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October 14, 2010

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"The World’s Financial System Has Become Unstable"

Posted: 14 Oct 2010 01:46 AM PDT

Simon Johnson argues that while China bears some responsibility, the main reason that the world "is on the brink of a nasty confrontation over exchange rates" ... is ... Europe's refusal to reform global economic governance, compounded by years of political mismanagement and self-deception in the United States."

But his main concern is not the prospect of a currency war, it's the stability of the world's financial system:

Who Caused the Currency Wars?, by Simon Johnson, Commentary, Project Syndicate: ...the US has run record current-account deficits over the past decade, as the political elite – Republican and Democrats alike – became increasingly comfortable with overconsumption. These deficits facilitate the surpluses that emerging markets such as China want to run...

Leading Bush administration officials used to talk of the US current-account deficit being a "gift" to the outside world. But, honestly, the US has been overconsuming – living far beyond its means – for the past decade. The idea that tax cuts would lead to productivity gains and would pay for themselves (and fix the budget) has proved entirely illusory. ...

[T]he net flow of capital is from emerging markets to the US – this is what it means to have current-account surpluses in emerging markets and a deficit in the US. But the gross flow of capital is from emerging market to emerging market, through big banks now implicitly backed by the state in both the US and Europe. From the perspective of international investors, banks that are "too big to fail" are the perfect places to park their reserves – as long as the sovereign in question remains solvent. But what will these banks do with the funds?

When a similar issued emerged in the 1970's – the so-called "recycling of oil surpluses" – banks in Western financial centers extended loans to Latin America, communist Poland, and communist Romania. That was not a good idea, as it led to a massive (for the time) debt crisis in 1982.

We are now heading for something similar, but on a larger scale. The banks and other financial players have every incentive to load up on risk as we head into the cycle; they get the upside (Wall Street compensation this year is set to break records again) and the downside goes to taxpayers.

The "currency wars" themselves are merely a skirmish. The big problem is that the core of the world's financial system has become unstable, and reckless risk-taking will once again lead to great collateral damage.

Won't the recent resolution authority announced by the FDIC end the too big to fail problem and the moral hazard (excessive risk taking) that comes with it? It's not clear that it will:

This is the Republican strategy for beating back effective regulation: just claim that what we're really doing is telling big banks, sternly, that there will be no more bailouts — they're not too big to fail.

And then, when the next financial crisis arrives — well, it will play just like 2008. President Palin or whoever will find themselves staring into the abyss — and conclude that they have to bail out the financial sector anyway.

In a crisis, the financial system will be bailed out. That's just a fact of life. So what we have to do is regulate the system to reduce the chances of crisis and the taxpayer costs when the bailout occurs.

In addition, attempts to come to agreement on international resolution authority have not gone well, and it's not clear that an agreement will be reached anytime soon. If banks will be bailed out in a crisis, then they have an incentive to take on too much risk, and strict regulation is needed to prevent that from happening.

"Are Public Sector Workers and David Brooks Overpaid?"

Posted: 14 Oct 2010 01:25 AM PDT

Dean Baker: responds to David Brooks' complaint that public sector employees are overpaid, in part because of unions:

[David] Brooks ... complains that AFSCME, the public employee's union, was the largest single contributor to political campaigns between 1989 and 2004. While this may be true in the sense that AFSCME gave more money than Robert Rubin or Rupert Murdoch, AFSCME represents more than a million workers. Certainly the million richest Wall Streeters, oil tycoons, or tech entrepreneurs gave far more money to candidates than AFSCME.

He also points to this:

The Wage Penalty for State and Local Government Employees, by John Schmitt, CEPR: State and local government budgets are under severe strain. Rather than blame the recession, which has simultaneously slashed tax revenues and increased the demand for social services, some conservatives have argued that excessive pay for public employees is the real cause of the financial woes. Several recent reports in the media have reinforced this view by emphasizing that, on average, government employees earn more than workers in the private sector. The problem with these analyses is that state and local government workers have much higher levels of formal education and are older (and therefore generally more experienced) than workers in the private sector. When state and local government employees are compared to private-sector workers with similar characteristics, state and local workers actually earn 4 percent less, on average, than their private-sector counterparts. This paper examines the wage penalty for working in the state-and-local sector.

