Economist's View

Brad DeLong: Three Cures for Three Crises

Brad DeLong says the cure for a financial crisis depends upon why the crisis exists:

Three cures for three crises, by J. Bradford Delong, Project Syndicate: A full-scale financial crisis is triggered by a sharp fall in the prices of a large set of assets that banks and other financial institutions own, or that make up their borrowers' financial reserves. The cure depends on which of three modes define the fall in asset prices.

The first -- and "easiest" -- mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.

The cure for this mode -- a liquidity crisis caused by declining confidence in the financial system -- is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.

This is the rule set out by Walter Bagehot more than a century ago: Calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times.

Once everybody is sure that, no matter how much others panic, financial institutions won't have to dump illiquid assets at a loss, the panic will subside. And the penalty rate means that financial institutions can't profit from the investment behavior that left them illiquid -- and creates an incentive to take due care to guard against such contingencies in the future.

In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.

This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren't solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.

In this case, applying the Bagehot rule would be wrong.

The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away, while the Bagehot rule -- with its high lending rate for banks -- would make matters worse.

Of course, easy monetary policy can cause inflation, and the failure to "punish" financial institutions that exercised poor judgment in the past may lead to more of the same in the future. But as long as the degree of insolvency is small enough that a relatively minor degree of monetary easing can prevent a major depression and mass unemployment, this is a good option in an imperfect world.

The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger. Easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system's capacity to guide resource allocation. But even this is almost surely better than a depression.

Since late summer, the US Federal Reserve has been attempting to manage the slow-moving financial crisis triggered by the collapse of the US housing bubble.

At the start, the Fed assumed that it was facing a first-mode crisis -- a mere liquidity crisis -- and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis -- more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.

As Fed Vice Chair Don Kohn recently put it: "We should not hold the economy hostage to teach a small segment of the population a lesson."

No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.

And, as if on cue, from the WSJ Economics blog:

Liquidity Threat Eases; Solvency Threat Still Looms, WSJ Economics Blog: As 2007 winds down, the much-feared year-end liquidity crisis appears to have been averted thanks to aggressive action by central banks. ... [A]s 2008 begins, it's solvency, not liquidity, that threatens the economy and the financial system. And at the root of the solvency threat is a likely decline in housing prices that will further undermine credit quality. Making banks more confident of their own ability to raise funds is not going to resolve a generalized shrinkage of lending driven by declining collateral values. ...

Paul Krugman: The Great Divide

Almost all of the Republican presidential candidates have embraced discredited voodoo economic policies, sometimes in contradiction to their previous policy positions. What does this tell us?:

The Great Divide, by Paul Krugman, Commentary, NY Times: Yesterday The Times published a highly informative chart laying out the positions of the presidential candidates on major issues. It was, I’d argue, a useful reality check for those who believe that the next president can somehow usher in a new era of bipartisan cooperation...

On one side, the Democrats are all promising to get out of Iraq and offering strongly progressive policies on taxes, health care and the environment. That’s understandable: the public hates the war, and public opinion seems to be running in a progressive direction.

What seems harder to understand is ... the degree to which almost all the Republicans have chosen to align themselves closely with the unpopular policies of an unpopular president. And I’m not just talking about ... the Iraq war. The G.O.P. candidates are equally supportive of Bush economic policies. ...

The “Bush boom,” such as it was, bypassed most Americans... Meanwhile, insecurity has increased... And things seem likely to get worse as the election approaches... All in all, ... you’d expect Republican politicians ... to distance themselves from the current administration’s economic policies and record...

In fact, however, ... Republican contenders ... assure voters that they will not deviate an inch from the Bush path. Why? Because the G.O.P. is still controlled by a conservative movement that does not tolerate deviations from tax-cutting, free-market, greed-is-good orthodoxy.

To see the extent to which Republican politicians still cower before the power of movement conservatism, consider the sad case of John McCain.

Mr. McCain’s lingering reputation as a maverick straight talker comes largely from his opposition to the Bush tax cuts of 2001 and 2003, which he said at the time were too big and too skewed to the rich. Those objections would seem to have even more force now, with America facing the costs of an expensive war — which Mr. McCain fervently supports — and with income inequality reaching new heights.

But Mr. McCain now says that he supports making the Bush tax cuts permanent. Not only that: he’s become a convert to crude supply-side economics, claiming that cutting taxes actually increases revenues. That’s an assertion even Bush administration officials concede is false.

Oh, and what about his earlier opposition to tax cuts? Mr. McCain now says he opposed the Bush tax cuts only because they weren’t offset by spending cuts.

Aside from the logical problem here — if tax cuts increase revenue, why do they need to be offset? — even a cursory look at what Mr. McCain said at the time shows that he’s ... clearly decided that it’s better to fib about his record than admit that he wasn’t always a rock-solid economic conservative.

So what does the conversion of Mr. McCain into an avowed believer in voodoo economics — and the comparable conversions of Mitt Romney and Rudy Giuliani — tell us? That bitter partisanship and political polarization aren’t going away anytime soon.

There’s a fantasy, widely held inside the Beltway, that men and women of good will from both parties can be brought together to hammer out bipartisan solutions to the nation’s problems.

If such a thing were possible, Mr. McCain, Mr. Romney and Mr. Giuliani — a self-proclaimed maverick, the former governor of a liberal state and the former mayor of an equally liberal city — would seem like the kind of men Democrats could deal with. (O.K., maybe not Mr. Giuliani.) In fact, however, it’s not possible, not given the nature of today’s Republican Party, which has turned men like Mr. McCain and Mr. Romney into hard-line ideologues. On economics, and on much else, there is no common ground between the parties.

"Why Do People Support Economic Systems That Seem To Be Against Their Self-Interest?"

When are people most likely to voluntarily redistribute income?:

The Thinkers: Playing fair, even when it hurts in the pocketbook, by Mark Roth, Pittsburgh Post-Gazette: ...Why do people support economic systems that seem to be against their self-interest? ... "Why do we see ... poor people ... who don't buy into an egalitarian system and ... rich people... who support it?" [Christina Fong of Carnegie Mellon University] asked. "That's a big puzzle in economics."...

"If only income mattered and beliefs about fairness didn't matter at all, then you should expect to see ... poor people demand redistribution [of tax revenue] and rich people oppose it. "The fact that we don't see that requires some explanation, and a big part of the explanation is that these beliefs about fairness matter a lot. So if you're poor but you think that the rich people really deserve to be rich, then you'll accept having less."

Much of Americans' beliefs revolve around whether they think the free-market economy is fair -- "in other words, people who work hard get more and people who don't get less" -- or whether they think it is basically unfair, so that "people are working really hard and not getting enough compensation."

links for 2007-12-31

• Record Industry Goes After Personal Use - washingtonpost.com
• Bipartisan Zombies - Hullabaloo
• Will raising rice paddy prices save farmers? - Taipei Times
• In Reagan’s Name - Patti Davis - Newsweek
• What Hope for Pakistan? - Project Syndicate
• Euro gains on dollar in official reserves - FT.com
• The IMF's data for global reserve growth in q3 - Brad Setser
• Un-'FairTax' - washingtonpost.com
• Mike Huckabee convinced by prankster - Robert's Stochastic thoughts

Increased Calls for Government Intervention into Private Markets

Is the idea that more government intervention is needed to regulate markets and redistribute income gaining wider acceptance?

The Free Market: A False Idol After All?, by Peter S. Goodman, NY Times:  For more than a quarter-century, the dominant idea guiding economic policy ... has been that the market is unfailingly wise. So wise that the proper role for government is to steer clear and not mess with the gusher of wealth that will flow, trickling down to the every level of society, if only the market is left to do its magic.

That notion has carried the day as industries have been unshackled from regulation, and as taxes have been rolled back, along with the oversight powers of government. Faith in markets has held sway as insurance companies have fended off calls for more government-financed health care, and as banks have engineered webs of finance that have turned houses from mere abodes into assets traded like dot-com stocks.

But lately, a striking unease with market forces has entered the conversation. ... Regulation — nasty talk in some quarters, synonymous with pointy-headed bureaucrats choking the market — is suddenly being demanded from unexpected places.

The Bush administration and the Federal Reserve have in recent weeks put aside laissez-faire rhetoric to wade into real estate, wielding new rules and deals they say are necessary to protect Americans from predatory bankers... Were the market left to its own devices, millions could lose their homes, the administration now says.

Central banks on both sides of the Atlantic are coordinating campaigns to flush cash through the global economy, lest frightened lenders hoard capital and suffocate growth. In Bali this month, world leaders gathered in the name of striking agreement to slow climate change. ...

Throughout history, regulation has tended to gain favor on the heels of free enterprise run amok. The monopolistic excesses of the Robber Barons led to antitrust laws. Not by accident did strict new accounting rules follow the unmasking of fraud at Enron and WorldCom. Now, the subprime fiasco and a still unfolding wave of home foreclosures are prompting many to call for new rules. ...

[I]n Washington, and under the roofs of many homes now worth less than a year ago, there appears to be a shift in the nation’s often-ambivalent attitude about regulation. ...

Liberal critics have long asserted that dogmatic devotion to market forces has skewed American society toward those of greatest means. More wealth is being concentrated in fewer hands, with rich people capturing the best housing, private education and health care services...

That critique informs proposals from Democrats vying for the presidency, as they debate how best to expand access to health care and ways to shift the tax burden to the rich. They are in essence calling for market intervention to redress imbalances. With the gap between the richest and poorest now greater than it has been since the 1920s, these pitches have emerged as central components of their campaigns

More notable, though, is how fervent proponents of unfettered market forces have lately come to embrace regulation.

The Bush administration, in seeking to freeze mortgage rates for some homeowners... Treasury Secretary Henry Paulson Jr. ... is demanding that banks accept smaller payments than promised, while describing the market as a fallible thing in need of supervision. “The government acted to prevent a market failure and to try to avoid unnecessary harm,” he said...

[W]hen things go wrong, demands grow for the government to step in and make them right. “Untethered market forces lead to bad things,” said [Jared] Bernstein of the Economic Policy Institute. “You simply can’t run an economy as complicated as ours on ideology alone.”

The statement "Democrats vying for the presidency ... debate how best to expand access to health care and ways to shift the tax burden to the rich." contains different types of intervention, one that addresses a market failure and another that redistributes the outcome of the market process.

Some types of government intervention - weights and measures, disclosure requirements, truth in advertising, safety requirements, etc., are intended to make markets work more efficiently by creating conditions that better approximate competitive ideals. The debate over health care can be cast in this light, i.e. as a debate about how best to solve a market failure that prevents broader coverage at lower prices.

As second type of intervention redistributes income ex-post, i.e. after the market process has occurred, often through taxation and spending programs. In an economy with significant market failures that cause an inequitable distribution of income and wealth, ex-post redistribution may be justified to redress the imbalances caused by the market failures (and to create equal opportunity).

Thus, the first two types of intervention occur due to market failures, in the first case the intervention is to correct the failures and improve market efficiency, and in the second case the intervention redistributes income ex-post to make-up for inequities caused by existing market failures.

There is also a third possibility, intervening when markets are working reasonably well. Here, the assumption is that even well-functioning markets can produce inequitable outcomes and hence ex-post redistribution is required. Unlike the first type of intervention which corrects market failures, this type of intervention often leaves markets functioning less efficiently. Much of the objection to government intervention is made on this basis.

Here is what I am trying to argue. One type of intervention attempts to correct market failures so that they function more efficiently. The recent calls for financial market regulation, for example, largely fall under this umbrella. Another type of intervention attempts to redress inequities brought about by markets that are not functioning properly, e.g. not rewarding capital and labor in the correct proportions. Calls for redistribution can arise from this type of reasoning.

The last type of intervention redistributes income even though there are no market failures. Here, even when the economic system functions perfectly, i.e. according to competitive ideals, the outcome is still deemed inequitable and hence redistribution is needed. Some of this is out there, i.e. this type of intervention has its advocates, but of the three types of intervention I think this is the least important factor. I don't think people have much problem accepting economic outcomes if they think the game was fair, even if the outcome is lopsided. It's when the game is unfair that there are objections and calls for intervention to correct the inequitable outcome, and to fix the game so the problems don't happen again in the future.

links for 2007-12-30

• Polls Indicate Voter Anxiety on Economy - New York Times
• To Botch a Forecast, Rely on Past Experience - New York Times
• Job Growth May Be Fading Fast - New York Times
• US politics has been wrecked by rigid party allegiances - Comment is free
• Bipartisan Group Eyes Independent Bid - washingtonpost.com
• My Friend Died. Now Her Country May Not Make It. - washingtonpost.com

"Democrats and the Meanings of Change"

In an introduction to a recent column, Paul Krugman wrote:

Broadly speaking, the serious contenders for the Democratic nomination are offering similar policy proposals... But there are large differences among the candidates in their beliefs about what it will take to turn a progressive agenda into reality.

At one extreme, Barack Obama insists that the problem with America is that our politics are so “bitter and partisan,” and insists that he can get things done by ushering in a “different kind of politics.”

