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November 30, 2009

Economist's View - 4 new articles

James Galbraith on the Crisis

Will Consumption Growth Return to Its Pre-Recession Level?

At MoneyWatch, Will Consumption Growth Return to Its Pre-Recession Level? discusses this graph comparing the path of consumption in the current recession to the path of consumption in the three most recent recessions, and there is a brief discussion of why consumption growth is likely to be lower in the future:

Consumption [click to enlarge]

Paul Krugman: The Jobs Imperative

It's (past) time for the administration to get serious about creating jobs:

The Jobs Imperative, by Paul Krugman, Commentary, NYTimes: If you're looking for a job right now, your prospects are terrible. There are six times as many Americans seeking work as there are job openings, and the average duration of unemployment ... is more than six months, the highest level since the 1930s.
You might think, then, that ... the employment situation would be a top policy priority. But now that total financial collapse has been averted, all the urgency seems to have vanished... There's a pervasive sense in Washington that ... we should just wait for the economic recovery to trickle down to workers.
This is wrong and unacceptable. ... Historically, financial crises have typically been followed ... by anemic recoveries; it's usually years before unemployment declines to anything like normal levels. And all indications are that ... the latest financial crisis is following the usual script. ...
And the damage from sustained high unemployment will last much longer. The long-term unemployed can lose their skills... Meanwhile, students who graduate into a poor labor market ... pay a price in lower earnings for their whole working lives. Failure to act on unemployment isn't just cruel, it's short-sighted.
So it's time for an emergency jobs program.
How is a jobs program different from a second stimulus? It's a matter of priorities. The 2009 Obama stimulus bill was focused on restoring economic growth. ... That strategy might have worked if the stimulus had been big enough — but it wasn't. And as a matter of political reality, it's hard to see how the administration could pass a second stimulus big enough to make up for the original shortfall.
So our best hope now is for a somewhat cheaper program that generates more jobs for the buck. Such a program should shy away from measures, like general tax cuts, that at best lead only indirectly to job creation... Instead, it should consist of measures that more or less directly save or add jobs.
One such measure would be another round of aid to beleaguered state and local governments... More aid would help avoid ... the elimination of hundreds of thousands of jobs.
Meanwhile, the federal government could provide jobs by ... providing jobs. It's time for at least a small-scale version of the New Deal's Works Progress Administration, one that would offer relatively low-paying (but much better than nothing) public-service employment. There would be accusations that the government was creating make-work jobs, but the W.P.A. left many solid achievements in its wake. And the key point is that direct public employment can create a lot of jobs at relatively low cost. ...[T]he Economic Policy Institute, a progressive think tank, argues that spending $40 billion a year for three years on public-service employment would create a million jobs, which sounds about right.
Finally, we can offer businesses direct incentives for employment. It's probably too late for a job-conserving program... But employers could be encouraged to add workers as the economy expands. The Economic Policy Institute proposes a tax credit for employers who increase their payrolls, which is certainly worth trying.
All of this would cost money, probably several hundred billion dollars, and raise the budget deficit in the short run. But this has to be weighed against the high cost of inaction in the face of a social and economic emergency.
Later this week, President Obama will hold a "jobs summit." Most of the people I talk to are cynical about the event, and expect the administration to offer no more than symbolic gestures. But it doesn't have to be that way. Yes, we can create more jobs — and yes, we should.

links for 2009-11-29

November 29, 2009

Economist's View - 3 new articles

"Will the Obey Plan End the War?"

If people had to pay for the cost of the war with an explicit, dedicated tax for that purpose, would they still support it? I think it's a good idea to make clear what the war costs - e.g. the $11 billion per month the war effort costs would pay for a lot of health care and other domestic needs - but I'm not sure that raising taxes during a recession (or during the inklings of a recovery) is a good idea.

The economic effects of a tax increase are one of the worries, though the size of those effects depends upon where the burden falls. If the Bush tax cuts didn't do much to help middle and lower class income and employment -- and I don't see any strong evidence that they did -- it's hard to see how reversing such taxes would have much of an effect either. But the tax surcharge proposal is broad-based, everyone would face higher taxes not just the wealthy, and the effects of a broad-based tax change might be larger. Why take a chance when the job market doing so poorly?

The main worry for me is not the size of the debt or the economic consequences (though the latter is of concern), it's the political message that raising taxes right now would send. Raising taxes to pay for the war would send the message that the federal debt is such a large problem we have to implement a tax surcharge even while the economy is struggling to recover from a recession. That is the opposite of the message I think we should be sending -- the economy and labor markets still need more help -- and it's hard to imagine how to get that help after sending a message that the debt is so worrisome.

We do have debt problems down the road, and rising health care costs are the driving force behind the budget trajectory. We will need to address this problem. In addition, we should pay for the wars and the stimulus package when the economy is on better footing. Thus, I would support legislation that raises taxes (or cuts "wasteful" spending, though good luck with that) to pay for these items at some point in the future. That would highlight the cost of the war without simultaneously sending a message that the budget problem is urgent, so urgent that it ties our hands from doing anything more. It would also blunt the inevitable "tax increases will kill jobs" objection that is sure to come.

So yes, let's raise taxes now to pay for these things, but the tax changes shouldn't take effect until the economy surpasses some metric for health -- unemployment falling below a particular number could be one trigger -- or it could come at some date certain in the future, e.g. two years from now, (assuming that gives the economy enough time to regain more solid footing).

If I thought that the Obey tax surcharge plan would actually end the war, or stop it sooner, I might see this differently. But it seems to me that highlighting budget problems now would be more likely to affect funding for needed social programs such as food stamps and unemployment compensation than it would be to affect the war effort.

