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October 31, 2008

Economist's View - 5 new articles

"Financial Crises and Democracy"

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.

"Greenspan's Folly"

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.

Paul Krugman: When Consumers Capitulate

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.

"The Economics of Labour Market Intermediation"

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.[1]

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.

Costly information

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.,, 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.

Adverse selection

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, 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.

Coordination failures

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.

Final thoughts

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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October 30, 2008

Economist's View - 5 new articles

Credit Markets and Macroeconomic Performance in the Great Depression

Given all the discussion recently about the relationship between credit flows and the macroeconomy, it seemed worthwhile to review what Ben Bernanke says about this topic with respect to the Great Depression. Bernanke's analysis concludes that the effects work through aggregate demand, not aggregate supply, i.e. that the problem was not one of "greater difficulties in funding large, indivisible projects." Instead, the "reluctance of even cash-rich corporations to expand production during the depression suggests ... consideration of the aggregate demand channel for credit market effects":

Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression, by Ben bernanke, American Econonomic Review, June 1983: During 1930-33, the U.S. financial system experienced conditions that were among the most difficult and chaotic in its history. Waves of bank failures culminated in the shutdown of the banking system (and of a number of other intermediaries and markets) in March 1933. On the other side of the ledger, exceptionally high rates of default and bankruptcy affected every class of borrower except the federal government.

An interesting aspect of the general financial crises - most clearly, of the bank failures - was their coincidence in timing with adverse developments in the macroeconomy.[l] Notably, an apparent attempt at recovery from the 1929-30 recession[2] was stalled at the time of the first banking crisis (November- December 1930); the incipient recovery degenerated into a new slump during the mid-1931 panics; and the economy and the financial system both reached their respective low points at the time of the bank" holiday" of March 1933. Only with the New Deals rehabilitation of the financial system in 1933-35 did the economy begin its slow emergence from the Great Depression. A possible explanation of these synchronous movements is that the financial system simply responded, without feedback, to the declines in aggregate output. This is contradicted by the facts that problems of the financial system tended to lead output declines, and that sources of financial panics unconnected with the fall in U.S. output have been documented by many writers. (See Section IV below.)

Among explanations that emphasize the opposite direction of causality, the most prominent is the one due to Friedman and Schwartz. Concentrating on the difficulties of the banks, they pointed out two ways in which these worsened the general economic contraction: first, by reducing the wealth of bank shareholders; second, and much more important, by leading to a rapid fall in the supply of money. There is much support for the monetary view. However, it is not a complete explanation of the link between the financial sector and aggregate output in the 1930's. One problem is that there is no theory of monetary effects on the real economy that can explain protracted nonneutrality. Another is that the reductions of the money supply in this period seems quantitatively insufficient to explain the subsequent falls in output. (Again, see Section IV.)

The present paper builds on the Friedman- Schwartz work by considering a third way in which the financial crises (in which we include debtor bankruptcies as well as the failures of banks and other lenders) may have affected output. The basic premise is that, because markets for financial claims are incomplete, intermediation between some classes of borrowers and lenders requires nontrivial market-making and information gathering services. The disruptions of 1930-33 (as I shall try to show) reduced the effectiveness of the financial sector as a whole in performing these services. As the real costs of intermediation increased, some borrowers (especially households, farmers, and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression. ...

III. Credit Markets and Macroeconomic Performance If it is taken as given that the financial crises during the depression did interfere with the normal flows of credit, it still must be shown how this might have had an effect on the course of the aggregate economy. There are many ways in which problems in credit markets might potentially affect the macroeconomy. Several of these could be grouped under the heading of "effects on aggregate supply." For example, if credit flows are dammed up, potential borrowers in the economy may not be able to secure funds to undertake worthwhile activities or investments; at the same time, savers may have to devote their funds to inferior uses. Other possible problems resulting from poorly functioning credit markets include a reduced feasibility of effective risk sharing and greater difficulties in funding large, indivisible projects. Each of these might limit the economy's productive capacity.

These arguments are reminiscent of some ideas advanced by John Gurley and E. S. Shaw (1955), Ronald McKinnon (1973), and others in an economic development context. The claim of this literature is that immature or repressed financial sectors cause the "fragmentation" of less developed economies, reducing the effective set of production possibilities available to the society.

