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March 9, 2009

Economist's View - 4 new articles

"Did Lehman Brothers's Failure Matter?"

James Surowiecki takes on John Taylor:

Did Lehman Brothers's Failure Matter?, The Financial Page: By this point, it's become conventional wisdom that the failure of Lehman Brothers last September was the catalyst for a massive selloff in the credit and stock markets and a general flight to safety from which the markets have yet to recover. ...

In the past few days, though, a new meme has started circulating through the economics blogosphere, suggesting that Lehman's failure actually did not wreak the havoc that everyone who lived through last September thought it wreaked. This argument ... is based on a paper ... by the Stanford economist John Taylor, which purports to show (pdf) that the credit markets actually did not react all that badly to Lehman going under, and that the crisis was really the product of market uncertainty about the effects of government action. Taylor's conclusion is based on one piece of evidence: a graph of the 3-Month LIBOR...

The problem is that the graph that Taylor relies on as his only piece of evidence (it's on p. 16 of his paper) doesn't demonstrate what he thinks it does. In fact, LIBOR rose sharply in the days just before Lehman failed—evidence that even the prospect of Lehman going under had people worried. It then dropped a little when AIG was rescued, but then went straight up again, so that in the seven days leading up to and just after Lehman's failure, LIBOR nearly doubled. That's hardly a sign of the market shrugging off the incident.

More important, Taylor's assumption in his paper is that investors would have known right away how severe the repercussions of Lehman's bankruptcy would be. But this is simply untrue—for whatever reasons (some suggest fraud, others panic), the hole in Lehman's balance sheet was much bigger than people initially thought... As the magnitude of the losses became clearer, so too did banks' risk aversion, since Lehman's failure seemed to demonstrate starkly the risks of lending to any other big financial institution.

In any case, no one is arguing that Lehman's failure alone was responsible for investors' flight from risk... But it was the first, and crucial, moment in last fall's market panic... In this case, then, conventional wisdom seems to be right. And in thinking about what Lehman's failure tells us about how we should deal with tottering financial institutions today, I think Paul Krugman put it well a couple of weeks ago: "The collapse of Lehman Brothers almost destroyed the world financial system, and we can't risk letting much bigger institutions like Citigroup or Bank of America implode."

This may seem like an academic debate. But it's not, because those who want to convince us that Lehman's failure was not a big deal are doing so in order to shape future policy. In other words, they are arguing that when it comes to institutions like, say, Citigroup, the government can, in fact, let them implode ... without any disastrous effects. Maybe they're right, but it's an awful big gamble to take on the basis of a single, dubiously-interpreted graph.

I'm with those who believe that letting Lehman fail was a big mistake.


Paul Krugman: Behind the Curve

[Behind the Curve, by Paul Krugman, Commentary, NY Times]

I've heard people say the debate over the size of the stimulus package was misrepresented in the media, that the media rarely presented the view that the plan was too small.

President Obama's plan to stimulate the economy was "massive," "giant," "enormous." So the American people were told... Watching the news, you might have thought that the only question was whether the plan was too big, too ambitious.

Yet many economists, myself included, actually argued that the plan was too small and too cautious. The latest data confirm those worries — and suggest that the Obama administration's economic policies are already falling behind the curve.

Why do you say that? Won't his plan create millions of jobs?

Mr. Obama's promise that his plan will create or save 3.5 million jobs by the end of 2010 looks underwhelming, to say the least. It's a credible promise... But 3.5 million jobs almost two years from now isn't enough in the face of an economy that has already lost 4.4 million jobs, and is losing 600,000 more each month.

Ah, I see. Even though it's likely to create 3.5 million jobs as promised, it's still millions short of what is needed. So how do we improve the plan?

There are now three big questions about economic policy. First, does the administration realize that it isn't doing enough? Second, is it prepared to do more? Third, will Congress go along with stronger policies?

What are the answers?

On the first two questions, I found Mr. Obama's latest interview with The Times anything but reassuring.

"Our belief and expectation is that we will get all the pillars in place for recovery this year," the president declared — a belief and expectation that isn't backed by any data or model I'm aware of. ... And there was no hint in the interview of readiness to do more.

Do you mean he doesn't seem ready to do more in terms of fiscal policy, or that he's not ready to do more of anything, in particular, more to help the banking system recover?

A real fix for the troubles of the banking system might help make up for the inadequate size of the stimulus plan... But he went on to dismiss calls for decisive action... As I read it, this dismissal — together with the continuing failure to announce any broad plans for bank restructuring — means that the White House has decided to muddle through on the financial front, relying on economic recovery to rescue the banks rather than the other way around. And with the stimulus plan too small to deliver an economic recovery ... well, you get the picture.

