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October 31, 2011

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Paul Krugman: Bombs, Bridges and Jobs

Posted: 31 Oct 2011 12:24 AM PDT

Apparently, Keynesian economics works for policies that Republicans favor:

Bombs, Bridges and Jobs, by Paul Krugman, Commentary, NY Times: A few years back Representative Barney Frank coined an apt phrase for many of his colleagues: weaponized Keynesians, defined as those who believe "that the government does not create jobs when it funds the building of bridges or important research or retrains workers, but when it builds airplanes that are never going to be used in combat, that is of course economic salvation."
Right now the weaponized Keynesians are out in full force... What's bringing out the military big spenders is the approaching deadline for the so-called supercommittee to agree on a plan for deficit reduction. If no agreement is reached, this failure is supposed to trigger cuts in the defense budget.
Faced with this prospect, Republicans — who normally insist that the government can't create jobs, and who have argued that lower, not higher, federal spending is the key to recovery — have rushed to oppose any cuts in military spending. Why? Because, they say, such cuts would destroy jobs. ...
First things first: Military spending does create jobs when the economy is depressed. ... Some liberals dislike this conclusion, but economics isn't a morality play... But why would anyone prefer spending on destruction to spending on construction, prefer building weapons to building bridges? ...
But there are also darker motives behind weaponized Keynesianism.
For one thing, to admit that public spending on useful projects can create jobs is to admit that ... sometimes government is the solution, not the problem. ...
Beyond that, there's a point made long ago by the Polish economist Michael Kalecki: to admit that the government can create jobs is to reduce the perceived importance of business confidence.
Appeals to confidence have always been a key debating point for opponents of taxes and regulation; Wall Street's whining about President Obama is part of a long tradition in which wealthy businessmen and their flacks argue that any hint of populism on the part of politicians will upset people like them, and that this is bad for the economy. Once you concede that the government can act directly to create jobs, however, that whining loses much of its persuasive power — so Keynesian economics must be rejected, except in those cases where it's being used to defend lucrative contracts.
So I welcome the sudden upsurge in weaponized Keynesianism... At a fundamental level, the opponents of any serious job-creation program know perfectly well that such a program would probably work... But they don't want voters to know what they know, because that would hurt their larger agenda — keeping regulation and taxes on the wealthy at bay.

links for 2011-10-31

Posted: 31 Oct 2011 12:06 AM PDT

Stavins: The Promise and Problems of Pricing Carbon

Posted: 30 Oct 2011 02:07 PM PDT

Robert Stavins:

The Promise and Problems of Pricing Carbon, by Robert Stavins: Friday, October 21st was a significant day for climate change policy worldwide and for the use of market-based approaches to environmental protection, but it went largely unnoticed across the country and around the world, outside, that is, of the State of California.  On that day, the California Air Resources Board voted unanimously to adopt formally the nation's most comprehensive cap-and-trade system, intended to provide financial incentives to firms to reduce the state's greenhouse gas (GHG) emissions, notably carbon dioxide (CO2) emissions, to their 1990 level by the year 2020...  Compliance will begin in 2013, eventually covering 85% of the state's emissions.
This policy for the world's eighth-largest economy is more ambitious than the much heralded (and much derided) Federal policy proposal – H.R. 2454, the Waxman-Markey bill – that was passed by the U.S. House of Representatives in June of 2009, and then died in the U.S. Senate the following year.  With a likely multi-year hiatus on significant climate policy action in Washington now in place, California's system – which will probably link with similar cap-and-trade systems being developed in Ontario, Quebec, and possibly British Columbia – will itself become the focal point of what may evolve to be the "North American Climate Initiative." ...
What Lies in the Future?
...Because a truly meaningful climate policy – whether market-based or conventional in design – will have significant impacts on economic activity in a wide variety of sectors and in every region of a country, proposals for these policies inevitably bring forth significant opposition, particularly during difficult economic times.
In the United States, political polarization – which began some four decades ago, and accelerated during the economic downturn – has decimated what had long been the key political constituency in the Congress for environmental action, namely, the middle, including both moderate Republicans and moderate Democrats.  Whereas Congressional debates about environmental and energy policy had long featured regional politics, they are now fully and simply partisan.  In this political maelstrom, the failure of cap-and-trade climate policy in the U.S. Senate in 2010 was essentially collateral damage in a much larger political war.
It is possible that better economic times will reduce the pace – if not the direction – of political polarization.  It is also possible that the ongoing challenge of large budgetary deficits in many countries will increase the political feasibility of new sources of revenue.  When and if this happens, consumption taxes (as opposed to traditional taxes on income and investment) could receive heightened attention, and primary among these might be energy taxes, which can be significant climate policy instruments, depending upon their design.
That said, it is probably too soon to predict what the future will hold for the use of market-based policy instruments for climate change.  Perhaps the two decades we have experienced of relatively high receptivity in the United States, Europe, and other parts of the world to cap-and-trade and offset mechanisms will turn out to be no more than a relatively brief departure from a long-term trend of reliance on conventional means of regulation.  It is also possible, however, that the recent tarnishing of cap-and-trade in U.S. political dialogue will itself turn out to be a temporary departure from a long-term trend of increasing reliance on market-based environmental policy instruments.  It is much too soon to say.

