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May 9, 2009

Economist's View - 6 new articles

"Are We Turning Japanese?"


Are We Turning Japanese?, by James Surowiecki: Over the past few days, the idea that the Obama Administration's failure to nationalize the banks may very well doom the U.S. economy to the kind of Lost Decade that Japan endured has become ubiquitous. (Here are Paul Krugman, Joseph Stiglitz, Mark Thoma, and Atrios on the danger of turning Japanese.) In the wake of the stress-test results, it's become obvious to everyone that the Administration is counting on banks to earn their way out of trouble—recapitalizing themselves over the next couple of years via profits. But the skeptics suggest that this is a recipe for disaster, because this didn't work in Japan, where banks that had been propped up by the government were never able to earn their way back to health, eventually requiring the government to step in and take more decisive action. ...

As I've said before, there's something peculiar about the repeated insistence that Japan's experience demonstrates that the Obama approach can't work. Japanese banks may not have been able to earn their way out of trouble in the nineteen-nineties, but American banks did, in both the early nineteen-eighties and the early nineteen-nineties. ...

The assumption behind the invocations of Japan is that the problem with the Japanese economy in the nineteen-nineties was that because the banks were zombies, they weren't able to lend enough to get the economy moving again, and so it stayed stuck in neutral. ... But let's accept for the sake of argument that if Japan's banks had been healthier, the economy would have been significantly stronger. The question, then, is: Why did Japan's banks stay so weak? In other words, why weren't they able, as U.S. banks have been, to earn their way out of trouble?

The conventional answer to that question is the zombie explanation. The real answer is that Japan's banks kept rolling over bad loans to weak borrowers. As this paper by Joe Peek and Eric Rosengreen shows, during the nineteen-nineties, Japanese banks constantly "evergreened"—they kept extending additional credit to companies that already had loans with them. By extending credit, the banks enabled weak corporate borrowers to keep making their interest payments, and to put off bankruptcy. That made the banks' balance sheets look better, and also kept companies afloat. The economists Ricardo Caballero, Takeo Hoshi, and Anil Kashyap, in fact, found that thirty per cent of publicly-traded firms were "on life support from banks in the early 2000s."

Evergreening had two effects. First, because the borrowers had little chance of ever actually paying off their debts (because their underlying businesses were so weak), it kept Japan's economy from making the adjustments necessary to start growing again. ... Second, it limited Japanese banks' profitability, because it effectively meant that, instead of making good new loans, they were constantly throwing good money after bad. As a result, they were never able to earn their way back to health. ...

In thinking about the relevance of the Japanese experience to our own, what's important to note is that Japanese banks did not engage in evergreening solely because it temporarily improved their balance sheets. Rather, they did so because social norms and explicit government pressure encouraged them to do so. ... In fact, Peek and Rosengren point out that government-controlled banks were more likely, not less, to keep extending credit to weak firms.

While U.S. banks have come under political attack at various times for being too tough on borrowers, there's been no concerted attempt to force them to evergreen. And, in contrast to Japanese banks, U.S. banks have proved more than willing in the past to be tough on old borrowers even while extending new loans. The result has been that at times like now—when net profit margins on loans are high—they have been able to become tremendously profitable, and to, in fact, earn their way out of trouble, as the Obama Administration is counting on. Unless you think that this is going to change—that U.S. banks are going to start evergreening their loans, and continuing to pile up new bad debts—then it seems unlikely that we're really heading down the road that Japan took.

My point has never been that the current strategy to fix the banking system cannot work. I've argued that it might work, and it's cheaper and more politically expedient than nationalization. But we don't know for sure that it will work, and it's not the fastest or most certain way to end the problems in the financial sector. But we didn't choose to nationalize, and now that we are now on the banks can "earn their way out of trouble" path, the politics and budgetary cost of changing course are prohibitive. That's what makes us likely to "muddle along" should the present course of action fail to produce the desired results. We didn't choose the optimal solution to begin with, and we are unlikely to move there any time soon even if the present policies fail, as I think they might. Instead, we'll keep hearing we're almost there and just a little more time and a few more dollars ought to do it and continue to prop up the system. That's why I hope the policies do work, and work well, because if they don't, there are no practical alternative choices to "the muddle-through strategy."

"The Failure of the Economy & the Economists"

A much shortened version of Benjamin Friedman review of Akerlof and Shiller's Animal Spirits: and Shiller's The Subprime Solution:

The Failure of the Economy & the Economists, by Benjamin M. Friedman, NYRB, Review of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof and Robert J. Shiller; and The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It by Robert J. Shiller: By now there are few people who do not acknowledge that the major American financial institutions and the markets they dominate turn out to have served the country badly in recent years. ...

But despite the universal agreement that no one wants any more such failures once this one has passed, there is a troubling lack of attention to reforms that might prevent such a crisis from recurring. ... As in past financial declines, what is sorely missing in this discussion is attention to what function the financial system is supposed to perform in the economy and how well it has been doing it. ... Another fundamental issue that the current discussion has overlooked almost entirely is the distinction between the losses to banks and other lenders that reflect genuine losses of wealth to the economy, and other losses that don't. ...

