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September 22, 2009

Economist's View - 6 new articles

Cynics, not Whiners?

Bruce Judson says effective financial reform is essential to restoring trust in government:

Restoring Trust in Our Economic System and the Institutions of Our Democracy, by Bruce Judson: The Financial Crisis Inquiry Commission (FCIC), which started work last week, will have a significant impact on the health of our democracy. When the FCIC completes its efforts, we will either be stronger or weaker as a nation. There is no middle ground. ...
The work of the Commission is important for two reasons. First, by openly educating the public about the causes of the financial crisis it will pave the way for reform. Existing interests will inevitably resist change. Reform becomes far easier when its advocates can point to a roadmap of specific problems that must be addressed. ...
Second, America is becoming an angry nation, with diminished faith in its institutions. There is a growing sense among all but the wealthiest Americans that "the game is rigged" against them. The public perception of the work of the FCIC will inevitably affect, for better or worse, our basic level of trust in the nation's democratic system.
In Trust, Francis Fukuyama demonstrated that societies with high trust are vibrant and productive, because individuals trust their interests will be protected. In the absence of trust, rigid work rules, contracts, litigation, and a range of other costs are created as everyone in the economy attempts to protect him or herself. In 1972, Kenneth Arrow, the Nobel laureate wrote, "Virtually every commercial transaction has within itself an element of trust." ...
When trust disappears, people become increasingly cynical. As this cynicism grows, citizens become disengaged from the political process: There's no point in voting or working toward any civic-related goal if you cynically believe nothing will ever change. At the same time, government becomes increasing ineffective as people no longer believe elected officials will fulfill their responsibilities or promises. As a result, a cynical society can quickly become a paralyzed society.
Ultimately, cynicism can also play a role in shifting a paralyzed society toward actual political instability. One of the causes of the collapse of the Soviet Union was the extraordinarily high degree of cynicism toward the government. ...
Last week, I wrote an ... article that ... critiqued the data and conclusions of a front page Wall Street Journal article that inaccurately down-played the extent of economic inequality. The article attracted hundreds of comments across the Web. The vast majority of these comments effectively said: What else did you expect? I discovered that cynicism is the reigning sentiment.
We are not becoming a nation of whiners. Far worse, we are becoming a nation of cynics.
To date, the growing cynicism of the American public is sadly justified. No one on Wall Street has apologized. No one has accepted responsibility for causing the crisis. While jobless victims of this crisis face increasing foreclosures, many of the firms that caused the crisis are—with government assistance—returning to past habits. ...
The work of the FCIC represents both ... opportunity and a potential danger. By shining a bright light on the causes of this crisis, the FCIC has the chance to once again demonstrate that no one is approve reproach and to provide a clear map of the problems that successful reform must address. With these results, the FCIC can demonstrate that the American system continues to work, and enhance trust in our democratic system.
The danger is that the FCIC does not fulfill this critical mandate, and it is ultimately perceived as failing to have aggressively searched for the truth. If this happens, my hypothesis is the nation will almost inevitably slide further on the path toward paralyzing cynicism. What happens then?

Have Plans Ready Next Time

I have another post at CBS Money Watch:

Why We Need Plans To Break Up Too-Big-to-Fail Banks, by Mark Thoma

This reiterates that we need to have plans ready to dissolve systemically important financial firms. What I didn't say is that we should also do our best to prevent firms from becoming a danger to the system due to their size of connectedness.

Predicting Crises

David Levine "aggressively argues":

our models don't just fail to predict the timing of financial crises - they say that we cannot.

The San Francisco Fed's Bharat Trehan says:

simple indicators based on asset market developments can provide early warnings about potentially dangerous financial imbalances. ... [W]e have taken two simple indicators off the shelf and shown that both would have signaled impending trouble prior to the current crisis. That makes it harder to argue that financial crises are, by their nature, unpredictable. And it shows that such simple indicators can be useful ... as signals of rising levels of risk in the economy.

See here. Or here.

We ought to be able to say, at the very least, something like:

If you keep eating that junky credit instead of a healthier financial diet, your monetary circulatory system is likely to have severe problems at some point in the future.