Yep. It's like one of those bad dreams where your feet won't move fast enough to get away from the impending doom closing in on you. Will the administration wake up and get moving?

Sooner or later the administration will realize that more must be done. But when it comes back for more money, will Congress go along?

One side won't, that's pretty clear, and I'm not so sure about the Democratic side of the aisle either.

Republicans are now firmly committed to the view that we should do nothing to respond to the economic crisis, except cut taxes — which they always want to do... If Mr. Obama comes back for a second round of stimulus, they'll respond not by being helpful, but by claiming that his policies have failed.

And if there are any small successes to point to Republicans will, of course, insist it was because of the tax cuts in the first round of stimulus. Where does the public stand at this point?

The broader public ... favors strong action. ... But will that support still be there, say, six months from now?

I wouldn't count on it.

Also, an overwhelming majority believes that the government is spending too much to help large financial institutions. This suggests that the administration's money-for-nothing financial policy will eventually deplete its political capital.

I don't suppose we can borrow political capital from China?

So here's the picture that scares me: It's September 2009, the unemployment rate has passed 9 percent, and despite the early round of stimulus spending it's still headed up. Mr. Obama finally concedes that a bigger stimulus is needed.

And at that point, he begins pushing a new plan?

But he can't get his new plan through Congress because approval for his economic policies has plummeted, partly because his policies are seen to have failed, partly because job-creation policies are conflated in the public mind with deeply unpopular bank bailouts. And as a result, the recession rages on, unchecked.

Would you bet some of your Nobel money on that prediction?

O.K., that's a warning, not a prediction. But economic policy is falling behind the curve, and there's a real, growing danger that it will never catch up.


"Seeds of its Own Destruction"

Martin Wolf looks at some of the ways the world may change in response to the crisis:

Seeds of its own destruction, by Martin Wolf , Commentary, Financial Times: ...In the west, the pro-market ideology of the past three decades was a reaction to the perceived failure of the mixed-economy, Keynesian model of the 1950s, 1960s and 1970s. The move to the market was associated with the election of Reagan ... in 1980 and the ascent to the British prime ministership of Margaret Thatcher the year before. ...

Today, with a huge global financial crisis and a synchronised slump in economic activity, the world is changing again. ... If the financial system has failed, what remains of confidence in markets? It is impossible at such a turning point to know where we are going. ... We are witnessing the deepest, broadest and most dangerous financial crisis since the 1930s. ...

Among the possible outcomes of this shock are: massive and prolonged fiscal deficits...; a prolonged world recession; a brutal adjustment of the global balance of payments; a collapse of the dollar; soaring inflation; and a resort to protectionism. The transformation will surely go deepest in the financial sector itself. ... After the crisis, we will surely "see finance less proud", as Winston Churchill desired back in 1925. Markets will impose a brutal, if temporary, discipline. Regulation will also tighten. ...

No less likely are big changes in monetary policy. ... Yet a huge financial crisis, together with a deep global recession, if not something far worse, is going to have much wider effects than just these. ...

One transformation that can already be seen ... is a ... shift in attitudes towards inequality: vast rewards were acceptable in return for exceptional competence; as compensation for costly incompetence, they are intolerable. Marginal tax rates on the wealthier are on the way back up.

Yet another impact will be on the sense of insecurity. ... The search for security will strengthen political control over markets. A shift towards politics entails a shift towards the national, away from the global. ... protectionist intervention is likely...

The impact of the crisis will be particularly hard on emerging countries: the number of people in extreme poverty will rise, the size of the new middle class will fall and governments of some indebted emerging countries will surely default. ... Helping emerging economies through a crisis for which most have no responsibility whatsoever is a necessity.

The ability of the west in general and the US in particular to influence the course of events will also be damaged. The collapse of the western financial system, while China's flourishes, marks a humiliating end to the "uni-polar moment". As western policymakers struggle, their credibility lies broken. Who still trusts the teachers?

These changes will endanger the ability of the world not just to manage the global economy but also to cope with strategic challenges: fragile states, terrorism, climate change and the rise of new great powers. ...

On June 19 2007, I concluded an article on the "new capitalism" with the observation that it remained "untested". The test has come: it failed. The era of financial liberalisation has ended. Yet, unlike in the 1930s, no credible alternative to the market economy exists and the habits of international co-operation are deep. ... The world of the past three decades has gone. Where we end up, after this financial tornado, is for us to seek to determine.


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