I'm curious to hear your thoughts on this:

Will the Obey Plan End the War?, by Bruce Bartlett, Commentary, Forbes: In recent years, Republicans have been characterized by two principal positions: They like starting wars and don't like paying for them. George W. Bush initiated two major wars in Iraq and Afghanistan, but adamantly refused to pay for either of them by cutting non-military spending or raising taxes. Indeed, at his behest, Congress actually cut taxes and established a massive new entitlement program, Medicare Part D.
Bush's actions were unprecedented. During every previous major war in American history, presidents demanded sacrifices from rich and poor alike. As Robert Hormats explains in his 2007 book, The Price of Liberty: Paying for America's Wars, "During most of America's wars, parochial desires--such as tax breaks for favored groups or generous spending for influential constituencies--have been sacrificed to the greater good. The president and both parties in Congress have come together … to cut nonessential spending and increase taxes."
During World War II, federal revenues roughly tripled as a share of the gross domestic product (GDP) and the number of people paying income taxes expanded tenfold, from 3% of the population in 1939 to 30% by 1943. In 1940, a family of four needed close to $80,000 of income in today's dollars before it paid any federal income taxes at all. By the war's end, it saw its effective tax rate rise from 1.5% to 15.1%. (Today such a family only pays a federal income tax rate of about 6%.) But taxes weren't the only way the war was paid for. Spending on nondefense programs was cut almost in half, from 8.1% of GDP in 1940 to 4.4% in 1945.
Even during wars closer in magnitude to those in which we are presently engaged, significant sacrifices were made. In 1950 and 1951 Congress increased taxes by close to 4% of GDP to pay for the Korean War, even though the high World War II tax rates were still largely in effect. In 1968, a 10% surtax was imposed to pay for the Vietnam War, which raised revenue by about 1% of GDP. And there was conscription during both wars, which can be viewed as a kind of tax that was largely paid by the poor and middle class--young men from wealthy families largely escaped its effects through college deferments.
However, Bush and his party, which controlled Congress from 2001 to 2006, never asked for sacrifices from anyone except those in our nation's military and their families. I think that's because the Republicans understood, implicitly, that the American people's support for the wars in Iraq and Afghanistan has always been paper thin. Asking them to sacrifice through higher taxes, domestic spending cuts or reinstatement of the draft would surely have led to massive protests akin to those during the Vietnam era or to political defeat in 2004. George W. Bush knew well that when his father raised taxes in 1990 in part to pay for the first Gulf War, it played a major role in his 1992 electoral defeat.
Consequently, Republicans resolved to fight our wars on the cheap and with deceptive cost estimates. On the eve of war in December 2002, Office of Management and Budget (OMB) director Mitch Daniels claimed that the war in Iraq could be fought at a total cost of $50 billion to $60 billion. Indeed, Bush even fired his top economic adviser, Lawrence Lindsey, for saying publicly that the war might cost between $100 billion and $200 billion.
Of course, both Daniels and Lindsey grossly underestimated the actual cost. According to a recent report from the Congressional Research Service (CRS), the wars in Iraq and Afghanistan have cost close to $1 trillion thus far. That is exactly what economists not on the White House payroll expected. (See this December 2002 report from the American Academy of Arts and Sciences.)
In his 2008 book, What a President Should Know, Lindsey said that lowballing the cost of the war was a "tactical blunder" because it allowed Bush's enemies to claim that he lied us into war. But at the same time, Lindsey acknowledges that the administration never rose to "Churchillian levels in talking about the sacrifices needed." He also says that asking for sacrifice in the form of spending cuts and tax increases would have served the important purpose of involving the American people in the war effort. As it is, war is largely out of sight and out of mind.
According to the CRS, the marginal cost of continuing the Iraq and Afghanistan wars is about $11 billion per month, with no end in sight. Although there has been some decline in spending for the Iraq war, it has been more than offset by the rising cost of the war in Afghanistan. According to OMB director Peter Orszag, it costs about $1 million per year per soldier in the field, so adding 30,000 additional troops in Afghanistan, as President Obama is expected to do next week, will cost another $30 billion per year.
The White House has given no indication of how it plans to pay for expanding the war in Afghanistan. More than likely, it will follow the Bush precedent and just put it all on the national credit card. But at least some members of Congress believe that the time has come to start paying for war. On Nov. 19, Rep. David Obey, D-Wis., introduced H.R. 4130, the "Share the Sacrifice Act of 2010." It would establish a 1% surtax on everyone's federal income tax liability plus an additional percentage on those with a liability over $22,600 (for couples filing jointly), such that revenue from the surtax would pay for the additional cost of fighting the war in Afghanistan.
It's doubtful that this legislation will be enacted. But that's not Obey's purpose. He will probably offer it as an amendment at some point just to have a vote. Republicans in particular will be forced to choose between continuing to fight a war that they started and still strongly support, or raising taxes, which every Republican in Congress would rather drink arsenic than do. If nothing else, it will be interesting to see those who rant daily about Obama's deficits explain why they oppose fiscal responsibility when it comes to supporting our troops.
Obey makes no secret of his motives. He knows that deficits need to be reduced at some point and this will put pressure on spending programs he supports. "If we don't address the cost of this war, we will continue shoving billions of dollars in taxes off on future generations and will devour money that could be used to rebuild our economy," Obey explained in a press statement.
He is not alone in his fear that war presents a threat to the Democratic agenda. As Boston University historian Robert Dallek told Obama at a White House meeting earlier this year, "war kills off great reform movements." He cited the impact of World War I in ending the Progressive Era, World War II in killing the New Deal, the Korean War in terminating Harry Truman's Fair Deal program and the Vietnam War in crushing Lyndon Johnson's Great Society.
At this point, Republicans are probably nodding in agreement. If it takes wars to end ill-conceived social programs, then that's another argument in favor of continuing the Iraq and Afghanistan campaigns. But that's a very short-sighted view because, as essayist Randolph Bourne once put it, "war is essentially the health of the State." Historians Robert Higgs and Bruce Porter, among others, have documented the pernicious effect of war on the size and scope of government. It creates a ratchet effect in which taxes and spending grow and civil liberties are restricted permanently, because when war ends, we never go back to the status quo ante.
If it takes the threat of a tax increase to get people to think seriously about whether it's worth continuing to fight wars far from home--wars that have only the most tenuous connection to the national interest--then it's a good idea. History shows that wars financed heavily by higher taxes, such as the Korean War and the first Gulf War, end quickly, while those financed largely by deficits, such as the Vietnam War and current Middle East conflicts, tend to drag on indefinitely.
If Americans aren't willing to follow John F. Kennedy and "pay any price, bear any burden, meet any hardship" to fight a war, then we shouldn't be fighting it.