Many people had a sense things were out of balance and that at some point it would cause us problems, but the indicators most people looked at pointed to a diagnosis involving exchange rate movements and an international unwinding. The discussion centered on issues such as whether we would have a hard or a soft landing as this process unfolded, there was little discussion of the type of crisis that actually occurred.

So we need two things. First, we need indicators such as those identified in the SF Fed article that can tell us when danger is building in the financial sector.

But that is not enough. Though many people had a sense from the indicators they looked at that things were out of balance, the indicators pointed to international financial issues rather than the true problem, and hence most of the analysis and policy discussions were devoted to guarding against problems related to international financial flows.

Thus, the second thing we have a need for is a set of indicators that do a better job of telling us where the problems are likely to occur. That is where we made the biggest mistake, misdiagnosing the type of crisis that was coming. Having indicators that can do a better job of identifying the type of financial crisis we are facing will allow us to design and implement effective policy responses rather than wasting time analyzing and planning for the wrong type of crisis.

"On the G20 Agenda"

Tim Duy:

On the G20 Agenda, by Tim Duy: Simon Johnson at the Baseline Scenario has a nice piece bemoaning the US pursuit of a rebalancing agenda at the upcoming G20 meeting. I largely agree with Johnson's tone. Something that sounds nice, but that to which no parties, particularly China and the US, can make a credible commitment. It is, however, keeping some poor staffer at the US Treasury busy 24-7. Johnson's third point, however, misses some important points:
Where is the evidence that this kind of "imbalance" had even a tangential effect on the build up of vulnerabilities that led to the global financial crisis of 2008-09? I understand the theoretical argument that current account imbalances could play a role in a US-based/dollar crisis, but remember: interest rates were low 2002-2006 because of Alan Greenspan (who controlled short-term dollar interest rates); the international capital flows that sought out crazy investments came from Western Europe, which was not a significant net exporter of capital (i.e., a balanced current account is consistent with destabilizing gross flows of capital); and the crisis, when it came, was associated with appreciation – not depreciation – of the dollar.
I believe Johnson underestimates just how close we came to a destabilizing collapse of the Dollar in 2008. That avoidance of that near collapse was well documented by Brad Setser in his legendary "quiet bailout" series:
...The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies — a fiscal stimulus, monetary easing — designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons – ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US — the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up — not down – at least in nominal terms.
So far that hasn't been a serious problem. Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets. But there are also growing signs that rapid reserve growth is causing some countries — including some big countries — trouble.
Later analysis can be found here. Had it not been for the supporting role that China and other central banks played in financing the US current account deficit, we would have seen a full blown currency crisis, well before the financial crisis of September 2008.
As an aside, the intervention to support the Dollar was also the key event that allowed the US recession to evolve in the pattern envisions by domestic-focused economists, as opposed to those seeped in the traditions of international finance. Brad Delong has a fantastic piece on this issue, including the key assumption failed the internationalists:
Before dinner one evening I was lectured by a prominent Washington-area international finance economist about all the reasons that the 1986-1990 U.S. experience was likely to be a bad guide to the future…
...The Japanese government was willing to buy very large amounts of dollar-denominated assets in the late 1980s to keep the decline in the value of the dollar "orderly." In so doing, it inflated its domestic credit base and touched off its own property bubble. No foreign government is going to risk this again just because the U.S. would rather that the decline in the dollar was slow and orderly.
I have no doubt that the willingness of central banks to flood the global economy with month in an effort to hold currency pegs contributed greatly to the great commodity price bubble that ultimately sent US real consumption into a tail spin well before the events in the fall of 2008.
As to the G20 proposal itself - easier said than done. Back on the real side of the economy, I believe the US economy is very structurally misaligned, to a disturbing degree. We simply do not make many of the products we want to buy, and have the capacity to make many products - like expensive housing - that no one wants to buy. Moreover, these structural misalignments have been building for at least 15 years, at least partly the consequence of the US strong Dollar policy that gave license for wholesale currency manipulation to support mercantilistic policy objectives. Reversing 15 years of policy in which deep structural shifts occurred will not happen overnight.
Nor do I think the Chinese are interested in making that transition happen. Thomas Freidman has a point here:
China now understands that. It no longer believes it can pollute its way to prosperity because it would choke to death. That is the most important shift in the world in the last 18 months. China has decided that clean-tech is going to be the next great global industry and is now creating a massive domestic market for solar and wind, which will give it a great export platform….So, if you like importing oil from Saudi Arabia, you're going to love importing solar panels from China.
This restructuring, not so much the financial restructuring, is what I suspect the Administration really wants to address.
Good luck with that.

