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June 19, 2009

Economist's View - 4 new articles

Samuelson: Fiscal Policy Must be Sustained

A few excerpts from the second part of Conor Clarke's interview with Paul Samuelson:

I have a couple of questions about the current debate. Do you think large fiscal stimulus should be controversial? ... Would you like to see a second or third stimulus, depending on where you start counting?

Well, in the first place, the E. Carey Brown analysis stressed that one shot spending gives you only one-shot response. It's gotta be sustained. The way we got out of the 1929 Great Depression in the US -- and this happened not only in the US but also in Germany... --- was heavy deficit spending. ...

For really depressed situations, unorthodox central banking is [also] needed. We're almost getting there. In one of Greg Mankiw's articles, he said that maybe when the interest rate gets down to zero and it's threatening to be negative, you should give a subsidy with it. Well, that's what fiscal policy is!

By the way, I don't want you to think that I think that everything for the next 15 years will be cozy. I think it's almost inevitable that, with a billion people in China wide awake for the first time, and a billion people in India, there's going to be some kind of a terrible run against the dollar. And I doubt it can stay orderly, because all of our own hedge funds will be right in the vanguard of the operation. And it will be hard to imagine that that wouldn't create different kind of meltdown.

Last thing. Mea culpa, mea culpa. MIT and Wharton and University of Chicago created the financial engineering instruments, which, like Samson and Delilah, blinded every CEO -- they didn't realize the kind of leverage they were doing and they didn't understand when they were really creating a real profit or a fictitious one. ...

Back to some middle-term and long-term policy questions..., do you worry about the rising deficit and the potential risk of inflation? There's been a lot of articles on this in the past two weeks -- Paul Krugman and Niall Ferguson and others.

I think it would be surprising if, down the road -- not in the long long run but in the somewhat short run -- we don't have some return of inflation. On the other hand, I'm of the view that if we come out of this with some kind of temporary stabilization at least, and the price level is let's say 10-12% above what it was before we got into the meltdown, I think that's a price I would be willing to pay! ...

Very last thing. What would you say to someone starting graduate study in economics? Where do you think the big developments in modern macro are going to be, or in the micro foundations of modern macro? Where does it go from here and how does the current crisis change it?

Well, I'd say, and this is probably a change from what I would have said when I was younger: Have a very healthy respect for the study of economic history, because that's the raw material out of which any of your conjectures or testings will come. And I think the recent period has illustrated that. ...

But history doesn't tell its own story. You've got to bring to it all the statistical testings that are possible. And we have a lot more information now than we used to.

Are you happy with the way economics is being taught now? You've mentioned Greg Mankiw's textbooks.

Well to say that I've read them would be an exaggeration. I looked into them, and I was disappointed that they were so bland. [Laughs] No, he's a gifted writer. But an economist with a facile pen isn't necessarily an overnight expert on the likelihoods in our inexact science.

Don't "Nullify" Fiscal Policy

My entry at the Romer Roundtable:

Don't "Nullify" Fiscal Policy, by Mark Thoma: When deciding between two alternatives such as whether the government should intervene in the economy with a fiscal stimulus or not, the choice of the null and alternative hypotheses influences the type of errors we are likely to make.

A standard example to illustrate this is the problem of deciding guilt and innocence. If we make guilt the null hypothesis, and only reject the null when there is overwhelming evidence to the contrary, then we are going to find people guilty unless there is enough evidence presented to convince jurors the person did not act as charged. The biggest risk here is that innocent people will be sent to jail since innocence must be established through overwhelming evidence, but guilt is presumed. It's possible that a guilty person will be found innocent, but the more evidence that we require to find someone innocent—e.g. a strict standard like beyond a reasonable doubt—the smaller the chance that the guilty will be set free.

If we make innocence the null hypothesis, then things are reversed. In this case we will only send someone to jail if the evidence overwhelmingly points to guilt, so the biggest risk under this null is that guilty people will be found innocent. Again, it's possible that an innocent person will be found guilty, but the system requires a high burden of proof so as to minimise the possibility of this happening.

In the US, we think sending innocent people to jail is a bigger mistake than setting guilty people free, so we make innocence the null hypothesis in court cases rather than guilt, and we require a high level of "proof" before rejecting the null. (When money rather than freedom is at stake as in civil cases, the standard for conviction is often lower. This causes more innocent people to have to pay fines, but fewer guilty people escape them).

What does this have to do with deficit spending and recessions? Our tendency is to assume that the economy is doing fine and doesn't need help from fiscal authorities unless there is clear evidence the economy is crashing. Only then does the government intervene with deficit spending.

Thus, our null hypothesis is that the economy does not need any help, and we require a fairly high burden of proof to overcome that presumption. Because of this, the error we are most likely to make is to do nothing when action is called for, and that includes ending help too soon, particularly given the information lags we face in assessing the state of the economy. It's possible that we could get fooled by the data into acting when it isn't necessary, but since we require clear signals that the economy is in trouble before we act, and because data are slow to arrive, acting when it isn't needed is less likely than doing nothing when, in fact, active intervention is called for.

Unlike in court cases, however, where a null of innocence allows us to minimise the costly error of jailing the innocent, the null that the economy is "innocent", i.e. that intervention from authorities is not required, leads us to minimise the wrong outcome.