At the opposite extreme, John Edwards blames the power of the wealthy and corporate interests for our problems, and says, in effect, that America needs another F.D.R. — a polarizing figure, the object of much hatred from the right, who nonetheless succeeded in making big changes.

Thomas Palley agrees that, for Obama, "change is a matter of political style," but he says there are key policy differences among the candidates that have not received the attention they deserve, partly due to intentional "bunching" of policy by the Clinton campaign:

Democrats and the Meanings of Change, by Thomas I. Palley [via email, no link yet]: Many people now believe the United States cannot afford to continue with the policies of the Bush – Cheney administration. Those policies have undermined global support for America that is a key part of national security, and have produced an economic expansion that has by-passed working families and looks like bequeathing years of house price pain.

However, if there is agreement that the heavy-fisted Bush-Cheney agenda is no longer acceptable, the question remains what will follow. Among Democratic presidential candidates, though there is much talk of change, its meaning remains unclear.

Beginning some thirty years ago, Ronald Reagan initiated a fundamental re-positioning of American politics that was later completed by Newt Gingrich, Dick Armey, and Tom Delay. That re-positioning shifted the entire political spectrum to the right.

This raises the question does change mean sticking with the political playing field we now have and just giving control of the football to new Democrats like Senator Hilary Clinton? Or does it mean re-positioning the playing field and shifting the political spectrum as proposed by progressive Democrats like Senator John Edwards?

Behind this difference lie vital real world consequences that will profoundly impact America’s working families. For Clinton-style centrists, today’s economy works reasonably well. Globalization delivers prosperity by providing cheap imports that lower prices; financial boom on Wall Street benefits all by raising stock prices; and higher corporate profits drive investment that increases growth and incomes. However, growth also creates losers which means the market’s “invisible hand” must be accompanied by a “helping hand”. Consequently, there is need for policies to supplement the incomes of the working-poor and to assist workers who lose their jobs because of trade.

For Edwards-style progressives the picture is very different. Globalization has created a divide between country and corporations, with companies abandoning the U.S. by shifting jobs and investment offshore. That maximizes profits but undermines wages and future prosperity. Higher profits have not raised growth, but have instead come at the expense of wages and increased income inequality. And Wall Street has spearheaded these changes by demanding that companies raise rates of return and rip up the old social contract with workers and their communities.

From a progressive standpoint the problem with new Democrats is they tackle symptoms, not causes. Though helping hand social policies are welcome, progressives believe such policies are not up to the challenge confronting America’s working families. Meeting that challenge requires deeper change, which is what the 2008 election is all about.

Yet, surfacing this difference has proved difficult. That is because the Clinton campaign has used the political tactic of “bunching” to obscure differences. That holds for every major issue from healthcare, to trade policy, to taxing Wall Street hedge fund incomes. On each issue the Clinton campaign has bunched up and signed-on, but always reluctantly and late.

This tactical effectiveness of bunching requires progressives to raise directly the question of change and its meaning. For Senator Obama change is a matter of political style. For Senator Clinton it means restoring the economic policies of the 1990s. However, with the exception of tax cuts, those policies are the policies of today. Thus, the 1990s ushered in NAFTA and free trade with China, and cemented trends from the 1980s regarding trade deficits, the separation of wages from productivity growth, and the dominance of Wall Street. What really saved the 1990s were the Internet and stock market bubbles, which is not a sustainable foundation for prosperity.

The 21st century has gotten off to a rocky start with America squandering much political and economic capital. Now, Americans want change. The Democratic primaries offer competing visions of change. One changes possession of the political football, the other changes the football field. That’s the debate the country needs, and it seems to be finally bubbling to the surface in the last days if the Iowa campaign.

I think the important distinction is between tackling symptoms (outcomes) and tackling causes. Is it enough to revamp the social safety net within the current economic structure, or does the structure itself need to be changed?

I think action on both fronts is needed, but my preference is to let market processes work without interference and then use the social safety net and other devices to correct distributional inequities ex-post.

But that is not to say that the structure itself does not need to be changed. When I say "market processes", I mean competitive markets, I don't mean monopolized markets, or markets that do not fully internalize costs, or markets that are manipulated through the political process, etc. Broadly, I am particularly concerned about the balance of power between firms and workers, i.e. that the labor market is not competitive and hence does not have the optimality properties we expect from well-functioning markets, that more should be done to cause firms to internalize environmental externalities, that firms have more political clout than workers, that opportunity is not equal, particularly educational opportunities and this limits mobility between economic classes, that there is too much concentration of ownership in key industries such as (but not limited to) the media, and that we are not paying enough attention to our domestic infrastructure needs. Plus all the ones I forgot.

Structural change to the economy, along with needed reform of the social safety net in areas such as health care, won't come without fierce resistance from the other side. Change, even change that is centrist in nature, will require a difficult political battle and there won't be a lot of time for learning on the job. I don't believe that a cooperative, compromise approach to policy will be successful in bringing about the change that is needed and I hope the Democratic nominee, whoever that might be, will be prepared to begin the difficult battle ahead of them from day one of their administration.

Update: From Paul Krugman, a link to more discussion along these lines:

I won’t write any more about this, by Paul Krugman: But I’ll link to Lambert, who channels me admirably.

Capping Malpractice Payments

The costs of capping malpractice payments fall disproportionately on low-income workers, children, and the elderly:

Lacking lawyers, justice is denied, by Daniel Costello, Los Angeles Times: ...In 1975, California enacted legislation capping malpractice payments after an outcry ... that oversized awards and skyrocketing insurance rates were driving physicians out of the state.

The law limited the amount of money for "pain and suffering" ... to $250,000. There is no limit on what patients can collect for loss of future wages or other expenses.

Over the years, it has been easy to quantify the effects of the law, known as the Medical Injury Compensation Reform Act, or MICRA. In the years since the law was enacted, malpractice premiums in California have risen by just a third of the national average, and doctors say the law now helps attract physicians to the state. Proponents also say it discourages frivolous lawsuits.

Thirty states have enacted similar legislation. Two Republican presidential candidates -- Mitt Romney and Rudolph W. Giuliani -- have recently endorsed the approach as a possible national model.

It's been harder to tally the law's costs. Critics say it is increasingly preventing victims and their families from getting their day in court, especially low-income workers, children and the elderly. Their reasoning: The cap on pain and suffering has never been raised nor tied to inflation.

Meanwhile, the costs of putting on trials are often paid by attorneys and continue to rise each year. That means those who rely mainly on pain and suffering awards -- typically people who didn't make much money at the time of their injury -- are increasingly unattractive to lawyers.

Several states have set their malpractice caps considerably higher than California's because of worries that they affected poorer patients the most. Some state courts have begun to examine the fairness of their malpractice laws, especially those not tied to inflation. ...

A 2003 Rand Corp. report found that the law has reduced jury awards by 30%, and that the savings have come largely at the expense of severely injured or impaired patients.

On average, California juries (which are rarely informed of the cap during trials) awarded $800,000 in malpractice death cases from 1995 to 1999, but the amounts were later reduced to $250,000 under the law. This suggests that medical malpractice victims and their families could be reaping much larger payouts... But proponents of MICRA say raising the cap could harm patients.

"Raising the MICRA cap would significantly increase healthcare costs, limiting patient access to doctors, hospitals and clinics throughout California," said Lisa Maas, executive director of ... a trade group. "MICRA protects patient access to healthcare." ...

The link between malpractice payouts and increases in doctors' insurance premiums, though, remains unclear. One of the largest studies done on the topic -- by Dartmouth College researchers in 2003 -- concluded that malpractice payments had risen in line with medical care costs, whereas doctors' insurance premiums grew far faster -- by double-digit percentages annually for some specialties.

To some, that suggests that recent malpractice premium increases may have had more to do with insurers' business models and financial investments -- including documented losses in their investment portfolios in recent years -- than with their core businesses. ...

Do malpractice awards increase healthcare costs? From the CBO:

Limiting Tort Liability for Medical Malpractice: To curb the growth of premiums, the Administration and Members of Congress have proposed several types of restrictions on malpractice awards. ... Limits of one kind or another on liability for malpractice injuries, or "torts," are relatively common at the state level: more than 40 states had at least one restriction in effect in 2002.

Evidence from the states indicates that premiums for malpractice insurance are lower when tort liability is restricted than they would be otherwise. But even large savings in premiums can have only a small direct impact on health care spending--private or governmental--because malpractice costs account for less than 2 percent of that spending. Advocates or opponents cite other possible effects of limiting tort liability, such as reducing the extent to which physicians practice "defensive medicine" by conducting excessive procedures; preventing widespread problems of access to health care; or conversely, increasing medical injuries. However, evidence for those other effects is weak or inconclusive.

So the argument that lack of malpractice limits "would significantly increase healthcare costs" seems fairly weak.

The CBO report also summarizes the efficiency and equity issues involved in caps:

Issues surrounding the effects of the malpractice system and of possible restrictions on it can be viewed as questions of economic efficiency (providing the maximum possible net benefits to society) and equity (distributing the benefits and costs fairly).

Fairness is ultimately in the eye of the beholder. But the common equity-related argument for malpractice liability is that someone harmed by the actions of a physician or other medical professional deserves to be compensated by the injuring party.

The efficiency argument is that, in principle, liability (as a supplement to government regulations, professional oversight, and the desire of health care providers to maintain good reputations) gives providers an incentive to control the incidence and costs of malpractice injuries. In practice, however, the effect on efficiency depends on the standards used to distinguish medical negligence from appropriate care and on the accuracy of malpractice judgments and awards. If malpractice is judged inaccurately or is not clearly defined, doctors may carry out excessive tests and procedures to be able to cite as evidence that they were not negligent. Likewise, if malpractice is defined clearly but too broadly or if awards tend to be too high, doctors may engage in defensive medicine, inefficiently restrict their practices, or retire. Conversely, if doctors face less than the full costs of their negligence--because they are insulated by liability insurance or because malpractice is unrecognized or undercompensated--they may have too little incentive to avoid risky practices. For all of those reasons, it is not clear whether trying to control malpractice by means of liability improves economic efficiency or reduces it.

The report concludes with:

In short, the evidence available to date does not make a strong case that restricting malpractice liability would have a significant effect, either positive or negative, on economic efficiency. Thus, choices about specific proposals may hinge more on their implications for equity--in particular, on their effects on health care providers, patients injured through malpractice, and users of the health care system in general.

There is reason to be concerned about the equity of limiting award payments as compensation for injuries, i.e. of having payments that are too low when injury or impairment is severe, particularly since there are no discernible efficiency gains from the restrictions. But there is also another reason to be concerned about equity. If, as claimed above, there are costs from the restrictions on awards that fall mainly on low-income workers, children, and the elderly, then that should also raise questions about the fairness of the restrictions.

links for 2007-12-29

• Cooking Up Bigger Brains - Scientific American
• In Japan, Inflation Surges and Job Market Sags - New York Times
• China Lets Currency Appreciate a Bit Faster - New York Times
• New-Home Sales Fell to 12-Year Low in November - New York Times
• As Iraqis See It - The New York Review of Books
• 'Supercapitalism': An Exchange - The New York Review of Books

Bill Kristol To Become NY Times Columnist?

Wow. What's up with this?:

Bill Kristol To Become New York Times Columnist, by Danny Shea, Huffington Post: The Huffington Post has learned that, in a move bound to create controversy, the New York Times is set to announce that Bill Kristol will become a weekly columnist in 2008. Kristol, a prominent neo-conservative who recently departed Time magazine in what was reported as a "mutual" decision, has close ties to the White House and is a well-known proponent of the war in Iraq. Kristol also is a regular contributor to Fox News' Special Report with Brit Hume.

"From Complacency to Crisis: Financial Risk Taking in the Early 21st Century"

This is from Danielle DiMartino, John V. Duca, and Harvey Rosenblum of the Dallas Fed. The main theme of this thorough discussion is that financial market risk has been underpriced recently and, although the current financial market problems may be painful, if the long-run outcome is that risk is priced correctly, then we will have salvaged something from the turmoil:

From Complacency to Crisis: Financial Risk Taking in the Early 21st Century, by Danielle DiMartino, John V. Duca and Harvey Rosenblum, Economic Letter, Federal Reserve Bank of Dallas: During the first half of this decade, the belief that new financial products would adequately shield investors from risk encouraged financial flows to less creditworthy households and businesses. By late 2006, U.S. financial markets were flashing warning signals of a potential financial crisis.

In a sign that investors had become too complacent, risk premiums had all but vanished in junk bond and emerging-market interest rate spreads. Then, conditions changed abruptly. In the important and usually stable market for asset-backed commercial paper, premiums on three-month paper over Treasury bills jumped from 0.17 percentage point in February 2007 to 2.15 points in August. Meanwhile, rising subprime mortgage defaults led investors to abandon their sanguine beliefs about the risk of many mortgage and nonmortgage products.

The backdrop for these events was a period of macroeconomic stability that fed complacency about risk. This relatively benign economic environment, when combined with the new, structured financial products, increased financial flows to nonprime mortgage and business borrowers. The result was an overeager acceptance of risk taking that began correcting itself only after mounting subprime mortgage defaults reverberated through the broader financial markets.