Did the financial crisis of the 1930's turn the United States into a "temporarily underdeveloped economy" (to use Bob Hall's felicitous phrase)? Although this possibility is intriguing, the answer to the question is probably no. While many businesses did suffer drains of working capital and investment funds, most larger corporations entered the decade with sufficient cash and liquid reserves to finance operations and any desired expansion (see, for example, Friedrich Lutz, 1945). Unless it is believed that the outputs of large and of small businesses are not potentially substitutes, the aggregate supply effect must be regarded as not of great quantitative importance.

The reluctance of even cash-rich corporations to expand production during the depression suggests that consideration of the aggregate demand channel for credit market effects on output may be more fruitful. The aggregate demand argument is in fact easy to make: A higher cost of credit intermediation for some borrowers (for example, households and smaller firms) implies that, for a given safe interest rate, these borrowers must face a higher effective cost of credit. (Indeed, they may not be able to borrow at all.) If this higher rate applies to household and small firm borrowing but not to their saving (they may only earn the safe rate on their savings), then the effect of higher borrowing costs is unambiguously to reduce their demands for current-period goods and services. This pure substitution effect (of future for present consumption) is easily derived from the classical two-period model of savings.[24]

Assume that the behavior of borrowers unaffected by credit market problems is unchanged. Then the paragraph above implies that, for a given safe rate, an increase in the cost of credit intermediation reduces the total quantity of goods and services currently demanded. That is, the aggregate demand curve, drawn as a function of the safe rate, is shifted downward by a financial crisis. In any macroeconomic model one cares to use, this implies lower output and lower safe interest rates. Both of these outcomes characterized 1930-33, of course.

Some evidence on the magnitude of the effect of the financial market problems on aggregate output is now presented. [From Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression, by Ben bernanke, American Econonomic Review, June 1983.]

Update: I probably shouldn't have left it there. Here are more recent thoughts from Bernanke on this topic, including a discussion of the financial accelerator and the bank lending channel for monetary policy:

...Market Frictions and the Real Effects of Financial and Credit Conditions Economists have not always fully appreciated the importance of a healthy financial system for economic growth or the role of financial conditions in short-term economic dynamics. As a matter of intellectual history, the reason is not difficult to understand. During the first few decades after World War II, economic theorists emphasized the development of general equilibrium models of the economy with complete markets; that is, in their analyses, economists generally abstracted from market "frictions" such as imperfect information or transaction costs. But without such frictions, financial markets have little reason to exist. For example, with complete markets (and if we ignore taxes), we know that whether a corporation finances itself by debt or equity is irrelevant (the Modigliani-Miller theorem).

The blossoming of work on asymmetric information and principal-agent theory, led by Nobel laureates Joseph Stiglitz and George Akerlof and with contributions from many other researchers, gave economists the tools to think about the central role of financial markets in the real economy. ...

My own first job as an academic was at Stanford University, where I arrived as an assistant professor in the Graduate School of Business in 1979. At the time, Stanford was a hotbed of work on asymmetric information, incentives, and the principal-agent problem; and even though my field was macroeconomics, I was heavily influenced by that intellectual environment. I became particularly interested in how this perspective on financial markets could help explain why financial crises--that is, extreme disruptions of the normal functioning of financial markets--seem often to have a significant impact on the real economy. Putting the issue in the context of U.S. economic history, I laid out, in a 1983 article, two channels by which the financial problems of the 1930s may have worsened the Great Depression (Bernanke, 1983).

The first channel worked through the banking system. As emphasized by the information-theoretic approach to finance, a central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems. By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop "informational capital." The widespread banking panics of the 1930s caused many banks to shut their doors; facing the risk of runs by depositors, even those who remained open were forced to constrain lending to keep their balance sheets as liquid as possible. Banks were thus prevented from making use of their informational capital in normal lending activities. The resulting reduction in the availability of bank credit inhibited consumer spending and capital investment, worsening the contraction.

