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June 16, 2009

Economist's View - 8 new articles

Blog Posts that Don't Compute

Someone name Dr. Manhattan at The Atlantic's Business Blog, in a post entitled "Sentences that Don't Compute" says:

Today's entry comes from Mark Thoma, who writes in a guest-blog at the Washington Post:

The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.

Is Dr. Manhattan seriously arguing that the financial market troubles began in the traditional, regulated banking sector even though commercial banks with insured deposits are doing just fine, it's the other sectors that are in trouble? Yes he or she is:

...the systemic breakdowns we have been experiencing over the past 18 months have been caused by problems at the major banks (even the former investment-only banks which weren't regulated by the Fed or FDIC cannot be called part of the "shadow banking system"), AIG (regulated by the state insurance commissioners...) ...

Here's why this is wrong. It defines sectors by institutions rather than by particular activities or products. Suppose there is a multi-product firm that produces products A and B, so it operates in two different sectors. Product A is heavily regulated, B is not regulated at all. If product B causes troubles, can we argue that ithis shows that the problems started in the regulated sector? That's what's being argued above.

For example, let's look at the AIG case a bit closer and see where they got into trouble, with the regulated or unregulated part of their business (I bet you can guess which it is):

Propping up a House of Cards, by Joe Nocera, NY Times: Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion ...

To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.) But one division, its "financial practices" unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street's insatiable appetite for mortgage-backed securities..., it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. ... When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That's why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn't have to put anything aside for losses. And it didn't. ... So when housing prices started falling, and losses started piling up, it had no way to pay them off. ...

So Dr. Manhattan's example proves my point, it was the unregulated component of AIG - the part operating within the shadow banking sector - that caused them problems. Thank you. The Dr. even cites Fannie and Freddie who, as has been well documented, followed the shadow sector down into the dumps when they began losing market share, in no sense did they lead the process. So the Fannie and Freddie example also proves the opposite case. Had the shadow sector been regulated in the same way that Fannie and Freddie were, that market share pressure would not have existed since the regulation would have taken away the advantage enjoyed by the unregulated banks, and Fannie and Freddie would have had no reason to follow the unregulated shadow banks downward.

Here's a simple rule to follow. If you are going to set yourself up as a critic, it's a good idea to have some idea what you're talking about.

Update: See also The Atlantic Monthly Crashes and Burns... by Brad DeLong for more on this.

Why Op-Eds?

Here's something I've been wondering. Now that we have blogs and the internet, why do high ranking government officials - Timothy Geithner and Larry Summers today in the Washington Post, or Peter Orszag in the Financial Times for example - publish op-eds behind paywalls?

Why should people be forced to pay to hear read important policy discussions? Doesn't that exclude a lot of people from participating in the discourse? Even if the policy discussions aren't behind paywalls, other papers don't reprint the remarks in full, at least hardly ever, so the distribution is still limited.

When, say, the president wants to say something, why publish it on the op-ed pages of the New York Times, the Washington Post, the Wall Street Journal, the Financial Times, etc.? Why not simply post it on the White House web site, and make it absolutely clear that anyone who wants to can republish it in its entirety. Instead of one paper publishing the remarks, wouldn't they likely appear in several if not all major papers, or at least be discussed in some fashion, and wouldn't the remarks also be reprinted in local papers and in many blogs? Wouldn't a lot more people be able to read the discussion, and, in fact, wouldn't it be likely that a lot more people would read it?

So why do they still use the old model? Is it because the general public isn't the real target of these communications, or have I missed something essential? [Note: added a bit more in comments.]

Obama's Health Care Plan

Peter Orzag, Director of the White House Office of Management and Budger, describes the administration's health care plans:

A plan to boost America's fiscal health, by Peter Orszag , Commentary, Financial Times: As the healthcare debate picks up in the US, there has been much discussion about how to pay for it. Coinciding with this debate are vocal concerns about the country's underlying fiscal position – which some have suggested as a reason to delay healthcare reform.

What this argument ignores is that healthcare is central to the long-term fiscal and economic prospects of the US. If costs per enrollee in Medicare and Medicaid grow at the same rate over the next four decades as they have over the past four, those two programmes will increase from 5 per cent of gross domestic product today to 20 per cent by 2050. ... Nothing else we do on the fiscal front will matter much if we fail to address rapidly rising healthcare costs.

The US spends almost 50 per cent more per person on healthcare than the next most costly nation, but our health outcomes lag those of most industrialised countries. For families, after adjusting for inflation, health insurance premiums have increased 58 per cent while wages have risen only 3 per cent since 2000. For states, rising healthcare costs are squeezing their budgets...