More Links

Thought I'd pass these along:

Felix Salmon has a nice explanation of CDOs and overcollaterilization.

Calculated Risk has More on New Home Sales.

Taylor Clark at Slate says Don't Fear Starbucks because having one open nearby - next door even - helps existing coffee shops. [Update] Why are there no Starbucks in Italy?

[Update] Paul Krugman looks at the big bubble in the price-rent ratio and wonders How far is down? for housing prices. [Update] Brad DeLong qualifies Paul Krugman's conclusion on the fall in housing prices. [Update] Richard Green says "Krugman thinks a 50 percent fall along the coasts is possible. I am doubtful." He also links to a paper on the problems with using PE ratios.

[Update] Paul Krugman says "It occurs to me that some readers might want to know a bit more about the history behind what I’m saying currently on trade." [Update] knzn continues the discussion. He says, "It helps, I think, to separate the positive question from the normative question. The positive question is, 'Who is helped by trade, and who is harmed?' The normative question, in the abstract, is, 'How much weight should we give to the interests of the various parties that are helped and harmed by trade?'"

Paul Krugman: Trouble With Trade

The consequences of increased trade with countries that are much poorer than we are:

Trouble With Trade, by Paul Krugman, Commentary, NY Times: While the United States has long imported oil and other raw materials from the third world, we used to import manufactured goods mainly from other rich countries like Canada, European nations and Japan.

But recently we crossed an important watershed:... a majority of our industrial trade is now with countries that are much poorer than we are and that pay their workers much lower wages.

For the world economy as a whole — and especially for poorer nations — growing trade between high-wage and low-wage countries is a very good thing. Above all, it offers backward economies their best hope of moving up the income ladder.

But for American workers the story is much less positive. In fact, it’s hard to avoid the conclusion that growing U.S. trade with third world countries reduces the real wages of many and perhaps most workers in this country. And that reality makes the politics of trade very difficult.

Let’s talk for a moment about the economics.

Trade between high-wage countries tends to be a modest win for all, or almost all, concerned. ... By contrast, trade between countries at very different levels of economic development tends to create large classes of losers as well as winners.

Although the outsourcing of some high-tech jobs to India has made headlines, on balance, highly educated workers in the United States benefit from higher wages and expanded job opportunities because of trade. For example, ThinkPad notebook computers are now made by a Chinese company, Lenovo, but a lot of Lenovo’s research and development is conducted in North Carolina.

But workers with less formal education either see their jobs shipped overseas or find their wages driven down ... as other workers ... crowd into their industries and look for employment to replace the jobs they lost to foreign competition. And lower prices at Wal-Mart aren’t sufficient compensation.

All this is textbook international economics:... economic theory says that free trade normally makes a country richer, but it doesn’t say that it’s normally good for everyone. Still, when the effects of third-world exports on U.S. wages first became an issue in the 1990s, a number of economists — myself included — looked at the data and concluded that any negative effects on U.S. wages were modest.

The trouble now is that these effects may no longer be as modest ... because imports of manufactured goods from the third world have grown dramatically... And the biggest growth in imports has come from countries with very low wages. ...

So am I arguing for protectionism? No..., keeping world markets relatively open is crucial to the hopes of billions of people.

But I am arguing for an end to the finger-wagging, the accusation either of not understanding economics or of kowtowing to special interests that tends to be the editorial response to politicians who express skepticism about the benefits of free-trade agreements.

It’s often claimed that limits on trade benefit only a small number of Americans, while hurting the vast majority. That’s still true of things like the import quota on sugar. But when it comes to manufactured goods, it’s at least arguable that the reverse is true. The highly educated workers who clearly benefit from growing trade with third-world economies are a minority, greatly outnumbered by those who probably lose.

As I said, I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect. ["Wonkish" follow up here.]

links for 2007-12-28

• Ours has become a four-tier world - Project Syndicate
• Benazir Bhutto and What's to Come - Robert Reich
• Europe Charges Airlines With Price Fixing - New York Times
• Bored? - Scientific American
• Are Subprime Losses Being Exaggerated? - Felix Salmon
• Rallying the middle class - John Edwards

The Maxwell Poll on Inequality

Here is a new Maxwell Poll on inequality. The website has a brief describing the poll:

The Maxwell Poll on Inequality is an annual survey of a representative sample of over 600 Americans on their perceptions of inequality and government action. The November 2007 Poll reveals that most Americans see inequality as growing. While trends are leveling in perceptions of the increase and the seriousness of the problem, the American public in general remains concerned. The Poll reveals that perceptions of inequality and desire for government action to address it are tied to party affiliation. This reveals the potential for the wealth gap to be an important election campaign issue with Democrats supporting candidates who promise to take more government action.

The full report is here, and, as just noted, there is also a brief summarizing the results.

links for 2007-12-27

• When Great Economists go Wrong. A tale in 2 parts - Kids Prefer Cheese
• Home Prices Fell Faster in October - New York Times
• Major Retailers Feel the Squeeze From Consumers - New York Times
• Forgive and Forget - James Surowiecki
• Relearning the significance of risk - Marketplace
• Man's best friend could now become panda savior - China Daily
• A Colony With a Conscience - New York Times
• East is the way to go for Africa’s students - Project Syndicate
• Wisdom From The Founding Rationalists - David Ignatius
• Only few economists get a voice - TwinCities.com
• Iraq needs a 'jobs surge' - International Herald Tribune
• Are Manufacturers' Inflation Worries Growing? - WSJ Economics Blog
• Home Prices: Few Metro Areas Spared - WSJ Economics Blog

John Berry: Subprime Fallout Won't be as Bad as Some are Predicting

John Berry says losses from the subprime mess will be big, but "not nearly enough to sink the U.S. economy":

Subprime Losses Are Big, Exaggerated by Some, by John M. Berry, Commentary, Bloomberg: As the U.S. savings and loan crisis worsened in the 1980s, analysts tried to top each other's estimates of the debacle's cost... Much the same thing is happening now with losses linked to subprime mortgages, with figures of $300 billion to $400 billion being bandied about.

A more realistic amount is probably half or less than those exaggerated projections -- say $150 billion. That's hardly chicken feed, though not nearly enough to sink the U.S. economy. ...

There are two reasons why the losses aren't likely to be so large.

First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value. When it is sold, the lender often will get 50 percent to 60 percent or more of the loan amount after foreclosure expenses.

Second, most subprime borrowers aren't going to default. ...

What does that mean for the broader economy, particularly consumer spending? ...

The economic repercussions of the housing bust and mortgage woes are limited to a great extent because less than half of American families own a home with a mortgage... Almost a third of all families rent their house or apartment, almost a fourth own and have no mortgage and the vast majority with a mortgage are current in their payments.

Even with about a tenth of all subprime mortgages now in foreclosure, only a small share of all American families -- about 0.3 percent -- own a home in foreclosure...

Comparisons in dollars of constant value between likely subprime losses and those incurred during the S&L crisis indicate the 1980s hit was significantly greater, though the current episode still has a long way to run. ...

Krugman: Forget the Middle Ground

Paul Krugman says Democrats "need to be ready to fight some very nasty political battles":

Progressives, To Arms! Forget about Bush—and the middle ground, by Paul Krugman, Slate: Here's a thought for progressives: Bush isn't the problem. And the next president should not try to be the anti-Bush. ...

I'm not saying that we should look kindly on the Worst President Ever... Nor ... that we should forgive and forget; I very much hope that the next president will open the records and let the full story of the Bush era's outrages be told.

But Bush will soon be gone. What progressives should be focused on now ... isn't Bush bashing—what we need is partisanship. ...

Progressives have an opportunity, because American public opinion has become a lot more liberal.

Not everyone understands that. In fact, the reaction of the news media to the first clear electoral manifestation of America's new liberalism—the Democratic sweep in last year's congressional elections—was almost comical in its denial.

Thus, in 1994, Time celebrated the Republican victory in the midterm elections by putting a herd of charging elephants on its cover. But its response to the Democratic victory of 2006 ... was a pair of overlapping red and blue circles, with the headline "The center is the place to be."

Oh, and the guests on Meet the Press the Sunday after the Democratic sweep were, you guessed it, Joe Lieberman and John McCain.

More seriously, many pundits have attributed last year's Republican defeat to Iraq, with the implication that once the war has receded as an issue, the right will reassert its natural political advantage—in spite of polls that show a large Democratic advantage on just about every domestic issue. ...

The question, however, is whether Democrats will take advantage of America's new liberalism. To do that, they have to be ready to forcefully make the case that progressive goals are right and conservatives are wrong. They also need to be ready to fight some very nasty political battles.

And that's where the continuing focus of many people on Bush, rather than the movement he represents, has become a problem.

A year ago, Michael Tomasky wrote a perceptive piece titled "Obama the anti-Bush," in which he described Barack Obama's appeal: After the bitter partisanship of the Bush years, Tomasky argued, voters are attracted to "someone who speaks of his frustration with our polarized politics and his fervent desire to transcend the red-blue divide." People in the news media, in particular, long for an end to the polarization and partisanship of the Bush years—a fact that probably explains the highly favorable coverage Obama has received.

But any attempt to change America's direction, to implement a real progressive agenda, will necessarily be highly polarizing. Proposals for universal health care, in particular, are sure to face a firestorm of partisan opposition. And fundamental change can't be accomplished by a politician who shuns partisanship.

I like to remind people who long for bipartisanship that ... we got Social Security because FDR wasn't afraid of division. In his great Madison Square Garden speech, he declared of the forces of "organized money": "Never before in all our history have these forces been so united against one candidate as they stand today. They are unanimous in their hate for me—and I welcome their hatred."

So, here's my worry: Democrats, with the encouragement of people in the news media who seek bipartisanship for its own sake, may fall into the trap of trying to be anti-Bushes—of trying to transcend partisanship, seeking some middle ground between the parties.

That middle ground doesn't exist—and if Democrats try to find it, they'll squander a huge opportunity. Right now, the stars are aligned for a major change in America's direction. If the Democrats play nice, that opportunity may soon be gone.

Trade Openness and Economic Development

Edward Glaeser notes that evidence on the relationship between trade openness and economic growth is murky and thus doesn't help much with the debate over how open trade should be:

Those Who Do Not Know the Past, by Edward Glaeser, Commentary, NY Sun: Should developing countries embrace free trade or shelter their nascent industries behind protectionist walls? This debate has been going on for two centuries since Adam Smith faced off against the mercantilists. Ha-Joon Chang's "Bad Samaritans" ... is a lively addition to the protectionist side of the debate. ...

Mr. Chang's main charge is that free trade advocates from wealthy countries are hypocrites, because the history of America and the United Kingdom is full of protectionism. Mr. Chang alleges, with scant evidence, that the two nations grew great because of these tariff barriers. First world economists have reaped the benefits of protection, he suggests, but are now trying to deprive the world's poor of the wonders of tariffs.

Mr. Chang also takes aim at other free market policies such as privatization and fiscal prudence. Again he argues that since rich countries have public ownership and deficits, it is rank hypocrisy for us to try to forbid them to the poor. An alternative view is that economists shouldn't be required to endorse the worst policies of their own countries. ...

The book would have made a more serious contribution if it shed more light on whether American or English protectionism helped or harmed these countries. .... Nineteenth-century America was protectionist, but that doesn't mean that protectionism played a positive role in our nation's growth. Did American protectionism really give us the textile mills of Lowell and the steel mills of Pittsburgh? Did English tariffs really foster the spinning jenny and the steam engine? The high physical costs of crossing the Atlantic in the age of sail made it natural, with or without tariffs, for the Lowells to want to weave cotton on this side of the pond.

Mr. Chang is going to have to do better than just point out that Americans and Englishmen had tariffs to make the case that tariffs produced rowth. There is a substantial empirical literature that looks at the relationship between trade openness and economic development over the last 40 years. An early wave of research, associated with Jeffrey Sachs among others, claimed that trade openness increased growth. A second wave of research, led by Francisco Rodriguez and Dani Rodrik ..., suggested that there was little robust connection across countries between trade and growth. My own research in this area found that openness had little impact on middle income places, but is particularly valuable for the poorest places. Certainly, there is no empirical consensus that openness is either good or bad for growth.

The lack of consensus on the connection between growth and openness does not imply that Mr. Chang's protectionism is equally attractive as the open borders urged by the Washington consensus. Adam Smith and David Ricardo didn't urge free trade because trade begets growth, but because trade makes goods cheaper for ordinary people. Smith's argument is still the strongest case for open borders. Even if protectionism does encourage industrial growth, it only does so by hurting ordinary people, who have to pay more to buy the goods of inefficient domestic producers.

Mr. Chang's protectionist brief suggests that the costs that tariffs impose on ordinary consumers are worth paying since the government can use tariffs to promote the right industries. Smith would have been skeptical about putting such faith in the government, and today's developing countries certainly deserve no more trust than the government of George III. Even if an incredibly wise tariff policy could protect future economic dynamos, the history of tariffs suggests that they are used more often to protect less than dynamic cronies.