"Dangers of an Overheated China"

Tyler Cowen:

Dangers of an Overheated China, by Tyler Cowen, Commentary, NY Times: ...Several hundred million Chinese peasants have moved from the countryside to the cities over the last 30 years... To help make this work, the Chinese government has subsidized its exporters by pegging the renminbi at an unnaturally low rate to the dollar...; additional subsidies have included direct credit allocation and preferential treatment for coastal enterprises.
These aren't the recommended policies you would find in a basic economics text, but it's hard to argue with success. ... Those same subsidies, however, have spurred excess capacity... China has been building factories and production capacity in virtually every sector of its economy... Automobiles, steel, semiconductors, cement, aluminum and real estate all show signs of too much capacity. ...
Regional officials have an incentive to prop up local enterprises and production statistics... Chinese fiscal and credit policies are geared toward jobs and political stability, and thus the authorities shy away from revealing which projects are most troubled or should be canceled.
Put all of this together and there is a very real possibility of trouble. ... What will the consequences be ... if and when the Chinese economic miracle encounters a major stumble? A lot of Chinese business ventures will stop being profitable, and layoffs and unrest will most likely rise. The Chinese government may crack down further on dissent. The Chinese public may wonder whether its future lies with capitalism after all, and foreign investors in China will become more nervous.
In economic terms, the prices of Chinese exports will probably fall, as overextended businesses compete to justify their capital investments... American businesses will find it harder to compete with Chinese companies, and there will be deflationary pressures in both countries. And ... the Chinese ... may have less to lend to the United States government. ... The United States will face higher borrowing costs, and its fiscal position may very quickly become unsustainable.
That's not so much a prediction as a very possible contingency, and we should be prepared for it. For now, we should avoid two big mistakes. The first would be to assume that just because borrowing costs are now low, we can postpone fiscal responsibility and keep running up the tab — with the aid of Chinese lending, of course. The history of financial crises shows that turning points can come swiftly...
The second mistake would be to demand too many concessions from the Chinese. What we see in the numbers today are a growing China... Yet there's a real chance that, soon enough, Chinese economic weakness will be a bigger problem than was Chinese economic strength.

links for 2009-11-28

November 28, 2009

Economist's View - 3 new articles

"Catastrophe Theory and the Business Cycle"

As a follow up to the recent post on non-linear dynamics that continued the discussion on what's wrong with modern macroeconomics, here is a paper written many years ago by Hal Varian that extends the Goodwin-Kaldor model of business cycles. It is old-fashioned macro, but the interesting part is the wealth effect causing the difference between recessions and depressions. In particular, the results of the paper imply that shocks to wealth that change savings propensities -- as we are seeing now -- can cause recoveries that "may take a very long time, and differ quite substantially from the recovery pattern of a [typical] recession."

Here are a few selections from the paper:

Catastrophe Theory and the Business Cycle, by Hal Varian: In this paper we examine a variation on Kaldor's (1940) model of the business cycle using some of the methods of catastrophe theory. (Thom (1975), Zeeman (1977)). The development proceeds in several stages. Section I provides a brief outline of catastrophe theory, while Section II applies some of these techniques to a simple macroeconomic model. This model yields, as a special case, Kaldor's business cycles. ... In Section III, we describe a generalization of Kaldor's model that allows not only for cyclical recessions, but also allows for long term depressions. Section IV presents a brief review and summary.

This paper is frankly speculative. It presents, in my opinion, some interesting models concerning important macroeconomic phenomena. However, the hypotheses of the models are neither derived from microeconomic models of maximizing behavior, nor are they subjected to serious empirical testing. The hypotheses are not without economic plausibility, but they are far from being established truths. Hence, this paper can only be said to present some interesting stories of macroeconomic instability. Whether these stories have any empirical basis is an important, and much more difficult, question. ...

Applied catastrophe theory is not without its detractors (Sussman and Zahler (1978)). Some of the applied work in catastrophe theory has been criticized for being ad hoc, unscientific, and oversimplified. As with any new approach to established subjects, catastrophe theory has been to some extent oversold. In some cases, applications of the techniques may have been overly hasty. Nevertheless, the basic approach of the subject seems, to this author at least, potentially fruitful. Catastrophe theory may provide some descriptive models and some hypotheses which, when coupled with serious empirical work, may help to explain real phenomena. ...

