – is largely dictated by the market imperfection that it addresses, and thus tells us much about its economic function.
In the textbook model of the labour market, there are no job search frictions. In reality, job search is costly. In addition to the costs of job advertisements, applications, and interviews, job seekers forego leisure while searching for work and firms forego production while holding vacancies. Information about job vacancies and job seekers is largely a public good and hence likely to be under-supplied by the market. This creates a business opportunity, which many labour market intermediaries step in to fill.
The leading contemporary example of an intermediary that provides job search information is the online job board (e.g., Monster.com, hotjobs.yahoo.com). Like their pre-Internet antecedents – such as help wanted advertisements, street corner day labour queues, and national job banks – online job boards are 'information only' intermediaries that aggregate, package and (in some case) resell information. Though I claimed above that compulsion is critical to the operation of most labour market intermediaries, it is apparent that information-only intermediaries exert only modest levels of compulsion: commercial job boards require users to post their CVs or job vacancies before they can view others' listings; government-run job registries often stipulate that employers should post all vacancies. Why isn't compulsion more forceful? The reason, I believe, is that the main challenge facing information-only intermediaries is free riding – all workers and firms would like to use the centralised resource, but none face full incentives to contribute to it. Since the cost to workers or firms of posting their own information is typically modest, the degree of compulsion needed to avert free riding is proportionately small.
Pure free riding, however, is unlikely to be the most significant market failure that results from costly information. Where information is incomplete, workers and firms face incentives to shade adverse information to raise their wages or profitability. This selective concealment generates negative externalities – adverse selection – that can depress the quality and quantity of trade in equilibrium (Akerlof, 1970). For example, if job candidates pad their resumes with bogus credentials or firms conceal hazardous working conditions, these actions reduce the equilibrium return to workers' skill investments and firms' provision of workplace safety. Mitigating adverse selection requires a mechanism that implicitly or explicitly compels market actors to disclose information that they would rather conceal. A set of labour market intermediaries appears purpose-built to perform this function.
A compelling example is the job search engine, AlmaLaurea, founded by a consortium of Italian universities. Distinct from commercial job boards like Monster.com, AlmaLaurea provides comprehensive administrative records – classes, grades, class rank – for essentially the full set of students graduating from the universities in the consortium, not just those applying for a particular job. This 'full disclosure' feature mitigates the risk of adverse selection that appears to pervade Internet search (Kuhn and Skuterud, 2004); employers screening candidates through AlmaLaurea face little uncertainty about applicants' credentials or their standing relative to their peers. Do employers take this information seriously? Manuel Bagues and Mauro Sylos Labini find that graduates of universities joining AlmaLaurea during 1998 to 2001 experienced a several percentage point reduction in non-employment – an economically large effect – relative to graduates of universities that had not yet joined AlmaLaurea.
Employers as well as employees face incentives to exploit asymmetric information. At the turn of the twentieth century, U.S. job seekers—cross-state migrants and unskilled labourers in particular—made extensive use of private, for-profit employment agencies. These unsophisticated job-seekers were ripe for exploitation by agencies armed with vastly superior labour market information. Some of the abuses perpetrated by agencies included sending job-seekers to non-existent firms in distant locales; bribing firms to temporarily hire job-seekers so that the agency could collect a commission; and referring unwitting female job-seekers to brothels.
As exposited in an insightful paper by Woong Lee, U.S. state governments devised an ingenious response to these abuses. Rather than attempting to monitor for-profit employment agencies – a formidable task since many agencies were fly-by-night operations – states created their own public employment offices that offered high quality employment assistance at zero cost to job seekers. These free, reputable offices undercut the business model of the fly-by-night agencies – only for-profit agencies offering significant value added could effectively compete with the no-cost state agencies.
That state governments found it necessary to intercede to thwart abuses of asymmetric information underscores that purging the taint of adverse selection from the labour market requires a mechanism to force information disclosure or simply drive adversely selected agents from the market. In the case of AlmaLaurea, the mechanism was 'full disclosure' of the job qualifications of the entire graduating population of member universities. In the case of public employment offices, the mechanism was subsidised competition that placed a floor on the quality of services offered by private entrants.
Providing information – even compelling it – is not necessarily sufficient to resolve market failures. Notifying a bank's deposit holders that the institution faces a small risk of insolvency does not reduce the risk of a bank run – in fact, it raises it. In such cases, rational agents acting with full information and mutually consistent expectations make decisions that are privately optimal yet collectively suboptimal – a coordination failure. There is potential in such settings for labour market intermediaries to improve upon competitive outcomes, but only if these intermediaries have the power to realign the maximising choices of agents with the common good.
One setting where coordination failures appear widespread is in entry-level labour markets for highly specialised professions, such as legal clerkships and medical specialties. Candidates in these fields are often compelled to sign binding employment contracts one or more years prior to the start of employment, well before the quality of job matches can be assessed. Such a matching process is likely allocatively inefficient.