The best thing to come out of this book is its challenge to the advocates of free markets to explain why England and America did so well despite embracing policies that were not always that free. Mr. Chang has not made the case that those policies were helpful, but free marketers have an obligation to help us understand why those policies did not do more harm.

"The End of Free Trade"

Robert Samuelson says the strong post World War II push toward open markets is beginning to fade:

The End of Free Trade, by Robert J. Samuelson, Commentary. Washington Post: ...[T]he "new mercantilism." [is] an ominous development affecting the world economy. Even as countries become more economically interdependent, they're also growing more nationalistic. They're adopting policies intended to advance their own economic and political interests at other countries' expense. As practiced until the mid-19th century, mercantilism aimed to do just that.

It was an economic philosophy that favored large trade surpluses. At the time, this had some logic. Trade was an adjunct to military power. Exports earned gold and silver coin, which financed armies and navies. But mercantilism fell into disfavor as a way to promote national prosperity. Free trade, argued Adam Smith and David Ricardo, would benefit all countries... The post-World War II economic order took free trade as its ideal, even though trade barriers were lifted slowly. Now mercantilism is making a comeback, as governments try to manipulate markets to their advantage. ...

The paradox is that as the Internet and multinational companies strengthen globalization, its political foundations are weakening. Of course, opposition is not new. Even if free trade benefits most countries, some firms and workers lose from added competition. But for most of the postwar era, a pro-trade consensus neutralized this opposition. That consensus is now fraying.

Two powerful forces had shaped it, notes Harvard political scientist Jeffry Frieden. First was the belief that protectionism worsened the Great Depression. Everyone wanted to avoid a repetition of that tragedy. The second was the Cold War. Trade was seen as a way of combating communism by promoting the West's mutual prosperity. Both ideas bolstered political support for free trade. For years the global trading system flourished on the inertia of these impulses, whose relevance has faded.

In a booming world economy, the resulting tensions have so far remained muted. China's discriminatory trade practices, for example, have excited angry rhetoric, but not much else. ...

But would a global slowdown change that if other countries blamed Chinese exports for destroying their domestic jobs? Would import quotas or tariffs follow? ... In the United States, the present pattern of global trade is viewed with increasing hostility: U.S. deficits are seen as eroding industrial jobs while providing surplus countries with the dollars to buy large pieces of American firms.

The world economic order depends on a shared sense that most nations benefit. The more some countries pursue narrow advantage, the more others will follow suit. ... It's an open question whether these conflicting forces -- growing economic interdependence and rising nationalism -- can coexist uneasily or are on a collision course.

links for 2007-12-26

• Social Security fix still feasible - TwinCities.com
• Health coverage improves health - EurekAlert
• Medicare Private Plan Abuses
• Winter 1968 and the dawn of McCarthy - The Boston Globe

Nouriel Roubini: Too Little, Too Late

Nouriel Roubini sees a hard landing ahead (though Jim Hamilton says "The bears must wait another quarter"):

The Global Economy’s Inevitable Hard Landing, by Nouriel Roubini, Project Syndicate: In recent weeks, the global liquidity and credit crunch that started last August has become more severe. ... To be sure, major central banks have injected dozens of billions of dollars of liquidity into the commercial banking sector, and the US Federal Reserve, the Bank of England, and the Bank of Canada have lowered their interest rates. But worsening financial conditions prove that this policy response has failed miserably.

So it is no surprise that central banks have become increasingly desperate... The recent announcement of coordinated liquidity injections by the Fed and four other major central banks is, to be blunt, too little too late.

These measures will fail ... because monetary policy cannot address the core problems underlying the crisis. The issue is not just illiquidity – financial institutions with short-term liabilities and longer-term illiquid assets. Many more economic agents face serious credit and solvency problems, including millions of households in the US, UK, and the Eurozone with excessive mortgages, hundreds of bankrupt sub-prime mortgage lenders, a growing number of distressed homebuilders, many highly leveraged and distressed financial institutions, and, increasingly, corporate-sector firms.

At the same time, monetary injections cannot resolve the generalized uncertainty of a financial system in which globalization and securitization have led to a lack of transparency that has undermined trust and confidence. When you mistrust your financial counterparties, you won’t want to lend to them, no matter how much money you have.

The US is now headed towards recession, regardless of what the Fed does. ... Other economies will also be pulled down as the US contagion spreads.

To mitigate the effects of a US recession and global economic slump, the Fed and other central banks should be cutting rates much more aggressively... The Fed’s 25-basis-point cut in December was puny relative to what is needed; similar cuts by the Bank of England and Bank of Canada do not even begin to address the increase in nominal and real borrowing rates that the sharp rise in Libor rates has induced. Central banks should have announced a coordinated 50 basis-point reduction to signal their seriousness about avoiding a global hard landing.

Likewise, the European Central Bank’s decision not to cut rates ... is mistaken..., the ECB is virtually ensuring a sharp euro-zone slowdown.

In any case, the actions recently announced by the Fed and other central banks are misdirected. Today’s financial markets are dominated by non-bank institutions – investment banks, money market funds, hedge funds, mortgage lenders that do not accept deposits, so-called “structured investment vehicles,” and even states and local government investment funds – that have no direct or indirect access to the liquidity support of central banks. All these non-bank institutions are now potentially at risk of a liquidity run.

Indeed, US legislation strictly forbids the Fed from lending to non-depository institutions, except in emergencies. But this implies a complex and cumbersome approval process and the provision of high-quality collateral. And never in its history has the Fed lent to non-depository institutions.

So the risk of something equivalent to a bank run for non-bank financial institutions, owing to their short-term liabilities and longer-term and illiquid assets, is rising – as recent runs on some banks (Northern Rock), money market funds, state investment funds, distressed hedge funds suggests. There is little chance that banks will re-lend to these non-banks the funds they borrowed from central banks, given these banks’ own severe liquidity problems and mistrust of non-bank counterparties.

Major policy, regulatory, and supervisory reforms will be required to clean up the current mess and create a sounder global financial system. Monetary policy alone cannot resolve the consequences of inaction by regulators and supervisors amid the credit excesses of the last few years. So a US hard landing and global slowdown is unavoidable. Much greater and more rapid reduction of official interest rates may at best affect how long and protracted the downturn will be.

"Sinte Klaas"

The transformation of St. Nicholas:

St. Nick in the Big City, by John Anthony McGuckin, Commentary, NY Times: St. Nicholas was a super-saint with an immense cult for most of the Christian past. There may be more icons surviving for Nicholas alone than for all the other saints of Christendom put together. So what happened to him? Where’s the fourth-century Anatolian bishop who presided over gift-giving to poor children? And how did we get the new icon of mass consumerism in his place?

Well, it’s a New York story.

In all innocence, the morphing began with the Dutch Christians of New Amsterdam, who remembered St. Nicholas from the old country and called him Sinte Klaas. They had kept alive an old memory — that a kindly old cleric brought little gifts to the poor in the weeks leading up to the Feast of the Nativity. While the gifts were important, they were never meant to overshadow the message of Jesus’s humble birth.

But today’s chubby Santa is not about giving to the poor. He has had his saintly garb stripped away. The filling out of the figure, the loss of the vestments, and his transformation into a beery fellow smoking a pipe combined to form a caricature of Dutch peasant culture. Eventually this Magic Santa (a suitable patron saint if there ever was one for the burgeoning capitalist machinery of the city) was of course popularized by the Manhattanite Clement Clarke Moore published in “A Visit From St. Nicholas,” in The Troy (New York) Sentinel on Dec. 23, 1823.

The newly created deity Santa soon attracted a school of iconographers: notable among them were Thomas Nast, whose 1863 image of a red-suited giant in Harper’s Weekly set the tone, and Haddon Sundblom, who drew up the archetypal image we know today on behalf of the Coca-Cola Company in the 1930s. This Santa was regularly accompanied by the flying reindeer: godlike in his majesty and presiding over the winter darkness like Odin the sky god returned.

The new Santa also acquired a host of Nordic elves to replace the small dark-skinned boy called Black Peter, who in Christian tradition so loved St. Nicholas that he traveled with him everywhere. But, some might say, wasn’t it better to lose this racially stereotyped relic? Actually, no, considering the real St. Nicholas first came into contact with Peter when he raided the slave market in his hometown and railed against the trade. The story tells us that when the slavers refused to take him seriously, he used the church’s funds to redeem Peter and gave the boy a job in the church.

And what of the throwing of the bags of gold down the chimney, where they landed in the stockings and little shoes that had been hung up to dry by the fireplace? Charming though it sounds, it reflected the deplorable custom, still prevalent in late Roman society when the Byzantine church was struggling to establish the supremacy of its values, of selling surplus daughters into bondage. This was a euphemism for sexual slavery — a trade that still blights our world.

As the tale goes, Nicholas had heard that a father in the town planned to sell his three daughters because his debts had been called in by pitiless creditors. As he did for Black Peter, Nicholas raided his church funds to secure the redemption of the girls. He dropped the gold down the chimney to save face for the impoverished father.

This tale was the origin of a whole subsequent series of efforts among the Christians who celebrated Nicholas to make some effort to redeem the lot of the poor — especially children, who always were, and still are, the world’s front-line victims. Such was the origin of Christmas almsgiving: gifts for the poor, not just gifts for our friends.

I like St. Nicholas. You can keep chubby Santa.

"Preventing the Next Bout of Looting"

Menzie Chinn is worried that the regulatory effort to prevent problems in mortgage markets from reemerging is failing to adequately address part of the problem:

A Thought on the Sub-prime Debacle, by Menzie Chinn: Most of the NYT's recent coverage of the subprime mess focused on Greenspan and the Federal Reserve System. However, it's clear that regulation was deficient along other fronts. From the NYT:

... The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all. ...

Ms. Bair was an exception, especially for the deregulation-minded Bush administration. As a former assistant secretary of the Treasury in 2001 and 2002, she had worked with Mr. Gramlich to raise concerns about abusive lending practices. Indeed, she tried to hammer out an agreement with mortgage lenders and consumer groups over a tough set of "best practices" that would have covered subprime mortgages.

But that effort largely stalled because of disagreement. Though some big lenders did endorse a broad code of conduct, she recalled, they soon began loosening standards as competition intensified. ...

I think that as we learn more and more about the run-up to current situation, we will find out that "looting" was the relevant phenomenon. From George Akerlof and Paul Roemer's 1993 discussion of the S&L crisis, in the Brookings Papers in Economic Activity:

"Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. ...[B]ankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values. ...

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses...."

Now instead of arguing against Fed intervention to try to mitigate the credit crunch, on the grounds of discouraging "moral hazard", (in Krugman's lexicon, that horse is already out the barn door) I would say we need to think now about how to prevent the next bout of "looting".

That involves a much more complicated and difficult task of insulating the regulatory authorities from political pressures (see "avoiding regulatory capture"). It also probably requires expanding and integrating regulatory charters.

I'm not sure how one would do that. But I know how not to do it. From the WSJ:

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. ...

So, let's think constructively about preventing the next bout of looting, even as we deal with the after-effects of the current bout.

One of These Things is Not Like the Others

Dean Baker on the similarities and differences among Democratic presidential candidates:

Challenging the powers that be, by Dean Baker, Comment is Free: It would be difficult to identify much difference between the three leading Democratic presidential candidates' positions on major economic issues. They have come forward with comparable positions on taxes, healthcare and trade. ...

On taxes, all three candidates have said they want the wealthy to pay a larger portion of the bill, which starts with taking back the Bush tax cuts on families earning more than $200,000 a year. All three have proposed eliminating various loopholes that primarily benefit the wealthy. Edwards has gone the furthest in this respect, calling for raising the capital gains tax rate back to the pre-Clinton level of 28%. This tax increase almost exclusively affects the wealthy. ...

All three contenders have proposed a national healthcare system... Both Clinton and Edwards would impose a mandate that everyone buy into this system. Obama has claimed that he would not require a mandate. As a practical matter, the healthcare system that any of them are able to put in place will depend on the arms they twist and the pressure they can bring to bear against the insurance companies, the pharmaceutical industry and other powerful actors who will be hurt by real reform.

Any serious plan will require a mandate - this directly follows from its requirement that insurers take all comers. Without a mandate, no one would buy insurance until they had serious bills. This would be like letting people buy car insurance after an accident, and then sending the company the bill. That doesn't work.

All three contenders have said that they want to break with the Bush-Clinton-Bush trade agenda. ... What their position means in practice remains to be seen. ... As a practical matter, the country has already gone about as far as it can in placing its manufacturing workers in competition with low-wage workers in the developing world. The impact of any future trade deals on the US economy will be almost imperceptible.

A decline of the dollar by an additional 10% against the currencies of our trading partners would swamp the impact of all currently pending trade deals. On this issue there are likely to be substantial differences among the candidates. Former Treasury secretary Robert Rubin is likely to be the guiding light for economic policy in a Clinton or Obama administration. Rubin was the architect of the high dollar policy of the 1990s... He remains an enthusiastic supporter of a high dollar. Therefore Clinton or Obama would be more likely than Edwards to sacrifice the jobs and wages of manufacturing workers in order to prop up the dollar.