[There's much more on this in the original post.]

"It Doesn’t Get Any More Immoral Than This"

Posted: 30 Oct 2011 09:36 AM PDT

Yesterday, Ross Douthat argued that "higher taxes on America's richest 1 percent" won't solve the problems with government. Thomas Friedman explains why that's wrong, and why a more equitable distribution of income is essential to stripping the ability of those at the top to control government:

Did You Hear the One About the Bankers?, by Thomas Friedman, Commentary, NY Times: Citigroup is lucky that Muammar el-Qaddafi was killed when he was. The Libyan leader's death diverted attention from a lethal article involving Citigroup... The news was that Citigroup had to pay a $285 million fine to settle a case in which, with one hand, Citibank sold a package of toxic mortgage-backed securities to unsuspecting customers — securities that it knew were likely to go bust — and, with the other hand, shorted the same securities — that is, bet millions of dollars that they would go bust.
It doesn't get any more immoral than this. ...
This gets to the core of why all the anti-Wall Street groups around the globe are resonating. I was in Tahrir Square in Cairo for the fall of Hosni Mubarak... When I talked to Egyptians, it was clear that what animated their protest, first and foremost, was ... a quest for "justice." Many Egyptians were convinced that they lived in a deeply unjust society where the game had been rigged by the Mubarak family and its crony capitalists. Egypt shows what happens when a country adopts free-market capitalism without developing real rule of law and institutions.
But, then, what happened to us? Our financial industry has grown so large and rich it has corrupted our real institutions through political donations. As Senator Richard Durbin, an Illinois Democrat, bluntly said in a 2009 radio interview, despite having caused this crisis, these same financial firms "are still the most powerful lobby on Capitol Hill. And they, frankly, own the place."
Our Congress today is a forum for legalized bribery. One consumer group using information from calculates that the financial services industry, including real estate, spent $2.3 billion on federal campaign contributions from 1990 to 2010, which was more than the health care, energy, defense, agriculture and transportation industries combined. Why are there 61 members on the House Committee on Financial Services? So many congressmen want to be in a position to sell votes to Wall Street. ...
U.S. congressmen should have to dress like Nascar drivers and wear the logos of all the banks, investment banks, insurance companies and real estate firms that they're taking money from. The public needs to know.
Capitalism and free markets are the best engines for generating growth and relieving poverty — provided they are balanced with meaningful transparency, regulation and oversight. We lost that balance in the last decade. If we don't get it back..., the cry for justice could turn ugly. ...

To what extent is fear of inflation, fear of deficits, and other fears holding up more government help for struggling, unemployed households the result of the powerful interests who control Congress standing in the way? My answer, as ought to be clear from recent columns (here, here, and here), is that the imbalance in political power that comes with such a large degree of inequality is a large factor in the government's tepid response to the unemployment crisis.

October 30, 2011

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links for 2011-10-30

Posted: 29 Oct 2011 10:16 PM PDT

"Dear Ben: It’s Time for Your Volcker Moment"

Posted: 29 Oct 2011 12:24 PM PDT

Christina Romer tells Ben Bernanke that we need "aggressive actions," including adopting a nominal GDP target, to "help to heal the economy"

Dear Ben: It's Time for Your Volcker Moment

No disagreement here about the need for more forceful monetary policy actions. We could use more help from fiscal policy too.

When It Reigns, It Poors

Posted: 29 Oct 2011 10:35 AM PDT

A correspondent wonders if Senator Orrin Hatch thinks he's king. He wants to "reign" in unions, perhaps by decree?:

10. Reform America's Labor Laws and Reign in the National Labor Relations Board (NLRB)
  • Pass legislation to give more oversight, accountability, and judicial review of the NLRB's decisions.
  • Pass the Employee Rights Act (S. 1507) to protect the rights of workers.
  • Repeal the prevailing-wage requirements in the Davis-Bacon Act.

The 10 point plan is to strip wage negotiation power from workers, cut benefits to working class households ("fiscal sanity"), repeal health care reform, repeal Dodd-Frank, repeal regulations on energy companies so they can drill pretty much anywhere, and cut taxes on businesses and the wealthy (never mind that this "fiscal insanity" will make the deficit worse and require bigger cuts to benefits). In other words, it's a mainstream Republican plan.

Somehow, it is claimed, after workers have lost power in wage negotiations, lost social insurance and other protections, live in more polluted environments, have fewer health care options, and are more likely to be asked to bail out deregulated banks yet again while getting no help themselves, they will be better off.

