Economist's View

Sad News

Calculated Risk:

Tanta Passes Away: My dear friend and co-blogger Doris “Tanta” Dungey passed away early this morning. I would like to express my deepest condolences to her family and friends. ... David Streitfeld at the NY Times: Doris Dungey, Prescient Finance Blogger, Dies at 47 ... This is a very sad day...

Bigger is Better

Joe Stiglitz:

A $1 Trillion Answer, by Joseph E. Stiglitz, Commentary, NY Times: What President-elect Barack Obama will need to do is horribly complicated but also very clear.

First, he must stop the economy from going deeper into recession. Then he needs to bring about a robust recovery, preferably in ways that support the long-term needs of the United States: by repairing our neglected public works, invigorating our technological leadership, making our society greener, fixing our health care problems, healing our social and economic divide, and restoring our social compact.

It will not be easy. President Bush’s legacy of debt and the opposition of those who benefit from the status quo present major obstacles.

There is an emerging consensus among economists that a big — very big — stimulus is needed, at least $600 billion to $1 trillion over two years. Mr. Obama’s announced goal of 2.5 million new jobs by 2011 is too modest. In the next two years, almost four million workers will enter the labor force — or would if there were jobs. Combined with the loss of employment this year, that means we should be striving to create more than five million jobs.

links for 2008-11-30

• The Housing-Bubble and the American Revolution - NYTimes.com
• You’re Leaving a Digital Trail. What About Privacy? - NYTimes.com
• Industrial agglomeration and entrepreneurship - voxeu.org
• Rubin's Teflon Finally Wears Off - Felix Salmon
• Sometimes the refs really do suck - Economic Policy Review
• Why does unrest spread? - UnderstandingSociety
• Deflation Can Happen - knzn
• Changes in money-wages and Amity Shlaes - Paul Krugman
• Krugman vs. Shlaes–Not A Fair Fight - The Big Picture

The Need for Reliable Information

There has been much debate about whether the financial crisis is driven by lack of liquidity or from fears about lack of adequate capital and solvency, but I'm starting to think a third component is important as well, the complete breakdown of traditional information flows, and a loss of confidence in the models used to evaluate that information. Markets need information to work properly, and the information financial markets need is not available.

For example, investors can no longer trust what ratings agencies tell them. A crucial piece of information, information designed to break informational asymmetries between firms and investors, turned out to be unreliable. In addition, investors can no longer believe the numbers they see on bank books. The numbers might say the bank is solvent, but how reliable are those numbers?  And even if the numbers are meaningful today, will they be meaningful tomorrow? Is there any way to actually value the assets a lot of these banks have on their books when there is essentially no market for them, no way to engage in price discovery? Investors no longer trust analysts and the models they use. They watched the business channel dutifully and all they heard was about the gold mine in housing. Sure, there were a few voices on the other side, but they were in the minority and mostly marginalized. All that bullish advice about housing turned out to be wrong. And there's no reason investors should trust the models used to process information either. The models used for risk assessment turned out to be far wide of the mark - a costly deviation - and if you go back and look at the Fed's forecasts of coming economic conditions (or the forecasts coming from the regional banks), it's very clear the models were underestimating the severity and length of the downturn, enough so to be relatively useless. At a more individual, face to face level, I suspect their are many homeowners who believed what their real estate or mortgage broker told them are now wondering how they could have been so foolish. They won't believe them next time. They won't know what to believe.

As I think through each stage of the mortgage process and what has gone wrong, it seems to me that the traditional information flows that are needed for people to make economic decisions, especially risky ones, are no longer present, or if they are present, simply not believed. And without the information people need to make decisions, the markets freeze up.

It's the feeling you have when you suddenly discover that everything you thought you knew about something, something you believed and relied upon for years, is wrong (like when you find out something your parents told you just isn't so). Those are moments that can stop you in your tracks while you reevaluate and figure out what it all means, while you take time to figure out how you should respond in the future.

We have recognized that liquidity and solvency are problems, and we have directed policy to try to address those problems, but I am not sure we are devoting enough attention to repairing the collapsed information structure. You can get around the problem through government guarantees or other types of insurance, but those create other problems, so it's best to avoid this if possible. However, it's going to be difficult to convince people they can trust this information again, people won't easily believe a ratings agency, real estate agent, risk assessment model, etc. just because someone announces that the problems are all fixed now, models can't be repaired overnight, so on some fronts time may be the only real solution. But on other fronts, perhaps we can do better. This is not my area, so maybe what we can do is limited here too, but is there more that the government could do, for example, with accounting standards or required disclosures that would help people evaluate the stability of a particular institution? Are there changes that could be made to give buyers and sellers more confidence that the people acting as their agents in the transaction have the right incentives? Is there some way to immediately change the regulation and structure of the ratings agencies that can help to restore confidence in their assessments of risk? The point is that we need to move now to start repairing the problems that are limiting the availability of information needed for these markets to function.

Perhaps the most important thing the government could provide is confidence in bank balance sheets. There are lots of ways to do this, e.g. the government could purchase toxic assets through auctions, and the auctions would serve as value discovery mechanisms, the government could flood the banks with capital so that there was no doubt about their solvency, or it could simply put a price floor under some of the assets on the books, i.e. say that they stand ready to buy any and all of a particular class of asset at a pre-set price (heavily discounted). People could then put a lower bound on the value of the asset side of the balance sheet, and they wouldn't have to worry that the banks own actions or events outside the institutions control - an unanticipated failure of another bank that undermines a class of assets in its portfolio - won't suddenly change it's balance sheet position beyond a known amount. Somehow people need to be able to evaluate the bounds of the risks they are taking.

Big shocks don't necessarily shake the informational foundations of markets. There can be an event that occurs in the tail of the distribution of possible events that is viewed as just that, an unusual, costly event, but not one that fundamentally upsets our understanding of how the world works while at the same time undercutting the informational flows we use to understand these markets. I don't think the dot.com  crash, for example, caused us to question the reliability of the information we receive the way this episode has. After the crash, we still thought we understood how to use models to process reliable information. But this crisis has destroyed confidence in the information and the models we use, and it won't be easy to bring this back.

As noted above, while there may be some steps the government can take to help, solving this problem won't be easy, it will take time to repair the models and the information flows. That will eventually happen, but in the short-run the government must find some way around the problem. One way, the best way I can think of, is through insurance (e.g. the price floor above) and I hope we will see more movement along these lines. The deal with Citibank can be viewed as a step in this direction (there is a 29 billion dollar deductible and a 10% copay in the insurance they were provided - see the update at the end of this post), but more can be done - more must be done - to overcome the lack of reliable information in these markets.

"The Road to Depression"

Brad DeLong says two big mistakes made the crisis worse:

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying..., above all, to avoid a deep depression.

They have also had three subsidiary objectives:

• Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
• Prevent the princes of Wall Street ... from profiting from the systemic risk that they created.
• Ensure that homeowners and small investors do not absorb too much loss, for their only "crime" was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess...

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse... The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished...

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail...

In retrospect, this was a major mistake. ... With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion..., but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called "lemon socialism," creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

links for 2008-11-29

• Was the Great Depression a monetary phenomenon? - Paul Krugman
• Friedman, revisited - Free exchange
• William Kristol on Economic Theory and Practice - Econbrowser
• Markets Don't Make Bubbles, People Do - washingtonpost.com
• Consumers still adding leverage to income - News N Economics
• What Would Keynes Have Done? - NYTimes.com
• The Keynesian moment - Paul Krugman

Krugman: What to Do

More from Paul Krugman. This is from the New York Review of Books (there's much more in the original):

What to Do, by Paul Krugman, NY Review of Books: What the world needs right now is a rescue operation. The global credit system is in a state of paralysis, and a global slump is building momentum as I write this. Reform of the weaknesses that made this crisis possible is essential, but it can wait a little while. First, we need to deal with the clear and present danger. To do this, policymakers around the world need to do two things: get credit flowing again and prop up spending.

The first task is the harder of the two, but it must be done, and soon. Hardly a day goes by without news of some further disaster wreaked by the freezing up of credit. ...

Even if the rescue of the financial system starts to bring credit markets back to life, we'll still face a global slump that's gathering momentum. What should be done about that? The answer, almost surely, is good old Keynesian fiscal stimulus. ...

I believe not only that we're living in a new era of depression economics, but also that John Maynard Keynes—the economist who made sense of the Great Depression—is now more relevant than ever. Keynes concluded his masterwork, The General Theory of Employment, Interest and Money, with a famous disquisition on the importance of economic ideas: "Soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

We can argue about whether that's always true, but in times like these, it definitely is. The quintessential economic sentence is supposed to be "There is no free lunch"; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work. The true scarcity in Keynes's world—and ours—was therefore not of resources, or even of virtue, but of understanding.

We will not achieve the understanding we need, however, unless we are willing to think clearly about our problems and to follow those thoughts wherever they lead. Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.

Paul Krugman: Lest We Forget

Financial reform and regulation of the shadow banking system cannot wait:

Lest We Forget, by Paul Krugman, Commentary, NY Times: A few months ago I found myself at a meeting of economists and finance officials, discussing — what else? — the crisis. There was a lot of soul-searching going on. One senior policy maker asked, “Why didn’t we see this coming?”

There was, of course, only one thing to say...: “What do you mean ‘we,’ white man?”

Seriously, though, the official had a point. Some people say that the current crisis is unprecedented, but ... there were plenty of precedents... Yet these precedents were ignored. And the story of how “we” failed to see this coming has a clear policy implication — namely, that financial market reform ... shouldn’t wait until the crisis is resolved. ...

Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories?

Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world?

Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer ... is that nobody likes a party pooper. While the housing bubble was still inflating, lenders[, investment banks, and money managers] were making lots of money... Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?

There’s also another reason the economic policy establishment failed to see the current crisis coming. ... [T]he crisis of 1997-98... showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World”... who “prevented a global meltdown.” In effect, everyone declared ... victory..., while forgetting to ask how we got so close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears,... investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed ... prudential regulation of the financial system.

Now we’re in the midst of another crisis, the worst since the 1930s. For the moment, all eyes are on the immediate response to that crisis. ...

And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be ... regulating the “shadow banking system” at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost.

So here’s my plea: even though the incoming administration’s agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.

The Need for a Lender of Last Resort

How important is the lender of last resort role played by central banks?:

Financial markets and a lender of last resort, by Eric Hughson and Marc Weidenmier, voxeu.org: The recent subprime mortgage crisis raises serious questions about the role of a lender of last resort and the appropriate role of monetary policy. Academics, policymakers, and the financial press have debated the extent to which central banks should intervene in the marketplace, provide liquidity, and even purchase the non-performing assets of troubled financial institutions. Although economists, Washington insiders, and the media may debate the extent to which the lender of last resort function should be intensified in wake of the current financial market meltdown, proponents and opponents of monetary policy generally agree that it is very difficult to identify the effect of the lender of last resort function on financial markets.

Fortunately, history provides some insight into the importance of a lender of last resort in dealing with a financial crisis, especially the provision of liquidity by financial institutions to help cash-strapped firms in the short run. Following the Panic of 1907, which was accompanied by one of the shortest but most severe financial crises in American history, the US Congress passed two important pieces of legislation that established a lender of last resort: (1) the Aldrich Vreeland Act of 1908 which allowed banks to temporarily increase the money supply during a financial crisis, and (2) the Federal Reserve Act of 1913 which replaced Aldrich-Vreeland and established a public central bank in the US (Moen and Tallman, 2000).