The second channel through which financial crises affected the real economy in the 1930s operated through the creditworthiness of borrowers. In general, the availability of collateral facilitates credit extension. The ability of a financially healthy borrower to post collateral reduces the lender's risks and aligns the borrower's incentives with those of the lender. However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments. Borrowers' cash flows and liquidity were also impaired, which likewise increased the risks to lenders. Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit. Incidentally, this information-based explanation of how the sharp deflation in prices in the 1930s may have had real effects was closely related to, and provided a formal rationale for, the idea of "debt-deflation," advanced by Irving Fisher in the early 1930s (Fisher, 1933).

The External Finance Premium and the Financial Accelerator Both real and monetary shocks produced the Great Depression, and in my 1983 paper I argued that banking and financial markets propagated both types of impulses, without distinguishing sharply between the two. My subsequent research and that of many others looked separately at the role of financial conditions in amplifying both monetary and nonmonetary influences.

On the nonmonetary side, Mark Gertler and I showed how, in principle, the effects of a real shock (such as a shock to productivity) on financial conditions could lead to persistent fluctuations in the economy, even if the initiating shock had little or no intrinsic persistence (Bernanke and Gertler, 1989). A key concept in our analysis was the external finance premium, defined as the difference between the cost to a borrower of raising funds externally and the opportunity cost of internal funds. External finance (raising funds from lenders) is virtually always more expensive than internal finance (using internally generated cash flows), because of the costs that outside lenders bear of evaluating borrowers' prospects and monitoring their actions. Thus, the external finance premium is generally positive. Moreover, the theory predicts that the external finance premium that a borrower must pay should depend inversely on the strength of the borrower's financial position, measured in terms of factors such as net worth, liquidity, and current and future expected cash flows. Fundamentally, a financially strong borrower has more "skin in the game," so to speak, and consequently has greater incentives to make well-informed investment choices and to take the actions needed to ensure good financial outcomes. Because of the good incentives that flow from the borrower's having a significant stake in the enterprise and the associated reduction in the need for intensive evaluation and monitoring by the lender, borrowers in good financial condition generally pay a lower premium for external finance.[1]

The inverse relationship of the external finance premium and the financial condition of borrowers creates a channel through which otherwise short-lived economic shocks may have long-lasting effects. In the hypothetical case that Gertler and I analyzed, an increase in productivity that improves the cash flows and balance sheet positions of firms leads in turn to lower external finance premiums in subsequent periods, which extends the expansion as firms are induced to continue investing even after the initial productivity shock has dissipated. This "financial accelerator" effect applies in principle to any shock that affects borrower balance sheets or cash flows. The concept is useful in that it can help to explain the persistence and amplitude of cyclical fluctuations in a modern economy.

Although the financial accelerator seems intuitive--certainly financial and credit conditions tend to be procyclical--nailing down this mechanism empirically has not proven entirely straightforward. ...

Financial accelerator effects need not be confined to firms and capital spending but may operate through household spending decisions as well.[3] Household borrowers, like firms, presumably face an external finance premium, which is lower the stronger their financial position. For households, home equity is often a significant part of net worth. Certainly, households with low mortgage loan-to-value ratios can borrow on relatively favorable terms through home-equity lines of credit, with the equity in their home effectively serving as collateral. If the financial accelerator hypothesis is correct, changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect because changes in homeowners' net worth also affect their external finance premiums and thus their costs of credit. If true, this hypothesis has various interesting implications. For example, unlike the standard view based on the wealth effect, this approach would suggest that the distribution of housing wealth across the population matters because the effect on aggregate consumption of a given decline in house prices is greater, the greater the fraction of consumers who begin with relatively low home equity. Another possible implication is that the structure of mortgage contracts may matter for consumption behavior. In countries like the United Kingdom, for example, where most mortgages have adjustable rates, changes in short-term interest rates (whether induced by monetary policy or some other factor) have an almost immediate effect on household cash flows. If household cash flows affect access to credit, then consumer spending may react relatively quickly. In an economy where most mortgages carry fixed rates, such as the United States, that channel of effect may be more muted. I do not think we know at this point whether, in the case of households, these effects are quantitatively significant in the aggregate. Certainly, these issues seem worthy of further study.