[I]t makes sense to model the system as if the state variables adjust immediately to some "short run" equilibrium, and then the parameters adjust in some "long run" manner. In the parlance of catastrophe theory, the state variables are referred to as "fast" variables, and the "parameters" are referred to as "slow" variables. This distinction is, of course, common in economic modeling. For example, when we model short run macroeconomic processes we take certain variables, such as the capital stock, as fixed at some predetermined level. Then when we wish to examine long run macroeconomic growth processes, we imagine that economy instantaneously adjusts to a short run equilibrium, and focus exclusively on the long run adjustment process.

Catastrophe theory is concerned with the interactions between the short run equilibria and the long term dynamic process. To be more explicit, catastrophe theory studies the movements of short run equilibria as the long run variables evolve. A particularly interesting kind of movement is when a short run equilibrium jumps from one region of the state space to another. Such jumps are known as catastrophes. Under certain assumptions catastrophes can be classified into a small number of distinct qualitative types. ... In the economic model that follows we will only utilize the two simplest catastrophes, the fold and the cusp. In these low dimensional cases, there are no restrictions on the nature of dynamical systems involved. ...

[One result from the macroeconomic model] is the case considered by Kaldor (1940) and, more rigorously, by Chang and Smyth (1972). It has been shown by Chang and Smyth that when the speed of adjustment parameter is large enough, and certain technical conditions are met, there must exist a limit cycle in the phase space. In the appendix I prove a slightly simplified and modified version of this result.

This "business cycle" proposition is clearly the result intuited by Kaldor thirty years ago. However, the existence of a regular, periodic business cycle causes certain theoretical and empirical difficulties. Recent theoretical work involving rational expectations (Lucas (1975)) and empirical work on business cycles (McCullough (1975), (1977), Savin (1977)) have argued that (1) regular cycles seem to be incompatible with rational economic behavior, and (2) there is little statistically significant evidence for a business cycle anyway.

However, there does seem to be some evidence for a kind of "cyclic behavior" in the economy. It is commonplace to hear descriptions of how exogenous shocks may send the economy spiraling into a recession, from which it sooner or later recovers. Leijonhufvud (1973) has suggested that economies operate as if there is a kind of "corridor of stability": that is, there is a local stability of equilibrium, but a global instability. Small shocks are dampened out, but large shocks may be amplified. ...

Such a story seems to me to be a reasonable description of the functioning of the commonly described "inventory recession." [L]et us, for the sake of argument, accept such a story as providing a possible explanation of the "cyclic" behavior of an economy. Then there is yet another puzzle. Each recession in this model will behave rather similarly: First some kind of shock, then a rapid fall, followed by a slow change in some stock variables with, eventually, a rapid recovery. Although this story seems to be descriptive of some recessions, it does not describe all types of fluctuations of income. Sometimes the economy experiences depressions. That is, sometimes the return from a crash is very gradual and drawn out. ...

Here is the interesting feature of the model. Suppose as before, that there is some kind of perturbation in one of the stock variables. For definiteness let us suppose [there is] some kind of shock (a stock market crash?).... If the shock is relatively small, we have much the same story as with the inventory recession... If on the other hand the shock is relatively large, wealth may decrease so much as to significantly affect the propensity to save. In this case,... national income will remain at a relatively low level rather than experience a jump return. Eventually the gradual increase in wealth due to the increased savings will move the system slowly back towards the long run equilibrium. ...

According to this story the major difference between a recession and a depression is in the effect on consumption. If a shock affects wealth so much as to change savings propensities, recovery may take a very long time, and differ quite substantially from the recovery pattern of a recession. This explanation does not seem to be in contradiction with observed behavior, but as I have mentioned earlier, it rests on unproven (but not implausible) assumptions about savings and investment behavior.

1.4 Review and summary

We have shown how nonlinearities in investment behavior can give rise to cyclic or cycle like behavior in a simple dynamic macroeconomic model.

This behavior shares some features with empirically observed behavior. If savings behavior also exhibits nonlinearities of a plausible sort, the model can allow for both rapid recoveries which characterize recessions, as well as extended recoveries typical of a depression.

"Independent Does Not Mean Unaccountable"

As you might guess given my recent posts defending Fed independence, I agree with this:

The right reform for the Fed, by Ben Bernanke, Commentary, Washington Post: For many Americans, the financial crisis, and the recession it spawned, have been devastating... Understandably, many people are calling for change. ... As a nation, our challenge is to design a system of financial oversight that will ... provide a robust framework for preventing future crises...
I am concerned ... that ... some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures ... would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution's ability to foster financial stability and to promote economic recovery without inflation. ...
The proposed measures are at least in part the product of public anger over ... the rescues of some individual financial firms. The government's actions... -- as distasteful and unfair as some undoubtedly were -- were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity...
Moreover, looking to the future, we strongly support measures -- including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system -- to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is "too big to fail" -- while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.
The Federal Reserve ... did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems. ... There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks...
This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed's unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.
Of course, the ... ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance...
Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities... Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation. ...
Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

While I agree on the independence and regulation statements, one thing I do wonder about is why there is such widespread acceptance of the idea that we have to live with institutions that are so big that their failure is a threat to the financial system and the economy. The notion seems to be that large, dangerous firms are inevitable, so we need special procedures in place that we hope will allow them to fail without the problems spreading and creating a devastating domino effect. The concern seems to be mainly about having the procedures and authority to allow orderly dissolution of large, dangerous firms rather than preventing these firms from getting too large and too interconnected to begin with.