Rubin's Wall Street agenda would also apply to other areas of economic policy, most importantly the budget. Rubin places balanced budgets and even budget surpluses at the centre of his economic vision. A push to a balanced budget will seriously curtail the ability to extend healthcare coverage, promote access to childcare, promote clean technologies and address other neglected priorities. By contrast, Edwards has clearly stated that he does not view a balanced budget as a priority... The willingness to accept deficits may prove especially important in the context of an economy that could be in recession when the next president takes office.

In short, Edwards has set himself apart from the other two top candidates by indicating a clear willingness to challenge an agenda set on Wall Street. If a President Edwards actually carried through with this course, he would pursue a very different economic agenda than his two leading rivals.

links for 2007-12-25

• More Retail Sales Hype - The Big Picture
• Are All Sovereign Investors Becoming More Activist? - RGE
• Ben Stein Addendum - naked capitalism
• Professor Cites Bible in Faulting Tax Policies - New York Times
• Bali conference allowed the world to go to work on the climate - Jeffrey Sachs
• Death and Tobacco Taxes - Project Syndicate

Paul Krugman: State of the Unions

Is it smart, in the current political and economic environment, for Democrats to distance themselves from unions?:

State of the Unions, by Paul Krugman, Commentary, NY Times: Once upon a time, back when America had a strong middle class, it also had a strong union movement.

These two facts were connected. Unions negotiated good wages and benefits for their workers, gains that often ended up being matched even by nonunion employers. They also provided an important counterbalance to the political influence of corporations and the economic elite.

Today, however, the American union movement is a shadow of its former self, except among government workers. ... Yet unions still matter politically. And right now they’re at the heart of a nasty political scuffle among Democrats. ...

It’s often assumed that the U.S. labor movement died a natural death, that it was made obsolete by globalization and technological change. But what really happened is that beginning in the 1970s, corporate America ... in effect declared war on organized labor. ...

But the times may be changing. A newly energized progressive movement seems to be on the ascendant, and unions are a key part of that movement. Most notably, the Service Employees International Union has played a key role in pushing for health care reform. And unions will be an important force in the Democrats’ favor in next year’s election.

Or maybe not — which brings us to the latest from Iowa.

Whoever receives the Democratic presidential nomination will receive labor’s support in the general election. Meanwhile, however, unions are supporting favored candidates. Hillary Clinton ... has received the most union support. John Edwards, whose populist message resonates with labor, has also received considerable labor support.

But Barack Obama, though he has a solid pro-labor voting record, has not — in part, perhaps, because his message of “a new kind of politics” that will transcend bitter partisanship doesn’t make much sense to union leaders who know, from ... confronting corporations and their political allies head on, that partisanship isn’t going away anytime soon.

O.K., that’s politics. But now Mr. Obama has lashed out at Mr. Edwards because two 527s — independent groups ...— are running ads on his rival’s behalf. They are, Mr. Obama says, representative of the kind of “special interests” that “have too much influence in Washington.”

The thing, though, is that both of these 527s represent union groups — in the case of the larger group, local branches of the S.E.I.U. who consider Mr. Edwards the strongest candidate on health reform. So Mr. Obama’s attack raises a couple of questions.

First, does it make sense, in the current political and economic environment, for Democrats to lump unions in with corporate groups as examples of the special interests we need to stand up to?

Second, is Mr. Obama saying that if nominated, he’d be willing to run without support from labor 527s, which might be crucial to the Democrats? If not, how does he avoid having his own current words used against him by the Republican nominee?

Part of what happened here, I think, is that Mr. Obama, looking for a stick with which to beat an opponent who has lately acquired some momentum,... failed to think about how his rhetoric would affect the eventual ability of the Democratic nominee, whoever he or she is, to campaign effectively. In this sense, his latest gambit resembles his previous echoing of G.O.P. talking points on Social Security.

Beyond that, the episode illustrates what’s wrong with campaigning on generalities about political transformation and trying to avoid sounding partisan.

It may be partisan to say that a 527 run by labor unions supporting health care reform isn’t the same thing as a 527 run by insurance companies opposing it. But it’s also the simple truth.

Update: Krugman has two follow ups posts to this column, Obama goes Harry and Louise and Oy, Kos.

"Different Market Baskets for Different Income Levels"

Richard Green wonders if there are measures of the cost of living that vary according to income group:

Different Market Baskets for Different Income Levels, by Richard Green: I keep reading stories about food pantries being under particular pressure this year. The stories would be more helpful if they could explain explicitly why the food stamp program (perhaps the most successful anti-poverty program in the US) isn't sufficient to prevent this. We do know that not everyone eligible for food stamps uses them, but this has always been true, and so wouldn't explain a change in demand at the pantries; we need to look elsewhere for an explanation.

My suspicion is that an accurate measure of CPI would vary by income group. The most obvious example is that low income people spend a higher fraction of income on heat, electricity and transportation than higher income people. Even if the entire CPI is flat, if the energy and transportation sectors see large rises in prices, it will likely have a particularly large impact on the bottom quintile of the income distribution, and hence cause real incomes within this group to fall. Of course, gas and heating oil prices gave risen a lot over the past couple of years.

When I look at the BLS web site, I don't find anything about different market baskets for different income classes--I do wonder if there is something out there.

Anyone? The best I can do is this 1998 working paper from the IMF ("Is the United States CPI Biased Across Income and Age Groups?," by S. Nuri Erbas and Chera L. Sayers) showing that the CPI understates the true cost of living for older and/or poorer households, and overstates the rate for younger and/or richer households. See, in particular, Table 3, Tables I2 and I3 in the appendix, and Chart 1.

I can think of public policy reasons to avoid having more than one measure, e.g. the potential for perverse incentives when earning additional income can change the CPI used to adjust income for changes in the cost of living, the cost of calculating more than one measure, and the difficult theoretical, statistical, and political problem of defining official income classes (how many income classes, where to draw the line between classes, what income measure to use, what exclusions to allow, etc.). But even if problems such as these prevent us from actually implementing cost of living measures that differ by income group, the extent to which the market basket and the associated cost of living varies across income (and other) groups is an interesting and important question.

links for 2007-12-24

• The bears must wait another quarter - Econbrowser
• Waterboarding - Ezra Klein
• Karl Case - Economic Principals
• Bested by the Brits in the fight against poverty - IHT
• Ben Stein Watch: December 23, 2007 - Felix Salmon
• Borrow as You Go - washingtonpost.com
• Quoted in the News? Post a Comment - New York Times
• Troll's Toll - WSJ.com (open link)
• Compulsory vs. Voluntary Voting - knzn

Be Evil?

I don't think Aaaron Edlin is a big fan of the market power exploiting profit maximizers at Microsoft:

System That Stole Christmas, by Aaron Edlin, Project Syndicate: Before asking for a new Windows PC this holiday season, remember the old adage: ''Be careful about what you wish for."

In the best of all worlds, we would all benefit from the so-called ''network effects'' that result from most people using the same software: everyone could easily communicate with each other and teach each other how to use the software efficiently. Unfortunately, since Microsoft uses network effects to maximize its profits rather than to benefit users, the world it delivers is far from the best.

Consider Vista, yet another "great" new operating system that Microsoft rolled out this year, together with Office 2007. The first person at my company to use Vista was our Executive Vice-President. He was furious. Vista and Office 2007 came with his new Dell computer by default. Dell didn't ask: "Would you prefer the old versions of the operating system and MS Office that you know how to use?" So our VP got a shiny new computer that he didn't know how to use: functions were rearranged, and keyboard shortcuts were different.

Think of the productivity cost of millions like him having to adjust to a new system. Moreover, his coworkers couldn't read the Microsoft Word files that he sent them in the new ".docx" format. They wrote back and asked him to resend files in the older ".doc" format ― which might not have worked if he had inadvertently used some new-fangled formatting feature.

To be sure, Microsoft does provide a patch that allows old versions of Office to read the new ".docx" format. But Microsoft doesn't publicize it ― or warn you if your Office 2007 file is about to become incompatible with older versions.

While Microsoft could have kept the traditional ".doc" as its default format for MS Word, this would not have served its purpose: eventually, after enough of the world pays for Office 2007, holdouts will be dragged along, kicking and screaming. Then, in four or five years, Microsoft will begin our agony all over again. ...

Whenever Microsoft rolls out a new operating system, the question is not whether you should switch, but when. Adding new features can speed the transition, but what is necessary is only that the new system be incompatible with existing systems in certain respects, and that a sufficient number of people expect that it will become the new standard.

Of course, creating new software is costly. So why should Microsoft bother?

The Nobel laureate Ronald Coase answered that question long ago. According to "the Coase Conjecture," a monopolist selling a durable good must sell it at marginal cost. For Microsoft, the problem is that the marginal cost of software is zero. As a result, Microsoft cannot extract anything close to its full monopoly rents unless it sells upgrades. ...

So, by creating incompatibilities, some subtle and some obvious, that make its old software obsolete, Microsoft can sell its operating systems at high profit margins without fear that people will wait until the price drops. The price will never drop, because Microsoft will just roll out a new system, again at high profit margins.

Microsoft has been in antitrust trouble for 15 years, and ... it will probably be in trouble again. When that happens, I hope the antitrust authorities will consider a remedy that Ian Ayres, Hal Varian, and I devised.

Suppose Microsoft had to license its old software freely whenever it brings out a new version. This would give the company an incentive to ensure that new versions are compatible with and significantly better than old versions ― otherwise the new versions wouldn't sell, or at least not easily. If Microsoft's new software had to compete successfully at least against its old software, we would know the world was improving.

In the meantime, I recommend installing the Microsoft patch to your old computer and just suffering the devil you know.

"Life after Peak Oil"

According to Gregory Clark, running out of fossil fuel may not reduce living standards by as much as you might think:

Life after peak oil, by Gregory Clark, Sacramento Bee: Oil prices have receded from their recent flirtation with $100 a barrel, but ... increased demand, high prices and the prospect of an eventual peak in oil production has caught Americans paralyzed between ... the fear that rampant consumption of oil and coal is irreversibly warming the Earth and the dread that without cheap oil our affluent lifestyles will evaporate. ...

Study of the long economic history of the world suggests two things, however. Cheap fossil fuels actually explain little of how we got rich since the Industrial Revolution. And after an initial period of painful adaptation, we can live happily, opulently and indeed more healthily, in a world of permanent $100-a-barrel oil or even $500-a-barrel oil. ...

Many people think mistakenly that modern prosperity was founded on this fossil energy revolution, and that when the oil and coal is gone, it is back to the Stone Age. If we had no fossil energy, then we would be forced to rely on an essentially unlimited amount of solar power, available at five times current energy costs. With energy five times as expensive ... we would take a substantial hit to incomes. Our living standard would decline by about 11 percent. But we would still be fantastically rich compared to the pre-industrial world. ... Our income would still be above the current living standards in Canada, Sweden or England. Oh, the suffering humanity! At current rates of economic growth we would gain back the income losses from having to convert to solar power in less than six years. ...

The ability to sustain such high energy prices at little economic cost depends on the assumption that we can cut back from using the equivalent of six gallons of gas per person per day to 1.5 gallons. Is that really possible? The answer is that we know already it is.

The economy would withstand enormous increases in energy costs with modest damage because energy is even now so extravagantly cheap that most of it is squandered in uses of little value. Recently, I drove my 13-year-old son 230 miles round-trip ... to play a 70-minute soccer game. Had every gallon of gas cost [considerably more], I am sure his team could have found opposition closer to home.

The median-sized U.S. home is now nearly 2,400 square feet, for an average family size of 2.6 people... Much of that heated, air-conditioned and lighted square footage rarely gets used. Cities ... that were developed in the world of cheap gas have sprawled across the landscape so that the only way to get to work or to shops is by car...

Some countries in Europe, such as Denmark, which have by public policy made energy much more expensive, already use only the equivalent of about three gallons of gas per person. I have been to Copenhagen, and believe me the Danes are not suffering a lot from those the daily three gallons of gas they gave up.

But can we get down to 1.5 gallons without huge pain? We can see even now communities where for reasons of land scarcity people have been forced to adopt a lifestyle that uses much less energy – places like Manhattan, London or Singapore. ... Housing space per person is much smaller, people walk or take public transit to work and to shop, and energy usage is correspondingly much lower, despite the inhabitants being very rich.

So the future after peak oil will involve living in such dense urban settings where destinations are walkable or bikeable, just as in pre-industrial cities (the city of London in 1801 had 100,000 inhabitants in one square mile). Homes will be much smaller... Nights will be darker. We will not have retail outlets lit up like the glare of the midday sun in Death Valley.

Such a lifestyle is not only possible it will be much healthier. We are not biologically adapted to the suburban lifestyle... – lots of cheap calories delivered right to your seat in the SUV that shuttles you from your sofa at home, to your chair at work, to the gym where you try and work on your weight problem. ...

So life after peak oil should hold no terror for us – unless, of course, you have invested in a lot of suburban real estate.