Why has there been so little discussion of fundamental issues like this distinction among losses? Why is so little said about the trade-off between the goal of allocating the economy's capital efficiently and the need to shrink the enormous costs of the financial industry in doing so? One obvious reason is political. There is a long arc from Roosevelt's acceptance of a useful role for government institutions and government regulation to the conviction of Reagan and Thatcher that the government is never the solution but actually the problem. A second, closely related reason is ideological: the faith, personified by Alan Greenspan with his early dedication to the writings of Ayn Rand and his staunch opposition to regulations while chairman of the Federal Reserve, that private, profit-driven economic activity is self-regulating and, when necessary, self-correcting.

The economists George Akerlof and Robert Shiller suggest a third reason. In their view, the problem is also intellectual—a systematic failure of thinking on the part of their fellow economists. Taking the title of their new book from a phrase famously used by John Maynard Keynes, Akerlof and Shiller argue that what is missing in the worldview of today's economists is sufficient attention to "animal spirits," by which they mean the psychological and even irrational elements that figure importantly in so many other familiar aspects of personal choices and personal behavior, and that, they believe, pervade economic behavior too.

Akerlof and Shiller identify five distinct elements in what they call "animal spirits": confidence, or the lack of it; concern for fairness, that is, for how people think they and others should behave—for example, that a hardware store shouldn't raise the price of snow shovels after a blizzard despite the increased demand; corruption and other tendencies toward antisocial behavior; "money illusion," meaning susceptibility to being misled by purely nominal price movements that, because of inflation or deflation, do not correspond to real values; and reliance on "stories"—for example, inspirational accounts of how the Internet led to a "new era" of productivity. The omission of these five aspects of "animal spirits," they argue, blocks conventional economics from either understanding today's crisis or providing useful ideas for dealing with it. ...

[T]he ... question is whether Akerlof and Shiller succeed in making more of the different kinds of research they report on in Animal Spirits than the sum of the book's disparate parts. The answer is yes in some respects, no in others.

They succeed in demonstrating both the narrowness of mainstream macroeconomic thinking in recent decades and the stranglehold that this thinking has placed on the economics profession's ability either to explain phenomena like today's crisis or to advance potential solutions. ...

Akerlof and Shiller succeed, too, in demonstrating that conventional macroeconomic analyses often fail because they omit not just readily observable facts like unemployment and institutions such as credit markets but also harder-to-document behavioral patterns that fall within the authors' notion of "animal spirits." Confidence plainly matters, and so does the absence of it. ...

As they argue, these effects can plausibly be larger than the fluctuations attributable to more concrete factors, such as monetary policy or oil prices, that economists more typically incorporate in their analysis. Money illusion, by which people are influenced by purely nominal price movements, is also clearly important to some aspects of how the economy in aggregate behaves. ...

The effort to "clean up macroeconomics and make it more scientific," to impose "research structure and discipline," has proved disastrously confining. But what then? Is there more to Animal Spirits than a list of important influences for economists to try to take into account? Akerlof and Shiller believe they have proposed a new model for macroeconomic analysis. ...

There is a difference between a series of ideas about different aspects of economic behavior and an integrated account of macroeconomic fluctuations. Akerlof and Shiller are surely on the right track in pointing to elements that are missing from today's conventional models, and in arguing that incorporating them into mainstream macroeconomic analysis would help. But they have neither done this nor shown others how to. Hence their goal of replacing what macroeconomists teach their students is likely to be disappointed, at least for now.

And because what they have here is a set of examples of how "animal spirits" matter for specific aspects of economic behavior, not a coherently worked out theory of how the macroeconomy behaves, it is not surprising that Animal Spirits is also thin on suggestions for what to do about the current crisis. ...

But their silence on ... policy issues and their lack of a full-blown "theory" to replace the strait-jacketed macroeconomics of the past few decades do not undercut the force of Akerlof and Shiller's central argument. Their harsh judgment of current mainstream macroeconomic thinking is true, and they are right about the importance of what they call "animal spirits" to many of its crippling shortcomings. Animal Spirits provides an agenda for new thinking, and one well worth pursuing. ... [full article]

Paul Krugman: Stressing the Positive

Will "the muddle-through strategy" work?:

Stressing the Positive, by Paul Krugman, Commentary, NY Times: Hooray! The banking crisis is over! Let's party! O.K., maybe not.

In the end, the actual release of the much-hyped bank stress tests ... came as an anticlimax. Everyone knew more or less what the results would say: some big players need to raise more capital, but over all, the kids, I mean the banks, are all right. Even before the results were announced, Tim Geithner ... told us they would be "reassuring."

But whether you actually should feel reassured depends on who you are: a banker, or someone trying to make a living in another profession. ... What we're really seeing here is a decision on the part of President Obama and his officials to muddle through the financial crisis, hoping that the banks can earn their way back to health.