Monetary Policy and the Credit Channel ...Some evidence suggests that the influence of monetary policy on real variables is greater than can be explained by the traditional "cost-of-capital" channel, which holds that monetary policy affects borrowing, investment, and spending decisions solely through its effect on the level of market interest rates. This finding has led researchers to look for supplementary channels through which monetary policy may affect the economy. One such supplementary channel, the so-called credit channel, holds that monetary policy has additional effects because interest-rate decisions affect the cost and availability of credit... The credit channel, in turn, has traditionally been broken down into two components or channels of policy influence: the balance-sheet channel and the bank-lending channel (Bernanke and Gertler, 1995). The balance-sheet channel of monetary policy is closely related to the idea of the financial accelerator that I have already discussed. ... For example, according to this view, a tightening of monetary policy that reduces the net worth and liquidity of borrowers would increase the effective cost of credit by more than the change in risk-free rates and thus would intensify the effect of the policy action.

In the interest of time I will confine the remainder of my remarks to the bank-lending channel. The theory of the bank-lending channel holds that monetary policy works in part by affecting the supply of loans offered by depository institutions. This concept is a cousin of the idea I proposed in my paper on the Great Depression, that the failures of banks during the 1930s destroyed "information capital" and thus reduced the effective supply of credit to borrowers. Alan Blinder and I adapted this general idea to show how, by affecting banks' loanable funds, monetary policy could influence the supply of intermediated credit (Bernanke and Blinder, 1988). ...

Feldstein: Avoiding a "Deep and Prolonged Recession"

Marty Feldstein says it's time to dampen the downward movement in housing prices to prevent overshooting the bottom, and to use government spending, including spending on infrastructure, to try to avoid a deepening recession:

The Stimulus Plan We Need Now, by Martin Feldstein, Washington Post: Further legislation to deal with the economic crisis should not wait until the new president takes office. Fortunately, the president-elect will be a senator and can propose legislation... Immediately after Nov. 4, the winner could, and should, take the lead in the legislative process.

The economy faces two separate problems: the downward spiral of home prices ... and the decline in aggregate spending, which could cause a deep and prolonged recession.

Home prices ... must fall an additional 10 to 15 percent to get back to pre-bubble levels. But they could fall much further than that as a result of mortgage defaults and foreclosures. ... Congress should enact policies to reduce defaults that could drive prices down much further. ... The mortgage replacement loan plan that I suggested on this page in June ... is one possible way to do that. ...

With the Fed's benchmark interest rate down to 1 percent, there is no scope for an easier monetary policy to stop the downward spiral in aggregate demand. Another round of one-time tax rebates won't do the job. ...

The only way to prevent a deepening recession will be a temporary program of increased government spending. Previous attempts to use government spending to stimulate an economic recovery, particularly spending on infrastructure, have not been successful because of long legislative lags... But while past recessions lasted an average of only about 12 months, this downturn is likely to last much longer, providing the scope for successful countercyclical spending.

A fiscal package of $100 billion is not likely to be large enough... The fall in household wealth resulting from the collapse of the stock market and the decline of home prices may cut aggregate spending by $300 billion a year or more.

The president-elect should focus on ... initiatives that can occur quickly and that would otherwise not be done. While it would be good if some of the increased spending also contributed to long-term productivity, the key is to stimulate demand. ...

The increased government spending should include not only money for infrastructure such as bridges and roads but also for a wide range of equipment. Rebuilding some of the military capacity that has been depleted by the wars in Iraq and Afghanistan could be done relatively quickly and should be part of the overall package.

Although the economy is facing severe challenges, the president-elect can turn the situation around by introducing legislation to deal with the downward spiral in home prices and with the declining level of aggregate demand ... as quickly as possible.

Since I've made many of the same points, it would be hard to disagree with the overall message. One thing though, the military will get its share one way or the other, so I'd rather see the increased spending directed elsewhere. Things, for example, "that would otherwise not be done."

Update: GDP falls in third quarter:

The Commerce Department reported this morning that consumers sharply cut their spending this summer, causing the United States economy to shrink at annual rate of 0.3 percent. By almost all accounts, the economy is now in recession.

The last quarter in which consumers reduced their spending came in 1991. ... Personal consumption fell at an annual rate of 3.1 percent in the third quarter of this year, its biggest drop since 1980, when the economy was in a deep recession. ...