The two acts were designed to increase the elasticity of the money supply, which was largely fixed by the supply of gold and the requirement that banks could only issue notes if they were sufficiently backed by US government bonds. The money supply was especially inelastic during the fall harvest seasons when the financial markets tended to be illiquid as cash moved from the money centre banks to the interior to finance the harvesting of crops. The financial stringency made New York financial market vulnerable to banking and financial crises in the fall as financial institutions were often forced to call in stock market loans in response to large unexpected withdrawals of cash in response to a greater than expected harvest season. Indeed, several of the largest financial crises of the National Banking Period (1870-1913) occurred during the fall harvest season including 1870, 1890, 1893, and 1907 (Kemmerer, 1910; Miron, 1986; Sprague, 1910).

links for 2008-11-28

• Radical Solutions For A Crazy Crisis - Roubini - Forbes.com
• Hoocoodanode? - Calculated Risk
• Rescue Plan Strained by Lack of Staff - WSJ.com
• Too many cooks in Obama’s economics kitchen - Willem Buiter
• The more the merrier - Econbrowser
• Dying of Consumption - Roach - NYTimes.com
• Thanksgiving: The Spin Statistics Theorem - Discover Magazine
• Shiller: Crisis May Run for `Years and Years' P1 - YouTube
• Climate change puts forests and people at risk - EurekAlert
• Recession vs inflation targeting - Stumbling and Mumbling
• How Geothermal Heat Pumps Could Power the Future - Yahoo! News
• India should hold a $1 trillion in foreign exchange reserves - voxeu.org
• The importance of pressing ahead with Doha - Comment is free
• Unorthodox monetary policy: Central banks as “stabilising speculators” - voxeu.org

Giving Thanks for Economists. Or Not.

Martin Wolf says " one of the big lessons of this experience is that economics is too compartmentalized":

A time for humility, Speech by Martin Wolf, FT: Last year I enjoyed telling a number of entirely unfair jokes about economists. This year, I looked at the same source and found only one joke about the profession’s involvement in depressions. Here it is:

Such a severe depression and banking crisis could not have been achieved by normal civil servants and politicians, it required economists’ involvement.

This, in short, is a time for humility. Why did we mostly get “it” so sensationally wrong? ... It is a pretty good question. It is a pretty embarrassing one, too. It is one everybody I meet now asks. ...

Perhaps this was more than could reasonably be expected. But I do think we need to ask ourselves whether we could have done a better job of understanding the processes at work.

The difficulty was that we all tend to look at just one bit of the clichéd elephant in the room. Monetary economists looked at monetary policy. Financial economists looked at risk management. International macroeconomists looked at global imbalances. Central bankers focused on inflation. Regulators looked at Basel capital ratios and even then only inside the banking system. Politicians enjoyed the good times and did not ask too many questions. And what of commentators? Well, they tended to indulge in the fantasy that the above knew what they were talking about. I am embarrassed to admit this.

I am not seeking to deny that a few people saw important pieces of the emerging puzzle and some saw more than a few pieces. ... But I would insist that one of the big lessons of this experience is that economics is too compartmentalised and so, too, are official institutions. To get a full sense of the risks being run, we needed to combine the worst scenarios of each sets of experts. Only then would we have had some sense of how the global imbalances, inflation targeting, the impact of China, asset price bubbles, financial innovation, deregulation and risk management systems might interact.

Alternatively, we could have spent more time studying the work of Hyman Minsky. We could also have considered the possibility that, just as Keynes’s ideas were tested to destruction in the 1950s, 1960s and 1970s, Milton Friedman’s ideas might suffer a similar fate in the 1980s, 1990s and 2000s. All gods fail, if one believes too much. Keynes said, of course, that “practical men … are usually the slaves of some defunct economist”. So, of course, are economists, even if the defunct economists are sometimes still alive.

These might seem idle thoughts: these errors are now bygones. But what if we are now making new and even bigger errors in rushing back to Keynes? The thought worries me. What if now that households in the US and UK are no longer able, or willing, to borrow any more, we are set on breaking the back of taxpayers, instead? Is the end of this crisis the destruction of the credit of some of the world’s most creditworthy governments? It is a thought I would like to suppress. But it haunts me. It should haunt you, too. ...

One might not expect much from economists, but one would surely expect them to warn us of a crisis on this scale. Some humility is in order. That is going to hurt. A humble economist? Surely not.

links for 2008-11-27

• The financial meltdown is an academic crisis too - voxeu.org
• $7.8 Trillion and Counting - The Baseline Scenario
• Gold Standard Does Not Always Bring Credibility - NBER
• Are Useful Projects Really Better than Useless Ones? - knzn
• Obama Picks Volcker to Head New Economic Panel - NYTimes.com
• The (Tuna) Tragedy of the Commons - NYTimes.com
• Food Prices Expected to Keep Going Up - NYTimes.com
• The Return of Larry Summers - NYTimes.com

"The Moral Stage of Wall Street"

George Packer wants Wall Street executives to grow up and apologize for their behavior:

The Moral Stage of Wall Street, by George Packer: Swiss bankers are not known as paragons of transparency and moral accountability, so it’s a nice surprise to read that the top officials of UBS, the foundering financial institution recently bailed out by the Swiss government, will forgo twenty-seven million dollars in compensation and bonuses. It appears that these Swiss bankers have a faint pulse of shame.

It has not gone remarked upon enough that their American counterparts apparently have none. Having brought the American and global economy to its knees through their reckless, short-sighted, downright stupid investments, and then looked to the government for a very expensive lifeline, the leaders of Citigroup, A.I.G., Goldman Sachs, Morgan Stanley, Lehman, and other financial giants are maintaining a carefully nonchalant public posture. Andrew Cuomo, New York’s Attorney General, had to hold a threatening press conference on Wall Street in order to frighten A.I.G. into announcing that raises, bonuses, and lavish retreats will be suspended. But fear is not the same thing as shame. Morally speaking, it’s inferior.

The moral code of these Wall Street executives corresponds to stage one of Lawrence Kohlberg’s famous stages of morality: “The concern is with what authorities permit and punish.” Morally, they are very young children. The Swiss bankers are closer to stage four, most common among late teens, where a concern for maintaining the good functioning of society takes hold. Stage six, an elaboration of universal moral principles based on an idea of the good society, is a distant dream for the titans of global finance.

In private life, extreme indebtedness, bankruptcy, the ruin of those close to you, and dependence on the government dole are generally thought to be causes for anguish, self-denial, and a degree of shame. But if you’re a financial executive with an exalted title, a big enough salary, a deep enough debt, and a vast enough handout, these same disasters entitle you to go on living and feeling about yourself much as you did before. You even have a right to think that the taxpayers owe it to you—that it’s for their own good, not yours. You don’t have to explain yourself; you certainly don’t have to apologize.

I would like to see these malefactors of great wealth apologize to the country. I would like to see them organize their own press conference in a lineup on Wall Street and, in the manner of disgraced Japanese officials, bow low to the pavement, express contrition, and beg their countrymen’s forgiveness. Such a scene would go some way toward cleansing the smell of the financial crisis.

Of course, nothing like this is going to happen. So instead, like the parents of two-year-olds, the next Congress should summon them to Washington and publicly punish these executives who, in Kohlberg’s terms, “see morality as something external to themselves, as that which the big people say they must do.”

Update: Arnold Kling comments:

I tend to agree with Tyler Cowen that individual moral propensities are less important than overall social context. To borrow from a different branch of social psychology, I would say that Packer is committing the Fundamental Attribution Error.

In my view, the problem comes from trying to use what I call letter-of-the-law regulation in finance. Call it L regulation. With L regulation, the regulator lays down specific, quantitative boundaries (think of risk-based capital requirements, with fixed numerical weights for various types of assets). The managers of financial institutions are told to stay within those boundaries.

In contrast, think of something I might call S regulation, for spirit of the law. With S regulation, the manager of a financial institution that enjoys some government protection would take an oath to maintain the safety and soundness of the institution. With S regulation, it is wrong to just tiptoe along the edge of the quantitative boundaries, without considering the potential risk to the firm.

Suppose we take it as given that government is going to protect some of the liabilities of some institutions, because of deposit insurance, implicit guarantees, "too big to fail," or other reasons. I would like to see such institutions be covered by S regulation even more than by L regulation.

I would like to see managers of government-protected institutions take an oath to safeguard the soundness of their companies. I would like to see them subjected to prison terms for violating that oath. The oath is a general promise, not satisfied simply by staying within the boundaries of L regulation.

I believe that S regulation would change the motives of bank managers. They would be looking for ways to avoid failure, rather than for ways to stay within the letter of the law.

There can be plenty of risk-taking institutions in our society. But they should not at the same time be institutions that enjoy government protection when they fail.

"The Rebirth of Keynes, and the Debate to Come"

Robert Reich on the question of tax cuts versus government spending as a stimulus measure:

The Rebirth of Keynes, and the Debate to Come, by Robert Reich: The economy has just about come to a standstill... Consumer spending has fallen off a cliff. Investment is drying up. And exports are dropping because the recession has now spread around the world.

So are we about to return to Keynesianism? Hopefully. Government is the spender of last resort, which means the new Obama administration should probably be considering a stimulus package in the range of $600 billion, roughly 4 percent of national product -- focused on building and repairing the nation’s crumbling infrastructure, providing help to states to maintain services, and investing in new green technologies in order to wean the nation off oil.

But between now and late January, when the stimulus package will be voted on, we're likely to be treated to a great debate over the wisdom of Keynesianism. ...

Conservative supply-siders ... will call for income-tax cuts rather than government spending, claiming that people with more money in their pockets will get the economy moving again more readily than can government. They're wrong, too. Income-tax cuts go mainly to upper-income people, and they tend to save rather than spend.

Even if a rebate could be fashioned for the middle class, it wouldn't do much good because, as we saw from the last set of rebate checks, people tend to use extra cash to pay off debts rather than buy goods and services. Besides, individual purchases wouldn't generate nearly as many American jobs as government spending on infrastructure, social services, and green technologies, because so much of we as individuals buy comes from abroad.

So the government has to spend big time. The real challenge will be for government to spend it wisely -- avoiding special-interest pleadings and pork projects such as bridges to nowhere. We’ll need a true capital budget that lays out the nation’s priorities rather than the priorities of powerful Washington lobbies. How exactly to achieve this? That's the debate we should be having between now and January 20 or 21st.

Fed Intervention: Managing Moral Hazard in Financial Crises

"Moral hazard has its costs, but it also has its benefits":

Fed Intervention: Managing Moral Hazard in Financial Crises, by Harvey Rosenblum, Danielle DiMartino, Jessica J. Renier and Richard Alm, Economic Letter, FRB Dallas: Editor’s note: Federal agencies and regulators have taken decisive steps to combat the financial crisis that began in the summer of 2007 and continued into the fall of this year. This Economic Letter focuses on key Federal Reserve actions through early October.

At the end of September 2008, U.S. policymakers had been working for more than a year to contain the shock waves from plunging home prices and the subsequent financial market turmoil. For the Federal Reserve, the crisis has given new meaning to the adage that extraordinary times call for extraordinary measures. The central bank has dusted off Depression-era powers and rewritten old rules to address serious risks to the global financial system.

The spreading financial crisis has led the Fed to pump liquidity into the economy and expand its lending beyond the commercial banking sector. In March, it assisted with J.P. Morgan Chase’s buyout of Bear Stearns, a cash-strapped investment bank and brokerage. Six months later, the Fed took direct action again, with an $85 billion bridge loan to prevent the disorderly failure of American International Group (AIG), a giant global company heavily involved in insuring against debt defaults.[1]

These Fed actions—part of a broader U.S. government effort to contain the financial crisis—call to mind two earlier financial interventions: in the case of Long-Term Capital Management (LTCM) in 1998 and in the aftermath of the Sept. 11, 2001, terrorist attacks.

In both episodes, the Fed felt compelled to protect the financial system from severe shocks and the overall economy from spillovers that might produce serious downturns. Inherent in the Fed’s moves was a natural by-product of intervention—moral hazard and the controversy that flows from it.