He adds:

It is likely the case that many state and local governments did not adequately budget for workers' pensions, but this is more an issue of failed accounting ... than excessive pensions. Brooks highlights an estimate that the amount of the average unfunded pension for all public sector workers is $87,000.

This does not seem particularly large. If we assume an average retirement of 20 years, this comes to $4,350 per worker pension year. Since many public sector workers do not have Social Security this hardly seems an excessive amount on the workers' part.

links for 2010-10-13

Posted: 13 Oct 2010 11:02 PM PDT

"Is Macroeconomics Just Looking Under the Streetlamp?"

Posted: 13 Oct 2010 03:12 PM PDT

Via Angus at Kids Prefer Cheese:

Is Macroeconomics just looking under the streetlamp?: A fascinating new paper by Ricardo Caballero basically says yes:

"In this paper I argue that the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in "fine-tuning" mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in "broad-exploration" mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected."

The piece is well worth reading both for its own arguments and the list of interesting "periphery" papers mentioned and cited.

Caballero says "we should be in "broad-exploration" mode." I can hardly disagree since that's what I meant when I said "While I think we should see if the current models and tools can be amended appropriately to capture financial crises such as the one we just had, I am not as sure as [Bernanke] is that this will be successful and I'd like to see [more] openness within the profession to a simultaneous investigation of alternatives."

Here's a bit more from the introduction to the paper:

The recent financial crisis has damaged the reputation of macroeconomics, largely for its inability to predict the impending financial and economic crisis. To be honest, this inability to predict does not concern me much. It is almost tautological that severe crises are essentially unpredictable, for otherwise they would not cause such a high degree of distress... What does concern me of my discipline, however, is that its current core—by which I mainly mean the so-called dynamic stochastic general equilibrium approach has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. ...
To be fair to our field, an enormous amount of work at the intersection of macroeconomics and corporate finance has been chasing many of the issues that played a central role during the current crisis, including liquidity evaporation, collateral shortages, bubbles, crises, panics, fire sales, risk-shifting, contagion, and the like.1 However, much of this literature belongs to the periphery of macroeconomics rather than to its core. Is the solution then to replace the current core for the periphery? I am tempted—but I think this would address only some of our problems. The dynamic stochastic general equilibrium strategy is so attractive, and even plain addictive, because it allows one to generate impulse responses that can be fully described in terms of seemingly scientific statements. The model is an irresistible snake-charmer. In contrast, the periphery is not nearly as ambitious, and it provides mostly qualitative insights. So we are left with the tension between a type of answer to which we aspire but that has limited connection with reality (the core) and more sensible but incomplete answers (the periphery).
This distinction between core and periphery is not a matter of freshwater versus saltwater economics. Both the real business cycle approach and its New Keynesian counterpart belong to the core. ...
I cannot be sure that shifting resources from the current core to the periphery and focusing on the effects of (very) limited knowledge on our modeling strategy and on the actions of the economic agents we are supposed to model is the best next step. However, I am almost certain that if the goal of macroeconomics is to provide formal frameworks to address real economic problems rather than purely literature-driven ones, we better start trying something new rather soon. The alternative of segmenting, with academic macroeconomics playing its internal games and leaving the real world problems mostly to informal commentators and "policy" discussions, is not very attractive either, for the latter often suffer from an even deeper pretense-of-knowledge syndrome than do academic macroeconomists. ...

I find it encouraging that Caballero has reached this conclusion, and was sufficiently motivated to write a paper about it.

Would a Currency War Be Helpful?

Posted: 13 Oct 2010 10:45 AM PDT

I forgot to post this yesterday -- I have a post at MoneyWatch on whether a currency war might actualy be helpful to the world economy:

Would a Currency War be Helpful?

Though some people have argued that it could be, I am convinced by Paul Krugman's argument that the answer is no.

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