We need procedures for orderly dissolution in any case -- we didn't think firms were systemically important before the crash, so we need to be ready (e.g., recall the many, many statements that the crisis would be "contained"). But what is the minimum efficient scale (MES) for financial firms? That is, what is the smallest size at which economies of scale and economies of scope are fully realized?

There has been some discussion of this (e.g. Economics of Contempt versus The Baseline Scenario), but it doesn't seem to me that this question is very close to being settled. I want to know how the MES relates to the minimum size where a bank becomes systemically important. If the MES is smaller than the size where banks become systemically dangerous, break them up - their size adds nothing but risk. But if the MES is greater than the minimum dangerous size, then we have a tradeoff to make -- safety for efficiency -- and we may or may not want to force firms to reduce their size and connectedness. It depends upon the tradeoff.

But until we know what these tradeoffs are -- and I don't think we have a good sense of this -- it's very difficult to determine if the costs of breaking up banks and reducing their connectedness are greater than the benefits. I suspect that if the MES is greater than the minimum safe size, then the extra safety from reducing bank size and connectedness would be worth the loss of efficiency, and I'd like to push that position much more than I have to date. But without knowing the MES, the minimum threatening size, the minimum threatening degree of connectedness, and the costs and benefits of reducing size and connectedness, it's hard to do so with confidence.

links for 2009-11-27

November 27, 2009

Economist's View - 4 new articles

DeLong: Time to Give Thanks for the Bailouts

Brad DeLong says those who argue that fiscal stimulus policies can't work and are too costly "rely on arguments that are incoherent at best, and usually simply wrong, if not mendacious":

Why Are Good Policies Bad Politics?, by J. Bradford DeLong, Commentary, Project Syndicate: From the day after the collapse of Lehman Brothers last year, the policies followed by the United States Treasury, the US Federal Reserve, and the administrations of Presidents George W. Bush and Barack Obama have been sound and helpful. The alternative – standing back and letting the markets handle things – would have brought ... higher unemployment than now exists. Credit easing and support of the banking system helped significantly...
The fact that investment bankers did not go bankrupt last December and are profiting immensely this year is a side issue. Every extra percentage point of unemployment lasting for two years costs $400 billion. A recession twice as deep as the one we have had would have cost the US roughly $2 trillion – and cost the world as a whole four times as much. In comparison, the bonuses at Goldman Sachs are a rounding error. ...
The Obama administration's fiscal stimulus has also significantly helped the economy. Though the jury is still out on the effect of the tax cuts in the stimulus, aid to states has been a job-saving success, and the flow of government spending on a whole variety of relatively useful projects is set to boost production and employment in the same way that consumer spending boosts production and employment.
And the cost of carrying the extra debt incurred is extraordinarily low: $12 billion a year of extra taxes ... at current interest rates. For that price, American taxpayers will get an extra $1 trillion of goods and services, and employment will be higher by about ten million job-years.
The valid complaints about fiscal policy ... are not that it has run up the national debt..., but rather that ... we ought to have done more. Yet these policies are political losers now: nobody is proposing more stimulus. This is strange... Good policies that are boosting production and employment without causing inflation ought to be politically popular, right?
With respect to Obama's stimulus package, it seems to me that there has been extraordinary intellectual and political dishonesty on the American right, which the press refuses to see. For two and a half centuries, economists have believed that the flow of spending in an economy goes up whenever groups of people decide to spend more... – and government decisions to spend more are as good as anybody else's. ...
Obama's Republican opponents, who claim that fiscal stimulus cannot work, rely on arguments that are incoherent at best, and usually simply wrong, if not mendacious. Remember that back in 1993, when the Clinton administration's analyses led it to seek to spend less and reduce the deficit, the Republicans said that that would destroy the economy, too. Such claims were as wrong then as they are now. But how many media reports make even a cursory effort to evaluate them?
A stronger argument, though not by much, is that the fiscal stimulus is boosting employment and production, but at too great a long-run cost because it has produced too large a boost in America's national debt. If interest rates on US Treasury securities were high and rising rapidly as the debt grew, I would agree... But interest rates on US Treasury securities are very low...
Those who claim that America has a debt problem, and that a debt problem cannot be cured with more debt, ignore (sometimes deliberately) that private debt and US Treasury debt have been very different animals – moving in different directions and behaving in different ways – since the start of the financial crisis. /blockquote>

What the market is saying is not that the economy has too much debt, but that it has too much private debt, which is why prices of corporate bonds are low and firms find financing expensive. The market is also saying – clearly and repeatedly – that the economy has too little public US government debt, which is why everyone wants to hold it.

Just one comment: Brad's right.

"Muddying the Waters on AIG"

John Berry defends the Fed and Treasury's assistance to AIG:

