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March 19, 2009

Economist's View - 7 new articles

Golden Geese

Becker and Murphy:

Do not let the 'cure' destroy capitalism, by Gary Becker and Kevin Murphy, Commentary, Financial Times: Capitalism has been wounded by the global recession, which unfortunately will get worse before it gets better. As governments continue to determine how many restrictions to place on markets, especially financial markets, the destruction of wealth from the recession should be placed in the context of the enormous creation of wealth and improved well-being during the past three decades. Financial and other reforms must not risk destroying the source of these gains in prosperity.

Consider the following extraordinary statistics... World real gross domestic product grew by about 145 per cent from 1980 to 2007, or by an average of roughly 3.4 per cent a year. ... Global health, as measured by life expectancy at different ages, has also risen rapidly, especially in lower-income countries.

Of course, the performance of capitalism must include this recession and other recessions along with the glory decades. Even if the recession is entirely blamed on capitalism, and it deserves a good share of the blame, the recession-induced losses pale in comparison with the great accomplishments of prior decades. ...

Governments should not so hamper markets that they are prevented from bringing rapid growth to the poor economies of Africa, Asia and elsewhere... New economic policies that try to speed up recovery should follow the first principle of medicine: do no harm. ...

The failure of financial innovations such as securities backed by subprime mortgages, problems caused by risk models that ignored the potential for steep falls in house prices and the overload of systemic risk represent clear market failures, although innovations in finance also contributed to the global boom over the past three decades.

The people who made mistakes lost, and many lost big. Institutions that made bad loans and investments had large declines in their wealth, while investors that funded these institutions without proper scrutiny have seen their wealth cut in half or much more. Households that overextended themselves have also been badly hurt.

Given the losses, actors in these markets have a strong incentive to correct their mistakes the next time. In this respect, many government actions have been counterproductive, shielding actors from the consequences of their actions and preventing private sector adjustments. ...

The claim that the crisis was due to insufficient regulation is also unconvincing. For example, commercial banks have been more regulated than most other financial institutions, yet they performed no better... Regulators got caught up in the same bubble mentality as investors and failed to use the regulatory authority available to them. ...

The Great Depression induced a massive worldwide retreat from capitalism, and an embrace of socialism and communism that continued into the 1960s. It also fostered a belief that the future lay in government management of the economy, not in freer markets. The result was generally slow growth during those decades in most of the undeveloped world, including China, the Soviet bloc nations, India and Africa.

Partly owing to the collapse of the housing and stock markets, hostility to business people and capitalism has grown sharply again. Yet a world that is mainly capitalistic is the "only game in town"... We hope our leaders do not deviate far from a market-oriented global economic system. To do so would risk damaging a system that has served us well for 30 years.

When the golden goose is too wild for its own good, you can clip its wings without killing it.

While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people like Kashyap and Mishkin arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

Galbraith: No Return to Normal

Update: Speaking of Jamie Galbraith, he says to watch this Paul O'Neill video:

This is by Jamie Galbraith. There's much, much more in the actual article:

No Return to Normal, by James K. Galbraith, Commentary, Washington Monthly: ...CBO's model is based on the postwar experience,... if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don't capture the key feature of that crisis—which is, precisely, the collapse of the financial system. ... Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt's ambition exceeded anything yet seen in this crisis:

[Roosevelt's] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York's Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country's entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

The New Deal rebuilt America physically, providing a foundation (the TVA's power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. ... If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn't overcome until the war ended.

It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. ... But the relaunching of private finance took twenty years, and the war besides.

A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

That being so, what must now be done?

The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief,... except in cases of speculative investment and borrower fraud. ...

Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income... For an increasing number of the elderly, Social Security and Medicare wealth are all they have. That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. ...

This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. ... In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.

Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?

Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. ...

As these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced—it is a good thing that they will encourage those at the top to retire. ...

Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. ...

Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they've lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years. Today the largest problems we face are energy security and climate change... And here, obviously, we need a comprehensive national effort. ...

This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.

A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.

"The Judgments of the Market are True and Righteous Altogether"

Christopher Carroll with an evidence based rebuttal to the "risk-is-holy view" advocating a free market, hands off approach to the financial crisis, and a call for the Fed to do what it always does in a crisis, manage the price of risk (which means going beyond measures such as the purchase of long-term government securities and taking risky assets onto the Fed's balance sheet):

Punter of last resort, Christopher D. Carroll, Vox EU: The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the "price of risk" is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that "If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether."