October 29, 2011

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Sachs: A Nation of Vidiots

Posted: 29 Oct 2011 12:15 AM PDT

Jeff Sachs does not like TV:

the mental-health effects of TV viewing might run even deeper than addiction, consumerism, loss of social trust, and political propaganda. Perhaps TV is rewiring heavy viewers' brains and impairing their cognitive capacities

links for 2011-10-29

Posted: 29 Oct 2011 12:06 AM PDT

"The Owners Will Say There’s Been a Franchise Bubble"

Posted: 28 Oct 2011 12:24 PM PDT interviews Kevin Murphy (he's an advisor to the players in their negotiations with NBA owners):

Kevin Murphy on the NBA Negotiations, The Sports Economist: ... The owners will say there's been a franchise bubble not unlike the housing bubble. A number of them bought high and don't think they'll see the equity growth.
KM: The fact is, guys have not done well over the last few years as asset prices generally have gone down. I don't doubt that. But to say that you lost money in the worst asset crash in memory — and franchises haven't gone down nearly as much as many assets have gone down — that's not telling you you need concessions going forward.
If you go back before the last 3-5 years, these guys did incredibly well. Their franchises weren't going up by 4 or 5 percent, they were going up by 8 or 9 percent a year. They were making money hand over fist. Should [the players] get credit for that? Should we get that money back? Now those are different people in some cases. They need to go get their money from the guys they bought the franchises from. That's the guy who has all your money. Not us.
But who bought anything in '07 that they're happy with the price they paid? If you bought a house in '07, if you bought stocks in '07, if you bought bonds in '07 — I don't care what you bought, you're not happy with the price you paid. When you buy at the top, you don't make your money. That's not unique to the NBA, that's everywhere in life. But by and large, NBA franchise ownership has been a good investment. You can't base long-run projections on how you did in the biggest financial downturn of the last 50 years. On that basis, there are no good investments out there. But we know that's not true.

October 28, 2011

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Five Books Interview

Posted: 28 Oct 2011 03:33 AM PDT

I was hesitant to do this, but did it anyway:

Five books, The Browser

The topic of the interview was a bit narrow -- my favorite books by Nobel prize winning time-series econometricians -- but it ranges into other areas.

Paul Krugman: The Path Not Taken

Posted: 28 Oct 2011 12:42 AM PDT

Austerity doesn't work:

The Path Not Taken, by Paul Krugman, Commentary NY Times: Financial markets are cheering the deal that emerged from Brussels early Thursday morning. Indeed,... the fact that European leaders agreed on something, however vague the details and however inadequate it may prove, is a positive development.
But it's worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine... The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So ... a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed. ...
The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks.
Some economists weren't convinced. ... But the doctrine has, nonetheless, been extremely influential. Expansionary austerity, in particular, has been championed both by Republicans in Congress and by the European Central Bank...
Now, however, the results are in, and the picture isn't pretty. Greece has been pushed by its austerity measures into an ever-deepening slump... Britain's economy has stalled under the impact of austerity...
So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? ...
Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position.
But a funny thing happened on the way to economic Armageddon: Iceland's very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver.
So how's it going? Iceland hasn't avoided major economic damage... But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable... "Things could have been a lot worse" may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph.
And there's a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn't and doesn't have to be this way.



links for 2011-10-28

Posted: 28 Oct 2011 12:06 AM PDT

Charlatans and Cranks

Posted: 27 Oct 2011 12:34 PM PDT

Suzy Khimm poses a question to the Perry campaign:

1) How will the new tax breaks for the wealthy be paid for?
Perry campaign: The purpose of this bold tax proposal is to give the economy the jumpstart it needs to get people back to work. ... Gov. Perry is confident that the economic growth that results from this plan will generate the necessary revenue to balance the budget by 2020.

So the tax cuts will pay for themselves? Greg Mankiw:

I used the phrase "charlatans and cranks" in the first edition of my principles textbook to describe some of the economic advisers to Ronald Reagan, who told him that broad-based income tax cuts would have such large supply-side effects that the tax cuts would raise tax revenue. I did not find such a claim credible, based on the available evidence. I never have, and I still don't.

There's no mystery here. The tax cuts for the wealthy will be paid for by cutting benefits for the working class, the poor, and others who are already having a tough time making ends meet.

GDP Grew by 2.5 Percent in the Third Quarter

Posted: 27 Oct 2011 09:54 AM PDT

I have some comments on the GDP report:

GDP Grew by 2.5 Percent in the Third Quarter

The main message is that even though the number improved over last quarter,  "policymakers should not conclude that they are off the hook."

October 27, 2011

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"Hayek on Monetary Policy and Unemployment"

Posted: 27 Oct 2011 12:33 AM PDT

David Glasner:

... Sixty years ago Hayek was arguing against an extreme version of Keynesian doctrine that viewed increasing aggregate demand as a panacea for all economic ills. Hayek did not win the battle himself, but his position did eventually win out, if not completely at least in large measure. Today, however, an equally extreme version of Hayek's position seems to have become ascendant. It denies that increasing aggregate demand can, under any circumstances, increase employment. I don't know what Hayek would think about all this if he were alive today, but I suspect that he would be appalled.

"The Elevated Position of the Financial Sector"

Posted: 27 Oct 2011 12:24 AM PDT

Wouter den Haan argues that measures of the financial sector's contribution to economic activity in the national income accounts overstate "its true value to a modern economy. As such, regulation that makes it more difficult for the sector to perform some activities is not necessarily a bad thing." This supports the arguments I've been making about the "mal-distribution of income" in recent years, so no disagreement here:

Why do we need a financial sector?, by Wouter den Haan, Vox EU: According to national-income account data, financial institutions are responsible for an important fraction of what countries produce each year. A standard way to measure a sector's contribution to GDP is to calculate its value added, that is, the difference between the value of the products produced minus the value of the products used in production.

