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August 26, 2009

Economist's View - 4 new articles

Do the Costs of Our Financial System Exceed the Benefits?

Does the total cost of our financial system exceed the total benefits at the current scale of operation? Like Benjamin Friedman, I wish I knew the answer, though I suspect that much of the recent innovation would be difficult to justify on the margin:

Overmighty finance levies a tithe on growth, by Benjamin Friedman, Commentary, Financial Times: ...The crucial role of the financial system in a mostly free-enterprise economy is to allocate capital investment towards the most productive applications. The energetic growth and technological advance of the western economies suggest that our financial system has done this job pretty well over long periods. ... The financially triggered Great Recession of 2008-? blemishes this record but does not wipe it away.

Aside from the recession, it is important to ask what this once-admired mechanism costs to run. If a new fertilizer offers ... a higher crop yield but its price and the cost of transporting and spreading it exceeds what the additional produce will bring at market, it is a bad deal for the farmer. A financial system, which allocates scarce investment capital, is no different.

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. ... The misused resources and the output foregone due to the recession are ... part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system. ...

One part of that cost is ... much of the best young talent in the western world [going] to private financial firms. ... At the individual level, no one can blame these graduates. But at the level of the aggregate economy, we are wasting one of our most precious resources..., much of their activity adds no economic value.

In the US, both the share of all wages and salaries paid by the financial firms and those firms' share of all profits earned have risen sharply in recent decades. In the early 1950s, the "finance" sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent.

These wages and profits – and the office rents, utility bills, advertising and travel expenses – are all parts of the cost of running the mechanism that allocates our economy's capital. To recall, what makes a new fertilizer a good deal for the farmer is not just that it delivers greater production per acre but that the added production is sufficient to buy the fertilizer and increase the farmer's own return.

What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. The more the financial system costs to run, the higher the hurdle. Does the increased efficiency our investment allocation system delivers meet that hurdle? We simply do not know.

Economic decisions are supposed to turn on weighing costs and benefits. It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that.

"The Dangers Ahead for Bernanke"

At the Room for Debate, we were asked "What's the biggest challenge Mr. Bernanke faces in his second term?" Here are the answers:

My response:

One important challenge Mr. Bernanke will face is to keep the financial sector recovery on track by not raising interest rates too soon, while avoiding inflation by not raising interest rates too late. It will be a difficult balancing act, particularly with the complications that a large budget deficit adds. I'm quite confident Mr. Bernanke is up to the task.

But the most important challenge is how to restructure the financial sector to reduce its vulnerability to a collapse like the one we just experienced. That's a task that will require both institutional and regulatory change.

Some of this the Fed can do on its own, but other parts require Congressional approval. As the financial sector has started to show signs of life, we are already hearing protests against regulation. The most prominent objection is that regulation will stifle new financial innovation (never mind that it was this innovation that helped to cause the predicament we are in).

My worry is that as time passes, we'll forget how bad things were and the desire to impose necessary new regulation will fade. Here's where I think Mr. Bernanke's experience will be crucial. He was there at every step in the development of the Fed's response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he'll be a forceful and passionate advocate for new regulation before Congress.

For example, the Fed needs the authority to dismantle "too big to fail" financial firms, authority it lacked but very much needed during the crisis. Mr. Bernanke knows first hand how hard it was to manage the crisis without this authority. He's also seen the consequences of an unregulated shadow banking sector, and he knows how bad incentives and poor market structures created problems that could have been avoided.

There are two other factors working in Mr. Bernanke's favor. If the financial recovery goes as I expect, his reputation will grow, giving him the authority he needs to persuade Congress to make needed regulatory changes. And just as important, unlike some past Fed chairmen, he's been able to articulate complex ideas in ways that legislators seem to understand.

Update: This is from Barry Ritholtz. It addresses the view held by many that Bernanke should not have been reappointed because he helped to create the housing bubble (which implicitly assumes the Fed is responsible for the bubble - I think the low interest rate policy after the crash was one source of the liquidity that fueled the housing boom, but not the only source, the global savings glut also played a role, and there were other failures, i.e. false promises of high returns with low risk, that caused the funds to flow into mortgage markets and related securities rather than into other investments):

I am less critical ... regarding the Bernanke renomination [and] his 3 year term as Governor. Let's not forget that Greenspan was known as the Maestro back then. Congress, which is now pillorying Bernanke every appearance, was adoring of Easy Al's visage and garbled Greenspeak each and every appearance. AG ran the Fed as an unchallenged stronghold, a fiefdom where he was the central-banker-in-chief as rock star. No one challenged him directly.

That seems to be lost in a lot of the revisionism now taking place. Roach writes "While America's head central banker deserves credit for being creative and courageous in orchestrating an unusually aggressive monetary easing programme, it is important to remember that his pre-crisis actions played an equally critical role in setting the stage for the most wrenching recession since the 1930s."

Not exactly. It was Greenspan's Fed. Under his leadership, the FOMC and its governors were all second bananas to the Wolrd's most famous banker. In Bailout Nation, I criticize this deference: "The Federal Open Market Committee (FOMC) must take responsibility for following [Greenspan] so obsequiously, especially in the latter years of his reign."

However much I blame the FOMC, I have a hard time holding them to the same level of accountability as I do Greenspan. He was the master architect, the maestro conducting the monetary policy orchestra.

Second bananas cannot should the blame for what the head of the bunch does. Once they become banana-in-chief, the standards and level of accountability all go up accordingly.

Blogger's Conference Video: Entrepreneurship and the U.S. Economy

I can't watch videos that I am in, so I have no idea what is on this video or what I said. The WSJ's Real Time Economics offers:

The "econoblogosphere" is taking the world by storm, it seems. The latest to draw attention to these bloggers is the Kauffman Foundation, with a new 20-minute video featuring bloggers including Tyler Cowen and Mark Thoma and their thoughts on entrepreneurship and the U.S. economy. "The people that are blogging are part journalist, part economist, part agitator, and we're seeing a whole new art form, if you will, develop right before our very eyes," says Robert E. Litan, the foundation's vice president of research and policy.

links for 2009-08-26

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