The deep origins of the cult, as always, are obscure; presumably they lie properly in the field of psychoanalysis. But to the extent that overt origins can be traced, the wellspring is the literature that attempts to explain the Mehra and Prescott (1985) 'equity premium puzzle.' The 'puzzle,' in a nutshell, is that asset prices have not, historically, exhibited a relationship between risk and return that is easy to reconcile with the rational behavior of a representative agent facing perfect markets. Many of the responses to this challenge start with the assumption that asset prices must be always and everywhere rational, and then proceed to work out the kind of preferences or environment that can rationalize observed prices. This game brings to mind Joan Robinson's comment that "utility maximization is a metaphysical concept of impregnable circularity," and Larry Summers's remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent's utility function was not a particularly good day for economic science. Oddly, even the failure of this literature to produce a widely agreed solution to the 'puzzle' does not seem to have weakened participants' belief in the soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect reflect the actual past practice of economic policymaking during crises. As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the "lender of last resort" role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today's terminology, 'an increase in the price of risk').1

Some economists, of course, view narrative history in the DeLong and Kindleberger mode as irrelevant to the practice of their science; they prefer hard numbers to mere narrative. For the numerically inclined, however, Figures 1a and 1b should be persuasive; they show that controlling a market price of risk is something the Federal Reserve has done since it first opened up shop. The top figure depicts a measure of what we are now pleased to call the 'risk-free' rate of interest in the United States – essentially, the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed.2 Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as 'risk-free' is that the Fed takes away the risk.3

Figure 1a Carroll1

Figure 1b Carroll2

Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last? It was, after all, the intolerable stresses caused by financial panics that ultimately led to the founding of the Federal Reserve, in the face of adamant opposition from people holding financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are eerily similar to dogmas that continue to be propounded today. The panic of 1907, in which J.P. Morgan effectively stepped in as a private lender of last resort, constituted the last straw for the unregulated financial system that preceded the managing of risky rates that we have had since the creation of the Fed.

A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all. But there is, at least, a perception that this way of operating is hallowed by time and practice: Since the Fed, the story goes, has spent most of its history ignoring risk, it shouldn't change that now.

But even this milder dogma does not match the facts. Recent work by Robert Barbera, Charles Weise, and David Krisch,4 shows that over the "Taylor Rule" era of systematic monetary policy (roughly since 1984), the Federal Reserve's choice of the short run interest rate has been powerfully correlated to market-based measures of risk such as the difference between the interest rates on corporate bonds and corresponding maturity Treasuries. When risk has been high, the Fed has felt the need to stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed's pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed's balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond perhaps some purchases of longer-dated Treasury securities, are not the voices of reason; they represent a howling dogma that was discredited in 1844 (when the Bank of England received its first implicit authority to intervene during panics; see DeLong (2008)), was discredited again in the panic of 1907, and again during the Great Depression (by being adopted in an extreme form), and is in the process of being discredited yet again today. (In fairness, during ordinary times it is probably wise for the authorities to avoid attempting systematic manipulation of the price of risk, for all the reasons Kindleberger (2005) and Robert Peel (1844) articulated. But this is no ordinary time).

Let's put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future.5 The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets. While I realize that some economists (and some politicians) might be willing even to undergo another Great Depression as the steep price of clinging to their faith, those of us who do not share that faith should not have to suffer such appalling consequences.

As the Economist magazine might put it, the problem is that the 'punters' (investors) who normally populate the financial marketplace and risk their fortunes for the prospect of return, have fled from the field in terror. Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the 'lender of last resort' to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed's appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks; it needs, in other words, to step up to the plate and become the punter of last resort.


Barbera, Robert J., and Charles L. Weise (2008): "Minsky Meets Wicksell: Using the Wicksellian Model to Understand the 21st Century Business Cycle," Manuscript, Gettysburg College.

DeLong, J. Bradford (2008): "Republic of the Central Banker," The American Prospect.

Holland, A. Steven, and Mark Toma (1991): "The Role of the Federal Reserve as "Lender of Last Resort" and the Seasonal Fluctuation of Interest Rates," Journal of Money, Credit and Banking, 23(4), 659–676.

Kindleberger, Charles P. (2005): Manias, Panics, and Crashes: A History of Financial Crises. Wiley, 5th Edition.

Macaulay, Frederick R. (1938): The Movements of Interest Rates, Bond Yields and Stock Prices in the United States Since 1856. National Bureau of Economic Research, New York.

Mehra, Rajnish, and Edward C. Prescott (1985): "The Equity Premium: A Puzzle," Journal of Monetary Economics, 15, 145–61.

Weise, Charles L., and David Krisch (2009): "The Monetary Response to Changes in Credit Spreads," Paper Presented at the Eastern Economic Meetings, March 1 2009.

"People are Hanging Tight"

The end of the great migration:

U.S. Migration Falls Sharply, by Conor Dougherty, WSJ: Migration around the U.S. slowed to a crawl last year ... as a weak housing market and job insecurity forced many Americans to stay put.

Demographers say the dropoff in migration, shown in Census data to be released Thursday, is among the sharpest since the Great Depression. It marks the end of what Brookings Institution demographer William Frey calls a "migration bubble."