Which is the bigger error, to deficit spend when it's not needed, or to fail to do so when it is? I think the bigger risk is doing nothing when it's needed, particularly when the economy has the type of difficulties we are seeing now. The risk of doing nothing is a severe depression, while the risk of overreacting is inflation or, perhaps, slightly slower growth for a period of time in the future. I don't see those risks as balanced at all, allowing a depression is—to me—the more severe error, the equivalent of sending the innocent to jail.

We saw the problem with having the wrong null hypothesis when the economy was slipping into the recession. The stimulus package should have been in place long before it was actually implemented in order to be maximally effective, but policymakers were reluctant to act until there could be no doubt that action was called for.

And we are seeing this again now. We may very well need another stimulus package, and we ought to be doing the work to get it ready, but there just isn't enough evidence to convince policymakers that's the case. They will have to see clear evidence of continuing troubles and also believe there's no chance that recovery is just around the corner before they will act, and that's a high standard to meet. And worse, as we've seen recently, as soon as the evidence that we are still in a recession becomes a bit foggy—at the first sign of green shoots—many people will be ready to end the intervention even though that may not be the right course of action.

I can understand the tendency to resist intervention at the first inkling of troubles. So on the front side of a recession, I can understand a null hypothesis that no action is needed, but it ought to be one that can be overturned with a fairly low burden of proof. We shouldn't have a "beyond a reasonable doubt" standard, it's not criminal to mistakenly intervene, it should be more like the "clear and convincing" standard sometimes used in civil procedures, or, even better, the weaker "preponderance of the evidence" standard used in civil cases.

But once we are in a recession, as now, I cannot understand why the null does not change to being one where the economy is presumed to need help until there is—beyond any reasonable doubt—evidence that the economy is on the path to recovery. Look at the 1937 experience on the graph in Mrs Romer's article again and see how costly it is to pull back too soon, then compare that to what the cost would have been to continue the policies for a year, or several years, even though they weren't needed. It seems pretty clear to me that the cost of pulling back too soon was the much bigger worry. We are facing the same choice now, or will soon. Do we pull back at the very first signs of green shoots, as we seem to want to do, or do we wait until we are much, much more certain that things have, in fact, improved to the point where recovery is all but certain before withdrawing stimulus measures?

As Brad DeLong notes, if it is the long-run budget you are worried about, ending the stimulus package, say, six months or a year earlier makes little difference to the long-term budget outlook. That being the case, and given the dangers of not doing enough and the dangers of ending the help too soon, why are we in such a hurry to end the stimulus package, and we are we so reluctant to consider doing more?

Other entries from:

Update: See also

Paul Krugman: Out of the Shadows

The good, the bad, and the ugly parts of the administration's financial reform proposal:

Out of the Shadows, by Paul Krugman, Commentary, NYTimes: Would the Obama administration's plan for financial reform do what has to be done? Yes and no. ...

Let's start with the good news. Our current system of financial regulation dates back to a time when everything that functioned as a bank looked like a bank. As long as you regulated big marble buildings with rows of tellers, you pretty much had things nailed down.

But ..., as Mr. Geithner pointed out, by 2007 more than half of America's banking ... was being handled by a "parallel financial system" — others call it "shadow banking" — of largely unregulated institutions. These non-bank banks, he ruefully noted, were "vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks."

When Lehman fell, we learned just how vulnerable shadow banking was: a global run on the system brought the world economy to its knees. One thing financial reform must do, then, is bring non-bank banking out of the shadows.

The Obama plan does this by giving the Federal Reserve the power to regulate any large financial institution it deems "systemically important" ... whether or not that institution is a traditional bank. ... And the government would have the authority to seize such institutions if they appear insolvent — the kind of power that ... has been lacking with regard to institutions like Lehman or A.I.G.

Good stuff. But what about the broader problem of financial excess?

President Obama's speech outlining the financial plan described the underlying problem very well. Wall Street developed a "culture of irresponsibility," the president said. Lenders didn't hold on to their loans, but instead sold them off to be repackaged into securities, which in turn were sold to investors who didn't understand what they were buying. "Meanwhile," he said, "executive compensation — unmoored from long-term performance or even reality — rewarded recklessness rather than responsibility."

Unfortunately, the plan as released doesn't live up to the diagnosis.

True, the proposed new Consumer Financial Protection Agency would help control abusive lending. And the proposal that lenders be required to hold on to 5 percent of their loans, rather than selling everything off to be repackaged, would provide some incentive to lend responsibly.

But 5 percent isn't enough to deter much risky lending, given the huge rewards to financial executives who book short-term profits. So what should be done about those rewards?

Tellingly, the administration's executive summary of its proposals highlights "compensation practices" as a key cause of the crisis, but ... [gives] a description of what should happen, rather than a plan to make it happen.

Furthermore, the plan says very little of substance about reforming the rating agencies, whose willingness to give a seal of approval to dubious securities played an important role in creating the mess we're in.

In short, Mr. Obama has a clear vision of what went wrong, but aside from regulating shadow banking — no small thing, to be sure — his plan basically punts on the question of how to keep it from happening all over again, pushing the hard decisions off to future regulators.

I'm aware of the political realities: getting financial reform through Congress won't be easy. And even as it stands the Obama plan would be a lot better than nothing.

But to live up to its own analysis, the Obama administration needs to come down harder on the rating agencies and, even more important, get much more specific about reforming the way bankers are paid.

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