Muddying the waters on AIG, by John M. Berry, Commentary, Reuters: Neil Barofsky, inspector general of the Troubled Asset Relief Program, is making a name for himself with a misleading analysis of actions by the Federal Reserve and Treasury in combating the financial crisis.
A column in the New York Times called Barofsky "one of the few truth tellers in Washington"... Barofsky's report, which is logically flawed, uses loaded language to create the impression that saving the economy wasn't the Fed's goal at all. No, it was all about helping the central bank's friends on Wall Street.
"Questions have been raised as to whether the Federal Reserve intentionally structured the AIG counterparty payments to benefit AIG counterparties...," the report says. ... The report duly notes that Fed officials deny a backdoor bailout was their objective. But the next sentence suggests the officials must be lying.
"Irrespective of their stated intent, however, there is no question that the effect of the Federal Reserve Bank of New York's decisions — indeed the very design of the federal assistance to AIG — was that tens of billions of dollars of Government money was funneled inexorably and directly to AIG's counterparties." (Emphasis in the original.)
Well, AIG had sold the counterparties a great many credit default swap contracts covering collateralized debt obligations secured by mortgages. ...AIG owed the counterparties a whole pot full of money which it couldn't pay.
If AIG was to be kept out of bankruptcy, of course the very design of the federal assistance had to include funneling tens of billions of dollars to the institutions to which it was owed. There was no other way to avoid a bankruptcy that would have affected not just big financial institutions but thousands of municipalities, individual savers and other investors. ... The report does not offer an alternative way to avoid an AIG bankruptcy, and there wasn't one. It does, however, suggest the Fed should have used its power as a banking regulator to force the AIG creditors to accept less than full payment of what they were owed.
The report acknowledges that the New York Fed tried to negotiate such a haircut... But the French banking regulator said it would be illegal for the two French institutions involved to take a haircut unless AIG was in formal bankruptcy, and the Fed said it had to treat all the banks the same way.
Nevertheless, Barofsky insists the Fed should have used its authority to force concessions. Unsaid, but implied: The Fed didn't do that because its goal was to help its Wall Street friends.
Barofsky is getting great press and kudos on Capitol Hill by pandering to the public anger at Wall Street. Pity he's not really a truth teller at all.

Paul Krugman: Taxing the Speculators

Is it time to impose a financial transactions tax?:

Taxing the Speculators, by Paul Krugman, Commentary, NY Times: Should we use taxes to deter financial speculation? Yes, say top British officials... Other European governments agree — and they're right.
Unfortunately, United States officials — especially Timothy Geithner... — are dead set against the proposal. Let's hope they reconsider: a financial transactions tax is an idea whose time has come.
The dispute began back in August, when Adair Turner, Britain's top financial regulator, called for a tax on financial transactions as a way to discourage "socially useless" activities. Gordon Brown, the British prime minister, picked up on his proposal...
Why is this a good idea? The Turner-Brown proposal is a modern version of an idea originally floated in 1972 by the late James Tobin, the Nobel-winning Yale economist. Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies.
Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, "throw some sand in the well-greased wheels" of speculation.
Tobin's idea went nowhere... But the Turner-Brown proposal, which would apply a "Tobin tax" to all financial transactions ... is very much in Tobin's spirit. It would ... deter much of the churning that now takes place in our hyperactive financial markets.
This would be a bad thing if financial hyperactivity were productive. But after the debacle of the past two years, there's broad agreement ... that a lot of what Wall Street and the City do is "socially useless." And a transactions tax could generate substantial revenue, helping alleviate fears about government deficits. What's not to like?
The main argument made by opponents of a financial transactions tax is that ... traders would find ways to avoid it. Some also argue that it wouldn't do anything to deter the socially damaging behavior that caused our current crisis. But neither claim stands up to scrutiny.
On the claim that financial transactions can't be taxed: modern trading is a highly centralized affair. ... This centralization keeps the cost of transactions low... It also, however, makes these transactions relatively easy to identify and tax.
What about the claim that a financial transactions tax doesn't address the real problem? It's true that a transactions tax wouldn't have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.
But bad investments aren't the whole story of the crisis. What turned those bad investments into catastrophe was the financial system's excessive reliance on short-term money.
As Gary Gorton and Andrew Metrick ... have shown, by 2007 the United States banking system had become crucially dependent on "repo" transactions... Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a "run on repo."
And a financial transactions tax, by discouraging reliance on ultra-short-run financing, would have made such a run much less likely. So contrary to what the skeptics say, such a tax would have helped prevent the current crisis — and could help us avoid a future replay.
Would a Tobin tax solve all our problems? Of course not. But it could be part of the process of shrinking our bloated financial sector. On this, as on other issues, the Obama administration needs to free its mind from Wall Street's thrall.

links for 2009-11-26

November 26, 2009

Economist's View - 3 new articles

On Buiter, Goodwin, and Nonlinear Dynamics

Rajiv Sethi continues the discussion on the state of modern macroeconomics:

