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August 18, 2010

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Latest Posts from Economist's View


"Policymakers Need to Re-Learn Their Keynes"

Posted: 18 Aug 2010 01:46 AM PDT

Robert Skidelsky says deficit hawks are "scraping the bottom of the intellectual barrel":

Fixing the Right Hole, by Robert Skidelsky, Commentary, Project Syndicate: ...When John Maynard Keynes talked of persistent under-employment, he did not mean that, following a big shock, economies stay frozen at one unchanging level of depressed activity. But he did think that, without external stimulus, recovery from the lowest point would be slow, uncertain, weak, and liable to relapse. His "under-employment equilibrium" is a form of gravitational pull rather than a fixed condition. ...
Contrary to Keynes, orthodox economists believe that, after a big shock, economies will "naturally" return to their previous rate of growth, provided that governments balance their budgets and stop stealing resources from the private sector. The theory underlying this way of thinking was set out in the July Bulletin of the European Central Bank.
Debt-financed public spending, the ECB argued, will "crowd out" private spending..., a fiscal stimulus will not only have no effect; the economy will be worse off, because public spending is inherently less efficient than private spending. ... The problem with fiscal stimulus, they say, is that it destroys confidence in government finances, thereby impeding recovery. So a credible deficit-reduction program is needed now to "consolidate recovery." ...
The ECB's arguments look to me like scraping the bottom of the intellectual barrel. The truth is that it is not fear of government bankruptcy, but governments' determination to balance the books, that is reducing business confidence by lowering expectations of employment, incomes, and orders. The problem is not the hole in the budget; it is the hole in the economy.
Let us assume, though, that the ECB is right and that fears of "unsound finance" are holding back economic recovery. The question still needs to be asked: are such fears rational? Are they not exaggerated in today's circumstances (except, possibly, in countries like Greece)? If so, is it not the duty of official bodies like the ECB to challenge irrational beliefs about the economy, rather than pander to them?
The trouble is that the current crisis finds governments intellectually disabled, because their theory of the economy is a mess. Events and common sense drove them to deficit finance in 2009-2010, but they have not abandoned the theory that depressions cannot happen, and that deficits are therefore always harmful (except in war!). So now they vie with each other in their haste to cut off the lifeline that they themselves extended.
Policymakers need to re-learn their Keynes, explain him clearly, and apply his lessons, not invent pseudo-rational arguments for prolonging the recession.

Actual versus Potential GDP

Posted: 18 Aug 2010 01:31 AM PDT

NBER Summer Institute 2010 - Methods Lectures: Financial Econometrics

Posted: 18 Aug 2010 12:48 AM PDT


The slides accompanying the video are in the bottom frame.

There are additional lectures here from Yacine Ait-Sahalia ("Asymptotic Theory and Continuous-Time Methods in Financial Econometrics"), Michael Brandt ("Linear Factor Models and Event Studies"), and Andrew Lo ("Financial Econometrics in Action: Analyzing Hedge Funds and Systemic Risk").

links for 2010-08-17

Posted: 17 Aug 2010 11:02 PM PDT

Congress vs. Fed Independence

Posted: 17 Aug 2010 08:01 PM PDT

Here is my first column for the Fiscal Times, and there will be more to follow:

Congress vs. Fed Independence

Some of you will be unhappy with the outlet. But I can't change the minds of people I can't talk to, and when it comes to certain groups, they aren't coming to me. So into the belly of the beast to stop the beast from being starved. Or something like that. I should add that I expect to have complete freedom in what I can say. If that turns out to be a false expectation, then I will stop doing this and I will let people know why. Also, I chose to begin by talking about the Fed's relationship to Congress, but it occurs to me that given how much many of you disagree with my views on the Fed, I might have chosen a different topic to start this off.