What is the fundamental problem? Muriel Niederle and Alvin Roth argue that it is market congestion. In professions where an entire cohort of entry-level candidates enters the labour market simultaneously (e.g., medical school graduates), there is inadequate time for employers to screen all relevant candidates before competing offers have been made and accepted. To reduce the chance that they are forced to choose among the 'leftover' candidates, employers make early, exploding offers to job candidates. This naturally leads to market unravelling; anticipating that their competitors will make exploding offers, each employer accelerates its own offers. This harms allocative efficiency by making markets artificially thin – job candidates are forced to make major, irreversible decisions before knowing their full choice sets.
If congestion is the cause of unravelling, the problem could in theory be averted if employers were prevented from making offers until a sufficient search period had elapsed. The National Resident Matching Program (NRMP), studied by Niederle and Roth, performs this function. The NRMP is a centralised clearinghouse that allocates candidates to fellowships using deferred acceptance algorithms. Candidates participating in the match are not bound by job offers initiated prior to the resolution of the match – thus nullifying the power of exploding offers. Employer participation in the match is, however, voluntary.
After widespread unravelling, the gastroenterology profession (GI) adopted the NRMP in 1989. Analysis by Niederle and Roth suggests that the match ameliorated some major market maladies. The highly dispersed timing of job offers (reflecting early, exploding offers) was greatly compressed, and the mobility of GI residents out of the hospitals where they performed their residences (indicative of monopsony power) rose substantially. While more difficult to measure, the match probably improved allocative efficiency by better pairing fellows with fellowships according to intellectual fit and geographic preference.
Ironically, the GI match itself unravelled ten years after implementation. The cause of this failure is revealing. When the GI profession chose to curtail entry into the profession in 1996, the size of new cohorts fell much faster than expected – to the point where the there were fewer fellows than fellowships. This gave hospitals a strong incentive to jump the queue so their fellowship slots would not go wanting. The NRMP was helpless to respond to these employer choices since employer participation in the match was voluntary. Initial defections spurred further defections, and the NRMP became irrelevant by 2000. The unravelling of a labour market intermediary designed to inhibit unravelling again highlights that the power to compel participation by at least one side of the market – workers, firms or both – is necessary condition for an intermediary to address collective action failures. The GI fellowship match had this power when the labour market was slack but not when it was tight.
One might have speculated that in an era of rapid information flows and substantial job mobility, the importance of labour market intermediaries would wane. Indeed, the most prominent labour market intermediary, the traditional labour union, has been in secular declines for decades. Yet, the decline of labour unions is the exception rather than the rule. Two of the intermediaries discussed above – online search engines and centralised medical matches – have only recently gained prominence. And another labour market intermediary not even considered above, temporary help agencies, has risen from relative obscurity to international significance over the last two decades. (Figure 1 provides many additional examples.)
Why has the vastly increased availability of information on the Internet not reduced the demand for labour market intermediaries? The reason, I believe, is that cheap information alone is rarely sufficient to solve the failures endemic to labour markets. Redressing adverse selection and reversing coordination failures ultimately requires labour market institutions that can variously compel disclosure of hidden information, coordinate the actions of participants in a congested market, or solve collective action problems among parties with complementary interests. Despite widely heralded advances in the technology of job matching, I anticipate that labour market intermediaries will continue to address, ameliorate, and exploit the imperfect environment in which workers and employers interact.
Figure 1 Labour market intermediaries, by market function and type of participation
Market failure Nature of participation Information provision/search costs Worker-side adverse selection Firm-side adverse selection Coordination & collective action Voluntary for workers and firms Voluntary for firms not workers Voluntary for workers not firms Traditional board jobs X X Comprehensive board jobs (e.g. AlmaLaurea) X X Criminal record providers X X Public employment offices X X Labour standards regulations X X Centralised medical job match X X Labour unions X X Temporary help agencies X X
Akerlof, George A. 1970. "The Market for 'Lemons:' Quality Uncertainty and the Market Mechanism" Quarterly Journal of Economics, 84, 488-500.
Autor, David H. (ed.). Forthcoming. Studies of Labor Market Intermediation. Chicago: University of Chicago Press.
Bagues, Manuel and Mauro Sylos Labini. Forthcoming. "Do Online Labor Market Intermediaries Matter? The Impact of AlmaLaurea on the University-to-Work Transition." in David H. Autor (ed), Studies of Labor Market Intermediation. Chicago: University of Chicago Press.
Kuhn, Peter, and Mikal Skuterud. 2004. "Internet Job Search and Unemployment Durations." American Economic Review, 94(1), 218-232.
Lee, Wong. Forthcoming. "Private Deception and the Rise of Public Employment Offices, 1890 – 1930." in David H. Autor (ed.), Studies of Labor Market Intermediation. Chicago: University of Chicago Press.
Mankiw, Gregory (2006). Principles of Economics, 4th Edition. South-Western College Pub.
Niederle, Muriel and Alvin E. Roth. Forthcoming. "The Effect of a Centralized Clearinghouse on Job Placement, Wages and Hiring Practices." in David H. Autor (ed.), Studies of Labor Market Intermediation. Chicago: University of Chicago Press.
1 This column draws upon a forthcoming NBER-University of Chicago Press Volume, "Studies in Labor Market Intermediation." The research cited below appears in this volume.
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