Concern about moral hazard helps explain why the Fed has traditionally intervened only rarely and reluctantly, trying to do what’s necessary, but as little as necessary, to achieve financial stability. Markets generally should and do self-correct. When potential financial problems arise, the Fed’s default reaction has usually been to do nothing and let the markets work their way through the difficulties.

On rare occasions, however, the markets themselves are at risk of failure. In such cases, the Fed can’t fulfill its obligation to promote financial stability without direct action. Two factors have strengthened the case for central bank intervention in the past decade—the financial system’s increased globalization and the untested nature of the new and complex financial instruments that have come under stress.

The escalation of what’s now recognized as a global financial crisis has changed the modus operandi of Fed interventions. The guiding principle of do what is necessary, but as little as necessary, has been replaced by the recognition—reinforced by actions—of the importance of doing whatever it takes to break the downward spiral in the financial and credit markets that has contaminated the overall economy. With a broad understanding of the consequences of inaction, the Fed has taken a hard turn toward intervention in an atmosphere in which fear of moral hazard has been displaced by the reality of systemic risk’s unacceptable consequences.

Why Did Forecasters Missed the Crisis?

Dean Baker will wonder why he was left off this list:

The vision thing, by Chris Giles, Commentary, Financial Times: It has been a bad year for economic forecasters. So bad that royalty wants to know what went wrong. “Why did no one see it coming?” Britain’s Queen Elizabeth asked during a visit to the London School of Economics this month. ...

Though there is great entertainment in looking back at the silly things economists have said, more is to be gained by examining the particular failings that contributed to forecasters’ general inability to warn of the current mess.

First is the unforeseen, but now evident, fragility of the global economy in the face of a systemic banking collapse. ... Second, as Stephen King, chief economist of HSBC, says: “Almost all economic models assume that the financial system ‘works’.” ...

Third was the deep squeeze on household and corporate incomes from the commodity boom of the first half of 2008, which almost no one predicted. This weakened the non-financial sector before banks had any chance to repair the damage from the subprime crisis...

Fourth, most economic models suggest the demand for money will be stable, but banks and households have now begun to hoard cash. This threatens to make monetary policy ineffective..., something that is not generally factored into forecasting models.

Fifth is an over-reliance on the output gap – the difference between the level of output and an estimate of what is sustainable – in forecasting. That allowed policymakers to believe everything was fine ... because inflation was under control and growth was not excessive.

Sixth is the natural tendency to seek rationales for events as they unfold, rather than question whether they are sustainable. ...

Mention must ... be given to the notable voices of doom, who got important bits of the puzzle correct even if the timing or other details eluded them. Prof Roubini ... wrote a paper with Brad Setser in August 2004 predicting that the world’s trade imbalances were unsustainable and likely to “crack the system in the next three to four years”. He has been prescient in understanding the links between financial markets and the real economy.

William White, the former chief economist of the Bank for International Settlements, the central bankers’ bank in Basel, Switzerland, was a persistent critic of lax monetary policy and the failure to stem credit expansion. Prof Rogoff also spotted the dangers of unsustainable global economic expansion in a 2004 paper with Maurice Obstfeld. In more recent work with Carmen Reinhart he has highlighted how policymakers fell into the “this time it’s different” trap that dates back to England’s 14th-century default.

Prof Persaud has made an honest living for many years warning about the fallibility of value-at-risk models and the tendency for them to encourage herd behaviour. And in the FT’s new year survey of economists for 2008, Wynne Godley of Cambridge university, also a permanent bear, said: “I think the seizing up of financial markets may well result in a collapse in lending in the US to the non-financial sector so large that it causes a recession deeper and more stubborn than any other for decades – and deeper than anyone else is expecting.” Quite.

Policymakers, too, have been far from consistently wrong. Mr Trichet dines out on stories of how he predicted the crisis and cites a Financial Times article as evidence... Mr King warned for years about the risks evident in the global economy and the IMF repeatedly warned about the unsustainable level of house prices.

Willem Buiter ... warns not to be too impressed by some forecasts that have turned out to be true, because they were lucky, not wise. “Hindsight is useless,” Prof Buiter insists. ...

Predictive Models: Blown Off Course by Butterflies

In the 1980s, it seemed that computers held the key to economic forecasting, writes John Kay. With large models and sufficient processing power, predictions would become more and more accurate.

This dream did not last long. We now understand that economies are complex, dynamic, non-linear systems...

So economic crystal ball-gazing remains unscientific. The trend is the forecaster’s friend. Extrapolation assumes that the future will be like the past, only more so. We project current preoccupations ... with exaggerated speed and to an exaggerated degree. ...

If extrapolation is the forecaster’s friend, mean reversion is the forecaster’s crutch. Much of the time, you can predict that next year’s figure will be somewhere between this year’s level and the long-run average. But mean reversion never anticipates anything out of the ordinary. Every few years, out-of-the-ordinary things happen. They just have.

Still, you might think there would be large rewards for those who succeed in anticipating these events. You would be wrong. People who worried before 2000 that the “new economy” was a bubble, or warned of the terrorist threat before September 11 2001, or saw that credit expansion was out of control in 2006, were not popular. They were killjoys.

Nor were they popular after these events. If these people had been right, then others had been blind or negligent, and the latter preferred to represent themselves as victims of unforeseeable events. As John Maynard Keynes observed, it is usually better to be conventionally wrong than unconventionally right.

"Woodward and Hall Analyze the Financial Crisis and the Recession"

I've been arguing that government spending is preferable to tax cuts as a means of stimulating the economy. Via an email from Bob Hall, an argument against that position from a paper described below:

General Stimulus

Current forecasts have real GDP reach its lowest value in the second quarter of 2009,... the total shortfall [is] $855 billion. This figure provides a way to think about the magnitude of a stimulus. Trying to push spending and output up to its trend level in a short time, would probably be unwise, for fear of overshooting. Eventually, the corrective forces of the economy would bring spending and output back to its long-run growth path. Policy fits in somewhere between, hastening the return to normal.

The case for stimulus is particularly strong with deflation hanging over the economy. But the Fed has a small amount of room left to stimulate through reductions in the fed funds rate—its target is currently one percent.

Fiscal stimulus will provide most of the needed boost. Fiscal actions take two forms, tax cuts and spending increases. Tax cuts raise consumer spending and business investment and thereby raise output and employment. When we speak of tax cuts, we include rebates paid to families who pay no income tax and we also include increase in social benefits, such as unemployment compensation. Spending increases go directly into higher output. Rebuilding a bridge produces output included in GDP and raises employment. The spending we are talking about here involves the government buying goods and services, not paying subsidies or benefits to families or businesses. Those go in the tax cut bucket. 25

Commentators apart from economists often compare the two types of policies in terms of bang for the buck. Bang is the amount added to GDP and thus to employment and buck is the amount of government money involved, or, equivalently, the addition to the government deficit. By this measure, spending stimulus comes out ahead of tax-cut stimulus. The spending automatically enters GDP and may have some second-round effects as well. Some part of a tax cut goes into saving, so the immediate increase in GDP is probably smaller. (John Taylor’s evidence) Earlier this year, the federal government used a tax-cut stimulus that helped delay the recession. Now advocates of spending stimulus are using the bang-for-the-buck criterion to argue that it is time to crank up spending.

Bang for the buck is not the right way to score stimulus measures. The nation is not limited to any particular level of government outlay or deficit level. The U.S. federal government has the best credit rating in the world because its current debt is small in relation to its ability to tax in the future. If consumers save half of a tax cut, the cut can be made twice as large as the desired increase in immediate spending.

Instead, the choice between tax cuts and spending increases should depend on the tradeoff between the value of the increased spending, which favors tax cuts, and precision of timing, which favors spending increases. Consumers respond to improved resources, from a tax cut or any other source, by adding the most valuable spending that they were unable to afford prior to the improvement. They are bound to spend a tax cut on something they want. By contrast, the government is not notably successful in picking good spending projects. Way too much money goes to inefficient operations like Amtrak and to build multilane interstates in Montana. Unlike the consumer, the government does not reliably spend extra resources on valuable purchases.

On the other hand, the government can, in principle, concentrate a spending stimulus in the time when it is most desirable, namely in the next few months. The government cannot concentrate the spending that consumers choose to make from a tax cut—part of that spending may occur way too late. Unfortunately, it is hard for the government to crank up spending quickly. Even if the government hires contractors quickly to fix creaky bridges, the stimulus only takes effect when the contractor hires the workers and puts them to work, a process that takes up to a year.

The government could concentrate the spending from a tax cut into a brief period with a novel kind of fiscal stimulus, a general consumption subsidy. Here consumers would receive, say, four percent back from the government, for consumption purchases in the first three months of 2009. The credit would be refundable to low-income families and phased out, as the current income tax does for deductions, for high-income families. The stimulus from this policy would be concentrated at the time when stimulus is most needed, sooner than any practical government spending increase. One way to generate the subsidy is to eliminate state sales taxes for a period. (Kotlikoff-Leamer proposal)

A second way to concentrate the stimulus is to cut the payroll tax for a period of a year or two. Half of the immediate benefit would go to employers and would encourage hiring and retaining workers while the other half would increase the take-home pay of workers. The employer effect would be in place only during the tax cut, so it is highly concentrated. The worker half would be more like a standard tax cut, subject to the problem of consumption deferral. Cutting only the employer part of the tax would be most effective at targeting the stimulus when most needed.

The text quoted above is from a website maintained by Susan Woodward and Bob Hall. The goal is to provide analysis of the financial crisis and to recommend policy responses, i.e. to "update this description of what has happened in the U.S. economy since the crisis began in 2007 and to give a commentary on the events and on actual and recommended policies to deal with financial stress and recession":

Woodward and Hall analyze the financial crisis and the recession: Susan Woodward is a financial economist with a specialty in the mortgage market. She served as the Chief Economist of the Department of Housing and Urban Development. Recently, she prepared a study of mortgage closing costs for HUD. Robert Hall is a macroeconomist at Stanford: his website. We are maintaining a 30-page document on the crisis and recession, with a good deal of data and many source references. Some of the ideas we promote in the document are:

• Low interest rates in the early part of the decade were responsible monetary policy to head off deflation, not an irresponsible contribution to a housing price bubble
• The most important fact about the economy today is the collapse of spending on home building and the resulting recession
• The aggressive response of financial policy seems to have contained the effects of the financial crisis on some key elements of spending, especially plant and equipment investment, through the third quarter this year
• The government is wasting money by not stating a formal guarantee of Fannie Mae's and Freddie Mac's debt
• Proposed and active programs for helping beleaguered homeowners reach only a small fraction of those in trouble and focus on the wrong goals
• The top policy priority is a large stimulus to the overall economy rather than actions aimed just at housing

Click here for the pdf containing the analysis with graphs, sources, and bibliography. Click here for the Excel file containing the relevant data.

Back to the fiscal policy versus tax cuts question, according to the argument above, one reason government spending dominates tax cuts is that the private sector will allocate the money more efficiently than government. Government "is not notably successful in picking good spending projects," while the private sector recipients of tax cuts devote the money to "the most valuable spending."

Like purchasing stocks and houses in a bubble, things like that? The private sector isn't perfect either, some businesses will fail miserably, the resources are wasted, not every private sector employee is the model of efficiency, and some consumers will come home with magic beans (you can find roads to nowhere in the private sector too - they go to housing developments where the streets are in place, but there's little or nothing built there). So we mean relative efficiency. I'm not saying the government is just as efficient as the private sector, only that the relative levels of wasted resources may not be quite as stark as we sometimes think.