Mel Brooks and the Bankers

Posted: 17 Aug 2010 07:08 PM PDT

This is from Thorvaldur Gylfason. He argues that bankers may have been playing a game similar to the game played in Mel Brooks' The Producers, and if that's true, "the perpetrators should be heading to jail":

Mel Brooks and the bankers, by Thorvaldur Gylfason, Vox EU: In Mel Brooks' brilliant film and Broadway musical The Producers, an over-the-hill Broadway producer, Max Bialystock and his hapless accountant, Leo Bloom recognize two great truths. It is very hard to produce a hit and very easy to produce a flop – and they can make more money by producing a flop than by producing a hit. Max uses his expertise to ensure that the play flops. He selects the worst play ever written (Springtime for Hitler) – an ode to Hitler, a terrible director, and an awful male lead. Max understands critics' key role in determining the success of Broadway plays, so he pretends to attempt to bribe the most prominent critic in order to enrage him and make sure that he will pan the play.

Max then (literally) seduces his investors, raising a million bucks from "little old ladies" by selling far more than 100% of the potential profits. If the play fails almost immediately, the investors will not expect to receive any money and Max and Leo can run away to Rio with the investors' money.

The plot fails, however, because the show turns out to be a hit. It is so excruciatingly bad that the audience assumes it is a clever satire. Bialystock and Bloom land in jail when they are unable to pay over 1000% of profits to the investors. In prison, Max and Leo promptly set out to try the same scam. The story ends there because even Mr. Brooks could not imagine what happened next.

Real-life Bialystocks and Blooms

Not all the CEOs running the fraudulent savings and loans (S&Ls) in California and Texas in the 1980s and 1990s saw The Producers, but all of them could have played Max's role convincingly. They shared Mr. Brooks' insight into why the massive frauds use accounting as their "weapon of choice", structure their efforts to fail, and recruit an accountant as their most valuable fraud ally. The fraudulent CEOs and their accounting allies were the real-life Bialystocks and Blooms. They bankrupted the S&Ls, enriching themselves and their friends along the way, at the expense of stockholders, creditors, and taxpayers.

Fraudulent lenders maximize their (fictional) income by making exceptionally bad loans and growing very rapidly. Borrowers that will frequently be unable to repay their loans are numerous (allowing the lender to grow rapidly) and will pay a higher interest rate (yield). The combination of rapid growth and high interest rates produced guaranteed, record income in the near term during the S&L debacle and the current subprime lending crisis.

During the ongoing subprime mortgage loan crisis, the rating agencies and the top tier audit firms played the real life role equivalent to the critic that Max pretended to try to bribe to make sure that Springtime for Hitler received a terrible review. Unlike the critics, who Max realised he could not succeed in bribing, the rating agencies and the top tier audit firms gave rave reviews to toxic subprime mortgage paper. The rating agencies claimed the toxic waste was pristine "AAA" – the safest of the safe. The elites that we count on to advise us on quality in the real world are more corruptible than the elites in the fictional world that Max and Leo inhabited.

In the words of Professor Paul Romer (quoted from Johnson and Kwak 2010), "Over the last fifty years, the Federal Aviation Administration, the airline manufacturers, and the airlines worked together to make a highly complex air travel system more efficient and much safer… in contrast, our financial regulators and banks have made our financial system less efficient and much more dangerous."

In time, the regulators and the American justice system caught up with the S&L frauds. More than a thousand priority white-collar felony convictions resulted from the S&L debacle. Also, high-ranking politicians who had aided and abetted the S&L operators and accepted donations from them were driven from office and power, including Jim Wright, Speaker of the House of Representatives from 1987 to 1989. The "Keating Five" were deeply embarrassed for their intervention on behalf of the most notorious fraud, that perpetrated by Charles Keating at Lincoln Savings. One senator was reprimanded by the Senate Ethics Committee, another two were criticized for acting improperly, and two more, while cleared of impropriety, were criticized for poor judgment, including Senator John McCain, the former presidential candidate.

Repeated games

But this is a trick you can pull only once, you might think. Well, a few years later the people in charge at Enron thought they might try something similar, and for a while it looked as if they might succeed. Their fraud was exposed as well, however, and they brought down with them Arthur Andersen, one of the big five accounting firms in the US. And then there was WorldCom, and hundreds of others. Prosecutors were able to arraign only the most notorious of these frauds.