On Buiter, Goodwin, and Nonlinear Dynamics, by Rajiv Sethi: A few months ago, Willem Buiter published a scathing attack on modern macroeconomics in the Financial Times. While a lot of attention has been paid to the column's sharp tone and rhetorical flourishes, it also contains some specific and quite constructive comments about economic theory that deserve a close reading. One of these has to do with the limitations of linearity assumptions in models of economic dynamics:
When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner. There is no 'bounded instability' in such models. The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories. What they were left with was something that, following an exogenous random disturbance, would return to the deterministic steady state pretty smartly. No L-shaped recessions. No processes of cumulative causation and bounded but persistent decline or expansion. Just nice V-shaped recessions.
Buiter is objecting here to a vision of the economy as a stable, self-correcting system in which fluctuations arise only in response to exogneous shocks or impulses. This has come to be called the Frisch-Slutsky approach to business cycles, and its intellectual origins date back to a memorable metaphor introduced by Knut Wicksell more than a century ago: "If you hit a wooden rocking horse with a club, the movement of the horse will be very different to that of the club" (translated and quoted in Frisch 1933). The key idea here is that irregular, erratic impulses can be transformed into fairly regular oscillations by the structure of the economy. This insight can be captured using linear models, but only if the oscillations are damped - in the absence of further shocks, there is convergence to a stable steady state. This is true no matter how large the initial impulse happens to be, because local and global stability are equivalent in linear models. A very different approach to business cycles views fluctuations as being caused by the local instability of steady states, which leads initially to cumulative divergence away from balanced growth. Nonlinearities are then required to ensure that trajectories remain bounded. Shocks to the economy can make trajectories more erratic and unpredictable, but are not required to account for persistent fluctuations. An energetic and life-long proponent of this approach to business cycles was Richard Goodwin, who also produced one of the earliest such models in economics (Econometrica, 1951). Most of the literature in this vein has used aggregate investment functions and would not be considered properly microfounded by contemporary standards (see, for instance, Chang and Smyth 1971, Varian 1979, or Foley 1987). But endogenous bounded fluctuations can also arise in neoclassical models with overlapping generations (Benhabib and Day 1982, Grandmont 1985). The advantage of a nonlinear approach is that it can accomodate a very broad range of phenomena. Locally stable steady states need not be globally stable, so an economy that is self-correcting in the face of small shocks may experience instability and crisis when hit by a large shock. This is Axel Leijonhufvud's corridor hypothesis, which its author has discussed in a recent column. Nonlinear models are also required to capture Hyman Minsky's financial instability hypothesis, which argues that periods of stable growth give rise to underlying behavioral changes that eventually destabilize the system. Such hypotheses cannot possibly be explored formally using linear models. This, I think, is the point that Buiter was trying to make. It is the same point made by Goodwin in his 1951 Econometrica paper, which begins as follows:
Almost without exception economists have entertained the hypothesis of linear structural relations as a basis for cycle theory. As such it is an oversimplified special case and, for this reason, is the easiest to handle, the most readily available. Yet it is not well adapted for directing attention to the basic elements in oscillations - for these we must turn to nonlinear types. With them we are enabled to analyze a much wider range of phenomena, and in a manner at once more advanced and more elementary.
By dropping the highly restrictive assumptions of linearity we neatly escape the rather embarrassing special conclusions which follow. Thus, whether we are dealing with difference or differential equations, so long as they are linear, they either explode or die away with the consequent disappearance of the cycle or the society. One may hope to avoid this unpleasant dilemma by choosing that case (as with the frictionless pendulum) just in between. Such a way out is helpful in the classroom, but it is nothing more than a mathematical abstraction. Therefore, economists will be led, as natural scientists have been led, to seek in nonlinearities an explanation of the maintenance of oscillation. Advice to this effect, given by Professor Le Corbeiller in one of the earliest issues of this journal, has gone largely unheeded.
And sixty years later, it remains largely unheeded.

Thank You

Thanks to everyone who visits this blog, and I hope you have a nice Thanksgiving.


links for 2009-11-25

November 25, 2009

Economist's View - 4 new articles

Worries about Budget Deficits and Inflation: Let's Avoid Repeating Our Mistakes

At MoneyWatch:

Worries about Budget Deficits and Inflation: Let's Avoid Repeating Our Mistakes, by Mark Thoma: There is a lot of concern about the future course of the economy, and there are two separate worries that are getting confused. The purpose of this post is to distinguish between the two sets of worries, and to discuss whether the worries are justified. ...

Fed Watch: Ahead of Black Friday

Tim Duy says -- correctly -- "that a significant portion of policymakers are simply clueless":

Ahead of Black Friday, by Tim Duy: We are embarking once again into that time of the year when reporters around the world become entranced and enthralled with that orgy of consumerism that defines Christmas in America. Soon we will be tracking the ups and downs of holiday sales with a zeal that is unmatched by any other regular economic event. Weary reporters - those who clearly disappointed their editors at some point during the year - will be dispatched to local big box stores across the nation to record the lines forming in anticipation of 5am openings on the fabled Black Friday. We will be bombarded with hundreds if not thousands of conflicting reports regarding the amount and patterns of holiday shopping, leaving overworked and underpaid analysts awash in data as they desperately try to quantify, once and for all, the "true" state of consumer spending - and thus by extension, the true state of the economy - in America.

Oooo, how I have come to loathe this exercise. And yet, here I am again, fretting over the financial state of US households in between checking off items on the Thanksgiving shopping list. It is like a car wreck - you don't want to watch, but you can't take your eyes off it.

Car wreck is something of an appropriate comparison. Recently I have begun using charts of this sort to depict the current economic environment:



Not fancy econometrics, I know - most of my audiences are not interested in unit root tests. The point, obviously, is that even as activity creeps upward, the gap between the past and current trajectory of consumer spending is likely still widening. Much, much faster growth is necessary to close that gap. And households as of yet are seeing nothing to convince them their fortunes are set to change, that some Christmas miracle awaits. To be sure, Bloomberg trumpeted today's data:

Confidence among U.S. consumers unexpectedly rose in November as a brightening outlook masked growing concern over joblessness.

How much did the outlook brighten? The story continues:

The Conference Board's confidence index increased to 49.5 from 48.7 the prior month. The New York-based Conference Board's index, which focuses on the labor market and purchase plans, averaged 58 in 2008 and 103.4 in 2007.

Not much brighter. Indeed, Economix more accurately reports the dismal mood of consumers, noting:

Over the last 30 years, the index has averaged about 95. In November, it was 49.5, up from 48.7 the previous month.