The New Gilded Age

An article in The Economist raises familiar objections to evidence of rising inequality and claims that people such as Krugman have been misled on the issue. Krugman, in response, explains the "four dodges" present in the article and I added a couple of points in rebuttal as well:

The new (improved) Gilded Age, The Economist: ...Paul Krugman ... has recently argued that contemporary America's widening income gap is ushering in a new age of invidious inequalities. But a peek at the numbers behind the numbers suggests that Mr. Krugman has been misled: far from a new Gilded Age, America is experiencing a period of unprecedented material equality.

This is not to deny that income inequality is rising... But measures of income inequality are misleading because an individual's income is, at best, a rough proxy for his or her real economic wellbeing. ... Consumption surveys, which track what people actually spend, sketch a more lifelike portrait of the material quality of life. According to one 2006 study, by Dirk Krueger ... and Fabrizio Perri ..., consumption inequality has barely budged for several decades, despite a sharp upswing in income inequality.

But consumption numbers, too, conceal as much as they illuminate. They can record only that we have spent, but not the value—the pleasure or health—gained in the spending. A stable trend in nominal consumption inequality can mask a narrowing of real or “utility-adjusted” consumption inequality. Indeed, according to happiness researchers, inequality in self-reported “life satisfaction” has been shrinking in wealthy market democracies ... suggesting that the quality of lives across the income scale are becoming more similar, not less.

You can see this levelling at work in markets for transport and appliances. You no longer need be a Vanderbilt to own a refrigerator or a car. Refrigerators are now all but universal in America, even though refrigerator inequality continues to grow. The Sub-Zero PRO 48, which the manufacturer calls “a monument to food preservation”, costs about $11,000, compared with a paltry $350 for the IKEA Energisk B18 W. The lived difference, however, is rather smaller than that between having fresh meat and milk and having none. Similarly, more than 70% of Americans under the official poverty line own at least one car. And the distance between driving a used Hyundai Elantra and a new Jaguar XJ is well nigh undetectable compared with the difference between motoring and hiking through the muck. ...

This compression is not a thing of the past. ... Wal-Mart's move into the grocery business has lowered food prices. ... As a rule, when the prices of food, clothing and basic modern conveniences drop relative to the price of luxury goods, real consumption inequality drops. But the point is not that in America the relatively poor suffer no painful indignities, which would be absurd. It is that, over time, the everyday experience of consumption among the less fortunate has become in many ways more similar to that of their wealthier compatriots. A widescreen plasma television is lovely, but you do not need one to laugh at “Shrek”. ... New technologies and knock-off fashions now spread down the price scale too fast to distinguish the rich from the aspiring for long.

This increasing equality in real consumption mirrors a dramatic narrowing of other inequalities between rich and poor, such as the inequalities in height, life expectancy and leisure. ...

Some worrying inequalities, such as the access to a good education, may indeed be widening, arresting economic mobility for the least fortunate and exacerbating income-inequality trends. Yet even if you care about those aspects of income inequality, the idea can send misleading signals about the underlying trends in real consumption and the real quality of life. Contrary to Mr Krugman's implications, today's Gilded Age income gaps do not imply Gilded Age lifestyle gaps...

Here is Paul Krugman's response:

Inequality denial, by Paul Krugman: Well, there they go again. The Economist has a piece asserting, as a critique of Conscience of a Liberal, that rising income inequality hasn’t translated into a big rise in social inequality. It’s actually an argument I take on explicitly in Chapter 12 . But The Economist nonetheless rounds up the usual suspects.

Inequality denial generally involves four dodges — all four of which are present in this article.

links for 2007-12-23

• A 1950 Plan: Arrest 12,000, Suspend Due Process - New York Times
• Tax lunacy - Comment is free
• Embrace China - Los Angeles Times
• Voter turnout's already too high - leave it alone! - YouNotSneaky
• FDIC chairwoman is right on the money - Los Angeles Times
• Saudis plan huge sovereign wealth fund - FT

Greg Mankiw: How to Avoid a Recession

Greg Mankiw says the Fed doesn't need any help from fiscal policy in fighting a possible recession, not yet anyway:

How to Avoid Recession? Let the Fed Work, by N. Gregory Mankiw, Economic View, NY Times: The economy is teetering on the edge. Many economists, as well as online betting sites, put the risk of recession next year at about 50 percent. Once we get the final numbers, we might even learn that a recession has already begun.

The question on the minds of many in Congress and in the White House is this: What they should be doing now to keep the economy on track? The right answer: absolutely nothing.

This advice isn’t easy for politicians to follow. Because economic downturns mean fewer jobs and falling incomes, they are painful... Voters can confuse inaction with nonchalance and send incumbents packing. But..., voters should be wary of politicians eager to treat every economic ill. Sometimes, ... wait-and-see [is] the best we can do.

Congress made its most important contribution to taming the business cycle back in 1913, when it created the Federal Reserve System. Today, the Fed remains the first line of defense against recession.

The Fed’s control over the money supply is a powerful lever to move overall demand for goods and services. ... The influence of interest rates on the economy is particularly strong in housing, where buyers are rate-sensitive. Because housing woes are the source of the current slowdown, the Fed’s tool kit is well suited for the task at hand.

The recession-fighting effects of monetary expansion, however, are not limited to the housing market. When lower interest rates make fixed-income investments less attractive, investors turn to the equity market and bid up stock prices. Higher stock prices, in turn, make consumers wealthier and more eager to spend. They also make it easier for corporations to expand their businesses with equity financing.

By making United States bonds less attractive to world investors, lower interest rates from a monetary expansion also weaken the dollar in currency markets. A depreciation of the currency is not in itself to be feared. ...

A weak currency is a problem if it results from investors losing confidence in an economy. The most damaging cases are the episodes of sudden capital flight... This outcome is unlikely for the fundamentally sound American economy, but fear of it is one reason that Treasury secretaries maintain public fealty to a strong dollar.

But if a weakened currency comes about because the central bank is trying to stimulate a lackluster economy, ... depreciation is not a malady but just what the doctor ordered. A weaker currency makes domestic goods more competitive... The dollar’s falling value is one reason exports of goods and services have grown more than 10 percent in the past year.

The Fed constantly monitors all these developments to ensure that the economy has the stimulus it needs, but not too much. ... As the economy flirts with recession, ... the ... Fed has cut its target for the benchmark federal fund rates to 4.25 percent from 5.25 percent last summer. It is a good bet that we will see further cuts... And if the chance of a recession turns into a real recession, you can count on it.

Admittedly, monetary policy can sometimes use an assist from fiscal policy. If an economic downturn is deep, if a recovery is anemic or if the Fed is running out of ammunition, Congress can help raise aggregate demand for goods and services. In 2003, the Fed had cut its target interest rate all the way to 1 percent, the economy was still suffering..., and there were increasing worries about deflation. A tax cut was a good complement to monetary expansion to get the economy going again...

Today’s situation is different. The Fed has plenty of room to cut rates further, if it deems such cuts necessary. At the moment, recession is only a possibility, and inflation is a bigger worry than deflation. In this environment, there is no need for a short-run fiscal stimulus. Congress is better off focusing on longer-term problems...

The Fed is now coming under heat for not having prevented the subprime crisis, for not fully anticipating it once it was inevitable, and for not responding more vigorously now that it has occurred. Daniel Gross ... has gone so far as to liken the Fed and its chairman, Ben S. Bernanke, to FEMA and its erstwhile head Michael Brown.

The truth is that the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team as we are ever likely to see. They will make their share of mistakes, but it is too easy to find flaws when judging with the benefit of hindsight. The best Congress can do now is to let the Bernanke bunch do its job.

I am not as sure as Greg is that falling interest rate will provide the needed stimulus in this economic environment, and thus I would think it prudent to begin planning and setting contingency plans for fiscal policy, plans that can be implemented immediately should things begin to look any worse. If we wait, given the recognition, legislative, implementation, and effectiveness lags in fiscal policy, it may be too late to react once the signs of a more severe problem are evident. Hopefully, we won't need to use fiscal policy, but just in case, we should be ready.

Compulsory Voting

Should U.S. citizens be forced to vote?:

A vote rule to rein in the free riders, by Peter Singer, Project Syndicate: As an Australian citizen, I voted in the recent federal election there. So did about 95 per cent of registered Australian voters. That figure contrasts markedly with elections in the United States, where the turnout in the 2004 presidential election barely exceeded 60 per cent. In congressional elections that fall in the middle of a president's term, usually fewer than 40 per cent of eligible Americans bother to vote. There is a reason why so many Australians vote. In the 1920s, when voter turnout fell below 60 per cent, parliament made voting compulsory. Since then, despite governments of varying political complexions, there has been no serious attempt to repeal the law, which polls show is supported by about 70 per cent of the population. ...

In practice, what is compulsory is not casting a valid vote, but going to the polling place, having one's name checked off, and putting a ballot paper in the box. The secrecy of the ballot makes it impossible to prevent people writing nonsense on their ballot papers or leaving them blank. While the percentage of invalid votes is a little higher where voting is compulsory, it comes nowhere near offsetting the difference in voter turnout. Compulsory voting is not unique to Australia. Belgium and Argentina introduced it earlier, and it is practised in many other countries, especially in Latin America, although both sanctions and enforcement vary. ...

When voting is voluntary, and the chance that the result will be determined by any single person's vote is extremely low, even the smallest cost -- for example, the time it takes to stroll down to the polling place, wait in line, and cast a ballot -- is sufficient to make voting seem irrational. Yet if many people follow this line of reasoning, and do not vote, a minority of the population can determine a country's future, leaving a discontented majority. ...

If we don't want a small minority to determine our government, we will favour a high turnout. Yet, since our own vote makes such a tiny contribution to the outcome, each of us still faces the temptation to get a free ride, not bothering to vote while hoping that enough other people will vote to keep democracy robust and to elect a government that is responsive to the views of a majority of citizens.

But there are many possible reasons for voting. Some people vote because they enjoy it... Others are motivated by a sense of civic duty that does not assess the rationality of voting in terms of the possible impact of one's own ballot.

Still others might vote not because they imagine that they will determine the outcome of the election, but because, like football fans, they want to cheer their team on. They may vote because if they don't, they will be in no position to complain if they don't like the government that is elected. Or they may calculate that while the chances of their determining the outcome are only one in several million, the result is of such importance that even that tiny chance is enough to outweigh the minor inconveniences of voting.

If these considerations fail to get people to the polls, however, compulsory voting is one way of overcoming the free-rider problem. The small cost imposed on not voting makes it rational for everyone to vote and at the same time establishes a social norm of voting.

Australians want to be coerced into voting. They are happy to vote, knowing that everyone else is voting, too. Countries worried about low voter turnout would do well to consider their compulsory model.

As much as I'd like to see turnout go up, I can't support compulsory voting. It's not because of any worry that voters will be uninformed, irrational, or anything like that, it's more that it seems like an impingement on freedom.

Morality and Economic Performance

Guido Tabellini presents new evidence on the role of morals for economic outcomes:

Morality matters for economic performance, Guido Tabellini, Vox EU: Economic backwardness is typically associated with a wide range of institutional, organisational and government failures – and these along many dimensions. In numerous poor or stagnating countries, politicians are ineffective and corrupt, public goods are under-provided and public policies confer rents to privileged élites, law enforcement is inadequate, and moral hazard is widespread inside public and private organisations. There is not just one institutional failure. Typically, the countries or regions that fail in one dimension also fail in many other aspects of collective behaviour.

An influential body of research in economic history, political economics and macroeconomics has shown that both economic and institutional backwardness are often a by-product of history – appearing in countries or regions that were ruled centuries ago by despotic governments, or where powerful élites exploited uneducated peasants or slaves (North 1981, Acemoglu, Johnson and Robinson 2001). But what is the mechanism through which distant political and economic history shapes the functioning of current institutions?

In a recent working paper (Tabellini 2007), I argue that to answer this question we have to look beyond pure economic incentives, and think about other factors motivating individual behaviour. One of these factors is morality. Conceptions of what is right or wrong, and of how one ought to behave in specific circumstances, exert a strong influence on behavioural aspects that directly affect economic outcomes. The list included voters' demands and expectations, citizens' participation in group activities, the extent of moral hazard inside public organisations, and the willingness of individuals to provide public goods.

Values also evolve slowly over time, as they are largely inherited from previous generations. Thus morality, defined as individual values and convictions about the scope of application of norms of good conduct, is an important channel through which distant political history can influence the functioning of current institutions.

links for 2007-12-22

• Has Housing Bubble Been Exaggerated? - WSJ Economics Blog
• Housing price-rental ratios - CBO Director’s Blog
• Skin game (healthcare) - Ezra Klein
• Counterintuitive Alert: Straight Hair Gets More Tangled - Discover
• A Complete Subprime User's Guide, 2007 Edition - Caroline Baum
• To worry or not to worry – more (sort of) scary graphs - Brad Setser
• Fed to Continue Auctions 'As Long as Necessary' - WSJ Economics Blog
• The endangered future of the past - International Herald Tribune
• Number of conflicts in the world no longer declining - EurekAlert
• Trends in voting by occupation - Andrew Gelman

Immigration Reform and Guest Workers

From Free Exchange,  a discussion of immigration reform and guest worker programs:

Visitation rights, by Free Exchange: However one feels about the politics of immigration, there can be no question that giving migrants from poor nations the ability to work in rich countries constitutes a massive upward mobility event and a significant source of aid to developing nations. It would therefore be a welcome turn of events if developed nations could find a politically acceptable way to accommodate such labour movements. ...