But here's the main question. Suppose we ask, "should we tax consumers and build a bridge, or should we let consumers keep the money?" If every time we ask that question the answer is "consumers should keep the money because they are more efficient," how does infrastructure ever get built? There must be times when there are public goods - goods the private sector will not build on its own - that have a net positive value to society. If that's the case, then there is a role for government to step in and provide those goods. So why not build what we need now? Tax cuts cannot be aggregated into large sums - the large amounts of money needed to build major infrastructure projects - but government can act as an intermediary by pooling the money into sums large enough to get the job done. This is a time when such pools of money will be available, so we should take advantage of the opportunity.

To be fair, the question in the previous paragraph is not quite the question Woodward and Hall are asking since it is also desirable to time the policy so as to optimally offset swings in GDP and employment. But I think that objection can be overcome with a combination policy that uses tax cuts to provide an immediate boost with infrastructure spending that maintains the boost over a longer time period.

A combination policy can also help with another problem. It is no easy task to find $700 billion dollars worth of infrastructure projects that clearly fit into the category of having net positive value to society. Spending the money just to spend it is wasteful, and it is detrimental to policymakers in the future who will have to live with precedent set by actions taken now. So we should invest the money where we get the most value, and also where it has the best chance of lifting us out of the recession.

Because of that, I would break up the stimulus into pieces, with part of it going to provide an immediate boost through targeted tax cuts of some sort, another part would be devoted to providing an ongoing stimulus through infrastructure spending - those projects with clear positive societal value - and the remainder would go to backfill shortages at the state and local level, enhance food stamp programs, extend unemployment insurance, fill lapses in health care coverage due to layoffs, and other such needs.

Knightian Uncertainty and the TARP

Ricardo Caballero and Arvind Krishnamurthy argue that the presence of Knightian uncertainty in financial markets means that recapitalization of financial institutions must be massive in order to work, larger than is likely to be practical. However, another solution - government insurance - can reduce the size of the required capital injection:

Knightian uncertainty and its implications for the TARP, by Ricardo Caballero and Arvind Krishnamurthy, FT Economist's Forum: ...To paraphrase a recent Secretary of Defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction ... has significant implications for economic behaviour and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. ...

The main implication of rampant uncertainty for the TARP and its relatives, is that capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, probably much-much more than the current TARP. The reason is that Knightian uncertainty generates a sort of double- (or more) counting problem, where scarce capital is wasted insuring against impossible events.

A simple example makes the point: Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays $1 to agent A, and the opposite happens in state Y. Thus, only $1 is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only $1 is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than $1. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.

Of course, real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.

But there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.

The Knightian uncertainty perspective also sheds light on some of the virtues of the now defunct asset-purchases programme of the original TARP. ... In such cases, removing the uncertainty-creating assets from the balance sheet of the financial institution reduces risk by multiples, and frees capital, more effectively than directly injecting equity capital.

Does this mean that there is no role for capital injections? Certainly not. Knightian uncertainty is not the only problem in financial markets, and capital injections are needed for conventional reasons. Our point is simply that these injections need to be supplemented by insurance contracts, unless the government is willing to increase the TARP by an order of magnitude...

links for 2008-11-26

• Synchronized Recession, Synchronized Stimulus? - Econbrowser
• The Fed is confusing me - Paul Krugman
• Bank Recapitalization Options and Recommendation - The Baseline Scenario
• Government by Contractor Is a Disgrace - WSJ.com
• Menu design tricks to get you to spend more - Nudges
• All Fall Down - Friedman - NYTimes.com
• Resurrection Science - Olivia Judson
• Procrastinating Again? How to Kick the Habit - Scientific American
• How should we think about the monetary transmission mechanism? - macroblog
• Don’t Just Spend, Do It Wisely - Economix
• Closed ports worse than free trade - Project Syndicate
• In Addition to a Team of Rivals: A Team of External Experts - Economix
• Balance sheets and income statements: breaking the downward spiral - FT
• Do Deficits Still Matter? - The Arena
• Disagreeing With Martin Feldstein - Capital Gains and Games
• Will Deficit Spending in fact be Money-Financed? - Nick Rowe
• Proof we are not in Kansas any more - Bronte Capital

Keynes' Open Letter to Roosevelt

This is "An open letter to President Roosevelt" that appeared in the New York Times on December 31, 1933:

Mr President: spend, spend, spend, Comment is Free: The following is an abridged text of an open letter [pdf] by John Maynard Keynes to the US president.

Dear Mr President,

You have made yourself the trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office. This is a sufficient reason why I should venture to lay my reflections before you, though under the disadvantages of distance and partial knowledge. ...

You are engaged on a double task, recovery and reform - recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range recovery, that you will have the driving force to accomplish long-range reform. On the other hand, even wise and necessary reform may, in some respects, impede and complicate recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. ...

My second reflection relates to the technique of recovery itself. The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, an increase of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out of their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees...; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse.

Cowen: The Free Market and Morality

Tyler Cowen:

Taylor: Why Permanent Tax Cuts Are the Best Stimulus

John Taylor is not ready to give up on tax cuts, nor is he ready to adopt traditional Keynesian ideas:

Why Permanent Tax Cuts Are the Best Stimulus, by John B. Taylor, Commentary, NY Times WSJ: The incoming Obama administration and congressional Democrats are now considering a second fiscal stimulus package, estimated at more than $500 billion, to follow the Economic Stimulus Act of 2008. As they do, much can be learned by examining the first.

The major part of the first stimulus package was the $115 billion, temporary rebate payment... The argument in favor of these temporary rebate payments was that they would increase consumption, stimulate aggregate demand... What were the results? ...[C]onsumption shows no noticeable increase at the time of the rebate [see chart]. Hence, by this simple measure, the rebate did little or nothing to stimulate consumption, overall aggregate demand, or the economy.

These results ... correspond very closely to what basic economic theory tells us. According to the permanent-income theory of Milton Friedman, or the life-cycle theory of Franco Modigliani, temporary increases in income will not lead to significant increases in consumption. However, if increases are longer-term, as in the case of permanent tax cut, then consumption is increased...

After years of study and debate,... the permanent-income model led many economists to conclude that discretionary fiscal policy actions, such as temporary rebates, are not a good policy tool. Rather, fiscal policy should focus on the "automatic stabilizers" (the tendency for tax revenues to decline ... and transfer payments such as unemployment compensation to increase in a recession), which are built into the tax-and-transfer system, and on more permanent fiscal changes that will positively affect the long-term growth of the economy. ...

What ... can Congress and the incoming Obama administration do to give the economy a real boost on Jan. 20? Here are a few fairly bipartisan measures worth considering:

First, make a commitment, passed into law, to keep all income-tax rates were they are now, effectively making current tax rates permanent. This would be a significant stimulus to the economy...

Second, enact a worker's tax credit equal to 6.2% of wages up to $8,000 as Mr. Obama proposed during the campaign -- but make it permanent rather than a one-time check.

Third, recognize explicitly that the "automatic stabilizers" are likely to be as large as 2.5% of GDP this fiscal year, that they will help stabilize the economy, and that they should be viewed as part of the overall fiscal package even if they do not require legislation.

Fourth, construct a government spending plan that meets long-term objectives, puts the economy on a path to budget balance, and is expedited to the degree possible without causing waste and inefficiency.

Some who promoted the first stimulus package have reacted to its failure by saying that we must now switch to large increases in government spending to stimulate demand. But government spending does not address the causes of the weak economy, which has been pulled down by a housing slump, a financial crisis and a bout of high energy prices, and where expectations of future income and employment growth are low.

The theory that a short-run government spending stimulus will jump-start the economy is based on old-fashioned, largely static Keynesian theories. These approaches do not adequately account for the complex dynamics of a modern international economy, or for expectations of the future that are now built into decisions in virtually every market.

I'll note in passing that the New Keynesian model incorporates expectations of the future, and accounts for complex dynamics as well as any model, so the criticism in the last paragraph is really about policy justified by traditional Keynesian theory, not the more modern version. But more to the point, I don't think anything he said rules out positive net present value investments in infrastructure. We should make these investments in any case if we want the economy to grow robustly, now just happens to be a good time to have the construction and maintenance work done since people need jobs, inputs to production are relatively cheap, and the political atmosphere is accommodating.

Update: Paul Krugman:

Conservative crisis desperation: So we’re having a crisis, reflecting the policy failures of the past 8 years. But the usual suspects insist that the crisis is all the more reason to persist with those policies — indeed, make them permanent.

Thus, John Taylor — a very good economist, when he wants to be — insists that we must respond to the economy’s temporary weakness with a permanent tax cut. Let us reason together. Does it make sense to let one recession dictate tax policy in perpetuity? What happens if there’s a boom; can we increase taxes (no, because then the cut wouldn’t have been permanent.) What if there’s another recession? Do we permanently cut taxes again? Is there a tax-cut ratchet (or maybe racket)? Think this through, and it makes no sense at all.

And Taylor’s argument against the obvious answer — government spending as stimulus — is pure gobbledygook:

The theory that a short-run government spending stimulus will jump-start the economy is based on old-fashioned, largely static Keynesian theories. These approaches do not adequately account for the complex dynamics of a modern international economy, or for expectations of the future that are now built into decisions in virtually every market.

Translation: la la la I can’t hear you.

Meanwhile, at a panel discussion with Rich Lowry of National Review, I heard the latest argument against the Employee Free Choice Act: now would be a really bad time to make union organizing easier, because it would hurt business confidence in a recession.

Recession, recovery, whatever: it’s always proof that the Bush years should continue forever.

New Consumer Lending Facility

Calculated Risk notes the latest keep the credit flowing facility:

New Lending Facility from Treasury, Fed for Consumer Lending: From Bloomberg: Treasury, Fed Said to Unveil Plan to Bolster Consumer Financing

The U.S. Treasury and Federal Reserve will unveil as soon as today a lending program to shore up the consumer-finance market, using money from the [TARP] ...

Treasury Secretary Henry Paulson ... scheduled a press conference for 10 a.m. New York time [Tuesday]

From the WSJ: New Facility Targets Consumer Lending

The lending facility, which will be operated by the Federal Reserve, is expected to provide loans to investors who want to buy securities backed by credit cards, auto loans and student loans ... Treasury will contribute between $25 billion to $100 billion to the facility from its $700 billion Troubled Asset Relief Program.

Your daily bailout facility ...

[Toles explains.]

links for 2008-11-25

• Bonfire of sovereign wealth funds? - Brad Setser
• Sync, and Swim Together - NYTimes.com
• Kevin Drum asks the Romers some questions - Angry Bear
• The 3 laws of risk - Rogue Economist Rants
• Toles Skewering Economists - Washington Post
• Interview with Christina and David Romer - Economist's View
• Carbon, trade policy, and carbon free trade areas - voxeu.org
• Tyler Cowen on Investment During the 1930’s - pgl
• The world’s central banks must buy assets - FT
• The Short-Selling Question - The Balance Sheet
• Archeology of homelessness - EurekAlert
• Why are we mean to car companies (and nice to the banks)? - Justin Fox
• The Real Great Depression - The Monkey Cage
• Anatomy of a Meltdown - The New Yorker
• Barack Obama's Treasury Secretary Geither is a safe pick - Dean Baker
• 76 percent of middle-class households not financially secure - EurekAlert

Is Fiscal Policy the Answer?

Does Christina Romer believe fiscal policy won't work to cure a recession? (No, she doesn't):

Dueling outlooks, Free Exchange: ...At the heart of depression economics, [Paul] Krugman has said, "is the collapse of policy certainties". Or as he put in in a paper on the Japanese liquidity crunch:

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem.

Virtue is vice; vice, virtue. But this view is not shared by everyone. In a weekend New York Times column on the New Deal, Tyler Cowen writes:

The good New Deal policies, like constructing a basic social safety net, made sense on their own terms and would have been desirable in the boom years of the 1920s as well. The bad policies made things worse. Today, that means we should restrict extraordinary measures to the financial sector as much as possible and resist the temptation to “do something” for its own sake. 

