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July 9, 2009

Economist's View - 4 new articles

"The Fall of the Toxic-Assets Plan"

I have the same worries, so I would like to hear why we shouldn't be concerned that banks are holding overvalued assets on their balance sheets. What's the counterargument to this?:

The Fall of the Toxic-Assets Plan, by Lucian Bebchuk, Real Time Economics: The plan for buying troubled assets — which was earlier announced as the central element of the administration's financial stability plan — has been recently curtailed drastically. The Treasury and the FDIC have attributed this development to banks' new ability to raise capital through stock sales without having to sell toxic assets. ...

What happened? Banks' balance sheets do remain clogged with toxic assets, which are still difficult to value. But the willingness of banks to sell toxic assets ... has been killed by decisions of accounting authorities and banking regulators. ...

Armed with ample government funding, the private managers running funds set under the program would be expected to offer fair value for banks' assets. Indeed, because the government's ... non-recourse financing, many have expressed worries that such fund managers would have incentives to pay even more than fair value... The problem, however, is that banks now have strong incentives to avoid selling toxic assets at any price below face value even when the price fully reflects fair value.

A month after the PPIP program was announced, under pressure from banks and Congress, the U.S. Financial Accounting Standards Board watered down accounting rules and made it easier for banks not to mark down the value of toxic assets. For many toxic assets..., banks may avoid recognizing the loss as long as they don't sell the assets. ...

In another blow to banks' potential willingness to sell toxic assets,... bank supervisors conducting stress tests ... explicitly didn't take into account the decline in the economic value of toxic loans and securities that mature after 2010 and that the banks won't have to recognize in financial statements until then.

Together, the policies adopted by accounting and banking authorities strongly discourage banks from selling any toxic assets maturing after 2010 at prices that fairly reflect their lowered value. ... [S]elling would require recognizing losses and might result in the regulators' requiring the bank to raise additional capital...

While the market for banks' toxic assets will remain largely shut down, we are going to get a sense of their value when the FDIC auctions off later this summer the toxic assets held by failed banks taken over by the FDIC. If these auctions produce substantial discounts to face value, they should ring the alarm bells. ... In the meantime, it must be recognized that the curtailing of the PIPP program doesn't imply that the toxic assets problem has largely gone away; it has been merely swept under the carpet.

"Will Europe's Economies Regain Their Footing?"

Kenneth Rogoff on the prospects for recovery in Europe:

Will Europe's Economies Regain Their Footing?, by Kenneth Rogoff, Commentary, Project Syndicate: What will Europe's growth trajectory look like after the financial crisis? ...

True, things are pretty ugly right now. ... Yet, ugly or not, the downturn will eventually end. Yes, there is still a real risk of hitting an iceberg, beginning perhaps with a default in the Baltics, with panic first spreading to Austria and some Nordic countries. But, for now, a complete meltdown seems distinctly less likely than gradual stabilization followed by a tepid recovery, with soaring debt levels and lingering high unemployment.

It is not a pretty picture. Some commentators have savaged Europe's policymakers for not orchestrating as aggressive a fiscal and monetary policy as their U.S. counterparts have. ...

But these critics seem to presume that Europe will come out of the crisis in far worse shape than the U.S., and it is too early to make that judgment. An epic, financial-crisis-driven recession, such as the one we are still experiencing, is not a one-year event. So policymakers' responses cannot be evaluated by short-term measures... It is just as important to ask what happens over the next five years as over the next six months, and the jury is still very much out on that.

America's hyper-aggressive fiscal response means a faster rise in government debt, while its hyper-expansive monetary policy means that an exit strategy to mop up all the excess liquidity will be difficult to execute. ... Europe's more tempered approach, while magnifying short-term risks, could pay off in the long run, especially if global interest rates rise, making it far more painful to carry oversized debt loads.

The real question is not whether Europe is using sufficiently aggressive Keynesian stimulus, but whether Europe will resume its economic reform efforts as the crisis abates. If Europe continues to make its labor markets more flexible, its financial market regulation more genuinely pan-European, and remains open to trade, trend growth can pick up again in the wake of the crisis. If European countries look inward, however, with Germany pushing its consumers to buy German cars, the French government forcing car companies to keep unproductive factories open, etc., one can expect a decade of stagnation.

Admittedly, the past year has not been a proud one for policy reform in Europe. Recessions have never proven an easy time for ... reforms. ...

The recent recession has presented challenges, but European leaders were right to avoid becoming intoxicated with short-term Keynesian policies, especially where these are inimical to addressing Europe's long-term challenges.

If reform resumes, there is no reason why Europe should not enjoy a decade of per capita income growth at least as high as that of the U.S. Moreover, with growing concerns about the sustainability of U.S. fiscal policy, the euro has a huge opportunity to play a significantly larger role as a reserve currency.

One shudders to think what will happen if Europe does not pull out of its current funk. ...

European leaders argued they didn't need to be as aggressive as the U.S. at putting new fiscal policy in place because they had much larger social safety nets that would kick in automatically as the crisis deepened. In addition, Europeans noted, they already had much higher levels of government spending as a share of output than the U.S., so it was much harder for them to increase this share further. Another way to say this is that Europeans do not believe they have an inferior short-run response, especially when it comes to labor and providing jobs.

Thus, the very thing that Rogoff believes is Europe's biggest long-run challenge - the extensive social safety net, including provisions affecting adjustment in labor markets - is the reason why Europe was able and willing to choose a different strategy relative to the U.S. to attenuate the effects of the recession. If the U.S. had European levels of debt and, more importantly, the same degree of social protections for people affected by recession, then the U.S. would not have needed or been able (politically) to increase deficit spending as much as it did. I am among those who believe Europe could have reacted more vigorously, and should have, but I don't think it's correct to say they avoided Keynesian type policy (and see this post concerning France's stimulus package).

