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April 23, 2010

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Latest Posts from Economist's View


Paul Krugman: Don’t Cry for Wall Street

Posted: 23 Apr 2010 12:42 AM PDT

The administration's proposal for financial reform doesn't do enough to cut the financial sector down to size:

Don't Cry for Wall Street, by Paul Krugman, Commentary, NY Times: On Thursday, President Obama went to Manhattan, where he urged an audience drawn largely from Wall Street to back financial reform. "I believe," he declared, "that these reforms are, in the end, not only in the best interest of our country, but in the best interest of the financial sector."
Well, I wish he hadn't said that... Mr. Obama should be trying to do what's right for the country — full stop. If doing so hurts the bankers, that's O.K.
More than that, reform actually should hurt the bankers. A growing body of analysis suggests that an oversized financial industry is hurting the broader economy. Shrinking that oversized industry won't make Wall Street happy, but what's bad for Wall Street would be good for America.
Now, the reforms currently on the table — which I support — ... only deal with part of the problem: they would make finance safer, but they might not make it smaller. ...
In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.
These profits were justified, we were told, because the industry was ... channeling capital to productive uses; it was spreading risk; it was enhancing financial stability. None of those were true. Capital was channeled not to job-creating innovators, but into an unsustainable housing bubble; risk was concentrated, not spread; and when the housing bubble burst, the supposedly stable financial system imploded...
So why were bankers raking it in? My take ... is that it was mainly about gambling with other people's money. The financial industry took big, risky bets with borrowed funds — bets that paid high returns until they went bad — but was able to borrow cheaply because investors didn't understand how fragile the industry was.
And what about the much-touted benefits of financial innovation? I'm with ... Andrei Shleifer and Robert Vishny, who argue ... a lot of that innovation was about creating the illusion of safety, providing investors with "false substitutes" for old-fashioned assets like bank deposits. Eventually the illusion failed — and the result was a disastrous financial crisis.
In his Thursday speech, by the way, Mr. Obama insisted — twice — that financial reform won't stifle innovation. Too bad.
And here's the thing..., financial-industry profits are soaring again. It seems all too likely that the industry will soon go back to playing the same games that got us into this mess in the first place.
So what should be done? As I said, I support the reform proposals of the Obama administration... Among other things, it would be a shame to see the antireform campaign by Republican leaders — a campaign marked by breathtaking dishonesty and hypocrisy — succeed.
But... We also need to cut finance down to size. ... An intriguing proposal is about to be unveiled from, of all places, the International Monetary Fund. In a leaked paper..., the fund calls for a Financial Activity Tax — yes, FAT — levied on financial-industry profits and remuneration.
Such a tax, the fund argues, could "mitigate excessive risk-taking." It could also "tend to reduce the size of the financial sector," which the fund presents as a good thing.
Now, the I.M.F. proposal is actually quite mild. Nonetheless, if it moves toward reality, Wall Street will howl.
But the fact is that we've been devoting far too large a share of our wealth, far too much of the nation's talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?

The Best Financial Reform?

Posted: 23 Apr 2010 12:25 AM PDT

James Grant wants an extreme version of capital requirements:

The best financial reform? Let the bankers fail, by James Grant, Commentary, Washington Post: The trouble with Wall Street isn't that too many bankers get rich in the booms. The trouble, rather, is that too few get poor -- really, suitably poor -- in the busts. To the titans of finance go the upside. To we, the people, nowadays, goes the downside. How much better it would be if the bankers took the losses just as they do the profits.
Happily, there's a ready-made and time-tested solution. Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. ... The plausible threat of personal bankruptcy would suffice to focus the minds of American financiers on safety and soundness...