Fed Watch: More Easing Expected

Today, the Fed lowered the target interest rate to 1%. Will the Fed lower the target rate even further if things don't improve?:

More Easing Expected, by Tim Duy: The FOMC performed as expected today, delivering a 50bp cut that returns rates to their lows of the Greenspan era. More importantly, Bernanke & Co. made clear that further policy easing remains on the table.

The FOMC statement describes an economy in recession without actually using the "R" word:

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Any other assessment would have been surprising; by all measures, economic activity fell off a cliff as we entered the second half of this year. Today's durable goods report is no exception, with nondefense, nonair capital goods declining 1.4% in September, extending a 2.2% decline the previous month. The intensification of the credit crunch (yes, Virginia, it is a crunch), increased hesitation to expand capital outlays in the current environment, and slowing global growth suggest that investment activity will show even greater declines in the months ahead.

Consistent with the darkening outlook, the incoming flow of data is likely to be horrid, especially during the next two quarters. In particular, the employment report will soon reveal the big declines in nonfarm payrolls consistent with a recession. An increased pace of job losses will sap aggregate household budgets of the real gains afforded by falling energy prices. Consequently, spending data will remain weak. Overall, the data will argue for additional policy response, and the Fed's statement makes clear that they are prepared to ease policy further as required.

But will that easing come in the form of lower rates? And how far would the Fed go?

Brad DeLong reminds us that the Taylor Rule places the policy rate at zero, but there is some concern that rates lower than 1% will interfere with the normal operations of money market funds – they need to remain profitable if the Fed expects them to continue to function. Also note that only four district banks requested a decrease in the discount rate, which some believe indicates the rate cut cycle is near its end, or that there was less support than the unanimous vote would seem to indicate. If so, expect some hawkish talk from district presidents.

Still, unless the Fed believes that technical reasons prevent moving much below 1%, I doubt anything short of a dramatic improvement in financial markets would eliminate the possibility of another rate cut. Even under such conditions, the pressure to ease further will be immense as labor markets deteriorate (this has always been a risk of the Fed's aggressive push). But suppose that conditions warrant a prolonged period of constant rates. In the current environment, even holding rates at 1% is not the same as the end of the easing cycle. Indeed, the effectiveness of rate cuts at this point is questionable. The reaction of market participants to the coordinated 50bp cut earlier this month was not exactly a vote of confidence in the efficacy of this particular policy tool. Given the ongoing problem in financial markets, are any of us under an illusion that the price of money is the dominant policy challenge? How many believe that the final 100bp will have a measurable impact on economic activity? This is especially true with regard to the near term; if the last 100bp has much effectiveness left, the impact will not be felt until late next year. That is not meant to say that we should reverse course and start raising rates. Only that future policy easing will be more about the extension of tools that increase the Fed's balance sheet rather than on the level of rates in the overnight markets.

Of course, expanding the balance sheet, effectively replacing liquidity that is drying up in various parts of the financial markets (by, for example, purchasing commercial paper), should not be seen as a panacea to the current turmoil. I view it, along with Treasury's capital injections, as more of an effort to prevent the turmoil from leading to an outright collapse in the banking system rather than something that will increase lending. Policymakers would be happy to see lending activity expand. But deleveraging threatens to dry up credit at a pace faster than the Fed and Treasury can compensate. Moreover, a portion of the credit crunch is attributable to a reversion to traditional underwriting standards; policy will be unlikely to reverse this trend (nor should it). And, with economic conditions deteriorating, and unemployment expected to rise, banks will increase their loan loss provisions, further weighing on lending activity. In short, at best Fed and Treasury can limit the extent of the crunch, and hopefully prevent significant overshooting.

With the reversal of commodity prices since the summer, policymakers no longer worry about inflation. This provides room for additional easing, although some think it is shortsighted:

With today's cut the Fed is throwing gasoline on an inflationary fire that it created but continues to ignore. The Fed has mistaken temporary drops in commodity prices, which merely resulted from de-leveraging, for clear evidence that the inflation menace has been quelled. However, once highly leveraged players have been flushed out, commodity prices will resume their ascent, pushed skyward by the most inflationary monetary policy in history. –Peter Schiff, Euro Pacific Capital

The argument is that underlying conditions place the Dollar's newfound gains at risk of another reversal. Once the deleveraging is complete, foreign investors will realize they are now awash in Dollar denominated assets at a time when the US Treasury is expected to unleash an unprecedented quantity of such assets on global financial markets. The Dollar and commodities will reverse direction accordingly. I admit to being sympathetic to this story, but would note that sufficient slack looks to be opening up in the global economy to absorb these assets (especially if China continues to backstop the US economy). I assume this is the Fed's view as well. If the Fed is in error, the yield curve should steepen dramatically in coming months. Bernanke & Co. would then be forced to reassess their policy choices.