So what's the right approach? Interestingly, Mr Cowen's column cites the work of Christina Romer, the Berkeley economist recently tapped to run Barack Obama's Council of Economic Advisers. He says:

"Financial Engineering is Much Too Important to Leave to Financial Engineers, ... But..."

How Much Does it Cost to Create a Job?

Some people are claiming that Obama's job package will cost $280,000 per job. The actual cost is not trivial, but I don't think that figure is correct (it simply divides a proposed stimulus amount, $700 billion, by the stated job goal of 2.5 million). I've also seen the claim that the $700 billion number is simply pulled out of a hat, but that's not right either, it's based upon transparent calculations.

So let's do the calculations.

Hamilton: The Fed Needs a New Plan

Jim Hamilton says it's time for change:

Time for a change at the Fed, by Jim Hamilton: Plan A didn't work. Plan B didn't work. I suggest the Fed get going on Plan C.

The Bureau of Labor Statistics announced last week that the seasonally adjusted consumer price index fell by 1% during the month of October, implying an annual deflation rate around -12%. That's the biggest monthly drop in the CPI since publication of seasonally adjusted changes began in February 1947. The core CPI (excluding food and energy) saw its first decline in a quarter century.

Does this mean that deflation is now upon us? Mike Bryan argues that despite the indication from the headline and core CPI, actual decreases in prices were not that widespread in October. ...

So maybe everything's OK? I think not. Two forward-looking indicators are profoundly troubling. First, the yields on inflation-indexed Treasuries for medium-term maturities are actually higher than those for regular Treasuries. If taken at face value, that means investors anticipate an average deflation over the next 5 years at a -1.29% annual rate. Perhaps one might dismiss this as another indication that the usual arbitrage activity is completely absent in current markets, so that the nominal-TIPS spread is no longer a meaningful indicator. ...

But a second and equally troubling suggestion of expected deflation is the extremely low yields on short-term Treasury bills. Again there may be those who interpret this not as a harbinger of deflation but instead as a reflection of the astonishing (and equally frightening) flight to quality that we have been witnessing.

"How to Design a Bank Bailout that Works"

Johm Hempton disagrees with me and others that the problem in financial markets is fundamentally one of solvency, i.e. lack of adequate bank capital. He says it is a matter of trust, trust that was destroyed by lies and deceptive practices among other things. If he is right, bank recapitalization alone will not bring back the trust that is needed - well capitalized banks can still lie - and because of that he believes some sort of "full guarantee of all sorts of bank debt" is needed to get bank credit flowing again from financial wholesalers to financial intermediaries. His preferred solution to provide the necessary trust is bank nationalization - the government won't default on its obligations to provide payment - and this allows taxpayers to fully participate in the upside in return for assuming the risk inherent in guaranteeing debt payments:

The Brad DeLong question - and how to design a bailout that works, Bronte Capital: Brad DeLong asks a question which seems obvious enough to me – but seems to elude him.

Le Citi Toujours Dormer...: Why oh why can't we have a better press corps? Eric Dash and Julie Creswell write that:

• Citigroup had poor risk controls.
• As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.
• They weren't.
• And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.

To which the only appropriate response is: "Huh?" How can losses out of $43 billion of optimistically overvalued asserts eliminate $224 billion of value? Eric Dash and Julie Creswell don't answer that question. They don't even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said "wait a minute! this doesn't add up!" is yet another signal that the New York Times is in its death spiral: not the place to go to learn anything about an issue.

I think he is a little rough to criticise the NYT for that – or for that matter any other paper – because at the moment the Treasury and the FDIC are also acting (at least until now) as if they do not know the answer.

The answer is that the crisis is not about the amount of losses yet realised or yet to be realised, and it is not about capital adequacy of the banks and it is not about their level of leverage. It is simply about the question “do we trust them to repay their debts”. You might think is about capital or losses or leverage – but even if the bank has adequate capital and losses come are relatively small if we believe collectively that they can’t repay then they can’t repay. Sure more capital would produce more trust – but the level of distrust at the moment is so high that nobody can tell you how much capital is needed. All estimates are a shot in the dark. In reality all that is needed is more trust.

The short answer to the Brad deLong question is that due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout. It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts. I can not understand them and I am a pretty sophisticated bank analyst. I know people I think are better than me – and they can’t understand Citigroup either. So Citigroup was always a “trust us” thing and now we do not trust.

The long answer has to be a replay of the various themes of this blog. So lets do it in pieces.

The Citigroup Bailout

It's bailout time. Let's start with Paul Kedrosky:

Good Bank, Bad Bank, and F---ed Bank: Apparently Citibank and the U.S. government (i.e., we taxpayers) have reached a deal whereby we will backstop something like $300-billion in screwed assets on Citi's balance sheet. ... Here is the gist:

• Citi will carve out $300-billion in troubled assets, which will remain on its balance sheet
  • The first $37-$40-billion in losses on those assets will go to Citi
  • The next $5-billion in losses will hit Treasury
  • The next $10-billion in losses will go to the FDIC
  • Any more losses will go to the Fed
• There will be no management changes at Citi, because, you know, they are all fine and upstanding people who have done nothing wrong
• There will be some compensation limitations, but those have not yet been made clear

To be clear, this is not a "bad bank" model. Assets are not, apparently, being taken off the Citi balance sheet and put into another entity walled off from the Citi biological host. Instead, they are being left on the Citi balance sheet, but tagged and bagged for eventual disposal via taxpayers. ...

I'll have more when there is more, and I know the equity futures markets like it -- it's admittedly less terrifying that letting Citi fail -- but so far I'm not impressed. ...

Yves Smith:

WSJ: US Agrees to Bail Out Citi (Updated):  ...Note key element of the deal is that the Federal government will guarantee $300 billion of Citi assets, a much bigger number than had been leaked earlier, with a rather convoluted loss-sharing arrangement, but the bottom line is that Citi is at risk for at most $40 billion. Citi also gets a $20 billion equity injection, on slightly more onerous terms than the initial TARP investments, but still more favorable than Warren Buffett's investment in Goldman. Oh, and it appears there will be NO management changes.

I do not see how GM can be denied a rescue now (not that that outcome is really in doubt, merely how much pain will be inflicted on management and the UAW). ...

Update 12:50 AM: Bloomberg's story puts the bad asset program slightly higher, at $306 billion. ...

Calculated Risk has the Joint Statement by Treasury, Federal Reserve, and the FDIC on Citigroup, while James Kwak says the bailout is "Weak, Arbitrary, Incomprehensible." I think he has it right:

Citigroup Bailout: Weak, Arbitrary, Incomprehensible: According to the Wall Street Journal, the deal is done. Here are the terms. In short: (a) Citi gets another $27 billion on the same terms as the first $25 billion, except that the interest rate is now 8% instead of 5%, and there is a cap on dividends of $0.01 per share per quarter; and (b) the government (Treasury, FDIC, Fed) agrees to absorb 90% of losses above $29 billion on a $306 billion slice of Citi’s assets, made up of residential and commercial mortgage-backed securities. (If triggered, some of that guarantee will be provided as a loan from the Fed.) There is also a warrant to buy up to $2.7 billion worth of common stock (I presume) at a staggeringly silly price of $10.61 per share (Citi closed at $3.77 on Friday).

The government (should have) had two goals for this bailout. First, since everyone assumes Citi is too big to fail, the bailout had to be big enough that it would settle the matter once and for all. Second, it had to define a standard set of terms that other banks could rely on and, more importantly, the market could rely on being there for other banks. This plan fails on both counts.

The arithmetic on this deal doesn’t seem to work for me (feel free to help me out). Citi has over $2 trillion in assets and several hundred billions of dollars in off-balance sheet liabilities. $27 billion is a drop in the bucket. Friedman Billings Ramsey last week estimated that Citi needed $160 billion in new capital. (I’m not sure I agree with the exact number, but that’s the ballpark.) Yes, there is a guarantee on $306 billion in assets (which will not get triggered until that $27 billion is wiped out), but that leaves another $2 trillion in other assets, many of which are not looking particularly healthy. If I’m an investor, I’m thinking that Citi is going to have to come back again for more money.

In addition, the plan is arbitrary and cannot possibly set an expectation for future deals. In particular, by saying that the government will back some of Citi’s assets but not others, it doesn’t even establish a principle that can be followed in future bailouts. In effect, the message to the market was and has been: “We will protect some (unnamed) large banks from failing, but we won’t tell you how and we’ll decide at the last minute.)” As long as that’s the message, investors will continue to worry about all U.S. banks.

The third goal should have been getting a good deal for the U.S. taxpayer, but instead Citi got the same generous terms as the original recapitalization. 8% is still less than the 10% Buffett got from Goldman; a cap on dividends is a nice touch but shouldn’t affect the value of equity any. By refusing to ask for convertible shares, the government achieved its goal of not diluting shareholders and limiting its influence over the bank. And an exercise price of $10.61 for the warrants? It is justified as the average closing price for the preceding 20 days, but basically that amounts to substituting what people really would like to believe the stock is worth for what it really is worth ($3.77).

How does this kind of thing happen? A weekend is really just not that much time to work out a deal. Maybe next time Treasury and the Fed should have a plan before going into the weekend?

What, and ruin a perfect record? Robert Reich:

Citigroup Scores: If you had any doubt at all about the primacy of Wall Street over Main Street; the utter lack of transparency behind the biggest government giveaway in history to financial executives, and their shareholders, directors, and creditors; and the intimate connections the lie between Administrations -- both Republican and Democratic -- and the heavyweights on Wall Street, your doubts should be laid to rest. Today it was decided the government will guarantee more than $300 billion of troubled mortgages and other assets of Citigroup under a federal plan to stabilize the lender after its stock fell 60 percent last week. The company will also will get a $20 billion cash infusion from the Treasury Department, adding to the $25 billion the bank received last month under the Troubled Asset Relief Program.

This is not a particularly good deal for American taxpayers, but it is a marvelous deal for Citi. In return for all the cash and guarantees they are giving away, taxpayers will get only $27 billion of preferred shares paying an 8 percent dividend. No other strings are attached. The senior executives of Citi, including those who have served at the highest levels in the US government, have done their jobs exceedingly well. The American public, including the media, have not the slightest clue what just happened.

Meanwhile, more than a million workers in the automobile industry, along with six million mortgagees, and a millions of Americans who depend on small businesses and retailers for paychecks, are getting nothing at all.

As I noted the other day, the difference in urgency between saving wall street and saving main street is apparent.

John Jansen says somebody will pay for this:

Reaction to the Bailout: Tokyo is closed so there is no US Treasury trading this evening. We will have to wait for Europe to arrive to get a reaction.

Stocks are higher. That also seems ludicrous. I do not care what they call this but Citibank is effectively acknowledging that they did not have the resources to survive alone without government assistance. I did not use the words bankrupt or insolvent.

I think that when participants think about this soberly they will be very disturbed and  I am saddened to say that the markets will line up one of the remaining survivors for a pre holiday turkey shoot. It has been the history of this rolling crisis since August 2007 that the worst outcome ensues. The market will seek another prey and relentlessly pursue it.

Update: Paul Krugman:

A bailout was necessary — but this bailout is an outrage: a lousy deal for the taxpayers, no accountability for management, and just to make things perfect, quite possibly inadequate, so that Citi will be back for more.

Amazing how much damage the lame ducks can do in the time remaining.

Update: More from Arnold Kling

For all of the Depression Mania, there is a lot of the U.S. economy that does not have to shrink. Manufacturing is pretty lean to begin with. Housing construction is already much lower than it has been in years. Unlike the 1930's, we have some very big sectors (health care, education, other government employment) that are unlikely to develop massive layoffs.

The one sector that definitely needs to contract is the financial sector. Maintaining Citi as a zombie bank is not really constructive. I would feel better if it were carved up, with the viable pieces sold to other firms and the remainder wound down by government. In my view, getting the financial sector down to the right size ought to be done sooner, rather than later.