That is why Barack Obama is committed to undertaking healthcare reform this year. Based on estimates by Dartmouth College and others, the US spends about $700bn a year on healthcare that does nothing to improve Americans' health outcomes.

Reducing the number of tests, procedures and other medical costs that do not improve health presents an enormous opportunity. ... If we slow the rate of healthcare cost growth by 1.5 percentage points per year, by 2030 we could reduce the federal budget deficit by 2.5 per cent of GDP...

Mr Obama is firmly committed to making healthcare reform deficit neutral over the next decade... with ... Medicare and Medicaid efficiencies (such as reducing Medicare overpayments to private insurers) and ... tax provisions limiting the itemised deduction rate for the wealthiest Americans to what it was when Ronald Reagan was president. On Saturday, Mr Obama also proposed an extra $313bn in Medicare and Medicaid savings proposals... Taken together, these ... total about $950bn over 10 years, an amount that puts us in a good position to fully fund health reform in a deficit neutral way.

We must also address the ... incentives for doctors and hospitals to provide more care, not the best care. A lack of information on what works leads to huge variations in the quality of care and its cost. ... The US must move towards a higher-quality, lower-cost system in which best practices are universal... The administration has therefore put forward initiatives such as health IT, research into what works, prevention and wellness, and changes in provider incentives. ...

This is not the end of our commitment to fiscal responsibility. Once healthcare reform is in place, the US can then focus on other aspects of fiscal sustainability, including Social Security reform. ...

[The line "including Social Security reform" will capture some attention - as it should.]

Lucas: Inflation is not the Biggest Worry

I thought maybe conservatives should hear from one of their own. Nobel prize winner Robert Lucas of the University of Chicago said the following in November:

The recession is the more immediate problem, Robert Lucas: In a financial crisis things happen fast... The responsibility of the Federal Reserve in this situation is to provide more cash reserves, and in that sense they are doing their job. ... This is good central banking.

Should we be concerned that people will just hold on to the new reserves and continue to reduce spending? Some of that is surely happening, but more reserves can always be added.

Should we be concerned about inflation? Of course, always.

But right now the recession is the more immediate problem. If inflation resumes, reserves can be taken out as quickly as they were added. This is a classic lender-of-last-resort situation and it is important to maintain focus.

In my view, these are the most important considerations for US policy today. I think if the current Federal Reserve lending policies are continued aggressively our chances of avoiding a recession larger than that of 1982 are very good. At this point, I think this is the best that can be hoped for and it is a lot better than a replay of the 1930s.

Importantly: "reserves can be taken out as quickly as they were added."

Paul Krugman: Stay the Course

It's too soon to ease up on monetary and fiscal policy:

Stay the Course, by Paul Krugman, Commentary, NY Times: The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts.

For those who know their history,... this is the third time ... that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts ... have reached their limit. ...

The first example of policy in a liquidity trap comes from the 1930s. The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while F.D.R. tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

The second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery... Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.

And here we go again.

On one side, the inflation worriers are harassing the Fed. The latest example: Arthur Laffer... Meanwhile, there are demands from several directions that President Obama's fiscal stimulus plan be canceled. Some ... argue ... the economy is already turning around. Others claim that government borrowing is driving up interest rates, and that this will derail recovery.

And Republicans, providing a bit of comic relief, are saying that the stimulus has failed, because the enabling legislation was passed four months ago — wow, four whole months! — yet unemployment is still rising. This suggests an interesting comparison with ... Ronald Reagan, whose 1981 tax cut was followed by no less than 16 months of rising unemployment.

O.K., time for some reality checks.

First of all,... unemployment is very high and still rising. That is, we're not even experiencing the kind of growth that led to the big mistakes of 1937 and 1997. It's way too soon to declare victory.

What about the claim that the Fed is risking inflation? It isn't. Mr. Laffer seems panicked by a rapid rise in the monetary base... But a rising monetary base isn't inflationary when you're in a liquidity trap. America's monetary base doubled between 1929 and 1939; prices fell 19 percent. Japan's monetary base rose 85 percent between 1997 and 2003; deflation continued apace.

Well then, what about all that government borrowing? All it's doing is offsetting a plunge in private borrowing — total borrowing is down, not up. Indeed, if the government weren't running a big deficit right now, the economy would probably be well on its way to a full-fledged depression.

Oh, and investors' growing confidence that we'll manage to avoid a full-fledged depression — not the pressure of government borrowing — explains the recent rise in long-term interest rates. These rates, by the way, are still low by historical standards.

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

Those demands should be ignored. It's much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss.