In next month's issue of Reason, Kerry Howley makes an important contribution to the discussion in constructing a compelling case for the adoption of a guest worker programme. Using Singapore's system as a case study, she helpfully notes the advantages and drawbacks of temporary residence visas in a piece that comes across primarily as a challenge to pro-immigrant groups on the left, who tend to oppose guest worker programmes as inimical to the American ideal and a poor substitute for a general liberalisation of border policies.

Certainly there's something to that. The potential gains to invited labourers should appeal to liberal sensibilities... Ms Howley ... recognises the potential for abuse--both of the programme's terms and of workers themselves--in such a system, but she argues convincingly that these difficulties can be overcome through appropriate regulation of the process... Just as important, she makes the point that an easier path into the American labour market should facilitate the return of immigrant labourers to their home country, as they needn't fear being shut out for good upon exiting.

Reading Ms Howley, one begins to bristle at the pettiness of liberal guest worker critics, who place their moral qualms regarding the corrupting influence of a large population of "second-class citizens" above concerns for the material well-being of poor labourers. This, however, is ... not an accurate description of the state of anti-immigration sentiment on the talk-show right. Rather, one hears again and again of the growing use of Spanish, the questionable loyalties of incoming migrants, and the negative effects they have on "traditional" American neighbourhoods. The most outspoken nativists, like Republican presidential candidate Tom Tancredo, call for reductions in legal immigration as well as illegal.

The conflict at the bottom of immigration disagreements, then, is not primarily economic, but cultural. Immigration opponents on the right detest the otherness of the immigrant, and a guest worker programme does nothing to eliminate that sentiment. In the end, immigration reform did not fail in America due to liberal quandaries on the ethics of guest worker programs; it failed because the Republican Party took a hard right turn on the issue. It seems odd to assume Republican intransigence and argue that Democratic politicians should pursue a guest-worker middle ground, when the real angst on the right is not over the status of the immigrants but their very presence.

Ms Howley does point out that the American public, in general, is amenable to a guest worker program. In general, polling on the issue indicates that a hardline position on immigration is a loser for Republican candidates. All the same, it is the position which has come to dominate the agenda of the national party. ... As it stands, I think liberal politicians are justified in worrying that a willingness to entertain a second-class role for immigrant labour may only empower the ugliest elements of the nativist movement.

A guest worker programme also leaves some of the most troublesome policy problems unaddressed. What, for example, should we do about the millions of undocumented workers already in the country? Are we willing to issue enough temporary visas to satisfy the demand for work in America? Otherwise, we can expect the flow of undocumented workers to continue... Is it conceivable that Americans could tolerate the strict, even ruthless rigorousness with which Singapore polices its guest worker program? And if guest workers come, work hard, and wish to stay, then what? ...

Given the large and growing immigrant population in this country, and a demonstrated willingness among immigrant groups to stand up for their interests, the debate over a guest worker program may soon enough be moot. In 2006, Republican candidates running on a restrictionist platform performed dismally... Ultimately, it seems probable that the Republicans will do the compromising, or the losing, or perhaps both.

From an economic standpoint, as I believe Ms Howley would agree, a guest worker programme is the second best-outcome. Constraints on labour mobility reduce the efficiency of resource allocations and impede development, while forcing governments to spend billions policing lines in the desert. If a guest worker programme is also politically second best--if Democrats can increase their majorities by letting Republicans hang themselves with a restrictionist rope--then the best advice may well be to wait until next year and see if we cannot do better than second best.

"Traffic Jam Mystery Solved"

Since I'm on the road today, this caught my attention. Apparently, there's a reason for traffic jams that seem to occur for no reason at all:

Traffic jam mystery solved by mathematicians, EurekAlert: Mathematicians ... have solved the mystery of traffic jams by developing a model to show how major delays occur on our roads, with no apparent cause. Many traffic jams leave drivers baffled as they finally reach the end of a tail-back to find no visible cause for their delay. Now, a team of mathematicians from the Universities of Exeter, Bristol and Budapest, have found the answer and published their findings...

Paul Krugman: Blindly Into the Bubble

The ideological basis for the subprime crisis:

Blindly Into the Bubble, by Paul Krugman, Commentary, NY Times: When announcing Japan’s surrender in 1945, Emperor Hirohito famously explained...: “The war situation has developed not necessarily to Japan’s advantage.”

There was a definite Hirohito feel to the explanation Ben Bernanke ... gave this week for the Fed’s locking-the-barn-door-after-the-horse-is-gone decision to modestly strengthen regulation of the mortgage industry: “Market discipline has in some cases broken down, and the incentives to follow prudent lending procedures have, at times, eroded.”

That’s quite an understatement. In fact, the explosion of “innovative” home lending ... was an unmitigated disaster. ... Apologists for the mortgage industry claim, as Mr. Greenspan does..., that “the benefits of broadened home ownership” justified the risks of unregulated lending.

But homeownership didn’t broaden. The great bulk of dubious subprime lending took place from 2004 to 2006 — yet homeownership rates are already back down to mid-2003 levels. With millions more foreclosures likely, it’s a good bet that homeownership will be lower at the Bush administration’s end than it was at the start.

Meanwhile, during the bubble years, the mortgage industry lured millions of people into borrowing more than they could afford, and simultaneously duped investors into investing vast sums in risky assets wrongly labeled AAA. ... So where were the regulators as one of the greatest financial disasters since the Great Depression unfolded? They were blinded by ideology. ...

Mr. Greenspan... [is] a disciple of Ayn Rand, the high priestess of unfettered capitalism... In a 1963 essay for Ms. Rand’s newsletter, Mr. Greenspan dismissed as a “collectivist” myth the idea that businessmen, left to their own devices, “would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings.” On the contrary, he declared, “it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product.”

It’s no wonder, then, that he brushed off warnings about deceptive lending practices... In Mr. Greenspan’s world, predatory lending — like attempts to sell consumers poison toys and tainted seafood — just doesn’t happen.

But Mr. Greenspan wasn’t the only top official who put ideology above public protection. Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.

Also in attendance were representatives of financial industry trade associations, which had been lobbying for deregulation. As far as I can tell..., there were no representatives of consumer interests on the scene.

Two months after that event the Office of the Comptroller of the Currency, one of the tree-shears-wielding agencies, moved to exempt national banks from state regulations that protect consumers against predatory lending. If, say, New York State wanted to protect its own residents — well, sorry, that wasn’t allowed.

Of course, now that it has all gone bad, people ... are rethinking their belief in the perfection of free markets. Mr. Greenspan has come out in favor of, yes, a government bailout. “Cash is available,” he says — meaning taxpayer money — “and we should use that in larger amounts, as is necessary, to solve the problems of the stress of this.”

Given the role of conservative ideology in the mortgage disaster, it’s puzzling that Democrats haven’t been more aggressive about making the disaster an issue for the 2008 election. They should be: It’s hard to imagine a more graphic demonstration of what’s wrong with their opponents’ economic beliefs.

Walking Away from the Mortgage Contract

As noted below, lenders are concerned that there has been a change in the willingness of homeowners to walk away from their mortgage contracts. Why is this happening? The decision to walk away from a mortgage can be viewed as an unexercised option contract, and that approach can shed light on the source the change in the number of homeowners choosing to default.

I'm sure most of you know what an option contract is, but just in case, here' a quick review. There are two types of options, calls and puts. A call option gives you the right to purchase an asset at a pre-specified price, called the strike or exercise price. The purchase must be made on or before a specific expiration date. For example, a March call option for Google stock with an exercise price of $75 gives you the option to purchase Google stock for $75 at any time up to and including the March expiration date. It doesn't matter what the actual market price of the stock is, you can always purchase at $75 so long as it's on or before the expiration date (there are actually two types of options, an American call option gives you the option to purchase the stock up to and including the expiration date, a European option can only be exercised on the expiration date, not before).

Options do not have to be exercised, the holder of the option chooses whether to exercise it or not. When would this option be exercised? Suppose the price of the stock increases to $100 after you purchase the option (when the market price of the stock exceeds the strike price it is said to be "in the money"). If you choose to exercise the option and purchase at $75, you could then sell the stock at $100 on the market making a gross gain of $25. Thus, whenever the market price exceeds the exercise price, the option is in the money and can be redeemed for a gain.

The purchase price of the option is called the premium. There are ways to value options and set the premium, and I will skip that, but let's just say that the price of the option, i.e. the premium, is $10 for illustration.

Recapping, you purchase a call option for $10 that allows you to buy the stock for $75 at any time between now and March. Then, after the option is purchased but before the expiration date, the stock rises to $100 so you exercise the option making a profit of $25-$10=$15. [If, on the other hand, the price never rises above $75 before expiration date in March, the option will be left unexercised and you will lose your $10.]

A put option is just the opposite, an option to sell rather than buy at a specified price on or before a specified date. For example, you might pay $10 for the right to sell the stock at $75 at any time through March, i.e. you hold a March put option. In this case, the option will be exercised only if the stock price falls below the exercise price. Thus, if the price falls to $50, you can buy the stock for $50 on the stock market, then turn around and sell it for $75 according to the option contract realizing a profit of $25-$10=$15. However, if the price stays above the exercise price, the option will remain unexercised through the end of the contract. [If my quick explanations aren't clear, the Wikipedia explanations linked above might help.]

Now, how does this relate to walking away from a mortgage? A mortgage contract grants an implicit call option contract to the borrower. [Any non-recourse loan backed by collateral has this property. A non-recourse loan means the lender may not sue the borrower for further payment beyond the value of the collateral even if the collateral is not enough to cover the loan]. To put the mortgage in option terms, think of the borrower as turning over the collateral (the house) to the lender with the option to reclaim the collateral by repaying the loan. If the loan is not repaid, if the borrower uses the option to walk away, then the lender keeps the collateral (is stuck with the house).

When should the borrower walk away? If the value of the loan is less than the value of the collateral, the best option for the borrower is to leave the option unexercised, i.e. to walk away without using the option to repay the loan and claim the collateral (you want the house only if it's worth more than the loan). I should note, however, that this abstracts from any future reputational effects (i.e. a bad credit rating in the future represents a cost that must be considered) or ethical behavior (you pay the loan even if it costs more than the collateral is worth to honor the contract you signed). That is, this is the case where the borrower and lender agree in advance that walking away is not a sign of bad faith. If that is not true, if walking away has future costs or is constrained by ethics, this must be considered in the analysis. But both the reputational and ethical effects are easy to incorporate, it just means that the loan value must exceed the collateral value by some critical amount (by the value of losing reputation or behaving unethically) before the borrower will choose to walk away from the contract.

Interestingly, there are indications that the reputational or ethical effects are becoming less of a constraint to borrowers walking away:

Jingle mail, jingle mail, jingle mail — eek!, by Paul Krugman: Via Calculated Risk: The WSJ reports that homeowners whose mortgages are bigger than their houses are worth are starting to walk away from their houses, even if they could afford the mortgage payments. ...

Here's a bit more from CR:

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

See these comments from Bank of America CEO Kenneth Lewis via the WSJ: Now, Even Borrowers With Good Credit Pose Risks

"There's been a change in social attitudes toward default," Mr. Lewis says. Bankers typically have believed that cash-strapped borrowers would fall behind on their credit cards, car payments and other debts -- but would regard mortgage defaults as calamities to be avoided at all costs. That isn't always so anymore, he says.

"We're seeing people who are current on their credit cards but are defaulting on their mortgages," Mr. Lewis says. "I'm astonished that people would walk away from their homes." The clear implication: At least a few cash-strapped borrowers now believe bailing out on a house is one of the easier ways to get their finances back under control.

... there is a new class of homeowners in name only. Because these people never put up much of their own money, they don't act like owners, committed to their property for the long haul. ...

So, there are three separate factors that could contributing to the increase in homeowners walking away from mortgage contracts, a fall in the price, a decreased concern with future reputation, and a decline in ethical behavior. Obviously the fall in price is a big factor, and it appears that an unexpected fall in the ethical or reputational effects may be contributing as well.