If, in the long-run, we look back and see that Europe's more extensive protections did, in fact, smooth the adjustment to the crisis, the motivation for long run change of the type Rogoff hopes for will diminish. If having European style social protections does lower growth - and that is a debatable assertion - that may be an insurance premium people are willing to pay to avoid more severe downturns. If the opposite happens, if the social safety net does not do its job (and that cannot be measured through unemployment rates alone), then the motivation for change could become stronger. But the crisis is far from over and the jury is still out.

"The New Kaldor Facts"

What does growth theory need to explain? Has there been progress?:

The New Kaldor Facts: Ideas, Institutions, Population, and Human Capital, by Charles I. Jones and Paul M. Romer, NBER WP 15094, June 2009 [open link]: 1. Introduction ...[I]t is easy to lose faith in scientific progress. ... In any assessment of progress, as in any analysis of macroeconomic variables, a long-run perspective helps us look past the short-run fluctuations and see the underlying trend. In 1961, Nicolas Kaldor stated six now famous "stylized" facts. He used them to summarize what economists had learned from their analysis of 20th-century growth and also to frame the research agenda going forward (Kaldor, 1961):

    1. Labor productivity has grown at a sustained rate.
    2. Capital per worker has also grown at a sustained rate.
    3. The real interest rate or return on capital has been stable.
    4. The ratio of capital to output has also been stable.
    5. Capital and labor have captured stable shares of national income.
    6. Among the fast growing countries of the world, there is an appreciable variation in the rate of growth "of the order of 2–5 percent."

Redoing this exercise nearly 50 years later shows just how much progress we have made. Kaldor's first five facts have moved from research papers to textbooks. There is no longer any interesting debate about the features that a model must contain to explain them. These features are embodied in one of the great successes of growth theory in the 1950s and 1960s, the neoclassical growth model. Today, researchers are now grappling with Kaldor's sixth fact and have moved on to several others that we list below.

One might have imagined that the first round of growth theory clarified the deep foundational issues and that subsequent rounds filled in the details. This is not what we observe. The striking feature of the new stylized facts driving the research agenda today is how much more ambitious they are. Economists now expect that economic theory should inform our thinking about issues that we once ruled out of bounds as important but too difficult to capture in a formal model.

Here is a summary of our new list of stylized facts, to be discussed in more detail below:

    1. Increases in the extent of the market. Increased flows of goods, ideas, finance, and people — via globalization as well as urbanization — have increased the extent of the market for all workers and consumers.
    2. Accelerating growth. For thousands of years, growth in both population and per capita GDP has accelerated, rising from virtually zero to the relatively rapid rates observed in the last century.
    3. Variation in modern growth rates. The variation in the rate of growth of per capita GDP increases with the distance from the technology frontier.
    4. Large income and TFP differences. Differences in measured inputs explain less than half of the enormous cross country differences in per capita GDP.
    5. Increases in human capital per worker. Human capital per worker is rising dramatically throughout the world.
    6. Long-run stability of relative wages. The rising quantity of human capital relative to unskilled labor has not been matched by a sustained decline in its relative price.

In assessing the change since Kaldor developed his list, it is important to recognize that Kaldor himself was raising expectations relative to the initial neoclassical model of growth as outlined by Solow (1956) and Swan (1956). When the neoclassical model was being developed, a narrow focus on physical capital alone was no doubt a wise choice. The smooth substitution of capital and labor in production expressed by an aggregate production function, the notion that a single capital aggregate might be useful, and the central role of accumulation itself were all relatively novel concepts that needed to be explained and assimilated. Moreover, even these small first steps toward formal models of growth provoked substantial opposition.

The very narrow focus of the neoclassical growth model sets the baseline against which progress in growth theory can be judged. Writing in 1961, Kaldor was already intent on making technological progress an endogenous part of a more complete model of growth. ...

Growth theorists working today have not only completed this extension but also brought into their models the other endogenous state variables excluded from consideration by the initial neoclassical setup. Ideas, institutions, population, and human capital are now at the center of growth theory. Physical capital has been pushed to the periphery.

Kaldor had a model in mind when he introduced his facts. So do we. ... In the near term, we believe that this model should capture the endogenous accumulation of and interaction between three of our four state variables: ideas, population, and human capital. For now, we think that progress is likely to be most rapid if we follow the example of the neoclassical model and treat institutions the way the neoclassical model treated technology, as an important force that enters the formalism but which evolves according to a dynamic that is not explicitly modeled. Out on the horizon, we can expect that current research on the dynamics of institutions and politics will ultimately lead to a simple formal representation of endogenous institutional dynamics as well.


4. Conclusion ...[T]he facts we highlight ... reveal important complementarities among the key endogenous variables [ideas, population, human capital, and institutions]... Such complementarities exemplify the value of the applied general equilibrium approach. They are the fundamental reason why we seek a unified framework for understanding growth. Going forward, the research agenda will surely include putting ingredients like those we have outlined in this paper together into a single formal model. Further out on the horizon, one may hope for a successful conclusion to the ongoing hunt for a simple model of institutional evolution. Combining that with the unified approach to growth outlined here would surely constitute the economics equivalent of a grand unified theory—a worthy goal by which we may be judged when future generations look back fifty years from now and quaintly revisit our "ambitious" list of stylized facts.

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