This "value added" is distributed as income or reinvested in the financial sector.

  • Figure 1 displays the fraction of US GDP produced by the financial and insurance sector. During the post-war period this fraction increased from 2% to 8%.
  • The UK's financial sector generated 9% of total British value added in the last quarter of 2008; this was only 5% in 1970.1

Figure1. Value added of the finance and insurance sectors in the US (% of GDP)

: Bureau of Economic Analysis

An increase in inputs (capital and labour) is only part of the story. Value added per worker has also increased substantially. Weale (2009) reports that earnings per employee in the UK financial sector were 2.1 times average earnings in 2007. In Philippon and Reshef (2008), it is shown that the rise in the relative financial wage is related to financial deregulation.

The elevated position of the financial sector is even more obvious when we take a look at corporate profits.

  • In the first couple of decades following the Second World War, profits in the financial sector were around 1.5% of total profits;
  • Recently, this number was as high as 15%.

Pay versus output

Without doubt, these numbers indicate that the stakeholders in the financial sector (employees and investors) receive a substantial chunk of GDP. But the numbers do not necessarily imply that the sector produces this much. Nor do they imply that the actual value of what the sector produces has gone up a lot during the post-war period.

To understand why there could be a difference between the income received and the value of what is being produced, consider the basis of this deduction. In a competitive economy, the price of a good equals its marginal cost, and consumers buy it up to the point where their marginal benefit equals the price. If it is an intermediate good, the price equals the value of the good's marginal productivity to the purchasers. Thus, the value of output works well as a measure of both the cost and the benefit to society. That's the magic of the market.

However, if the sector is imperfectly competitive, the price will exceed the social marginal cost and we'll see value added being artificially transferred between sectors. As the financial sector is very concentrated, this is one reason we should expect the payments to factors in banking to exceed the value created – taking, as a base case, the prices that would be observed if the sector were competitive.

A second wedge between wage and value arises from the implicit insurance that the financial sector gets. As financial service providers do not pay for the "moral hazard" they create, the true value of financial services is systematically less than the payment to factors. Curry and Shibut (2000) calculate that the fiscal cost, net of recoveries, of the 1980s US Savings and Loan Crisis was $124 billion, or roughly 3% of GDP. This cost ignores other costs such as output losses, and this was a relatively mild crisis. Laeven and Valencia (2008) consider 42 crisis episodes and find an average net fiscal cost of 13.3%.2 It would not be fair to attribute these losses solely to the financial sector, but the magnitudes of the numbers suggest that this wedge could quantitatively be very important.

A third wedge comes from negative spillovers. The financial sector may provide services that are useful to a client, but not to society as a whole. For example, a financial institution may help to structure a firm's financing in such a way that the firm pays less taxes. Such a transaction would not increase production, unless lower taxes help the firm to produce more. Nevertheless, such transactions will count as value added generated by the financial sector. A rather stark analogy could be drawn with the cigarette industry, where it is quite clear that the payments to factors do not really measure social value added since the cost of smoking-induced health problems falls on the taxpayer (in most nations).

Although the sector's contribution is not easy to measure, there are some things we do know.

  • First, the financial sector provides useful services. That is, the sector's value added should be positive.
  • Second, financial-sector value added reported in the national income accounts was probably overvalued in the years leading up to Great Recession.

The financial sector extracted huge fees from the rest of the economy to construct opaque securities that were so complex that only a few understood how risky they were.3 If fees (prices) had accurately reflected the true value of the products, then some of these fees should have been negative, since many such products were not beneficial to the buyer or to society as a whole.

Several important questions need answers.

  • What are the reasons for the observed substantial increase in the share of GDP received by the financial sector?
  • What are the services that the financial sector in today's world does (or should) provide that increase the production of things we care about?
  • What is the value of these services? This is a tough question for the type of products delivered by the financial sector, because the nature of the services changes over time. For products like computers, we can measure characteristics such as speed and memory and measure how much computing power you get. If a bank becomes better at preventing default, then it provides more "financial services" for each unit of loans issued. But how can we correct for such changes in risk exposure? One possibility to measure the effectiveness of the services provided is to investigate how differences in financial sectors across countries are related to valuable characteristics such as smaller business cycles, better life-time consumption patterns, and innovative firms not facing financing constraints.4

What is the value of modern finance versus traditional finance?

Although the financial sector has been in the limelight since the outbreak of the crisis, these questions have received little attention. There is a substantial academic literature investigating the positive (and negative) effects of the presence of developed financial markets on long-term growth.5 But there is not that much research done on the question of which aspects of the current financial system are important for today's economies.

One would think that it is essential to fully understand what contributions the financial sector, and especially banks, can offer before engaging in a discussion on how to regulate this sector. If the key aspects of the financial sector that foster growth are relatively simple, then we would not have to worry that, say, increased capital requirements would have negative impacts on the economy. Then it would make more sense to worry about there being enough competition, so that we do not pay a lot for relatively simple activities. But if sustained economic growth requires a creative financial sector capable of performing complex tasks, then we should worry that regulation is not going to debilitate this sector.