As asset values rose fairly steadily in the past decade, Americans young and old moved around the country in search of jobs or better weather. In many cases, people living in higher-cost housing markets such as San Francisco and New York cashed in their real-estate winnings and moved to outlying counties, or to states like Florida and Nevada, hoping to find a cheaper house and pocket the difference. Now, "people are hanging tight; they're too scared to do anything," said Mr. Frey. ...

Migration typically slows during recessions. But in past downturns, the slowdown has been more regional in scope, with workers fleeing weaker job markets for places where companies were still hiring. ... What's unique this time is migration has slowed almost everywhere. The sharpest year-to-year changes were among what demographers call "domestic migrants," people who moved within the U.S. ... The Census data show that the biggest falloffs were in the worst housing markets. ...

Having a key resource - labor - largely frozen in place doesn't help the economy at all. People are in no mood to take risks by moving to a new job, they probably can't find a job anyway, and if they do, will they be able to sell their house? And if all that goes right, they find a job, it's a good enough opportunity to be a risk they're willing to take, and they found a buyer for their house, will the loan be so far underwater that they can't afford to sell it?

links for 2009-03-19

"Selfish Punishment"

How does altruism survive?:

Thriving on Selfishness, by Marina Krakovsky, Scientific American: It's the altruism paradox: If everyone in a group helps fellow members, everyone is better off—yet as more work selflessly for the common good, cheating becomes tempting, because individuals can enjoy more personal gain if they do not chip in. But as freeloaders exploit the do-gooders, everybody's payoff from altruism shrinks.

All kinds of social creatures, from humans down to insects and germs, must cope with this problem; if they do not, cheaters take over and leech the group to death. So how does altruism flourish? Two answers have predominated...: kin selection, which explains altruism toward genetic relatives—and reciprocity— the tendency to help those who have helped us. Adding to these solutions, evolutionary biologist Omar Tonsi Eldakar came up with a clever new one: cheaters help to sustain altruism by punishing other cheaters, a strategy called selfish punishment.

"All the theories addressed how altruists keep the selfish guys out," explains Eldakar... Because selfishness undermines altruism, altruists certainly have an incentive to punish cheaters—a widespread behavior pattern known as altruistic punishment. But cheaters, Eldakar realized, also have reason to punish cheaters...: a group with too many cheaters does not have enough altruists to exploit. ... That is why, he points out, some of the harshest critics of sports doping, for example, turn out to be guilty of steroid use themselves: cheating gives athletes an edge only if their competitors aren't doing it, too. ...

In a colony of tree wasps..., a special caste of wasps sting other worker wasps that try to lay eggs, even as the vigilante wasps get away with laying eggs themselves. In a strange but mutually beneficial bargain, punishing other cheaters earns punishers the right to cheat. ...

[T]he idea of a division of labor between cooperators and policing defectors appeals to Pete Richerson, who studies the evolution of cooperation at the University of California, Davis. "It's nothing as complicated as a salary, but allowing the punishers to defect in effect does compensate them for their services in punishing other defectors...," he says. After all, policing often takes effort and personal risk, and not all altruists are willing to bear those costs.

Corrupt policing may evoke images of the mafia, and indeed Eldakar notes that when the mob monopolizes crime in a neighborhood, the community is essentially paying for protection from rival gangs—a deal that, done right, lowers crime and increases prosperity. But mob dynamics are not always so benign... "What starts out as a bunch of goons with guns willing to punish people [for breaching contracts] becomes a protection racket," Richerson says. The next question, therefore, is, What keeps the selfish punishers themselves from overexploiting the group?

Wilson readily acknowledges this limitation of the selfish punishment model..., "there's nothing telling us that that mix is an optimal mix," he explains. The answer to that problem, he says, is competition not between individuals in a group but between groups. That is because whereas selfishness beats altruism within groups, altruistic groups are more likely to survive...

"China Toys With Biting Hand Feeding Its Surplus"

John Berry:

China Toys With Biting Hand Feeding Its Surplus, by John M. Berry, Bloomberg: If Chinese Premier Wen Jiabao is so worried about the safety of China's investment in U.S. Treasury securities, he can order the money be moved elsewhere.

Of course, that likely would drive down the value of the dollar, push up U.S. interest rates and cause huge losses in China's $700 billion portfolio of Treasuries.

The reality is that Wen and China are stuck. They have no viable alternative so long as China continues to accumulate large amounts of foreign currencies as a result of its big trade surplus. ... [C]ontinuation of a big trade surplus is ... critical to China -- something Wen conveniently forgets. ...

There will still be a large deficit to be financed, and China and the U.S. will still be intertwined both economically and financially. Wen must know that.

What he doesn't seem to accept is that anything he and other senior Chinese officials do to raise questions about U.S. creditworthiness or the value of the dollar could come back to haunt them.

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