Bottom Line: The combination of the Fed's statement and the likely path of data suggest another 25bp of easing in December. The global slowdown, dollar strength, and commodity reversal all leave inflation off the table as a concern. Only technical considerations or a dramatic improvement in financial markets would prevent the Fed from further cuts, but with the ability to pay interest on deposits, a zero interest rate is not an impediment to expanding the Fed's balance sheet. Indeed, this is almost certainly the policy focus at this point. Inflation hawks might be unsettled by continued rate cuts, but hawks have had little impact on policy outcomes in this cycle. Consequently, the safe bet has always been for additional easing – even when only 100bp remain.

The DOJ Blesses Merger between Delta and Northwest

James Kwak at Baseline Scenario:

Things That Don't Make Sense, Airline Edition, by James Kwak: ...Earlier today, the Department of Justice approved the merger of Delta and Northwest, which I believe closed later this evening. In its statement, the Antitrust Division blessed the merger, saying:

the proposed merger between Delta and Northwest is likely to produce substantial and credible efficiencies that will benefit U.S. consumers and is not likely to substantially lessen competition. . . .

Consumers are also likely to benefit from improved service made possible by combining under single ownership the complementary aspects of the airlines' networks.

Now, for literally years, every expert on the airline industry has been saying that the industry needs less competition, less capacity, and higher prices (bad for consumers), and consolidation is the way to achieve that end. Put another way, if Delta and Northwest actually believed the DOJ's statement, they wouldn't have bothered merging in the first place.

I'm not saying that the DOJ should have blocked the merger - not being an expert on the airline industry (although I am an expert on flying on airlines), I defer to those who say mergers are necessary for the health of the industry. But since when did the DOJ become their PR firm?

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October 29, 2008

Economist's View - 5 new articles

Econ Bloggers

From Tyler Cowen:

Econ bloggers gain clout in financial crisis, Marginal Revolution: Here is the article, there is lots from me and from Mark Thoma, among others.

On a more casual note, I've enjoyed blogging the same topic week after week after week. I wonder at what point I will feel like cracking?

I'm not sure the quote about doctors came out quite right:

Are the econ bloggers able to better explain and analyze the often-complex factors that have led to the current crisis?

"I'm in academics," he replied. "On the academics side, you don't ever diagnose the patient. It's all theoretical, and what I'm doing now, especially with the financial crisis, is like having a patient show up at the doctor's office and say, 'I've got these symptoms, what's wrong with me?' And the doctor sticks him. That's a completely different use of economics -- a real time analysis -- that I haven't seen before."

Instead of "and the doctor sticks him," I meant that the doctor is asked to diagnose what is wrong and recommend a prescription - a cure of some sort - that will fix the problem (or explain why no cure is available and the patient will have to suffer through the problem until it fixes itself). You don't have the luxury you have as an academic of waiting until it's all over, looking at the data, and then figuring out how well the policy worked, what could have been done better, etc. Part of real-time policymaking is learning what to look at ("Get me a TED spread, stat!"), and then learning how to interpret the diagnostics that you get so that you can understand what is happening and recommend a course of action. Real-time policy making is not easy, and you find out very fast just how good your models really are, and I've gained a lot of respect for those who do it and do it well since I've started doing this.

As in the medical profession, we need an interface between theory and practice - in economics the gulf has been too wide for too long - and I think blogs are one way the profession has started to close the gap between the theoretical community and policymakers. Practitioners have a lot to learn from the theoretical research in medicine and in economics, but there also has to be a feedback in the other direction where the practitioners can say, "this treatement doesn't work, has the following flaws, etc., and it would work better if..." so that the theorists can provide better tools for polcymakers and other practitioners. The Fed and other policymaers have always had to do this - make policy decisions in real-time - but the process wasn't very visible. With blogs, it's starting to come out into the open, e.g. look what Krugman did on his as policies to abate the financial crisis were proposed, and I think that's a very healthy development.