It's a strategy that might work. After all, right now the banks are lending at high interest rates, while paying virtually no interest on their (government-insured) deposits. Given enough time, the banks could be flush again.

But it's important to ... understand ... that ... the financial system won't function normally until the crucial players get much stronger financially than they are now. Yet the Obama administration has decided not to do anything dramatic to recapitalize the banks.

Can the economy recover even with weak banks? Maybe. Banks won't be expanding credit any time soon, but government-backed lenders have stepped in to fill the gap. ... So maybe we can let the economy fix the banks instead of the other way around.

But there are many things that could go wrong. It's not at all clear that credit from the Fed, Fannie and Freddie can fully substitute for a healthy banking system. If it can't, the muddle-through strategy will turn out to be a recipe for a prolonged, Japanese-style era of high unemployment and weak growth.

Actually, a multiyear period of economic weakness looks likely in any case..., it's very hard to see where a real recovery will come from. And if the economy does stay depressed for a long time, banks will be in much bigger trouble than the stress tests — which looked only two years ahead — are able to capture.

Finally, given the possibility of bigger losses in the future, the government's evident unwillingness either to own banks or let them fail creates a heads-they-win-tails-we-lose situation. If all goes well, the bankers will win big. If the current strategy fails, taxpayers will be forced to pay for another bailout.

But what worries me most ... is ... my sense that the prospects for fundamental financial reform are fading.

Does anyone remember the case of H. Rodgin Cohen...? He briefly made the news in March when he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary.

Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won't be very different from its recent past, declaring, "I am far from convinced there was something inherently wrong with the system." Hey, that little thing about causing the worst global slump since the Great Depression? Never mind.

Those are frightening words. They suggest that while the Federal Reserve and the Obama administration continue to insist that they're committed to tighter financial regulation and greater oversight, Wall Street insiders are taking the mildness of bank policy so far as a sign that they'll soon be able to go back to playing the same games as before.

So as I said, while bankers may find the results of the stress test "reassuring," the rest of us should be very, very afraid.

Stiglitz: The Spring of the Zombies

More on "the muddle-through strategy":

The Spring of the Zombies , by Joseph Stiglitz, Commentary, Project Syndicate: As spring comes to America, optimists are seeing "green sprouts" of recovery... The good news is that we may be at the end of a free fall. The rate of economic decline has slowed. The bottom may be near - perhaps by the end of the year. But that does not mean that the global economy is set for a robust recovery any time soon. Hitting bottom is no reason to abandon the strong measures that have been taken to revive the global economy.

This downturn is complex: an economic crisis combined with a financial crisis. Before its onset, America's debt-ridden consumers were the engine of global growth. That model has broken down, and will not be replaced soon. ... The collapse of credit made matters worse; and firms, facing high borrowing costs and declining markets, responded quickly, cutting back inventories. Orders dropped abruptly ...

We are likely to see a recovery in some of these areas... But examine the fundamentals:... real estate prices continue to fall, millions of homes are underwater..., and unemployment is increasing... States are being forced to lay off workers as tax revenues plummet.

The banking system has just been tested to see if it is adequately capitalized - a "stress" test that involved no stress - and some couldn't pass muster. But, rather than welcoming the opportunity to recapitalize, perhaps with government help, the banks seem to prefer a Japanese-style response: we will muddle through.

"Zombie" banks - dead but still walking among the living - are, in Ed Kane's immortal words, "gambling on resurrection." Repeating the Savings & Loan debacle of the 1980's. the banks are using bad accounting... Worse still, they are being allowed to borrow cheaply from the United States Federal Reserve, on the basis of poor collateral, and simultaneously to take risky positions. ...

The American government, too, is betting on muddling through: the Fed's measures and government guarantees mean that banks have access to low-cost funds, and lending rates are high. If nothing nasty happens - losses on mortgages, commercial real estate, business loans, and credit cards - the banks might just be able to make it through... In a few years time, the banks will be recapitalized, and the economy will return to normal. This is the rosy scenario.

But experiences around the world suggest that this is a risky outlook. Even were banks healthy, the deleveraging process and the associated loss of wealth means that, more likely than not, the economy will be weak. And a weak economy means, more likely than not, more bank losses. ...

Fixing the financial system is necessary, but not sufficient, for recovery. America's strategy for fixing its financial system is costly and unfair, for it is rewarding the people who caused the economic mess. But there is an alternative...: a debt-for-equity swap.

With such a swap, confidence could be restored to the banking system, and lending could be reignited with little or no cost to the taxpayer. It's neither particularly complicated nor novel. Bondholders obviously don't like it - they would rather get a gift from the government. But there are far better uses of the public's money, including another round of stimulus. ...

In spite of some spring sprouts, we should prepare for another dark winter: it's time for Plan B in bank restructuring and another dose of Keynesian medicine.

Stress Tests


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