The crisis that started in 2007 also contains significant elements of fraud. The crooks still understand Max and Leo's scam, but this time the regulators and prosecutors appear to be as clueless as the little old ladies that Max conned.

Perhaps we need to send the regulators and prosecutors to remedial showings of The Producers. Alternatively, we could have them become familiar with modern economics and white-collar criminology. Inspired by the experience of regulators who had dealt with the S&Ls and understood fraud – and perhaps also by Mel Brooks – George Akerlof, the Nobel-Prize winning economist, and Paul Romer published in 1993 a famous article entitled "Looting: The Economic Underworld of Bankruptcy for Profit." In 2005, the white-collar criminologist, economist, and lawyer William Black published a book entitled "The best way to rob a bank is to own one". Again, the title says it all. In an appendix, the book reproduces a memo from Charles Keating that reads, in part, "get Black – kill him dead." In the 1980s, Mr. Keating ran the Lincoln S&L Association, running it into the ground in 1989 at a cost to the federal government of over $3 billion and leaving about 23,000 customers with worthless bonds. Mr. Keating, a generous backer of the five aforementioned senators, the "Keating Five", served four and a half years in jail.

Built to fail

Mr. Black has listed the four main characteristics of fraudulent banks.

  • They grow very rapidly;
  • They make really bad loans at high yields (because only borrowers who have no intention of paying back will borrow at exorbitant interest);
  • They pile up huge debts; and
  • They set aside pitifully small loss reserves.

This, in a nutshell, is what many of the failed S&Ls in California and Texas did in the 1980s. The key thing to realize is that such banks are built to fail. The owners and operators of the S&Ls could live lavishly as long as their scam lasted, or longer, as many of them, even after serving time in jail, walked away rich at the expense of innocent bystanders.

At some point, though, the threat of getting caught may lead some to try to subvert the law. As Professor James Galbraith put it in his testimony in the US Senate 4 May 2010, "This is where crime and politics intersect." This is where law and order enter the picture if financial regulation has failed to rein in the banks as it did before the onset of the current crisis in 2007. The National Transport Safety Board investigates every civil-aviation crash in the US. In Europe, national Civil Aviation Accidents Commissions perform this vital role. Their principal concern is public safety. For reasons of consumer protection and public safety, finance needs to be viewed the same way as civil aviation. When things go wrong, there is a clear need for credible crash analysis to secure full disclosure. If laws were broken, the public has a right to know. Mel Brooks would agree – Bialystock and Bloom went to jail.

References

Akerlof, George A and Paul M Romer (1993), "Looting: The Economic Underworld of Bankruptcy for Profit", Brookings Papers on Economic Activity 2, 1-73.

Black, William K (2005), The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, University of Texas Press.

Brooks, Mel (1968), The Producers – A Gay Romp with Adolf and Eva at Berchtesgaden, a film written and directed by Mel Brooks starring Zero Mostel and Gene Wilder. Academy Award for best original screenplay.

Brooks, Mel (2001), The Producers, a Broadway musical based on the film. Three Tony Awards, including for Best Musical and Best Book of a Musical.

Brooks, Mel (2005), The Producers, a film adapted from the Broadway adaptation.

Galbraith, James K (2010), "Statement before the Subcommittee on Crime, Senate Judiciary Committee".

Johnson, Simon, and James Kwak (2010), 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books.

"Is the Unemployment Problem Cyclical or Structural?"

Posted: 17 Aug 2010 11:25 AM PDT

I see that the issue of structural versus cyclical unemployment is rearing its head again. Here's something I posted at MoneyWatch a couple of weeks ago on this topic:

Is the Unemployment Problem Cyclical or Structural?: As I noted in a previous post, economists define three types of unemployment: frictional, structural, and cyclical:

Frictional unemployment is defined as the unemployment that occurs because of people moving or changing occupations. Demographic change can also play a role in this type of unemployment since young or first-time workers tend to have higher-than-normal turnover rates as they settle into a long-term occupation. An important distinguishing feature of this type of unemployment, unlike the two that follow it, is that it is voluntary on the part of the worker.