From my perspective, the whole TARP/bailout concept is misconceived. The priority should not be saving firms. The priority should be pruning the industry. Get rid of the weak firms, and make good on deposit insurance. Then let the remaining firms provide the lending that the economy needs.

Update: Felix Salmon says the bailout is underwhelming.

Update: John Hempton:

The consensus is that the Citigroup bailout was bad...I am going to differ here.  The bailout was well designed...

except

1).  The Government should have taken a much larger fee - at least 20 percent ownership of Citigroup - and arguably more.  Shareholders should be punished.

2).  The attachment point of the excess of loss policy is too high.   If the attachment point had been 80 billion Citigroup would survive.  There was no need for a 40 billion dollar attachment point. 

The problem with the bailout was not the design - it was the amount extracted from Citigroup shareholders.  The government took too much risk for too little reward.

I am surprised that the shareholders were not effectively wiped out as per Fannie, Freddie, AIG.

Not displeased - but somewhere I wish the government would get a happy medium somewhere - rather than one rule Citigroup and one rule for Fannie.

Update: Andrew Samwick:

The technical term for this is a joke.

Citigroup has plenty of assets.  It has just written too many claims on those assets.  Those holding those claims need to face the reality that their claims are worth less than they were promised and adjust to that reality.  That means either liquidating the firm, selling off the assets to the highest bidders, or becoming the new equity holders of the firm.  The FDIC can get involved as needed to manage its contingent liabilities to insured depositors.

If the government is to get involved beyond that, it should be senior debt to the restructured entity, not preferred equity (i.e. junior to the most junior debt) to the existing entity.

Update: Barry Ritholtz:

Un-fricking-believable.

The US is guaranteeing $306 billion on bad investments (So much for Capitalism without failure). For Citi, its a great deal — but its a terrible one for taxpayers.

The dividend payment has been restricted to one cent per quarter for 3 years. Can someone explain why even a penny is allowed?

Where is the “Protection” for the taxpayers? Where are the clawbacks? How about going after the idiots that bought a third of a trillion dollars worth of junk, and then got paid large on it? Where is the sense of outrage and justice?

At what point do taxpayers demand that the people responsible for creating this mess must pay their pound of flesh?

Update: Brad DeLong:

It is unclear to me why they aren't just buying common stock. As it is, they're endangering their own reputations to an extraordinary degree...

"Towards A Health-Care Fed"

Are you ready for a Federal Health Board?:

Towards a Health-Care Fed, by David Warsh, Economic Principals: ...The current economic emergency will pass. ... Stability in property markets will be restored. New frameworks for the domestic and international financial systems will be established. ...

But even as it addresses these urgent but essentially cyclical matters, the Obama administration has begun moving on two pressing structural reforms: it intends to reorganize markets for health insurance to provide universal coverage, and to take some tentative but long-lasting measures to cope with climate change.

President-elect Obama’s strategy on the first problem became clear last week when he chose Tom Daschle to lead the push for universal healthcare as Secretary of Health and Human Services.

Daschle,.. last spring, in Critical: What We Can Do About the Health-Care Crisis,... (aided by writers Jeanne Lambrew and Scott Greenberger) described a broad plan by which to proceed. Forget about trying to spell out the details of universal health care coverage in a single great omnibus Act of Congress. That was the approach that failed in 1993, brought down by intense pressure from interest groups.

Instead, he proposed, create a Federal Health Board (FHB), loosely modeled on the Federal Reserve System, with a mandate to provide a public framework for a largely private health-care delivery system. ... [S]uch a board could create standards that would serve as models for private insurers..., especially in devising distinctions between basic and supplementary plans.

links for 2008-11-24

• Stupid Pundit Tricks - Ezra Klein
• FDR explains how liquidity crises happen - Richard Green
• Democrats' Stimulus Plan May Reach $700 Billion - washingtonpost.com
• Quo vadis Islamic finance? - voxeu.org
• Should "bad" financial contracts be banned? - Interfluidity
• Memo to Tim Geithner: Retire the TIPS - knzn
• Ben Stein Watch - Felix Salmon
• Has the Fed changed its policy unannounced? Part 2 - News N Economics
• Stanley, is that you? - The Edge of the American West

Does Not! Does Too!

The WSJ argues with itself:

The Fed Is Out of Ammunition - WSJ.com

Fed Has More Ammunition After Firing Rate-Cut Bullets - WSJ.com

Women's Legislative Power

Lane Kenworthy:

Leading the Way in Political Opportunity?: Following up a previous post on political opportunity in the United States and Europe, this graph shows the share of seats held by women in the main legislative body (parliament’s “lower” house) in the U.S. and nineteen other rich democracies. The data are from the Inter-Parliamentary Union. Though not far behind France, the United Kingdom, and Italy, America’s share is one of the lowest. When the new Congress convenes in January, women will hold just 17% of the seats in the House of Representatives (and 17% in the Senate). The figure for Germany is 32%. In Sweden, at the high end, it’s 47%.

A report on how women fared in the 2008 U.S. elections is here. A good introduction to cross-country differences and over-time developments is Women, Politics, and Power, by Pam Paxton and Melanie Hughes.

"The Moral Dimension of Boom and Bust"

"This monstrous conceit of contemporary economics has brought the world to the edge of disaster":

The moral dimension of boom and bust, by Robert Skidelsky, Project Syndicate: After the first world war, HG Wells wrote that a race was on between morality and destruction. Humanity had to abandon its warlike ways, Wells said, or technology would decimate it.

Economic writing, however, conveyed a completely different world. Here, technology was deservedly king. ... In the economists' world, morality should not seek to control technology, but should adapt to its demands. Only by doing so could economic growth be assured and poverty eliminated.

We have clung to this faith in technological salvation as the old faiths waned and technology became ever more inventive. Our belief in the market – the midwife of technological invention – was the result. We have embraced globalisation, the widest possible extension of the market economy.

For the sake of globalisation, communities are denatured, jobs offshored, and skills continually reconfigured. We are told by its apostles that the wholesale impairment of most of what gave meaning to life is necessary to achieve an "efficient allocation of capital" and a "reduction in transaction costs". Moralities that resist this logic are branded "obstacles to progress". ...

That today's global financial meltdown is the direct consequence of the west's worship of false gods is a proposition that cannot be discussed, much less acknowledged. One of its leading deities is the efficient market hypothesis – the belief that the market accurately prices all trades at each moment in time, ruling out booms and slumps, manias and panics. Theological language that might have decried the credit crunch as the "wages of sin", a comeuppance for prodigious profligacy, has become unusable. ...

Mathematical whizzkids developed new financial instruments, which, by promising to rob debt of its sting, broke down the barriers of prudence and self-restraint. The great economist Hyman Minsky's "merchants of debt" sold their toxic products not only to the credulous and ignorant, but also to greedy corporations and supposedly savvy individuals.

The result was a global explosion of Ponzi finance ... which purported to make such paper as safe and valuable as houses. ...

The key theoretical point in the transition to a debt-fuelled economy was the redefinition of uncertainty as risk. Whereas guarding against uncertainty had traditionally been a moral issue, hedging against risk is a purely technical question.

A Domestic Surge

Thomas Friedman says we need an immediate surge of overwhelming force:

We Found the W.M.D., by Thomas Friedman, Commentary, NY Times: ...This financial crisis is so far from over. We are just at the end of the beginning. ... If I had my druthers right now we would convene a special session of Congress, amend the Constitution and move up the inauguration from Jan. 20 to Thanksgiving Day. Forget the inaugural balls; we can't afford them. Forget the grandstands; we don't need them. Just get me a Supreme Court justice and a Bible...

Unfortunately, it would take too long for a majority of states to ratify such an amendment. What we can do now, though, said the Congressional scholar Norman Ornstein,... is "ask President Bush to appoint Tim Geithner, Barack Obama's proposed Treasury secretary, immediately." Make him a Bush appointment and let him take over next week. This is not a knock on Hank Paulson. It's simply that we can't afford two months of transition where the markets don't know who is in charge or where we're going. At the same time, Congress should remain in permanent session to pass any needed legislation.

This is the real "Code Red." As one banker remarked to me: "We finally found the W.M.D." They were buried in our own backyard - subprime mortgages and all the derivatives attached to them.

Yet, it is obvious that President Bush can't mobilize the tools to defuse them - a massive stimulus program to improve infrastructure and create jobs, a broad-based homeowner initiative to limit foreclosures and stabilize housing prices, and therefore mortgage assets, more capital for bank balance sheets and, most importantly, a huge injection of optimism and confidence that we can and will pull out of this with a new economic team at the helm.

The last point is something only a new President Obama can inject. ... I have no illusions that Obama's arrival on the scene will be a magic wand, but it would help.

Right now there is something deeply dysfunctional, bordering on scandalously irresponsible, in the fractious way our political elite are behaving - with business as usual in the most unusual economic moment of our lifetimes. They don't seem to understand: Our financial system is imperiled. ... The stock and credit markets ... have started to price financial stocks at Great Depression levels, not just recession levels. With $5, you can now buy one share of Citigroup and have enough left over for a bite at McDonalds.

As a result, Barack Obama is possibly going to have to make the biggest call of his presidency - before it even starts.

"A great judgment has to be made now as to just how big and bad the situation is," says Jeffrey Garten, the Yale School of Management professor of international finance. "This is a crucial judgment. Do we think that a couple of hundred billion more and couple of bad quarters will take care of this problem, or do we think that despite everything that we have done so far ... the bottom is nowhere in sight and we are staring at a deep hole that the entire world could fall into?"

If it's the latter, then we need a huge catalyst of confidence and capital to turn this thing around. Only the new president and his team, synchronizing with the world's other big economies, can provide it.

"The biggest mistake Obama could make," added Garten, "is thinking this problem is smaller than it is. On the other hand, there is far less danger in overestimating what will be necessary to solve it." ...

There are lots of uncertainties right now. For example, very few of the econometric estimates we have cover time periods where the conditions we are seeing today were in effect, so there is uncertainty about the right values to use in calculations concerning the size of the stimulus (will Okun's law still hold if firms have excess capacity allowing them to increase production without adding many new employees?). Many of the estimates are also based upon the assumption that the unemployment rate will reach 3.5% above normal (without intervention), but that number is not known with certainty either. You can use that uncertainty to tell a "maybe it won't be so bad so let's not panic and do a large stimulus" story, but the uncertainty also works in the other direction and things could be worse than expected (or the stimulus less could be less powerful than expected). Since the loss function is asymmetric - doing too little is more costly than doing too much - we need to be sure that the stimulus is large enough to provide some degree of insurance against unexpectedly bad outcomes. And the sooner we do this, the better.

links for 2008-11-23

• WaPo: Regulatory Failure at the Office of Thrift Supervision - Calculated Risk
• Kohn on Excess Reserves & the 2003 Deflation Scare - David Beckworth
• Why all those Great Depression analogies are wrong - Daniel Gross
• Why Great Depression analogies are not wrong - Paul Krugman
• The Citigroup Betting Pool - The Baseline Scenario
• The Price of Our Good Name - NYTimes.com
• How Obama is Already Taking Charge - Robert Reich
• Markets, Property Rights, and Air Pollution - Matthew Yglesias
• Liquidity Premium Sign of the Times - David Beckworth
• Dawn of A New Interregnum - The Baseline Scenario
• Monetise public debt and deficits - Willem Buiter
• Better regulation: Let banks be banks, let investors be investors - voxeu.org
• 5 Myths About Our Ailing Health-Care System - washingtonpost.com
• Caste & Marriage Markets in India - İyigün Blog

"Why Sheila Bair Must Resign"

John Hempton is still unhappy with Sheila Bair:

Why Sheila Bair must resign, Bronte Capital: Sheila Bair is doing a fine job at one thing – modifying mortgage terms in the mortgages she has taken over – particularly those at Indy Mac. As a liberal I would be expected to applaud – but I am profoundly glad that Obama did not do as Robert Kuttner suggested and nominate Sheila Bair for the Treasury Secretary post.