"Making Financial Regulation Work"

This is something I did for the The Hearing blog at the Washington Post:

Making Financial Regulation Work: 50 More Years, by Mark Thoma: Banking regulation imposed in response to the Great Depression and the recurrent panics of the 1800s and early 1900s gave us 50 years of stability in the financial system without impeding economic growth. That's quite a record to overcome for those who say regulation does not work. But the stability began to break down with the savings and loan problems in the 1980s, and the growing instability since that time is evident in the severe meltdown we are experiencing today. What happened? Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all. The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system. We need to bring the shadow banking system - essentially any institution that takes deposits and makes loans either directly or indirectly - under the same regulatory umbrella as the traditional banking system. What type of regulation should we impose to give us the best chance of achieving another 50 years or more of relative calm?

Initially my concerns were with the economic issues, and the focus was on designing a regulatory system that would overcome the market failures that led to excess risk-taking and to institutions that were too big and too interconnected to fail. But large financial firms exert more than their share of political power, and this adds another dimension to the problem. Banks that are too big and too interconnected to fail pose an economic risk to the overall economy. However, firms can also be "too big for politicians to ignore." When this happens, they can exert undue influence on legislation or capture the regulatory process in ways that allow them to escape enforcement of rules already in place. So regulation is needed to limit political power as well as economic power. But that is not enough. The environment the regulatory process operates in must also be changed if we are going to bring about a more stable, more reliable financial system. Today's problems could have been eased or perhaps even avoided entirely if regulators would have simply enforced regulations already in place, or called for new ones when existing tools were inadequate. But instead, regulations were not enforced to the extent they could have been, and there was little internal opposition when they were lifted. The attitudes within regulatory agencies were driven by the widely held belief that the discipline of the marketplace would not allow the accumulation of excessive risk. Regulators did not believe that the type of meltdown we have just experienced could occur. Problems could develop in individual markets, and those could be troublesome, but the system-wide, falling-domino-type collapse we've just observed just couldn't happen -- not in modern financial markets with all their digital technology, fancy mathematics, and complicated risk-dispersing products. Or so it was believed. If you don't believe something can occur, you won't be sensitive to signs that it might be about to happen. Regulators missed the signs of the crash because they didn't think a crash of this breadth and magnitude was possible. Besides, more benign explanations could be made to fit the facts. We now know that a system-wide financial breakdown was in the realm of possibility, and that should change how regulators view market developments in the future. They won't soon forget that markets can and do collapse when left unattended, and they will interpret developments in financial markets with that in mind. So what should we do? In very broad terms, we need:

  • Regulations that limit both economic and political power and discourage the buildup of excessive risk.
  • Regulators willing to assertively enforce existing regulation, think outside the ideological box and take an active role in identifying areas where regulation is inadequate.
  • Regulators with the means and power to stand up to the biggest and most powerful financial institutions. Making financial institutions less powerful by breaking them up into smaller entities is one means to this end.
  • A culture within regulatory agencies and their supporting institutions that reinforces and encourages the regulatory process.

It won't be easy to bring about the needed regulatory change, not with still-too-powerful financial companies lobbying against it, but it's essential that we do.

[You can leave comments here as usual, and, if you want to extend the reach of what you have to say, you can comment here too.]

Geithner and Summers: A New Financial Foundation

Here is a "brief preview of the administration's forthcoming proposals" to strengthen regulation of the financial sector.

A New Financial Foundation, by Timothy Geithner and Lawrence Summers, Commentary, Washington Post: Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world. ...

This current financial crisis had many causes. ... But it was also the product of basic failures in financial supervision and regulation. Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.

That is why, this week ... the administration will put forward a plan to modernize financial regulation and supervision. ... In developing its proposals, the administration has focused on five key problems in our existing regulatory regime...

First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe...

The administration's proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision...

Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system...

The administration's plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.

The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems... All derivatives contracts will be subject to regulation...

Third, our current regulatory regime does not offer adequate protections to consumers and investors. ... The crisis ... revealed the inadequacy of consumer protections across a wide range of financial products... [T]he administration will offer a stronger framework for consumer and investor protection across the board.

Fourth, the federal government does not have the tools it needs to contain and manage financial crises. ... To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will ... help ensure that the government is no longer forced to choose between bailouts and financial collapse.

Fifth, and finally, we live in a globalized world, and the actions we take here at home ... will have little effect if we fail to raise international standards... We will lead the effort to improve regulation and supervision around the world.

The discussion here presents only a brief preview of the administration's forthcoming proposals. ... Now is the time to act.

Sounds good, and hits the right notes, but let's wait to see what legislation actually emerges. There are already signs that it's not going to be easy.

links for 2009-06-15

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