The last question to ask, I suppose, is why has there been a decline in the stigma from walking away? One potential reason is that the news media has played this as largely arising from predatory behavior by lenders, and therefore going into default is not seen as a personal failing as in the past, but rather as being a victim of unscrupulous behavior. Second, mortgage problems are being reported as widespread, not isolated, and the "everyone else is doing it" effect lessens the stigma. Third, that a more general decline in social behavior has caused what's individually rational from an economic perspective to be valued more, and concerns based upon the social stigma from being a "deadbeat" valued less. That is, general societal changes have caused individualism to become more important, and social interactions (e.g. what other people think of you)  less important. But I'm not so sure about the last one, or that the three together capture all of the reasons for the change in behavior. Any other ideas?

links for 2007-12-21

• Clarence Thomas hates his job - Think Progress
• Poverty and Hardship Affect Tens of Millions Of Americans - CBPP
• Medical myths even doctors believe - EurekAlert
• Economic Outlook - Larry Summers answers questions - washingtonpost.com
• Peak gold and the gold standard - Andrew Leonard
• The problem with populism - Free exchange
• U.S. Fertility Rate Hits 35-Year High, Stabilizing Population - washingtonpost.com

"Hoover Economics" at the State and Local Level

Menzie Chinn's post on the pro-cyclical nature of state and local government spending, "Make that Four Reasons Why Recession May be Averted," reminded me of this editorial written by a colleague exactly six years ago. Menzie is analyzing and disputing a claim that robust state and local government spending will help to avert a recession. As he notes, due to reasons such as balanced budget requirements at the state and local levels and borrowing constraints, in recessions revenues fall as income falls, and since the budget must be balanced, spending falls as well (and the fall in property taxes in the current case could make things worse than usual). This is about Oregon, but the principles apply to all state and local government spending  where budgets are required to be in balance year by year. [For a bit of background, in Oregon (where there is no sales tax) if state revenues are more than 2% above the forecasted amount, the entire amount of the surplus must be refunded to taxpayers - I received a check a couple of weeks ago since revenues have been higher than anticipated this year even though future finances are in question if the economy falls into a recession. It works the other way too - if revenues are too low there are automatic cuts in state spending. This editorial was written when state and local government services were being cut by quite a bit due to revenue problems from the 2001 recession.]:

Commentary: State badly needs a rainy day fund, by George Evans, Commentary, The Register-Guard, December 20, 2001: Oregon's budget crisis is the direct result of the lack of a rainy day fund and indirectly due to past tax kickers. The principle of the rainy day fund is simple: income tax revenue automatically rises in boom times and falls in recessions, so common sense and a sound economic policy dictate that part of the revenue during periods of strong growth be set aside in a special fund to finance expenditures in recessions.

This is common sense, because it is a principle that would be followed by a prudent household facing systematic fluctuations in income. It is sound economics because it helps to smooth government expenditures and stabilize the state economy. Economists agree that government budgets should also be balanced over the business cycle, running surpluses in booms and using them to finance deficits in recessions. Such a policy acts as an automatic stabilizer, restraining the economy during booms and stimulating the economy during recessions.

The way to implement this policy at the state level is through a rainy day fund. The advantage of such a fund is painfully obvious now that we have entered a recession, but it should have been anticipated by setting up a rainy day fund in Oregon in the early 1990s.

What political forces prevented setting up a rainy day fund that would have avoided the current budget crisis? The principal obstacle has been the "tax kicker," which returns to households the "excess" tax revenues that are generated during booms.

I understand the argument made in favor of the kicker, that it prevents state spending from increasing if politicians are tempted to spend the excess tax revenues. But this argument fails to apply if the excess tax funds are instead set aside in a rainy day fund that can only be tapped during recessions. In contrast, the kicker operates with a perverse and devastating cyclical timing. Because the kicker deprives us of the rainy day fund, it in practice leads to downward pressure on state government spending during recessions, and therefore acts to intensify the recession. ...

The current State budget crisis would have been much less acute, and possibly entirely avoided, if a rainy day fund had been in place, and tapping the rainy day fund would have also helped reduce the extent of the recession in Oregon.

The current regime of balancing the budget year by year is bad economics. At the national level this "Hoover economics" approach to fiscal policy is widely understood to be discredited. The same principle applies at the state level. Current budgetary choices remain critical, but we are operating under artificial constraints. Not having a rainy day fund in place is subjecting us to unnecessary economic distress. Surely we can at least now agree to change our flawed budget policy design so that we are never again compelled to face a recession so unprepared.

I wonder how much additional stabilization could be achieved at the national level if all states had such a fund to stabilize their economies over the business cycle.

Paulson Sells His Plan for the Subprime Problem

Treasury Secretary Paulson has been making the rounds selling his plan to help with the mortgage crisis, a plan that has "government facilitating the [financial] industry coming together to prevent a market failure." The plan is too limited in scope to have much of an effect, so the plan and the current sales blitz is more of a political effort than a means of averting a crisis.

This is part of a much longer interview Secretary Paulson did with the LA Times as part of the attempt to sell the policy. In this part of the interview, Paulson attempts to identify the market failure that justifies government intervention, but it's hard to call the attempt successful. He does talk about coordination failure among lenders that prevents private sector solutions from emerging, and he references resource constraints that prevent lenders from underwriting new loans on a case by case basis on better terms to prevent foreclosure, but he doesn't explicitly explain the market failure and he does not project the sense that he has a firm grasp of the nature of the market failure he is asserting:

These are Not Normal Times, Commentary, LA Times: ...Market failure defined

Peter Hong: Could you be a little clearer on what you mean by "market failure"?

Henry Paulson: As I've said, chaos. If ever there is a role for government to bring the private sector together to deal with a situation that — when I say market failure I say that we have an unprecedented situation, and the private sector has to find a way to deal with that. Otherwise you're going to see them drowning in people who can't make resets, whom they would ordinarily want to keep in a home.

And again, I think if you take the time, call in servicers, talk to people at Wells Fargo and others, take the time to really understand it, they'll see that once you get into the process of underwriting a new loan — refinancing or modification — and you go through all the paperwork they have to go through and collect the data, that takes a long time. And they don't have the resources to do that and handle the volume at the same time.

Stabilization Policy

Currently, there are quite a few people advocating the use of tax cuts to combat a potential slowdown in the economy due to the financial crisis. That is certainly an option, if the tax cuts are well-targeted so that they do, in fact, provide the intended stimulus to the economy, and if they can be put into place quickly enough to hit before the economy recovers on its own. But there is another aspect of using tax cuts for stabilization policy that needs to be in place that would be difficult to achieve in the current political environment.

If we are going to use tax cuts as a fiscal policy tool to stabilize the economy, we have to be willing to move the tax rate in both directions, up as well as down. We are quite willing, currently, to move the tax rate down but when people like Martin Feldstein call for a temporary tax cut to stimulate the economy, if such a policy were to be enacted does anyone doubt the difficulty of raising taxes again later even with automatic expiration provisions?

Backing up slightly, why do we need to increase taxes again instead of leaving them where they are? This is stabilization policy, not growth policy, and the goal is to keep the economy anchored as closely as possible to the target rate of output. If in each successive business cycle the tax rate is lowered, but it is never raised again, there will eventually come a time when the tax rate cannot be lowered any further. If a severe recession then hits, and monetary policy isn't providing the needed stimulus or interest rates are already so low that further decreases will be ineffective, then fiscal policy will be unavailable as a backup stimulus device, much to our detriment.

Instead, assuming as in most models that the target rate of output is centrally located, the goal is to bring the economy up when the economy is dragging (use tax cuts that increase the deficit) and to slow the economy down when it begins to overheat (use tax increases that reduce the deficit). Managed properly over business cycles, tax cuts in bad times, tax increases in good times, the economy will stabilize around the target and there will be no long-run consequences for the deficit or the size of government. But if we insist that only tax cuts are available, that there is a ratchet effect in place and taxes can never be increased again, then - abstracting for the moment from changes in government spending or assuming that changes in spending are infeasible for use as a stabilization tool -  at some point we could well run out of options.

links for 2007-12-20

• In An Interview With TPM, Krugman Ramps Up Case Against Obama - TPM
• Morgan Stanley Roundtable on Managing Financial Trouble - J Appl Corp Fin
• Economic Outlook - Jeffrey M. Lacker - FRB Richmond
• CSPAN’s coverage is 51% right wing think tank - Think Progress
• Europe’s poor research performance - Vox EU
• Republican Obstructivism - Ezra Klein
• Closest Whale Cousin—A Fox-Size Deer? - Scientific American
• Europe's Central Bank is out of step - Melvyn Krauss
• Schumer Presents Four Subprime Myths - WSJ Economics Blog

EPA Denies California a Waiver

David Roberts of Grist with an analysis of the EPA's decision to deny California a waiver from federal fuel economy standards. California wants to implement its own greenhouse gas emissions standards that force a reduction in tailpipe emissions, but the request was denied:

Johnson's nuts, by David Roberts: As I mentioned below, today the U.S. EPA denied California's request for a waiver exempting it from federal fuel economy standards, allowing it to implement its own standards. EPA administrator Stephen Johnson announced the decision in a rushed press conference following President Bush's signing of the energy bill.

The announcement came with a veritable torrent of dishonest spin. Let me try to disentangle some of it.

"Who is a Populist?"

Barkley Rosser at EconoSpeak asks "Who is a Populist":

Who is a "Populist"?, by Barkley Rosser: In recent election cycles the term "populist" has been applied to such varied figures as John Edwards, Mike Huckabee, Patrick Buchanan, and Ross Perot, arguably sharing a sort of economic nationalism for the poor. Originating in anti-aristocratic agrarian movements in Europe, especially the Russian Narodniki of the late 1800s, the movement in the US attempted to encompass the urban working class as well, as symbolized by the rural Scarecrow marching along with the urban Tin Woodman on the Yellow Brick Road to defeat the Wicked Witch of the East, with populist heroine Dorothy and the Cowardly Lion stand-in for fundamentalist and anti-imperialist populist William Jennings Bryan, he of the "Cross of Gold" speech, in Baum's populist fantasy novel. The movement would be partly absorbed by the later Progressive and New Deal movements.

The movement has always had a deep divide, with race the central issue. So, on the one hand we have the progressive wing, symbolized by the remnant Democratic-Farmer-Labor Party of Minnesota and the presidential candidacy in 1948 of FDR's former Ag Secretary, Henry Wallace for the Progressive Party. On the other, in the Deep South, we got "Pitchfork" Ben Tillman in South Carolina, whose follower, Strom Thurmond, would run as the "Dixiecrat" in the 1948 presidential campaign. Today, this divide most clearly shows up in the struggle over immigration.

Given recent discussions here, I was thinking of doing a similar post discussing the term "populist", but never made it past the Wikipedia entry. [Update: Peter Dorman at EconoSpeak follows up.]

Comment Problem

I just noticed the TypePad problem and will be approving comments caught in the spam filter, then deleting duplicates. There are currently about 80 comments in the filter, but a lot of these are multiple attempts (and none are actual spam). This is annoying - apologies.

[Please leave comments as always, and if it's caught in the filter (most aren't), I will approve it as soon as possible. Once I catch it - and I'll try to check often - it doesn't take long to move it out of the spam list.]

Update: See Moon of Alabama's "TypePad Sucks" for more on this. Update: Barry Ritholtz is also having problems. Update: TypePad tells me they've tweaked the filter and it ought to be better now.

Subprime Response

Larry Summers is worried:

Ex-Treasury Secretary Calls For Tax Cut, Spending Plan, by Michael M. Phillips, WSJ: Former Treasury Secretary Lawrence Summers, once a fiscal hawk among Clinton Democrats, said the government should consider a $50 billion to $75 billion tax-cut and spending package to stave off a deep recession.

Mr. Summers ... also urged the Federal Reserve to take more aggressive action to ensure that its rate cuts actually reduce consumers' interest charges and stimulate spending.

"Insufficient action to contain recessionary forces has much more serious consequences than excessive action to contain recessionary forces," Mr. Summers said...

Mr. Summers's comments put him among the most pessimistic economic prognosticators and were a slap at the Bush administration's handling of the subprime-mortgage crisis and the constriction of U.S. credit markets. "The kind of comprehensive approach that is necessary to minimize the risks is neither in place nor in immediate prospect," he said. ...

"I believe that slow growth is a near certainty, that a recession is more than a 50% chance, and that there's a distinct possibility of a more serious recession that will lead to the worst economic performance since the late 1970s and early 1980s," he said.

Even a mild recession, he said, would cost the average family of four between $4,000 and $5,000 in lost income each year, while driving up the annual government deficit by $100 billion.

The government, he said, should counter the downturn through targeted, temporary spending, including a pre-emptive extension in unemployment benefits, an increase in food stamps and a universal tax rebate. Taxpayers shouldn't have to pay income taxes on the value of any mortgage reduction that lenders grant them amid the current crisis, he said.

Mr. Summers's critique also extended to the Fed. He said the effect of the central bank's rate-cutting has been blunted by the reluctance of financial institutions to extend credit. ... To correct that, the Fed should pull its monetary-policy levers to the extent necessary...

He leveled a similar broadside against the centerpiece of the Bush administration's response... Treasury Secretary Henry Paulson has backed a voluntary industry plan that would expedite new mortgages or rate freezes ... over the next two years.

Mr. Summers projected that the plan -- aimed only at subprime borrowers who are current on their payments -- would result in a total reduction in mortgage payments of less than $5 billion and would miss the millions of other borrowers whose payments are also expected to jump.

Instead, he proposed changes in bankruptcy laws to allow insolvent homeowners to reduce their existing mortgage debt. He argued that such moves would allow more borrowers to keep their homes, and ultimately cost lenders less money than would a raft of foreclosures...