Krugman and Wells: Our Giant Banking Crisis - What to Expect

Posted: 23 Apr 2010 12:21 AM PDT

Here are a few passages from a much longer article by Robin Wells and Paul Krugman in the New York Review of Books:

Our Giant Banking Crisis - What to Expect, by Robin Wells and Paul Krugman, NYRB:
This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff
World Economic Outlook, April 2009: Crisis and Recovery by the International Monetary Fund (available at imf.org)
World Economic Outlook, October 2009: Sustaining the Recovery by the International Monetary Fund (available at imf.org)
...From an economist's point of view, there are two striking aspects of This Time Is Different. The first is the sheer range of evidence brought to bear. ... The second ... is the absence of fancy theorizing. ... This Time Is Different takes a Sergeant Friday, just-the-facts-ma'am approach: before we start theorizing, let's take a hard look at what history tells us. ...
So what is the message of This Time Is Different? In a nutshell, it is that too much debt is always dangerous. It's dangerous when a government borrows heavily from foreigners—but it's equally dangerous when a government borrows heavily from its own citizens. It's dangerous, too, when the private sector borrows heavily...
Yet people—both investors and policymakers—tend to rationalize away these dangers. After any prolonged period of financial calm, they either forget history or invent reasons to believe that historical experience is irrelevant. Encouraged by these rationalizations, people run up ever more debt—and in so doing set the stage for eventual crisis. ...

So now we've experienced a severe financial crisis, fundamentally similar to those of the past. What does history tell us to expect next? That's the subject of Reinhart and Rogoff's Chapter 14... This chapter can usefully be read in tandem with two studies by the International Monetary Fund... All three studies offer a grim prognosis: the aftermath of financial crises tends to be nasty, brutish, and long. That is, financial crises are typically followed by deep recessions, and these recessions are followed by slow, disappointing recoveries. ...

History says that the next few years will be difficult. But can anything be done to improve the situation? Unfortunately, This Time Is Different says little on this score. ... That said, history can offer some evidence on the extent to which Keynesian policies work as advertised. ... Thus the IMF, squinting hard at a relatively limited run of experience..., finds evidence that boosting government spending in the face of a financial crisis shortens the slump that follows—but also finds (weak) evidence that such policies might backfire when governments already have a high level of debt... Interestingly, the IMF also finds that monetary policies, usually the recession-fighting tool of choice, don't appear effective in the wake of financial crises...

Much of This Time Is Different is devoted to sovereign debt crises.... Implicitly,... the book warns against taking it for granted that nations can get away with deficit spending. On the other hand, advanced nations have historically been able to go remarkably deeply into debt without creating a crisis. ...

So should we be comforted or worried by the historical record? ... The truth is that the historical record on the consequences of government debt is ... ambiguous... We read the evidence as supporting a policy of stimulate now, pay later: spend strongly to promote employment in the crisis, but take measures to curb spending and raise revenue once the crisis has passed. Others will see it differently. The main thing to notice, perhaps, is that there is no safe path: debt has long-term risks, but so does failing to engineer a solid recovery. ...

Clearly, the best way to deal with debt crises is not to have them. Is there anything in the historical record indicating how we can do that? Reinhart and Rogoff don't address this question directly, but Chapter 16... is suggestive. What the data show is a dramatic drop in the frequency of crises of all kinds after World War II, then an irregularly rising trend after about 1980... What changed after World War II, and what changed it back? The obvious answer is regulation. ...
Why didn't more people see this coming? One answer, of course, lies in Reinhart and Rogoff's title. There were superficial differences between debt now and debt three generations ago: more elaborate financial instruments, seemingly more sophisticated techniques of assessment, an apparent wider spreading of risks (which turned out to have been an illusion). So financial executives, policymakers, and many economists convinced themselves that the old rules didn't apply.
We should not forget, too, that some people were making a lot of money from the explosive growth both of debt and of the financial industry, and money talks. The world's two great financial centers, in New York and London, wielded vast influence over their respective governments, regardless of party. The Clinton administration in the US and the Labour government in Britain succumbed alike to the siren song of financial innovation—... politicians were all too easily convinced that having a large financial industry was a wonderful thing. Only when the crisis struck did it become clear that the growth of Wall Street and the City actually exposed their home nations to special risks...
Now that the multiple bubbles have burst, there's obviously a strong case for a return to much stricter regulation. It's by no means clear, however, whether this will actually happen. For one thing, the ideology used to justify the dismantling of regulation has proved remarkably resilient. ...
Equally important, the financial industry's political power has not gone away. ... Despite the steady drumbeat of scandalous revelations ... top financial executives continue to have ready access to the corridors of power. And as many have noted, President Obama's chief economic and financial officials are men closely associated with Clinton-era deregulation and financial triumphalism; they may have revised their views but the continuity remains striking.
In that sense, this time really is different: while the first great global financial crisis was followed by major reforms, it's not clear that anything comparable will happen after the second. And history tells us what will happen if those reforms don't take place. There will be a resurgence of financial folly, which always flourishes given a chance. And the consequence of that folly will be more and quite possibly worse crises in the years to come.