Yes, for three decades the Conference Board measure of confidence has averaged nearly twice current levels. This tells us something about the strength of consumer spending. Using the parallel measure from the University of Michigan:


Real year over year growth in the 1% range is not going to bring households back to trend anytime soon. To be sure, given the dependence of household on debt financed spending, it is arguably correct that past trends were unsustainable, that the only possible outcome from this mess was a permanent shock to the level of household spending. That, however, is likely cold comfort to the millions of Americans - those not employed by Goldman Sachs, of course - who are just now realizing that their standard of living has shifted permanently lower. Lacking sufficient income gains and the ability to use debt to cover up their relative poverty, households are not seeing a path to a brighter future. And they will increasingly look for someone to blame. No wonder the knives are sharpening for Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke. They are the public faces for an Administration that now owns this economy.

And where are policymakers as we slog through the final month of 2009? The Administration is poised to do virtually nothing:

The White House is lukewarm about proposals by congressional Democrats to introduce broad legislation to create jobs, instead favoring targeted measures that would be less likely to inflate the deficit, administration officials said.

There is as yet no agreement within the White House or in Congress on how to try to curb the U.S. jobless rate. But the differences in opinion suggest that rifts could emerge among Democrats as they wrestle with how to beat back the highest unemployment rate in a generation.

...Hamstrung by the nation's $1.4 trillion deficit and his pledge not to raise taxes on middle-class Americans, Mr. Obama is keen to avoid any measures suggestive of a second, big-ticket stimulus.

Indeed, the failure of the Administration to take bold moves early in the year now cripples it in any attempt to take bold action now. Apparently, the best we can expect now is a "Cash for Caulkers" program that will dribble money into the economy, ensuring that we do little if any better than limp along.

Likewise, monetary policymakers too are caught in the headlights. As has already been widely noted, the minutes of the most recent FOMC meeting reiterated the Fed's eagerness to reverse, not extend, policy:

...Overall, many participants viewed the risks to their inflation outlooks over the next few quarters as being roughly balanced. Some saw the risks as tilted to the downside in the near term, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation. To keep inflation expectations anchored, all participants agreed that it was important for policy to be responsive to changes in the economic outlook and for the Federal Reserve to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.

Read that carefully and realize this: An apparently not insignificant portion of the FOMC believes that there is a terrible risk that banks loosen their credit standards and increase lending at a time when, even if the economy posts expected gain, unemployment remains at unacceptably high levels. Silly me, I thought increased lending was the whole point of the exercise to lower interest and expand the balance sheet. That whole credit channel thing. If not to expand lending during a credit crunch, then what else are they expecting?

I am in shock that this sentence made it into the minutes. One can only conclude that a significant portion of policymakers are simply clueless. Or, more disconcerting, they have lost all faith in the ability of financial institutions to channel capital into activities with any hope of financial returns. Has the Fed now embraced the view that they manage the economy through little else then fueling and extinguishing bubbles?

At this juncture, only St. Louis Fed President James Bullard is signaling a willingness to at least keep the option of ongoing balance sheet expansion alive:

Federal Reserve Bank of St. Louis President James Bullard wants the Fed to continue to buy mortgage-backed securities beyond the March 2010 cutoff to give policy makers more flexibility as they seek to shepherd the economy toward recovery.

"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.

Mr. Bullard will be a voting member on the interest-rate-setting Federal Open Market Committee in 2010. In its statement after the November FOMC meeting, the central bank reiterated that it will continue to monitor its asset-purchase programs "in light of the evolving economic outlook and conditions in financial markets."

Maybe if unemployment continues to rise Bullard's vote will matter next year. Maybe.

Considering what all this means in light of Black Friday, I tend to think Phil Izzo at the Wall Street Journal is on the right path:

New reports Monday didn't paint an encouraging picture. The Conference Board released a survey of spending intentions that showed U.S. households expect to spend an average of $390 this season, down 7% from estimates of $418 last year. That number is especially distressing because consumers were unusually pessimistic last year as the financial crisis went into full swing just as holiday shopping was getting underway.

"Job losses and uncertainty about the future are making for a very frugal shopper. Retailers will need to be quite creative to entice consumers to spend, both in stores and online this holiday season," said Lynn Franco, director of the Conference Board Consumer Research Center.

A separate report from retail-tracking firm NPD Group indicated consumers may not be flocking to the mall for Black Friday. Just 32% of respondents said that they expect to begin their holiday shopping on Thanksgiving weekend or earlier.

Still, more broadly, whether sales gain 2% or 4% this holiday season may have great influence on the animal spirits that govern equity markets, I doubt it would alter much what should be our overall assessment of the economy: Economic activity is now increasing, something for which we should all be thankful this weekend. The alternative would be very unpleasant. But that growth should not lull us into policy complacency with regards to the very real economic stress felt across the nation. By all forecasts, it simply falls far short of what is necessary to restore confidence among households. 2.8% just won't cut it.

"Interest Rates at Center Stage"

Like Tim Duy in the post above this one, David Altig is also puzzled by analysts who, to quote from the FOMC minutes highlighted in Tim's post, that "banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially":

Interest rates at center stage, by David Altig: In case you were just yesterday wondering if interest rates could get any lower, the answer was "yes":

The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end.

"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. ...

The intuition behind this point really is pretty simple. When the economy is struggling ... the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:

"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. ..."

Demand also appears to be quite weak:

"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."

This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:

The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Not everyone is buying my story, of course, and there is a growing global chorus of folk who see a policy mistake at hand:

Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.

Last weekend, Liu Mingkang, China's banking regulator, criticised the US Federal Reserve for fuelling the 'dollar carry-trade', in which investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets abroad.

The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:

But the quantity of bank lending is decidedly not on the rise:

There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?

If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?

links for 2009-11-24