Sheila Bair is simply wrong when she implies that the problem started with mortgages and therefore it will end with mortgages. The problem with mortgages is no more than a trillion dollars (say 20 percent of the mortgages in the US defaulting with a 50% loss). Indeed it is much less than a trillion. If the financial crisis were about mortgages it would be over now – what with 500 billion of capital raising, a few hundred billion chipped in elsewhere (either by the Government into AIG or Maiden Lane or by Lehman and Washington Mutual bond holders and all the Fannie and Freddie losses that will be picked up by the Feds). The financial crisis is not about mortgages – it is about trust.

The people who provide finance to financial institutions (inter-bank and otherwise) no longer believe they will get their money back – and so are no longer willing to provide finance. The unwillingness to lend to financial institutions dooms them regardless of their solvency. The crisis is about trust.

It is alarming enough that the head of the FDIC in so self serving a manner misdiagnoses the nature of the financial crisis – self serving because her institution is building up enviable expertise in modifying mortgage terms. ... But if misdiagnosis of the crisis were the end of it then there would be no pressing need for Sheila Bair to resign. It is not the end of it. Sheila Bair is an obstacle – indeed one of the principal obstacles in the way of reinstalling trust to American financial institutions.

Public Works and Politics

Richard Green is worried about leaving the choice of where to invest in infrastructure to the political process:

Public Works, by Richard Green: I watched President-Elect Obama's weekly address this morning on You-tube, in which he called for a massive public works programs to help us crawl out of recession.

In principle, this is a very good idea. One of the deficiencies of policy over the past eight years (and for 20 or the past 28) has been an ideological denial of the existence and importance of public goods--goods with high fixed costs, close-to-zero marginal costs (i.e., non-rival), and goods where it is difficult to exclude. The Republican throwaway lines--you are always better at spending your own money than the government, and government doesn't solve the problem, it is the problem--represent the contempt Republicans have for public goods.

Many public goods, however, are manifestly beneficial to the economy. Even George Will cites the Interstate Highway System as an unambiguous success. Rural electrification, which has a heavily subsidized enterprise, was almost certainly a positive net present value investment for the country, as were the California aqueducts (or for that matter, the Roman aqueducts). The bridges and tunnels of New York City helped it become the world's leading city. One could go on and on.

When one looks at the long term insufficiency of our roads, our water systems, our power grid, our ports and our airports, it is clear that there are many positive NPV opportunities for government now--particularly in light of the low cost of long-term Treasury debt.

The problem is that government usually allocates investment funds via a political process, rather than a feasibility process. Government officials also often prefer grand, ineffective projects to more pedestrian, effective projects (transit officials here in LA prefer extended light rail to synchronizing the traffic lights). So if we are about to spend a lot on public works, I think we need some sort of non-partisan entity, such as the CBO, that develops a rigorous capital budget process for determining spending priorities. In the absence of such a process, we will spend money on negative NPV bridges to nowhere.

"The New Deal Didn’t Always Work, Either"

I agree with some of this, but I don't think the main thrust of Tyler Cowen's lessons from the New Deal are the same as mine (e.g. see "Validating Fiscal Stimulus"):

The New Deal Didn’t Always Work, Either, by Tyler Cowen, Economic View, NY Times: Many people are looking back to the Great Depression and the New Deal for answers to our problems. But while we can learn important lessons from this period, they’re not always the ones taught in school. ... I would start with the following lessons:

Monetary Policy is Key As Milton Friedman and Anna Jacobson Schwartz argued in a classic book,... the single biggest cause of the Great Depression was that the Federal Reserve let the money supply fall by one-third, causing deflation. Furthermore, banks were allowed to fail, causing a credit crisis. Roosevelt’s best policies were those designed to increase the money supply, get the banking system back on its feet and restore trust in financial institutions. ...

Today, expansionary monetary policy isn’t so easy to put into effect, as we are seeing a shrinkage of credit and a contraction of the “shadow banking sector,”... So don’t expect the benefits of monetary expansion to kick in right now, or even six months from now.

Still, the Fed needs to stand ready to prevent a downward spiral and to stimulate the economy once it’s possible.

Get the Small Things Right ...Roosevelt instituted a disastrous legacy of agricultural subsidies and sought to cartelize industry... Neither policy helped the economy recover.

He also took steps to strengthen unions and to keep real wages high. This helped workers who had jobs, but made it much harder for the unemployed to get back to work. One result was unemployment rates that remained high throughout the New Deal period.

Today, President-elect Barack Obama faces pressures to make unionization easier, but such policies are likely to worsen the recession for many Americans.

Don't Raise Taxes in a Slump The New Deal’s legacy of public works programs has given many people the impression that it was a time of expansionary fiscal policy, but that isn’t quite right. Government spending went up considerably, but taxes rose, too. ... When all of these tax increases are taken into account, New Deal fiscal policy didn’t do much to promote recovery.

War Isn't the Weapon World War II did help the American economy, but the gains came in the early stages, when America was still just selling war-related goods to Europe and was not yet a combatant. ...

While overall economic output was rising, and the military draft lowered unemployment, the war years were generally not prosperous ones. As for today, we shouldn’t think that fighting a war is the way to restore economic health.

You Can't Turn Bad Into Good The good New Deal policies, like constructing a basic social safety net, made sense on their own terms and would have been desirable in the boom years of the 1920s as well. The bad policies made things worse. Today, that means we should restrict extraordinary measures to the financial sector as much as possible and resist the temptation to “do something” for its own sake. ...

Our current downturn will end as well someday, and, as in the ’30s, the recovery will probably come for reasons that have little to do with most policy initiatives.

Update: Tyler Cowen adds:

For critical responses, perhaps you can try the comments section at Mark Thoma's. For reasons of space, it was not possible to specify that I was praising the proposed Obama middle-class tax cut.  I do not, however, think it will do much (if anything) to end the current recession, although tax hikes could make things worse.

Update: Eric Rauchway responds.

"Cooperative Global Political Leadership is More Important than Ever"

Jeff Sachs:

A worldwide vision of sustainable recovery, by Jeffrey Sachs, Commentary, Project Syndicate: The global recession now under way is the result not only of a financial panic, but also of more basic uncertainty about the future direction of the world economy. ...

To a large extent, economic recovery will depend on a much clearer sense of the direction of future economic change. That is largely the job of government. After the confused and misguided leadership of the administration of US President George W. Bush, which failed to give any clear path to energy, health, climate and financial policies, president-elect Barack Obama will have to start charting a course that defines the US economy’s future direction.

The US is not the only economy in this equation. We need a global vision of sustainable recovery that includes leadership from China, India, Europe, Latin America and, yes, even Africa...

There are a few clear points amidst the large uncertainties and confusions. First, the US cannot continue borrowing from the rest of the world as it has for the past eight years. The US’ net exports will have to increase... The adjustments needed amount to ... about US$700 billion in the US current account, or nearly 5 percent of US GNP. ...

Second, the decline in US consumption should also be partly offset by a rise in US investment. However, private business will not step up investment unless there is a clear policy direction for the economy. Obama has emphasized the need for a “green recovery,” that is, one based on sustainable technologies, not merely on consumption spending.

The US auto industry should be retooled for low carbon emission automobiles, either plug-in hybrids or pure battery-operated vehicles. Either technology will depend on a national electricity grid that uses low emission forms of power generation, such as wind, solar, nuclear, or coal-fired plants that capture and store the carbon dioxide emissions. All of these technologies will require public funding alongside private investment.

Third, the US recovery will not be credible unless there is also a strategy for getting the government’s own finances back in order. Bush’s idea of economic policy was to cut taxes three times while boosting spending on war. The result is a massive budget deficit, which will expand to gargantuan proportions in the coming year...

Obama will need to put forward a medium-term fiscal plan that restores government finances. This will include ending the war in Iraq, raising taxes on the rich and also gradually phasing in new consumption taxes. The US currently collects the lowest ratio of taxes to national income among rich nations. This will have to change.

Fourth, the ... World Bank, the European Investment Bank, the US Export-Import Bank, the African Development Bank and other public investment funds should be financing large-scale infrastructure spending in Africa to build roads, power plants, ports and telecommunications systems. ... The benefits would be extraordinary for both Africa and the rich countries...

In typical business cycles, countries are usually left to manage the recovery largely on their own. This time we will need global cooperation. Recovery will require major shifts in trade imbalances, technologies and public budgets.

These large-scale changes will have to be coordinated, at least informally if not tightly, among the major economies. ... We have arrived at a moment in history when cooperative global political leadership is more important than ever. Fortunately, the US has taken a huge step forward with Obama’s election. Now to action.

links for 2008-11-22

• Citigroup, Under Siege, Holds Talks With U.S. - NYTimes.com
• For Treasury, Geithner Said to Be Choice - NYTimes.com
• Motown meltdown - Thomas Palley
• Blanket of Soil May Hide Vast Martian Glaciers - NYTimes.com
• Making It Explicit - The Washington Monthly

"Recession? Why Worry?"

In an oldie, John Kenneth Galbraith explains why, for many, there is no rush to enact stabilization policy when the economy turns downward:

Recession? Why Worry?, by John Kenneth Galbraith, Commentary, NY Times: Reputable economic attitudes hold that the economic norm is high, if not quite full, employment and a reliable rate of expansion in economic output. Recessions are an aberrant departure from that norm. Correction must come. ...

One must, however, challenge all accepted attitudes on the next point. It is that recession is uniformly adverse in its effect and thus by everyone deplored. A great many people and an even higher proportion of those who have political voice and vote, though perhaps not a majority, find a recession quite comfortable, and certainly more so than the measures that do anything effective about it. This, however, no one dreams of saying.

Economists and all approved economic doctrine have made high employment and economic growth a sacred good. With this no one can openly disagree.

There are the many who live in recession with a wholly secure livelihood and with a lessened fear of price increases, of inflation. They are in no real danger of loss or diminution of income. Present here are the more secure parts of the modern corporate bureaucracy. ...

Similarly secure are many in the professions, professors, needless to say, some public servants, lawyers, doctors and media stars. Also very important is the modern large rentier class. And many who live on Social Security or pensions.

For all these, recessions mean stable or even falling prices and no serious reduction of income. ...

Also, in an economy where services are increasingly important, a recession means a more willing and pliant labor supply, an underclass more available for the unpleasant toil that makes life for the rest of us more agreeable. And for employers.

A recession in modern times is also for many far more attractive than remedial action against it.

The possible positive lines of action against recession are three: taxes can be reduced to enhance the flow of consumer and investment spending, or so it is hoped; interest rates can be lowered to enhance investment spending and consumer purchases of houses, automobiles, refrigerators and electronics, or so it is also hoped; the Government can undertake direct, forthright job creation. This is the holy trinity. Prayer and repetitive prediction of recovery apart, there are no other lines of action.

Tax reduction has its proponents, notably among those who pay the taxes. Unfortunately, its relation to recovery is theoretical. There is the difficult question as to whether the revenues released will be spent or invested; they may be held as cash or unused bank balances. And tax reduction would increase the deficit, concern with which has now reached near paranoiac proportions. Again, better the recession.

Next, there is monetary policy: the reduction of interest rates by the Federal Reserve. This is believed to have a peculiar magic. It calls for no big bureaucratic effort, carries no threat of taxes -- and a special intelligence is taken to characterize those who are associated occupationally with money.

But monetary policy works against recession by reducing interest rates and therewith rentier income. This is by no means welcomed by those who enjoy such income. They are not without political influence. Any talk of an easier monetary policy automatically brings grave and urgent warnings of the danger of inflation. This, too, is a threat to those on stable incomes.