It is surprising that these questions currently get so little attention. In an abstract sense, we know what roles financial institutions fulfil. In particular, (i) financial institutions avoid duplication both when monitoring loans and collecting information, (ii) they help to smooth consumption, and (iii) they provide liquidity.6 There are many enjoyable descriptions of some activities enacted in the financial sector that seem hard to reconcile with the laudable tasks thought of by economists. Moreover, knowing what the tasks of the financial sector are in theory does not tell us whether those tasks are fulfilled efficiently and at the right price. Nor does it tell us why the income earned by the financial sector has increased so much. As pointed out by Philippon (2008), in the 1960s outstanding economic growth was achieved with a small financial sector. Has it become more difficult to obtain information so that we now need to allocate more resources to the financial sector?

Some articles in the literature address the questions posed here. Chari and Kehoe (2009) use US firm-level data and find that the amount spent on investment exceeds the amount of internally-available funds (revenues minus wages minus material costs minus interest payments minus taxes) for only 16% of all firms considered. If investment could in principal be done using the firms' own funds, then the role for financial intermediaries is obviously diminished. Haldane (2010) discusses in detail the earnings of the financial sector and concludes that "risk illusion, rather than a productivity miracle, appears to have driven high returns to finance". Philippon and Reshef (2008) study wages earned in the financial sector and conclude that a large part of the observed wage differential between the financial sector and the rest of the economy cannot be explained by observables like skill differences, but is likely to be due to the presence of rents. Philippon (2008) argues that an increase in the types of firms that invest (young firms) can explain part of the increased income share of the financial sector; the increase in the last decade remains puzzling.

A similar view is expressed by Popov and Smets (2011), who argue that deeper financial markets in the US relative to those of the European continent are, to a large extent, responsible for the larger increases in productivity and faster pace of industrial innovation. One piece of evidence supporting this view is the empirical study of Popov and Roosenboom (2009), who find that better access to private equity and venture capital have a positive impact on the number of patents. Den Haan and Sterk (2011) reconsider the popular hypothesis that innovations in financial markets should make it easier for financial institutions to smooth business cycles. The idea of this hypothesis is that better access to bank finance ensures that consumers and firms do not have to make decisions that are bad for the economy as a whole, such as firing workers or postponing purchases which in turn could trigger additional layoffs. Den Haan and Sterk (2011) analyse in detail the behaviour of consumer loans and real activity, and find that there is no evidence that supports the hypothesis that financial innovations dampened business cycles, even when the recent crisis is excluded. Lozej (2011) addresses the same question using firm loans. Although the evidence presented by Lozej (2011) is a bit more mixed, there is at best weak evidence that the changes in the financial sector contributed to smaller business cycles during the period before the recent crisis.


The literature indicates that some tasks of the financial sector are beneficial, some attributes of financial institutions matter, and others matter less so or not at all. The recent publication of the Vickers report is a good occasion to investigate what activities of the financial sector are beneficial for today's way of life, and whether they are affected by proposed regulation. Without doubt, various proposed changes in regulation will be costly for the financial sector and make it more difficult for the sector to perform some activities. But that is not necessarily a bad thing. If a change would cost the financial sector, say, one billion a year but does not affect the total amount being produced, then it just means that there is an extra billion for the other sectors.


Chari, V. V., and Patrick J. Kehoe (2009), "Confronting models of financial frictions with the data", mimeo.
Curry, T., and L. Shibut (2000), "The cost of the savings and loan crisis: Truth and consequences", FDIC Banking Review, vol 13 no 2.
Demirguc-Kunt, Asli, Thorsten Beck, and Patrick Honohan (2008), "Finance for all? Policies and pitfalls in expanding access", World Bank: Washington, DC.
Den Haan, Wouter J., and Vincent Sterk (2011), "The myth of financial innovation and the great moderation", The Economic Journal 121, 707-739.
Gorton, Gary, and Andrew Winton (2003), "Financial intermediation", in George. M. Constantinides, Milton Harris and René. M. Stulz (eds.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, 431-552, Elsevier, Amsterdam.
Haldane, Andrew (2010), The contribution of the financial sector – miracle of mirage?,BIS.
Laeven, Luc and Fabian Valencia (2008), "Systemic Banking Crises: A new database", IMF working paper WP/08/224.
Levine, Ross (2005), "Finance and growth: theory and evidence", in Philippe Aghion and Steven Durlauf (eds.), Handbook of Economic Growth, edition 1, volume 1, chapter 12, 865-934, Elsevier, Amsterdam.
Lewis, Michael (1989), Liar's poker: rising through the wreckage on Wall Street, W.W. Norton & Company, New York.
Lowenstein, Roger (2000), When genius failed: the rise and fall of Long-Term Capital Management, Random House, New York.
Partnoy, Frank (1997), F.I.A.S.C.O.: blood in the water on Wall Street, W.W. Norton & Company, New York.
Philippon, Thomas (2008), "The evolution of the US financial industry from 1860 to 2007: theory and evidence", manuscript New York University.
Philippon, Thomas and Ariell Reshef (2008), "Wages and human capital in the US Financial Industry: 1909-2006", manuscript New York University and University of Virginia.
Popov, Alexander and Peter Rosenboom (2009), "Does private equity investment spur innovation", ECB working paper 1063.
Popov, Alexander, and Frank Smets (2011), "Financial markets: Productivity, procyclicality, and policy", manuscript European Central Bank.