Fed Cuts Target Rate to 1 Percent

As expected:

Press Release Release Date: October 29, 2008

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

"Destructive Protectionism"

Richard Baldwin:

The bindings that tie trade together, Free Exchange: You know the world is knee deep in it when Jeff Sachs says the International Monetary Fund has a role to play in global governance! More generally, the crisis is proving the worth of our global economic institutions, but one has been woefully under-noticed—the World Trade Organisation.

The WTO is a set of fair-play rules and a list of tariff ceilings that its members have negotiated over the past 60 years (and much else). ...

But the bindings (as ceilings are called in WTO jargon) do not apply to all WTO members. Under a principle called the "Enabling Clause"..., developing nations are bound by only some of their tariffs, and the bound ones have ceilings far above the tariff rates that actually apply today.

This means they are free to snap their tariffs back up to the ceilings—that is, engage in the mutually destructive beggar-thy-neighbour policies of the 1930s. Consider some history.

In the 1997 Asian Crisis ... all five "crisis" countries temporarily raised tariffs in 1998. ... Back then, America played the role of importer-of-last-resort, but this time, even the big boys will be hurting, and likely to pull out the stops when it comes to anti-dumping measures.

I would be very surprised if we don't see this same Prisoner's Dilemma tragedy playing out as the global recession deepens. National politicians, who have not had the wisdom to constrain themselves in the WTO, will find it almost irresistible to attempt to shift demand to local producers by raising tariffs on final goods.

On the bright side, this destructive protectionism will highlight the value of the tariff bindings that developing nations are offering in the Doha Round negotiations. So far, industrialised country exporters have turned their noses up at the tariff bindings offered by developing countries in the negotiation since they often don't lower the actual tariff rates.

In financial terms, tariff bindings are options. The value of options rise with volatility—a fact that will become abundantly clear as recession spreads around the globe via trade accounts.

World leaders should seize the moment and "buy" these options now by finishing the Doha Round negotiations. This would send a great positive signal that they are aware that coordinated action is needed on the current account as well as the capital account.

Shared Appreciation Mortgages

Not too long ago, in response to a suggestion for a mortgage foreclosure voucher program, I said:

Whatever plan is ultimately implemented to stave off foreclosures, should taxpayers demand a share of any profit (equity) the bailed out homeowner makes if the house is sold later, much like the equity stakes taxpayers will have in banks that are bailed out? ...

My impression from comments is that people do not favor this approach.

Here's Andrew Caplin , Thomas Cooley , Noel Cunningham and Mitchell Engler in the WSJ:

We Can Keep People in Their Homes: ...[W]hile the rescue plan may help the balance sheets of financial institutions, it does nothing to help the balance sheets of households. Their problems must be addressed.

The way to do so is through the shared appreciation mortgage, or SAM. The concept is simple: Homeowners are offered the chance to write down a portion of their mortgage debt, but at the same time, they are required to share future appreciation gains with those who helped them out. ...

By the time housing prices stabilize, as many as 20 million households may be upside down on their mortgages, creating incentives to default.

These defaults set in motion a vicious cycle. Foreclosure is a slow and costly process. Foreclosed properties diminish the worth of nearby homes, driving yet more homeowners into default. Taxpayers are the next casualties. ...

The federal government needs to give taxpayers an ownership stake in the future. The SAM does just this. For example, a homeowner unable to support payments on a house purchased for $200,000 that today is worth only $150,000 might be offered a write-down of up to $50,000. But this would not be a free lunch.

With the SAM, once the value began appreciating above $150,000, the mortgage holders would be due their share. ...[O]ne way to give lenders a share of the upside would be to pay back some of the write down if the house is later sold, in the scenario above, for more than $150,000. This is a model in which both parties benefit, preventing default while giving future taxpayers a fighting chance at some real upside to the investment we're forcing on them. ...

The SAM was pioneered by banks in the U.S. some 40 years ago, but it has been allowed to languish due to an archaic, IRS-imposed block. (The IRS hasn't ruled whether such a contract is a mortgage because it combines elements of equity and debt.) This block could be removed at the stroke of the Treasury secretary's pen. ...

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