"A Vision for Innovation, Growth, and Quality Jobs"

Larry Summers, blogging from the White House, says the administration's policies will create jobs and help to ensure that "the entrepreneurial spirit that Schumpeter recognized in the early twentieth century will continue to drive the American economy":

A Vision for Innovation, Growth, and Quality Jobs, by Lawrence H. Summers: President Obama laid out his vision for innovation, growth, and quality jobs earlier today at Hudson Valley Community College. The President's plan is grounded not only in the American tradition of entrepreneurship, but also in the traditions of robust economic thought.
During the past two years, the ideas propounded by John Maynard Keynes have assumed greater importance than most people would have thought in the previous generation. As Keynes famously observed, during those rare times of deep financial and economic crisis, when the "invisible hand" Adam Smith talked about has temporarily ceased to function, there is a more urgent need for government to play an active role in restoring markets to their healthy function.
The wisdom of Keynesian policies has been confirmed by the performance of the economy over the past year. After the collapse of Lehman Brothers last September, government policy moved in a strongly activist direction.
As a result of those policies, our outlook today has shifted from rescue to recovery, from worrying about the very real prospect of depression to thinking about what kind of an expansion we want to have.
An important aspect of any economic expansion is the role innovation plays as an engine of economic growth. In this regard, the most important economist of the twenty-first century might actually turn out to be not Smith or Keynes, but Joseph Schumpeter.
One of Schumpeter's most important contributions was the emphasis he placed on the tremendous power of innovation and entrepreneurial initiative to drive growth through a process he famously characterized as "creative destruction." His work captured not only an economic truth, but also the particular source of America's strength and dynamism.
One of the ways to view the trajectory of economic history is through the key technologies that have reverberated across the economy. In the nineteenth century, these included the transcontinental railroad, the telegraph, and the steam engine, among others. In the twentieth, the most powerful innovations included the automobile, the jet plane, and, over the last generation, information technology.
While we can't know exactly where the next great area of American innovation will be, we already see a number of prominent sectors where American entrepreneurs are unleashing explosive, innovative energy:
In information technology, where tremendous potential remains for a range of applications to increase for years to come;
In life-science technologies, where developments made at the National Institutes of Health and in research facilities around the country will have profound implications not just for human health, but also for the environment, agriculture, and a range of other areas that require technological creativity; and,
In energy, where the combination of environmental and geopolitical imperatives have created the context for an enormously productive period in developing energy technologies as well.
Looking across the breadth of the U.S. economy, the prospects for transformational innovation to occur are enormous. But to ensure that the entrepreneurial spirit that Schumpeter recognized in the early twentieth century will continue to drive the American economy in the twenty-first century requires a role for government as well: to create an environment that is conducive to generating those developments.
The President's program is directed at strengthening our economic ecology—an educated workforce, a fluid environment that stimulates entrepreneurship, and building blocks in key areas of the economy—that has long been central to America's prosperity. These were core design considerations in putting together over $100 billion of Recovery Act funds that support innovation and they will continue to be core concerns going forward. With steps like these, the entrepreneurial spirit that Schumpeter recognized in the early twentieth century will continue to drive the American economy in the twenty-first century.
I hope you'll take a few minutes to read the President remarks today or, to delve into more detail, into a new white paper prepared by the National Economic Council about the policies President Obama is implementing to create a broader, more inclusive, more prosperous America based on the ingenuity of our people.

links for 2009-09-21

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