1 Unless stated otherwise, the numbers in this paragraph are from Haldane (2010).
2 The highest net fiscal cost was equal to 55.1% and attained during the 1980 Argentinian crisis. In contrast, the net fiscal cost of the banking crisis in Sweden during the early 1990s was close to zero.
3 There are many other examples. I recently transferred €10,000 from a Dutch Euro account to a Euro account held by a British bank. The transfer cost me €455. That is, a personal loss of 4.6% in one day. Given that the costs are virtually zero, the fees would be almost fully counted as value added in the national income accounts.
4 An example is Popov and Roosenboom (2009).
5 Levine (2005) provides an excellent survey and concludes that a well-developed financial sector is beneficial for growth. Demirguc-Kunt, Beck, Honohan (2008) argue that in some cases the effect could be the opposite.
6 See Gorton and Winton (2003).
7 See, for example, Lewis (1989), Lowenstein (2000), and Partnoy (1997).

links for 2011-10-27

Posted: 27 Oct 2011 12:06 AM PDT

Fed Watch: Waiting, Waiting, Waiting"

Posted: 26 Oct 2011 03:24 PM PDT

Another post from Tim Duy:

Waiting, Waiting, Waiting, by Tim Duy: US markets are closed, with everyone left waiting for the news from Europe and the 3Q11 US GDP report. Expectations appear to be high for both, but I am considerably more certain the latter will deliver on those expectations. Europe is certainly more interesting. Over the last few weeks, market participants looked to have grasped at every little straw that offered hope on the European story, and it remains to be seen whether or not that will continue when rumours turn to news.

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months. Some specific concerns:

The goalposts are already moving. The Eurozone economy is headed into recession - the combination of fiscal austerity and financial turmoil have already set in motion the inevitable contraction of demand that will soon threaten deficit reduction goals across the continent. And it is only a matter of time before the ratings agencies recognize this as well. The European solution, of course, will be additional fiscal austerity. It didn't work in Greece, and it won't work for the Eurozone as a whole.

The lack of sufficient ECB participation. The German contingent has effectively shut down the ECB. From the Wall Street Journal:

Lawmakers also pressed Ms. Merkel to push banks considered systemically relevant to raise core capital to 9% by a deadline of June 30, 2012 and urged her to insist on an end to the European Central Bank's program of purchasing euro-zone bonds on the open market to prop up weakened euro-zone members as soon as the EFSF is launched. German lawmakers also called for a clear European commitment to the ECB's independence.

The Germans fear the inflationary consequences if the ECB essentially monetizes the debt of the periphery. But the lack of a credible lender of last resort is crippling rescues efforts, and will continue to do so.

When in doubt, turn to financial engineering. The faith in financial engineering never ceases to amaze me. Efforts to leverage up the EFSF are almost comical, and they reveal another problem in this exercise - no one (in particular, Germany) is willing to bring sufficient resources to the table. Wolfgang Munchau:

Leverage can have different economic functions, but in these cases it simply disguises a lack of money.

The whole issue of leverage looks to be little more than a smoke and mirrors effort to make the real firepower of the fund appear to be much greater than reality.

Turning to developing nations for help. If it wasn't so sad, it would almost be funny. Reports of BRIC participation as EFSF investors have been circulated for weeks. The latest version that reportedly sparked today's market rally:

French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.

My goodness, have the Europeans learned nothing from the Americans? Sure, we let the fox into the hen house and didn't have the common sense to chase him out a decade ago. The Europeans are now opening the doors and inviting in the fox. Michael Pettis had a long, must read piece on this topic earlier this month:

In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.

Foreign money does not solve the credibility problem. What's worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.

The idea on the table is for the BRICs to buy into the EFSF, not struggling debt directly. Even so, they need Euros to buy EFSF debt, which will represent a capital inflow into Europe. The periphery nations are struggling to rebalance internally. The strong Euro is not helping matters. Ultimately, additional capital inflows from the BRICs will only add additional strength to the Euro, encouraging further contractionary external adjustment that only complicates the internal adjustment challenges. The Europeans really should be seeking a European solution, not adding more external stakeholders to the fray.

I guess we should all get some good sleep tonight, as tomorrow will be a busy day.

Wither CDS?

Posted: 26 Oct 2011 11:07 AM PDT

Tim Duy:

Wither CDS?, by Tim Duy: Something I have been wondering about in the context of the supposed "voluntary" writedowns being forced upon holders of Greek debt - what exactly is the point of the credit default swap market for sovereign debt if politicians will act to ensure that any default never triggers a credit event? The FT provides an answer:

Now, politicians are seeking to take their revenge: not just with the recent introduction of bans on some trading of credit default swaps but also in their attempts to ensure that any haircut on Greek government bonds does not trigger a credit event.

Combined, these two events could spell the end of the credit default swaps market, say bankers.