Structural unemployment is defined as unemployment arising from technical change such as automation, or from changes in the composition of output due to variations in the types of products people demand. For example, a decline in the demand for typewriters would lead to structurally unemployed workers in the typewriter industry.

Cyclical unemployment is defined as workers losing their jobs due to business cycle fluctuations in output, i.e. the normal up and down movements in the economy as it cycles through booms and recessions over time.

In a recession, frictional unemployment tends to drop since people become afraid of quitting the job they have due to the poor chances of finding another one. People that already have another job lined up will still be willing to change jobs, though there will be fewer of them since new jobs are harder to find. However, they aren't counted as part of the unemployed. Thus, the fall in frictional unemployment is mainly due to a fall in people quitting voluntarily before they have another job lined up.

But the drop in frictional unemployment is relatively small and more than offset by increases in cyclical and structural unemployment. One of the big questions right now is whether the US economy is suffering, for the most part, from structural or cyclical unemployment. If it's cyclical, then there's a good chance that government intervention can help. If it's structural, i.e. a decline in automobile production and manufacturing more generally, a decline in home construction, and a decline in the financial industry all of which free workers that need to be absorbed elsewhere in the economy, there's less that can be done and some do not think that government can do much at all about this type of problem (though as I note below, I disagree). Thus, the debate is between those who say our current unemployment problem is largely cyclical and hence we need more government action, and those who say it's structural and hence there's very little that government can do. We will just have to wait for the structural changes to take place, and that takes time.

I don't think this debate can be answered by moving close to the polar extremes and declaring it's mainly a structural or cyclical problem. For me, it seems obvious that part of the problem is structural. The real question is how large the structural component is and what can be done about it. But no matter how large it is -- take a very liberal estimate of the size -- I don't think there's any way to deny that there is a substantial cyclical component on top of it that demands government action. It's true that the size of the government action to offset the the cyclical downturn should be connected to the size of the cyclical unemployment problem, but the problem is big enough that politicians won't come anywhere near to overdoing it. The most optimistic view of what Congress might do would still leave them short of what is needed. We don't know the exact structural-cyclical breakdown, but the cyclical problem is certainly larger than any imaginable Congressional response. So the excuse for inaction based upon the "it's all structural" claim isn't persuasive.

What about the structural problem, does government have any role to play, or does it have to rely upon the private sector to solve this problem by itself? Several points on this. First, even if the problem is mostly structural, the government can still provide people with jobs to bridge the gap until the structural changes are complete. To me, this is better than simply extending unemployment compensation since it allows individuals to contribute something (e.g. work on a project the local community needs). And by giving people jobs, or at least government aid through unemployment compensation, we increase aggregate demand and the that helps firms to do better and speeds the transition.

Second, government can ease the structural problem by making it easier for businesses and individuals to relocate. People are understandably reluctant to leave the place they have lived for years and years, but government incentives to relocate (tax breaks, subsidies, etc.), can help. So can efforts to provide individuals in communities suffering from high unemployment with information about where job prospects are better, as can retraining programs (though these aren't always as effective as hoped). In a deep, widespread recession places that need workers may be hard to find, but not always and knowing where there are better opportunities for employment can be helpful. Businesses can also be induced to relocate through tax and other incentives, though the tax competition that accomplishes this may strip local governments of needed tax revenue, so I'd prefer these programs originate at the federal level. And there can also be government encouragements to speed the investments that are needed to complete the transition.

But the main things I want to emphasize are that no matter how large the structural problem is, cyclical unemployment is also a big problem, so the claim that government is powerless because it's all structural doesn't hold.  And the claim that the existence of a structural problem means there's nothing the government can do is also incorrect. If nothing else, the government can help workers during the transition. In addition, though the opportunities here are more limited, there are also things the government can do to make the transition happen sooner rather than later.

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