Additionally, there is the sad fact that in a recession monetary policy doesn't work. The elasticity of the response to reduced interest rates is then very low. People and firms spend and invest, or fail to do so, pretty much as before.

Finally, there is direct Government expenditure and employment. For those resting comfortably in recession, this is the worst of all. It could raise prices, risk inflation. Much worse, it promises higher taxes at some time yet to come. ...

We pride ourselves in being plain-spoken, free from cant and certainly from any pathological self-delusion. Given a fact, we face it. Let us now face the fact that for many a recession is a tolerable, even pleasant thing. And let us say so. This will not be popular. There could be indignant denial. That is often the response to unwelcome truth.

Is Unemployment Due to Decreased Demand or More Expensive Financing?

"In short, cheap capital is important for employment.":

Assessing the impact of the financial crisis on the US labour market, by Peter Auer, Raphael Auer, and Simon Wehrmüller, VoxEU.org: ...In this column, we examine the extent to which the high cost of obtaining external funds has affected employment in US industries... We document that employment in sectors that are relatively more in need of external finance has indeed decreased to a much larger extent than employment in sectors less dependent on external sources of financing. In the aggregate, our results suggest that the increasing cost of external finance can account for much of the decline in employment witnessed in US industry since August 2007. ...

Conclusion ... We are now witnessing the start of potentially severe real consequences of the financial crisis. Our results suggest that much of these real consequences are driven by credit constraints rather than negative demand shocks or layoffs in sectors that are directly affected by the crisis.

Consequently, our results strengthen the case for measures aimed directly at restoring well-functioning financial markets. However, while reconstructing sustainable financial systems will be necessary, this alone will most probably not be sufficient for leading out of the crisis. Indeed, as the financial crisis enters more deeply into the real economy, also aggregate demand falters, which may justify demand-supporting policies. ...

While freeing financial markets will certainly help, at this point we need a fiscal stimulus package, and we needed it to be in place months ago. I am disappointed that Congress is not giving the employment crisis the same amount of attention and concern that has been given to the financial sector. This is an economic emergency and every day that we wait to put a fiscal stimulus package in place costs more jobs and ruins more lives. There's no excuse for taking those lives lightly. Congress needs to be working on this night and day, Democrats need to use every means at its disposal to round up the votes needed to override a potential veto from Bush, and they need to use public opinion to pressure Bush to sign the bill once it is ready (and why isn't it ready now?). It may be fruitless presently given the administration's opposition to offering the help that is needed, but the situation is dire and that's not an excuse not to try. If there is strong public support for action, who knows, the administration may come around. In any case, by starting now we are more likely to have the stage set for immediate action once the new administration takes over. Even if the plan is vetoed, having the necessary debate and getting the stimulus package ready now lets those who will be responsible for implementing the plans once the new administration takes over know the broad outlines of what will be done, and this will give then a head start in planning for action. There's no time to waste.

Paul Krugman: The Lame-Duck Economy

The outlook for the economy is deteriorating, yet economic policy "seems to have gone on vacation":

The Lame-Duck Economy, by Paul Krugman, Commentary, NY Times: Everyone’s talking about a new New Deal, for obvious reasons. In 2008, as in 1932, a long era of Republican political dominance came to an end in the face of an economic and financial crisis that, in voters’ minds, both discredited the G.O.P.’s free-market ideology and undermined its claims of competence. And for those on the progressive side of the political spectrum, these are hopeful times.

There is, however, another and more disturbing parallel between 2008 and 1932 — namely, the emergence of a power vacuum at the height of the crisis. The interregnum of 1932-1933, the long stretch between the election and the actual transfer of power, was disastrous for the U.S. economy, at least in part because the outgoing administration had no credibility, the incoming administration had no authority and the ideological chasm between the two sides was too great to allow concerted action. And the same thing is happening now. ...

How much can go wrong in the two months before Mr. Obama takes the oath of office? The answer, unfortunately, is: a lot. ... The prospects for the economy look much grimmer now than they did as little as a week or two ago.

Yet economic policy, rather than responding to the threat, seems to have gone on vacation. In particular, panic has returned to the credit markets, yet ... Henry Paulson ... has announced that he won’t even go back to Congress for the second half of the $700 billion already approved for financial bailouts. And financial aid for the beleaguered auto industry is being stalled by a political standoff.  ...

What’s really troubling ... is the possibility that some of the damage being done right now will be irreversible. I’m concerned, in particular, about the two D’s: deflation and Detroit.

About deflation: Japan’s “lost decade” in the 1990s taught economists that it’s very hard to get the economy moving once expectations of inflation get too low (it doesn’t matter whether people literally expect prices to fall). Yet there’s clear deflationary pressure on the U.S. economy right now, and every month that passes without signs of recovery increases the odds that we’ll find ourselves stuck in a Japan-type trap for years.

About Detroit: There’s now a real risk that, in the absence of quick federal aid, the Big Three automakers and their network of suppliers will be forced ... to shut down, lay off all their workers and sell off their assets. And if that happens, it will be very hard to bring them back.

Now, maybe letting the auto companies die is the right decision, even though an auto industry collapse would be a huge blow to an already slumping economy. But it’s a decision that should be taken carefully, with full consideration of the costs and benefits — not a decision taken by default, because of a political standoff between Democrats who want Mr. Paulson to use some of that $700 billion and a lame-duck administration that’s trying to force Congress to divert funds from a fuel-efficiency program instead.

Is economic policy completely paralyzed between now and Jan. 20? No, not completely. Some useful actions are being taken. For example, Fannie Mae and Freddie Mac ... have taken the helpful step of declaring a temporary halt to foreclosures, while Congress has passed a badly needed extension of unemployment benefits now that the White House has dropped its opposition.

But nothing is happening on the policy front that is remotely commensurate with the scale of the economic crisis. And it’s scary to think how much more can go wrong before Inauguration Day.

"Uncertainty, Climate Change, and the Global Economy"

This research concludes that "global warming will be a major problem even under very optimistic circumstances":

Uncertainty, climate change, and the global economy, by Torsten Persson and David von Below, VoxEU.org: What will the climate be like in a hundred years’ time? The answer to this question is highly uncertain, and will depend on a number of socio-economic as well as natural processes, which describe the links between human activity, emissions of greenhouse gases, and warming of the atmosphere. The existing policy discussion in important forums, such as the IPCC and Stern reports (see this Vox column), is largely based on the uncertainty about the biogeophysical and biogeochemical systems, as are analyses such as that of Wigley and Raper (2001). In a recent paper, we include such uncertainty – but highlight uncertainty about the drivers of climate change in the socioeconomic system. [...continue reading...]

links for 2008-11-21

• Not a good sign: the Treasury once again can borrow for free - Brad Setser
• Are we seeing the end of a 15-year stock price bubble? - Stephen Gordon
• Food prices and food security: Don’t blame liberalisation - voxeu.org
• Sheila Bair and seizing Citigroup - Bronte Capital
• A thousand of Keynes’s (and my) words - Edge of the American West
• The Big Easing - Models & Agents
• A Gaping Hole in the Safety Net - Howard Rosen
• Sen. James Inhofe calls out Andrew Leonard - Andrew Leonard
• In defense of mortgage backed securities - Richard Green

Fed Watch: Policy Adrift

Tim Duy lets loose:

Policy Adrift, by Tim Duy: I understand the Federal Reserve Chairman Ben Bernanke is considered something of a sacred cow, our one point of light in an uncertain world. An academic who cannot be questioned by other academics. A smart person who has mastered the Great Depression and therefore “knows” what to do, and is providing the leadership to do it.

I am beginning to question all of these assumptions.

I am hoping Bernanke can step forward and clarify the direction of policy. At this moment, he has the best perch from which to guide policy between administrations. He has the opportunity to show leadership. But for now, I see a distinct lack of leadership from the Federal Reserve, and it suggests that Bernanke has used up his bag of tricks. And I don’t think that he knows what to do next. Indeed, Fedspeak is now littered with confusing statements that leave the true policy of the Federal Reserve in question.

First, policymakers appear uncertain about what to do with the Fed Funds target. The minutes of the most recent meeting tell the story:

"An Auto Bailout Would Be Terrible for Free Trade"

How will foreign investors react to an auto bailout?:

An Auto Bailout Would Be Terrible for Free Trade, by Matthew Slaughter, Commentary, WSJ: Congress is now considering a federal bailout for America's Big Three automobile companies. Many want to grant them at least $25 billion ... on top of $25 billion in low-interest loans approved earlier this year. ... There are at least three important ways an industry bailout could damage America's engagement in the global economy and hurt U.S. companies, workers and taxpayers.

The first global cost of a bailout could be less foreign direct investment (FDI) coming into the United States. ...

Will fewer companies look to insource into America if the federal government is willing to bail out their domestic competitors?

The answer is an obvious yes. Ironically, proponents of a bailout say saving Detroit is necessary to protect the U.S. manufacturing base. But too many such bailouts could erode the number of manufacturers willing to invest here.

The bailout's second global cost could hit U.S.-headquartered companies that run multinational businesses. ...

Will a U.S.-government bailout go ignored by policy makers abroad? No. A bailout will likely entrench and expand protectionist practices across the globe, and thus erode the foreign sales and competitiveness of U.S. multinationals. ... That would be bad for America.

Rising trade barriers would also hurt the Big Three, all of which are multinational corporations that depend on foreign markets. ...

The bailout's third global cost could fall on the U.S. dollar. ... Will a federal bailout that politicizes American markets bolster foreign-investor demand for U.S. assets?

Not likely. Instead, America runs the risk of creating the kind of "political-risk premium" that investors have long placed on other countries -- and that would reduce demand for U.S. assets and thereby the value of the U.S. dollar. ...

This week Congress is weighing the cost of the bailout. Let us hope that lawmakers realize that the true cost of such a bailout is far larger than any check the U.S. Treasury will have to write in the coming months.

Many foreign companies are highly dependent upon the general state of the U.S. economy, especially, of course, those operating within our borders. There is also an argument that bailing out the automakers is in the interest of these companies because it lowers the chances of a prolonged, deep recession that would substantially reduce their sales and profits.

Are Big Bonuses Counterproductive?

Does exceptional pay encourage exceptional effort?:

What’s the Value of a Big Bonus?, by Dan Ariely, Commentary, NY Times: By withholding bonuses from their top executives, Goldman Sachs and UBS may soften negative reaction from Congress and the public... But will they also suffer because their executives, lacking the motivation that big bonuses are thought to provide, will not do their jobs well? ...[D]oesn’t the promise of a big bonus push people to work to the best of their ability?

To look at this question, three colleagues and I conducted an experiment. We presented 87 participants with an array of tasks that demanded attention, memory, concentration and creativity. ... We promised them payment if they performed the tasks exceptionally well. About a third of the subjects were told they’d be given a small bonus, another third were promised a medium-level bonus, and the last third could earn a high bonus.

We did this study in India, where the cost of living is relatively low so that we could pay people amounts that were substantial to them but still within our research budget. ...

What would you expect the results to be? When we posed this question to a group of business students, they said they expected performance to improve with the amount of the reward. But this was not what we found. The people offered medium bonuses performed no better, or worse, than those offered low bonuses. But what was most interesting was that the group offered the biggest bonus did worse than the other two groups across all the tasks.

We replicated these results in a study at the Massachusetts Institute of Technology... We found that as long as the task involved only mechanical skill, bonuses worked as would be expected... But when we included a task that required even rudimentary cognitive skill, the outcome was the same as in the India study: the offer of a higher bonus led to poorer performance.

If our tests mimic the real world, then higher bonuses may not only cost employers more but also discourage executives from working to the best of their ability. ... For most bankers, a multimillion-dollar compensation package could easily be counterproductive. ...