The end of the credit default swap market might not be without consequences:

But these aims could backfire. Some bankers believe, rather than lowering borrowing costs, these moves will have the reverse effect and also restrict lending to their banks and companies.

In the wake of the CDS ban, some banks are already pushing alternative strategies that risk driving up government bond yields even further. Last week Citigroup, the leading US bank, recommended selling the bonds of France, Italy and Spain because of the trading ban while other banks have warned they could unload peripheral bonds if CDS payouts are ruled out on Greece.

Not exactly a good time for higher rates in the periphery. Will the loss of the CDS market ultimately improve or undermine financial market functioning? This is outside my area of expertise, leaving me particularly curious on how events unfold.

October 26, 2011

Latest Posts from Economist's View

Latest Posts from Economist's View

"Important Ideas Have Been Discovered—or, Rather, Rediscovered"

Posted: 26 Oct 2011 12:33 AM PDT

John Cassidy:

Where Is the New Keynes?, by John Cassidy: On Monday, I was on Leonard Lopate's WNYC radio show talking about my recent article on John Maynard Keynes. (The piece is no longer behind a firewall. You can read it here, and listen to the interview here.) At the end of the show, Leonard asked me an interesting question: Has the financial crisis and Great Recession produced any big new economic ideas? ...
Certainly, there is no new Keynes. But I do think that some important ideas have been discovered—or, rather, rediscovered. Here are six of them...:
1. Finance matters. This lesson might seem obvious to the man in the street, but many economists somehow managed to forget it. ...
2. Credit busts are different from ordinary recessions. ...
3. Positive feedback and multiple equilibria have to be taken seriously. With the rise of rational expectations theory, the idea that financial markets and entire economies can spiral into bad outcomes—and for no very good reason—was relegated to a mathematical curiosity: so called "sunspots." Now, the notion is back, and for good reason. It appears to describe the world pretty well. ...
4. Especially in financial markets, self-regarding rational behavior isn't necessarily socially optimal. ...
5. Monetary policy doesn't always work very well. This lesson should have been relearned in Japan. One person who did relearn it was Paul Krugman. ...
6. Fiscal stimulus programs don't provide a panacea for deep recessions, but the alternatives—do-nothing policies or austerity—are much worse. If you doubt this, I would suggest you look at what is happening in Greece and the United Kingdom, where austerity programs have been in effect for more than a year. As for the Obama stimulus, most serious studies show it did have a positive impact on G.D.P. growth and job creation—as detailed in this helpful post by Dylan Matthews...
Looking at this list, anyone familiar with Keynes will quickly realize that almost all of the points on it can be found in his writings, at least in embryo form. ...

I'll add one more: Before the crisis Alan Greenspan assured us that there wasn't a housing bubble, and even if there was, and it popped, the Fed could contain its effects and clean up afterward. Nothing to worry about. That was wrong.

That points to one more: The Fed needs better ways to identify bubbles. Because of the belief that bubbles could be contained and easily mopped up, little effort was made to find ways to identify bubbles as they were inflating. Now that we know how much damage bubbles can do -- something we should have known already -- we need to put effort into finding reliable indications of bubbles, and then take action to stop them from doing severe damage.

Another: In this type of recession, saving banks is not enough to restore the economy. It's critical to help households too.

"Trends in the Distribution of Income"

Posted: 26 Oct 2011 12:24 AM PDT

This is from the CBO:

Trends in the Distribution of Income, by Edward Harris and Frank Sammartino, CBO Director's Blog: From 1979 to 2007, real (inflation-adjusted) average household income, measured after government transfers and federal taxes, grew by 62 percent. That growth was not equal across the income distribution: Income after government transfers and federal taxes (denoted as after-tax income) for households at the higher end of the income scale rose much more rapidly than income for households in the middle and at the lower end of the income scale.

In a study prepared at the request of the Chairman and former Ranking Member of the Senate Committee on Finance, CBO examines the trends in the distribution of household income between 1979 and 2007. (Those endpoints allow comparisons between periods of similar overall economic activity.)

After-Tax Income Grew More for the Highest-Income Households

CBO finds that between 1979 and 2007:

  • For the 1 percent of the population with the highest income, average real after-tax household income grew by 275 percent (see figure below).
  • For others in the 20 percent of the population with the highest income, average real after-tax household income grew by 65 percent.
  • For the 60 percent of the population in the middle of the income scale, the growth in average real after-tax household income was just under 40 percent.
  • For the 20 percent of the population with the lowest income, the growth in average real after-tax household income was about 18 percent.

Growth in Real After-Tax Income from 1979 to 2007

As a result of that uneven income growth, the distribution of after-tax household income in the United States was substantially more unequal in 2007 than in 1979: The share of income accruing to higher-income households increased, whereas the share accruing to other households declined. Specifically:

  • The share of after-tax household income going to the highest income quintile grew from 43 percent in 1979 to 53 percent in 2007. (Each quintile contains one-fifth of the population, ranked by adjusted household income.)
  • The share of after-tax household income for the 1 percent of the population with the highest income more than doubled, climbing from nearly 8 percent in 1979 to 17 percent in 2007.
  • The population in the lowest income quintile received about 7 percent of after-tax household income in 1979; by 2007, their share of after-tax income fell to about 5 percent. The middle three income quintiles all saw their shares of after-tax income decline by 2 to 3 percentage points between 1979 and 2007.