links for 2010-04-22

Posted: 22 Apr 2010 11:02 PM PDT

Eichengreen: Why China is Right on the Renminbi

Posted: 22 Apr 2010 11:16 AM PDT

Barry Eichengreen says that China's exchange rate policy is "exactly right":

Why China is Right on the Renminbi, by Barry Eichengreen, Commentary, Project Syndicate: After a period of high tension between the United States and China, culminating earlier this month in rumblings of an all-out trade war, it is now evident that ... China is finally prepared to let the renminbi resume its slow but steady upward march. ...
Some observers, including those most fearful of a trade war, will be relieved. Others, who see a substantially undervalued renminbi as a significant factor in US unemployment, will be disappointed by gradual adjustment. They would have preferred a sharp revaluation of perhaps 20%...
Still others dismiss the change in Chinese exchange-rate policy as beside the point. For them, the Chinese current-account surplus and its mirror image, the US current-account deficit, are the central problem. ... The US is running external deficits because of a national savings shortfall, which once reflected spendthrift households but now is the fault of a feckless government.
There is no reason, they conclude, why a change in the renminbi-dollar exchange rate should have a first-order impact on savings or investment in China, much less in the US. There is no reason, therefore, why it should have a first-order impact on the bilateral current-account balance, or, for that matter, on unemployment, which depends on the same saving and investment behavior.
In fact, both sets of critics have it wrong. China was right to wait in adjusting its exchange rate, and it is now right to move gradually rather than discontinuously. ...
China successfully navigated the crisis, avoiding a significant slowdown, by ramping up public spending. But, as a result, it now has no further scope for increasing public consumption or investment.
To be sure, building a social safety net, developing financial markets, and strengthening corporate governance to encourage state enterprises to pay out more of what they earn would encourage Chinese households to consume. But such reforms take years to complete. In the meantime, the rate of spending growth in China will not change dramatically.
As a result, Chinese policymakers have been waiting to see whether the recovery in the US is real. If it is, China's exports will grow more rapidly. And if its exports grow more rapidly, they can allow the renminbi to rise. ...
Evidence that the US recovery will be sustained is mounting. As always, there is no guarantee. ... Because the increase in US spending on Chinese exports will be gradual, it also is appropriate for the adjustment in the renminbi-dollar exchange rate to be gradual. ...

Chinese officials have been on the receiving end of a lot of gratuitous advice. They have been wise to disregard it. In managing their exchange rate, they have gotten it exactly right.

Is the Six Percent Rise in Producer Prices a Signal that Inflation is Coming?

Posted: 22 Apr 2010 10:17 AM PDT

At MoneyWatch, why the 6 percent headline inflation number for producer prices announced this morning does not signal that inflation is imminent, and why core inflation rate of .9 percent is a better measure to look at:

Is the Six Percent Rise in Producer Prices a Signal that Inflation is Coming?, by Mark Thoma: Many news reports are noting the six percent increase in the producer price index on a year over year basis and wondering if it signals that inflation is back. However, this report should not be read as a warning that inflation is just around the corner.

Why? The pass through from producer prices to consumer prices is less than 100 percent in any case, and in some cases it is close to zero. Pass through to consumer prices is smaller when the change in producer prices is temporary, and core inflation measures indicate that most of the rise in producer prices was due to a rise in food and energy prices. Once the temporary changes in food and energy prices are stripped out, the core inflation rate only increased .9 percent over the previous year, and that isn't much different from previous measures.

But which measure of inflation should we pay attention to if we want to predict future inflation? Why do we use core inflation instead of "headline" inflation for this purpose?...[...continue reading...]...

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