Market Income Shifted Toward Higher-Income Households

The major reason for the growing unevenness in the distribution of after-tax income was an increase in the concentration of market income—income measured before government transfers and taxes—in favor of higher-income households. Specifically, over the 1979 to 2007 period, the highest income quintile's share of market income increased from 50 percent to 60 percent (see figure below), while the share of market income for every other quintile declined. In fact, the distribution of market income became more unequal almost continuously between 1979 and 2007 except during the recessions in 1990–1991 and 2001.

Shares of Market Income, 1979 and 2007

Two factors accounted for the changing distribution of market income. One was an increase in the concentration of each source of market income, which consists of labor income (such as cash wages and salaries and employer-paid health insurance premiums), business income, capital gains, capital income, and other income. All of those sources of market income were less evenly distributed in 2007 than they were in 1979.

The other factor was a shift in the composition of market income. Labor income has been more evenly distributed than capital and business income, and both capital income and business income have been more evenly distributed than capital gains. Between 1979 and 2007, the share of income coming from capital gains and business income increased, while the share coming from labor income and capital income decreased.

Market Income Grew Rapidly for the Highest-Income Households

The rapid growth in average real household market income for the 1 percent of the population with the highest income was a major factor contributing to the growing dispersion of income. Average real household market income for the highest income group tripled over the period, whereas such income increased by about 19 percent for a household at the midpoint of the income distribution. As a result, the share of total market income received by the top 1 percent of the population more than doubled between 1979 and 2007, growing from about 10 percent to more than 20 percent.

The precise reasons for the rapid growth in income at the top are not well understood, though researchers have offered several potential rationales, including technical innovations that have changed the labor market for superstars (such as actors, athletes, and musicians), changes in the governance and structure of executive compensation, increases in firms' size and complexity, and the increasing scale of financial-sector activities.

The composition of income for the 1 percent of the population with the highest income changed significantly from 1979 to 2007, as the shares from labor and business income increased and the shares of income represented by capital income decreased as a share of their income.

Government Transfers and Federal Taxes Became Less Redistributive

Although an increasing concentration of market income was the primary force behind growing inequality in the distribution of after-tax household income, shifts in government transfers (cash payments to individuals and estimates of the value of in-kind benefits) and federal taxes also contributed to that increase in inequality. CBO estimates that the dispersion of market income grew by about one-quarter between 1979 and 2007, while the dispersion of income after government transfer and federal taxes grew by about one-third.

Because government transfers and federal taxes are both progressive, the distribution of after-transfer, after-federal-tax household income is more equal than is the distribution of market income. Nevertheless, the equalizing effect of transfers and federal taxes on household income was smaller in 2007 than it had been in 1979.

Specifically, in 1979, households in the bottom quintile received more than 50 percent of transfer payments. In 2007, similar households received about 35 percent of transfers. That shift reflects the growth in spending for programs focused on the elderly population (such as Social Security and unemployment compensation), in which benefits are not limited to low-income households.

Likewise, the equalizing effect of federal taxes was smaller. Over the 1979–2007 period, the overall average federal tax rate fell by a small amount, the composition of federal revenues shifted away from progressive income taxes to less-progressive payroll taxes, and income taxes became slightly more concentrated at the higher end of the income scale. The effect of the first two factors outweighed the effect of the third, reducing the extent to which taxes lessened the dispersion of household income.

links for 2011-10-26

Posted: 26 Oct 2011 12:06 AM PDT

Inequality and Mobility

Posted: 25 Oct 2011 12:06 PM PDT

New column:

Income Inequality Is Hobbling the Middle Class

It's on inequality and economic mobility.

Regulatory Uncertainty is Not the Problem

Posted: 25 Oct 2011 08:46 AM PDT

The Treasury Department's new chief economist, Jan Eberly, says regulatory uncertainty is not the cause of slow job growth:

 Is Regulatory Uncertainty a Major Impediment to Job Growth?, by Dr. Jan Eberly, Treasury Notes: Last week at a Senate hearing Secretary Geithner said, "I'm very sympathetic to the argument you want to be careful to get the rules better and smarter, but I don't think there's good evidence in support of the proposition that it's regulatory burden or uncertainty that's causing the economy to grow more slowly than any of us would like."
Economists from across the political spectrum have also weighed into this debate and reached the same conclusion. ... Nonetheless, two commonly repeated misconceptions are that uncertainty created by proposed regulations is holding back business investment and hiring and that the overall burden of existing regulations is so high that firms have reduced their hiring.
If regulatory uncertainty was a major impediment to hiring right now, we would expect to see indications of this in one or more of the following: business profits; trends in the workforce, capacity utilization, and business investment; differences between industries undergoing significant regulatory changes and those that are not; differences between the United States and other countries that are not undergoing the same changes; or surveys of business owners and economists.  As discussed in a detailed review of the evidence below, none of these data support the claim that regulatory uncertainty is holding back hiring. ...